1

Given below are important questions and answers of important questions

asked in the previous papers of the Institute.

Students are requested to refer to the prescribed modules of the Institute,

Accounting Standards, SAP's and Guidance notes to get a clear
understanding of the same.

Students should also go through the disclaimer as put up by the Institute

regarding the suggested answers

1. Define and explain the following terms with suitable examples.

Fraud

Error

2. What are the Auditor’s responsibilities for non-detection of Frauds and

Errors?

3. Write short notes on:

a) Specific Reserves

b) Intangible Assets

c) Qualified Audit Report

d) Reliance on “Third Party Confirmations” as Audit Evidence.

4. What principal aspects are to be covered in an audit?

5. During the course of your audit of the accounts of a large manufacturing

company for the year ended 31st March, 1994, you find the following: -
 2

a) The sale proceeds of some machinery have been credited to the Plant
and Machinery Account.

b) An amount of Rs. 5,00,000 in respect of insurance of machinery for the

period from 1st January 1994 to 31st December 1994 has been shown as
insurance in the Profit and Loss Account.

State whether you consider the treatment satisfactory or not and the reasons
for your opinion.

6. Distinguish between the following: -

a) Internal check and internal control.

b) Prepaid expenses and expenses relating to previous year.

c) Internal evidence and external evidence.

7. Vouching has been described as ‘the essence of auditing’. Amplify

this statement and state why you should attach such importance to vouching.

8. State briefly how would you vouch ‘payment for Acquisition of

Assets’?

9. State briefly how would you vouch the ‘Sale of Investments’.

10. Explain the Extraordinary Items?

11. Explain the ‘Examination in Depth’?

12. Explain reporting on matters contained in ‘the Directors Report’?

13. Explain changes in ‘Accounting Policies’?

14. What are the Auditor’s duties regarding verification and valuation of
inventories?

15. State principles governing an Audit?

16. Discuss general considerations in framing a system of internal check?

 3

17. Discuss “test check” approach in auditing and the risks involved therein.
Is test check approach a scientific one?

18. Discuss briefly the advantages of Independent Audit.

Answer 1:

SAP.4 on “Fraud and Error” defines the terms fraud and error. According to
it

i) The term “Fraud” refers to intentional misrepresentations regarding

financial information by one or more individuals among management,
employees or third parties.

Fraud may involve:

a) Manipulation, falsification or alteration of records or documents,

b) Misappropriation of assets,

c) Suppression or omission of the effects of transactions from records or

documents,

d) Recording of transactions without substance, or

e) Misapplication of accounting policies.

ii) The term “Error” on the other hand refers to unintentional mistakes in
financial information, such as:

a) Mathematical or clerical mistakes in the underlying records and

accounting data,

b) Oversight or misinterpretation of facts, or

c) Misapplication of accounting policies.

 4

As is clear from the above, fraud may be perpetrated by manipulation of

accounts e.g. recording false entries of sales or purchases, under or over
valuation of stocks, booking capital expenditure to revenue amount or vice
versa, etc. Goods may be misappropriated. Cash may be embezzled by
omission of cash receipts, recording fewer amounts than actually received,
including fictitious payments in the cashbook, etc. Even accounting policies
can be conveniently manipulated in the areas of depreciation. Valuation of
stocks, investments etc. Which may impair the truthfulness and fairness of
financial statements. Errors, on the other hand, may creep in accounts due to
omission or clerical errors on the part of employees. There may be certain
errors, which may compensate each other and hence are difficult to detect.
Some errors of principle may also occur, particularly which selecting
inappropriate accounting policies or changing capital, expenditure to
revenue or vice versa on account lack of management’s knowledge and
awareness.

Answer 2.

The responsibility for the prevention and detection of fraud and error rests
with management through the implementation and continued operation of an
adequate system of internal control. Such a system reduces but does not
eliminate the possibility of fraud and error.

In forming his opinion, the auditor carries out procedures designed to obtain
evidence that will provide reasonable assurance that the financial
information is properly stated in all material respects. Consequently, the
auditor seeks reasonable assurance that fraud or error which may be material
to the financial information has not occurred or that; if it has occurred, the
effect of fraud is properly reflected in the financial information or the error
is corrected. The auditor, therefore, should plan his audit so that he has a
reasonable expectation of detecting material mis-statements in the financial
information resulting from fraud or error. The degree of assurance of
detecting errors would normally be higher than that of detecting fraud, since
fraud is usually accompanied by acts specifically designed to conceal its
existence. Due to the inherent limitations of an audit there is a possibility
that material mis-statements of the financial information resulting from fraud
and, to a lesser extent, error may not be detected. The subsequent discovery
 5

of material mis-statement of the financial information resulting from fraud

or error existing during the period covered by the auditor’s report does no, in
itself, indicate that the auditor has adhered to the basic principles governing
au audit. The question of whether the auditor has adhered to the basic
principles governing an audit (such as performance of the audit work with
requisite skills and competence, documentation of important matters, details
of the audit plan and reliance placed on internal controls, nature and extent
of compliance and substantive tests carried out etc.) is determined by the
adequacy of the procedures undertaken in the circumstances and the
suitability of the auditor’s report based on the results of these procedures.
The liability of the auditor for failure to detect fraud exists only which such
failure is clearly due to not exercising reasonable case and skill. The extent
of liability can be of a varying degree depending upon the user.

Answer 3.

a) Specific Reserves:

Specific reserves are created for some definite purpose out of the profits of
the company. The purpose may be anything connected with the business,
which the Articles of Association or the directors want to be provided for
such as dividend equalization, replacement of fixed assets etc. As specific
reserves are tied to a specific purpose, these are not ordinarily available for
purposes other than for purposes for which they are created. For example,
ordinarily the dividend equalization reserve can only be used for the purpose
of payment of dividend when profits are inadequate. Similarly, reserve
created for redemption of debentures can be applied only for the purpose of
redemption of debentures. However, as specific reserves are nothing but an
appropriation of profit, in case of need and at the discretion of the Board can
be applied for a purpose other than the one for which it was created, say the
plant replacement reserve may be used in payment of dividend.

b) Intangible Assets:
An intangible asset is that asset which does not have a physical identity but
which is real and substantial in the commercial sense. Such asset does not
have any physical existence but their presence in the business is indicated
with a value placed thereon. These assets confer rights and benefits to
 6

owners subject to their being useful. Examples of intangible assets are

goodwill, patents, copyright, etc. Normally, intangible assets are valued at
cost less the expired value of their utility to the business. The method of
assessing the valuation of some of the intangible assets is discussed here
under:

Goodwill: Ordinarily, if goodwill has been purchased, the cost of

purchase will be the value of goodwill. There is no mandatory requirement
to depreciate goodwill. However, if the company has a policy for writing off
goodwill, it is to be seen that goodwill has been depreciated accordingly.

Patents: It is to been seen that patent is valued at cost less depreciation.

Cost is the acquisition cost which may be purchase cost or invention cost.
Also, the cost of registration of patent should be included in the valuation,
which the renewal fees should be charged off to revenue. Since, a patent
suffers depreciation through efflux of time, it is preferable to adopt fixed
installment method of charging depreciation based on its legal life; if
commercial life is expected to be shorter, it should be restricted to that. If it
is found that products under the patent are not selling well, such patents
should be written off quickly. The span of such write off should be
determined based on the facts of the situation.

c) Qualified Audit Report:

Qualified audit report is one, which does not give a clean chit about the truth
and fairness of the financial statements but makes certain reservations. The
gravity of such reservations will vary depending upon the circumstances. In
a majority of cases items, which are the subject matter of qualification, are
not so material as to affect the truth and fairness of the whole of the accounts
but merely create uncertainly about a particular item. In such cases it is
possible for the auditors to report that in their opinion but subject to specific
qualifications mentioned, the accounts present a true and fair view. Thus, an
auditor may give his particular objection or reservation in the audit report
and state, “Subject to the above, we report that balance sheet shows a true
and fair view ...........” The auditor must clearly express the nature of
qualifications in the report. The auditor should also give reasons for
qualification. In the case of the companies there is a legal requirement under
Section 227(4) of the Companies Act, 1956 which provides that where the
auditor answers any of the statutory affirmations in the negative or with a
qualifications, his report shall state the reasons for such answer.
 7

According to ‘Statement on Qualifications in Auditors Report, issued by the

ICAI, all qualifications should be contained in the auditor’s report. The
words “subject to” are essential to state any qualification. It is also
necessary that the auditors should quantify, wherever possible the effect of
these qualifications on the financial statements in clear and unambiguous
manner if the same is material. Many a time financial statements contain
notes given by the management. Some of these notes may be subject matter
of qualification while some notes may be merely of a clarificatory nature. It
is necessary that the auditors should reproduce the notes of a qualificatory
nature in their report to enable the reader to know the importance of these
qualifications. The word ‘reproduce’ does not imply a verbatim
reproduction. Where notes of a qualificatory nature appear in the accounts,
the auditors should state all qualifications independently in their report in an
adequate manner so that a reader can assess the significance of these
qualifications. For this purpose where a note is already given in detail by the
management it is not necessary to reproduce verbatim such a note in the
audit report and a brief self-explanatory statement may be sufficient. Where
the qualifications are so material as to negate the main report itself it will be
proper to give an adverse opinion rather than a qualified report.

d) Reliance on “Third Party Confirmations” as an audit Evidence:

The reliability of audit evidence depends on its source-internal or external

and its nature-visual documentary or oral. Third party confirmations may be
obtained from sundry debtors, sundry creditors, from banks in respect of
bank balances and securities held on behalf of client, confirmation of loans
etc. Such confirmations obtained from third parties constitute external
evidence as the same has been obtained from persons outside the entity.
SAP-5, on “Audit Evidence” puts forth a generalisation in this regard that
“external evidence (e.g. confirmation received from a third party) is usually
more reliable than internal evidence”. It is because of the fact that third
parties are not normally interested in manipulation of accounting
information of the entity. Therefore, the auditor can always put more
reliance on confirmation obtained from third parties. Infact, as the present
trend indicates, that auditors attempt to obtain independent confirmations
from third parties more and more.
 8

Answer 4.

The scope of an audit as described in SAP-2 on “Objective and Scope of the

Audit of Financial Statements” is reproduced below:

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

auditor having regard to the terms of the engagement, the requirement of
relevant legislation and the pronouncement of the Institute. The terms of
engagement cannot, however, restrict the scope of an audit in relation to
matters, which are prescribed by legislation or by the pronouncement of the
Institute.

The audit should be organized to cover adequately all aspects of the

enterprise as far as they are relevant to the financial statements being
audited. To form an opinion on the financial statements, the auditor should
be reasonably satisfied as to whether the information contained in the
underlying accounting records and other source data is reliable and sufficient
as a basis for preparation of the financial statements. In forming his opinion,
the auditor should also decide whether the relevant information is properly
disclosed in the financial statements subject to statutory requirements, where
applicable.

The principal aspects to be covered in an audit are the following: -

i) An examination of the system of accounting and internal control to

ascertain whether it is appropriate for the business and helps in properly
recording all transactions. This is followed by the tests and enquiries as are
considered necessary to ascertain whether the system is in actual operation.
These steps are necessary to form an opinion as to whether reliance can be
place on the records as a basis for the preparation of final statements of
account.

ii) Reviewing the systems and procedures to find out whether they are
adequate and comprehensive and incidentally whether material inadequacies
and weaknesses exist to allow frauds and errors going unnoticed.

iii) Checking of the arithmetical accuracy of the books of account by the

verification of postings, balances etc.
 9

iv) Verification of the authenticity validity of transactions entered into by

making an examination of entries in the books of account with the relevant
supporting documents.

v) Ascertaining that a proper distinction has been made between items of

capital and of revenue nature and that the amounts of various items of
income and expenditure adjusted in the accounts correspond to the
accounting period.

vi) Comparison of the balance sheet and profit and loss account or other
statements with the underlying records in order to see that they are in
accordance therewith.

vii) Verification of the title, existence and value of the assets appearing in
the balance sheet.

viii)Verification of the liabilities stated in the balance sheet.

ix) Checking the results shown by the profit and loss account and to see
whether the results shown are true and fair.

x) Where the audit is of a corporate body, confirming that the statutory

requirements have been complied with.

xi) Reporting to the appropriate person/body whether the statements of

accounts examined do reveal a true and fair view of the state of affairs and
of the profit and loss of the organisation.

Answer 5.

a) As per the generally accepted accounting principles, it is not proper to

credit sale proceeds of machinery to the plant and machinery account
because the plant and machinery account of a company must show the
original cost of plant and machinery, while the depreciation provided in
respect thereof must be recorded in a separate account called “Provision for
Depreciation Account”. If the sale proceeds of machinery sold are credited
to the plant and machinery account without any further adjustment, that
 10

account will not show the original cost of the remaining plant and
machinery. Therefore, the following adjusting entries must be made: -

i. The depreciation provided in respect of machinery sold must be

transferred from the Provision for Depreciation Account to the credit of
Plant and Machinery account.

ii. The original cost of machinery sold must be compared with the amount
of sale proceeds after taking into account the depreciation provided in
respect thereof. This profit or loss must be transferred from the plant and
machinery account to the profit and loss account of the company.

After making these adjustments the balance of the plant and machinery
account will correctly reflect the cost of machinery.

It may, however, be pointed out that crediting the sale proceeds of

machinery sold to the plant and machinery account is permissible only in
cases where the original cost of machinery sold cannot be ascertained
without unreasonable expense and delay.

b) The accounting treatment of debiting the profit and loss account for the
year ended 31st March 1994 with the full amount of Rs. 5,00,000 is not
proper and the profit or loss disclosed by it will not reflect a true and fair
view because Rs. 3,75,000 out of it is on account of the next accounting
year. Therefore Rs. 3,75,000 must be transferred from Insurance Account to
Prepaid Insurance Account, sot the amount of insurance to be debited to the
profit and loss account for the year ended 31st March to be Rs. 1,25,000.
Rs. 3,75,000 being the amount of prepaid insurance will then be shown in
the Balance Sheet as on 31st March 1994 as an asset under the sub-heading
“Loans and Advances”.

Answer 6.

a) The concept Internal check has been defined by the Institute of

Chartered Accountants in England and Wales, as the “checks on day-to-day
transactions which operate continuously as part of the routine system
whereby the work of one person is proved independently or complementary
 11

to the work of another, the object being the prevention or earlier detection of
error or fraud”. The system of internal check in accounting implies
organisation of the system of bookkeeping and arrangement of staff duties in
such a manner that no one person can completely carry through a transaction
and record every aspect thereof.

According to SAP-6 entitled, Study and Evaluation of the Accounting

system and related Internal Controls in connection with an Audit, “The
system of internal control may be defined as a plan of organisation and all
the methods and procedures adopted by the management of an entity to
assist in achieving management’s objective of ensuring, as far as practicable,
the orderly and efficient conduct of its business, including adherence to a
management policies, the safeguarding of assets, prevention and detection of
fraud and error, the accuracy and completeness of the accounting records,
and the timely preparation of reliable financial information. The system of
internal control extends beyond those matters, which relate directly to the
functions of the accounting system. The internal audit function constitutes a
separate component of internal control with the objective of determining
whether other internal controls are well-designed and properly operated.”

Therefore, internal control is a much broader concept than internal check

and includes even administrative controls apart from accounting control and
internal audit. Internal check, on the other hand, is only an arrangement of
bookkeeping duties as a part of over-all control system.

b) Prepaid expenses fall in the category of outstanding assets representing

expenditure already incurred, some portion or the whole of which relates to a
period subsequent to the date of the balance sheet. Such items are shown in
the balance sheet under the payments in advance or prepayments. In order
that the profit or loss is to be correctly stated, it is important that only
expenditure relating to the period under review is included, for example, rent
and rates, insurance paid in advance etc. The auditor has to see that any
amount paid relating to the period subsequent to the date of the balance sheet
has been carried forward. On the other hand, expenses relating to previous
year are those expenses, which have to be accounted for, will result in
suppression of expenses for the year. For example, salaries and wages of the
last month are paid in the beginning of the next year; provision for such
expenses should be made in the accounts so that the full expenses of the year
are recorded in the year. The auditor should ensure that expenses relating to
 12

previous year have been shown under ‘Current Liabilities’ in the balance
sheet.

c) Internal evidence is one, which has been created within the client’s
organisation. Examples are sales invoices, employees’ time reports,
inventory reports, wage sheets, counter-foil of receipts, purchase
requisitions, minute books etc. External evidence on the other hand, is one,
which originates from outside the client’s organisation. A document issued
by a person with whom some business transactions had been entered into or
who paid or was advanced an amount constitutes such evidence, for
example, payee’s receipt, purchase invoice, lease agreement, bank statement,
canceled cheques, insurance policies. These documents are prepared in the
normal course of business activities of the organisation and form part of its
records.

Sometimes in certain transactions external evidence is obtained directly by

the auditor, as for example, certificate as regards bank balance, confirmation
of balances of debtors and creditors, etc.

Thus it is clear from the above that internal evidence is created and retained
within the organisation while external evidence is obtained from outside
parties. It may also be noted that usually external evidence is considered
more reliable than internal evidence.

Answer 7.

Vouching may be defined as the examination by the auditor of all

documentary evidence, which is available to support the genuineness of
transactions entered in client’s records. Vouching is a substantive auditing
procedure designed to obtain evidence as to the completeness, accuracy and
validity of the data produced by the accounting system. While obtaining
evidence through vouching, the auditor aims to obtain reasonable assurance
in respect of following assertions in regard to transactions recorded in the
books of account, namely,

i) A transaction is recorded in the proper account and revenue or expense is

properly allocated to the accounting period;
 13

ii) A transaction pertains to entity and took place during the relevant period;

iii) All transactions which have actually occurred have been recorded; and

v) Transactions have been classified and disclosed in accordance with

recognised accounting policies and practices.

Thus, it is through vouching that the auditor comes to know the genuineness
of transactions recorded in the client’s books of account wherefrom the
financial statements are drawn up. Apart from genuineness, vouching also
helps the auditor to know the regularity and validity of the transaction in the
context of the client’s business, nature of the organisation and organizational
rules.

The audit normally takes place long after the transactions have taken place,
and the auditor, not being in picture at the time, cannot have the benefit of
direct experience of the transactions. Necessarily, he has to depend on
evidence, and the voucher constitutes the necessary evidence of transaction.
The auditor’s basic duty is to examine the accounts, not merely to see their
arithmetical accuracy but also to see their substantial accuracy and then to
make a report thereon. This substantial accuracy of the accounts and
emerging financial statements can be known principally be examination of
vouchers, which are the primary documents, relating to transactions. If the
primary document is wrong or irregular, the whole accounting statement
would, in turn, become wrong and irregular. Precisely the auditor’s role is
to see whether or not the financial statements are correct and fair and for
this, vouching is simply imperative. The importance of vouching was also
highlighted in the case of Armitage Vs. Brewer & Knott wherein it was held
that the auditors were not vigilant and did not follow up discrepancies and
find out the total fraud.

Vouching is also the basis for verification of assets and liabilities. For
example, let us take an asset like Sundry Debtors. The auditor has to finally
certify that it (along with the other assets and liabilities) has been correctly
stated in the Balance Sheet. For this, he has to check the account of every
debtor. This means that he should vouch the entries in the Sales Book, Sales
Returns Book, Cash Book, Bill Receivable Book and the Journal in relation
to the debtors. He has to compare the entries with vouchers like invoices,
credit notes, duplicate receipts, correspondence and minutes, verify the
 14

postings into the debtors’ accounts and see that bad debts have been written
off and adequate provision has been made for doubtful debts. Hence it can
be seen that vouching is the basis of verification of the balance of sundry
debtors.

Thus it is clear from the aforesaid that vouching perhaps constitutes the
backbone of auditing. However it must be stated that over a time period,
vouching is not done on cent percent basis, rather, it is expected that after
evaluating the internal control system, the auditor decides the extent of
vouching to be done. Though in United States, the importance of vouching
has gone down considerably but in a country like ours, vouching may be
considered as the essence of auditing.

Answer 8.

The purchase of an asset must be duly supported by the receipt for the
amount paid. In case of an immovable property the auditor must also
inspect the title deeds. The title of an immovable property passes only on
registration. It is therefore; essential for the auditor to see that property has
been registered in the purchaser’s name as required by the Transfer of
Property Act, 1882 and also that the title of the seller to sell property has
been verified by a solicitor or an advocate.

In the case of movable property requiring registration of ownership e.g. for a

car or a ship, it must be verified that such a registration has been made in
favour of the purchaser. It is necessary for the auditor to satisfy generally as
regards existence, value and title of the assets acquired. It must be also be
verified that the assets were purchased only by a person who had the
authority to do so. Section 292 of the Companies Act, 1956 provides that
only the Board of Directors can invest the funds of the company. Thus the
Board alone can auction the purchase of a fixed asset. If the benefit of an
item of an expense has been acquired by the purchaser along with the asset,
its value should be debited to a separate account e.g. when a motor car has
been purchased on which certain taxes and insurance charges were paid by
the seller for a period that had not expired. In the case of an asset
constructed or manufactured by the client himself e.g. where a building has
 15

been constructed or a plant or machinery manufactured by the concern with

its labour and materials, it must be verified that the cost of labour, materials
and other direct expenses incurred has been charged as cost of the asset on a
proper allocation of the total expenditure debited under these heads. This is
because, if a larger sum is capitalised than warranted in the circumstances, it
would inflate the profit and if a smaller amount is debited, it would have the
effect of unduly reducing the profit. Also corresponding values of assets
would not be properly recorded. It must also be seen that neither expenses
on repairs and maintenance have been capitalized not the cost of additions to
assets charged off as revenue expenses.

Q.9. State briefly how would you vouch the ‘Sale of Investments’.

Answer 9.

Examine broker’s Sold Note while vouching the receipt on account of sale
of investments.

See that the dividend is received and recorded subsequently, where the
investments are sold “ex-dividend”.

Ensure that the profit or loss on the sale of the investment has been adjusted.

Ensure that the profit or loss on the sale of the investment has been
transferred to the earmarked fund account if the investments pertain to some
earmarked funds
 16

Answer 10.

Accounting to AS-5, extraordinary items “are gains or losses which arise

from events or transactions that are distinct from the ordinary activities of
the business and which are both material and expected not to recur
frequently or regularly. These would also include material adjustments
necessitated by the circumstances, which though related to previous period
are determined in the current period.

Extraordinary items are sometimes termed “unusual items”. Some examples

of such items could be the sale of a significant part of the business, the sale
of an investment not acquired with the intention of resale or a liability
arising on account of legislative changes or judicial pronouncements etc.
The nature and amount of each extraordinary items are separately disclosed
so that users of financial statements can evaluate the relative significance of
such items and their effect on the operating results. Income or expenses
arising from the ordinary activities of the enterprise though abnormal in
amount or infrequent in occurrence do not qualify as extraordinary. An
example of such an item would be the write-off of a very large receivable
from a regular trade customer.

Extraordinary items of the enterprise during the period should be disclosed

in the statement of profit or loss as part of net income. The nature and
amount of each such item should be separately disclosed in a manner that
their relative significance and effect on the current operating results of the
period can be perceived.

Q.11 Explain the ‘Examination in Depth’?

Answer 11.

It implies examination of a few selected transactions from the beginning to

the end through the entire flow of the transaction, i.e. from initiation to the
completion of the transaction by receipt or payment of cash and delivery or
receipt of goods. This examination consists of studying the recording of
transactions at the various stages through which they have passed. At each
 17

stage, relevant records and authorities are examined; it is also judged

whether the person who has exercised the authority in relation to the
transactions is fit to do so in terms of the prescribed procedure. For
example, a purchase of goods may commence when a predetermined re-
order level has been reached.

The ensuring stages may be summarised as follows: -

1. Requisition: pre-printed, pre-numbered and authorised;

2. Official company order, also sequentially pre-numbered, authorised

and placed with approved suppliers only;

3. Receipt of supplier’s invoice;

4. Receipt of supplier’s statement;

5. Entries in purchases day book;

6. Postings to purchase ledger and purchase ledger control account;

7. Cheque in settlement;

8. Entry on bank statement and returned “paid” cheque (if requested);

9. Cash book entry;

10. Posting from cash book to ledger and control account, taking in any
discount;

11. Receipt of goods, together with delivery/advice note;

12. Admission of goods to stores;

13. Indication, by initials or rubber stamp on internal goods inwards note,

of compliance with order regarding specification, quantity and quality;

14. Entries in stores records.

 18

It should be noted that the above list is not necessarily comprehensive, nor
do its constituent stages inevitably take place in the sequence suggested.
The important point to note is that from the moment it was realised that re-
order level had reached a chain of event was put in motion, together leaving
what may be termed an “audit trail”. Each item selected for testing must be
traced meticulously, and although sample sizes need not be large, they must,
of course, be representative.

It is an acceptable practice to check a slightly smaller number of transactions

at each successive stage within a depth test, on the statistical grounds (based
on probability theory) that the optimum sample size decreases as the
auditor’s “level of confidence” concerning the functioning of the system
increases. Examination in depth has been found indispensable in modern
auditing practice and, if intelligently conducted, its reconstruction of the
audit trail reveals more about the functioning (or malfunctioning) of the
client’s system in practice than the haphazard and mechanical approach to
testing.

Q.12 Explain reporting on matters contained in ‘the Directors Report’?

Answer 12.

Section 217 of the Act specifies the contents to be included in the Boards of
Directors report and specifies that there shall be attached to every balance
sheet laid before a company in general meeting, a report by its Board of
Directors, with respect to: -

The state of the company’s affairs;

The amounts, if any, which it proposes to carry to any reserves in such

balance sheet;

The amount, if any, which it recommends should be paid by way of

dividend;
 19

Material changes and commitments, if any, affecting the financial position

of the company which have occurred between the end of the financial year
of the company to which the balance sheet relates and the date of the report;

Conservation of energy, technology absorption, foreign exchange earnings

and outgo, in such manner as may be prescribed.

The Board’s report shall also contain the material aspects relating to
appreciation of the state of company’s affairs and deal with important
changes. The Board shall also be bound to give the fullest information and
explanation in it report aforesaid, or in case falling under the proviso to
Section 222, in an addendum to that report, on every reservation,
qualification or adverse remark in the auditor’s report.

Section 227 of the Act states that it is the duty of an auditor to make a report
to the members of the company on the accounts examined by him on every
balance sheet and profit and loss account, and every other document
declared by this /act to be part of or annexed to the balance sheet or profit or
loss account which are laid before the company in general meeting during
his tenure of office.

Section 227 of the Act makes it clear that Board’s report is attached to the
annual accounts. Therefore, normally the auditors’ report does not cover
authentication of various matters contained in the Board’s report.
However, if any information which is required by this Act to be given in the
accounts, and is allowed by it to be given in a statement annexed to the
accounts, may be get in the Board’s report instead of in the accounts; and if
any such information is so given the report shall be annexed to the accounts
and this Act shall apply in relation thereto accordingly, except that the
auditor shall report thereon only in so far as it gives the said information.
 20

Q.13 Explain changes in ‘Accounting Policies’?

Answer 13.

Accounting Standard-1 on accounting polices issued by the ICAI defines

accounting policies are those which refer to the specific accounting
principles and the methods of applying those principles adopted by the
enterprise in the preparation and presentation of financial statements.
Further, it may be noted that consistency is one of the fundamental
accounting assumptions and thus it is assumed that accounting policies are
consistent from one period to another. Therefore, any change in any
accounting policy, which has a material effect, should be disclosed. The
amount by which any item in the financial statements is affected by such
change should also be disclosed to the extent ascertainable. Where such
amount is not ascertainable, wholly or in part, the fact should be indicated.
If a change is made in the accounting policies which has no material effect
on the financial statements for the current period but which is reasonably
expected top have a material effect in later periods, the fact of such change
should be appropriately disclosed in the period in which the change is
adopted.

Accounting Standard-5, on Prior Period and Extraordinary items and

Changes in the Accounting Policies specifies the circumstances in which a
change in an accounting policy may be done by an enterprise. According to
it a change in an accounting policy is made only in exceptional
circumstances i.e. if the adoption of a new accounting policy is required by
statute or compliance with an accounting standard or if it is considered that
the change would result in a more appropriate presentation of the financial
statements of an enterprise.
 21

Q.14 What are the Auditor’s duties regarding verification and valuation of
inventories?

Answer 14.

The auditor’s duties regarding verification and valuation of inventories are

well enunciated in the professional pronouncements issued by the Institute
of Chartered Accountants of India (hereinafter Institute) in this context.
These pronouncements are also based on various legal decisions affecting
the auditor in this regard. It has been one of the established principles
followed in many famous cases like the Kingston Cotton Mills Case (1896)
and West Minister Road Construction and Engineering Company Ltd.
(1932) that it is no part of the auditor’s duty to physically verify the stock
and for the purpose he can rely upon statements and reports made available
to him in regard to the valuation of stocks so long there is no circumstance
which may arouse his suspicion. However, the auditor would be falling in
his duty if he does not take reasonable care in verifying the statement of
stock, which are put up to him, having regard to the information in his
possession and the expert knowledge expected of him in regard to methods
of verification of stock. As it stands today, as per the Statement on Auditing
Practices (ASP) issued by the Institute, the verification of inventories by
physical count is primarily the duty of the management. The auditor is not
required to carry out such a verification and in many cases, he is not
professionally qualified to do so on account of his lack of technical
knowledge and requisite staff. In the MAOCAR Order, there is an implied
acceptance of this position. The Order requires the management to conduct
physical verification of inventories at reasonable intervals and the auditor is
to report thereon. The Order also contemplates, on the part of the auditor, to
see whether the procedures of physical verification of stocks followed by the
management are reasonable and adequate in relation to the size of the
company and the nature of its business. Regarding valuation, the auditor is
required to state whether on the basis of his examination of stocks he is
satisfied that such valuation is fair and proper in accordance with the
normally accepted accounting principles and whether the basis of valuation
of stocks its same as in the preceding year. Thus the auditor is expected to
exercise reasonable care and skill to satisfy himself that the procedures laid
down by the management are adequate and reasonable and the valuation
placed to be fair and proper.
 22

The following duties and responsibilities have been stipulated for the auditor
in the aforesaid statement issued by the Institute in connection with the
verification: -

1. Year-end Verification

(i) The auditor should suggest to the management that, before

commencement of verification, instructions be issued to the staff entrusted
with the work of verification to be carried out by the management and
should ask for a copy each of the instructions and the program for
verification for his review.

(ii) He should examine the instructions and the programme of verification to

satisfy himself that the work is properly organised to adequately cover the
different locations and types of stocks.

(iii) The auditor should review the original verification sheets and trace
selected items including the more valuable ones into the final inventories.

(iv) Wherever practicable, he should, by special arrangement with the client,

be present for at least part of the time, when the physical verification is done
and also carry out a test check of the work performed. In respect of
locations stocking major items of stocks, not generally visited by the auditor;
there should be a system of visit by the auditor by rotation.

2. Where the management takes the inventory on a day before the year-end,
the auditor may inspect the verification sheets and satisfy himself that the
stock records are duly adjusted for shortages and excesses noticed. Also, he
should see that proper and reliable stock records have been maintained.

3. Where inventories have been verified by means of continuous

stocktaking, the auditor should do the following: -

Suggesting to the management about personnel deployment for stoke-taking

to ensure that they are reasonably competent, have reasonable time to devote
to the job of stocktaking and rare not responsible for maintenance of stock
records or custody of stocks.

Reviewing the records of the verifiers and ascertaining whether a substantial

part of inventory has been covered during the year.
 23

Ensuring that the discrepancies observed in the course of verification have

been properly adjusted in the stock records.

Test checking the physical existence of stocks to see that the stock records
do in fact correctly reflect the stocks in hand.

Test checking annual inventories with the stock records.

Some of the other duties which the auditor is required to perform in

connection with the verification of inventories are as under: -

In respect of the stocks lying with others, the auditor must examine
confirmations from parties holding the stocks.

The auditor should ensure that a proper cut-off procedure was followed.

He should devote attention to the existence of obsolete and slow moving

items and see whether proper adjustments have been carried out therefore.

He should satisfy himself that the management has taken inventory at a

reasonable interval and all the significant discrepancies noticed have been
adjusted.

Auditor’s duties regarding Valuation of Inventories:

The basis on which inventories are valued is determined by the management.

According to Accounting Standard-2 on Valuation of inventories the normal
basis of valuation of inventories is cost or net realizable value whichever is
lower. The auditor is not a valuer but he is expected to examine the
valuation of inventories in the following respects: -

Within the limits of his knowledge and by means of a test check of the
records and other information available to him, he must satisfy himself that
the inventories have been correctly valued on the basis stated.

He must ensure that the basis of valuation has been consistently adopted
from year to year. Where the basis of valuation is changed, it would amount
to a change in the basis of accounting and if the effect on profits is material,
 24

adequate disclosure should be made in the accounts or the notes with

quantification.

In carrying out his examination of the existence and valuation of inventories,

the auditor is expected to used his own discretion regarding the extent of
examination and in suitable circumstances may adopt a system of test
checking by statistical sampling or otherwise. He is, however, expected to
make an intelligent scrutiny of the stock sheets and within the limits of his
knowledge and ability to devote particular attention to items, which have a
material bearing on the inventory, and to items whose quantities or values
appear to be unreasonable.

Finally, the SAP also recommends that the auditor should maintain in his
audit file, a summary of each inventory as also details regarding the extent
of his verification. He should also obtain from the management a certificate
concerning the existence, title and value of the inventories and containing
details of charges, if any, created against them.

Q.15 State principles governing an Audit?

Answer 15.

The Statement on Standard Auditing Practices-1, issued by the Institute

describes the basic principles which govern the auditor’s professional
responsibilities and which should be complied with whenever an audit is
carried out. Compliance with the basic principles requires the application of
auditing procedures and reporting practices appropriate to the particular
circumstances.

The basic principles as stated in this statement are: -

 25

Integrity, Objectivity and Independence: The auditor should be

straightforward, honest and sincere in his approach to his professional work.
He must be fair and must not allow prejudice or bias to override his
objectivity. He should maintain an impartial attitude and both be and appear
to be free of any interest which might be regarded, whatever its actual effect,
as being incompatible with integrity and objectivity.

Confidentiality: The auditor should respect the confidentiality of

information acquired in the course of his work and should not disclose any
such information to a third party without specific authority or unless there is
a legal or professional duty to disclose.

Skills and Competence: The audit should be performed and the report
prepared with due professional care by persons who have adequate training,
experience and competence in auditing. The auditor requires specialised
skills and competence which are acquired through a combination of general
education, technical knowledge obtained through study and formal courses
concluded by a qualifying examination recognised for this purpose and
practical experience under proper supervision.

Work performed by Others: When the auditor delegates work to assistants

or uses work performed by other auditors and experts, he will continue to be
responsible for forming and expressing his opinion on the financial
information. However, he will be entitled to rely on work performed by
others provided he exercises adequate skills and care and is not aware of any
reason to believer that he should not have so relied. The auditor should
carefully direct, supervise and review work delegated to assistants. The
auditor should obtain reasonable assurance that work performed by other
auditors or experts is adequate for his purpose.

Documentation: The auditor should document matters, which are important

in providing evidence that the audit was carried out in accordance with the
basic principles.

Planning: The auditor should plan his work to enable him to conduct an
effective audit in an efficient and timely manner. Plans should be based on
knowledge of the clients’ business. Plans should be made to cover, among
other things:
 26

Acquiring knowledge of the client’s accounting system, policies and internal

control procedures;

Establishing the expected degree of reliance to be placed on internal control;

Determining and programming the nature, timing and extent of the audit
procedures to be performed; and

Coordinating the work to be performed.

Plans should be further developed and revised as necessary during the course
of the audit.

Audit Evidence: The Auditor should obtain sufficient appropriate audit

evidence through the performance of compliance and substantive procedures
to enable him to draw reasonable conclusions therefrom on which to base his
opinion on the financial information. Compliance procedures are tests
designed to obtain reasonable assurance that those internal controls on which
audit reliance is to be placed are in effect. Substantive procedures are
designed to obtain evidence as to the completeness, accuracy and validity of
the data produced by the accounting system.

Accounting System and Internal Control: Management is responsible for

maintaining an adequate accounting system incorporating various internal
controls to the extent appropriate to the size and nature of the business. The
auditor should reasonably assure himself that the accounting system is
adequate and that all the accounting information, which should be recorded,
has in fact been recorded. Internal controls normally contributed to such a
assurance.

The auditor should gain an understanding of the accounting system and

related internal controls and should study and evaluate the operation of those
internal controls upon which he wishes to rely in determining the nature,
timing and extent of other audit procedures. Where the auditor concludes
that he can rely on certain internal controls, his substantive procedures
would normally be less extensive than would otherwise be required and may
also differ as to their nature and timing.
 27

Audit Conclusions and Reporting: The auditor should review and assess the
conclusions drawn from the audit evidence obtained and from his knowledge
of business of the entity as the basis for the expression of his opinion on the
financial information. This review and assessment involves forming an
overall conclusion as to whether: -

The financial information has been prepared using acceptable accounting

policies which have been consistently applied;

The financial information complies with relevant regulations and statutory

requirements;

There is adequate disclosure of all material matters relevant to the proper

presentation of the financial information, subject to statutory requirements,
where applicable.

The audit report should contain a clear written expression of opinion on the
financial information and if the form or content or the report is laid down in
or prescribed under any agreement or statute or regulation, the audit report
should comply with such requirements. An unqualified opinion indicates
the auditor’s satisfaction in all material respects with the matter stated above
or as may be laid down or prescribed under the relevant agreement or statute
or regulation as the case may be.

When a qualified opinion, adverse opinion or a disclaimer of opinion is to be

given or reservation of opinion on any matter is to be made, the audit report
should state the reasons therefore.
 28

Q.16 Discuss general considerations in framing a system of internal

check?

Answer 16.

No single person should have an independent control over any important

aspect of the business. All dealings and acts of every employee should, in
the ordinary course, come under the review of another.

The duties of members of the staff should be changes from time to time
without any previous notice so that the same officer or subordinate does not,
without a break, perform the same function for a considerable period of
time.

Every member of the staff should be encouraged to go on leave at least once

in a year. Experience has shown that frauds successfully concealed by
employees are often unearthed when they are on leave.

Persons having physical custody of assets may boot be permitted to have

access to the books of account?

There should exist an accounting control in respect of each important class

of assets; in addition, these should be periodically inspected so as to
establish their physical existence.

To prevent loss or misappropriation of cash, mechanical devices, such as the

automatic cash register, should be employed.

For stocktaking, at the close of the year, trading activities should, if possible,
be suspended. Staff belonging to several sections of the organization should
do the task of stocktaking and evaluation. It may prove dangerous to depend
exclusively on the stock section staff for these tasks, since they may be
tempted to under or overstate the stock.

The financial and administrative powers should be distributed very

judiciously amount different officers and the manner in which these are
actually exercised should be reviewed periodically.

Procedures should be laid down for periodical verification and testing of

different sections of accounting records to ensure that they are accurate.
 29

Accounting procedures should be reviewed periodically; even well-designed

and carefully installed procedures, in course of time, cease to be effective.

Q.17 Discuss “test check” approach in auditing and the risks involved
therein. Is test check approach a scientific one?

Answer 17.

The test check approach in auditing is resorted to where an audit is

conducted on the basis of a part checking. Instead of a complete
examination of all the transactions recorded in the books of account only
some of the transactions are selected and verified. The underlying intention
is to test check some of the transactions to form an opinion for the whole.

It is a common knowledge that the volume of transactions of a business is

enormous now a days and within the time and cost constraints, in which
auditing is done, it is physically impossible to check each and every
transaction of a business. Under the circumstances, the auditor has to rely
on some test checking. Thus this system involves selecting and checking
some of the transactions for the purpose of arriving at the final judgment as
to the whole set consists of selecting and checking a proportion of
transactions selected by the auditor. The auditor, according to his best
judgment and having regard to the nature, size and materiality of
transactions, fixes up the entries for examination. Normally, entries
involving large amounts or relating to material accounts are seen
exhaustively and other entries are picked up for verification from the
remainder according to a certain plan. Sometimes entries are checked for a
few specified months exhaustively and the rest go unchecked. For instance,
the audit programme may contain instructions like check all purchases of
January and December. The instruction may also be given to check 100 per
cent of the postings from cashbook to general ledger for any two months of
the year. There could be various other forms of instructions.
 30

Test checking is extensively applied in various facets of auditing.

Arithmetical accuracy checks, confirmation of debtors or verification of
stock items are some of the areas where test checking is resorted. It is
normally planned in such a way that the audit programmes for 3 to 5 years
cover all types of transactions in case of a medium or large sized company.
Thus, if in one year the months of January, June and December are checked,
April, July and September may be checked in the second year and so on.
One of the important aspects of the test check approach is that it must
contain an element of surprise. The staff and the management of the
organization under audit should not be able to anticipate the pattern of test
checking otherwise they will anticipate the areas and periods to be covered
in any one year and will be careful regarding the same. If test checking
becomes routine, predictable and mechanical, it loses its value and the
auditor cannot reach reasonable conclusions regarding the transactions as a
whole through selective verification. It is, therefore, important that the
auditor keeps changing the methods of test checking. Finally, the extent of
test checking would primarily depend on the auditor’s judgment of a
particular situation. This judgment in turn depends on the previous
experience of the auditor, current developments and the efficacy of the
internal control system. It is, therefore, very difficult to suggest any
standards for test checking. The extent to which test checking can be
resorted to is a matter of auditor’s personal assessment.

As discussed above, though the test check approach is adaptation of the

sampling theory in its most rudimentary form but in reality it lacks the
authenticity and precision and also lacks any acceptable basis and gives the
auditor no idea about the degree of reliability that he can place on the
findings for application to the whole set of entries. The test check approach
also does not ensure selection of representative samples of adequate size and
offers opportunities for bias to enter into selection process. Therefore, a risk
is involved in the system of test checking. The adoption of test check
approach is also criticized because it runs the risk that some of the material
error may not be discovered or entries may selected in such a manner that
they may not represent every description of transactions taking place in the
organization and some of the important areas may go unaudited in the
process. Though there are certain risks associated with the test check
approach yet this approach should not be rejected purely on this ground.
Because risk cannot be eliminated even if all the entries that are recorded in
the books of account are thoroughly checked.
 31

Scientific Test check approach:

The test check approach though owes its origin to the statistical theory of
sampling but it expends on the subjective judgment of the auditor depending
on the situations of individual cases. As described above, it involves lot of
arbitrariness on the part of the auditor in determining and selecting the
number of transactions. Therefore, the approach cannot be considered as a
scientific one as it suffers from various defects. For example, by simply
stating that 20 per cent of the postings should be selected for checking or
two months posting should be checked does not seem to follow any
scientific basis except the auditor’s own personal judgment. Simply stating
the percentage of the sample without any reference to the total number of
transactions doesn’t have much meaning. Further, how one can draw
conclusions about the transactions of the whole year merely by checking
transactions of a few specified months specially as the levels of activity and
work may vary from month to month. Again, if we check the closing and
the opening months every year, the surprise element is not there and the
client’s staff would take extra care in regard to these two months, thus
defeating the whole purpose of exercise.

In the test check approach, the manner in which specified percentage of the
transactions is to be selected may not be stated and thus the audit assistants
consciously or unconsciously may select only those transactions, which are
simpler and easy to negotiate. Therefore, if the audit assistants are entrusted
wit the task of test checking transactions, they may select the transactions at
will, and thus the element of bias may creep in. It is, therefore, important
that the method of selection of transactions for detailed checking be such
that it gives an equal chance of selection to all transactions without bias on
the part of the auditor or his assistants. The greatest drawback of the test
check approach is that an auditor cannot determine the extent of risk he is
taking in reporting upon the financial statements. When he selects 20
percent of transactions without reference to the total population, he cannot
say how much risk he is taking or how sure he is that the transactions
selected reflect the characteristic of the population in all material aspects.
He also does not know as to how far his risk would be reduced if he raises
the extent of checking to, say 25 percent.

Thus it can be seen that a scientific method of test checking must be one
which is based on the appropriate size of the representative sample selected
on a random basis reducing the chance of arbitrariness or bias in selection of
 32

the sample and is capable of giving results with a calculated degree of risk.
Therefore, it can be said that the test check approach as such is not a
scientific one.

Q.18 Discuss briefly the advantages of Independent Audit.

Answer 18.

An independent audit whether statutory or voluntary has distinct advantages

for every type of organisation. As the audit is conducted by a person who is
independent of the organisation whose accounts are being audited itself
lends credibility to financial statements prepared by the organisation. The
very fact that the audit has been made compulsory by law in certain cases
like companies, co-operative societies, public and charitable trusts, local
authorities etc. It shows that an independent audit is quite useful. The
compulsory introduction of tax audit, audit of non-corporate bank borrowers
and stock brokers’ audit in the recent past also goes on to prove that an
independent audit enhances the usefulness of financial statements. Apart
from this, there are other advantages of an independent audit, which are of
considerable value even to those organisations where audit is not
compulsory. The advantages arising from an independent audit are given
below: -

It safeguards the financial interest of persons who are not associated with the
management of the organisation whether they are partners or shareholders.

It acts as a moral check on the employees.

Audited statements of account are helpful in settling liability for taxes,

negotiating loan and for determining the purchase consideration for a
business.
 33

Audited statements are also useful for settling trade disputes for higher
wages or bonus as well as claims in respect of damages suffered by property
by fire or some other calamity.

It also helps in the detection of wastages and losses and shows the different
ways by which these might be checked especially those that occur due to the
absence or inadequacy of internal checks or internal control measures.

It is an agency which ensures that persons acting for others have properly
accounted for the amounts collected by them e.g. Partners, Agents,
Liquidators, Receivers, Trustees, etc. In the year of dispute pertaining to
accounts, audited statements of account facilitate its settlement.

Independent audit ascertains whether the necessary books of account and

allied records have been properly kept and helps the client in making good
deficiencies or inadequacies in this respect.

As an appraisal function, audit reviews the existence and operations to

various controls in the organisation and reports inadequacies, weaknesses
etc. in them.

Audited accounts are of great help in the settlement of accounts at the time
of admission or death of the partner.

Government may require audited and certified statements before it gives

assistance or issues a license for a particular trade.

Questions 19 to 33

Important Topics

Accounting Standards
 34

Standard Auditing Practices

Guidance Notes

--------------------------------------------------------------------------------

Accounts | Financial Management | Auditing | Law | Costing |

SADP | OR | Indirect Tax | Buy Books | Jobs
Accounts | Auditing | Law | Costing | O&M | EDP | Direct Taxes
| Buy Books | Jobs | LogOff |

Important Questions
SAP
Guidance Notes
Accounting Standards
Important Questions
Bare Acts
Main Page
Important Questions
Important Questions
Important Case Laws
Articleship
Chartered Accountants
Inter > Audit >Important Questions
Foundation Home > Final Home

--------------------------------------------------------------------------------

Given below are important questions and answers of important questions

asked in the previous papers of the Institute.
 35

Students are requested to refer to the prescribed modules of the Institute,

Accounting Standards, SAP's and Guidance notes to get a clear
understanding of the same.

Students should also go through the disclaimer as put up by the Institute

regarding the suggested answers.>

19. What is meant by the ‘Cut Off’ procedure?

20. How would you verify the Goodwill?

21. How would you verify the Leasehold Property?

22. How would you verify the Plant and Machinery?

23. How would you verify the Cash in hand?

24. Under what circumstances a retiring auditor of a company cannot be

reappointed?

25. Under what circumstances can the Central Government direct special
audit? What action may be taken by the government on receipt of special
audit report?

26. Distinguish between Confirmation and verification?

27. Distinguish between ‘Provisions and Reserves’?

28. Distinguish between ‘Internal audit and External audit’?

29. Distinguish between ‘Qualified Report and Adverse Report’?

30. What are the rights of an auditor with reference to the examination of
books of accounts and allied matters of a company?

31. What is audit program and how it is useful to the auditor?

 36

32. What is internal audit? How far the internal audit is useful to the
statutory auditor? To what extent the Statutory auditor can rely on the
internal audit report?

33. Can a properly appointed auditor be removed before the expiry of his
term? If yes, then give the procedure for such removal and mention the
rights available to the auditor?

Q.19 What is meant by the ‘Cut Off’ procedure?

Answer 19.

The cut-off procedure refers to the procedure adopted by the management to

ensure that transactions of one period are separated from those at the
commencement of the next following year. These procedures are generally
applied to trading transactions. The Cut-Off procedure is very significant so
as to ensure that revenue and expenditure of one year do not get recorded in
the following year, as that will distort the true and fair view of the accounts.

These procedures are applied to ensure that: -

a) Goods purchased, property in which has passed to the client, have in

fact been included in the inventories and that the liability has been provided
for in case of credit purchases;

b) Goods sold have been excluded from the inventories and credit has been
taken for the sales; if the value of the sales is to be received, the concerned
party has been debited; and

(c) The proper procedure has been followed for adjusting the inventory to
take into account movements to an from stock which have taken place
between the stock taking date and the balance sheet date where stock has
been taken on a date other than the balance sheet date.
 37

Q.20 How would you verify the Goodwill?

Answer 20.
1. The auditor should ascertain the existence of goodwill in the
organisation to see whether the business is earning a profit, which is above
normal profit in similar businesses. Mere presence of a value for goodwill
in the books does not testify that the business has goodwill in real terms.

2. The auditor should examine the relevant purchase agreement if

goodwill has been purchased. If goodwill is raised merely as a book entry,
the authorization of the board for raising goodwill should also be seen.

3. The goodwill will be valued at cost if has been purchased. There is no

mandatory requirement to depreciate goodwill. However, if the company
has a policy for writing off goodwill, it is to be seen that goodwill has been
depreciated entry only; the basis of the working should be examined.
Goodwill may be revalued form time to time. The reasonability of the basis
of revaluation should be examined. The auditor should also verify that if a
company is persistently incurring losses, the management should be advised
to write off the goodwill. Disclosure of goodwill in the balance sheet should
also be seen.

Q.21 How would you verify the Leasehold Property?

Answer 21.

1. The auditor should examine the lease deed and see that the conditions
and covenants are duly fulfilled and lease is in force.

2. The receipt of the last payment of the lease rent and/or the premium
paid under the fire insurance policy, if any, should be verified to see that
they are not in arrear.

3. If expenses in the nature of improvements to the leasehold property

have been incurred, the auditor should see that they have been brought to
accounts and written off over the remaining life of the lease. If possible, the
auditor should physically inspect the property to ascertain whether the same
 38

conforms to the description and details in the lease deed and with the
documents relating to subsequent improvements and constructions.

4. If the leasehold property has been mortgaged, the title deed will be in
the possession of the mortgagee or his solicitor. The auditor in such cases
should obtain a certificate to that effect.

5. If the property is received by the client in second or subsequent lease,

the auditor should inspect the assignment of the lease. If the leasehold
property has been sub-let, the right for sub-letting should be determined with
reference to original deed and the tenants’ agreement.

6. The leasehold property should be amortized on straight-line basis and

the auditor should verify that the necessary provisions therefore, including
for the cost of dilapidation on an estimated basis has been made in the
accounts. The relevant particulars including the number and location of
leasehold property should be traced in the fixed asset’s register especially in
the case of a company.

7. The auditor should also see manner of disclosure in the balance sheet.
In case of a company whether or not requirements of the Companies Act,
1956 have been followed.

Q.22 How would you verify the Plant and Machinery?

Answer 22.

1) The auditor should verify the existence of plant and machinery is by

reference to documentary evidence available and by evaluation of internal
controls. Plant and machinery in existence at the commencement of the year
is normally verified by examining the schedule of plant and machinery and
the fixed asset’s register. Acquisition during the year can be verified by
reference to the Board’s minutes, purchase invoice and entry in the fixed
assets register.

2) The auditor is not required to physically verify the plant and

machinery. Under the Manufacturing and Other Companies Auditor’s
Report Order applicable to companies physical verification of the fixed
 39

assets including plant and machinery is the responsibility of the

management. The auditor is required to comment on the verification made
by the management. Thus he can do by examination of physical verification
instructions, programme and working papers.

3) The auditor should also see that the various items of plant and
machinery possessed by the client at the year end are recorded in the
financial ledger and in the fixed asset’s register. Proper inquiry should be
made to ensure that plant and machinery scrapped, destroyed or sold during
the year has been properly adjusted in the books of account as also in the
fixed asset’s register. If on physical verification, material discrepancies are
found, the auditor should see that the discrepancies have been properly
adjusted in the books of account.

4) As regards valuation, the cost price of any plant and machinery

including freight and insurance plus any cost of installation should be
vouched with relevant invoices etc. The auditor should verify that due
provision for depreciation has been made. When an asset has been revalued,
depreciation should be provided on the revised value and not on the historic
value. Mode of disclosure in the balance sheet should also be seen.

Q.23 How would you verify the ‘Cash in hand’?

Answer 23.

The auditor should carry our physical verification of cash in hand at the
year-end or by way of a surprise check any time during the year provided the
internal control on cash is effective. In a balance sheet, the items ‘cash in
hand’ may include cash balance in hand, petty cash balance in hand, balance
of postage stamps in hand, cash in transit, cash at branches and with agents.
The first three items should be verified by actual count. The cash in transit
and that with branches and agents is verified from documentary evidence
available and the advice in respect of their subsequent remittance in whole
or part. The auditor may also carry out surprise cash verification whenever
he visits any branch or factory during the course of his audit.
 40

In there are more than one cash balance, for example, when there is a
cashier, a petty cashier and, in addition, there are imprest balances with
employees, all of them should be checked simultaneously as far as
practicable so that the shortage in one balance is not made good by transfer
of amount from others. If the cashier has access to funds belonging to other
entities, for example, associated companies, staff clubs etc. The auditor
should seek the co-operation of these entities in ensuring that all funds are
checked simultaneously.

If the auditor finds any slips, chits or I.O.U. in respect of temporary

advances paid to employees included as part of the cash balance, the matter
must be taken up with a senior official of the company and an explanation
obtained. In any case he should get these initialed by a responsible official
and debited to appropriate accounts.

Q.24 Under what circumstances a retiring auditor of a company cannot be

reappointed?

Answer 24.

Section 224 (2) of the Companies Act, 1956 provides that a retiring auditor
shall be re-appointed at any general meeting subject to provisions of section
224 (IB) and 224A. According to Section 224 (2), a retiring auditor of a
company cannot be re-appointed under the following circumstances: -

i) If the auditor is not qualified for re-appointment;

ii) If he has given the company a notice in writing of his unwillingness to

be reappointed;

iii) a resolution has been passed at that meeting appointing somebody

instead of him or providing expressly that he shall not be reappointed ; or

iv) Where notice has been given of an intended resolution to appoint some
person or persons in the place of a retiring auditor, and by reason of the
 41

death, incapacity or disqualification of that person or of all those persons, as

the case may be, the resolution cannot be proceeded with.

As stated above, the retiring auditor has to be reappointed subject to

provisions of sections 224(IB and 224A, these provisions are discussed
hereunder: -

i) Under Section 224(IB), a company or its Board of Directors shall not

appoint or reappoint any person qualified to be appointed as the auditor who
is in full time employment elsewhere or a firm of chartered accountants as
its auditor if such person or firm is, at the date of such appointment or
reappointment, holding appointment as auditor of the specified number of
companies or more than the specified number of companies. The number is
20 per partner excluding such partner of a firm who is in full-time
employment out of which at least ten companies should be such as have a
paid of capital of less than Rs. 25 lakhs.

Note: Students may note that the Section 224 (1B) has been recently
amended by the Companies (Amendment) Act, 1988. The possible intention
of the Government in amending Section 224(1B) was to plug the loophole
whereby even a chartered accountant in a full time employment could audit
20 companies if he held the certificate of practice. However, there seems to
be a drafting error. The amended section tends to suggest that the limit of 20
audits is not applicable to individual chartered accountants in practice
provided they are not in full time employment and that an individual
chartered accountant in practice in full time employment can audit upto 20
companies. This anomaly is under the consideration of the Department of
Company Affairs.

ii) Under Section 224A, in case of a company in which not less than 25%
of the subscribed share capital is held, either singly or in aggregate by the
specified bodies and institutions, the appointment has to be made by a
special resolution, failing which it will be assumed that no appointment has
been made.
 42

Q.25 Under what circumstances can the Central Government direct special
audit?

What action may be taken by the government on receipt of special audit

report?

Answer 25.

Section 233 of the Companies Act provides the power to the Central
Government to conduct a special audit of the accounts of a company for a
specified period, if in its opinion any of the following circumstances exists:
-

i) That the affairs of the company are not being managed in accordance
with sound business principles or prudent commercial practices; or

ii) That the company is being managed in a manner likely to caused

serious injury or damage to the interest of the trade, industry or business to
which it pertains; or

iii) That the financial position of the company is such as to endanger its
solvency.

The Central Government can order a special audit of the accounts of a

company, if it has reasons to believe that any of three circumstances
mentioned above exists.

Sub-section 6 of section 233A states that on receipt of the report of the

special auditor, the Central Government may take such action on the report
as it considers necessary in further provides that if the Central Government
does not take any action on the report within copy of, or relevant extracts
from, the report with its comments thereon and require the company either to
circulate that copy or those extracts to the members or to have such copy or
extracts read before the company at its next general meeting.

Q.26 Distinguish between Confirmation and verification?

 43

Answer 26.

Confirmation is an accepted auditing technique, which involves response to

an inquiry to corroborate information contained in the accounting records.
For examples, the auditor normally requests confirmation of receivable
balances by direct communication with the debtors. Confirmation technique
is also appropriate in relation to confirmation of bank balances or securities
lodged with others. On the other hand, the term verification applies to the
auditing procedure by which the auditor examines by appropriate manner
whether assets and liabilities are properly stated in the balance sheet. It also
applies to items of profit and loss account for verification of the account
balances and their presentation. Verification in the context of balance sheet
items involves an inquiry into the ownership, valuation, existence, and
presentation of assets and liabilities. Infact, while performing verification
procedure, the auditor occasionally makes used of confirmation technique to
verify various assets and liabilities contained in the balance sheet in respect
of which the party concerned is capable of providing confirmation e.g.
debtors for balance due by them, bank for balance held, etc. Verification is a
broader term and includes confirmation.

Q.27 Distinguish between ‘Provisions and Reserves’?

Answer 27.

The term ‘Reserves’ has been defined in Part-III of Schedule VI to the

Companies Act in a negative manner. According to the definition, the term
reserves shall not include any amount written off or retained by way of
providing for depreciation, renewals or diminution in value of assets or
retained by way of providing for any known liability.

In the same part of the schedule, the term provisions has been defined which
means any amount written of or retained by way of providing for
depreciation, renewals or diminution in value of assets or retained by way of
providing for any know liability of which the amount cannot be determined
with substantial accuracy.
 44

From the above, it can be seen that a basic distinction exists between
provisions and reserves in as much as reserves exclude provisions. Since the
term ‘reserve’ is not conceptually defined in the aforesaid provision of law,
the generally accepted idea of ‘reserve’ in accounting has to be recognised.
Reserve means retention of profit. Therefore, reserve can be created only
where there is a profit (save a few exceptions like reserve for investment
allowance). However, provision, as per the definition given above, is a
charge on the revenue arising on account of loss in value of assets or for
expenses incurred. The important distinction, therefore, is in their
relationship with profit. Reserve is an appropriation of profit (like general
reserve) and provisions is a charge on the profit (like provision for bad
debts). It follows that provision is to be created even where there is no
profit, to reflect a true and fair result of the operations. Resource cannot be
created unless there is a profit. Further, creation of provision is a necessity
arising out of accounting principle. Reserve on the other hand is not
necessarily to be created as an accounting requirement. For sound
accounting practice, of course, creation of reserve in a profit situation always
recommended. Provisions are shown in the profit and loss account above
the line whereas appropriation for reserve is made below the line. In the
balance sheet provision against loss of value of assets is usually deducted
from the value of the concerned asset. Reserve is always shown in the
liabilities side separately.

Q.28 Distinguish between ‘Internal audit and External audit’?

Answer 28.

Internal audit is an independent appraisal function within an organisation for

the review of activities as a service to all levels of management. It is a
control, which measure, evaluates and reports upon the effectiveness of
internal controls, financial and others, as contribution to the efficient use of
resources within the organisation. The external audit on the other hand
generally refers to an independent audit of financial or other quantitative
information of any entity with a view to express an opinion thereon. The
term ‘external’ is used as against the term ‘internal’ implying thereby that
such an audit is conducted by a person who is not a part of the organisation
 45

and can very well be considered as an outsider or external in relation to the

organisation while internal auditor is considered as an internal man of the
organisation. The external audit has developed as an expert and objective
examination of management prepared statements by an independent and
impartial competent third party who expresses an opinion on the financial
statements. Generally speaking, internal audit is voluntary and is authorized
by the management for and on its own behalf while external audit is
normally compulsory under the relevant statute to which the economic entity
is subject to.

There can also be voluntary external audit, where no statutory compulsion

exists e.g. audit of a sole proprietary or partnership firm not covered by
section 44AB of the Income tax Act. The scope of the work of internal
auditor is determined by the management ranging from the pure review of
accounting functions to the review of various operational services in the
organisation. The external auditor’s scope of duties arises from the
responsibilities place on him by the statute or the terms of engagement and
generally does not go beyond the normal accounting functions performed by
the organisation. The internal auditor’s approach is to ensure that the
accounting system is efficient so that the accounting information presented
to the management throughout the period is accurate and discloses all the
information that management desires or requires. The approach of the
external auditor is, however, governed by the requirements of relevant
statute and in case of a company the guiding consideration is that the
accounts to be presented to the members should show a trued and fair view
of the profit/loss and of the company’s financial affairs. Thus the internal
audit is management oriented while the external audit, though primarily
oriented towards the information needs of owners not in the management but
caters to the general needs of the users of financial statement.

Q.29 Distinguish between ‘Qualified Report and Adverse Report’?

Answer 29.

A qualified report is one wherein an auditor gives an opinion subject to

certain reservations. For example, in an audit of financial statements, an
 46

auditor may give his particular reservation in the audit report and state:
“Subject to the above, we report that the balance sheet shows a true and fair
view ..........”. On the other hand when the auditor concludes that based on
his examination he does not agree with the affirmations to b made, he gives
an adverse report. For example, in an audit of financial statements, the
auditor gives an adverse report when he states that the financial statements
do not present a true and fair view of the state of affairs and the working
results of the organisation. An adverse report is given when the reservations
or objections of the auditor are so material that he feels that overall view of
the account as presented would be a serious distortion. The basic distinction
between a qualified report and an adverse report is that in the case of former,
the accounts present a true and fair view subject to certain reservations while
in the case of latter the accounts do not present a true and fair view on the
whole. In practice, it is quite common to come across qualified reports
while adverse reports are quite rare. It may be clearly understood that
qualification is made in the audit report when the auditor has reservation on
specific item or items of material nature.

Q.30 What are the rights of an auditor with reference to the examination of
books of accounts and allied matters of a company?

Answer 30.

Various rights of an auditor with reference to the examination of books of

accounts and allied matters of a company are discussed below :-

i) Right of access to books and vouchers: Section 227(1) of the

Companies Act, provides that the auditor of a company shall have a right of
access, at all times, to the books and accounts and vouchers of the company
whether kept at the head office or elsewhere. This right of the auditor is the
fundamental basis on which the auditor can proceed to examine and inspect
the records of the company for the purpose of making his report. The work
‘books’ includes all types of books such as financial, statutory and statistical
books. Even memoranda records and quantitative records relating to
production, sales etc. Are covered by this term. The term ‘voucher’ means a
form of documentary evidence in support of a transaction entered into by the
 47

auditee and includes documents, correspondence, agreements etc. Finally,

the right of access ‘at all times’ implies that an auditor can inspect the
books, accounts and vouchers of the company during the normal business
hours of the auditee.

ii) Right to obtain information and explanations: Section 227(1) entitles

the auditor to require from the officers of the company such information and
explanations to the right to ask for information and explanations, section 221
of the Act also makes it obligatory for the concerned officers of the company
to furnish without delay the relevant information to the auditor.

iii) Right to visit branch offices and access to branch accounts: Section
228(2) of the Companies Act gives specific rights to the company auditor
where the accounts of any branch office are audited by another person. The
company auditor has the right to visit the branch office, if he deems it
necessary t do so for the performance of his duties and has the right of
access to books and accounts and vouchers maintained at the branch office.
However, the auditor does not have any right to visit foreign branches of a
banking company and it will be adequate if he is allowed access to such
copies of extracts from the books or accounts of the branch as have been
sent to the principal office in India. The company auditor has also the right
to receive the audit report from the branch auditor for his consideration and
deal with it in such a manner, as he considers necessary while preparing his
report on the account of the company.

iv) Right to receive notices and to attend general meetings: Section 231 of
the ‘Companies Act, entitles the auditors of a company to attend any general
meeting of auditor. He is also entitled to receive all notices and
communications relating to any company. Thus, this section imposes a duty
on the company to send all communications and notices relating to any
general meeting whenever the same are sent to any member. It should be
noted that the auditors have no obligation to attend such meetings. The
auditors will ‘however’ be free to attend such meetings and will be entitled
to speak on any part of the business, which concerns them.

v) Right to make representation: Pursuant to section 225, the retiring

auditor is entitled to receive a copy of the special notice intending to remove
his or proposing to appoint any other person as auditor. Further, the retiring
auditor sought to be removed has a right to make his representation in
writing and request that the same be circulated amongst the members of the
 48

company. In case, the same could not be circulated, the auditor may require
that the representation shall be read out at the general meeting. The auditor
also has the right to be heard at the general meeting.

Q.31 What is audit program and how it is useful to the auditor?

Answer 31.

An audit program is predetermined detailed plan of the auditing work to be

performed, specifying the procedures to be followed in verification of each
item in the financial statements, allocation of the audit staff and the time
frame to be followed in conducting the audit. The audit program also
contains the audit objectives for each area of work to be performed. Thus,
an audit program is a written plan for the conduct of an audit specifying
what work to be done, when to be done and by whom to be done. It consists
of a series of verifications procedure to be applied to the financial statements
and accounts of a given company for the purpose of obtaining sufficient and
appropriate evidence to enable the auditor to express an informed opinion on
such statements.

Now-a-days, standard audit programmes are available. But the auditor

should not use such programmes in a mechanical manner and must
formulate the program on the basis of knowledge of the client’s business and
nature of controls operating in the organisation. An audit program should be
flexible and must be continuously reviewed to keep it up to date.

Usefulness of Audit Program to the Auditor: -

The audit program is useful to the auditor in the following manner:

i) It provides a total perspective of the audit work to be performed;

ii) It provides assistants with a clear set of instructions about the audit
work to be performed;

iii) The location of audit work becomes easier when the work is defined
and planned in a systematic manner;
 49

iv) The danger of ignoring or overlooking certain books and records and
areas of work is significantly reduced;

v) The responsibility of the audit work carried out by the assistants can be
pin pointed as they are required to put their signatures on the program in
respect of work performed by them;

vi) The rotation of the audit staff is possible from one assignment to
another. It also helps to pick up the remaining threads of work when any
assistant goes on leave;

vii) It serves as a useful guide for conducting audits to be carried out in the
succeeding years;

viii)It serves as evidence in the event of any charge of negligence being

brought against the auditor. It is of considerable value in establishing that he
performed the audit work by exercising reasonable care and skill; and

ix) The progress of various audits being conducted simultaneously can be

controlled by the principal by examination of respective audit programmes.

Q.32 What is internal audit? How far the internal audit is useful to the
statutory auditor? To what extent the Statutory auditor can rely on the
internal audit report?

Answer 32.

Traditionally the concept of internal audit developed as an audit on behalf of

the management to ensure that the existing internal controls are adequate and
effective, the financial accounting and other records and reports show results
of actual operations accurately and promptly and the policies and procedures
as laid down by the management are adhered to. Thus, in the olden days the
scope of internal audit has been restricted to reassure the management that
the accounts are being properly maintained and the system contains adequate
safeguards to check any leakage of revenue or misappropriation of property
or assets and the operations have been carried out in conformity with the
 50

plans of the management. The modern concept of internal audit goes far
beyond the traditional view and it is no longer considered as a mere routine
review of operations and records by specially assigned staff. Internal
auditing has been defined by the Institute of Internal Auditors, USA as an
‘Independent appraisal’ function within an organisation to examine and
evaluate its activities as a service to the organisation. The objective of
internal auditing is to assist members of the organisation in the effective
discharge of their responsibilities. To this end, internal auditing furnishes
them with analyses, appraisals, recommendations, counsel and information
concerning the activities reviewed. The modern concept of internal audit
clearly shows that an internal auditor has to go beyond the books of account
and the related records and appraise the quality of various activities of the
organisation. The internal auditor is not to confine himself to the routine
search for clerical errors and accounting documents but has to conduct an
appraisal of the various operations reviewed by him. Thus, the internal
auditors have extended the scope of the work into operational areas in a
significant way crossing the tradition boundary of accounting records. In all
major undertakings a separate internal audit department is set up to
undertake the carried out by professional firm of auditors on assignment
basis.

Usefulness of Internal Audit to the Statutory Auditor

Generally the internal audit work carried out in the organisation is quite
useful to the statutory auditor because there are substantial similarities in the
area of operations. For instance, both internal and statutory auditor are
interested in ascertaining whether there is a adequate accounting system to
provide the necessary information for preparing true and fair financial
statements. The nature of work carried out by both is also similar as regards
the examination and checking of accounting records and statements and as
regards the examination of the system of internal check for both soundness
in principle and effectiveness in operation. The Statutory Auditor may be
able to rely to a great extent on the Internal Auditor in ascertaining as to
whether the system of Internal check is operating satisfactorily and also in
assessing the general reliability of the accounting records. The degree of
reliance that can be placed on accounting records and the system of internal
check would depend on the individual judgment of the Statutory Auditor in
organization to organisation. The detailed and extensive checking done by
the internal auditor in routine and repetitive areas throughout the year is also
useful to the statutory auditor in planning his work. He can concentrate
 51

more on weak areas observed by internal audit. He may also curtail detailed
checking when there was satisfactory coverage by internal audit. Therefore,
the statutory auditor can take into account the work of internal auditor in
determining the nature, timing and extent of conducting audit procedures
while formulating the audit program. However, the judgment as to
sufficiency of test performed, materiality and other matters having bearing
on the truthfulness and fairness of financial statements must remain his own.

The duty cast upon the statutory auditor in the Manufacturing and Other
Companies (Auditor’s Report) Order 1975, issued under Section 227(4A) of
the Companies Act in regard to internal audit system in companies above a
certain size is an indirect recognition of statutory auditor’s concern for
internal audit.

Extent of Reliance on Internal Audit Reports:

The internal auditor’s report can provide valuable information on the

working, state of internal controls and specific areas of irregularities in the
organisation. These report, being based on detailed verification of
transactions and controls on a day-to-day basis, are revealing in character
and would help the statutory auditor to framed his audit program as also to
decide the extent of co-operation that he may seek from the internal auditor.
Also, by perusal of the internal audit reports, it is possible to form an idea on
the coverage of the internal audit as well as the quality of work done. The
statutory auditor may, in the exercise of his judgment based on proper
evaluation of the quality and coverage of the internal audit, place reliance on
internal audit reports in the discharge of his responsibilities as an auditor.
However, if he is of the opinion that internal auditing and the resulting
reports do not suggest any meaningful work having been carried out by the
internal audit, or if he finds that the internal audit findings often are
controverted and not followed up, it suggests that the internal auditing
suffers from weaknesses in respect of authority and inadequacy. In such
circumstances, reliance on internal audit report is not advisable. In any
event, the statutory auditor remains responsible for the work done and report
made by him irrespective of whether he has put any reliance on the internal
audit. The reliance, if any, placed by him is a matter of his professional
judgment for which he alone would be responsible. If, by perusal of the
internal audit work and related reports, he finds that certain areas have been
well covered and reliable work has been performed, he may place reliance,
on such of the reports, while he may choose not to put any reliance on other
 52

areas covered by internal audit. As has been indicated above, reliance on

internal audit report does not absolve the statutory auditor from any failure
in the discharge of his professional duty.

Q.33 Can a properly appointed auditor be removed before the expiry of his
term? If yes, then give the procedure for such removal and mention the
rights available to the auditor ?

Answer 33.

Any auditor appointed by what so ever authority can be removed before the
expiry of his term. The first auditor appointed by the Board of Directors can
be removed by a company at a general meeting before the expiry of his term
without obtaining the previous approval of the Central Government. An
auditor of a company, other than the first auditor, can also be removed
before the expiry of his term by the company only at a general meeting, after
obtaining prior approval of the Central Government.

The detailed procedure to remove the first statutory auditor and the existing
statutory auditor before the expiry of their term is given below: -

I . Procedure to remove the existing statutory auditor before the expiry of

his term:

a) The company should obtain prior approval of the Central Government

to remove the existing statutory auditor.

b) The existing statutory auditor can be removed only at the general

meeting.

c) The intimation of the proposal for change should be sent forthwith to

the auditor concerned.

d) The procedures given under sub-sections (2) and (3) of Section 225 of
the Companies Act are to be followed. Section 225(2) provides that on
receipt of notice, the company shall send a copy of the notice to the retiring
auditor forthwith. The company shall also notify its members that it has
 53

received a notice regarding a resolution intending to remove the auditor, not

less than seven days before the meeting. Section 225(3) affords the
opportunity to the retiring auditor to make written representation not
exceeding a reasonable length, to the company and for its circulation to the
members of the company. On receipt of representation, the company shall
state the fact of such representation being made in any notice of resolution
and send a copy thereof to members of the company unless it is received too
late. In case, the written representation could not be sent, the representation
shall be read out at the general meeting and the auditor will have the right to
be heard at the general meeting.

e) The company in a general meeting has to consider the question of the

removal and resolution has to be passed to remove the auditor.

f) The general meeting may appoint a new auditor at same meeting or the
Board may fill the casual vacancy caused by the removal of the auditor.

II. Procedure to remove the first statutory auditor appointed by the Board:

a) There should be nomination of a new auditor by any member of the

company.

b) The notice for the nomination has to be circulated to the members of

the company not less than fourteen days before the date of the general
meeting of the company.

c) The procedures given under sub-sections (2) and (3) of Section 225 of
the Companies act are to be followed. Section 225(2) provides that on
receipt of the notice, the company shall send a copy of the notice to the
retiring auditor forthwith. Section 225(3) affords the opportunity to the
retiring auditor to make written representation not exceeding a reasonable
length, to the company and for its circulation to the members of the
company. On receipt of representation, the company shall state the fact of
such representation being made in any notice of resolution and send a copy
thereof to members of the company unless it is received too late. In case the
written representation could not be sent, the representation shall be read out
at the general meeting and the auditor will have the right to be heard at the
general meeting.
 54

d) The general meeting will consider the nomination and if it is accepted,

the earlier auditor appointed by the Board will cease to hold office on the
conclusion of the meeting and the new incumbent will assume the office of
the auditor.

Rights available to the Retiring Auditor:

The retiring auditor has certain rights as prescribed in Section 225(3). The
same has been discussed in point (d) of Part ( i ) above.

Statement on Standard Auditing Practices (SAP 1)*

Basic Principles Governing an Audit
The following is the text of the Statement on Standard
Auditing Practices (SAP) 1 issued by the Council of the
Institute of Chartered Accountants of India on “Basic
Principles Governing an Audit”. This Statement should be
read in conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute1

Introduction
1. This Statement describes the basic principles which
govern the auditor’s professional responsibilities and which
should be complied with whenever an audit is carried out.
______________________________
 55

1
With the formation of the Auditing Practices Committee in
1982, the Council of the Institute has been issuing a series
of Statements on Standard Auditing Practices (SAPs).
Statements on Standard Auditing Practices lay down the
principles governing an audit. These principles apply
whenever an independent audit is carried out. Statements
on Standard Auditing Practices become mandatory on the
dates specified in the respective SAPs. The mandatory
status implies that, while discharging their attest function,
it will be the duty of the members of the Institute to ensure
that SAPs are following in the audit of financial information
covered by their audit reports. If, for any reason, a member
has not been able to perform an audit in accordance with
the SAPs, his report should draw attention to the material
departures therefrom.
2. An audit is the independent examination of financial
information of any entity, whether profit oriented or not,
and irrespective of its size or legal form, when such an
examination is conducted with a view to expressing an
opinion thereon1. In this Statement the term “financial
information” encompasses financial statements.
3. Other Statements on Standard Auditing Practices to be
issued by the Institute will elaborate on the principles set
out herein to give guidance on auditing procedures and
reporting practices.
4. Compliance with the basic principles requires the
application of auditing procedures and reporting practices
appropriate to the particular circumstances.
______________________________
1
See para. 3.1 of the “Preface to the Statements on
Standard Auditing Practices” issued by the Council of the
Institute of Chartered Accountants of India.

Integrity, Objectivity and Independence

5. The auditor should be straightforward, honest and
sincere in his approach to his professional work. He must be
fair and must not allow prejudice or bias to override his
 56

objectivity. He should maintain an impartial attitude and

both be and appear to be free of any interest which might
be regarded, whatever its actual effect, as being
incompatible with integrity and objectivity.

Confidentiality
6. The auditor should respect the confidentiality of
information acquired in the course of his work and should
not disclose any such information to a third party without
specific authority or unless there is a legal or professional
duty to disclose.

Skills and Competence

7. The audit should be performed and the report prepared
with due professional care by persons who have adequate
training, experience and competence in auditing.
8. The auditor requires specialised skills and competence
which are acquired through a combination of general
education, technical knowledge obtained through study and
formal courses concluded by a qualifying examination
recognised for this purpose and practical experience under
proper supervision. In addition, the auditor requires a
continuing awareness of developments including
pronouncements of ICAI on accounting and auditing
matters, and relevant regulations and statutory
requirements.

Work Performed by Others

9. When the auditor delegates work to assistants or uses
work performed by other auditors and experts, he will
continue to be responsible for forming and expressing his
opinion on the financial information. However, he will be
entitled to rely on work performed by others, provided he
exercises adequate skill and care and is not aware of any
reason to believe that he should not have so relied. In the
case of any independent statutory appointment to perform
the work on which the auditor has to rely in forming his
opinion, such as in the case of the work of branch auditors
 57

appointed under the Companies Act, 1956 the auditor’s

report should expressly state the fact of such reliance.
10. The auditor should carefully direct, supervise and
review work delegated to assistants. The auditor should
obtain reasonable assurance that work performed by other
auditors or experts is adequate for his purpose.

Documentation
11.9;The auditor should document matters which are
important in providing evidence that the audit was carried
out in accordance with the basic principles.
12. The auditor should plan his work to enable him to
conduct an effective audit in an efficient and timely
manner. Plans should be based on a knowledge of the
client’s business.
13. Plans should be made to cover, among other things:
(a) Acquiring knowledge of the client’s accounting
system, policies and internal control procedures;
(b) Establishing the expected degree of reliance to be
placed on internal control;
(c) Determining and programming the nature, timing,
and extent of the audit procedures to be performed;
and
(d) Coordinating the work to be performed.
14. Plans should be further developed and revised as
necessary during the course of a audit.

Audit Evidence
15. The auditor should obtain sufficient appropriate audit
evidence through the performance of compliance and
substantive procedures to enable him to draw reasonable
conclusions therefrom on which to base his opinion on
the financial information.
16. Compliance procedures are tests designed to obtain
reasonable assurance that those internal controls on
which audit reliance is to be placed are in effect.
 58

17. Substantive procedures are designed to obtain

evidence as to the completeness, accuracy and validity of
the data produced by the accounting system.
They are of two types
(i) Tests of details of transactions and balances;
(ii) Analysis of significant ratios and trends including
the resulting enquiry of unusual fluctuations and items.

Accounting System and Internal Control

18. Management is responsible for maintaining an
adequate accounting system incorporating various
internal controls to the extent appropriate to the size and
nature of the business. The auditor should reasonably
assure himself that the accounting system is adequate
and that all the accounting information, which should be
recorded, has in fact been recorded. Internal controls
normally contribute to such assurance.
19. The auditor should gain an understanding of the
accounting system and related internal controls and
should study and evaluate the operation of those internal
controls upon which he wishes to rely in determining the
nature, timing and extent of other audit procedures.
20. Where the auditor concludes that he can rely on
certain internal controls, his substantive procedures
would normally be less extensive than would otherwise
be required and may also differ as to their nature and
timing.

Audit Conclusions and Reporting

21. The auditor should review and assess the conclusions
drawn from the audit evidence obtained and from his
knowledge of business of the entity as the basis for the
expression of his opinion on the financial information.
This review and assessment involves forming an overall
conclusion as to whether:
(a) The financial information has been prepared
using acceptable accounting policies, which have been
consistently applied;
 59

(b) The financial information complies with relevant

regulations and statutory requirements;
(c) There is adequate disclosure of all material
matters relevant to the proper presentation of the
financial information, subject to statutory
requirements, where applicable.
22. The audit report should contain a clear written
expression of opinion on the financial information and if
the form or content of the report is laid down in or
prescribed under any agreement or statute or regulation,
the audit report should comply with such requirements.
An unqualified opinion indicates the auditor’s satisfaction
in all material respects with the matters dealt with in
paragraph 21 or as may be laid down or prescribed under
the relevant agreement or statute or regulation, as the
case may be.
23. When a qualified opinion, adverse opinion or a
disclaimer of opinion is to be given or reservation of
opinion on any matter is to be made, the audit report
should state the reasons therefor.

Effective Date
24. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1985

Statement on Standard Auditing Practices (SAP 2)*

Objective and Scope of the Audit of Financial
Statements
The following is the text of the Statement on Standard
Auditing Practices (SAP) 2 issued by the Council of the
Institute of Chartered Accountants of India on “Objective
and Scope of the Audit of Financial Statements”. This
Statement should be read in conjunction with the “Preface
to the Statements on Standard Auditing Practices” issued by
the Institute.
 60

Introduction
1. The following is the text of the Statement on Standard
Auditing Practices (SAP) 2 issued by the Council of the
Institute of Chartered Accountants of India on “Objective
and Scope of the Audit of Financial Statements”. This
Statement should be read in conjunction with the
“Preface to the Statements on Standard Auditing
Practices” issued by the Institute.

Objective of an Audit
2. The objective of an audit of financial statements,
prepared within a framework of recognised accounting
policies and practices and relevant statutory
requirements, if any, is to enable an auditor to express an
opinion on such financial statements.
3. The auditor’s opinion helps determination of the true and
fair view of the financial position and operating results of
an enterprise. The user, however, should not assume that
the auditor’s opinion is an assurance as to the future
viability of the enterprise or the efficiency or
effectiveness with which management has conducted the
affairs of the enterprise.
______________________________
*Issued in June, 1985

Responsibility for the Financial Statements

4. While the auditor is responsible for forming and
expressing his opinion on the financial statements, the
responsibility for their preparation is that of the
management of the enterprise. Management’s
responsibilities include the maintenance of adequate
accounting records and internal controls, the selection
and application of accounting policies and the
safeguarding of the assets of the enterprise. The audit of
the financial statements does not relieve management of
its responsibilities.
 61

Scope of an Audit
5. The scope of an audit of financial statements will be
determined by the auditor having regard to the terms of
the engagement, the requirements of relevant legislation
and the pronouncements of the Institute. The terms of
engagement cannot, however, restrict the scope of an
audit in relation to matters, which are prescribed by
legislation or by the pronouncements of the Institute.
6. The audit should be organised to cover adequately all
aspects of the enterprise as far as they are relevant to the
financial statements being audited. To form an opinion on
the financial statements, the auditor should be
reasonably satisfied as to whether the information
contained in the underlying accounting records and other
source data is reliable and sufficient as the basis for the
preparation of the financial statements. In forming his
opinion, the auditor should also decide whether the
relevant information is properly disclosed in the financial
statements subject to statutory requirements, where
applicable.
7. The auditor assesses the reliability and sufficiency of the
information contained in the underlying accounting
records and other source data by:
(a) Making a study and evaluation of accounting
systems and internal controls on which he wishes to
rely and testing those internal controls to determine
the nature, extent and timing of other auditing
procedures; and
(b) Carrying out such other tests, enquiries and other
verification procedures of accounting transactions and
account balances, as he considers appropriate in the
particular circumstances.
8. The auditor determines whether the relevant information
is properly disclosed in the financial statements by:
(a) Comparing the financial statements with the
underlying accounting records and other source data
to see whether they properly summarise the
transactions and events recorded therein; and
 62

(b) Considering the judgements that management has

made in preparing the financial statements;
accordingly, the auditor assesses the selection and
consistent application of accounting policies, the
manner in which the information has been classified,
and the adequacy of disclosure.
9. The auditor’s work involves exercise of judgement, for
example, in deciding the extent of audit procedures and
in assessing the reasonableness of the judgements and
estimates made by management in preparing the
financial statements. Furthermore, much of the evidence
available to the auditor can enable him to draw only
reasonable conclusions therefrom. Because of these
factors, absolute certainty in auditing is rarely attainable.
10. In forming his opinion on the financial statements, the
auditor follows procedures designed to satisfy himself
that the financial statements reflect a true and fair view
of the financial position and operating results of the
enterprise. The auditor recognises that because of the
test nature and other inherent limitations of an audit,
together with the inherent limitations of any system of
internal control, there is an unavoidable risk that some
material misstatement may remain undiscovered. While
in many situations the discovery of a material
misstatement by management may often arise during the
conduct of the audit, such discovery is not the main
objective of audit nor is the auditor’s programme of work
specifically designed for such discovery. The audit
cannot, therefore, be relied upon to ensure the discovery
of all frauds or errors but where the auditor has any
indication that some fraud or error may have occurred
which could result in material misstatement, the auditor
should extend his procedures to confirm or dispel his
suspicions.
11. The auditor is primarily concerned with items, which
either individually or as a group are material in relation
to the affairs of an enterprise. However, it is difficult to
lay down any definite standard by which materiality can
be judged. Material items are those, which might
 63

influence the decisions of the user of the financial

statements. * It is a matter in which a decision is arrived
at on the basis of the auditor’s professional experience
and judgement.
12. The auditor is not expected to perform duties, which
fall outside the scope of his competence. For example,
the professional skill required of an auditor does not
include that of a technical expert for determining
physical condition of certain assets.
13. Constraints on the scope of the audit of financial
statements that impair the auditor’s ability to express an
unqualified opinion on such financial statements should
be set out in his report, and a qualified opinion or
disclaimer of opinion should be expressed as appropriate.

Effective Date
14. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1985.

Statement on Standard Auditing Practices (SAP 3)*

Documentation
The following is the text of the Statement on Standard
Auditing Practices (SAP) 3 issued by the Council of the
Institute of Chartered Accountants of India on
“Documentation”. This Statement should be read in
conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute.

Introduction
1. Statement on Standard Auditing Practices (SAP 1), “Basic
Principles Governing an Audit” (Paragraph 11), states:
“The auditor should document matters which are
important in providing evidence that the audit was
carried out in accordance with the basic principles.” The
purpose of this Statement is to amplify the basic principle
outlined above.
 64

2. Documentation, for purposes of this Statement, refers to

the working papers prepared or obtained by the auditor
and retained by him, in connection with the performance
of his audit.
3. Working papers:
 Aid in the planning and performance of the audit;
 Aid in the supervision and review of the audit work;
and
 Provide evidence of the audit work performed to
support the auditor’s opinion.

Form and Content

4. Working papers should record the audit plan, the nature,
timing and extent of auditing procedures performed, and
the conclusions drawn from the evidence obtained.
5. The form and content of working papers are affected by
matters such as:
 The nature of the engagement.
 The form of the auditor’s report.
 The nature and complexity of the client’s business.
 The nature and condition of the client’s records and
degree of reliance on internal controls.
 The needs in particular circumstances for direction,
supervision and review of work performed by
assistants.
6. Working papers should be designed and properly
organised to meet the circumstances of each audit and
the auditor’s needs in respect thereof. The
standardisation of working papers (for example
checklists, specimen letters, standard organisation of
working papers) improves the efficiency with which they
are prepared and reviewed. It also facilitates the
delegation of work while providing a means to control its
quality.
7. Working papers should be sufficiently complete and
detailed for an auditor to obtain an overall understanding
of the audit. The extent of documentation is a matter of
professional judgement since it is neither necessary nor
practical that every observation, consideration or
 65

conclusion is documented by the auditor in his working

papers.
8. All significant matters, which require the exercise of
judgement, together with the auditor’s conclusion
thereon, should be included in the working papers.
9. To improve audit efficiency, the auditor normally obtains
and utilises schedules, analyses and other working
papers prepared by the client. In such circumstances, the
auditor should satisfy himself that these working papers
have been properly prepared. Examples of such working
papers are detailed analyses of important revenue
accounts, receivables, etc.
10. In the case of recurring audits, some working paper
files may be classified as permanent audit files, which are
updated currently with information of continuing
importance to succeeding audits, as distinct from current
audit files, which contain information relating primarily
to the audit of a single period.
11. A permanent audit file normally includes:
 Information concerning the legal and organisational
structure of the entity. In the case of a company, this
includes the Memorandum and Articles of Association.
In the case of a statutory corporation, this includes the
Act and Regulations under which the corporation
functions.
 Extracts or copies of important legal documents,
agreements and minutes relevant to the audit.
 A record of the study and evaluation of the internal
controls related to the accounting system. This might
be in the form of narrative descriptions, questionnaires
or flow charts, or some combination thereof.
 Copies of audited financial statements for previous
years.
 Analysis of significant ratios and trends.
 Copies of management letters issued by the auditor, if
any.
 Record of communication with the retiring auditor, if
any, before acceptance of the appointment as auditor.
 Notes regarding significant accounting policies.
 66

 Significant audit observations of earlier years.

12. The current file normally includes:
 Correspondence relating to acceptance of annual
reappointment.
 Extracts of important matters in the minutes of Board
Meetings and General Meetings, as are relevant to
audit.
 Evidence of the planning process of the audit and audit
programme.
 Analysis of transactions and balances.
 A record of the nature, timing and extent of auditing
procedures performed, and the results of such
procedures.
 Evidence that the work performed by assistants was
supervised and reviewed.
 Copies of communications with other auditors, experts
and other third parties.
 Copies of letters or notes concerning audit matters
communicated to or discussed with the client,
including the terms of the engagement and material
weaknesses in relevant internal controls.
 Letters of representation or confirmation received
from the client.
 Conclusions reached by the auditor concerning
significant aspects of the audit, including the manner
in which exceptions and unusual matters, if any,
disclosed by the auditor’s procedures were resolved or
treated.
 Copies of the financial information being reported on
and the related audit reports.

Ownership and Custody of Working Papers

13. Working papers are the property of the auditor. The
auditor may, at his discretion, make portions of or
extracts from his working papers available to his client.
14. The auditor should adopt reasonable procedures for
custody and confidentiality of his working papers and
should retain them for a period of time sufficient to meet
 67

the needs of his practice and satisfy any pertinent legal

or professional requirements of record retention.

Effective Date
15. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after July 1, 1985.

Statement on Standard Auditing Practices (SAP 4)*

Fraud and Error
The following is the text of the Statement on Standard
Auditing Practices (SAP) 4 issued by the Council of the
Institute of Chartered Accountants of India on “Fraud and
Error”. This Statement should be read in conjunction with
the “Preface to the Statements on Standard Auditing
Practices” issued by the Institute.

Introduction
1. Statement on Standard Auditing Practices (SAP) 2,
Objective and Scope of the Audit of Financial
Statements” states (paragraph 10):
“In forming his opinion on the financial statements, the
auditor follows procedures designed to satisfy himself
that the financial statements reflect a true and fair view
of the financial position and operating results of the
enterprise. The auditor recognises that because of the
test nature and other inherent limitations of an audit,
together with the inherent limitations of any system of
internal control, there is an unavoidable risk that some
material misstatement may remain undiscovered. While
in many situations the discovery of a material
misstatement by management may often arise during the
conduct of the audit, such discovery is not the main
objective of audit nor is the auditor’s programme of work
specifically designed for such discovery. The audit
cannot, therefore, be relied upon to ensure the discovery
 68

of all frauds or errors but where the auditor has any

indication that some fraud or error may have occurred
which could result in material misstatement, the auditor
should extend his procedures to confirm or dispel his
suspicions.”
In this Statement, the term “financial information”
encompasses financial statements as defined in para 1 of
the Statement on Standard Auditing Practices (SAP) 2,
“Objective and Scope of the Audit of Financial Statements”.
The purpose of this Statement is to discuss the auditor’s
responsibility for the detection of material misstatements
resulting from fraud and error when carrying out an audit of
financial information and to provide guidance as to the
procedures that the auditor should perform when he
encounters circumstances that cause him to suspect, or
when he determines, that fraud or error has occurred.
2. The term “fraud” refers to intentional misrepresentations
of financial information by one or more individuals among
management, employees, or third parties. Fraud may
involve:
(a) Manipulation, falsification or alteration of records
or documents. For example, in a period of rising prices,
sales contract documents may be ante-dated to record
sales at prices lower than the prices at which sales
have actually taken place;
(b) Misappropriation of assets. For example, cash
sales may not be fully accounted for;
(c) Suppression or omission of the effects of
transactions from records or documents. For example,
goods sold may not be recorded as sales but included
in inventories;
(d) Recording of transactions without substance. For
example, goods delivered on consignment basis may be
recorded as sales; or
(e) Intentional misapplication of accounting policies.
For example, where a contracting firm follows the
‘completed contract’ method of accounting but does
not provide for a known loss on incomplete contracts.
 69

3. The term “error” refers to unintentional mistakes in

financial information such as:
(a) Mathematical or clerical mistakes in the
underlying records and accounting data;
(b) Oversight or misinterpretation of facts; or
(c) Misapplication of accounting policies.

Responsibility for the Detection of Fraud and Error

4. The responsibility for the prevention and detection of
fraud and error rests with management through the
implementation and continued operation of an adequate
system of internal control. Such a system reduces but
does not eliminate the possibility of fraud and error.
5. The objective of an audit of financial information is to
enable an auditor to express an opinion on such financial
information. In forming his opinion, the auditor carries
out procedures designed to obtain evidence that will
provide reasonable assurance that the financial
information is properly stated in all material respects.
Consequently, the auditor seeks reasonable assurance
that fraud or error which may be material to the financial
information has not occurred or that, if it has occurred,
the effect of fraud is properly reflected in the financial
information or the error is corrected. The auditor,
therefore, should so plan his audit that he has a
reasonable expectation of detecting material
misstatements in the financial information resulting from
fraud or error. The degree of assurance of detecting
errors would normally be higher than that of detecting
fraud, since fraud is usually accompanied by acts
specifically designed to conceal its existence.
6. Due to the inherent limitations of an audit (see
paragraphs 7-9) there is a possibility that material
misstatement of the financial information resulting from
fraud and, to a lesser extent, error may not be detected.
The subsequent discovery of material misstatement of the
financial information resulting from fraud or error
existing during the period covered by the auditor’s report
does not, in itself, indicate that the auditor has failed to
 70

adhere to the basic principles governing an audit. The

question of whether the auditor has adhered to the basic
principles governing an audit (such as performance of the
audit work with requisite skills and competence,
documentation of important matters, details of the audit
plan and reliance placed on internal controls, nature and
extent of compliance and substantive tests carried out
etc.) is determined by the adequacy of the procedures
undertaken in the circumstances and the suitability of the
auditor’s report based on the results of these procedures.

Inherent Limitations of an Audit

7. The test nature of an audit of financial information
involves judgement as to the areas to be tested and the
number of transactions to be examined. Furthermore,
much audit evidence is persuasive rather than conclusive
in nature; for example, confirmation of a debt by a
customer is not conclusive evidence that the debt is good
and recoverable. Therefore, it should be recognised that
the auditor’s examination is subject to the inherent
limitation that some material misstatements of the
financial information resulting from fraud or error, if
either exists, may not be detected.
8. The risk of not detecting material misstatement resulting
from fraud is greater than the risk of not detecting a
material misstatement resulting from error, because
fraud usually involves acts designed to conceal it, such as
collusion, forgery, deliberate failure to record
transactions, or intentional misrepresentations being
made to the auditor. Unless the auditor’s examination
reveals evidence to the contrary, he is entitled to accept
representations as truthful and records and documents as
genuine. However, the auditor should plan and perform
his audit recognising that he may encounter conditions or
events during his examination that would lead him to
question whether fraud or error exists.
9. While the existence of an effective system of internal
control reduces the probability of misstatement of
financial information resulting from fraud or error, there
 71

will always be some risk of internal controls failing to

operate as designed. Furthermore, any system of internal
control may be ineffective against fraud involving
collusion among employees or fraud committed by
management. Certain levels of management may be in a
position to override controls that would prevent similar
frauds by other employees; for example, by directing
subordinates to record transactions incorrectly or to
conceal them, or by suppressing information relating to
transactions.

Risk of Fraud and Error

10. In planning and performing his examination the
auditor should take into consideration the risk of material
misstatement of the financial information caused by fraud
or error. He should inquire of management as to any
fraud or significant error, which has occurred in the
reporting period, and modify his audit procedures, if
necessary. For example, in a fraud involving removal of
stocks from the company’s godowns without the same
being accounted for, the auditor should enlarge the
coverage of his substantive tests regarding despatches of
stocks and correlation of such despatches with invoices
raised. This would be further supplemented by surprise
physical verifications and stock reconciliations.
11. Weaknesses in the design of the internal control
system and non-compliance with identified control
procedures increase the risk of fraud or error. Other
conditions or events which increase the risk of fraud or
error include:
(a) Doubts regarding the integrity or competence of
management;
(b) Unusual pressures within an entity;
(c) Unusual transactions;
(d) Problems in obtaining sufficient appropriate audit
evidence.
Examples of these conditions or events are set forth in the
Appendix.
 72

Procedures When There is an Indication that Fraud or

Error may exist
12. If circumstances indicate the possible existence of
fraud or error, the auditor should consider the potential
effect of the suspected fraud or error on the financial
information. If the auditor believes the suspected fraud or
error could have a material effect on the financial
information, he should perform such modified or
additional procedures as he determines to be
appropriate. The extent of such modifications or
additional procedures depends on the auditor’s
judgement as to:
(a) The types of fraud or error that could occur;
(b) The relative risk of their occurrence;
(c) The likelihood that a particular type of fraud or
error could have a material effect on the financial
information.
13. Performing modified or additional procedures will
normally enable the auditor to confirm or dispel a
suspicion of fraud and error. Where the suspicion is
confirmed, he should satisfy himself that the effect of
fraud is properly reflected in the financial information or
the error is corrected.
14. However, the auditor may be unable to obtain audit
evidence either to confirm or dispel a suspicion of fraud.
In this circumstance, the auditor should consider the
possible impact on the financial information and the
effect on his report. The auditor will also need to consider
relevant laws and regulations and may wish to obtain
legal advice before rendering any report on the financial
information or before withdrawing from the engagement.
15. Unless circumstances clearly indicate otherwise, the
auditor should not assume that an instance of fraud or
error is an isolated occurrence. If the fraud or error
should have been prevented or detected by the system of
internal control, the auditor should reconsider his prior
evaluation of that system and, if necessary, adjust the
nature, timing and extent of his substantive procedures.
 73

16. When fraud or error involves a member of

management, the auditor should reconsider the reliability
of any representations made by that person to the
auditor.

Other Reporting Responsibilities

17. The auditor should communicate his findings to
management on a timely basis if fraud or significant error
is found to exist.
18. In determining an appropriate representative of the
entity to whom to report occurrences of fraud or
significant error, the auditor would consider all the
circumstances. With respect to fraud, he would assess
the likelihood of senior management involvement. In most
cases involving fraud, it would be appropriate to report
the matter to a level in the organisation structure of the
entity above that responsible for the persons believed to
be implicated. When those persons ultimately responsible
for the overall direction of the entity are doubted, the
auditor may seek legal advice to assist him in the
determination of procedures to follow.
19. The auditor should also consider the implications of
the circumstances on the true and fair view, which the
financial statements ought to convey and frame his report
appropriately.
20. Where a significant fraud has occurred the auditor
should consider the necessity for a disclosure of the fraud
in the financial statements and if adequate disclosure is
not made, the necessity for a suitable disclosure in his
report.

Effective Date
21. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after July 1, 1987.

Appendix
Examples of Conditions or Events, Which Increase the Risk
of Fraud or Error
 74

A. Questions with respect to the integrity or

competence of management
(1) Management is dominated by one person (or a
small group) and there is no effective oversight board
or committee.
(2) There is a complex corporate structure where
complexity does not seem to be warranted.
(3) There is a continuing failure to correct major
weaknesses in internal control where such corrections
are practicable.
(4) There is a high turnover rate of key accounting
and financial personnel.
(5) There is significant and prolonged understaffing
of the accounting department.
(6) There are frequent changes of legal counsel or
auditors.

B. Unusual pressures within an entity

(1) The industry is declining and failures are
increasing.
(2) There is inadequate working capital due to
declining profits or too rapid expansion.
(3) The quality of earnings is deteriorating, for
example, increased risk-taking with respect to credit
sales, changes in business practice or selection of
accounting policy alternatives that improve income.
(4) The entity needs a rising profit trend to support
the market price of its shares due to a contemplated
public offering, a takeover or other reason.
(5) The entity has a significant investment in an
industry or product line noted for rapid change.
(6) The entity is heavily dependent on one or a few
products or customers.
(7) Pressure is exerted on accounting personnel to
complete financial statements in an unusually short
time period.
 75

C. Unusual transactions
(1) Unusual transactions, especially near the year-
end, those have a significant effect on earnings.
(2) Transactions with related parties.
(3) Payments for services (for example, to lawyers,
consultants or agents) that appear excessive in relation
to the services provided.

D. Problems in obtaining sufficient appropriate

audit evidence
(1) Inadequate records, for example, incomplete files,
excessive adjustments to books and accounts,
transactions not recorded in accordance with normal
procedures and out of balance control accounts.
(2) Inadequate documentation of transactions, such
as lack of proper authorisation, supporting documents
not available and alteration to documents (any of these
documentation problems assume greater significance
when they relate to large or unusual transactions).
(3) An excessive number of differences between
accounting records and third party confirmations,
conflicting audit evidence and unexplainable changes
in operating ratios.
(4) Evasive or unreasonable responses by
management to audit inquiries.
Some factors unique to an EDP environment which
relate to the conditions and events in A through D
above include:
 Inability to extract information from computer files due
to lack of, or non-current, documentation of record
contents or programs.
 Large numbers of program changes that are not
documented, approved and tested.
 Inadequate overall balancing of computer transactions
and data bases to the financial accounts.
 76

Statement on Standard Auditing Practices (SAP 5)*

Audit Evidence
The following is the text of the Statement on Standard
Auditing Practices (SAP) 5 “Audit Evidence”, issued by the
Council of the Institute of Chartered Accountants of India.
The Statement should be read in conjunction with the
“Preface to the Statements on Standard Auditing Practices”
issued by the Institute.

Introduction
1. Statement on Standard Auditing Practices (SAP) 1, “Basic
Principles Governing an Audit”, states (paragraphs 15-
17):
“The auditor should obtain sufficient appropriate audit
evidence through the performance of compliance and
substantive procedures to enable him to draw reasonable
conclusions therefrom on which to base his opinion on
the financial information.
 77

Compliance procedures are tests designed to obtain

reasonable assurance that those internal controls on
which audit reliance is to be placed are in effect.
Substantive procedures are designed to obtain evidence
as to the completeness, accuracy and validity of the data
produced by the accounting system.
They are of two types:
(i) Tests of details of transactions and balances;
(ii) Analysis of significant ratios and trends including
the resulting enquiry of unusual fluctuations and
items.”
The purpose of this Statement is to amplify the basic
principle outlined above. In this Statement, the term
“financial information” encompasses financial statements.

Sufficient Appropriate Audit Evidence

2. Sufficiency and appropriateness are interrelated and
apply to evidence obtained from both compliance and
substantive procedures. Sufficiency refers to the
quantum of audit evidence obtained; appropriateness
relates to its relevance and reliability. Normally, the
auditor finds it necessary to rely on evidence that is
persuasive rather than conclusive. He may often seek
evidence from different sources or of different nature to
support the same assertion (see paragraphs 5 and 6).
3. The auditor should evaluate whether he has obtained
sufficient appropriate audit evidence before he draws his
conclusions therefrom. The audit evidence should, in
total, enable the auditor to form an opinion on the
financial information. In forming such an opinion, the
auditor may obtain audit evidence on a selective basis by
way of judgmental or statistical sampling procedures. For
example, the auditor may select only certain accounts
receivable for confirmation purposes, or make a selection
of personnel records for the purpose of testing that
changes in payroll rates have been properly authorised.
 78

4. The auditor’s judgement as to what is sufficient

appropriate audit evidence is influenced by such factors
as:
(a) The degree of risk of misstatement which may be
affected by factors such as:
(i) The nature of the item;
(ii) The adequacy of internal control;
(iii) The nature or size of the business carried on by
the entity;
(iv) Situations which may exert an unusual influence
on management;
(v) The financial position of the entity.
(b) The materiality of the item.
(c) The experience gained during previous audits.
(d) The results of auditing procedures, including
fraud or error, which may have been found.
(e) The type of information available.
(f) The trend indicated by accounting ratios and analysis.
5. Obtaining audit evidence from compliance procedures is intended to reasonably assure the auditor in
respect of the following assertions:
Existence That the internal control exists.
Effectiveness That the internal control is
operating effectively.
Continuity That the internal control has so
operated throughout the period of
intended reliance.
6. Obtaining audit evidence from substantive procedures is intended to reasonably assure the auditor in
respect of the following assertions:
Existence That an asset or a liability exists at
a given date.
Rights and That an asset is a right of the entity
Obligations and a liability is an obligation of the
entity at a given date.
Occurrence That a transaction or event took
place, which pertains to the entity
during the relevant period.
Completeness That there are no unrecorded
assets, liabilities or transactions.
Valuation That an asset or liability is recorded
 79

at an appropriate carrying value.

Measurement That a transaction is recorded in the
proper amount and revenue or
expense is allocated to the proper
period.
Presentation and An item is disclosed, classified, and
Disclosure described in accordance with
recognised accounting policies and
practices and relevant statutory
requirements, if any.
The extent and nature of substantive procedures to be
performed will vary with respect to each of the above
assertions.
Obtaining evidence relevant to one of the above assertions
will not compensate for failure to do so with respect to
another matter concerning the same item, e.g., existence of
inventory and its valuation.
7. The reliability of audit evidence depends on its source -
internal or external, and on its nature - visual,
documentary or oral. While the reliability of audit
evidence is dependent on the circumstances under which
it is obtained, the following generalisations may be useful
in assessing the reliability of audit evidence:
 External evidence (e.g. confirmation received from a
third party) is usually more reliable than internal
evidence.
 Internal evidence is more reliable when related
internal control is satisfactory.
 Evidence in the form of documents and written
representations is usually more reliable than oral
representations.
 Evidence obtained by the auditor himself is more
reliable than that obtained through the entity.
8. The auditor may gain increased assurance when audit
evidence obtained from different sources or of different
nature is consistent. In these circumstances, he may
obtain a cumulative degree of assurance higher than that
which he attaches to the individual items of evidence by
 80

themselves. Conversely, when audit evidence obtained

from one source is inconsistent with that obtained from
another, further procedures may have to be performed to
resolve the inconsistency.
9. The auditor should be thorough in his efforts to obtain
evidence and be objective in its evaluation.
10. When the auditor is in reasonable doubt as to any
assertion of material significance, he would attempt to
obtain sufficient appropriate evidence to remove such
doubt. If he is unable to obtain sufficient appropriate
evidence he should not express an unqualified opinion.

Obtaining Audit Evidence

11. The auditor obtains evidence in performing compliance
and substantive procedures by one or more of the
following methods:
 Inspection
 Observation
 Computation
 Analytical review
The timing of such procedures will be dependent, in part,
upon the periods of time during which the audit evidence
sought is available.

Inspection
12. Inspection consists of examining records, documents,
or tangible assets. Inspection of records and documents
provides evidence of varying degrees of reliability
depending on their nature and source and the
effectiveness of internal controls over their processing.
Four major categories of documentary evidence, which
provide different degrees of reliability to the auditor, are:
 Documentary evidence originating from and held by
third parties;
 Documentary evidence originating from third parties
and held by the entity;
 Documentary evidence originating from the entity and
held by third parties; and
 81

 Documentary evidence originating from and held by

the entity.
Inspection of tangible assets is one of the methods to obtain
reliable evidence with respect to their existence but not
necessarily as to their ownership or value.

Observation
13. Observation consists of witnessing a process or
procedure being performed by others. For example, the
auditor may observe the counting of inventories by client
personnel or the performance of internal control
procedures that leave no audit trail.

Inquiry and Confirmation

14. Inquiry consists of seeking appropriate information
from knowledgeable persons inside or outside the entity.
Inquiries may range from formal written inquiries
addressed to third parties to informal oral inquiries
addressed to persons inside the entity. Responses to
inquiries may provide the auditor with information, which
he did not previously possess or may provide him with
corroborative evidence.
15. Confirmation consists of the response to an inquiry to
corroborate information contained in the accounting
records. For example, the auditor requests confirmation
of receivables by direct communication with debtors.

Computation
16. Computation consists of checking the arithmetical
accuracy of source documents and accounting records or
performing independent calculations.

Analytical Review
17. Analytical review consists of studying significant ratios
and trends and investigating unusual fluctuations and
items.
 82

Effective Date
18. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after January 1, 1989
 83

Statement on Standard Auditing Practices (SAP 6)*

Study and Evaluation of the Accounting System and
Related Internal Controls in Connection with an Audit
The following is the text of the Statement on Standard
Auditing Practices (SAP) 6, “Study and Evaluation of the
Accounting System and Related Internal Controls in
Connection with an Audit” issued by the Council of the
Institute of Chartered Accountants of India. The Statement
should be read in conjunction with the “Preface to the
Statements on Standard Auditing Practices” issued by the
Institute.

Introduction
Statement on Standard Auditing Practices (SAP) 1, “Basic
Principles Governing an Audit” states (paragraphs 18-20):
“Management is responsible for maintaining an adequate
accounting system incorporating various internal controls
to the extent appropriate to the size and nature of the
business. The auditor should reasonably assure himself
that the accounting system is adequate and that all the
accounting information, which should be recorded, has in
fact been recorded. Internal controls normally contribute
to such assurance.
The auditor should gain an understanding of the
accounting system and related internal controls and
should study and evaluate the operation of those internal
controls upon which he wishes to rely in determining the
nature, timing and extent of other audit procedures.
Where the auditor concludes that he can rely on certain
internal controls, his substantive procedures would
normally be less extensive than would otherwise be
required and may also differ as to their nature and
timing.”
 84

2. Statement on Standard Auditing Practices (SAP) 2

“Objective and Scope of the Audit of Financial
Statements” states (paragraph 7):
“The auditor assesses the reliability and sufficiency of the
information contained in the underlying accounting
records and other source data by:
(a) Making a study and evaluation of accounting systems
and internal controls on which he wishes to rely and
testing those internal controls to determine the nature,
extent and timing of other auditing procedures...”1
3. The purpose of this Statement is to discuss the
procedures to be followed to comply with the basic
principle described above in connection with the audit of
financial information. In this statement the term ‘financial
information’ encompasses financial statements. The
Statement does not deal with the procedures to be
adopted in an electronic data processing environment.2
______________________________
1
It may be mentioned that the Manufacturing and Other
Companies (Auditor’s Report) Order, 1975, also requires the
auditor of a company which is engaged in one or more of
the specified activities to include in his report a statement
on specified aspects of internal control. Reference may be
made in this regard to the “Statement on the Manufacturing
and Other Companies (Auditor’s Report) Order, 1975
(issued under Section 227(4A) of the Companies Act. 1956)”
issued by the Institute of Chartered Accountants of India in
1977.
2
A subsequent Statement will deal with applying these
procedures in an electronic data processing environment.

Accounting System and Internal Control

4. An accounting system can be defined as the series of
tasks in an entity by which transactions are processed as
a means of maintaining financial records. Such a system
should recognise, calculate, classify, post, analyse,
summarise and report transactions.
 85

5. The system of internal control is the plan of organisation

and all the methods and procedures adopted by the
management of an entity to assist in achieving
management’s objective of ensuring, as far as
practicable, the orderly and efficient conduct of its
business, including adherence to management policies,
the safeguarding of assets, prevention and detection of
fraud and error, the accuracy and completeness of the
accounting records, and the timely preparation of reliable
financial information. The system of internal control
extends beyond those matters, which relate directly to
the functions of the accounting system. The internal audit
function constitutes a separate component of internal
control with the objective of determining whether other
internal controls are well designed and properly
operated.
6. The environment in which internal control operates has
an impact on the effectiveness of the specific control
procedures. A strong control environment, for example,
one with tight budgetary controls and an effective
internal audit function, can significantly complement
specific control procedures. However, a strong
environment does not, by itself, ensure the effectiveness
of the overall system of internal control. The system of
internal control must be under continuing supervision by
management to determine that it is functioning as
prescribed and is modified as appropriate for changes in
conditions. The internal control environment may be
affected by:
(a) Organisational structure
The organisational structure of an entity serves as a
framework for the direction and control of its activities.
An effective structure provides for the communication of
the delegation of authority and the scope of
responsibilities. It should be designed, insofar as
practicable, to preclude an individual from overriding the
control system and should provide for the segregation of
incompatible functions. Functions are incompatible if
their combination may permit the commitment or
 86

concealment of fraud or error. Functions that typically

are segregated are access to assets, authorisation of
transactions, execution thereof, and record keeping.
(b) Management Supervision
Management is responsible for devising and maintaining
the system of internal control. In carrying out its
supervisory responsibility, management should review
the adequacy of internal control on a regular basis to
ensure that all significant controls are operating
effectively. When an entity has an internal audit system,
management may entrust to it some of its supervisory
functions, especially with respect to the review of
internal control.
©Personnel
The proper functioning of any system depends on the
competence and integrity of those operating it. The
qualifications, selection and training as well as the
personal characteristics of the personnel involved are
important features in establishing and maintaining a
system of internal control.

Objectives of Internal Controls Relating to Accounting

System
7. Internal controls relating to the accounting system are
concerned with achieving the following objectives:
a) Transactions are executed in accordance with
management’s general or specific authorisation;
b) All transactions are promptly recorded in the correct
amount in the appropriate accounts and in the
accounting period in which executed so as to permit
preparation of financial information within a
framework of recognised accounting policies and
practices and relevant statutory requirements, if any,
and to maintain accountability for assets;
c) Assets are safeguarded from unauthorised access, use
or disposition; and
 87

d) The recorded assets are compared with the existing

assets at reasonable intervals and appropriate action is
taken with regard to any differences.
8. Internal control can provide only reasonable, but not
absolute, assurance that the objectives stated above is
achieved. This is because there are some inherent
limitations of internal control, such as:

Inherent Limitations of Internal Control

a) Management’s consideration that a control be cost-
effective;
b) The fact that most controls do not tend to be directed
at transactions of unusual nature;
c) The potential for human error;
d) The possibility of circumvention of controls through
collusion with parties outside the entity or with
employees of the entity;
e) The possibility that a person responsible for exercising
control could abuse that authority, for example, a
member of management overriding a control;
f) The possibility that procedures may become
inadequate due to changes in conditions and
compliance with procedures may deteriorate;
g) Manipulations by management with respect to
transactions or estimates and judgements required in
the preparation of financial statements.

Audit Procedures
9. The auditor, in forming his opinion on financial
information, needs reasonable assurance that
transactions are properly authorised and recorded in the
accounting records and that transactions have not been
omitted. Internal controls, even if fairly simple, may
contribute to the reasonable assurance the auditor seeks.
The auditor’s objective in studying and evaluating
internal controls is to establish the reliance he can place
thereon in determining the nature, timing and extent of
his substantive auditing procedures.
 88

10. The auditor obtains an understanding of the

accounting system to identify points in the processing of
transactions and handling of assets where errors or fraud
may occur. It is at these points that the auditor must be
satisfied that internal control procedures applied by the
enterprise are effective for his purposes.
11. Compliance procedures are tests designed to obtain
reasonable assurance that those internal controls on
which audit reliance is to be placed are in effect. These
procedures include tests requiring inspection of
documents supporting transactions to gain evidence that
controls have operated properly (for example, verifying
that the document has been authorised) and enquiries
about the observation of controls, which leave no audit
trail (for example, determining who actually performs
each function not merely who is supposed to perform it).
12. Substantive procedures are designed to obtain
evidence as to the completeness, accuracy and validity of
the data produced by the accounting system. These
procedures comprise tests of details of transactions and
balances, and analysis of significant ratios and trends
including the resulting investigation of unusual
fluctuations and items.
13. While compliance procedures and substantive
procedures are distinguishable as to their purpose, the
results of either type of procedure may contribute to the
purpose of the other. Errors discovered in conducting
substantive procedures may cause the auditor to modify
his evaluation based on compliance procedures that
controls were adequate for his purposes.

Review and Preliminary Evaluation

14. The auditor should review the accounting system and
related internal controls to gain an understanding of the
flow of transactions and the specific control procedures
to be able to make a preliminary evaluation and
identification of those internal controls on which it might
be effective and efficient to rely in conducting his audit.
 89

However, such review would depend on the size of the

enterprise and the extent of controls as stated in para 25.
15. Unless circumstances clearly indicate otherwise, the
auditor should not assume that an instance of fraud or
error is an isolated occurrence. If the fraud or error
should have been prevented or detected by the system of
internal control, the auditor should reconsider his prior
evaluation of that system and, if necessary, adjust the
nature, timing and extent of his substantive procedures.
15. The review of internal control consists mainly of
enquiries of personnel at various organisational levels
within the enterprise together with reference to
documentation such as procedures manuals, job
descriptions and flow charts, to gain knowledge about the
controls, which the auditor has identified as significant to
his audit. In a continuing engagement, the auditor will be
aware of internal controls through work carried out
previously but will need to update his knowledge.
16. It may be useful to trace a few transactions through
the accounting system to assist in understanding that
system and its related internal controls. When the
transactions selected are representative of the type of
transactions that usually pass through the system, this
procedure may be treated as part of the compliance
procedures.
17. Different techniques may be used to record
information relating to an internal control system.
Selection of a particular technique is a matter for the
auditor’s judgement. Common techniques, used alone or
in combination, are narrative descriptions, questionnaires
and flow charts. The auditor should maintain adequate
documentation about those internal controls on which he
intends to rely.
18. The auditor’s preliminary evaluation of the internal
controls should be made on the assumption that the
controls operate generally as described and that they
function effectively throughout the period of intended
reliance. The purpose of the preliminary evaluation is to
identify the particular controls on which the auditor still
 90

intends to rely and to test through compliance

procedures.
19. The auditor may decide not to rely on particular
internal controls because, for example,
a) They are defective in design and therefore their
operation would provide insufficient assurance as to
the accuracy and completeness of information
produced by the accounting system, or
b) The audit effort required to test compliance with those
internal controls is not commensurate with the
reduction in effort that could be achieved by placing
reliance on them.

Compliance Procedures
20. Compliance procedures should be conducted by the
auditor to gain evidence that those internal controls on
which he intends to rely operate generally as identified
by him and that they function effectively throughout the
period of intended reliance. The concept of effective
operation recognises that some deviations from
prescribed controls may have occurred.
21. Deviations from prescribed controls may be caused by
such factors as changes in key personnel, significant
seasonal fluctuations in volume of transactions, and
human error. The auditor should make specific enquiries
concerning these matters, particularly as to the timing of
staff changes in key control functions. He should then
ensure that his compliance procedures appropriately
cover such a period of change or fluctuation.
22. Based on the results of his compliance procedures, the
auditor should evaluate whether the internal controls are
adequate for his purposes.
23. If, based on the results of the compliance procedures,
the auditor concludes that it is not appropriate to rely on
a particular internal control to the degree previously
contemplated, he should ascertain whether there is
another control which would satisfy his purpose and on
which he might rely (after applying appropriate
compliance procedures). Alternatively, he may modify the
 91

nature, timing or extent of his substantive audit

procedures.
24. The auditor’s compliance procedures normally should
be applied to transactions selected from those of the
entire period under examination. When, however, a
shorter period is initially tested, the auditor needs to
consider what is necessary to provide reasonable
assurance as to the reliability of the accounting records
for the whole period. The auditor’s judgement as to the
nature, timing and extent of compliance or substantive
procedures to be applied to transactions occurring in the
remaining period will be affected by such factors as the
following:
a) The results of the procedures already conducted;
b) The responses to enquiries as to whether the internal
control system is still operating in the same manner as
when studied and evaluated;
c) The length of the remaining period;
d) The nature and amount of the transactions or balances
involved;
e) The auditor’s evaluation of the internal control
environment, especially supervisory controls; and
f) The substantive procedures which the auditor intends
to carry out irrespective of the adequacy of internal
controls.

Internal Control in the Small Business

25. The auditor needs to obtain the same degree of
assurance in order to give an unqualified opinion on the
financial statements of both small and large entities.
However, many controls, which would be relevant to
large entities, are not practical in the small business. For
example, in small business, few persons may perform
accounting procedures. These persons may have both
operating and custodial responsibilities, and segregation
of functions may be missing or severely limited.
Inadequate segregation of duties may, in some cases, be
offset by owner/ manager supervisory controls, which
may exist because of direct personal knowledge of the
 92

business and involvement in the business transactions. In

circumstances where segregation of duties is limited or
evidence of supervisory controls is lacking, the evidence
necessary to support the auditor’s opinion on the
financial information may have to be obtained largely
through the performance of substantive procedures.

Communication of Weaknesses in Internal Control

26. As a result of his study and evaluation of internal
control and other auditing procedures, the auditor may
become aware of weaknesses in internal control. For the
benefit of the entity, the auditor should make
management aware, on a timely basis, of material
weaknesses, which have come to his attention. Such
weaknesses are usually communicated in writing. It is
important to indicate in such communication that it
discusses only weaknesses which have come to the
attention of the auditor as a result of his audit, and that
his examination has not been designed to determine the
adequacy of internal control for management purposes.

Effective Date
27.This Statement on Standard Auditing Practices becomes
operative for all audits relating to accounting periods
beginning on or after January 1, 1989.

Statement on Standard Auditing Practices (SAP 7)*

Relying Upon the Work of an Internal Auditor
The following is the text of the Statement on Standard
Auditing Practices (SAP) 7, “Relying upon the Work of an
Internal Auditor”, issued by the Council of the Institute of
Chartered Accountants of India. The Statement should be
read in conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute. This
Statement on Standard Auditing Practices supersedes the
 93

Guidance Note on “Co-ordination between the Internal

Auditor and Statutory Auditors” issued by the Institute in
1979.

Introduction
1. Statement on Standard Auditing Practices (SAP) 6,
“Study and Evaluation of the Accounting System and
Related Internal Controls in Connection with an Audit”,
states (paragraph 5):
“The system of internal control is the plan of organisation
and all the methods and procedures adopted by the
management of an entity to assist in achieving
management’s objective of ensuring, as far as
practicable, the orderly and efficient conduct of its
business, including adherence to management policies,
the safeguarding of assets, prevention and detection of
fraud and error, the accuracy and completeness of the
accounting records, and the timely preparation of reliable
financial information. The system of internal control
extends beyond those matters, which relate directly to
the functions of the accounting system. The internal audit
function constitutes a separate component of internal
control established with the objective of determining
whether other internal controls are well designed and
properly operated.”
2. The purpose of this Statement is to provide guidance as
to the procedures, which should be applied by the
external auditor in assessing the work of the internal
auditor for the purpose of placing reliance upon that
work.
3. With the introduction of the Manufacturing and Other
Companies (Auditor’s Report) Order, 1988, internal audit
function has acquired special significance as the
statutory auditor is required to state, in relation to a
company having a paid-up capital exceeding Rs. 25 lakhs
or having an average annual turnover exceeding Rs. 2
crore for a period of three consecutive financial years
immediately preceding the financial year concerned to
which the Order applies, whether the internal audit
 94

system is commensurate with the size and nature of its

business.1
______________________________
1
Reference may be made to the Institute’s Statement on
Manufacturing and Other Companies (Auditor’s Report)
Order for a study of various factors to be considered by the
auditor in evaluating the adequacy of the internal audit
system for the purposes of reporting under the Order.

Accounting System and Internal Control

4. In this Statement, “financial information” encompasses
financial statements.
5. While the external auditor has sole responsibility for his
report and for the determination of the nature, timing
and extent of the auditing procedures, much of the work
of the internal audit function may be useful to him in his
examination of the financial information.

Scope and Objectives of the Internal Audit Function

6. The scope and objectives of internal audit vary widely
and are dependent upon the size and structure of the
entity and the requirements of its management.
Normally, however, internal audit operates in one or
more of the following areas:
(a) Review of accounting system and related internal
controls: The establishment of an adequate accounting
system and the related controls is the responsibility of
management, which demands proper attention on a
continuous basis. The internal audit function is often
assigned specific responsibility by management for
reviewing the accounting system and related internal
controls, monitoring their operation and
recommending improvements thereto.
(b) Examination for management of financial and
operating information: This may include review of the
means used to identify, measure, classify and report
such information and specific inquiry into individual
items including detailed testing of transactions,
balances and procedures.
 95

(c) Examination of the economy, efficiency and

effectiveness of operations including non-financial
controls of an organisation: Generally, the external
auditor is interested in the results of such audit work
only when it has an important bearing on the reliability
of the financial records.
(d) Physical examination and verification: This would
generally include examination and verification of
physical existence and condition of the tangible assets
of the entity.

Relationship between Internal and External Auditors

7. The role of the internal audit function within an entity is
determined by management and its prime objective
differs from that of the external auditor who is appointed
to report independently on financial information.
Nevertheless, some of the means of achieving their
respective objectives are often similar and thus much of
the work of the internal auditor may be useful to the
external auditor in determining the nature, timing and
extent of his procedures.
8. The external auditor should, as part of his audit, evaluate
the internal audit function to the extent he considers that
it will be relevant in determining the nature, timing and
extent of his compliance and substantive procedures.
Depending upon such evaluation, the external auditor
may be able to adopt less extensive procedures than
would otherwise be required.

Inherent Limitations of Internal Control

9. By its very nature, the internal audit function cannot be
expected to have the same degree of independence as is
essential when the external auditor expresses his opinion
on the financial information. The report of the external
auditor is his sole responsibility, and that responsibility is
not by any means reduced because of the reliance he
places on the internal auditor’s work.
 96

General Evaluation of Internal Audit Function

10. The external auditor’s general evaluation of the
internal audit function will assist him in determining the
extent to which he can place reliance upon the work of
the internal auditor. The external auditor should
document his evaluation and conclusions in this respect.
The important aspects to be considered in this context
are:
(a) Organisational Status. Whether internal audit is
undertaken by an outside agency or by an internal
audit department within the entity itself, the internal
auditor reports to the management. In an ideal
situation he reports to the highest level of management
and is free of any other operating responsibility. Any
constraints or restrictions placed upon his work by
management should be carefully evaluated. In
particular, the internal auditor should be free to
communicate fully with the external auditor.
(b) Scope of Function. The external auditor should
ascertain the nature and depth of coverage of the
assignment, which the internal auditor discharges for
management. He should also ascertain to what extent
the management considers, and where appropriate,
acts upon internal audit recommendations.
(c) Technical Competence. The external auditor
should ascertain that internal audit work is performed
by persons having adequate technical training and
proficiency. This may be accomplished by reviewing
the experience and professional qualifications of the
persons undertaking the internal audit work.
(d) Due Professional Care. The external auditor
should ascertain whether internal audit work appears
to be properly planned, supervised, reviewed and
documented. An example of the exercise of due
professional care by the internal auditor is the
existence of adequate audit manuals, audit
programmes, and working papers.
 97

Coordination
11. Having decided in principle that he intends to rely
upon the work of the internal auditor, it is desirable that
the external auditor ascertains the internal auditor’s
tentative plan for the year and discusses it with him at as
early a stage as possible to determine areas where he
considers that he could rely upon the internal auditor’s
work. Where internal audit work is to be a factor in
determining the nature, timing and extent of the external
auditor’s procedures, it is desirable to plan in advance
the timing of such work, the extent of audit coverage, test
levels and proposed methods of sample selection,
documentation of the work performed, and review and
reporting procedures.
12. Coordination with the internal auditor is usually more
effective when meetings are held at appropriate intervals
during the year. It is desirable that the external auditor is
advised of, and has access to, relevant internal audit
reports and in addition is kept informed, along with
management, of any significant matter that comes to the
internal auditor’s attention and which he believes may
affect the work of the external auditor. Similarly, the
external auditor should ordinarily inform the internal
auditor of any significant matters, which may affect his
work.

Evaluating Specific Internal Audit Work

13. Where, following the general evaluation described in
paragraph 10, the external auditor intends to rely upon
specific internal audit work as a basis for modifying the
nature, timing and extent of his procedures, he should
review the internal auditor’s work, taking into account
the following factors:
(a) The scope of work and related audit programmes
are adequate for the external auditor’s purpose.
(b) The work was properly planned and the work of
assistants was properly supervised, reviewed, and
documented.
 98

(c) Sufficient appropriate evidence was obtained to

afford a reasonable basis for the conclusions reached.
(d) Conclusions reached are appropriate in the
circumstances and any reports prepared are consistent
with the results of the work performed
(e) Any exceptions or unusual matters disclosed by
the internal auditor’s procedures have been properly
resolved.
The external auditor should document his conclusions in
respect of the specific work, which he has reviewed.
14. The external auditor should also test the work of the
internal auditor on which he intends to rely. The nature,
timing and extent of the external auditor’s tests will
depend upon his judgement as to the materiality of the
area concerned to the financial statements taken as a
whole and the results of his evaluation of the internal
audit function and of the specific internal audit work. His
tests may include examination of items already examined
by the internal auditor, examination of other similar
items, and observation of the internal auditor’s
procedures.

Effective Date
15. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1989.
Statement on Standard Auditing Practices (SAP 8)*
Audit Planning
The following is the text of the Statement on Standard
Auditing Practices (SAP) 8, “Audit planning”, issued by the
Council of the Institute of Chartered Accountants of India.
The Statement should be read in conjunction with the
“Preface to the Statements on Standard Auditing Practices”
issued by the Institute.

Introduction
1. Statement on Standard Auditing Practices 1, “Basic
Principles Governing an Audit”, states (paragraphs 12-
14):
 99

“The auditor should plan his work to enable him to

conduct an effective audit in an efficient and timely
manner. Plans should be based on knowledge of the
client’s business.
Plans should be made to cover, among other things:
(a) Acquiring knowledge of the client’s accounting
systems, policies and internal control procedures;
(b) Establishing the expected degree of reliance to be
placed on internal control;
(c) Determining and programming the nature, timing,
and extent of the audit procedures to be performed;
and
(d) Coordinating the work to be performed.
Plans should be further developed and revised as
necessary during the course of the audit.”
The purpose of this Statement is to amplify the basic
principle outlined above.
2. This Statement applies to the planning process of the
audit of both financial statements and other financial
information. The Statement is framed in the context of
recurring audits. In a first audit the auditor may need to
extend his planning process beyond the matters
discussed herein.
3. Planning should be continuous throughout the
engagement and involves:
 Developing an overall plan for the expected scope and
conduct of the audit; and
 Developing an audit programme showing the nature,
timing and extent of audit procedures.
Changes in conditions or unexpected results of audit
procedures may cause revisions of the overall plan and of
the audit programme. The reasons for significant changes
may be documented.
4. Adequate audit planning helps to:
 Ensure that appropriate attention is devoted to
important areas of the audit;
 Ensure that potential problems are promptly identified;
 100

 Ensure that the work is completed expeditiously;

 Utilise the assistants properly; and
 Co-ordinate the work done by other auditors and
experts.
5. In planning his audit, the auditor will consider factors
such as complexity of the audit, the environment in which
the entity operates, his previous experience with the
client and knowledge of the client’s business.
6. The auditor may wish to discuss elements of his overall
plan and certain audit procedures with the client to
improve the efficiency of the audit and to coordinate
audit procedures with work of the client’s personnel. The
overall audit plan and the audit programme, however,
remain the auditor’s responsibility.

Knowledge of the Client’s Business

Normally, however, internal audit operates in one or more
of the following areas:
7. The auditor needs to obtain a level of knowledge of the
client’s business that will enable him to identify the
events, transactions and practices that, in his judgement,
may have a significant effect on the financial information.
Among other things, the auditor can obtain such
knowledge from:
 The client’s annual reports to shareholders.
 Minutes of meetings of shareholders, board of
directors and important committees.
 Internal financial management reports for current and
previous periods, including budgets, if any.
 The previous years audit working papers, and other
relevant files.
 Firm personnel responsible for non-audit services to
the client who may be able to provide information on
matters that may affect the audit.
 Discussions with client.
 The client’s policy and procedures manual.
 Relevant publications of the Institute of Chartered
Accountants of India and other professional bodies,
 101

industry publications, trade journals, magazines,

newspapers or text books.
 Consideration of the state of the economy and its effect
on the client’s business.
 Visits to the client’s premises and plant facilities.
8. With respect to the previous year’s audit working papers
and other relevant files, the auditor should pay particular
attention to matters that required special consideration
and decide whether they might affect the work to be done
in the current year.
9. Discussions with the client might include such subjects
as:
 Changes in management, organisational structure, and
activities of the client.
 Current Government legislation, rules, regulations and
directives affecting the client.
 Current business developments affecting the client.
 Current or impending financial difficulties or
accounting problems.
 Existence of parties in whom directors or persons who
are substantial owners of the entity are interested and
with whom transactions are likely.
 New or closed premises and plant facilities.
 Recent or impending changes in technology, type of
products or services and production or distribution
methods.
 Significant matters arising from previous year’s
financial statements, audit report and management
letters, if any.
 Changes in the accounting practices and procedures
and in the system of internal control.
 Scope and timing of the examination.
 Assistance of client personnel in data preparation.
 Relevance of any work to be carried out by the client’s
internal auditors.
10. In addition to the importance of knowledge of the
client’s business in establishing the overall audit plan,
such knowledge helps the auditor to identify areas of
special audit consideration, to evaluate the
 102

reasonableness both of accounting estimates and

management representations, and to make judgements
regarding the appropriateness of accounting policies and
disclosures.

Development of an Overall Plan

11. The auditor should consider the following matters in
developing his overall plan for the expected scope and
conduct of the audit:
 The terms of his engagement and any statutory
responsibilities.
 The nature and timing of reports or other
communication.
 The applicable legal or statutory requirements.
 The accounting policies adopted by the client and
changes in those policies.
 The effect of new accounting or auditing
pronouncements on the audit.
 The identification of significant audit areas.
 The setting of materiality levels for audit purposes.
 Conditions requiring special attention, such as the
possibility of material error or fraud or the involvement
of parties in whom directors or persons who are
substantial owners of the entity are interested and
with whom transactions are likely.
 The degree of reliance he expects to be able to place
on accounting system and internal control.
 Possible rotation of emphasis on specific audit areas.
 The nature and extent of audit evidence to be obtained.
 The work of internal auditors and the extent of their
involvement, if any, in the audit.
 The involvement of other auditors in the audit of
subsidiaries or branches of the client.
 The involvement of experts.
 The allocation of work to be undertaken between joint
auditors and the procedures for its control and review.
 Establishing and coordinating staffing requirements.
12. The auditor should document his overall plan. The
form and extent of the documentation will vary
 103

depending on the size and complexity of the audit. A time

budget, in which hours are budgeted for the various audit
areas or procedures, can be an effective planning too

Developing the Audit Programme

13. The auditor should prepare a written audit programme
setting forth the procedures that are needed to
implement the audit plan. The programme may also
contain the audit objectives for each area and should
have sufficient details to serve as a set of instructions to
the assistants involved in the audit and as a means to
control the proper execution of the work.
14. In preparing the audit programme, the auditor, having
an understanding of the accounting system and related
internal controls, may wish to rely on certain internal
controls in determining the nature, timing and extent of
required auditing procedures. The auditor may conclude
that relying on certain internal controls is an effective
and efficient way to conduct his audit. However, the
auditor may decide not to rely on internal controls when
there are other more efficient ways of obtaining sufficient
appropriate audit evidence. The auditor should also
consider the timing of the procedures, the coordination of
any assistance expected from the client, the availability of
assistants, and the involvement of other auditors or
experts.
15. The auditor normally has flexibility in deciding when to
perform audit procedures. However, in some cases, the
auditor may have no discretion as to timing, for example,
when observing the taking of inventories by client
personnel or verifying the securities and cash balances at
the year-end.
16. The audit planning ideally commences at the
conclusion of the previous year’s audit, and along with
the related programme, it should be reconsidered for
modification as the audit progresses. Such consideration
is based on the auditor’s review of the internal control,
his preliminary evaluation thereof, and the results of his
compliance and substantive procedures.
 104

Effective Date
17. This Statement on Standard Auditing Practices
becomes operative in respect of all audits relating to
accounting periods beginning on or after 1.4.1989.

Statement on Standard Auditing Practices (SAP 9)*

Using the Work of an Expert
The following is the text of the Statement on Standard
Auditing Practices (SAP) 9, “Using the Work of an Expert”,
issued by the Council of the Institute of Chartered
Accountants of India. The Statement should be read in
conjunction with the ‘Preface to the Statements on Standard
Auditing Practices’ issued by the Institute.

Introduction
1. Statement on Standard Auditing Practices (SAP) 1, Basic
Principles Governing an Audit, states (paragraphs 9-10):
“When the auditor delegates work to assistants, or uses
work performed by other auditors and experts, he will
continue to be responsible for forming and expressing his
opinion on the financial information. However, he will be
entitled to rely on work performed by others, provided he
exercises adequate skill and care and is not aware of any
reason to believe that he should not have so relied. In the
case of any independent statutory appointment to
perform the work on which the auditor has to rely in
forming his opinion, such as in the case of the work of
branch auditors appointed under the Companies Act,
1956 the auditor’s report should expressly state the fact
of such reliance.
“The auditor should carefully direct, supervise and
review work delegated to assistants. The auditor should
obtain reasonable assurance that work performed by
other auditors or experts is adequate for his purpose.”
(This Statement discusses the auditor’s responsibility in
relation to, and the procedures the auditor should
 105

consider in, using the work of an expert as audit

evidence.1 in this Statement, the term ‘financial
information’ encompasses financial statements.
2. The auditor’s education and experience enable him to be
knowledgeable about business matters in general, but he
is not expected to have the expertise of a person trained
for, or qualified to engage in, the practice of another
profession or occupation, such as an actuary or engineer.
______________________________
1
A subsequent Statement will deal with the auditor’s
responsibility in relation to, and the procedures the auditor
should consider in, using the work of another auditor as
audit evidence.
3. An expert (or a specialist), for the purpose of this
Statement, is a person, firm or other association of
persons possessing special skill, knowledge and
experience in a particular field other than accounting and
auditing. An ‘expert’ may be:
 Engaged by the client,
 Engaged by the auditor,
 Employed by the client, or
 Employed by the auditor.
4. When the auditor uses the work of an expert employed by
him, he is using that work in the employee’s capacity as
an expert rather than delegating the work to an assistant
on the audit. Accordingly, in such circumstances, he
should apply relevant procedures described in this
Statement in satisfying himself as to his employee’s work
and findings.

Determining the Need to Use the Work of an Expert

5. During the audit the auditor may seek to obtain, in
conjunction with the client or independently, audit
evidence in the form of reports, opinions, valuations and
statements of an expert. Examples are:
 Valuations of certain types of assets, for example, land
and buildings, plant and machinery, works of art, and
precious stones.
 106

 Determination of quantities or physical condition of

assets, for example, minerals stored in stockpiles,
mineral and petroleum reserves, and the remaining
useful life of plant and machinery.
 Determination of amounts using specialised techniques
or methods, for example, an actuarial valuation.
 The measurement of work completed and to be
completed on contracts in progress for the purpose of
revenue recognition.
 Legal opinions concerning interpretations of
agreements, statutes, regulations, notifications,
circulars, etc.
6. When determining whether to use the work of an expert
or not, the auditor should consider:
 The materiality of the item being examined in relation
to the financial information as a whole,
 The nature and complexity of the item including the
risk of error therein, and
 The other audit evidence available with respect to the
item.

Skills and Competence of the Expert

7. When the auditor plans to use the expert’s work as audit
evidence, he should satisfy himself as to the expert’s
skills and competence by considering the expert’s:
 Professional qualifications, licence or membership in
an appropriate professional body, and
 Experience and reputation in the field in which the
evidence is sought.
However, when the auditor uses the work of an expert
employed by him, he will not need to inquire into his skills
and competence.

Objectivity of the Expert

8. The auditor should also consider the objectivity of the
expert. The risk that an expert’s objectivity will be
impaired increases when the expert is:
 Employed by the client, or
 Related in some other manner to the client.
 107

Accordingly, in these circumstances, the auditor

should (after taking into account the factors in
paragraphs 6 and 7) consider performing more
extensive procedures than would otherwise have been
planned, or he might consider engaging another
expert.

Evaluating the Work of an Expert

9. When the auditor intends to use the work of an expert, he
should examine evidence to gain knowledge regarding
the terms of the expert’s engagement and such other
matters as:
 The objectives and scope of the expert’s work,
 A general outline as to the specific items in the
expert’s report,
 Confidentiality of the expert’s work, including the
possibility of its communication to third parties,
 The expert’s relationship with the client, if any,
 Confidentiality of the client’s information used by the
expert.
10. The auditor should seek reasonable assurance that the
expert’s work constitutes appropriate audit evidence in
support of the financial information, by considering: -
 The source data used,
 The assumptions and methods used and, if appropriate,
their consistency with the prior period, and
 The results of the expert’s work in the light of the
auditor’s overall knowledge of the business and of the
results of his audit procedures.
 The auditor should also satisfy himself that the
substance of the expert’s findings is properly reflected
in the financial information.
11. The auditor should consider whether the expert has
used source data, which are appropriate in the
circumstances. The procedures to be applied by the
auditor should include
 Making inquiries of the expert to determine how he
has satisfied himself that the source data are sufficient,
relevant and reliable, and
 108

 Conducting audit procedures on the data provided by

the client to the expert to obtain reasonable assurance
that the data are appropriate.
12. The appropriateness and reasonableness of
assumptions and methods used and their application are
the responsibility of the expert. The auditor does not have
the same expertise and, therefore, cannot always
challenge the expert’s assumptions and methods.
However, the auditor should obtain an understanding of
those assumptions and methods to determine that they
are reasonable based on the auditor’s knowledge of the
client’s business and on the results of his audit
procedures.
13. Normally, completion of the above procedures will
provide the auditor with reasonable assurance that he
has obtained appropriate audit evidence in support of the
financial information. In exceptional cases where the
work of an expert does not support the related
representations in the financial information, the auditor
should attempt to resolve the inconsistency by
discussions with the client and the expert. Applying
additional procedures, including possibly engaging
another expert, may also assist the auditor in resolving
the inconsistency.
14. If, after performing these procedures, the auditor
concludes that:
 The work of the expert is inconsistent with the
information in the financial statements, or that
 The work of the expert does not constitute sufficient
appropriate audit evidence (e.g., where the work of the
expert involves highly technical matters or where, on
grounds of confidentiality, the expert refuses to make
available to the auditor the source data used by him),
He should express a qualified opinion, a disclaimer of
opinion or an adverse opinion, as may be appropriate.
Reference to an Expert in the Auditor’s Report
15. When expressing an unqualified opinion, the auditor
should not refer to the work of an expert in his report. If,
as a result of the work of an expert, the auditor decides
 109

to express other than an unqualified opinion, it may in

some circumstances benefit the reader of his report if the
auditor, in explaining the nature of his reservation, refers
to or describes the work of the expert. Where, in doing
so, the auditor considers it appropriate to disclose the
identity of the expert, he should obtain prior consent of
the expert for such disclosure if such consent has not
already been obtained.

Effective Date
16. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1991.

Statement on Standard Auditing Practices (SAP 10)*

Using the Work of Another Auditor
The following is the text of the Statement on Standard
Auditing Practices (SAP) 10, Using the Work of Another
Auditor, issued by the Council of the Institute of Chartered
Accountants of India. The Statement should be read in
conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute. From
the date this Statement on Standard Auditing Practices
becomes effective, paragraphs 17-29 of the “Statement on
the Responsibility of Joint Auditors” issued by the Institute
shall stand withdrawn.

Introduction
1. The Statement on Standard Auditing Practices (SAP) 1,
Basic Principles Governing an Audit, states (paragraph
9):
 110

“When the auditor delegates work to assistants or uses

work performed by other auditors and experts, he will
continue to be responsible for forming and expressing his
opinion on the financial information. However, he will be
entitled to rely on work performed by others, provided he
exercises adequate skill and care and is not aware of any
reason to believe that he should not have so relied. In the
case of any independent statutory appointment to
perform the work on which the auditor has to rely in
forming his opinion, such as in the case of the work of
branch auditors appointed under the Companies Act,
1956 the auditor’s report should expressly state the fact
of such reliance.”
2. This Statement discusses the procedures to be applied in
situations where an independent auditor (referred to
herein as the principal auditor), reporting on the financial
statements of an entity, uses the work of another
independent auditor (referred to herein as the other
auditor) with respect to the financial statements of one or
more divisions or branches (referred to herein as
components) included in the financial statements of the
entity. This Statement also discusses the principal
auditor’s responsibility in relation to his use of the work
of the other auditor.
3. The Statement does not deal with those instances where
two or more auditors are appointed as joint auditors1 nor
does it deal with the auditor’s relationship with a
predecessor auditor.
4. When the principal auditor concludes that the financial
statements of a component are immaterial, the
procedures outlined in this Statement do not apply. When
several components, immaterial in themselves, are
together material in relation to the financial statements
of the entity as a whole, the procedures outlined in this
Statement should be considered.
______________________________
1
A separate statement will deal with the audit procedures to
be employed where two or more auditors are appointed as
joint auditors.
 111

The Principal Auditor’s Procedures

5. In certain situations, the statute governing the entity may
confer a right on the principal auditor to visit a
component and examine the books of account and other
records of the said component, if he thinks it necessary to
do so. Where another auditor has been appointed for the
component, the principal auditor would normally be
entitled to rely upon the work of such auditor unless
there are special circumstances to make it essential for
him to visit the component and/or to examine the books
of account and other records of the said component.
6. When using the work of another auditor, the principal
auditor should ordinarily perform the following
procedures:
(a) Advise the other auditor of the use that is to be
made of his work and report. The principal auditor
should also inform the other auditor of other matters
related thereto, such as areas requiring special
consideration and the timetable for completion of the
audit. He should make sufficient arrangements for the
co-ordination of their efforts at the planning stage of
his audit.
(b) Advise the other auditor of the significant
accounting, auditing and reporting requirements and
obtain representation as to compliance with them.
(c) Ascertain from the other auditor any limitation on
the scope of his work imposed by the terms of
engagement of the other auditor.
(d) Consider the significant audit findings of the
other auditor.
7. The principal auditor is not required to evaluate the
professional competence or independence of the other
auditor, except in situations, which create doubt about
the professional competence or independence of the
other auditor.
8. The principal auditor might discuss with the other auditor
the audit procedures applied or review a written
summary of the other auditor’s procedures and findings,
 112

which may be in the form of a completed questionnaire or

check-list.
9. The principal auditor may consider it appropriate to
discuss with the other auditor and the management of the
component the audit findings or other matters affecting
the financial statements of the components. He may also
decide that supplemental tests of the records or the
financial statements of the component are necessary. He
may request the other auditor to perform such tests or
alternatively, he may perform them himself.
10. In certain circumstances, the other auditor may
happen to be a person other than a professionally
qualified auditor. This may happen, for instance, where a
component is situated in a foreign country and the
applicable laws permit a person other than a
professionally qualified auditor to audit the financial
statements of such component. In such circumstances,
the procedures outlined in paragraphs 5-9 assume added
importance.

Documentation
11. The principal auditor should document in his working
papers the components whose financial statements were
audited by other auditors; their significance to the
financial statements of the entity as a whole; the names
of the other auditors; and any conclusions reached that
individual components are not material. He should also
document how he applied the procedures he performed
and the conclusions he reached. Where the other
auditor’s report is other than unqualified, the principal
auditor should also document how he has dealt with the
qualifications or adverse remarks contained in the other
auditor’s report in framing his own report.

Co-ordination between Auditors

12. There should be sufficient liaison between the principal
auditor and the other auditor. For this purpose, the
principal auditor may find it necessary to issue a written
communication to the other auditor.
 113

13. The other auditor, knowing the context, in which his

work is to be used by the principal auditor, should co-
operate with him and assist him actively, for example, by
bringing to the principal auditor’s immediate attention
any significant findings requiring to be dealt with at
entity level, adhering to the time-table for audit of the
component, etc. He should ensure compliance with the
relevant statutory requirements. Similarly, the principal
auditor should advise the other auditor of any matters
that come to his attention that he thinks may have an
important bearing on the other auditor’s work.
14. When considered necessary by him, the principal
auditor may require the other auditor to answer a
detailed questionnaire regarding matters on which the
principal auditor requires information for discharging his
duties. The other auditor should respond to such
questionnaire on a timely basis.

Reporting Considerations
15. The principal auditor should qualify his report or
disclaim an opinion when he concludes, based on his
procedures, that he cannot use the work of the other
auditor and has not been able to perform sufficient
additional procedures with respect to the financial
statements of the component reported on by the other
auditor.
16. In all circumstances, if the other auditor qualifies his
report, the principal auditor should consider whether the
subject of the qualification is of such nature and
significance, in relation to the financial statements of the
entity on which the principal auditor is reporting, that it
requires a qualification in his report.

Division of Responsibility
17. The principal auditor would not be responsible in
respect of the work entrusted to the other auditors,
except in circumstances, which should have aroused his
suspicion about the reliability of the work performed by
the other auditors.
 114

18. When the principal auditor has to base his opinion on

the financial statements of the entity as a whole relying
upon the statements and reports of the other auditors, his
report should state clearly the division of responsibility
for the financial statements of the entity by indicating the
extent to which the financial statements of components
audited by the other auditors. Have been included in the
financial statements of the entity, e.g., the number of
branches/divisions audited by other auditors.

Effective Date
19. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1995.
 115

Statement on Standard Auditing Practices (SAP 11)*

Representations by Management
The following is the text of the Statement on Standard
Auditing Practices (SAP) 11, “Representations by
Management”, issued by the Council of the Institute of
Chartered Accountants of India. The Statement should be
read in conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute.

Introduction
1. The purpose of this Statement is to establish standards
on the use of management representations as audit
evidence, the procedures to be applied in evaluating and
documenting management representations, and the
action to be taken if management refuses to provide
appropriate representations.
2. The auditor should obtain representations from
management, where considered appropriate.

Acknowledgement by Management of its

Responsibility for the Financial Information
3. The auditor should obtain evidence that management
acknowledges its responsibility for the appropriate
preparation and presentation of financial information and
that management has approved the financial information.

Representations by Management as Audit Evidence

4. The auditor should exercise his professional judgement in
determining the matters on which he wishes to obtain
representations from management. Similarly, the matters
on which the auditor wishes to obtain such
representations in writing should also be determined by
the auditor using his professional judgement. However,
representations should be obtained from management
invariably in writing on matters material to financial
information, either individually or collectively, when
other sufficient appropriate audit evidence cannot
reasonably be expected to exist. Matters, which might be
included in a representation letter from management in
 116

an audit of financial statements, are contained in the

example of a management representation letter in the
Appendix.
5. During the course of an audit, management makes many
representations to the auditor, either unsolicited or in
response to specific enquiries. When such
representations relate to matters which are material to
the financial information, the auditor should:
(a) Seek corroborative audit evidence from sources
inside or outside the entity;
(b) Evaluate whether the representations made by
management appear reasonable and consistent with
other audit evidence obtained, including other
representations; and
(c) Consider whether the individuals making the
representations can be expected to be well informed
on the matter.
6. Representations by management cannot be a substitute
for other audit evidence that the auditor could reasonably
expect to be available. For example, a representation by
management as to the quantity, existence and cost of
inventories is no substitute for adopting normal audit
procedures regarding verification and valuation of
inventories. If the auditor is unable to obtain sufficient
appropriate audit evidence that he believes would be
available regarding a matter, which has or may have a
material effect on the financial information, this will
constitute a limitation on the scope of his examination
even if he has obtained a representation from
management on the matter.
7. In certain instances such as where knowledge of the facts
is confined to management or where the matter is
principally one of intention, a representation by
management may be the only audit evidence, which can
reasonably be expected to be available; for example,
intention of management to hold a specific investment for
long-term appreciation.
8. If a representation by management is contradicted by
other evidence, the auditor should examine the
 117

circumstances and, when necessary, reconsider the

reliability of other representations made by management.

Documentation of Representations by Management

9. The auditor should document in his working papers
evidence of management’s representations.
10. A written representation is better audit evidence than
an oral representation and can take the form of:
(a) A representation letter from management;
(b) A letter from the auditor outlining the auditor’s
understanding of management’s representations, duly
acknowledged and confirmed by management;
(c) A duly authenticated copy of relevant minutes of
meetings of the board of directors or similar body.

Basic Elements of a Management Representation

Letter
11. A management representation letter should be
addressed to the auditor containing the relevant
information and be appropriately dated and signed.
12. A management representation letter would normally be
dated the same date as the auditor’s report on the
financial information or a date prior thereto. However, in
certain circumstances, in respect to specific transactions
or events, separate representation letters may also be
obtained during the course of audit.
13. A management representation letter should ordinarily
be signed by the members of management who have
primary responsibility for the entity and its financial
aspects, e.g., managing director, and finance director.
14. If management refuses to provide representations on
any matter that the auditor considers necessary, this will
constitute a limitation on the scope of his examination. In
such circumstances, the auditor should evaluate any
reliance he has placed on other representations made by
management during the course of his examination and
consider if the refusal may have any additional effect on
his report.
 118

15. In case management is not willing to give in writing

the representations made by it during the course of audit,
the auditor should himself prepare a letter in writing
setting out his understanding of management’s
representations that have been made to him during the
course of audit and send it to management with a request
to acknowledge and confirm that his understanding of the
representations is correct. If the management refuses to
acknowledge or confirm the letter sent by the auditor,
this will constitute a limitation on the scope of his
examination. In such circumstances, the auditor should
evaluate any reliance on those representations and
consider if the refusal may have any additional effect on
his report.

Effective Date
16. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1995.
APPENDIX
EXAMPLE OF A MANAGEMENT REPRESENTATION
LETTER IN AN AUDIT OF FINANCIAL STATEMENTS
(Ref. Paragraph 4)
The following letter is for use as a general guide in
conjunction with the considerations set forth in this
statement. Representations by management will vary from
one entity to another, and from one year to the next.
Therefore, this letter is not intended to be a standard letter
and should be adapted in the light of individual
requirements and circumstances.
[Letterhead of Entity]
[Dated]
[Name and Address of the Auditor]
Dear Sir
This representation letter is provided in connection with
your audit of the financial statements of ................ for the
year ended ... for the purpose of expressing an opinion as to
 119

whether the financial statements give a true and fair view of

the financial position of ................ as of ... and of the results
of operations for the year then ended. We acknowledge our
responsibility for preparation of financial statements in
accordance with the requirements of the Companies Act,
19561 and recognised accounting policies and practices,
including the Accounting Standards issued by the Institute
of Chartered Accountants of India.
We confirm, to the best of our knowledge and belief, the
following representations:
______________________________
1
or other relevant statute.

ACCOUNTING POLICIES
1. The accounting policies, which are material or critical in
determining the results of operations for the year or
financial position are set out in the financial statements
and are consistent with those adopted in the financial
statements for the previous year. The financial
statements are prepared on accrual basis.

ASSETS
2. The company has a satisfactory title to all assets and
there are no liens or encumbrances on the company’s
assets, except for those that are disclosed in Note X to
the financial statements.

Fixed Assets
3. The net book values at which fixed assets are stated in
the balance sheet are arrived at:
(a) after taking into account all capital expenditure
on additions thereto, but no expenditure properly
chargeable to revenue;
(b) after eliminating the cost and accumulated
depreciation relating to items sold, discarded,
demolished or destroyed;
(c) after providing adequate depreciation on fixed
assets during the period.
 120

Capital Commitments
4. At the balance sheet date, there were no outstanding
commitments for capital expenditure excepting those
disclosed in Note X to the financial statements.

Investments
5. The current investments as appearing in the balance
sheet consist of only such investments as are by their
nature readily realisable and intended to be held for not
more than one year from the respective dates on which
they were made. All other investments have been shown
in the balance sheet as ‘long-term investments’.
6. Current investments have been valued at the lower of
cost and fair value. Long-term investments have been
valued at cost, except that any permanent diminution in
their value has been provided for in ascertaining their
carrying amount.
7. In respect of offers of right issues received during the
year, the rights have been either been subscribed to, or
renunciated, or allowed to lapse. In no case have they
been renunciated in favour of third parties without
consideration which has been properly accounted for in
the books of account.
8. All the investments produced to you for physical
verification belong to the entity and they do not include
any investments held on behalf of any other person.
9. The entity has clear title to all its investments including
such investments which are in the process of being
registered in the name of the entity or which are not held
in the name of the entity and there are no charges
against the investments of the entity except those
appearing in the records of the entity.

Inventories
10. Inventories at the year-end consisted of the following:
Raw Rs .
Materials ......
(including ..
components)
 121

Work-in- Rs .
Process ......
..
Finished Rs .
Goods ......
(including by- ..
products)
Maintenance Rs .
supplies and ......
Stores and ..
Spare Parts
Loose Tools Rs .
......
..
Others Rs .
(specify each ......
major head ..
separately)
------
------
-
Total Rs .
......
..
------
------
-
11. All quantities were determined by actual physical
count or weight or measurement that was taken under
our supervision and in accordance with written
instructions, on ............ (date/dates of physical
verification), except as follows:1
...............
...............
______________________________
1
Where physical verification of inventories is carried out at
a date other than the closing date, this paragraph may be
modified as below: Inventories recorded in the books as
at ...........(date of balance sheet) aggregating to Rs. .........
 122

are based upon the physical inventories taken as at ..........

(date of physical verification) by actual count, weight or
measurement. The material discrepancies noticed on
physical verification of stocks as compared to book records
have been properly dealt with in the books of account and
subsequent transactions recorded in the accounts fairly
reflect the changes in the inventories up to ........... (balance
sheet date).
12. All goods included in the inventory are the property of
the entity, none of the goods are held as consignee for
others or as bailee, and, except as set out below, none of
the goods are subject to any charge.
...............
...............
13. All inventories owned by the entity, wherever located,
have been recorded, including goods sent on
consignment.
14. Inventories do not include goods sold to customers for
which delivery is yet to be made.
15. Inventories have been valued on the following
basis/bases:
Raw Materials (including components)
Work-in-Process
Finished Goods (including by-products)
Maintenance supplies and Stores and Spare Parts
Loose Tools
Others (specify each major head separately)
(In describing the basis/bases of valuation, the method of
ascertaining the cost (e.g. FIFO, Average Cost or LIFO)
should also be stated. Similarly, the extent to which
overheads have been included in the cost should also be
stated.)
16. The following provisions have been made in respect of
excess, slow moving, damaged, or obsolete inventories
and these, in our view, are adequate.
...............
...............
 123

17. No item of inventories has a net realisable value in the

ordinary course of business, which is less than the
amount at which it is included in inventories.
18. The basis/bases of valuation is/are the same as
that/those used in the previous year, except as set out
below:
Class of Basis of Effect of
inventor Valuatio change
y n in Basis
of
Valuatio
n
........ ........ ........ ........
........ ........ ........ ........
Debtors, Loans and Advances
19. The following items appearing in the books as at .......(date of the Balance Sheet) are considered good
and fully recoverable with the exception of those specifically shown as “doubtful” in the Balance
Sheet.
Sundry Rs .
Debtors ......
..
Loans and Rs .
Advances ......
..
Other Current Assets
20. In the opinion of the Board of Directors, other current
assets have a value on realisation in the ordinary course
of the company’s business, which is at least equal to the
amount at which they are stated in the balance sheet,
except as stated in Note X to the financial statements.

LIABILITIES
21. We have recorded all known liabilities in the financial
statements.
22. We have disclosed in notes to the financial statements
all guarantees that we have given to third parties and all
other contingent liabilities.
23. Contingent liabilities disclosed in the notes to the
financial statements do not include any contingencies,
 124

which are likely to result in a loss and which, therefore,

require adjustment of assets or liabilities.

Provisions for Claims and Losses

24. Provision has been made in the accounts for all known
losses and claims of material amounts.
25. There have been no events subsequent to the balance
sheet date, which require adjustment of, or disclosure in,
the financial statements or notes thereto.

PROFIT AND LOSS ACCOUNT

26. Except as disclosed in the financial statements, the
results for the year were not materially affected by:
(a) transactions of a nature not usually undertaken by
the company;
(b) circumstances of an exceptional or non-recurring
nature;
(c) charges or credits relating to prior years;
(d) changes in accounting policies.

GENERAL
27. The following have been properly recorded and, when
appropriate, adequately disclosed in the financial
statements:
(a) Losses arising from sale and purchase
commitments.
(b) Agreements and options to buy back assets
previously sold.
(c) Assets pledged as collateral.
28. There have been no irregularities involving
management or employees who have a significant role in
the system of internal control that could have a material
effect on the financial statements.
29. The financial statements are free of material
misstatements, including omissions.
30. The company has complied with all aspects of
contractual agreements that could have a material effect
on the financial statements in the event of non-
compliance. There has been no non-compliance with
 125

requirements of regulatory authorities that could have a

material effect on the financial statements in the event of
non-compliance.
31. We have no plans or intentions that may materially
affect the carrying value or classification of assets and
liabilities reflected in the financial statements.

Statement on Standard Auditing Practices (SAP 12)*

Responsibility of Joint Auditors
The following is the text of the Statement on Standard
Auditing Practices (SAP) 12, “Responsibility of Joint
Auditors” issued by the Council of the Institute of Chartered
Accountants of India. The Statement should be read in
conjunction with the “Preface to the Statements on
Standard Auditing Practices” issued by the Institute.
The Statement on the Responsibility of Joint Auditors issued
by the Institute earlier shall stand completely withdrawn in
respect of all audits relating to accounting periods
beginning on or after April 1, 1996.1

Introduction
1. The practice of appointing more than one auditor to
conduct the audit of large entities is in vogue these days.
Such auditors, known as joint auditors, conduct the audit
jointly and report on the financial statements of the
entity. This statement deals with the professional
responsibilities, which the auditors undertake, in
accepting such appointments as joint auditors. The
 126

statement does not deal with the relationship between a

principal auditor who is appointed to report on the
financial statements of an entity and another auditor who
is appointed to report on the financial statements of one
or more divisions or branches included in the financial
statements of the entity, e.g., the relationship between a
company auditor appointed under section 224 of the
Companies Act, 1956 and a branch auditor appointed
under section 228 of the said Act.2
______________________________
1
Paragraphs 17-29 of the Statement on the Responsibility of
Joint Auditors already stand withdrawn in respect of all
audits relating to accounting periods beginning on or after
April 1, 1995, pursuant to the issuance of SAP 10, Using the
Work of Another Auditor.
2
These aspects have been dealt with in Statement on
Standard Auditing Practices (SAP) 10, using the Work of
Another Auditor. It may also be mentioned that presently,
there is no legal requirement under the Companies Act,
1956 to prepare consolidated accounts or group accounts.
Section 212 of the Companies Act, 1956 requires that the
accounts of a holding company shall have attached thereto
the Balance Sheet, Profit and Loss Account, Directors’
Report and Auditors’ Report of each subsidiary company.
Certain additional information is also required. In view of
the fact that a subsidiary is a separate legal entity, the
Council of the Institute is of the opinion that no
responsibility is cast upon the auditors of a holding
company in respect of the work performed by the auditors
of the subsidiary.

Division of Work
2. Where joint auditors are appointed, they should, by
mutual discussion, divide the audit work among
themselves. The division of work would usually be in
terms of audit of identifiable units or specified areas. In
some cases, due to the nature of the business of the
entity under audit, such a division of work may not be
possible. In such situations, the division of work may be
 127

with reference to items of assets or liabilities or income

or expenditure or with reference to periods of time.
Certain areas of work, owing to their importance or
owing to the nature of the work involved, would often not
be divided and would be covered by all the joint auditors.
3. The division of work among joint auditors as well as the
areas of work to be covered by all of them should be
adequately documented and preferably communicated to
the entity.

Coordination
4. Where, in the course of his work, a joint auditor comes
across matters which are relevant to the areas of
responsibility of other joint auditors and which deserve
their attention, or which require disclosure or require
discussion with, or application of judgement by, other
joint auditors, he should communicate the same to all the
other joint auditors in writing. This should be done by the
submission of a report or note prior to the finalisation of
the audit.

Relationship among joint auditors

5. In respect of audit work divided among the joint auditors,
each joint auditor is responsible only for the work
allocated to him, whether or not he has prepared a
separate report on the work performed by him. On the
other hand, all the joint auditors are jointly and severally
responsible -
(a) in respect of the audit work which is not divided
among the joint auditors and is carried out by all of
them;
(b) in respect of decisions taken by all the joint
auditors concerning the nature, timing or extent of the
audit procedures to be performed by any of the joint
auditors. It may, however, be clarified that all the joint
auditors are responsible only in respect of the
appropriateness of the decisions concerning the
nature, timing or extent of the audit procedures agreed
upon among them; proper execution of these audit
 128

procedures is the separate and specific responsibility

of the joint auditor concerned;
(c) in respect of matters which are brought to the
notice of the joint auditors by any one of them and on
which there is an agreement among the joint auditors
(d) for examining that the financial statements of the
entity comply with the disclosure requirements of the
relevant statute; and
(e) for ensuring that the audit report complies with
the requirements of the relevant statute.
6. If any matters of the nature referred to in paragraph 4
above are brought to the attention of the entity or other
joint auditors by an auditor after the audit report has
been submitted, the other joint auditors would not be
responsible for those matters.
7. Subject to paragraph 5(b) above, it is the responsibility of
each joint auditor to determine the nature, timing and
extent of audit procedures to be applied in relation to the
area of work allocated to him. The issues such as
appropriateness of using test checks or sampling should
be decided by each joint auditor in relation to his own
area of work. This responsibility is not shared by the
other joint auditors. Thus, it is the separate and specific
responsibility of each joint auditor to study and evaluate
the prevailing system of internal control relating to the
work allocated to him. Similarly, the nature, timing and
extent of the enquiries to be made in the course of audit
as well as the other audit procedures to be applied are
solely the responsibility of each joint auditor.
8. In the case of audit of a large entity with several
branches, including those required to be audited by
branch auditors, the branch audit reports/returns may be
required to be scrutinised by different joint auditors in
accordance with the allocation of work. In such cases, it
is the specific and separate responsibility of each joint
auditor to review the audit reports/returns of the
divisions/branches allocated to him and to ensure that
they are properly incorporated into the accounts of the
entity. In respect of the branches, which do not fall within
 129

any divisions, or zones, which are separately assigned to

the various joint auditors, they may agree among
themselves as regards the division of work relating to the
review of such branch returns. It is also the separate and
specific responsibility of each joint auditor to exercise his
judgement with regard to the necessity of visiting such
divisions/branches in respect of which the work is
allocated to him.
9. A significant part of the audit work involves obtaining and
evaluating information and explanations from the
management. This responsibility is shared by all the joint
auditors unless they agree upon a specific pattern of
distribution of this responsibility. In cases where specific
divisions, zones or units are allocated to different joint
auditors, it is the separate and specific responsibility of
each joint auditor to obtain appropriate information and
explanations from the management in respect of such
divisions/zones/units and to evaluate the information and
explanations so obtained by him.
10. Each joint auditor is entitled to assume that the other
joint auditors have carried out their part of the audit
work in accordance with the generally accepted audit
procedures.3 It is not necessary for a joint auditor to
review the work performed by other joint auditors or
perform any tests in order to ascertain whether the work
has actually been performed in such a manner. Each joint
auditor is entitled to rely upon the other joint auditors for
bringing to his notice any departure from generally
accepted accounting principles or any material error
noticed in the course of the audit.
______________________________
3
Reference may be made in this regard to the Statements on
Standard Auditing Practices and other mandatory
Statements relating to auditing matters issued by the
Council of the Institute from time to time.
11. Where separate financial statements of a
division/branch are audited by one of the joint auditors,
the other joint auditors are entitled to proceed on the
basis that such financial statements comply with all the
 130

legal and professional requirements regarding the

disclosures to be made and present a true and fair view
of the state of affairs and of the working results of the
division/branch concerned, subject to such observations
as may be communicated by the joint auditor concerned.

Reporting Responsibilities
12. Normally, the joint auditors are able to arrive at an
agreed report. However, where the joint auditors are in
disagreement with regard to any matters to be covered
by the report, each one of them should express his own
opinion through a separate report. A joint auditor is not
bound by the views of the majority of the joint auditors
regarding matters to be covered in the report and should
express his opinion in a separate report in case of a
disagreement.

Effective Date
13. This Statement on Standard Auditing Practices
becomes operative in respect of all audits relating to
accounting periods beginning on or after April 1, 1996.
 131

Statement on Standard Auditing Practices (SAP 13)*

Audit Materiality
The following is the text of the Statement on Standard
Auditing Practices (SAP) 13, “Audit Materiality” issued by
the Council of the Institute of Chartered Accountants of
India. The Statement should be read in conjunction with the
‘Preface to the Statements on Standard Auditing Practices’
issued by the Institute.

Introduction
1. The purpose of this Statement is to establish standards
on the concept of materiality and its relationship with
audit risk.
2. The auditor should consider materiality and its
relationship with audit risk when conducting an audit.

Materiality
3. Information is material if its misstatement (i.e., omission
or erroneous statement) could influence the economic
decisions of users taken on the basis of the financial
information. Materiality depends on the size and nature
of the item, judged in the particular circumstances of its
misstatement. Thus, materiality provides a threshold or
cut-off point rather than being a primary qualitative
characteristic, which the information must have if it is to
be useful.
4. The objective of an audit of financial information
prepared within a framework of recognised accounting
policies and practices and relevant statutory
requirements, if any, is to enable the auditor to express
an opinion on such financial information. The assessment
of what is material is a matter of professional judgement.
5. The concept of materiality recognises that some matters,
either individually or in the aggregate, are relatively
important for true and fair presentation of financial
information in conformity with recognised accounting
policies and practices. The auditor considers materiality
at both the overall financial information level and in
relation to individual account balances and classes of
 132

transactions. Materiality may also be influenced by other

considerations, such as the legal and regulatory
requirements, non-compliance with which may have a
significant bearing on the financial information, and
considerations relating to individual account balances
and relationships. This process may result in different
levels of materiality depending on the matter being
audited.
6. Although the auditor ordinarily establishes an acceptable
materiality level to detect quantitatively material
misstatements, both the amount (quantity) and nature
(quality) of misstatements need to be considered. An
example of a qualitative misstatement would be the
inadequate or improper description of an accounting
policy when it is likely that a user of the financial
statements would be misled by the description.
7. The auditor needs to consider the possibility of
misstatements of relatively small amounts that,
cumulatively, could have a material effect on the financial
information. For example, an error in a month-end (or
other periodic) procedure could be an indication of a
potential material misstatement if that error is repeated
each month or each period, as the case may be.
8. Materiality should be considered by the auditor when -
(a) determining the nature, timing and extent of audit
procedures;
(b) evaluating the effect of misstatements.

The Relationship Between Materiality and Audit Risk1

9. When planning the audit, the auditor considers what
would make the financial information materially
misstated. The auditor’s preliminary assessment of
materiality, related to specific account balances and
classes of transactions, helps the auditor decide such
questions as what items to examine and whether to use
sampling and analytical procedures. This enables the
auditor to select audit procedures that, in combination,
can be expected to support the audit opinion at an
acceptably low degree of audit risk.
 133

10. There is an inverse relationship between materiality

and the degree of audit risk, that is, the higher the
materiality level, the lower the audit risk and vice versa.
For example, the risk that a particular account balance or
class of transactions could be misstated by an extremely
large amount might be very low, but the risk that it could
be misstated by an extremely small amount might be very
high. The auditor takes the inverse relationship between
materiality and audit risk into account when determining
the nature, timing and extent of audit procedures. For
example, if, after planning for specific audit procedures,
the auditor determines that the acceptable materiality
level is lower, audit risk is increased. The auditor would
compensate for this by either:
(a) reducing the assessed degree of control risk,
where this is possible, and supporting the reduced
degree by carrying out extended or additional tests of
control; or
(b) reducing detection risk by modifying the nature,
timing and extent of planned substantive procedures.
______________________________
1
A separate Statement on Standard Auditing Practices will
deal with the concept of audit risk, its constituents (viz.,
inherent risk, control risk and detection risk) and
assessment of audit risk.

Materiality And Audit Risk In Evaluating Audit

Evidence
11. The auditor’s assessment of materiality and audit risk
may be different at the time of initially planning the
engagement from that at the time of evaluating the
results of his audit procedures. This could be because of
a change in circumstances or a change in the auditor’s
knowledge as a result of the audit. For example if the
audit is planned prior to period end, the auditor will
anticipate the results of operations and the financial
position. If actual results of operations and financial
position are substantially different, the assessment of
materiality and audit risk may also change. Additionally,
 134

the auditor may, in planning the audit work, intentionally

set the acceptable cut off level for verifying individual
transactions at a lower level than is intended to be used
to evaluate the results of the audit. This may be done to
cover a larger number of items and thereby reduce the
likelihood of undiscovered misstatements and to provide
the auditor with the margin of safety when evaluating the
effect of misstatements discovered during the audit.
12. In forming his opinion on the financial information, the
auditor should consider whether the effect of aggregate
uncorrected misstatements on the financial information is
material. Qualitative considerations also influence an
auditor in reaching a conclusion as to whether the
misstatements are material.
13. The aggregate of uncorrected misstatements
comprises:
(a) specific misstatements identified by the auditor
including the net effect of uncorrected misstatements
identified during the audit of previous periods; and
(b) the auditor’s best estimate of other misstatements
which cannot be specifically identified (that is,
projected errors).
14. When the auditor tests an account balance or class of
transactions by an analytical procedure, he ordinarily
would not specifically identify misstatements but would
only obtain an indication of whether misstatements might
exist in the balance or class and possibly its approximate
magnitude. If the analytical procedure indicates that
misstatements might exist, but not its approximate
amount, the auditor ordinarily would have to employ
other procedures to enable him to estimate the aggregate
misstatement in the balance or class
15. When an auditor uses audit sampling to test an
account balance or class of transactions, he projects the
amount of known misstatements identified by him in his
sample to the items in the balance or class from which his
sample was selected. That projected misstatement, along
with the results of other substantive tests, contributes to
 135

the auditor’s assessment of aggregate misstatement in

the balance or class.
16. If the aggregate of the uncorrected misstatements that
the auditor has identified approaches the materiality
level, or if auditor determines that the aggregate of
uncorrected misstatements causes the financial
information to be materially misstated, he should
consider requesting the management to adjust the
financial information or extending his audit procedures.
In any event, the management may want to adjust the
financial information for known misstatements. The
adjustment of financial information may involve, for
example, application of appropriate accounting
principles, other adjustments in amounts, or the addition
of appropriate disclosure of inadequately disclosed
matters. If the management refuses to adjust the
financial information and the results of extended audit
procedures do not enable the auditor to conclude that the
aggregate of uncorrected misstatements is not material,
the auditor should express a qualified or adverse opinion,
as appropriate.

Effective Date
17. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1996.
 136

Statement on Standard Auditing Practices (SAP 14)*

Analytical Procedures
The following is the text of Statement on Standard Auditing
Practices (SAP) 14, “Analytical Procedures”, issued by the
Council of the Institute of Chartered Accountants of India.
The Statement should be read in conjunction with the
“Preface to the Statements on Standard Auditing Practices”
issued by the Institute.

Introduction
1. The purpose of this Statement on Standard Auditing
Practices (SAP) is to establish standards on the
application of analytical procedures during an audit.
2. The auditor should apply analytical procedures at the
planning and overall review stages of the audit.
Analytical procedures may also be applied at other
stages.
3. “Analytical procedures” means the analysis of significant
ratios and trends including the resulting investigation of
fluctuations and relationships that are inconsistent with
 137

other relevant information or which deviate from

predicted amounts.

Nature and Purpose of Analytical Procedures

4. Analytical procedures include the consideration of
comparisons of the entity’s financial information with, for
example:
 Comparable information for prior periods.
 Anticipated results of the entity, such as budgets or
forecasts.
 Predictive estimates prepared by the auditor, such as
an estimation of depreciation charge for the year.
 Similar industry information, such as a comparison of
the entity’s ratio of sales to trade debtors with industry
averages, or with other entities of comparable size in
the same industry.
5. Analytical procedures also include consideration of
relationships:
 Among elements of financial information that would be
expected to conform to a predictable pattern based on
the entity’s experience, such as gross margin
percentages.
 Between financial information and relevant non-
financial information, such as payroll costs to number
of employees.
6. Various methods may be used in performing the above
procedures. These range from simple comparisons to
complex analyses using advanced statistical techniques.
Analytical procedures may be applied to consolidated
financial statements, financial statements of components
(such as subsidiaries, divisions or segments) and
individual elements of financial information. The auditor’s
choice of procedures, methods and level of application is
a matter of professional judgement.
7. Analytical procedures are used for the following
purposes:
(a) to assist the auditor in planning the nature,
timing and extent of other audit procedures;
 138

(b) as substantive procedures when their use can be

more effective or efficient than tests of details in
reducing detection risk for specific financial statement
assertions; and
(c) as an overall review of the financial statements in
the final review stage of the audit.

Analytical Procedures in Planning the Audit

8. The auditor should apply analytical procedures at the
planning stage to assist in understanding the business
and in identifying areas of potential risk. Application of
analytical procedures may indicate aspects of the
business of which the auditor was unaware and will assist
in determining the nature, timing and extent of other
audit procedures.
9. Analytical procedures in planning the audit use both
financial and non-financial information, for example, the
relationship between sales and square footage of selling
space or volume of goods sold.

Analytical Procedures as Substantive Procedures

10. The auditor’s reliance on substantive procedures to
reduce detection risk relating to specific financial
statement assertions may be derived from tests of details,
from analytical procedures, or from a combination of
both. The decision about which procedures to use to
achieve a particular audit objective is based on the
auditor’s judgement about the expected effectiveness and
efficiency of the available procedures in reducing
detection risk for specific financial statement assertions.
11. The auditor will ordinarily inquire of management as to
the availability and reliability of information needed to
apply analytical procedures and the results of any such
procedures performed by the entity. It may be efficient to
use analytical data prepared by the entity, provided the
auditor is satisfied that such data is properly prepared.
12. When intending to perform analytical procedures as
substantive procedures, the auditor will need to consider
a number of factors such as the:
 139

 Objectives of the analytical procedures and the extent

to which their results can be relied upon (paragraphs
14-16).
 Nature of the entity and the degree to which
information can be disaggregated, for example,
analytical procedures may be more effective when
applied to financial information on individual sections
of an operation or to financial statements of
components of a diversified entity, than when applied
to the financial statements of the entity as a whole.
 Availability of information, both financial, such as
budgets or forecasts, and non-financial, such as the
number of units produced or sold.
 Reliability of the information available, for example,
whether budgets are prepared with sufficient care.
 Relevance of the information available, for example,
whether budgets have been established as results to be
expected rather than as goals to be achieved.
 Source of the information available, for example,
sources independent of the entity are ordinarily more
reliable than internal sources.
 Comparability of the information available, for
example, broad industry data may need to be
supplemented to be comparable to that of an entity
that produces and sells specialised products.
 Knowledge gained during previous audits, together
with the auditor’s understanding of the effectiveness of
the accounting and internal control systems and the
types of problems that in prior periods have given rise
to accounting adjustments.

Analytical Procedures in the Overall Review at the End

of the Audit
13. The auditor should apply analytical procedures at or
near the end of the audit when forming an overall
conclusion as to whether the financial statements as a
whole are consistent with the auditor’s knowledge of the
business. The conclusions drawn from the results of such
procedures are intended to corroborate conclusions
 140

formed during the audit of individual components or

elements of the financial statements and assist in arriving
at the overall conclusion as to the reasonableness of the
financial statements. However, in some cases, as a result
of application of analytical procedures, the auditor may
identify areas where further procedures need to be
applied before the auditor can form an overall conclusion
about the financial statements.

Extent of Reliance on Analytical Procedures

14. The application of analytical procedures is based on
the expectation that relationships among data exist and
continue in the absence of known conditions to the
contrary. The presence of these relationships provides
audit evidence as to the completeness, accuracy and
validity of the data produced by the accounting system.
However, reliance on the results of analytical procedures
will depend on the auditor’s assessment of the risk that
the analytical procedures may identify relationships as
expected when, in fact, a material misstatement exists.
15. The extent of reliance that the auditor places on the
results of analytical procedures depends on the following
factors:
(a) materiality of the items involved, for example,
when inventory balances are material, the auditor does
not rely only on analytical procedures in forming
conclusions. However, the auditor may rely solely on
analytical procedures for certain income and expense
items when they are not individually material;
(b) other audit procedures directed toward the same
audit objectives, for example, other procedures
performed by the auditor in reviewing the collectability
of accounts receivable, such as the review of
subsequent cash receipts, might confirm or dispel
questions raised from the application of analytical
procedures to an aging schedule of customers’
accounts;
(c) accuracy with which the expected results of
analytical procedures can be predicted. For example,
 141

the auditor will ordinarily expect greater consistency

in comparing gross profit margins from one period to
another than in comparing discretionary expenses,
such as research or advertising; and
(d) assessments of inherent and control risks, for
example, if internal control over sales order processing
is weak and, therefore, control risk is high, more
reliance on tests of details of transactions and balances
than on analytical procedures in drawing conclusions
on receivables may be required.
16. The auditor will need to consider testing the controls,
if any, over the preparation of information used in
applying analytical procedures. When such controls are
effective, the auditor will have greater confidence in the
reliability of the information and, therefore, in the results
of analytical procedures. The controls over non-financial
information can often be tested in conjunction with tests
of accounting-related controls. For example, an entity in
establishing controls over the processing of sales invoices
may include controls over the recording of unit sales. In
these circumstances, the auditor could test the controls
over the recording of unit sales in conjunction with tests
of the controls over the processing of sales invoices.

Investigating Unusual Items

17. When analytical procedures identify significant
fluctuations or relationships that are inconsistent with
other relevant information or that deviate from predicted
amounts, the auditor should investigate and obtain
adequate explanations and appropriate corroborative
evidence.
18. The investigation of unusual fluctuations and
relationships ordinarily begins with inquiries of
management, followed by:
(a) corroboration of management’s responses, for
example, by comparing them with the auditor’s
knowledge of the business and other evidence obtained
during the course of the audit; and
 142

(b) consideration of the need to apply other audit

procedures based on the results of such inquiries, if
management is unable to provide an explanation or if
the explanation is not considered adequate.

Effective Date
19. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1997.

Statement on Standard Auditing Practices (SAP 15)*

Audit Sampling
The following is the text of Statement on Standard Auditing
Practices (SAP) 15, “Audit Sampling”, issued by the Council
of the Institute of Chartered Accountants of India. The
Statement should be read in conjunction with the “Preface
to the Statements on Standard Auditing Practices” issued by
the Institute.

Introduction
1. The purpose of this Statement on Standard Auditing
Practices (SAP) is to establish standards on the design
and selection of an audit sample and the evaluation of the
sample results. This SAP applies equally to both
statistical and non-statistical sampling methods. Either
method, when properly applied, can provide sufficient
appropriate audit evidence.
2. When using either statistical or non-statistical sampling
methods, the auditor should design and select an audit
sample, perform audit procedures thereon, and evaluate
sample results so as to provide sufficient appropriate
audit evidence.
3. “Audit sampling” means the application of audit
procedures to less than 100% of the items within an
account balance or class of transactions to enable the
auditor to obtain and evaluate audit evidence about some
 143

characteristic of the items selected in order to form or

assist in forming a conclusion concerning the population.
4. It is important to recognise that certain testing
procedures do not come within the definition of sampling.
Tests performed on 100% of the items within a population
do not involve sampling. Likewise, applying audit
procedures to all items within a population which have a
particular characteristic (for example, all items over a
certain amount) does not qualify as audit sampling with
respect to the portion of the population examined, nor
with regard to the population as a whole, since the items
were not selected from the total population on a basis
that was expected to be representative. Such items might
imply some characteristic of the remaining portion of the
population but would not necessarily be the basis for a
valid conclusion about the remaining portion of the
population.

Design of the Sample

5. When designing an audit sample, the auditor should
consider the specific audit objectives, the population from
which the auditor wishes to sample, and the sample size.

Audit Objectives
6. The auditor would first consider the specific audit
objectives to be achieved and the audit procedures,
which are likely to best, achieve those objectives. In
addition, when audit sampling is appropriate,
consideration of the nature of the audit evidence sought
and possible error conditions or other characteristics
relating to that audit evidence will assist the auditor in
defining what constitutes an error and what population to
use for sampling. For example, when performing tests of
control over an entity’s purchasing procedures, the
auditor will be concerned with matters such as whether
an invoice was clerically checked and properly approved.
On the other hand, when performing substantive
procedures on invoices processed during the period, the
auditor will be concerned with matters such as the
 144

proper reflection of the monetary amounts of such

invoices in the financial statements.

Population
7. The population is the entire set of data from which the
auditor wishes to sample in order to reach a conclusion.
The auditor will need to determine that the population
from which the sample is drawn is appropriate for the
specific audit objective. For example, if the auditor’s
objective were to test for overstatement of accounts
receivable, the population could be defined as the
accounts receivable listing. On the other hand, when
testing for understatement of accounts payable, the
population would not be the accounts payable listing, but
rather subsequent disbursements, unpaid invoices,
suppliers’ statements, unmatched receiving reports, or
other populations that would provide audit evidence of
understatement of accounts payable.

Audit Evidence
8. The individual items that make up the population are
known as sampling units. The population can be divided
into sampling units in a variety of ways. For example, if
the auditor’s objective were to test the validity of
accounts receivables, the sampling unit could be defined
as customer balances or individual customer invoices.
The auditor defines the sampling unit in order to obtain
an efficient and effective sample to achieve the particular
audit objectives.

Stratification
9. To assist in the efficient and effective design of the
sample, stratification may be appropriate. Stratification is
the process of dividing a population into sub-populations,
each of which is a group of sampling units, which have
similar characteristics (often monetary value). The strata
need to be explicitly defined so that each sampling unit
can belong to only one stratum. This process reduces the
variability of the items within each stratum. Stratification
 145

therefore, enables the auditor to direct audit efforts

towards the items, which, for example, contain the
greatest potential monetary error. For example, the
auditor may direct attention to larger value items for
accounts receivable to detect overstated material
misstatements. In addition, stratification may result in a
smaller sample size.

Sample Size
10. When determining the sample size, the auditor should
consider sampling risk, the tolerable error, and the
expected error. Examples of some factors affecting
sample size are contained in Appendix 1 and Appendix 2.
11. Sampling risk1 arises from the possibility that the
auditor’s conclusion, based on a sample, may be different
from the conclusion that would be reached if the entire
population were subjected to the same audit procedure.
12. The auditor is faced with sampling risk in both tests of
control and substantive procedures as follows:
(a) Tests of Control:
(i) Risk of Under Reliance: The risk that, although
the sample result does not support the auditor’s
assessment of control risk, the actual compliance
rate would support such an assessment.
(ii) Risk of Over Reliance: The risk that, although
the sample result supports the auditor’s assessment
of control risk, the actual compliance rate would not
support such an assessment.
(b) Substantive Procedures:
(i) Risk of Incorrect Rejection: The risk that,
although the sample result supports the conclusion
that a recorded account balance or class of
transactions is materially mis-stated, in fact it is not
materially misstated.
(ii)Risk of Incorrect Acceptance: The risk that,
although the sample result supports the conclusion
that a recorded account balance or class of
transactions is not materially misstated, in fact it is
materially misstated.
 146

______________________________
1
Sampling risk can be contrasted with non-sampling risk,
which arises when the auditor uses any audit procedures.
Non-sampling risk arises because, for example, most audit
evidence is persuasive rather than conclusive, the auditor
might use inappropriate procedures or might mis-interpret
evidence and, thus, fail to recognise an error. The auditor
attempts to reduce non-sampling risk to a negligible degree
by appropriate planning, direction, supervision and review.
13. The risk of under reliance and the risk of incorrect
rejection affect audit efficiency as they would ordinarily
lead to additional work being performed by the auditor,
or the entity, which would establish that the initial
conclusions were incorrect. The risk of over reliance and
the risk of incorrect acceptance affect audit effectiveness
and are more likely to lead to an erroneous opinion on
the financial statements than either the risk of under
reliance or the risk of incorrect rejection.
14. Sample size is affected by the level of sampling risk the
auditor is willing to accept from the results of the sample.
The lower the risk the auditor is willing to accept, the
greater the sample size will need to be.

Tolerable Error
15. Tolerable error is the maximum error in the population
that the auditor would be willing to accept and still
concludes that the result from the sample has achieved
the audit objective. Tolerable error is considered during
the planning stage and, for substantive procedures, is
related to the auditor’s judgement about materiality. The
smaller the tolerable error, the greater the sample size
will need to be.
16. In tests of control, the tolerable error is the maximum
rate of deviation from a prescribed control procedure
that the auditor would be willing to accept, based on the
preliminary assessment of control risk. In substantive
procedures, the tolerable error is the maximum monetary
error in an account balance or class of transactions that
the auditor would be willing to accept so that when the
 147

results of all audit procedures are considered, the auditor

is able to conclude, with reasonable assurance, that the
financial statements are not materially mis-stated.

Expected Error
17. If the auditor expects error to be present in the
population, a larger sample than when no error is
expected ordinarily needs to be examined to conclude
that the actual error in the population is not greater than
the planned tolerable error. Smaller sample sizes are
justified when the population is expected to be error free.
In determining the expected error in a population, the
auditor would consider such matters as error levels
identified in previous audits, changes in the entity’s
procedures, and evidence available from other
procedures.

Selection of the Sample

18. The auditor should select sample items in such a way
that the sample can be expected to be representative of
the population. This requires that all items in the
population have an opportunity of being selected.
19. While there are a number of selection methods, three
methods commonly used are:
 Random selection, which ensures that all items in the
population have an equal chance of selection, for
example, by use of random number tables.
 Systematic selection, which involves selecting items
using a constant interval between selections, the first
interval having a random start. The interval might be
based on a certain number of items (for example, every
20th voucher number) or on monetary totals (for
example, every Rs 1,000 increase in the cumulative
value of the population). When using systematic
selection, the auditor would need to determine that the
population is not structured in such a manner that the
sampling interval corresponds with a particular
pattern in the population. For example, if in a
population of branch sales, a particular branch’s sales
 148

occur only as every 100th item and the sampling

interval selected is 50, the result would be that the
auditor would have selected all, or none, of the sales of
that particular branch.
 Haphazard selection, which may be an acceptable
alternative to random selection, provided the auditor
attempts to draw a representative sample from the
entire population with no intention to either include or
exclude specific units. When the auditor uses this
method, care needs to be taken to guard against
making a selection that is biased, for example, towards
items, which are easily located, as they may not be
representative.

Evaluation of Sample Results

20. Having carried out, on each sample item, those audit
procedures that are appropriate to the particular audit
objective, the auditor should:
(a) analyse any errors detected in the sample;
(b) project the errors found in the sample to the
population; and
(c) reassess the sampling risk.

Analysis of Errors in the Sample

21. In analysing the errors detected in the sample, the
auditor will first need to determine that an item in
question is in fact an error. In designing the sample, the
auditor will have defined those conditions that constitute
an error by reference to the audit objectives. For
example, in a substantive procedure relating to the
recording of accounts receivable, a mis-posting between
customer accounts does not affect the total accounts
receivable. Therefore, it may be inappropriate to consider
this an error in evaluating the sample results of this
particular procedure, even though it may have an effect
on other areas of the audit such as the assessment of
doubtful accounts.
22. When the expected audit evidence regarding a specific
sample item cannot be obtained, the auditor may be able
 149

to obtain sufficient appropriate audit evidence through

performing alternative procedures. For example, if a
positive account receivable confirmation has been
requested and no reply was received, the auditor may be
able to obtain sufficient appropriate audit evidence that
the receivable is valid by reviewing subsequent payments
from the customer. If the auditor does not, or is unable
to, perform satisfactory alternative procedures, or if the
procedures performed do not enable the auditor to obtain
sufficient appropriate audit evidence the item would be
treated as an error.
23. The auditor would also consider the qualitative aspects
of the errors. These include the nature and cause of the
error and the possible effect of the error on other phases
of the audit.
24. In analysing the errors discovered, the auditor may
observe that many have a common feature, for example,
type of transaction, location, product line, or period of
time. In such circumstances, the auditor may decide to
identify all items in the population, which possess the
common feature, thereby producing a sub-population,
and extend audit procedures in this area. The auditor
would then perform a separate analysis based on the
items examined for each sub-population.

Projection of Errors
25. The auditor projects the error results of the sample to
the population from which the sample was selected.
There are several acceptable methods of projecting error
results. However, in all the cases, the method of
projection will need to be consistent with the method
used to select the sampling unit. When projecting error
results, the auditor needs to keep in mind the qualitative
aspects of the errors found. When the population has
been divided into sub-population, the projection of errors
is done separately for each sub-population and the results
are combined.
 150

Reassessing Sampling Risk

26. The auditor needs to consider whether errors in the
population might exceed the tolerable error. To
accomplish this, the auditor compares the projected
population error to the tolerable error taking into account
the results of other audit procedures relevant to the
specific control or financial statement assertion. The
projected population error used for this comparison in
the case of substantive procedures is net of adjustments
made by the entity. When the projected error exceeds
tolerable error, the auditor reassesses the sampling risk
and if that risk is unacceptable, would consider extending
the audit procedure or performing alternative audit
procedures.

Effective Date
27. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1998.
APPENDIX 1
FACTORS INFLUENCE SAMPLE SIZE FOR TESTS OF
CONTROL

Conditions Leading To
Factor Smaller Larger
Sample Size Sample Size
Assessment Higher Lower
of control preliminary preliminary
risk assessment assessment
of control of control
risk risk
Tolerable Higher Lower
error acceptable acceptable
rate of rate of
deviation deviation
Allowable Higher risk of Lower risk of
risk of over over reliance over reliance
reliance
 151

Expected Lower Higher

error expected rate expected rate
of deviation of deviation
in population in population*
Number of Virtually no
items in effect on
population sample size
unless
population is
small
*
High expected deviation rates ordinarily warrant little, if
any, reduction of control risk and, therefore, tests of
controls might be omitted.

APPENDIX 2

EXAMPLES OF FACTORS INFLUENCING SAMPLE

SIZE FOR SUBSTANTIVE PROCEDURES

Conditions Leading To
Factor Smaller Higher
Sample Size Sample Size
Assessment Lower Higher
of control control risk control risk
risk
Reduction in Greater use Reduced use
detection risk of other of other
because of substantive substantive
other tests tests
substantive
tests related
to the same
financial
statement
assertions
Tolerable Large Smaller
error measure of measure of
tolerable tolerable
 152

error error
Expected Smaller Larger errors
error errors or or higher
lower frequency
frequency
Population Smaller Larger
value monetary monetary
significance significance
to the to the
financial financial
statements statements
Number of Virtually no
items in effect on
population sample size
unless
population is
small
Acceptable Higher Lower
level of acceptable acceptable
detection risk level of level of
detection risk detection risk
Stratification Stratification No
of the stratification
population, if of the
appropriate population

Statement on Standard Auditing Practices (SAP 16)*

Going Concern
 153

The following is the text of Statement on Standard Auditing

Practices (SAP) 16, “Going Concern”, issued by the Council
of the Institute of Chartered Accountants of India. The
Statement should be read in conjunction with the “Preface
to the Statements on Standard Auditing Practices” issued by
the Institute.

Introduction
1. The purpose of this Statement on Standard Auditing
Practices (SAP) is to establish standards on the auditor’s
responsibilities in the audit of financial statements
regarding the appropriateness of the going concern
assumption as a basis for the preparation of the financial
statements.
2. When planning and performing audit procedures and in
evaluating the results thereof, the auditor should
consider the appropriateness of the going concern
assumption underlying the preparation of the financial
statements.
3. The auditor’s report helps establish the credibility of the
financial statements. However, the auditor’s report is not
a guarantee as to the future viability of the entity.
4. An entity’s continuance as a going concern for the
foreseeable future, generally a period not to exceed one
year after the balance sheet date, is assumed in the
preparation of financial statements in the absence of
information to the contrary. Accordingly, assets and
liabilities are recorded on the basis that the entity will be
able to realise its assets and discharge its liabilities in the
normal course of business. If this assumption is
unjustified, the entity may not be able to realize its assets
at the recorded amounts and there may be changes in the
amounts and maturity dates of liabilities. As a
consequence, the amounts and classification of assets
and liabilities in the financial statements may need to be
adjusted.
 154

Appropriateness of the Going Concern Assumption

5. The auditor should consider the risk that the going
concern assumption may no longer be appropriate.
6. Indications of risk that continuance as a going concern
may be questionable could come from the financial
statements or from other sources. Examples of such
indications that would be considered by the auditor are
listed below. This listing is not all-inclusive nor does the
existence of one or more always signify that the going
concern assumption needs to be questioned.

Financial Indications
 Negative net worth or negative working capital.
 Fixed-term borrowings approaching maturity without
realistic prospects of renewal or repayment, or
excessive reliance on short-term borrowings to finance
long-term assets.
 Adverse key financial ratios.
 Substantial operating losses.
 Substantial negative cash flows from operations.
 Arrears or discontinuance of dividends.
 Inability to pay creditors on due dates.
 Difficulty in complying with the terms of loan
agreements.
 Change from credit to cash-on-delivery transactions
with suppliers.
 Inability to obtain financing for essential new product
development or other essential investments.
 Entering into a scheme of arrangement with creditors
for reduction of liability.

Operating Indications
 Loss of key management without replacement.
 Loss of a major market, franchise, licence, or principal
supplier.
 Labour difficulties or shortages of important supplies.
 155

Other Indications
 Non-compliance with capital or other statutory
requirements.
 Pending legal proceedings against the entity that may,
if successful, result in judgments that could not be
met.
 Changes in legislation or government policy.
 Sickness of the entity under any statutory definition.
7. The significance of such indications can often be
mitigated by other factors. For example, the effect of an
entity being unable to make its normal debt repayments
may be counterbalanced by management’s plans to
maintain adequate cash flows by alternative means, such
as by disposal of assets, rescheduling of loan repayments,
obtaining additional capital or having funding
arrangements backed by government. Similarly, the loss
of a principal supplier may be mitigated by the
availability of a suitable alternative source of supply.

Audit Evidence
8. When a question arises regarding the appropriateness of
the going concern assumption, the auditor should gather
sufficient appropriate audit evidence to attempt to
resolve, to the auditor’s satisfaction, the question
regarding the entity’s ability to continue in operation for
the foreseeable future.
9. During the course of the audit, the auditor carries out
audit procedures designed to obtain audit evidence as the
basis for the expression of an opinion on the financial
statements. When a question arises regarding the going
concern assumption, certain of these procedures may
take on additional significance or it may be necessary to
perform additional procedures or to update information
obtained earlier. Procedures that are relevant in this
connection may include:
 Analyse and discuss cash flow, profit and other
relevant forecasts with management.
 156

 Review events after the balance sheet date for items

affecting the entity’s ability to continue as a going
concern.
 Analyse and discuss the entity’s latest available interim
financial statements.
 Review the terms of debentures and loan agreements
and determine whether any have been breached.
 Read minutes of the meetings of shareholders, the
board of directors and important committees for
reference to financing difficulties.
 Review the status of matters under litigation and
claims.
 Confirm the existence, legality and enforceability of
arrangements to provide or maintain financial support
with related and third parties and assess the financial
ability of such parties to provide additional funds.
 Consider the entity’s position concerning unfilled
customer orders.
10. When analysing cash flow, profit and other relevant
forecasts, the auditor would consider the reliability of the
entity’s system for generating such information. The
auditor would also consider whether the assumptions
underlying the forecast appear appropriate in the
circumstances. In addition, the auditor would compare
the prospective data for recent prior periods with
historical results, and would compare the prospective
data for the current period with results achieved to date.
11. The auditor would also consider and discuss with
management its plans for future action, such as plans to
liquidate assets, borrow money or restructure debt,
reduce or delay expenditure, or increase capital. The
relevance of such plans to an auditor generally decreases
as the time period for planned actions and anticipated
events increases. Particular emphasis is ordinarily placed
on plans that might have a significant effect on the
entity’s solvency within the foreseeable future. The
auditor would obtain sufficient appropriate audit
evidence that these plans are feasible, are likely to be
implemented and that the outcome of these plans will
 157

improve the situation. The auditor would ordinarily seek

written representations from management regarding
these plans.

Audit Conclusions and Reporting

12. After the procedures considered necessary have been
carried out, all the information required has been
obtained, and the effect of any plans of management and
other mitigating factors have been considered, the
auditor would decide whether the question raised
regarding the going concern assumption has been
satisfactorily resolved.

Going Concern Assumption Considered Appropriate

13. If, in the auditor’s judgement, sufficient appropriate
audit evidence has been obtained to support the going
concern assumption, the auditor would not qualify his
report on this account.
14. If, in the auditor’s judgement, the going concern
assumption is appropriate because of mitigating factors,
in particular management’s plans for future action, the
auditor should consider whether such plans or other
factors need to be disclosed in the financial statements.
Where the auditor concludes that such plans or other
factors need to be disclosed, but have not been
adequately disclosed, the auditor should express a
qualified or adverse opinion, as appropriate.

Going Concern Question not Resolved

15. If, in the auditor’s judgement, the going concern
question is not satisfactorily resolved, the auditor would
consider whether the financial statements:
(a) adequately describe the principal conditions that
raise substantial doubt about the entity’s ability to
continue in operation for the foreseeable future;
(b) state that there is significant uncertainty that the
entity will be able to continue as a going concern and,
therefore, may be unable to realise its assets and
 158

discharge its liabilities in the normal course of

business; and
(c) state that the financial statements do not include
any adjustments relating to the recoverability and
classification of recorded asset amounts, or to amounts
and classification of liabilities that may be necessary if
the entity is unable to continue as a going concern.
Provided the disclosure is considered adequate, the auditor
would not express a qualified or adverse opinion.
16. If adequate disclosure is made in the financial
statements, the auditor should ordinarily express an
unqualified opinion. However, he should, in his report,
add a paragraph that highlights the going concern
problem by drawing attention to the note in the financial
statements that discloses the matters set out in
paragraph 15. The following is an example of such a
paragraph:
“We draw attention to Note X in the financial statements.
The Company incurred a net loss of XXX during the year
ended March 31, 19X1 and, as of that date, the
Company’s current liabilities exceeded its current assets
by XXX and its total liabilities exceeded its total assets by
XXX. These factors, along with other matters as set forth
in Note X, raise substantial doubt that the Company will
be able to continue as a going concern.”
The auditor is not precluded from expressing a disclaimer
of opinion for a going concern uncertainty.
17. If adequate disclosure is not made in the financial
statements, the auditor should express a qualified or
adverse opinion, as appropriate. The following is an
example of the explanation and opinion paragraphs when
a qualified opinion is to be expressed:
“The Company has been unable to renegotiate its
borrowings from its bankers. Without such financial
support there is substantial doubt that it will be able to
continue as a going concern. Consequently, adjustments
may be required to the recorded asset amounts and
 159

classification of liabilities. The financial statements (and

notes thereto) do not disclose this fact.
In our opinion, subject to the omission of the information
dealt with in the preceding paragraph, the financial
statements give a true and fair view of the financial
position of the Company at March 31, 19X1 and the
results of its operations for the year then ended.”

Going Concern Assumption Considered Inappropriate

18. If, on the basis of the additional procedures carried out
and the information obtained, including the effect of
mitigating circumstances, the auditor’s judgment is that
the entity will not be able to continue in operation for the
foreseeable future, the auditor would conclude that the
going concern assumption used in the preparation of the
financial statements is inappropriate. If the result of
the inappropriate assumption used in the
preparation of the financial statements is so
material and pervasive as to make the financial
statements misleading, the auditor should express
an adverse opinion.

Effective Date
19. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1999.
 160

Statement on Standard Auditing Practices (SAP 17)*

Quality Control for Audit Work
The following is the text of Statement on Standard Auditing
Practices (SAP) 17, “Quality Control for Audit Work”, issued
by the Council of the Institute of Chartered Accountants of
India. The Statement should be read in conjunction with the
“Preface to the Statements on Standard Auditing Practices”
issued by the Institute. From the date this Statement on
Standard Auditing Practices becomes effective, the
Guidance Note on Control of the Quality of Audit Work
issued by the Institute shall stand withdrawn.

Introduction
1. The purpose of this Statement on Standard Auditing
Practices (SAP) is to establish standards on the quality
control:
(a) policies and procedures of an audit firm regarding
audit work generally; and
(b) procedures regarding the work delegated to
assistants on an individual audit.
2. Quality control policies and procedures should be
implemented at both the level of the audit firm and on
individual audits.
3. In this SAP the following terms have the meaning
attributed below:
(a) “the auditor” means the person with final
responsibility for the audit;
(b) “audit firm” means either the partners of a firm
providing audit services or a sole practitioner
providing audit services, as appropriate;
 161

(a) “personnel” means all partners and professional

staff engaged in the audit practice of the firm; and
(b) “assistants” means personnel involved in an
individual audit other than the auditor.

Audit Firm
4. The audit firm should implement quality control policies
and procedures designed to ensure that all audits are
conducted in accordance with Statements on Standard
Auditing Practices (SAPs).
5. Compliance with Statements on Standard Auditing
Practices is essential whenever an audit is carried out
and requires the application of auditing procedures and
reporting practices appropriate to the particular
circumstances. An audit firm needs to implement
appropriate quality control policies and procedures to
ensure that all audits are carried out in accordance with
Statements on Standard Auditing Practices.
6. The objectives of the quality control policies to be
adopted by an audit firm will ordinarily incorporate the
following:
a) Professional Requirements:
Personnel in the firm are to adhere to the principles of
Independence, Integrity, Objectivity, Confidentiality
and Professional Behaviour.
(b) Skills and Competence1:
The firm is to be staffed by personnel who have
attained and maintain the Technical Standards and
Professional Competence required to enable them to
fulfil their responsibilities with Due Care.
(c) Assignment:
Audit work is to be assigned to personnel who have the
degree of technical training and proficiency required in
the circumstances.
(d) Delegation:
There is to be sufficient direction, supervision and
review of work at all levels to provide reasonable
 162

assurance that the work performed meets appropriate

standards of quality.
(e) Consultation:
Whenever necessary, consultation within or outside the
firm is to occur with those who have appropriate
expertise.
(f) Acceptance and Retention of Clients:
An evaluation of prospective clients and a review, on
an ongoing basis, of existing clients is to be conducted.
In making a decision to accept or retain a client, the
firm’s independence and ability to serve the client
properly are to be considered.
(g) Monitoring:
The continued adequacy and operational effectiveness
of quality control policies and procedures is to be
monitored.
______________________________
1
Refer to SAP 1, ‘Basic Principles Governing an Audit
7. The firm’s general quality control policies and procedures
should be communicated to its personnel in a manner
that provides reasonable assurance that the policies and
procedures are understood and implemented.

Individual Audits
8. The auditor should implement those quality control
procedures, which are, in the context of the policies and
procedures of the firm, appropriate to the individual
audit.
9. The auditor, and assistants with supervisory
responsibilities, will consider the professional
competence of assistants performing work delegated to
them when deciding the extent of direction, supervision
and review appropriate for each assistant.
10. Any delegation of work to assistants would be in a
manner that provides reasonable assurance that such
work will be performed with due care by persons having
 163

the degree of professional competence required in the

circumstances.

Direction
11. Assistants to whom work is delegated need appropriate
direction. Direction involves informing assistants of their
responsibilities and the objectives of the procedures they
are to perform. It also involves informing them of
matters, such as the nature of the entity’s business and
possible accounting or auditing problems that may affect
the nature, timing and extent of audit procedures with
which they are involved.

Audit Conclusions and Reporting

12. The audit programme is an important tool for the
communication of audit directions. Time budgets and the
overall audit plan are also helpful in communicating audit
directions.

Supervision
13. Supervision is closely related to both direction and
review and may involve elements of both.
14. Personnel carrying out supervisory responsibilities
perform the following functions during the audit:
(a) monitor the progress of the audit to consider
whether:
(i) assistants have the necessary skills and competence
to carry out their assigned tasks;
(ii) assistants understand the audit directions; and
(iii) the work is being carried out in accordance with
the overall audit plan and the audit programme;
(b) Become informed of and address significant
accounting and auditing questions raised during the
audit, by assessing their significance and modifying the
overall audit plan and the audit programme as
appropriate; and
(c) Resolve any differences of professional judgement
between personnel and consider the level of
consultation that is appropriate.
 164

Review
15. The work performed by each assistant needs to be
reviewed by personnel of at least equal competence to
consider whether:
(a) The work has been performed in accordance with
the audit programme;
(b) The work performed and the results obtained
have been adequately documented;
(c) All significant audit matters have been resolved or
are reflected in audit conclusions;
(d) The objectives of the audit procedures have been
achieved; and
(e) The conclusions expressed are consistent with the
results of the work performed and support the audit
opinion.
16. The following need to be reviewed on a timely basis:
(a) overall audit plan and the audit programme;
(b) assessments of inherent and control risks,
including the results of tests of control and the
modifications, if any, made to the overall audit plan
and the audit programme as a result of tests of control;
(c) Documentation of the audit evidence obtained
from substantive procedures and the conclusions
drawn therefrom, including the results of
consultations; and
(d) Financial statements, proposed adjustments in
financial statements arising out of the auditor’s
examination, and the auditor’s proposed
observations/report.
17. The process of reviewing an audit may include,
particularly in the case of large complex audits,
requesting personnel not otherwise involved in the audit
to perform certain additional procedures before issuing
the auditor’s report.

Effective Date
18. This Statement on Standard Auditing Practices
becomes operative for all audits relating to accounting
periods beginning on or after April 1, 1999.
 165

Statement on Standard Auditing

Practices (SAP) 18

Audit of Accounting Estimates

The following is the text of Statement on
Standard Auditing Practices (SAP) 18, "Audit
of Accounting Estimates", issued by the
Council of the Institute of Chartered
Accountants of India. The Statement should
be read in conjunction with the "Preface to
the Statements on Standard Auditing
Practices" issued by the Institute.
INTRODUCTION
1. The purpose of this Statement on
Standard Auditing Practice (SAP) is to
establish standards on the audit of
accounting estimates contained in financial
statements. This SAP is not intended to be
applicable to the examination of prospective
financial information2.
2. The auditor should obtain sufficient
appropriate audit evidence regarding
accounting estimates.
3. "Accounting estimate" means an
approximation of the amount of an item in
the absence of a precise means of
measurement. Examples are:
 Allowances to reduce inventory and
accounts receivable to their estimated
realisable value.
 Provisions to allocate the cost of fixed
assets over their estimated useful
lives.
 Accrued revenue.
 Provision for taxation.
 Provision for a loss from a lawsuit.
 Insurer's liability for outstanding
claims.
 Losses on construction contracts in
 166

progress.
 Amortisation of certain items like
goodwill and deferred revenue
expenditure.
 Provision to meet warranty claims.
1
With the formation of the Auditing Practices
Committee in 1982, the Council of the
Institute has been issuing a series of
Statements on Standard Auditing Practices
(SAPs). Statements on Standard Auditing
Practices lay down the principles governing
an audit. These principles apply whenever
an independent audit is carried out.
Statements on Standard Auditing Practices
become mandatory on the dates specified in
the respective SAPs. Their mandatory status
implies that, while discharging their attest
function, it will be the duty of the members of
the Institute to ensure that the SAPs are
followed in the audit of financial information
covered by their audit reports. If, for any
reason, a member
2
In this regard, it may be noted that the
Institute of Chartered Accountants of India
has issued a Guidance Note on
Accountant's Report on Profit Forecasts
and/or Financial Forecasts.
 Provision to meet warranty claims.
 Provision for retirement benefits in the
financial statements of employers.
4. Management is responsible for making
accounting estimates included in financial
statements. These estimates are often made
in conditions of uncertainty regarding the
outcome of events that have occurred or are
likely to occur and involve the use of
judgment. As a result, the risk of material
misstatement is greater when accounting
estimates are involved.
THE NATURE OF ACCOUNTING
 167

ESTIMATES
5. The determination of an accounting
estimate may be simple or complex,
depending upon the nature of the item. For
example, accruing a charge for rent may be
a simple calculation, whereas estimating a
provision for slow-moving or surplus
inventory may involve considerable analysis
of current data and a forecast of future
sales. In complex estimates, a high degree
of special knowledge and judgment may be
required.
6. Accounting estimates may be determined
as part of the routine accounting system
operating on a continuing basis, or may be
non-routine, operating only at the end of the
period. In many cases, accounting estimates
are made by using a formula based on
experience, such as the use of standard
rates for depreciating each category of fixed
assets or a standard percentage of sales
revenue for computing a warranty provision.
In such cases, the formula needs to be
reviewed regularly by management, for
example, by reassessing the remaining
useful lives of assets or by comparing actual
results with the estimate and adjusting the
formula when necessary.
7. The uncertainty associated with an item,
or the lack of objective data may make it
incapable of reasonable estimation, in which
case, the auditor needs to consider the
same while expressing his opinion on the
financial statements.
AUDIT PROCEDURES
8. The auditor should obtain sufficient
appropriate audit evidence as to whether
an accounting estimate is reasonable in
the circumstances and, when required, is
appropriately disclosed in the financial
 168

statements. The evidence available to

support an accounting estimate will often be
more difficult to obtain and less conclusive
than evidence available to support other
items in the financial statements.
9. An understanding of the procedures and
methods, including the accounting and
internal control systems, used by
management in making the accounting
estimates is often important for the auditor to
plan the nature, timing and extent of the
audit procedures.
10. The auditor should adopt one or a
combination of the following approaches
in the audit of an accounting estimate:
a. review and test the process used by
management to develop the
estimate;
b. use an independent estimate for
comparison with that prepared by
management; or
c. review subsequent events which
confirm the estimate made.
Reviewing and Testing the Process Used
by Management
11. The steps ordinarily involved in
reviewing and testing of the process
used by management are:
a. evaluation of the data and
consideration of assumptions on
which the estimate is based;
b. testing of the calculations involved
in the estimate;
c. comparison, when possible, of
estimates made for prior periods
with actual results of those periods;
and
d. consideration of management's
approval procedures.
Evaluation of Data and Consideration of
 169

Assumptions
12. The auditor would evaluate whether
the data on which the estimate is based
is accurate, complete and relevant. When
accounting data is used, it will need to be
consistent with the data processed
through the accounting system. For
example, in substantiating a warranty
provision, the auditor would obtain audit
evidence that the data relating to
products still within the warranty period,
at period end, agree with the sales
information within the accounting
system.
13. External evidence is, usually, more
reliable for the purpose of an audit than
internal evidence. Accordingly, obtaining
external evidence may be warranted in
certain circumstances. For example,
where there may be uncertainties with
regard to the anticipated future sales of
products requiring provision for
obsolescence of inventories, the auditor
in addition to examining internal data
such as past levels of sales, orders on
hand etc., may seek external evidence to
corroborate the requirement for inventory
obsolescence provision. Similarly, in
respect of claims against the entity
arising out of litigation, internal evidence
may be required to be corroborated by
making a reference to entity's lawyers, if
so required. Internal evidence relating to
provision for gratuity, pension or other
terminal benefits for the staff, where
funded by external agencies, may sought
to be corroborated by external evidence.
14. The auditor would evaluate whether
the data collected is appropriately
analysed to form a reasonable basis for
 170

determining the accounting estimate. For

example, the analysis of the age of
accounts receivable to estimate the
provision for doubtful debts and
advances.
15. The assumptions used in the
accounting estimate will be specific to
the entity and would be based on
internally generated data, while in other
cases, the assumptions may be based on
industry or government statistics. The
auditor would evaluate whether the entity
has an appropriate base for the principal
assumptions used in the accounting
estimate.
16. In evaluating the assumptions on
which the estimate is based, the auditor
would consider, among other things,
whether they are:
 Reasonable in light of actual results
in prior periods.
 Consistent with those used for
other accounting estimates.
 Consistent with management's
plans which appear appropriate.
The auditor would need to pay particular
attention to assumptions which are
sensitive to variation, subjective or
susceptible to material misstatement.
17. In the case of complex estimating
processes involving specialised
techniques, it may be necessary for the
auditor to use the work of an expert, for
example, engineers for estimating
quantities in stock piles of mineral ores.
Requirements as to how to use the work
of an expert are prescribed in SAP 9,
"Using the Work of an Expert."
18. The auditor would review the
continuing appropriateness of formulae
 171

used by management in the preparation

of accounting estimates. For this
purpose, the auditor's knowledge of the
financial results of the entity in prior
periods, practices used by other entities
in the industry and the future plans of
management as disclosed to the auditor
would be useful.
Testing of Calculations
19. The auditor would test the calculation
procedures used by management. The
nature, timing and extent of the auditor's
testing will depend on such factors as
the complexity involved in calculating the
accounting estimate, the auditor's
evaluation of the procedures and
methods used by the entity in producing
the estimate and the materiality of the
estimate in the context of the financial
statements.
Comparison of Previous Estimates with
Actual Results
20. When possible, the auditor would
compare accounting estimates made for
prior periods with actual results of those
periods to assist in:
a. obtaining evidence about the
general reliability of the entity's
estimating procedures;
b. considering whether adjustments to
estimating formulae may be
required; and
c. evaluating whether differences
between actual results and previous
estimates have been quantified and
that, where necessary, appropriate
adjustments or disclosures have
been made.
Consideration of Management's Approval
Procedures
 172

21. Material accounting estimates are

ordinarily reviewed and approved by
management. The auditor would consider
whether such review and approval is
performed by the appropriate level of
management and that it is evidenced in
the documentation supporting the
determination of the accounting estimate.
Use of an Independent Estimate
22. The auditor may make or obtain an
independent estimate and compare it
with the accounting estimate prepared by
management. When using an
independent estimate the auditor would
ordinarily evaluate the data, consider the
assumptions and test the calculation
procedures used in its development. It
may also be appropriate to compare
accounting estimates so made for prior
periods with actual results of those
periods.
Review of Subsequent Events
23. Transactions and events which occur
after period end, but prior to completion
of the audit, may provide audit evidence
regarding an accounting estimate made
by management. The auditor's review of
such transactions and events may
reduce, or even remove, the need for the
auditor to review and test the process
used by management to develop the
accounting estimate or to use an
independent estimate in assessing the
reasonableness of the accounting
estimate.
EVALUATION OF RESULTS OF AUDIT
PROCEDURES
24. The auditor should make a final
assessment of the reasonableness of the
estimate based on the auditor's
 173

knowledge of the business and whether

the estimate is consistent with other
audit evidence obtained during the audit.
25. The auditor would consider whether
there are any significant subsequent
transactions or events which affect the
data and the assumptions used in
determining the accounting estimate.
26. Because of the uncertainties inherent
in accounting estimates, evaluating
differences can be more difficult than in
other areas of the audit. When there is a
difference between the auditor's estimate
of the amount best supported by the
available audit evidence and the
estimated amount included in the
financial statements, the auditor would
determine whether such a difference
requires adjustment. If the difference is
reasonable, for example, because the
amount in the financial statements falls
within a range of acceptable results, it
may not require adjustment. However, if
the auditor believes the difference is
unreasonable, management would be
requested to revise the estimate. If
management refuses to revise the
estimate, the difference would be
considered a misstatement and would be
considered with all other misstatements
in assessing whether the effect on the
financial statements is material. However,
the auditor would also consider whether
individual differences which have been
accepted as reasonable are biased in one
direction, so that, on a cumulative basis,
they may have a material effect on the
financial statements. In such
circumstances, the auditor would
evaluate the accounting estimates taken
 174

as a whole.
EFFECTIVE DATE
27. This Statement on Standard Auditing

Statement on Standard Auditing Practices (SAP) 19

SUBSEQUENT EVENTS
The following is the text of Statement on Standard Auditing Practices
(SAP) 19, “Subsequent Events”, issued by the Council of the Institute
of Chartered Accountants of India. The Statement should be read in
conjunction with the "Preface to the Statements on Standard Auditing
Practices" issued by the Institute.
Introduction
1. The purpose of this Statement on Standard Auditing Practices
(SAP) is to establish standards on the auditor's responsibility
regarding subsequent events. In this SAP, the term "subsequent
events" is used to refer to significant events occurring between the
balance sheet date and the date of the auditor's report. In the context
of audit of a component, such as a branch or division, of an entity
“subsequent events” would refer to significant events upto the date of
the report of the auditor of that component of the entity.
2. The auditor should consider the effect of subsequent events on the
financial statements and on the auditor's report.
3. Accounting Standard (AS) 4, “Contingencies and Events Occurring
After the Balance Sheet Date”, issued by the Institute of Chartered
Accountants of India, deals with the treatment in financial statements
of events, both favourable and unfavourable, occurring between the
balance sheet date and the date on which the financial statements
are approved by the Board of Directors in the case of a company,
and, by the corresponding approving authority in the case of any
other entity. AS 4 identifies two types of events:
a. (a) those which provide further evidence of conditions that
existed at the balance sheet date; and
b. those which are indicative of conditions that arose subsequent
to the balance sheet date.
Audit Procedures
4. The auditor should perform procedures designed to obtain
sufficient appropriate audit evidence that all events up to the
 175

date of the auditor's report that may require adjustment of, or

disclosure in, the financial statements have been identified.
These procedures are in addition to routine procedures which may be
applied to specified transactions occurring after the balance sheet
date to obtain audit evidence as to account balances as at the
balance sheet date, for example, the testing of inventory cutoff and
payments to creditors. The auditor is not, however, expected to
conduct a continuing review of all matters to which previously applied
procedures have provided satisfactory conclusions.
With the formation of the Auditing Practices Committee in 1982, the
Council of the Institute has been issuing a series of Statements on
Standard Auditing Practices (SAPs). Statements on Standard
Auditing Practices lay down the principles governing an audit. These
principles apply whenever an independent audit is carried out.
Statements on Standard Auditing Practices become mandatory on
the dates specified in the respective SAPs. Their mandatory status
implies that, while discharging their attest function, it will be the duty
of the members of the Institute to ensure that the SAPs are followed
in the audit of financial information covered by their audit reports. If,
for any reason, a member has not been able to perform an audit in
accordance with the SAPs, his report should draw attention to the
material departures therefrom.
5. The procedures to identify events that may require adjustment of,
or disclosure in, the financial statements would be performed as near
as practicable to the date of the auditor's report and ordinarily include
the following:
 Reviewing procedures that the management has established to
ensure that subsequent events are identified.
 Reading minutes of the meetings of shareholders, the board of
directors and audit and executive committees held after the
balance sheet date and inquiring about matters discussed at
meetings for which minutes are not yet recorded.
 Reading the entity's latest available interim financial statements
and, as considered necessary and appropriate, budgets, cash
flow forecasts and other related management reports.
 Inquiring, or extending previous oral or written inquiries, of the
entity's lawyers concerning litigation and claims.
 Inquiring of management as to whether any subsequent events
have occurred after the balance sheet date which might affect
 176

the financial statements. Examples of inquiries of management

on specific matters are:
 The current status of items that were accounted for on the basis
of preliminary or inconclusive data.
 Whether there have been any developments regarding risk
areas and contingencies.
 Whether any unusual accounting adjustments have been made
or are contemplated.
 Whether any events have occurred or are likely to occur which
will bring into question the appropriateness of accounting
policies used in the financial statements as would be the case,
for example, if such events call into question the validity of the
going concern assumption.
6. When a component, such as a division or a branch, of an entity,
has already been audited by another auditor, the principal auditor
would make similar enquiries as set out in para 5 in respect of events,
occurring between the date of signing of the report of the auditor of
the component of the entity and signing of his report.
7. When the auditor becomes aware of events which materially
affect the financial statements, the auditor should consider
whether such events are properly accounted for in the financial
statements. When the management does not account for such
events that the auditor believes should be accounted for, the
auditor should express a qualified opinion or an adverse opinion
as appropriate.
Effective Date
8. This Statement on Standard Auditing Practices becomes operative
for all audits commencing on or after 1st April, 2000.
Statement on Standard Auditing Practices (SAP) 20
Knowledge of the Business
The following is the text of the Statement on Standard Auditing
Practices (SAP) 20, “Knowledge of the Business”, issued by the
Council of the Institute of Chartered Accountants of India. This
Statement should be read in conjunction with the “Preface to the
Statements on Standard Auditing Practices”, issued by the Institute.
Introduction
1. The purpose of this Statement is to establish standards on what is
knowledge of the business, why it is important to the auditor and to
members of the audit staff working on an engagement, why it is
 177

relevant to all phases of an audit, and how the auditor obtains and
uses that knowledge.
2.In performing an audit of financial statements, the auditor
should have or obtain knowledge of the business sufficient to
enable the auditor to identify and understand the events,
transactions and practices that, in the auditor's judgment, may
have a significant effect on the financial statements or on the
examination or audit report. Such knowledge is used by the auditor
in assessing inherent and control risks and in determining the nature,
timing and extent of audit procedures.
3. The auditor's level of knowledge for an engagement would include
a general knowledge of the economy and the industry within which
the entity operates, and a more particular knowledge of how the entity
operates. The level of knowledge required by the auditor would,
however, ordinarily be less than that possessed by management. A
list of matters to be considered in a specific engagement is set out in
the Appendix.
Obtaining the Knowledge
4. Prior to accepting an engagement, the auditor would obtain a
preliminary knowledge of the industry and of the nature of ownership,
management and operations of the entity to be audited, and would
consider whether a level of knowledge of the business adequate to
perform the audit can be obtained.
5. Following acceptance of the engagement, further and more
detailed information would be obtained. To the extent practicable, the
auditor would obtain the required knowledge at the start of the
engagement. As the audit progresses, that information would be
assessed and updated and more information would be obtained.
Obtaining the required knowledge of the business is a continuous and
cumulative process of gathering and assessing the information and
relating the resulting knowledge to audit evidence and information at
all stages of the audit. For example, although information is gathered
at the planning stage, it is ordinarily refined and added to in later
stages of the audit as the auditor and the members of his audit staff
learn more about the business.
With the formation of the Auditing Practices Committee in 1982, the
Council of the Institute has been issuing a series of Statements on
Standard Auditing Practices (SAPs). Statements on Standard
Auditing Practices lay down the principles governing an audit. These
principles apply whenever an independent audit is carried out.
 178

Statements on Standard Auditing Practices become mandatory on

the dates specified in the respective SAPs. Their mandatory status
implies that, while discharging their attest function, it will be the duty
of the members of the Institute to ensure that the SAPs are followed
in the audit of financial information covered by their audit reports. If,
for any reason, a member has not been able to perform an sudit in
accordance with the SAPs, his report should draw attention to the
material departures therefrom.
7. For continuing engagements, the auditor would update and re-
evaluate information gathered previously, including information in the
prior year's working papers. The auditor would also perform
procedures designed to identify significant changes that have taken
place since the last audit.
8. The auditor can obtain knowledge of the industry and the entity
from a number of sources. For example:
 Previous experience with the entity and its industry.
 Discussion with people with the entity (for example, directors
and senior operating personnel).
 Discussion with internal audit personnel and review of internal
audit reports.
 Discussion with other auditors and with legal and other advisors
who have provided services to the entity or within the industry.
 Discussion with knowledgeable people outside the entity (for
example, industry economists, industry regulators, customers
and suppliers).
 Publications related to the industry (for example, government
statistics, surveys, texts, trade journals, reports prepared by
banks and institutions and financial newspapers).
 Legislation and regulations that significantly affect the entity.
 Visits to the entity premises and plant facilities.
 Documents produced by the entity (for example, minutes of
meetings, material sent to shareholders or furnished to
regulatory authorities, promotional literature, prior years' annual
and financial reports, budgets, internal management reports,
interim financial reports, management policy manual, manuals
of accounting and internal control systems, chart of accounts,
job descriptions, marketing and sales plans).
Using the Knowledge
 179

9. Knowledge of the business is a frame of reference within which the

auditor exercises professional judgment. Understanding the business
and using this information appropriately assists the auditor in:
 Assessing risks and identifying problems.
 Planning and performing the audit effectively and efficiently.
 Evaluating audit evidence.
 Providing better service to the client.
10. The auditor makes judgments about many matters throughout the
course of the audit where knowledge of the business is important. For
example:
 Assessing inherent risk and control risk.
 Considering business risks and management's response
thereto.
 Developing the overall audit plan and the audit programme.
 Determining a materiality level and assessing whether the
materiality level chosen remains appropriate.
 Assessing audit evidence to establish its appropriateness and
the validity of the related financial statement assertions.
 Evaluating accounting estimates and management
representations.
 Identifying areas where special audit consideration and skills
may be necessary.
 Identifying related parties and related party transactions.
 Recognising conflicting information (for example, contradictory
representations).
 Recognising unusual circumstances (for example, fraud and
non-compliance with laws and regulations, unexpected
relationships of statistical operating data with reported financial
results).
 Making informed inquiries and assessing the reasonableness of
answers.
 Considering the appropriateness of accounting policies and
financial statement disclosures.
11. The auditor should ensure that the audit staff assigned to an
audit engagement obtain sufficient knowledge of the business to
enable them to carry out the audit work delegated to them. The
auditor would also ensure that the audit staff understand the need to
be alert for additional information and the need to share that
information with the auditor and other audit staff.
 180

12. To make effective use of knowledge about the business, the

auditor should consider how it affects the financial statements
taken as a whole and whether the assertions in the financial
statements are consistent with the auditor's knowledge of the
business.
Effective Date
13. This Statement on Standard Auditing Practices becomes
operative for all audits commencing on or after 1st April, 2000.
APPENDIX
Knowledge of the Business - Matters to Consider
This list covers a broad range of matters applicable to many
engagements; however, not all matters will be relevant to every
engagement and the listing is only illustrative.
A. General economic factors
General level of economic activity (for example, recession, growth)
 Interest rates and availability of finance
 Inflation, currency revaluation
 Government policies :-
- monetary
- fiscal
- taxation-corporate and other
- financial incentives (for example, government grants and
subsidies)
- tariffs, trade restrictions
 Foreign currency rates and controls
B. The industry - important conditions affecting the client's business
 The market and competition
 Cyclical or seasonal activity .
 Changes in product technology
 Business risk (for example, high technology, high fashion, ease
of entry for competition)
 Declining or expanding operations
 Adverse conditions (for example, declining demand, excess
capacity, serious price competition)
 Key ratios and operating statistics
 Specific accounting practices and problems
 Environmental requirements and problems
 Legislation and Regulatory framework
 Energy supply and cost
 181

 Specific or unique practices (for example, relating to labour

contracts, financing methods, accounting methods)
C The entity
1. Management and ownership - important characteristics
 Structure of entity (corporate and non-corporate) - private,
public, government (including any recent or planned changes)
 Beneficial owners and related parties (local, foreign, business
reputation and experience)
 Capital structure (including any recent or planned changes)
 Organizational structure
 Management objectives, philosophy, strategic plans
 Business restructuring - Acquisitions, mergers or disposals of
business activities (planned or recently executed)
 Sources and methods of financing (current, historical)
 Board of directors - Corporate form
- composition
- business reputation and experience of individuals
- independence from and control over operating
management
- frequency of meetings
- existence of audit committee and scope of its activities
- existence of policy on corporate conduct
 Members of the Managing Committee (by whatever name
called) - non-corporate entities
- composition and election of members
- business reputation and experience of individuals
- independence from and control over operating
management
- frequency of meetings
- existence of policy on conduct of business by the
enterprise
 Operating Management
- experience and reputation
- turnover
- key financial personnel and their status in the organization
- staffing of accounting department
- incentive or bonus plans as part of remuneration (for
example, based on profit)
- use of forecasts and budgets
 182

- pressures on management (for example, over-extended

dominance by one individual, , unreasonable deadlines for
announcing results)
- management information systems
 Internal audit function (existence, quality)
 Attitude to internal control environment
2. The entity's business - products, markets, suppliers, expenses,
operations.
 Nature of business(es) (for example, manufacturer, wholesaler,
financial services, import/export)
 Location of production facilities, warehouses, offices
 Employment (for example, by location, supply, wage levels,
union contracts, pension commitments, government regulation)
 Products or services and markets (for example, major
customers and contracts, terms of payment, profit margins,
market share, competitors, exports, pricing policies, reputation
of products, warranties, order book, trends, marketing strategy
and objectives, manufacturing processes)
 Important suppliers of goods and services (for example, long-
term contracts, stability of supply, terms of payment, imports,
methods of delivery such as "just-in-time")
 Inventories (for example, locations, quantities)
 Franchises, licenses, patents
 Important expense categories
 Research and development
 Foreign currency assets, liabilities and transactions - by
currency hedging
 Legislation and regulation that significantly affect the entity
 Information systems - current, plans to change
3. Financial performance - factors concerning the entity's financial
condition and profitability
 Key ratios and operating statistics
 Trends
 Debt structure, including covenants and restrictions

4. Reporting environment - external influences which affect

management in the preparation of the financial statements

5. Legislation
 Regulatory environment and requirements
 183

 Taxation, both direct and indirect

 Measurement and disclosure issues peculiar to the business
 Audit reporting requirements
 Users of the financial statements

Guidance Note on Treatment of Reserve Created on Revaluation of

Fixed Assets

1. In the preparation of the financial statements of a

company, various fixed assets are stated on the bases of
their historical cost. Sometimes, in order to bring into
the Balance Sheet their replacement cost, a company
revalues its fixed assets on the basis of a valuation made
by competent values. When the value of fixed assets is
written up in the books of account of a company on
revaluation, a corresponding credit is given to the
Revaluation Reserve. Such reserve represents the
difference between the estimated present market values
and the book values of the fixed assets. When such
reserve is created, a question arises about its nature and
the manner in which it can be utilized. This guidance not
deals with accounting treatment of the reserve created
on revaluation of fixed assets (herein referred to as
“Revaluation Reserve”).
2. Part I of Schedule VI to the Companies Act, 1956
provided that every company shall classify its fixed assets
under convenient heads and show under each head the
original cost, additions/deductions and the total
depreciation provided upto the end of each accounting
period. When a company revalues its fixed assets, it is
necessary for the company to how separately the date of
revaluation and, for a period of five years thereafter, the
amount of increase made.
3. When a company revalues its fixed assets, depreciation
should be provided on the basis of the revalued figures.
4. A view has been expressed in some quarters that, for
measurement of profits, revenue is deemed to have arisen
 184

when it is actually collected or when a justifiable claim to

collect it arises (e.g. credit sale) or when there is
knowledge and evidence that its capable of being
collected if a sale were to be made (i.e. prevailing market
price). According to this view, this principle will apply to
current and fixed assets and, therefore, when fixed assets
are written up to their present value, the corresponding
Revaluation Reserve cannot be considered as an
unrealised reserve. It is, therefore, argued that past
accumulated losses as well as depreciation for the year or
arrears of depreciation for earlier years, which are
required to be provided under Section 205 of the
Companies Act, can be written of or adjusted against
such Revaluation Reserve.
5. There is a contrary view that such Revaluation Reserve is
created as a result of a book adjustment only and,
therefore, such a reserve is an unrealised reserve, which
is not available for distribution as dividends. When
accounts are prepared on the basis of historical cost,
measurement of profits can be made by comparing the
cost of the assets at the beginning and at the end of the
accounting period. As such there is no justification for
taking credit for unrealised gains because the increase in
market value may be due to various extraneous factors
such as fall in the purchasing power of currency or other
factors not related to the operation of the company. So
far as fixed assets are concerned, these are held for the
use in the business and not for sale in the normal course
of business. In the circumstance, the difference between
the market value and the book vale does not represent
realised gain and cannot be treated as such in the books
of account.
6. Section 205 of the Companies Act provides that a
company can declare or pay dividend only out of its
profits. The profits for this purpose are to be arrived at
after providing for depreciation. If dividend is to be
declared out of the profits of any earlier year or years, it
is necessary that such profits should be arrived at after
providing for depreciation for the respective years.
 185

7. Proviso (a) to Section 205 (1) of the Companies Act reads

as under: -
“If the company has not provided for depreciation for any
previous financial year or year which falls or fall after the
commencement of the Companies (Amendment) Act,
1960, it shall before declaring or paying dividend for any
financial year provide for such depreciation out of the
profits of that financial year or out of the profits of any
other previous financial year or year.”
This proviso makes it clear that it is necessary to provide for
arrears of depreciation of earlier years, if any dividend is
to be declared out of profits of any subsequent year. For
this purpose depreciation (or arrears of depreciation) is
to be provided out of the profits of the company. Indeed,
a reference to Part II of Schedule VI to the Companies
Act indicates that the Profit and Loss Account is to be so
made as clearly to disclose the result of working of the
company during the period covered by the account.
8. When accumulated losses and depreciation (including
arrears of depreciation) are adjusted against Revaluation
Reserve it will amount to setting off actual losses against
unrealised gains. If dividend is declared out of the
current profits after adjusting accumulated losses or
arrears of depreciation against the Revaluation Reserve,
it will mean that dividend is declared out of profits which
should, in fact, have been utilised in setting off past
losses and arrears of depreciation. In effect, the
company will be declaring dividend out of profits, which
are not available for distribution. By adopting this
method, the company will be declaring dividend out of
unrealised gains appearing in the accounts in the form of
Revaluation Reserve. Accordingly, accumulated losses or
arrears of depreciation should not be set off against
Revaluation Reserve.
9. A question may arise, as to whether the additional
depreciation provision required in consequence of
revaluation can be adjusted against “Revaluation
Reserve”. As stated earlier, depreciation is required to
be provided with reference to the total value of the fixed
 186

assets as appearing in the account after revaluation.

However, for certain statutory purposes e.g. dividends,
managerial remuneration etc., only depreciation relatable
to the historical cost of the fixed assets to be provided out
of the current profits of the company. In the
circumstance, the additional depreciation relatable to
revaluation may be adjusted against “Revaluation
Reserve” by transfer to Profit and Loss Account. In other
words, as per the requirements of Part II of Schedule VI
to the Companies Act, the company will have to provide
the depreciation on the total book value of the fixed
assets (including the increased amount as a result of
revaluation) in the Profit and Loss Account of the relevant
period, and thereafter the company can transfer an
amount equivalent to the additional depreciation from the
Revaluation Reserve. Such transfer from Revaluation
Reserve should be shown in the Profit and Loss Account
separately and an appropriate note by way of disclosure
would be desirable. Such a disclosure would appear to
be in consonance with the requirement of Part I of
Schedule VI to the Companies Act, prescribing disclosure
of write-up in the value of fixed asset for the first five
years after revaluation.
10. If a company has transferred the difference between
the revalued figure and the book value of fixed assets to
the “Revaluation Reserve” and has charged the additional
depreciation related thereto to its Profit and Loss
Account, it is possible to transfer an account equivalent
to accumulated additional depreciation from the
revaluation reserve to the Profit and Loss Account or to
the General Reserve as the circumstances may permit,
provided suitable disclosure is made in the accounts as
recommended in this guidance note.
11. The Revaluation Reserve is not available for
payment of dividends. This view is also supported
by the Companies (Declaration of Dividend out of
Reserves) Rules, 1975. Similarly, accumulated
losses or arrears of depreciation should not be set
off against Revaluation Reserve. However, the
 187

revaluation reserve can be utilized for adjustment of

the additional depreciation on the increased
amount due to revaluation from year to year or on
the retirement of the relevant fixed assets (as
discussed in par 9 and 10 above respectively).
The revaluation of fixed assets is normally done in order to bring into books
the replacement cost of such assets. This is a healthy trend as it recognizes
the importance of retaining sufficient funds through additional depreciation
in the business for replacement of fixed assets. As such, it will be prudent
not to charge the additional depreciation against revaluation reserve, though
this may result in reduction of distribution profits. This practice would also
give a more realistic appraisal of the company’s operations in an inflationary
situation.

Guidance Note for Provision for Liability for Taxation

1. This statement summarises the Council’s view on the

responsibility of the Auditor relating to the provision for
liability for taxation and replaces all earlier statements on
this subject.
2. The liability for taxation arises not later than the last day
of the accounting period for which the accounts are
prepared. Therefore, provision for the anticipated tax
liability in respect of the profit for such period has to be
made irrespective of the fact that the Finance Act for the
succeeding assessment year may not have been enacted.
This provision has to be made on the basis of the law and
rates as known at the time when the accounts are
finalised and may be adjusted if any subsequent change
takes place in the law or in the rates.
3. The attention of the Council has been drawn to the fact
that there is a practice prevalent whereby Companies do
not make provision for taxation even when such a liability
is anticipated. This practice is based on a view that, if a
Company does not debit to its Profit and Loss Account the
amount of provision or taxation and conveys the
information through a Note, it would be adequate
compliance with the provision of the Companies Act. The
 188

Council, however, believes that, on an overall

consideration of the relevant proves on of law; non-
provision for taxation would amount to contravention of
the provisions of Sections 209 and 211 of the Companies
Act. Accordingly, it is necessary for the Auditor to qualify
his Report, and such qualification should bring out in
what manner the Accounts do not disclose a “true and
fair” view of the state of affairs of the Company and the
profit or loss of the company. An example of the manner
in which the statement in the report that the Balance
Sheet and Profit and Loss Account disclose a true and fair
view may be qualified, is given below: -
“The Company has not provided for taxation in respect of
its profits, and the estimated aggregate amount of
taxation not so provided for is Rs........ including
Rs.........for the year ended on ............To the extent of
such non-provision for the year, the profits of the
Company for the financial year, under report have been
over-stated, and to the extent, of such aggregate non-
provision, the Reserves of the company appearing in the
Balance Sheet have been over-stated and the Current
Liabilities and Provisions appearing in the said Balance
Sheet have been under-stated.
4. It may happen that the Balance Sheet and Profit and Loss
Account prepared by the Board of Directors of the
Company includes a Note stating the fact of non-provision
for taxation. If the Note is substantially on the lines
similar to the illustration indicated above and if the
Auditor is satisfied that it adequately brings out the
qualification in respect of the “true and fair” view, he
may instead of repeating the qualification in its entirely
in his report, invite a reference to the note and make his
report subject to the note. An example of the manner in
which this may be done is given below: -
“Subject to Note(s)..............regarding the non-provision
for taxation the Balance Sheet............”
5. The examples in para 3 and 4 are restricted to the
question of non-provision for taxation. If there are other
items for which provision is necessary but has not been
 189

made, the qualification may be suitably amended in the

light of the method of accounting adopted and other
circumstances of each case.
6. The attention of the Council has also been drawn to the
act that there are cases of Companies where the Profit
and Loss Account shows a balance of Profit but their is
either no provision for taxation or the provision is of a
figure which is materially lower than the amount which
should be arrived at by applying the applicable rate of tax
to such profits. In many cases, there is no note on the
accounts explaining the reasons as to why provision for
taxation has been made or has been made for a smaller
amount.
It is possible that such a situation may arise inter alia due
to the fact that in computing the liability for taxation,
credit has been taken for past unabsorbed depreciation of
losses or for relief’s under the Income-tax Act such as
development rebate and deductions under Chapter VIA of
the Income-Tax Act, 1961 or because of difference
between depreciation charged in the accounts and the
depreciation allowable for tax purposes. While in such
cases the non-provisions for taxation or the prevision of a
smaller amount might be justified, the Council feels that
in the interest of a better presentation of accounts and
the disclosure of pertinent information to the users of
such accounts, it would be desirable if the accounts
contain a note explaining the reasons why the provision
for taxation has not been made or has been made for a
smaller amount.

Examples of such a note would be as under:

i. No provision for taxation has been considered necessary

in view of the unabsorbed depreciation and / or
unabsorbed development rebate and / or deficiency under
Section 80J and / or losses brought forward from previous
years.
ii. Provision for taxation has been made after taking into
account unabsorbed depreciation and / or unabsorbed
 190

development rebate and / or deficiency under Section 80J

and / or losses brought forward from previous years.
iii.No provision for taxation has been considered necessary
in view of the allowance of development rebate and / or
deductions allowable under Chapter VIA of the Income-
tax Act, 1961.