paper – 3 : advanced auditing and professional ethics

PAPER – 3 : ADVANCED AUDITING AND PROFESSIONAL ETHICS QUESTIONS

Standards on Auditing, Statements and Guidance Notes 1. You are engaged to review the system and the information generated from financial statements.

Discuss the detailed procedures (General Points only) that may be performed by you as company auditor for review of financial statements.

2. The training partner in your office is aware that you have covered SA 550 Related Parties in your professional studies. He has asked you to help him prepare for a training session he is about to give. Requirements Prepare notes for a training session for junior staff on how to verify the existence of related party transactions.

Audit Strategy Planning and Programming 3. Your new client, Raja Ltd, sells cars, parts and accessories and undertakes workshop

repairs. The company operates through five divisions/locations in the Mumbai. Each division deals with a different overseas vehicle supplier and has three managers, one for each trading activity. Each division makes sales to companies and individuals, but only corporate customers are granted credit terms.

The computer-based accounting systems are based in the head office which is annexed to the premises of the largest division. All nominal ledger codes are suffixed 1 to 5 identify each division’s transactions.

Detailed inventory records include date of movements, original purchase price and latest selling price. Purchase requisitions are computer-generated when inventory line quantities fall to pre-determine re-order levels.

Gross selling prices for cars and parts are established on receipt of each consignment at standard markups on cost, as specified in the franchise agreements with each manufacturer. Parts transferred to workshops are charged at cost plus 10%. At the end of each month the computer generates trading and profit and loss accounts and balance sheets for each division, and ‘consolidated’ results for the company. New car sales managers prepare monthly returns showing the number of cars sold, gross selling prices extra and discounts.

All salaries and wages are processed centrally at head office. Divisional managers all have profit-related bonus incentives.

Requirement Identify, from the situation outlined above, circumstances particular to Raja Ltd that

should be taken into account when planning the audit. Briefly explain why these matters should be taken into account and set out the effect on our audit approach.

© The Institute of Chartered Accountants of India

PAPER – 3 : ADVANCED AUDITING AND PROFESSIONAL ETHICS 83

Risk Assessment and Internal Control 4. You are the senior auditor in charge of the audit of Cibaca Ltd., a manufacturing

company. You have been talking with the payroll supervisor who has commented on the strength of the company’s payroll internal control system. She has assumed that this internal control system guarantees the completeness, accuracy and validity of the payroll accounting records.

Requirements (a) State whether you agree with the supervisor’s assumption that an internal control

system can guarantee the completeness, accuracy and validity of the records, supporting your answer by using examples from a payroll system.

(b) The supervisor has also asked you to explain some internal control terminology which she does not understand. Explain the meaning of the following terms, using payroll examples different from chose you have given above. (i) Segregation of duties (ii) Approval and control of documents

Audit under CIS Environment and Special Audit Techniques 5. (a) “On-line real time processing system and batch processing system have their

inherent strengths and weaknesses.” Please comment. (b) Discuss some problems that will be encountered in CIS Environment in

implementation of internal control. The Company Audit and Liabilities of Auditors 6. Comment on the following as an auditor:

(a) Yuki Ltd. purchased an existing bottling unit. The method of charging depreciation on machinery of the acquired unit was different from that followed by the company in its other units. The company wants to continue to charge depreciation for the acquired unit, in the method followed earlier by them and which was too consistent with their own method.

(b) In the previous year “Bhumi” Ltd. has made a provision of 10% of the contract value on an ongoing project. The actual loss on completion of the contract in the subsequent year was 11%. The management adjusted the difference in the previous year’s account.

Liabilities of Auditor 7. You are the auditor of a company, which raised finance from the capital market on the basis

of a prospectus issued a few years back. The main object for raising the finance was specified to be setting up a project on information technology.


84 FINAL EXAMINATION: MAY, 2014

The company advanced monies so raised to various parties ‘related’ to directors. These parties had no standing whatsoever with information technology. In the Balance Sheet, these advances appeared as a current asset under the head “loans unsecured – considered good”. There was no mention in the notes to accounts about nature and purpose of such advances. You have given routine audit report without any qualifications. One fine morning the directors and these ‘related’ parties disappear. The company has just vanished.

Can you be hauled up for professional misconduct? Do you have any liability under any law? Audit Report 8. Shahjahan Pvt. Ltd. has submitted the financial statements for the year ended 31-3-13

for audit. The audit assistant observes and brings to your notice that the company's records show following dues:

Income Tax relating to Assessment Year 2007-08 ` 157 lacs - Appeal is pending before Hon'ble ITAT since 30-9-10.

Customs duty ` 65 lakhs - Demand notice received on 15-9-12 but no action has been taken to pay or appeal.

As an auditor, how would you bring this fact to the members? 9. (a) Om Ltd. has taken a term loan from a nationalized bank in 2008 for ` 150 lakhs

repayable in five equal instalments of ` 30 lakhs from 31st March, 2009 onwards. It had repaid the loans due in 2009 & 2010, but defaulted in 2011, 2012 & 2013. As the auditor of Om Ltd. what is your responsibility assuming that company has sought reschedulement of loan?

(b) B and S Ltd. received a show cause notice from central excise department intending to levy a demand of ` 25 lakhs in December 2011. The company replied to the above notice in January 2012 contending that it is not liable for the levy. No further action was initiated by the central excise department upto the finalization of the audit for the year ended on 31st March, 2013. As the auditor of the company, what is your role in this?

(c) Director of Tui Ltd. draws an advance of US$ 200 per day in connection with the foreign trip undertaken on behalf of the company. On his return he files a declaration stating that entire advance was expended without any supporting or evidence. Tui Ltd. books the entire expenses on the basis of such declaration. As the auditor of Tui Ltd. how do you deal with this?

Audit Committee and Corporate Governance 10. (a) Briefly explain the concept of Corporate Governance. (b) State the main features of the Qualified and Independent Audit Committee set up

under clause 49 of the listing agreement.



Audit of Consolidated Financial Statements 11. (a) “Permanent Consolidation Adjustments are made only on the first occasion of the

preparation and presentation of consolidated financial statements”. Explain the role of auditor in the context of Permanent Consolidation Adjustments.

(b) While doing the audit of consolidated Financial Statements, which current period consolidation adjustments are to be taken into account?

Audit of Banking Company 12. (a) What are the principal enactments governing bank audit? (b) As a branch auditor of a nationalised bank, how would you verify the following? (1) Bills Purchased and Discounted (2) Third Party Guarantees (3) Provision for Non-performing assets Audit of General Insurance Company 13. “In an audit of an insurance company, the Receipts and Payments Account is also

subjected to audit”. Comment. Audit of Co-operative Societies 14. (a) Discuss briefly the special feature in the audit of a Co-operative Society. (b) Mention the duties of Auditor of Co-operative Societies in regard to the following: (i) Over-due interest. (ii) Compliance with provisions of Co-operative Act and Rules thereunder. Audit under Fiscal Laws 15. (a) Titu Ltd's previous year ended on 31st March 2012. During that period it made a claim

for refund of customs duty which was admitted as due by the customs authorities during April 2012. Titu Ltd neither credited the claim in the profit and loss account nor reported the same in clause 13(b) of Form 3CD for the reason that this has been admitted as due by the authorities only in the next financial year. Further Titu Ltd had changed the method of determination of cost formula for the purpose of stock valuation from FIFO basis to Weighted Average Cost basis, but that was also not reflected in clause l1(b) of Form 3CD which requires reporting on change in accounting method employed. Comment.

(b) Mr. Raj, the Tax Auditor finds that some payments inadmissible under Section 40 A(3) were made, and advised the client to report the same in form 3CD. The client contends that cash payments were made since the other parties insisted upon the same and did not have Bank Accounts. Comment.



Audit of Public Sector Undertakings 16. “Comprehensive audit involves assessing efficiency and effectiveness of public

enterprises.” Discuss what is Comprehensive Audit? Enlist some of the areas to be examined therein.

Internal Audit, Management and Operational Audit 17. A large manufacturing company is suffering from working capital crunch. You as a

Management Auditor enlist and discuss the related areas to overcome the company’s problem.

Investigation and Due Diligence 18. Smita wants to join PQR Ltd, a partnership firm as 25% sharing partner. Advice Seema,

what important steps she should take while conducting Investigation on behalf of Smita as an Incoming Partner?

Professional Ethics 19. Comment on the following with reference to the Chartered Accountants Act, 1949 and

schedules thereto: (a) The Cashier of a company committed a fraud and absconded with the proceeds

thereof. This happened during the course of the accounting year. The Chief Accountant of the company also did not know about fraud.

In the course of the audit, at the end of the year, the auditor failed to discover the fraud. After the audit was completed, however, the fraud was discovered by the Chief Accountant. Investigation made at that time indicates that the auditor did not exercise proper skill and care and performed his work in a desultory and haphazard manner. With this background, the Directors of the company intend to file disciplinary proceedings against the auditor.

Discuss the position of the auditor with regard to the disciplinary proceedings. (b) Priya Co. Ltd. has applied to a bank for loan facilities. The bank on studying the

financial statements of the company notices that you are the auditor and requests you to call at the bank for a discussion. In the course of discussions, the bank asks for your opinion regarding the company and also asks for detailed information regarding a few items in the financial statements. The information is available in your working paper file. What should be your response and why?

(c) Binaca & Co, a firm of Chartered Accountants, accepted an assignment for audit under State level VAT Act, without any prior communication with the previous auditor.

(d) Qurashi, a Chartered Accountant, failed to report to the shareholders of the Zee Ltd, about the non-creation of a sinking fund in accordance with the Debenture Trust Deed and did not make clear that the amount shown as Sinking Funds were borrowed from the Managing Agents of the Zee Ltd.



(e) M/s. Appu, a firm of Chartered Accountants responded to a tender from a State Government for computerization of property takings records. For this purpose, the firm also paid ` 60, 000 as earnest deposit as part of the terms of the tender.

Other Miscellaneous Chapters 20. Write a short note on the following (a) Financial Indications and Going Concern. (b) Reconciliation of cost and financial accounts. (c) Cut-off Procedures (d) Facultative reinsurance under Insurance Act, 1938

SUGGESTED ANSWERS/HINTS

1. Procedures for Review of Financial Statements: As per SRE 2400 “Engagements to Review Financial Statements”, procedures for the review of financial statements will ordinarily include:

(i) Discuss terms and scope of the engagement with the client and the engagement team.

(ii) Prepare an engagement letter setting forth the terms and scope of the engagement. (iii) Obtain an understanding of the entity’s business activities and the system for

recording financial information and preparing financial statements. (iv) Inquire whether all financial information is recorded: (a) Completely; (b) Promptly; and (c) After the necessary authorisation. (v) Obtain the trial balance and determine whether it agrees with the general ledger and

the financial statements. (vi) Consider the results of previous audits and review engagements, including

accounting adjustments required. (vii) Inquire whether there have been any significant changes in the entity from the

previous year (e.g., changes in ownership or changes in capital structure). (viii) Inquire about the accounting policies and consider whether: (a) They comply with the applicable accounting standards; (b) They have been applied appropriately; and (c) They have been applied consistently and, if not, consider whether disclosure



has been made of any changes in the accounting policies. (ix) Read the minutes of meetings of shareholders, the board of directors and other

appropriate committees in order to identify matters that could be important to the review.

(x) Inquire if actions taken at shareholder, board of directors or comparable meetings that affect the financial statements have been appropriately reflected therein.

(xi) Inquire about the existence of transactions with related parties, how such transactions have been accounted for and whether related parties have been properly disclosed.

(xii) Inquire about contingencies and commitments. (xiii) Inquire about plans to dispose of major assets or business segments. (xiv) Obtain the financial statements and discuss them with management. (xv) Consider the adequacy of disclosure in the financial statements and their suitability

as to classification and presentation. (xvi) Compare the results shown in the current period financial statements with those

shown in financial statements for comparable prior periods and, if available, with budgets and forecasts.

(xvii) Obtain explanations from management for any unusual fluctuations or inconsistencies in the financial statements.

(xviii)Consider the effect of any unadjusted errors – individually and in aggregate. Bring the errors to the attention of management and determine how the unadjusted errors will influence the report on the review.

(xix) Consider obtaining a representation letter from management. 2. Verification of Existence of Related Parties: SA 550 “Related Parties”, During the

audit, the auditor shall remain alert, when inspecting records or documents, for arrangements or other information that may indicate the existence of related party relationships or transactions that management has not previously identified or disclosed to the auditor. • Entity income tax returns. • Information supplied by the entity to regulatory authorities. • Shareholder registers to identify the entity’s principal shareholders. • Statements of conflicts of interest from management and those charged with

governance. • Records of the entity’s investments and those of its pension plans. • Contracts and agreements with key management or those charged with

governance.



• Significant contracts and agreements not in the entity’s ordinary course of business. • Specific invoices and correspondence from the entity’s professional advisors. • Life insurance policies acquired by the entity. • Significant contracts re-negotiated by the entity during the period. • Internal auditors’ reports. • Documents associated with the entity’s filings with a securities regulator (e.g,

prospectuses). Arrangements that may indicate the existence of previously unidentified or undisclosed

related party relationships or transactions In particular, the auditor shall inspect the following for indications of the existence of

related party relationships or transactions that management has not previously identified or disclosed to the auditor:

(a) Bank, legal and third party confirmations obtained as part of the auditor’s procedures;

(b) Minutes of meetings of shareholders and of those charged with governance; and (c) Such other records or documents as the auditor considers necessary in the

circumstances of the entity. 3. Audit Planning

Circumstances Why taken into account Effect on audit approach This is a new audit client (i) Lack of cumulative/prior

knowledge, from which assurance can be derived, increases inherent risk.

(ii) Adequate planning is essential for audit efficiency to prevent over-auditing in first year.

(i) Accounting systems and internal controls need to be ascertained. Flowcharting will probably be appropriate.

(ii) Current period audit work should have regard to the opening balances to provide assurance as to the accuracy of the opening position

The accounts of each division are not being reported on individually.

Materiality, risk, the audit approach and extent of audit procedures must be assessed in the context of the company (‘consolidated’) accounts.

Sample sizes should be apportioned between divisions (e.g. by stratifying populations to divisions) to curb tendency to over audit.

The company operates Assets which are material to the balance sheet (inventory

The year end attendance at inventory counts should cover



from five locations and possibly premises, equipment, fixtures, etc.) are kept at five different locations.

all locations and take the opportunity to verify other assets, including tangible non-current assets and cash.

Cash sales are made to individuals

Increases the risk of misappropriation of cash and understatement of sales.

(i) Controls over cash must be evaluated and any weaknesses reported to management.

(ii) Audit effort should be directed to confirming the completeness of recorded sales for parts and accessories, and workshop in particular.

Computerised inventory information includes dates of movements, cost and selling price relevant to determining the adequacy of inventory provisions.

Computerised inventory records should be materially accurate and up-to-date (otherwise they would not be appropriate for raising purchase requisitions).

(i) If there are no significant differences between physical and book inventories

- Reliance may be placed on the accuracy of accounting entries to inventory records.

- Annual count need not be confined to year end as ‘roll-forward’ is possible.

- Continuous inventory checking may be facilitated.

(ii) Audit software may be used to produce an inventory ageing and report by exception.

- Slow-moving items (e.g. no movements in x months)

- Actual selling price less than original purchase price.

Standard mark-ups are used

Standard marks-ups facilitate budgetary control of divisional activities

Analytical procedures including ‘proof in total’ may confirm the completeness (or otherwise) of



recorded revenue. Parts transferred to workshops are charged at cost plus 10%

(i) Divisional trading at lower mark-ups gives incentive to interdivisional trading and could.

- Distort GP% subjected to analytical procedures.

- Conceal parts sales at more than the allowed margin.

(ii) Value of parts inventories held by workshop is inflated by 10% unrealised profit

(i) Inter-divisional trading should separately identified.

(ii) Although this is unlikely to be sufficiently material to warrant a year end adjustment, consideration should be given to the level of parts inventories held in the workshops. Quantities should be sufficient (to meet most immediate requirements) but not excessive (giving rise to risk of damage/theft)

Sales are made under franchise agreements with each manufacturer

A breach of franchise terms and conditions e.g. concerning prescribed mark-ups) could bring penalty clauses into effects.

(i) This aspect of inherent risk must be assessed. e.g.

- If low, there may be no implications for the financial statements (e.g. any contingent liability may be disregarded as being remote)

- If high (see also management bias) a provision for penalties could be required.

(ii) The appropriateness of the going concern assumption should be considered in the light of



- Any known breaches - Foreseeable renewals.

Monthly accounts and returns are prepared

These indicate a control conscious head office to mitigate the inherent risk attributable to divisional operations.

(i) The disaggregated financial information (by divisions and certain activities) should highlight key audit areas and fluctuations requiring investigation.

(ii) For analytical procedures on the company’s ‘consolidated’ accounts, the inter-divisional trading and balances must be eliminated.

Divisional managers have profit-related bonus incentives.

Inherent risk is increased by possible management bias to overstate profit by - Overstating sales - Understating expenses

(i) This bias may reduce other aspects of inherent risk (e.g. of loss of cash/inventory through unrecorded sales)

(ii) Risk of sales overstatement may not be great, since

- Maximum prices set by franchise agreement, and

- Market is fiercely competitive at present time.

(iii) Risk of expense understatement is restricted (e.g. because head office controls payroll expenditure)

(iv) Audit tests should be directed to most likely area of misstatement (e.g. ‘errors’ arising through suppression of invoices.

4. (a) Supervisor’s assumptions Objectives and limitations: Due to inherent limitations (including human

error/misunderstanding, collusion and override), an internal control system can only



provide reasonable confidence that internal control objectives (including completeness, accuracy and validity) are met.

(i) Completeness To ensure that all workers who should be paid are included on the payroll:

Payroll expense could be reconciled to production output records, and Management could review exception reports of employees having

personnel records but not included on the payroll. However, Cost/benefit i.e. the expense of setting up computerised personnel

records may outweigh the benefit to the company.(Risk is of over payment as employees entitled to pay are likely to bring non-payment to management’s attention promptly)

Changes in conditions A reduction in the ratio or production to support staff may limit the usefulness

of production output records as a basis of comparison. (ii) Accuracy

To prevent errors in payroll deductions: Calculations of PAYE,NICs etc. can be checked prior to processing and Non-statutory deductions (e.g. pension contributions, union subscriptions)

should require prior authorisation in writing. However, Human error/misunderstanding i.e. errors in deductions may not

be detected, due to fatigue, distraction, misjudgment or misinterpretation. Non-routing transactions

Systematic checking procedure may be directed at routing deductions (e.g. PAYE) rather than non-routing transactions) e.g. give as you earn, maintenance payments)

(iii) Validity To ensure that employee are only paid for work done

Hours worked per time sheets(or clock cards) can be approved by a departmental manager (or-supervisor), and

The duties of payroll preparation and payment should be segregated. However, Abuse or override i.e. authorisation could be given for a new

employee to be added to the payroll without the proper checks being carried out by the authoriser.

Collusion The person responsible for paying wages could collude with the person



responsible for accounting for wages to perpetrate and conceal a theft of wages. (b) Internal control terminology (i) Segregation of duties

Meaning: Segregation of duties is a factor reflected in the control environment (the overall attitude, awareness and actions of management regarding internal controls in the entity).

If one person has responsibility for the recording and processing of a complete transaction, he may also have the power to falsify the records or to misappropriate money or assets without being discovered.

Separation of these responsibilities will reduce the risk of intentional or unintentional errors occurring.

The functions that should normally be separated include authorisation, execution, custody and recording.

Example Calculation of PAYE and NIC deductions should be reviewed and

authorised by the payroll supervisor who is not actually involved in performing the calculations.

Unclaimed wages should be kept by someone (e.g. the cashier) other than the person responsible for recording payroll entries, otherwise there could be a temptation to falsify the figures and pocket some of the wage.

(ii) Approval and control of documents Meaning: Approval and control of documents is a specific control procedure

(aimed at preventing or detecting and correcting errors) Approval is concerned with ensuring that transactions are properly authorised

prior to execution. Control of documents is aimed at ensuring that all, and only valid transactions,

are promptly recorded. Example

Overtime pay should be approved by manager or director prior to payroll preparation, to ensure that employees are paid at authorised rates.

Clock cards should be batched and control totals established (e.g. number of cards, total hours worked, hash total of employee number) prior to submission to payroll department, to prevent (or detect for early investigation ) any omissions (or unauthorised insertions)

The numerical sequence of forms for new joiners should be checked periodically to detect omissions (or unauthorised insertions).



5. (a) On-line Real Time Processing System vs. Batch Processing System In an on-line real-time (OLRT) processing system, transactions are entered as they occur, and are processed as they are entered. These systems form the heart of management information systems. Given the continuous updating of the database as transactions are entered, the status of such files as accounts receivable, accounts payable, and inventory may be determined at any time. In an on-line real-time processing system, individual transactions are entered at terminal devices, validated and used to update related computer files immediately. An example is the application of cash receipts directly to customers’ accounts. The results of such processing are then available immediately for inquiries or reports.

In a system with on-line batch processing, individual transactions are entered at a terminal device, subjected to certain validation checks and added to a transaction file that contains other transactions entered during the period. Later, during a subsequent processing cycle, the transaction file may be validated further and then used to update the relevant master-file. For example, journal entries may be entered master-file being updated on a monthly basis. Inquiries of, or reports generated from, the master-file will not include transactions entered after the last master-file update. In a batch processing system which is not on-line, transactions are accumulated and processed in group sales orders for the day, invoices to be recorded, and daily cash receipts might each be viewed as a “batch” of transactions, to be processed as a group. Batch processing systems are distinguished by their relative simplicity and reliability. They do not process transactions as quickly as the more advanced systems, nor do they possess the potential for providing timely information concerning the files updated by transactions processing. Given these limitations, the use of networked PCs terminals has become widespread, even among small entities. Batch processing systems are rarely found in today’s systems environment.

Although powerful in terms of information capability, OLRT systems are more complex than batch processing systems. Moreover, they ordinarily do not provide the extent of audit trail documentation produced by batch system and for this they are more difficult to audit in terms of obtaining satisfaction concerning the existence of necessary controls, and of designing substantive testing procedures.

Conversely, in a batch processing system, the transaction are accumulated and processed in batches or groups. Control totals, both monetary and documentary, are also available for review to ensure completeness and accuracy of data being processed. The system is simple and reliable. However, its deficiency lies in the MIS is not updated on a concurrent basis and, therefore, information is not available on a timely basis.

Accordingly, it is a question of cost-benefit analysis as to which system will be more preferable to an entity.



(b) Internal control system include separation of duties, delegation of authority and responsibility, a system of authorisation, adequate documents and records, physical control over assets and records, management supervision, independent checks on performance and periodic reconciliation of assets with records. In CIS environment, all these components must exist but computers affects the implementation of these internal controls in many ways. Some of the effects are as under: (1) Separation of Duties - In a manual system, different persons are responsible

for carrying out function like initiating, recording of transaction, safeguarding of assets, does not always apply in a computer system. For example, in a computer system, a program may carryout reconciliation of vendor invoice against a receipt document and also prepares a cheque payable to creditors. Such operation through a program will be considered as incompatible functions in a manual system.

In minicomputer and microcomputer environments, separation of incompatible function could be even more difficult. Some such forms, allows, users to change programs and data entry without providing a record of these changes. Thus, it becomes difficult to determine whether incompatible function have been performed by system users.

(2) Delegation of Authority and Responsibility - A structured authority and responsibility is an essential control within manual and computer environment. In a computer system however, a clean line of authority and responsibility might be difficult to establish because some resources are shared among multiple users. For instance, one objective of using a data base management system is to provide multiple users with access to the same data, thereby reducing the control problems that arise with maintaining redundant data, when multiple users have access to the same data and the integrity of the data is somehow violated, it is not always easy to trace who is responsible for corrupting the data and who is responsible for identifying and correcting the error. Some organisation identified a single user as the owner of the data.

(3) Competent and Trustworthy Personnel - Skilled, competent, well-trained and experienced in formation system personnel have been in short supply. Since substantial power is often vested in the person responsible for the computer information system development, implementation, operation and maintenance within the organisation, competent and trustworthy personnel is very much in demand. Unfortunately, the non availability of competent personnel, forced many organisation to compromise on their choice of staff. Moreover, it is not always easy for organisation to assess the competence and integrity of their system staff. High turnover among those staff has been the norm. Some information systems personnel lack a well developed sense of ethics and some enjoy in subverting controls.

(4) System of Authorisation - Management authorisation of transaction may be either: (a) general authorisation to establish policies for the organisation,



(b) specific authorisation applying to individual transactions. In manual system, auditors evaluate the adequacy of procedures for authorisation by examining the work of employees. In a computer system, authorisation procedures often are embedded within a computer program. In a computer system, it is also more difficult to assess whether the authority assigned to individual persons is constant with managements policies. Thus, in evaluating the adequacy of authorisation procedures, auditors have to examine not only the work of employees but also the veracity of the programme processing.

(5) Adequate Documents and Records - In a manual system, adequate documents and records are required to provide an audit trail of activities within the system. In computer system, document support might not be necessary to initiate, execute and records some transaction. The task of a visible audit trail is not a problem for auditors, provided the systems have been designed to maintain a record of all events and that they are easily accessible. In well-designed computer systems, audit trails are more extensive than those maintained in manual systems unfortunately not all computer systems are well designed. This creates a serious control problem.

(6) Physical Control over Assets And Records - Physical access to assets and records is critical in both manual systems and computer system. In a computer system the information system assets and records may be concentrated at a single site. The concentration of information systems assets and record also increases the losses that can arise from computer abuse or disaster. If the organisation does not have another suitable backup, it might be unable to continue operations.

(7) Adequate Management Supervision - In a computer system, supervision of employee might have to be carried out remotely. Supervisory controls must be built into the computer system to compensate for the controls that usually can be exercised through observation and in inquiring computer system also make the activities of employees less visible to management. Because many activities are electronically controlled managers must periodically access the audit trial of employee activities and examine it for unauthorised actions.

(8) Independent Checks On Performance - Checks by an independent person help to detect any errors or irregularities. In a computer system, if a program code is authorised accurate, and complete the system will always follow the laid down procedures in absence of other type of failures like hardware or systems software failure. Thus, independent checks on the performance of programs often have little value. Instead, the control emphasis shifts to ensuring the veracity of programme code. Auditors, must now evaluate the controls established for program development, modification operation and maintenance.



(9) Comparing Recorded Accountability with Assets - In a manual system, independent staff prepares the basic data used for comparison purposes. In a computer system software is used to prepare this data. If unauthorised modifications occur to the program or the data files that the program uses, an irregularity might not be discovered, because traditional separation of duties no longer applies to the data being prepared for comparison purposes.

6. (a) Guidance Note on Accounting for Depreciation in companies issued by the Institute recommends that a company may adopt more than one method of depreciation. Therefore, it is permissible to adopt or follow different methods of depreciation, for different types of assets, provided the same methods are consistently adopted every year in terms of section 205(2) of the Companies Act, 1956. Also units in different geographical locations can follow different methods of depreciation on machinery provided the same are consistently followed. Therefore, Yuki Ltd. could continue to follow the previous method of charging depreciation for the acquired company, even if it is not in agreement with the method followed by Yuki Ltd. for their other units.

(b) The provision of loss of 10% of the contract value by Bhumi Ltd. in previous year is in the nature of accounting estimate since due to uncertainties inherent in any business activity; it is difficult to measure such item in a precise manner. Accordingly, adjusting the difference in the previous years’ account is not correct. AS-5 on Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies, states that the effect of a change in an accounting estimate should be included in determination of net profit or loss in the period of the change, if the change affects the period only. Thus, the management should adjust the difference in the current period only. Alternatively, the auditor should qualify his report.

7. Revised Schedule VI to the Companies Act, 1956 requires specific disclosure of loans granted by the company to its directors or parties such as firms or private companies in which director is a member or a director or a member. Thus, the company has failed to comply with the requirements of schedule VI vitiating true and fair view.

Further, the Companies Act, 1956 specifically deals with transactions in which particular directors are interested. Section 297 specifies that Board’s consent is required for certain contracts in which particular directors are interested i.e. a director of the company or his relative, a firm in which such a director or relative is a partner, any other partner in such a firm, or a private company of which the director is a member or director, for the sale, purchase or supply of any goods, materials or services. Section 299 requires disclosure of interest by a director as also lays down the procedure to be followed in this regard. Section 301 of the Companies Act, 1956 requires that every company shall keep one or more registers in which shall be entered separately particulars of all contracts or arrangements to which Section 297 or Section 299 applies, including the following particulars to the extent they are applicable in each case, namely:

(a) the date of the contract or arrangement;



(b) the names of the parties thereto; (c) the principal terms and conditions thereof; (d) in the case of a contract to which Section 297 applies or in the case of a contract or

arrangement to which sub-section (2) of Section 299 applies, the date on which it was placed before the Board;

(e) the names of the directors voting for and against the contract or arrangement and the names of those remaining neutral.

Thus, it is quite natural that all these particulars should have been recorded in such registers since the company advanced monies to various parties “related” to directors.

Still further, CARO, 2003 specifically requires the auditor to comment on the rate of interest and other terms and conditions of loans granted by the company (whether secured or unsecured) to companies, firms or other parties listed in the register maintained under Section 301 of the Act. There may be situations where the company has not properly maintained the register required to be maintained by it under Section 301. In such a case, the auditor should obtain the necessary information regarding the loans taken by the company from companies, firms or other parties in which the directors are interested, from the management of the company. However, while reporting on this clause, the auditor is required to clearly mention the fact of non-maintenance/improper maintenance of the aforesaid register. The auditor’s duty is to determine whether, in his opinion, the rate of interest and other terms and conditions of the loans are prima facie prejudicial to the interest of the company.

The aforesaid provisions aim to prevent siphoning off of funds as also exercise propriety in case of transactions with related parties and disclosure of the same. It appears that the auditor did not perform his duties properly. In the case of Deputy Secretary of the Government of India, Ministry of Finance vs. S.N. Dasgupta, the learned judge made certain observation as regards the duties of the auditor and method they should follow for discharging them satisfactorily and stated that, “verifying not merely the arithmetical accuracy of the statements of account but also their substantial accuracy by confirming that they include all the particulars requiring disclosure by the Articles or the Companies Act and otherwise represents true and fair state of affairs of the company.”

Therefore, the auditor has specific obligation to report under the Companies Act, 1956. Thus, he is liable under the Companies Act, 1956 and may be penalised under section 233 since he has performed his duties in a negligent manner. The auditor would also be held liable for professional misconduct under clause 7 of Second Schedule to the Chartered Accountants Act, 1949.

8. Reporting under Paragraph 4 (ix) of CARO, 2003: (I) As per Paragraph 4(ix)(b) CARO, 2003 “In case dues of Income Tax/Sales

Tax/Service Tax/ Customs Duty/ Wealth Tax/ Excise Duty/ Cess have not been deposited on account of any dispute, then the amounts involved and the forum



where dispute is pending shall be mentioned. However, a mere representation to the Department shall not constitute the dispute.”

The auditor should also obtain a management representation about the disputed dues, the amounts involved and the forum where the dispute is pending. The auditor should carry out necessary audit procedures to verify the information provided by the management.

The information may be reported in the Statement of Disputed Dues as nature of the dues, amounts, period which the amount relates and forum where dispute is pending.

In the present case, there is Income Tax demand of ` 157 Lacs and the company has gone for an appeal, it needs considerations as to whether the entire demand is disputed, because it is difficult to presume that the demand by Income Tax authority is without any basis. Therefore, As per AS 29 partly to the extent the company considered that the demand is based on some logical basis, that amount may be provided for and the remaining may be disclosed as the contingent liability. Further, it should be brought to notice of members by reporting under Paragraph 4(ix) (b) of CARO, 2003 as per the requirement mentioned therein;

(II) As per Paragraph 4 (ix) (a), the auditor has to report upon the regularity of the company in depositing undisputed statutory dues including provident fund, investor education and protection fund, employees’ state insurance, income-tax, sales-tax, wealth-tax, service tax, custom duty, excise duty, cess and any other statutory dues to appropriate authorities. If the company is not regular in depositing the above mentioned undisputed statutory dues, the auditor is required to state the extent of arrears of statutory dues which have remained outstanding as at the last day of the financial year concerned for a period of more than six months from the date they became payable.

With reference to the regularity, in case of custom duty on import of goods or demands arising on account of assessment orders etc., which a company is required to pay as and when an event giving rise to the liability of the company occurs. Such dues should be construed to have been paid regularly if the company deposits them as and when they become due. However, the auditor would be required to comment upon the regularity of the company in depositing the installments, if any, granted by an authority in respect of a demand against the company.

In the instant case, the demand notice has been received for Custom Duty of ` 65 Lacs on 15.09.2012 and is outstanding for more than 6 months, for which no action has been taken by the management, leads to the irregularity which should be brought to notice of members by reporting under Paragraph 4(ix)(a) of CARO, 2003.

9. (a) As per Para 4 (xi) of CARO, 2003 the auditors of a company has to state in his report that whether the Company has defaulted in repayment of its dues to financial institutions or bank or debentures holders and if yes the period and amount of



default to be reported. In this case Om Ltd has defaulted in repayment of dues for three years. Application

for rescheduling will not change the default position. Hence the auditor has to report in his audit report that the Company has defaulted in its repayment of dues to the bank to the extent of ` 90 lakhs.

(b) The auditor’s report under section 227 the Companies Act, 1956 has to specifically include certain matters specified in Para 4 and Para 5 of CARO 2003.

One of such matter is payment of dues to Government. As per Para 4 (ix)(b) of CARO, 2003, “In case dues of Income Tax/ Sales Tax/ Service Tax/ Customs Duty/ Wealth Tax/ Excise Duty/Cess have not been deposited on account of any dispute, then the amounts involved and the forum where dispute is pending shall be mentioned. A mere representation to the Department shall not constitute the dispute.”

In the present case issuance of show cause notice by Excise Department does not tantamount to demand payable by the Company. In as much as the Company has replied to the notice and no further correspondence was received from the Department, it has to be construed that there is no demand. The auditor needs not to report on this.

(c) SA 500 “Audit Evidence” states that an auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base his option.

Section 227 (IA) (e) the Companies Act, 1956 requires an auditor to report when personal expenses have been charged to revenue account.

In the context of the facts of case, ascertain whether the payment made by the company for the foreign trip form an “allowance” or “reimbursement”. An allowance is a fixed sum of money allowed or the basis of specified criteria. No evidence supporting the expenditure is required for payment of allowance to the director. On the other hand, if the payment is reimbursement should be against actual expenditure.

The director concerned should provide proof of expenditure. Since the director has given only a declaration, the auditor should ascertain other relevant facts as to whether the advance paid is pursuant to the policy of the company which is based on approximate estimation of the expenditure normally incurred by a person of the status of a director and the same is applicable to persons of a similar status within the company. If the auditor considers the advance taken is reasonable then the declaration can be considered adequate, otherwise he may have to call for additional documentary evidences.

10. (a) Corporate Governance: The word ‘Corporate’ is associated by legal enactment for the transaction of a business. Similarly, the word ‘Governance’ means exercise of



authority, direction or control. Thus, the concept of ‘Corporate Governance’ is the system by which the management of a business entity directs and controls the activities in the best interest of the stakeholder.

As per N. R Narayana Murthy, Chairman, Committee on Corporate Governance, SEBI, Mumbai, February 8, 2003

“Corporate governance is the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company.”

Clause 49 of the listing agreement covers SEBI guidelines regarding Corporate Governance. Issues addresses in Clause 49 regarding Corporate Governance are: • Board’s Director including its composition and compensation; • Provisions regarding Board’s Committee including composition and functioning

of Audit Committee which is an important pillar of the Corporate Governance; • Management of subsidiary companies; • Disclosures of important issues regarding related party transactions accounting

policies, principle of risk management, accounting for proceeds from public issues, right issues, preferential issues, etc;

• Content of management discussion and analysis; • Information to shareholders; • CEO/ CFO certification; • Report of Corporate Governance and compliance certificate.

(b) The main features of a qualified and independent audit committee to be set up under clause 49 of listing agreement are as follows: (i) The audit committee shall have minimum three directors as members. Two-

thirds of the members of audit committee shall be independent directors (ii) All members of audit committee shall be financially literate and at least one

member shall have accounting or related financial management expertise. (iii) The Chairman of the Audit Committee shall be an independent director (iv) The Chairman of the Audit Committee shall be present at Annual General

Meeting to answer shareholder queries (v) The audit committee may invite such of the executives, as it considers

appropriate (and particularly the head of the finance function) to be present at the meetings of the committee, but on occasions it may also meet without the presence of any executives of the company. The finance director, head of internal audit and a representative of the statutory auditor may be present as



invitees for the meetings of the audit committee (vi) The Company Secretary shall act as the secretary to the committee.

The term "financially literate" means the ability to read and understand basic financial statements i.e. balance sheet, profit and loss account, and statement of cash flows.

A member will be considered to have accounting or related financial management expertise if he or she possesses experience in finance or accounting, or requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.

11. (a) Permanent Consolidation Adjustments - Permanent consolidation adjustments are those adjustments that are made only on the first occasion of the preparation and presentation of consolidated financial statements. Permanent consolidation adjustments are: (i) determination of excess or deficit of the cost to the parent of its investment in a

subsidiary over the parent’s portion of equity of the subsidiary, at the date on which investment in the subsidiary is made (determination of goodwill or capital reserve);

(ii) determination of the amount of equity attributable to minorities at the date on which investment in subsidiary is made; and

(iii) determination of goodwill or capital reserve arising on application of equity method to account for investments in associates in consolidated financial statements.

The auditor should verify that the above calculations have been made appropriately. The auditor should pay particular attention to the determination of pre-acquisition reserves of the subsidiary and associates. Date(s) of investment in subsidiary and associates assumes importance in this regard. The auditor should also examine whether the pre-acquisition reserves have been allocated appropriately between the parent and the minorities of the subsidiary. The auditor should also verify the changes that might have taken place in these permanent adjustments on account of subsequent acquisition of shares in the subsidiary/ associates, disposal of the subsidiary/associate in the subsequent years. The auditor should also examine the joint venture agreements, to establish whether any change has taken place in the interest of the parent in the joint venture.

It may happen that in the case of one subsidiary, goodwill arises and in the case of another subsidiary a capital reserve arises. The parent may choose to net off these amounts to disclose a single amount in the consolidated balance sheet. In such cases, the auditor should verify that the gross amounts of goodwill and capital



reserves arising on acquisition of various subsidiaries have been disclosed in the notes to the consolidated financial statements to reflect the excess/shortage over the parents’ portion of the subsidiary’s equity.

(b) Following are the current period consolidation adjustments while making consolidation of financial statements. - Elimination of intra-group transactions relating to interest or management fees

etc. - Elimination of unrealized intra-group profits on assets acquired from other

subsidiaries. - Elimination of intra-group indebtedness. - Adjustments for harmonizing different accounting policies of parent unit and its

subsidiaries. - Adjustments for impairment loss that might exist for goodwill. - Adjustment for significant events that occur between date of financial

statements of the parent and of its components when the date/s of financial statements of components are different from the reporting date.

- Determination of movement in equity attributable to the minorities since the date of acquisition of the subsidiary.

- Treatment of minority interests’ share of the losses, if such losses exceed the minority interests’ share in the equity.

12. (a) There is an elaborate framework governing the functioning of banks in India. The whole of banking sector can be categorised into several sectors such as commercial banks, co-operative banks, foreign banks, etc. The principal enactments which govern the functioning of various types of bank are as under: ♦ Banking Regulation Act, 1949 ♦ State Bank of India Act, 1955 ♦ Companies Act, 1956 ♦ State Bank of India (Subsidiary Banks) Act, 1959 ♦ Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 ♦ Regional Rural Banks Act, 1976 ♦ Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 ♦ Information Technology Act, 2000 ♦ Prevention of Money Laundering Act, 2002 ♦ Securitisation and Reconstruction of Financial Assets and Enforcement of

Security Interest Act, 2002



♦ Credit Information Companies Regulation Act, 2005 ♦ Payment and Settlement Systems Act, 2007

Besides, the above enactments, the provisions of the Reserve Bank of India Act, 1934, also affect the functioning of banks. The Act gives wide powers to the RBI to give directions to banks which also have considerable effect on the functioning of banks

(b) (1) Verification of Bills Purchased and Discounted (a) The auditor should familiarise himself with the guidelines issued by the

RBI and the policies framed by the bank itself regarding the discounting and rediscounting of bills. The auditor should ascertain that the policy framed by the bank conforms to the requirements laid down by the RBI.

(b) Bills purchased and discounted have to be shown separately in the balance sheet as a part of ‘advances’. Further, under the head ‘advances outside India’ in the balance sheet, bills purchased and discounted outside India have to be shown separately. This category will include bills covering export of goods, bills discounted by foreign branches of the bank and payable in their respective countries, etc.

(c) Banks purchase or discount bills of exchange drawn or endorsed by their customers. The bank credits the amount of the bill to its customer after deducting the discount. The total amount of such bills is shown as an asset in the balance sheet.

In certain eligible cases, the bills purchased or discounted by the bank may be rediscounted by it with the RBI IDBI/SIDBI. Such bills would not be included under advance but would constitute a contingent liability.

(d) Bills purchased and discounted by the bank are generally drawn on outstation parties and are, therefore, sent by the bank to its branches or agents for collection immediately after their receipt. They are generally not in the possession of the bank on the closing date. The auditor therefore has to rely upon the Register of Bills Purchased and Discounted and the party-wise Register of Bills maintained by the bank. The auditor should examine these registers and satisfy himself that: (i) all the outstanding bills have been taken in the balance sheet; (ii) all the details, including the nature of the bills and documents, are

mentioned in the register and that the bills have been correctly classified;

(iii) the bills purchased or discounted from different parties are in accordance with the agreements with them and the total of outstanding bills of each party is not in excess of the sanctioned limit; and



(iv) the bills are not overdue. If there are any overdue bills, the auditors should ascertain the reasons for the delay and the action taken by the bank.

(a) The auditor should examine whether registers of bills purchased and discounted are properly maintained and the transactions are recorded therein correctly.

(b) Auditor should also examine whether the bills and the documents accompanying the bills are properly endorsed and assigned in favour of the bank. In checking the bills, it should be ensured that the bills are held along with the documents of title. In the case of documentary bills, it should be ensured that the related RRs/TRs are held along with the invoices/ hundies / bills and that these have not been parted with. Wherever such RRs/TRs are not held on record, the fact should be duly considered by the auditor.

(c) The auditor should also examine bills collected subsequent to the year-end to obtain assurance regarding completeness and validity of the recorded bill amounts

(2) Verification of Third Party Guarantees (a) The auditor should examine the guarantee bonds and the demand

promissory notes in order to verify the third party liability. (b) The auditor should also satisfy himself that the guarantee is in force as at

the date of the balance sheet. (c) In the absence of a provision to the contrary, a guarantee terminates by

revocation or upon death of the surety. The surety is also discharged (unless there is a specific covenant to the contrary) if the creditor arranges with the principal debtor for composition, or agrees to give time or agrees not to sue him, without consulting the surety.

(d) If any variation is made in the terms of the contract between the principal debtor and the creditor without the surety’s consent, it discharges the surety as to transactions subsequent to the variation.

(e) The guarantee forms used by banks normally seek to ensure the continuing obligation of the guarantor in spite of these contingencies.

(3) Verification of Provision for Non-performing assets (a) An important aspect of audit of advances relates to their classification and

provisioning. This implies that a proper provision should be made in respect of advances where the recovery is doubtful. Reserve Bank has prescribed objective norms for determining the quantum of provisions required in respect of advances. The auditors must take / download the latest Master Circular of RBI to familiarise himself fully with the norms



prescribed by RBI in this regard. The circulars issued by RBI after the date of issue of Master Circular and till the date of audit should also be taken / downloaded and reviewed by the auditors for its adherence. However, these norms should be construed as laying down the minimum provisioning requirements and wherever a higher provision is warranted in the context of the threats to recovery, such higher provision should be made.

(b) The accounting entry for provision in respect of debts that are doubtful of recovery is usually made at the head office level and is not recorded in the books at the branch level. The amount of provision to be made at the head office level is based largely on the classification of various advances into standard, sub-standard, doubtful and loss categories.

(c) The auditor should carefully examine whether the classification made by the branch is appropriate. In doing so, he should particularly examine the classification of advances where there are threats to recovery.

(d) The auditor should also examine whether the secured and the unsecured portions of advances have been segregated correctly and provisions have been calculated properly.

(e) As per the Reserve Bank guidelines, if an account has been regularised before the balance sheet date by payment of overdue amount through genuine sources, the account need not be treated as NPA. Where, subsequent to repayment by the borrower (which makes the account regular), the branch has provided further funds to the borrower (including by way of subscription to its debentures or in other accounts of the borrower), the auditor should carefully assess whether the repayment was out of genuine sources or not. Where the account indicates inherent weakness on the basis of the data available, the account should be deemed as a NPA. In other genuine cases, the banks must furnish satisfactory evidence to the Statutory Auditors about the manner of regularisation of the account to eliminate doubts on their performing status.

It is to be ensured that the classification is made as per the position as on date and hence classification of all standard accounts be reviewed as on balance sheet date. The date of NPA is of significant importance to determine the classification and hence specific care be taken in this regard.

13. Audit of Receipts and Payments Account: Section 11(1A) of the Insurance Act, 1938 provides that every insurer, in respect of insurance business transacted by him and in respect of his shareholders’ funds, should prepare at the end of each financial year, a Balance Sheet, a Profit and Loss Account, a separate account of receipts and payments and a Revenue Account in accordance with the Regulations made by the IRDA. Since



receipts and payments account has been made a part of financial statements of an insurer, it is implied that the receipts and payments account is also required to be audited.

The IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2002 require that the auditor of an insurance company should:

(i) report whether the receipts and payments account of the insurer is in agreement with the books of account and returns;

(ii) express an opinion as to whether the receipts and payments account has been prepared in accordance with the provisions of the relevant statutes; and

(iii) express an opinion whether the receipts and payments account give a true and fair view of the receipts and payments of the insurer for the financial year/period under audit.

It may hence be said that auditor is required to audit the Receipts and Payments Account of the insurer and also express an opinion on the same.

14. (a) Following are the special features in the audit of a cooperative society: - Examination of overdue debts. - Special treatment of over due interest in the determination of profit. - Certification of bad debts before write off. - Valuation of assets and liabilities - Adherence to co-operative Principles. - Observations of the Provisions of the Act and Rules - Verification of members’ Register and examination of their pass books - Special report to the registrar on fraud, mismanagement and personal

profiteering. - Audit classification of society based on the audit findings - Discussion of draft audit report with the managing committee. (b) (i) Overdue interest: Overdue interest should be excluded from interest

outstanding and accrued due while calculating profit. Overdue interest is interest accrued or accruing in accounts, the amount of which the principal is overdue. In practice an overdue interest reserve is created and the credit of overdue interest credited to interest account is reduced.

(ii) Compliance with provisions of the Act and Rules: An auditor of a co-operative society is required to point out the infringement with the provisions of the relevant Co-operative Act Rules and bye-laws. The auditor of a co-operative society is also required to point out various irregularities, improprieties, and departure from the provision of the Act, rules framed thereunder and the bye-laws of the society. The financial implications of such



infringements should be properly assessed and quantified by the auditor and they should be reported. Some of the State laws contain restrictions on the payment of dividends, which should be noted by the auditor and if dividend is declared in excess of the prescribed percentage, the fact should be reported by the auditor. Auditor should also ensure that various provisions in the Co-operative Societies Act, such as, restriction on borrowings, investment of funds, contribution to education funds, restriction on loans, etc are also complied with.

15. (a) Reporting requirement under Form 3CD: As per Clause 13(b) of Form 3CD, the details of the Refund duty of custom, if

admitted as due by the concerned authorities but not credited to the profit and loss account, are to be stated. But the Credits/Claims which have been admitted as due after the relevant previous year need not be reported in Form 3 CD.

In the instant case, the action of Titu Ltd in not crediting the claim to the profit and loss account and also not reporting of the same in Clause 13(b) of Form 3CD is in order.

Further Clause 11(b) requires reporting when there has been any change in the method of accounting employed vis-a-vis the accounting method employed in the immediately preceding year. However, change in an accounting policy will not amount to a change in the method of accounting and hence such change in the accounting policy need not be mentioned under Clause 11(b). It may be noted that change in the method of valuation of stock will amount to a change in accounting policy. However, it should be disclosed in the financial statements.

In the instant case, non-reporting of the change in the method of determination of cost formula of valuation of stock from FIFO to Weighted average Cost basis, in clause 11(b) of Form 3CD is in order.

Hence in the above situation, there is no reporting requirement under Clause 13(b) and Clause 11(b).

(b) Form 3 CD: The audit under section 44 AB of the Income Tax Act 1961 requires that the tax auditor should report whether in his opinion the particulars in respect of Form 3CD are true and correct. It is the primary responsibility of the assessee to prepare the information in form 3 CD. The auditor has to examine whether the information given is true and correct. The form 3 CD is not a report of Tax Auditor. The report is in the form of 3 CA or 3 CB depending on the nature of the organization of the entity. If the tax auditor is satisfied that the information contained in form 3 CD is true and correct then he can give unqualified report in form 3 CA or 3 CB saying" in my opinion and to the best of my information and according to the explanations given to me and considering the materiality the particulars given in form 3 CD are true and correct.” But in the given case the tax auditor has found that the form 3 CD contains the incomplete, misleading and false information.



Disallowance under section 40A(3) is attracted if the assessee incurs any expenses in respect of which payment of aggregate of payments made to a person in a day, otherwise than by an account payee cheque drawn on bank or account payee draft exceeds `20,000/- . However, exemption is provided in respect of certain expenditure in Rule 6DD. In such cases, disallowance under section 40A (3) would not be attracted.

Under clause 17 (h) of Form 3CD, amounts inadmissible under section 40A (3), read with Rule 6DD, have to be reported. Cash payment made on insistence of other parties on the contention that they do not have bank accounts is not covered under the list of exceptions provided under Rule 6DD.

Mr. Raj has to report the payments inadmissible under section 40A (3) under clause 17(h) of Form 3CD.

16. Comprehensive Audit of Public Enterprises: Areas to be examined: The scope and extent of audit of public sector enterprises is determined by the Comptroller and Auditor General of India. Audit of public enterprises in India is not restricted to financial and compliance audit; it extends also to efficiency, economy and effectiveness with which these operate and fulfill their objectives and goals. Another aspect of such audit relates to questions of propriety; this audit is directed towards an examination of management decisions in sales, purchases, contracts, etc. to see whether these have been taken in the best interests of the undertaking and conform to accepted principles of financial propriety. Comprehensive audit involves assessing efficiency and effectiveness of public enterprises in its entirety to be conducted on the basis of certain standards and criterion. Public enterprises have been set-up with socio-objectives. An objective assessment with reference to such objectives’ fulfillment would require comprehensive audit.

The starting point of a comprehensive audit of a public enterprise, which covers aspects of economy, efficiency and effectiveness, is the preparation of an audit programme based on the study of decisions relating to the setting up of the enterprise, its objectives, the areas of operation, organisation, financial and operational details available in the annual reports and accounts, capital and operational budgets, deliberations of the board of directors, material in the earlier audit inspection reports on the enterprise and other relevant available papers. These audit programmes (or guidelines) identify the areas/aspects which require further detailed audit analysis and criteria, the data required for such analysis and the sources of such data, the extent of the audit analysis including the test checks to be applied and the instructions to the audit parties assigned to the work.

The areas covered by comprehensive audit are those of investment decisions, project formulation and management, organisation, delegation of powers and management information systems, organisational effectiveness, capacity utilisation, management of equipment, plant and machinery, production performance, use of materials, productivity of labour, idle capacity, costs and prices, development of complementary ancillary small scale industries, materials management, sales and credit control, budgetary and internal control systems, etc. The areas covered in comprehensive audit will naturally vary from



enterprise to enterprise depending on the nature of the enterprise, its objectives and operations. Some of the broad areas are listed below: ♦ Comparison of overall capital cost of the project with the approved planned costs. ♦ Production or operational outputs vis-a-vis under-utilisation of the installed capacity. ♦ Systems of project formulation and implementation. ♦ Cost control measures. ♦ Research and development programmes. ♦ System of repairs and maintenance.

17. Adequate working capital is required for liquidity and smooth operations of the company. To ensure an adequate flow of working capital to the manufacturing company, the following action plan may be considered: (i) Working Capital Estimation: The company should start by preparing a statement

of the projected working capital requirements. This should be based on the functional budgets in sales, production, expenses, capital expenditure and the master budget consisting of projected profit and loss and the balance sheet.

(ii) Cash Flow Statement / Cash Budget: Month-wise cash budgets showing inflows and outflows of cash heading-wise should be prepared to analyse the major inflows and outflows affecting the entity. At this stage any wasteful outflow can be traced and eliminated. Bank reconciliation should be undertaken periodically so that outstandings can be traced and acted upon. This is also necessary to reduce the float time.

(iii) Inventory/Stock Management: Raw materials and inventories should be classified properly to determine the level of stock of materials. The method of costing also needs to be looked at minutely. There is a need to establish linkage with the production pattern and work backwards accounting for time factor in receipt of material. This needs to be worked out carefully since at no cost, production schedule should be hampered. The caution also needs to be exercised that there is no unused/obsolete inventory. The system of inventory management needs to be looked at so as to check the avoidable wastes/scraps generated during storage and handling. Just in time philosophy will enable the company to reduce processing time, stocks and related costs. The adoption of such a mechanism would bring down the cost to a considerable extent.

(iv) Credit Management: The Company should lay down a proper policy for evaluating customers, determining the credit period and offering discounts for early payment. An age-wise analysis of debtors should also be prepared so as to avoid credit to defaulters. The sale department needs to be geared up so that realisation can be made in time. A careful analysis should be done of various customers according to pattern of sales so as to exercise control on their respective debit balances. The



company should through its purchase department endeavour to avail the maximum credit period from its creditors. This would enhance the working capital of the company.

(v) Funds Flow Analysis: The Company should prepare a funds flow analysis, distinguishing between long-term and short-term sources and applications.

(vi) Investment Management: The idle funds of the company, if any, should be invested in short-term securities to augment the income.

(vii) WIP Analysis: Minimum WIP should be monitored and for the purpose it is necessary to ensure that no bottlenecks develop at any stage during the production process.

18. Steps involved while conducting investigation on behalf of an incoming partner: The general approach of the investigating accountant in this type of investigation would be more or less similar, irrespective of the nature of business of the firm-manufacturing, trading or rendering a service. Primarily, an incoming partner would be interested to know whether the terms offered to him are reasonable having regard to the nature of the business, profit records, capital distribution, personal capability of existing partners, socio-economic setting, etc. and whether he would be capable for services to be rendered, which can be justified by the overall economic conditions prevailing and other considerations considering his own personality and achievements. In addition, he would be interested to ascertain whether the capital to be contributed by him would be safe and applied usefully. Broadly, the steps should be taken by Seema on behalf of Smita are as under: (a) Ascertaining the history of the firm PQR Ltd since inception and growth of the firm. (b) Studies of the provisions of the Deed of Partnership, particularly for composition of

partners, their capital contribution, drawing rights, retirement benefits, job allocation, etc. (c) Scrutiny of the record of profitability of the PQR Ltd’s business over a suitable

number of years, with usual adjustments that are necessary in ascertaining the true record of business profits. Particular attention should, however, be paid to the nature and profitability of the business, qualification and expertise of the partners and such others as may be relevant.

(d) Examination of the asset and liability position to determine the tangible asset, partners, investment, appraisal of the value of intangibles like goodwill, know-how, patents, etc impending liabilities including contingent liabilities and those for pending tax assessment.

(e) Assess position of order at hand and the range and quality of clientele should be thoroughly examined under which the PQR Ltd. is presently operating.

(f) Scrutinise terms of loan finance to assess its usefulness and the implication for the overall financial position.

(g) Study important contractual and legal obligations should be ascertained and their nature studied. It may be the case that the firm PQR Ltd. has standing agreement



with the employees as regards salary and wages, bonus, gratuity and other incidental benefits. Full import of such standing agreements would be gauged before a final decision is reached.

(h) Study the composition and quality of key personnel employed by the PQR Ltd and any likelihood of their leaning the organisation.

(i) Ascertain reasons for the offer of admission to a new partner and it should be determined whether the same synchronizes with the retirement of any senior partner whose association may have had considerable impact having on the PQR Ltd’s successes.

(j) Appraisal of the record of capital employed and the rate of returns. It is necessary to have a comparison with alternative business avenues for investments and evaluation of possible results on a changed capital and organisation structure.

(k) Ascertain manner of computation of goodwill on admission as also on retirement, if any. (l) Examine whether any special clause exist in the Deed of Partnership to allow

admission in future a new partner. 19. (a) Failure to Exercise Reasonable Care and Skill: Apparently, as it appears from the

facts of the case that the auditor did not exercise proper skill and care and that he performed his work in a desultory and haphazard manner. In this matter, the test for auditor’s liability lies in whether he has applied reasonable care, skill and caution called for in the circumstances of the case and whether he reasonably used all the information that he came across in the course of audit.

Cash is a very significant item in any situation and the fact that the cashier had left during the year without notice should have placed the auditor on alert as regards the cash book. In fact, the very fact that the cashier was absconding, i.e., left without any notice constituted sufficient circumstances to excite suspicion of the auditor to probe to the bottom. As per SA 240, “The Auditor’s Responsibilities relating to Fraud in an Audit of Financial Statements”, it can be concluded that the auditor did not plan and perform the audit with an attitude of professional skepticism. Thus, having regard to this and a fraud has actually taken place during the year, committed by the absconding cashier, it is reasonable to think that prima facie there is a case against the auditor for gross negligence.

Clause (7) of Part I of Second Schedule to the CA Act, 1949 requires that it is the duty of an auditor to bring to bear in the work he has to perform that skill, care and caution as per the circumstances in an honest and reasonable manner. As it appears from the facts of the case, the auditor has been grossly negligent in performing his duties which constitutes professional misconduct. Conclusion:

Thus, such instances require reference to Disciplinary Committee of the Council of the Institute. If a member is found guilty by the Council of any of the acts or



omissions stated in the Schedule, its finding with recommendations are to be referred to the High Court for decision.

(b) Clause (1) of Part I of the Second Schedule to the Chartered Accountants Act, 1949 states that a chartered accountant in practice shall be deemed to be guilty of professional misconduct if he discloses information acquired in the course of his professional engagement to any person other than his client, without the consent of the client or otherwise than as required by law for the time being in force. SA 200 on "Basic Principles Governing an Audit" also reiterates that, "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". In the instant case, the bank has asked the auditor for detailed information regarding few items in the financial statements available in his working papers. Having regard to the position stated earlier, the auditor cannot disclose the information in his possession without specific permission of the client as far as working papers are concerned, SA 230 on "Audit Documentation" states "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". Conclusion:

Thus, there is no requirement compelling the auditor to divulge information obtained in the course of audit and included in the working papers to any outside agency except as and when required by any law.

(c) As per Clause 8 of Part I of First Schedule to the CA Act, 1949, A chartered accountant in practice is deemed to be guilty of professional misconduct if he accepts a position as auditor previously held by another chartered accountant or a certified auditor who has been issued certificate under the Restricted Certificates Rules 1932, without first communicating with him in writing.

In the instant case, Binaca & Co. accepted VAT – audit under State Level Act, carried out by another firm of chartered accountants in the previous year, without prior communication with the previous auditor. Conclusion:

A communication is mandatory requirement for all types of audit, if the previous auditor is a chartered accountant. Hence, the firm is guilty of professional misconduct.

(d) As per Clause 5 of Part I of Second Schedule to the Chartered Act, 1949, if a chartered accountant in practice shall be deemed to be guilty of professional misconduct, if he fails to disclose a material fact known to him which is not disclosed in the financial statement, but disclosure of which is necessary in making such financial statement in a professional capacity.



In the instant case, Qurashi was in duty bound to see that the nature and subject matter of the charge over a security and the nature and mode of valuation of the Sinking Fund Investments were disclosed in the Balance Sheet of Zee Ltd., in accordance with Form F. Conclusion:

Hence, Q was found guilty of misconduct. (e) Responding to Tenders: Clause (6) of Part I of the First Schedule to the Chartered

Accountants Act, 1949 lays down guidelines for responding to tenders, etc. As per the guidelines if a matter relates to any services other than audit, members can respond to any tender. Further, in respect of a non-exclusive area, members are permitted to pay reasonable amount towards earnest money/security deposits.

In the instance case, since computerisation of property takings records does not fall within exclusive areas for chartered accountants, M/s Appu can respond to tender as well as deposit ` 60,000 as earnest deposit and shall not have committed any professional misconduct.

20. (a) Financial Indications and Going Concern: SA 570 on “Going Concern”, aims 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. The following are the financial indications to be considered:

♦ Net liability or net current liability position. ♦ Fixed-term borrowings approaching maturity without realistic prospects of

renewal or repayment; or excessive reliance on short-term borrowings to finance long-term assets.

♦ Indications of withdrawal of financial support by creditors. ♦ Negative operating cash flows indicated by historical or prospective financial

statements. ♦ Adverse key financial ratios. ♦ Substantial operating losses or significant deterioration in the value of assets

used to generate cash flows. ♦ Arrears or discontinuance of dividends. ♦ Inability to pay creditors on due dates. ♦ Inability to comply 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.



(b) Reconciliation of Cost and Financial Accounts: A cost auditor is ultimately required to express an opinion as to whether the company has maintained proper cost accounting records so as to give a true and fair view of cost of production etc. In arriving at this opinion, the cost auditor is required to ascertain about multitude of information such as cost of raw materials consumed, cost of power and scrap fuel cost of stock, employer costs, provision for depreciation, royalty and technical payment, abnormal cost, etc. Annexure to the cost audit reports requires detailed information in respect of financial position including capital employed, net worth, profit, net rates, operating profit, unit cost of power and fuel, total wages and salaries etc. It is obvious therefore that cost audit cannot be done without reference to financial books, more so in the context of the statutory requirement to have a statement of reconciliation with financial accounts as part of cost audit report. Further the cost statements are to contain a summary of all expenditure incurred by the company and the share in such expenditure attributable to the activities covered by Cost Accounting Records Rules; Overhead expenditure also needs allocation between activities covered by rules and activities not so covered. Naturally this can be done only with reference to financial ledger. Under Part II of Schedule VI to the Companies Act, 1956, quite a few matters which are to be mentioned in the Profit and Loss Account of the company are also to be covered in cost statements such as consumption of raw materials in quantity and value, sale of finished goods under classified headings in quantity and nature, actual production quantity of value, inventory in quantity of value for each class of goods, etc. A correlation between consumption of raw materials as per cost records and financial records may through up the need for inquiry into errors, mistakes and manipulation. Material discrepancy between financial records and cost records will be highlighted in the reconciliation statement which would required that the cost auditor may examine deviation before reporting on the same. Thus it is imperative for the cost auditor to refer to financial records.

(c) Cut-off Procedures: Cut-off procedures mean procedures employed to ensure the separation of transactions at the end of one year from those in the commencement of the next year. Usually, the problem of overlapping is found in inventory accounting since quite often goods are sold but passed on to the buyer only after the year is over or goods are bought but received only after the close of the year. This situation may create considerable problem for the proper stock taking of inventory. Therefore, the principal areas of application of cut-off procedures involve sales, purchases and stock. The auditor should satisfy himself by examination and test check that these procedures adequately ensure that: (a) Goods purchased for which property has passed to the client have in fact been

included in inventories and that the liability if any, has been provided for. (b) Goods sold have been excluded from the inventories and credit has been

taken for sales. The auditor may examine a sample of documents evidencing the movement of



stocks into and out of stores, including documents pertaining to period shortly before and shortly after the cut-off date, and check whether the stocks represented by those documents were included or excluded, as appropriate, during the stock-taking.

(d) Facultative Re-Insurance: It is that type of reinsurance whereby contract relates to one particular risk and is expressed in the reinsurance policy. Each transaction has to be negotiated individually. Each party has free choice i.e., ceding company to offer and insurer to accept. The Insurance is used when: (i) Automatic cover has exhausted. (ii) Risk is excluded from treaties (iii) Reinsurance treaties have not to be over burdened for abnormal risks. (iv) When insurer has no automatic cover. (v) Where technical guidance is required at each stage of acceptance of risk.
