PAPS 1006: Audits of the Financial Statements of Banks PDF

PAPS 1006 Auditing Standards and Practices Council Philippine Auditing Practice Statement 1006 AUDITS OF THE FINANCIAL STATEMENTS OF BANKS  PAPS 1006 PHILIPPINE AUDITING PRACTIC...

PAPS 1006 Auditing Standards and Practices Council Philippine Auditing Practice Statement 1006 AUDITS OF THE FINANCIAL STATEMENTS OF BANKS  PAPS 1006 PHILIPPINE AUDITING PRACTICE STATEMENT 1006 AUDITS OF THE FINANCIAL STATEMENTS OF BANKS CONTENTS Paragraphs Introduction 1-8 Audit Objectives 9-11 Agreeing the Terms of Engagement 12-14 Planning the Audit Introduction 15 Obtaining a Knowledge of the Business 16-28 Development of an Overall Audit Plan 29-55 Internal Control Introduction 57 Identifying, Documenting and Testing Control Procedures 58-67 Example of Controls 68 Inherent Limitations of Internal Control 69 Considering the Influence of Environmental Factors 70 Performing Substantive Procedures Introduction 71-72 Audit Procedures 73-81 Specific Procedures in Respect of Particular Items in the Financial Statements 82-100 Reporting on the Financial Statements 101-103 Effective Date 104-105 Acknowledgment 106-107  PAPS 1006 -2- Appendices: Appendix 1: Risks and Issues in Respect of Fraud and Illegal Acts Appendix 2: Examples of Internal Control Considerations and Substantive Procedures for Two Areas of a Bank’s Operations Appendix 3: Examples of Financial Information, Ratios and Indicators Commonly Used in the Analysis of a Bank’s Financial Condition and Performance Appendix 4: Risks and Issues in Securities Underwriting and Securities Brokerage Appendix 5: Risks and Issues in Private Banking and Asset Management Appendix 6: Glossary of Terms Appendix 7: Reference Materials  PAPS 1006 -3- Philippine Auditing Practice Statements (PAPSs or Statements) are issued by the Philippine Auditing Standards and Practices Council (ASPC) to provide practical assistance to auditors in implementing the Philippine Standards on Auditing (PSAs) or to promote good practice. Statements do not have the authority of PSAs. This Statement is based on IAPS 1006, issued in December 2001 by the International Auditing Practices Committee (IAPC) of the International Federation of Accountants. The IAPC bank audit sub-committee included observers from the Basel Committee on Banking Supervision (the Basel Committee)*. This Statement does not establish any new basic principles or essential procedures; its purpose is to assist auditors, and to develop good practice, by providing guidance on the application of the PSAs to the audits of the financial statements of banks. The auditor exercises professional judgment to determine the extent to which any of the audit procedures described in this Statement may be appropriate in the light of the requirements of the PSAs and the bank’s particular circumstances. * The Basel Committee on Banking Supervision is a committee of banking and supervisory authorities that was established by the central bank governors of ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. It usually meets at the Bank of International Settlements in Basel, where its permanent secretariat is located.  PAPS 1006 Audits of the Financial Statements of Banks Introduction 1. The purpose of this Statement is to provide practical assistance to auditors and to promote good practice in applying Philippine Standards on Auditing (PSAs) to the audit of banks’ financial statements. It is not, however, intended to be an exhaustive listing of the procedures and practices to be used in such an audit. In conducting an audit in accordance with PSAs the auditor complies with all the requirements of all the PSAs. 2. The Bangko Sentral ng Pilipinas (BSP) requires that the auditor report certain events to them or make regular reports to them in addition to the audit report on the banks’ financial statements. This Statement does not deal with such reports. PAPS 1004, “The Relationship Between Bangko Sentral ng Pilipinas (BSP) and Bank’s External Auditors” discusses that subject in more detail. 3. For the purpose of this Statement, a bank is a type of financial institution whose principal activity is the taking of deposits and borrowing for the purpose of lending and investing and that is recognized as a bank by the BSP1. The guidance in this Statement is applicable to audits of financial statements that cover the banking activities carried out by those entities. It also applies to the audits of consolidated financial statements that include the results of banking activities carried out by any group member. This Statement addresses the assertions made in respect of banking activities in the entity’s financial statements and so indicates which assertions in a bank’s financial statements cause particular difficulties and why they do so. This necessitates an approach based on the elements of the financial statements. However, when obtaining audit evidence to support the financial statement assertions, the auditor often carries out procedures based on the types of activities the entity carries out and the way in which those activities affect the financial statement assertions. 4. Banks commonly undertake a wide range of activities. However, most banks continue to have in common the basic activities of deposit taking, borrowing, lending, settlement, trading and treasury operations. This Statement’s primary purpose is the provision of guidance on the audit implications of such activities. In addition, this Statement provides limited guidance in respect of securities underwriting and brokerage, and asset management, which are activities that 1 Under the General Banking Law of 2000 (R.A. 8791), “banks” refers to entities licensed by the BSP that are engaged in the lending of funds obtained in the from of deposits. Banks are classified as: (a) universal banks (UBs); (b) commercial banks (KBs); (c) thrift banks (TBs) composed of savings and mortgage banks and stock savings and loan associations; (d) rural banks (RBs); (e) cooperative banks; (f) Islamic banks; and (g) other classification of banks as may be determined by the Monetary Board of the BSP.  PAPS 1006 -2- auditors of banks’ financial statements frequently encounter. Banks typically undertake activities involving derivative financial instruments. This Statement gives guidance on the audit implications of such activities when they are part of the bank’s trading and treasury operations. PAPS 1012, “Auditing Derivative Financial Instruments” gives guidance on such activities when the bank holds derivatives as an end user. 5. This Statement is intended to highlight those risks that are unique to banking activities. There are many audit-related matters that banks share with other commercial entities. The auditor is expected to have a sufficient understanding of such matters and so, although those matters may affect the audit approach or may have a material effect on the bank’s financial statements, this Statement does not discuss them. This Statement describes in general terms aspects of banking operations with which an auditor becomes familiar before undertaking the audit of a bank’s financial statements: it is not intended to describe banking operations. Consequently, this Statement on its own does not provide an auditor with sufficient background knowledge to undertake the audit of a bank’s financial statements. However, it does point out areas where that background knowledge is required. Auditors will supplement the guidance in this Statement with appropriate reference material and by reference to the work of experts as required. 6. Banks have the following characteristics that generally distinguish them from most other commercial enterprises: They have custody of large amounts of monetary items, including cash and negotiable instruments, whose physical security has to be safeguarded during transfer and while being stored. They also have custody and control of negotiable instruments and other assets that are readily transferable in electronic form. The liquidity characteristics of these items make banks vulnerable to misappropriation and fraud. Banks therefore need to establish formal operating procedures, well-defined limits for individual discretion and rigorous systems of internal control. They often engage in transactions that are initiated in one jurisdiction, recorded in a different jurisdiction and managed in yet another jurisdiction. They operate with very high leverage (that is, the ratio of capital to total assets is low), which increases banks’ vulnerability to adverse economic events and increases the risk of failure. They have assets that can rapidly change in value and whose value is often difficult to determine. Consequentially, a relatively small decrease in asset values may have a significant effect on their capital and potentially on their regulatory solvency.  PAPS 1006 -3- They generally derive a significant amount of their funding from short- term deposits (either insured or uninsured). A loss of confidence by depositors in a bank’s solvency may quickly result in a liquidity crisis. They have fiduciary duties in respect of the assets they hold that belong to other persons. This may give rise to liabilities for breach of trust. They therefore need to establish operating procedures and internal controls designed to ensure that they deal with such assets only in accordance with the terms on which the assets were transferred to the bank. They engage in a large volume and variety of transactions whose value may be significant. This ordinarily requires complex accounting and internal control systems and widespread use of Information Technology (IT). They ordinarily operate through networks of branches and departments that are geographically dispersed. This necessarily involves a greater decentralization of authority and dispersal of accounting and control functions, with consequential difficulties in maintaining uniform operating practices and accounting systems, particularly when the branch network transcends national boundaries. Transactions can often be directly initiated and completed by the customer without any intervention by the bank’s employees, for example over the Internet or through automatic teller machines (ATMs). They often assume significant commitments without any initial transfer of funds other than, in some cases, the payment of fees. These commitments may involve only memorandum accounting entries. Consequently, their existence may be difficult to detect. They are regulated by the BSP, whose regulatory requirements often influence the accounting principles that banks follow. Non-compliance with regulatory requirements, for example, capital adequacy requirements, could have implications for the bank’s financial statements or the disclosures therein. Customer relationships that the auditor, assistants, or the audit firm may have with the bank might affect the auditor’s independence in a way that customer relationships with other organizations would not. They generally have exclusive access to clearing and settlement systems for checks, fund transfers, foreign exchange transactions, etc.  PAPS 1006 -4- They are an integral part of, or are linked to, national and international settlement systems and consequently could pose a systemic risk to the countries in which they operate. They may issue and trade in complex financial instruments, some of which may need to be recorded at fair values in the financial statements. They therefore need to establish appropriate valuation and risk management procedures. The effectiveness of these procedures depends on the appropriateness of the methodologies and mathematical models selected, access to reliable current and historical market information, and the maintenance of data integrity. 7. Special audit considerations arise in the audits of banks because of matters such as the following: The particular nature of the risks associated with the transactions undertaken by banks. The scale of banking operations and the resultant significant exposures that may arise in a short period. The extensive dependence on IT to process transactions. The effect of the regulations in the various jurisdictions in which they operate. The continuing development of new products and banking practices that may not be matched by the concurrent development of accounting principles or internal controls. 8. This Statement is organized into a discussion of the various aspects of the audit of a bank with emphasis being given to those matters that are either peculiar to, or of particular importance in, such an audit. Included for illustrative purposes are appendices that contain examples of: (a) typical warning signs of fraud in banking operations; (b) typical internal controls, tests of control and substantive audit procedures for two of the major operational areas of a bank: treasury and trading operations and lending activities; (c) financial ratios commonly used in the analysis of a bank’s financial condition and performance; and (d) risks and issues in securities operations, private banking and asset management.  PAPS 1006 -5- Audit Objectives 9. PSA 200, “Objective and General Principles Governing an Audit of Financial Statements,” states: The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with generally accepted accounting principles in the Philippines. 10. The objective of the audit of a bank’s financial statements conducted in accordance with PSAs is, therefore, to enable the auditor to express an opinion on the bank’s financial statements, which are prepared in accordance with accounting principles generally accepted in the Philippines. 11. The auditor’s report indicates that accounting principles generally accepted in the Philippines have been used to prepare the bank’s financial statements. When reporting on financial statements of a bank prepared specifically for use in a country other than the Philippines, the auditor considers whether the financial statements contain appropriate disclosures about the financial reporting framework used. Paragraphs 101–103 of this Statement discuss the auditor’s report in more detail. Agreeing the Terms of the Engagement 12. As stated in PSA 210, “Terms of Audit Engagements”: The engagement letter documents and confirms the auditor’s acceptance of the appointment, the objective and scope of the audit, the extent of the auditor’s responsibilities to the client and the form of any reports. 13. Paragraph 6 lists some of the characteristics that are unique to banks and indicates the areas where the auditor and assistants may require specialist skills. In considering the objective and scope of the audit and the extent of the responsibilities, the auditor considers his own skills and competence and those of his assistants to conduct the engagement. In doing so, the auditor considers the following factors: the need for sufficient expertise in the aspects of banking relevant to the audit of the bank’s business activities; the need for expertise in the context of the IT systems and communication networks the bank uses; and  PAPS 1006 -6- the adequacy of resources or inter-firm arrangements to carry out the work necessary at the number of domestic and international locations of the bank at which audit procedures may be required. 14. In addition to the general factors set out in PSA 210, the auditor considers including comments on the following when issuing an engagement letter. The use and source of specialized accounting principles, with particular reference to: o any requirements contained in the law or regulations applicable to banks; o pronouncements of the BSP and other regulatory authorities (e.g., the Philippine Deposit Insurance Commission); o pronouncements of relevant professional accounting bodies, for example, the Philippine Accounting Standards Council; o pronouncements of the Basel Committee on Banking Supervision; and o industry practice. The contents and form of the auditor’s report on the financial statements and any special-purpose reports required from the auditor in addition to the report on the financial statements.2 This includes whether such reports refer to the application of regulatory or other special purpose accounting principles or describe procedures undertaken especially to meet regulatory requirements. The nature of any special communication requirements or protocols that may exist between the auditor and the BSP and other regulatory authorities (e.g., the Philippine Deposit Insurance Commission, SEC). The access that the BSP will be granted to the auditor’s working papers, and the bank’s advance consent to this access. 2 The auditor should consider including in the engagement letter the reports required by the BSP on certain matters under Circular No. 245, Series of 2000, dated May 25, 2000, as amended by BSP Circular No. 318, series of 2000. See also PAPS 1004.  PAPS 1006 -7- Planning the Audit Introduction 15. The audit plan includes, among other things: obtaining a sufficient knowledge of the entity’s business and governance structure, and a sufficient understanding of the accounting and internal control systems, including risk management and internal audit functions; considering the expected assessments of inherent and control risks, being the risk that material misstatements occur (inherent risk) and the risk that the bank’s system of internal control does not prevent or detect and correct such misstatements on a timely basis (control risk); determining the nature, timing and extent of the audit procedures to be performed; and considering the going concern assumption regarding the entity’s ability to continue in operation for the foreseeable future, which will be the period used by management in making its assessment under generally accepted accounting principles in the Philippines. This period will ordinarily be for a period of at least one year after the balance sheet date. Obtaining a Knowledge of the Business 16. Obtaining a knowledge of the bank’s business requires the auditor to understand: the bank’s corporate governance structure; the economic and regulatory environment in which the bank operates; and the market conditions existing in each of the significant sectors in which the bank operates. 17. Corporate governance plays a particularly important role in banks; the BSP sets out requirements for banks to have effective corporate governance structures. Accordingly, the auditor obtains an understanding of the bank’s corporate governance structure and how those charged with governance discharge their responsibilities for the supervision, control and direction of the bank. 18. Similarly the auditor obtains and maintains a good working knowledge of the products and services offered by the bank. In obtaining and maintaining that knowledge, the auditor is aware of the many variations in the basic deposit, loan and treasury services that are offered and continue to be developed by banks in  PAPS 1006 -8- response to market conditions. The auditor obtains an understanding of the nature of services rendered through instruments such as letters of credit, acceptances, interest rate futures, forward and swap contracts, options and other similar instruments in order to understand the inherent risks and the auditing, accounting and disclosure implications thereof. 19. If the bank uses service organizations to provide core services or activities, such as cash and securities settlement, the responsibility for compliance with rules and regulations and sound internal controls remains with those charged with governance and the management of the outsourcing bank. The auditor considers legal and regulatory restrictions,3 and obtains an understanding of how the management and those charged with governance monitor that the system of internal control (including internal audit) operates effectively. PSA 402, “Audit Considerations Relating to Entities Using Service Organizations” gives further guidance on this subject. 20. There are a number of risks associated with banking activities that, while not unique to banking, are important in that they serve to shape banking operations. The auditor obtains an understanding of the nature of these risks and how the bank manages them. This understanding allows the auditor to assess the levels of inherent and control risks associated with different aspects of a bank’s operations and to determine the nature, timing and extent of the audit procedures. Understanding the nature of banking risks 21. The risks associated with banking activities may broadly be categorized as: Country risk: the risk of foreign customers and counterparties failing to settle their obligations because of economic, political and social factors of the counterparty’s home country and external to the customer or counterparty; Credit risk: the risk that a customer or counterparty will not settle an obligation for full value, either when due or at any time thereafter. Credit risk, particularly from commercial lending, may be considered the most important risk in banking operations. Credit risk arises from lending to individuals, companies, banks and governments. It also exists in assets other than 3 BSP Circular No 268, Series of 2000, dated December 5, 2000, discusses the duties and responsibilities of banks and their directors/officers with respect to outsourcing of banking functions. Circular 268 provides that no bank shall outsource inherent banking functions. (Outsourcing of inherent banking functions refers to any contract for outsourcing of services related to the deposit transactions of the bank.) It also discusses functions that may be outsourced by a bank subject to Monetary Board approval (such as information technology systems/processes).  PAPS 1006 -9- loans, such as investments, balances due from other banks and in off-balance sheet commitments. Credit risk also includes country risk, transfer risk, replacement risk and settlement risk. Currency risk: the risk of loss arising from future movements in the exchange rates applicable to foreign currency assets, liabilities, rights and obligations. Fiduciary risk: the risk of loss arising from factors such as failure to maintain safe custody or negligence in the management of assets on behalf of other parties. Interest rate risk: the risk that a movement in interest rates would have an adverse effect on the value of assets and liabilities or would affect interest cash flows. Legal and the risk that contracts are documented incorrectly or documentary risk: are not legally enforceable in the relevant jurisdiction in which the contracts are to be enforced or where the counterparties operate. This can include the risk that assets will turn out to be worth lesser, liabilities will turn out to be greater than expected because of inadequate or incorrect legal advice or documentation. In addition, existing laws may fail to resolve legal issues involving a bank; a court case involving a particular bank may have wider implications for the banking business and involve costs to it and many or all other banks; and laws affecting banks or other commercial enterprises may change. Banks are particularly susceptible to legal risks when entering into new types of transactions and when the legal right of a counterparty to enter into a transaction is not established. Liquidity risk: the risk of loss arising from the changes in the bank’s ability to sell or dispose of an asset. Modeling risk: the risk associated with the imperfections and subjectivity of valuation models used to determine the values of assets or liabilities. Operational risk: the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.  PAPS 1006 -10- Price risk: the risk of loss arising from adverse changes in market prices, including interest rates, foreign exchange rates, equity and commodity prices and from movements in the market prices of investments. Regulatory risk: the risk of loss arising from failure to comply with regulatory or legal requirements in the relevant jurisdiction in which the bank operates. It also includes any loss that could arise from changes in regulatory requirements. Replacement risk: (sometimes called performance risk) the risk of failure of a customer or counterparty to perform the terms of a contract. This failure creates the need to replace the failed transaction with another at the current market price. This may result in a loss to the bank equivalent to the difference between the contract price and the current market price. Reputational risk: the risk of losing business because of negative public opinion and consequential damage to the bank’s reputation arising from failure to properly manage some of the above risks, or from involvement in improper or illegal activities by the bank or its senior management, such as money laundering or attempts to cover up losses. Settlement risk: the risk that one side of a transaction will be settled without value being received from the customer or counterparty. This will generally result in the loss to the bank of the full principal amount. Solvency risk: the risk of loss arising from the possibility of the bank not having sufficient funds to meet its obligations, or from the bank’s inability to access capital markets to raise required funds. Transfer risk: the risk of loss arising when a counterparty’s obligation is not denominated in the counterparty’s home currency. The counterparty may be unable to obtain the currency of the obligation irrespective of the counterparty’s particular financial condition.  PAPS 1006 -11- 22. Banking risks increase with the degree of concentration of a bank’s exposure to any one customer, industry, geographic area or country. For example, a bank’s loan portfolio may have large concentrations of loans or commitments to particular industries, and some, such as real estate, shipping and natural resources, may have highly specialized practices. Assessing the relevant risks relating to loans to entities in those industries may require a knowledge of these industries, including their business, operational and reporting practices. 23. Most transactions involve more than one of the risks identified above. Furthermore, the individual risks set out above may be correlated with one another. For example, a bank’s credit exposure in a securities transaction may increase as a result of an increase in the market price of the securities concerned. Similarly, non-payment or settlement failure can have consequences for a bank’s liquidity position. The auditor therefore considers these and other risk correlations when analyzing the risks to which a bank is exposed. 24. Banks may be subject to risks arising from the nature of their ownership. For example, a bank’s owner or a group of owners might try to influence the allocation of credit. In a closely held bank, the owners may have significant influence on the bank’s management affecting their independence and judgment. The auditor considers such risks. 25. In addition to understanding the external factors that could indicate increased risk, the auditor considers the nature of risks arising from the bank’s operations. Factors that contribute significantly to operational risk include the following: The need to process high volumes of transactions accurately within a short time. This need is almost always met through the large-scale use of IT, with the resultant risks of: o failure to carry out executed transactions within the required time, causing an inability to receive or make payments for those transactions; o failure to carry out complex transactions properly; o wide-scale misstatements arising from a breakdown in internal control; o loss of data arising from systems’ failure; o corruption of data arising from unauthorized interference with the systems; and o exposure to market risks arising from lack of reliable up-to-date information.  PAPS 1006 -12- The need to use electronic funds transfer (EFT) or other telecommunications systems to transfer ownership of large sums of money, with the resultant risk of exposure to loss arising from payments to incorrect parties through fraud or error. The conduct of operations in many locations with a resultant geographic dispersion of transaction processing and internal controls. As a result: o there is a risk that the bank’s worldwide exposure by customer and by product may not be adequately aggregated and monitored; and o control breakdowns may occur and remain undetected or uncorrected because of the physical separation between management and those who handle the transactions. The need to monitor and manage significant exposures that can arise over short time-frames. The process of clearing transactions may cause a significant build-up of receivables and payables during a day, most of which are settled by the end of the day. This is ordinarily referred to as intra-day payment risk. These exposures arise from transactions with customers and counterparties and may include interest rate, currency and market risks. The handling of large volumes of monetary items, including cash, negotiable instruments and transferable customer balances, with the resultant risk of loss arising from theft and fraud by employees or other parties. The inherent complexity and volatility of the environment in which banks operate, resulting in the risk of inappropriate risk management strategies or accounting treatments in relation to such matters as the development of new products and services. Operating restrictions may be imposed as a result of the failure to adhere to laws and regulations. Overseas operations are subject to the laws and regulations of the countries in which they are based as well as those of the country in which the parent entity has its headquarters. This may result in the need to adhere to differing requirements and a risk that operating procedures that comply with regulations in some jurisdictions do not meet the requirements of others. 26. Fraudulent activities may take place within a bank by, or with the knowing involvement of, management or personnel of the bank. Such frauds may include fraudulent financial reporting without the motive of personal gain, (for example, to conceal trading losses), or the misappropriation of the bank’s assets for  PAPS 1006 -13- personal gain that may or may not involve the falsification of records. Alternatively, fraud may be perpetrated on a bank without the knowledge or complicity of the bank’s employees. PSA 240, “Fraud and Error,” gives more guidance on the nature of the auditor’s responsibilities with respect to fraud. Although many areas of a bank’s operations are susceptible to fraudulent activities, the most common take place in the lending, deposit-taking and dealing functions. The methods commonly used to perpetrate fraud and a selection of the fraud risk factors that indicate that a fraud may have occurred are set out in Appendix 1. 27. By the nature of their business, banks are ready targets for those engaged in money laundering activities by which the proceeds of crime are converted into funds that appear to have a legitimate source. In recent years drug traffickers in particular have greatly added to the scale of money laundering that takes place within the banking industry. Republic Act No. 9160, “The Anti- Money Laundering Act of 2001” requires banks to establish policies, procedures and controls to deter and to recognize and report money laundering activities. These policies, procedures and controls commonly extend to the following. A requirement to obtain customer identification (“know your client”). Staff screening. A requirement to know the purpose for which an account is to be used. The maintenance of transaction records. The reporting to the authorities of suspicious transactions or of all transactions of a particular type, for example, cash transactions over a certain amount. The education of staff to assist them in identifying suspicious transactions. An auditor who discovers a possible instance of noncompliance with laws or regulations considers the implications for the financial statements and the audit opinion thereon. PSA 250, "Consideration of Laws and Regulations in an Audit of Financial Statements" gives further guidance on this matter. Understanding the risk management process 28. Management develops controls and uses performance indicators to aid in managing key business and financial risks. An effective risk management system in a bank generally requires the following: Oversight and involvement in the control process by those charged with governance  PAPS 1006 -14- Those charged with governance should approve written risk management policies. The policies should be consistent with the bank’s business strategies, capital strength, management expertise, regulatory requirements and the types and amounts of risk it regards as acceptable. Those charged with governance are also responsible for establishing a culture within the bank that emphasizes their commitment to internal controls and high ethical standards, and often establish special committees to help discharge their functions. Management is responsible for implementing the strategies and policies set by those charged with governance and for ensuring that an adequate and effective system of internal control is established and maintained. Identification, measurement and monitoring of risks Risks that could significantly impact the achievement of the bank’s goals should be identified, measured and monitored against pre-approved limits and criteria. This function may be conducted by an independent risk management unit, which is also responsible for validating and stress testing the pricing and valuation models used by the front and back offices. Banks ordinarily have a risk management unit that monitors risk management activities and evaluates the effectiveness of risk management models, methodologies and assumptions used. In such situations, the auditor considers whether and how to use the work of that unit. Control activities A bank should have appropriate controls to manage its risks, including effective segregation of duties (particularly between front and back offices), accurate measurement and reporting of positions, verification and approval of transactions, reconciliations of positions and results, setting of limits, reporting and approval of exceptions to limits, physical security and contingency planning. Monitoring activities Risk management models, methodologies and assumptions used to measure and manage risk should be regularly assessed and updated. This function may be conducted by an independent risk management unit. Internal auditing should test the risk management process periodically to check whether management polices and procedures are complied with and whether the operational controls are effective. Both the risk management unit and internal auditing should have a reporting line to those charged with governance and management that is independent of those on whom they are reporting.  PAPS 1006 -15- Reliable information systems Banks require reliable information systems that provide adequate financial, operational and compliance information on a timely and consistent basis. Those charged with governance and management require risk management information that is easily understood and that enables them to assess the changing nature of the bank’s risk profile. Development of an Overall Audit Plan 29. In developing an overall plan for the audit of the financial statements of a bank, the auditor gives particular attention to: the complexity of the transactions undertaken by the bank and the documentation in respect thereof; the extent to which any core activities are provided by service organizations; contingent liabilities and off-balance sheet items; regulatory considerations; the extent of IT and other systems used by the bank; the expected assessments of inherent and control risks; the work of internal auditing; the assessment of audit risk; the assessment of materiality; management’s representations; the involvement of other auditors; the geographic spread of the bank’s operations and the co-ordination of work between different audit teams; the existence of related party transactions; and going concern considerations. These matters are discussed in subsequent paragraphs. The complexity of transactions undertaken 30. Banks typically have a wide diversity of activities, which means that it is sometimes difficult for an auditor to fully understand the implications of particular transactions. The transactions may be so complex that management  PAPS 1006 -16- itself fails to analyze properly the risks of new products and services. The wide geographic spread of a bank’s activities can also lead to difficulties. Banks undertake transactions that have complex and important underlying features that may not be apparent from the documentation that is used to process the transactions and to enter them into the bank’s accounting records. This results in the risk that all aspects of a transaction may not be fully or correctly recorded or accounted for, with the resultant risks of: loss due to the failure to take timely corrective action; failure to make adequate provisions for loss on a timely basis; and inadequate or improper disclosure in the financial statements and other reports. The auditor obtains an understanding of the bank’s activities and the transactions it undertakes 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. 31. Many of the amounts to be recorded or disclosures made in the financial statements involve the exercise of judgment by management, for example, loan loss provisions, and provisions against financial instruments such as liquidity risk provision, modeling risk provision and reserve for operational risk. The greater the judgment required, the greater the inherent risk and the greater the professional judgment required by the auditor. Similarly, there may be other significant items in the financial statements that involve accounting estimates. The auditor considers the guidance set out in PSA 540, “Audit of Accounting Estimates.” The extent to which any core activities are provided by service organizations 32. In principle, the considerations when a bank uses service organizations are no different from the considerations when any other entity uses them. However, banks sometimes use service organizations to perform parts of their core activities, such as credit and cash management.4 When the bank uses service organizations for such activities, the auditor may find it difficult to obtain sufficient appropriate audit evidence without the cooperation of the service organization. PSA 402 provides further guidance on the auditing considerations and the types of reports that auditors of service organizations provide to the organization’s clients. Contingent liabilities and off-balance sheet items 4 See footnote 3.  PAPS 1006 -17- 33. Banks also typically engage in transactions that: have a low fee revenue or profit element as a percentage of the underlying asset or liability; local regulations may not require to be disclosed in the balance sheet, or even in the notes to the financial statements; are recorded only in memorandum accounts; or involve securitizing and selling assets so that they no longer appear in the bank’s financial statements. Examples of such transactions are safe custody services, guarantees, comfort letters and letters of credit, interest rate and currency swaps and commitments and options to purchase and sell foreign exchange. 34. The auditor reviews the bank’s sources of revenue, and obtains sufficient appropriate audit evidence regarding the following: (a) the accuracy and completeness of the accounting records relating to such transactions; (b) the existence of proper controls to limit the banking risks arising from such transactions; (c) the adequacy of any provisions for loss which may be required; and (d) the adequacy of any financial statement disclosures which may be required. Regulatory considerations 35. PAPS 1004 provides information and guidance on the relationship between bank’s external auditors and BSP. The Basel Committee and the BSP have issued supervisory guidance regarding sound banking practices for managing risks, internal control systems, loan accounting and disclosure, other disclosures and for other areas of bank activities. In addition, the Basel Committee has issued guidance on the assessment of capital adequacy and other important supervision topics. This guidance is available to the auditor and to the public on the internet web site of the Bank for International Settlements (BIS) and BSP. 36. In accordance with PSA 310, the auditor considers whether the assertions in the financial statements are consistent with the auditor’s knowledge of the business.  PAPS 1006 -18- In many regulatory frameworks5, the level and types of business a bank is allowed to undertake depend upon the level of its assets and liabilities and the types and perceived risks attached to those assets and liabilities (a risk-weighted capital framework). In such circumstances, there are greater pressures for management to engage in fraudulent financial reporting by miscategorizing assets and liabilities or by describing them as being less risky than they actually are, particularly when the bank is operating at, or close to, the minimum required capital levels. 37. There are many procedures that both auditors and the BSP perform, including: the performance of analytical procedures; obtaining evidence regarding the operation of the internal control system; and the review of the quality of a bank’s assets and the assessment of banking risks. The auditor therefore finds it advantageous to interact with the BSP and to have access to communications that the BSP may have addressed to the bank management on the results of their work. The assessment made by the BSP in important areas such as the adequacy of risk management practices and provisions for loan losses, and the prudential ratios used by the BSP can be of assistance to the auditor in performing analytical procedures and in focusing attention on specific areas of supervisory concern. The extent of IT and other systems 38. The high volume of transactions and the short times in which they must be processed typically result in most banks making extensive use of IT, EFT and other telecommunications systems. The control concerns arising from the use of IT by a bank are similar to those arising when IT is used by other organizations. However, the matters that are of particular concern to the auditor of a bank include the following. The use of IT to calculate and record substantially all of the interest income and interest expense, which are ordinarily two of the most important elements in the determination of a bank’s earnings. The use of IT and telecommunications systems to determine the foreign exchange security and derivative trading positions, and to calculate and record the gains and losses arising from them. 5 In the Philippines, the type of business a bank is allowed to undertake depends on the type of bank license (e.g., universal bank, commercial bank, thrift bank, rural bank, etc.) and the special authorities granted to it by the BSP.  PAPS 1006 -19- The extensive, and in some cases almost total, dependence on the records produced by IT because they represent the only readily accessible source of detailed up-to-date information on the bank’s assets and liability positions, such as customer loan and deposit balances. The use of complex valuation models incorporated in the IT systems. The models used to value assets and the data used by those models are often kept in spreadsheets prepared by individuals on personal computers not linked to the bank’s main IT systems and not subject to the same controls as applications on those systems. PAPS 1001, “CIS Environments—Stand-Alone Personal Computers” provides guidance to auditors in respect of these applications. The use of different IT systems resulting in the risk of loss of audit trail and incompatibility of different systems. EFT systems are used by banks both internally (for example, for transfers between branches and between automated banking machines and the computerized files that record account activity) and externally between the bank and other financial institutions (for example, through the SWIFT network) and also between the bank and its customers through the internet or other electronic commerce media. 39. The auditor obtains an understanding of the core IT, EFT and telecommunication applications and the links between those applications. The auditor relates this understanding to the major business processes or balance sheet positions in order to identify the risk factors for the organization and therefore for the audit. In addition, it is important to identify the extent of the use of self-developed applications or integrated systems, which will have a direct effect on the audit approach. (Self-developed systems require the auditor to focus more extensively on the program change controls.) 40. When auditing in a distributed IT environment, the auditor obtains an understanding of where the core IT applications are located. If the bank’s wide area network (WAN) is dispersed over several countries, specific legislative rules might apply to cross-border data processing. In such an environment, audit work on the access control system, especially on the access violation system, is an important part of the audit. 41. An electronic commerce environment changes significantly the way the bank conducts its business. Electronic commerce presents new aspects of risk and  PAPS 1006 -20- other considerations that the auditor addresses.6 For example, the auditor considers the following. The business risks the bank’s e-commerce strategy presents. The risks inherent in the technology the bank has chosen to implement its e-commerce strategy. Management’s responses to the risks identified, including control considerations regarding: o compliance with legal and regulatory requirements in respect of cross-border transactions; o the security and privacy of transmissions across the Internet; and o the completion, accuracy, timeliness and authorization of Internet transactions as they are recorded in the bank’s accounting system. The level of IT and e-commerce skill and competence the auditor and assistants possess. 42. An organization may outsource IT or EFT related activities to an external service provider. The auditor gains an understanding of the outsourced services and the system of internal controls within the outsourcing bank and the vendor of the services, in order to determine the nature, extent and timing of substantive procedures. PSA 402 gives further guidance on this subject. Expected assessment of inherent and control risks 43. The nature of banking operations is such that the auditor may not be able to reduce audit risk to an acceptably low level by the performance of substantive procedures alone. This is because of factors such as the following. The extensive use of IT and EFT systems, which means that much of the audit evidence is available only in electronic form and is produced by the entity’s own IT systems. The high volume of transactions entered into by banks, which makes reliance on substantive procedures alone impracticable. The geographic dispersion of banks’ operations, which makes obtaining sufficient coverage extremely difficult. 6 See BSP guidelines on electronic banking activities (e.g., Circular No. 240 and 269, Series of 2000) and “Electronic Commerce Act of 2000” (R.A. No. 8792).  PAPS 1006 -21- The difficulty in devising effective substantive procedures to audit complex trading transactions. In most situations, the auditor will not be able to reduce audit risk to an acceptably low level unless management has instituted an internal control system that allows the auditor to be able to assess the level of inherent and control risks as less than high. The auditor obtains sufficient appropriate audit evidence to support the assessment of inherent and control risks. Paragraphs 56–70 discuss matters relating to internal control in more detail. The work of internal auditing 44. The scope and objectives of internal auditing may vary widely depending upon the size and structure of the bank and the requirements of management and those charged with governance. However, the role of internal auditing ordinarily includes the review of the accounting system and related internal controls, monitoring their operation and recommending improvements to them. It also generally includes a review of the means used to identify, measure and report financial and operating information and specific inquiry into individual items including detailed testing of transactions, balances and procedures. The factors referred to in paragraph 43 also often lead the auditor to use the work of internal auditing. This is especially relevant in the case of banks that have a large geographic dispersion of branches. Often, as a part of the internal audit department or as a separate component, a bank has a loan review department that reports to management on the quality of loans and the adherence to established procedures in respect thereof. In either case, the auditor often considers making use of the work of the loan review department after an appropriate review of the department and its work. Guidance on the use of the work of internal auditing is provided in PSA 610, “Considering the Work of Internal Auditing.” Audit risk 45. The three components of audit risk are: (a) inherent risk (the risk that material misstatements occur); (b) control risk (the risk that the bank’s system of internal control does not prevent or detect and correct such misstatements on a timely basis); and (c) detection risk (the risk that the auditor will not detect any remaining material misstatements). Inherent and control risks exist independently of the audit of financial information and the auditor cannot influence them. The nature of risks associated with banking activities, which are discussed in paragraphs 21 to 25, indicate that the  PAPS 1006 -22- assessed level of inherent risk in many areas will be high. It is therefore necessary for a bank to have an adequate system of internal control if the levels of inherent and control risks are to be less than high. The auditor assesses these risks and designs substantive procedures so as to reduce audit risk to an acceptably low level. Materiality 46. In making an assessment of materiality, in addition to the considerations set out in PSA 320, “Audit Materiality,” the auditor considers the following factors. Because of high leverage, relatively small misstatements may have a significant effect on the results for the period and on capital, even though they may have an insignificant effect on total assets. A bank’s earnings are low when compared to its total assets and liabilities and its off-balance sheet commitments. Therefore, misstatements that relate only to assets, liabilities and commitments may be less significant than those that may also relate to the statement of earnings. Banks are often subject to regulatory requirements, such as the requirement to maintain minimum levels of capital. A breach of these requirements could call into question the appropriateness of management’s use of the going concern assumption. The auditor therefore establishes a materiality level so as to identify misstatements that, if uncorrected, would result in a significant contravention of such regulatory requirements. The appropriateness of the going concern assumption often depends upon matters related to the bank’s reputation as a sound financial institution and actions by regulators. Because of this, related party transactions and other matters that would not be material to entities other than banks may become material to a bank’s financial statements if they might affect the bank’s reputation or actions by regulators. Management’s representations 47. Management’s representations are relevant in the context of a bank audit to assist the auditor in determining whether the information and evidence obtained is complete for the purposes of the audit. This is particularly true of the bank’s transactions that may not ordinarily be reflected in the financial statements (off- balance sheet items), but which may be evidenced by other records of which the auditor may not be aware. It is often also necessary for the auditor to obtain from management representations regarding significant changes in the bank’s business and its risk profile. It may also be necessary for the auditor to identify areas of a bank’s operations where audit evidence likely to be obtained may need to be  PAPS 1006 -23- supplemented by management’s representations, for example, loan loss provisions and the completeness of correspondence with regulators. PSA 580, “Management Representations” provides guidance as to the use of management representations as audit evidence, the procedures that the auditor applies in evaluating and documenting them, and the circumstances in which representations should be obtained in writing. Involvement of other auditors 48. As a result of the wide geographic dispersion of offices in most banks, it is often necessary for the auditor to use the work of other auditors in many of the locations in which the bank operates. This may be achieved by using other offices of the auditor’s firm or by using other auditing firms in those locations.7 49. Before using the work of another auditor, the auditor: considers the independence of those auditors and their competence to undertake the necessary work (including their knowledge of banking and applicable regulatory requirements); considers whether the terms of the engagement, the accounting principles to be applied and the reporting arrangements are clearly communicated; and performs procedures to obtain sufficient appropriate audit evidence that the work performed by the other auditor is adequate for this purpose by discussion with the other auditor, by a review of a written summary of the procedures applied and findings, by a review of the working papers of the other auditor, or in any other manner appropriate to the circumstances. PSA 600, “Using the Work of Another Auditor” provides further guidance on the issues to be addressed and procedures to be performed in such situations. Coordinating the work to be performed 50. Given the size and geographic dispersion of most banks, coordinating the work to be performed is important to achieve an efficient and effective audit. The coordination required takes into account factors such as the following. The work to be performed by: o experts; o assistants; 7 The auditor should consider whether the other auditors who will be involved in the audit are accredited by the BSP. For banks with foreign operations, the auditor should consider discussing with the bank the accreditation of the auditors of such foreign operations.  PAPS 1006 -24- o other offices of the auditor’s firm; and o other audit firms. The extent to which it is planned to use the work of internal auditing. Required reporting dates to shareholders and the regulatory authorities. Any special analyses and other documentation to be provided by bank management. 51. The best level of coordination between assistants can often be achieved by regular audit-status meetings. However, given the number of assistants and the number of locations at which they will be involved, the auditor ordinarily communicates all or relevant portions of the audit plan in writing. When setting out the requirements in writing, the auditor considers including commentary on the following matters. The financial statements and other information that are to be audited (and if considered necessary, the legal or other mandate for the audit). Details of any additional information requested by the auditor, for example, information on certain loans, portfolio composition, narrative commentary on the audit work to be performed (especially on the areas of risk described in paragraphs 21 to 25 which are important to the bank) and on the results of the audit work, potential points for inclusion in letters to management on internal control, local regulatory concerns, and if relevant, the forms of any required reports. That the audit is to be conducted in accordance with PSAs and any local regulatory requirements (and, if considered necessary, information on those requirements). The relevant accounting principles to be followed in the preparation of the financial statements and other information (and, if considered necessary, the details of those principles). Interim audit status reporting requirements and deadlines. Particulars of the entity’s officials to be contacted. Fee and billing arrangements.  PAPS 1006 -25- Any other concerns of a regulatory, internal control, accounting or audit nature of which those conducting the audit should be aware. Related party transactions 52. The auditor remains alert for related party transactions during the course of the audit, particularly in the lending and investment areas. Procedures performed during the planning phase of the audit, including obtaining an understanding of the bank and the banking industry, may be helpful in identifying related parties. Under BSP regulations8, related party transactions are subject to quantitative or qualitative restrictions. The auditor determines the extent of any such restrictions. Going concern considerations 53. PSA 570, “Going Concern” provides guidance as to the auditor’s consideration of the appropriateness of management’s use of the going concern assumption. In addition to matters identified in that PSA, events or conditions such as the following may also cast significant doubt on the bank’s ability to continue as a going concern. Rapid increases in levels of trading in derivatives. This may indicate that the bank is carrying out trading activities without the necessary controls in place. Profitability performance or forecasts that suggest a serious decline in profitability, particularly if the bank is at or near its minimum regulatory capital or liquidity levels. Rates of interest being paid on money market and depositor liabilities that are higher than normal market rates. This may indicate that the bank is viewed as a higher risk. Significant decreases in deposits from other banks or other forms of short term money market funding. This may indicate that other market participants lack confidence in the bank. Actions taken or threatened by regulators that may have an adverse effect on the bank’s ability to continue as a going concern. Increased amount due to BSP, which may indicate that the bank was unable to obtain liquidity from normal market sources. High concentrations of exposures to borrowers or to sources of funding. 8 See Section 36 of the General Banking Law 2000.  PAPS 1006 -26- 54. PSA 570 also provides guidance to auditors when an event or condition that may cast significant doubt on the bank’s ability to continue as a going concern has been identified. The PSA indicates a number of procedures that may be relevant, and in addition to those, the following procedures may also be relevant. Reviewing correspondence with the BSP. Reviewing reports issued by the BSP as a result of regulatory inspections. Discussing the results of any inspections currently in process. 55. The BSP may require the auditor to disclose concerns that the auditor may have about the bank’s ability to continue as a going concern. PAPS 1004 provides further discussion of the relationship between the auditor and the BSP. Internal Control Introduction 56. The Basel Committee on Banking Supervision has issued a policy paper, "Framework for Internal Control Systems in Banking Organisations" (September 1998), which provides banking supervisors with a framework for evaluating banks’ internal control systems. This framework is used by many banking supervisors, and may be used during supervisory discussions with individual banking organizations. Auditors of banks’ financial statements may find a knowledge of this framework useful in understanding the various elements of a bank’s internal control system. 57. Management’s responsibilities include the maintenance of an adequate accounting system and internal control system, the selection and application of accounting policies, and the safeguarding of the assets of the entity. The auditor obtains an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach. After obtaining the understanding, the auditor considers the assessment of inherent and control risks so as to determine the appropriate detection risk to accept for the financial statement assertions and to determine the nature, timing and extent of substantive procedures for such assertions. Where the auditor assesses control risk at less than high, substantive procedures are ordinarily less extensive than are otherwise required and may also differ in their nature and timing. Identifying, Documenting and Testing Control Procedures  PAPS 1006 -27- 58. PSA 400, "Risk Assessments and Internal Control" indicates that internal controls relating to the accounting system are concerned with achieving objectives such as the following. Transactions are executed in accordance with management’s general or specific authorization (paragraphs 59–61). All transactions and other events are promptly recorded at the correct amount, in the appropriate accounts and in the proper accounting period so as to permit preparation of financial statements in accordance with accepted principles generally accepted in the Philippines (paragraphs 62 and 63). Access to assets is permitted only in accordance with management’s authorization (paragraphs 64 and 65). Recorded assets are compared with the existing assets at reasonable intervals and appropriate action is taken regarding any differences (paragraphs 66 and 67). The audit considerations in relation to each of these objectives are discussed in the subsequent paragraphs. In the case of banks, a further objective of internal controls is to ensure that the bank adequately fulfills its regulatory and fiduciary responsibilities arising out of its trustee activities. The auditor is not directly concerned with these objectives except to the extent that any failure to comply with such responsibilities might have led to the financial statements being material misstated. 59. The overall responsibility for the system of internal control in a bank rests with those charged with governance, who are responsible for governing the bank’s operations. However, since banks’ operations are generally large and dispersed, decision-making functions need to be decentralized and the authority to commit the bank to material transactions is ordinarily dispersed and delegated among the various levels of management and staff. Such dispersion and delegation will almost always be found in the lending, treasury and funds transfer functions, where, for example, payment instructions are sent via a secure message. This feature of banking operations creates the need for a structured system of delegation of authority, resulting in the formal identification and documentation of: (a) those who may authorize specific transactions; (b) procedures to be followed in granting that authorization; and  PAPS 1006 -28- (c) limits on the amounts that can be authorized, by individual employee or by staff level, as well as any requirements that may exist for concurring authorization. Those charged with governance also need to ensure that appropriate procedures exist for monitoring the level of exposures. This will ordinarily involve the aggregation of exposures, not only within, but also across, the different activities, departments and branches of the bank. 60. An examination of the authorization controls will be important to the auditor in considering whether transactions have been entered into in accordance with the bank’s policies and, for example, in the case of the lending function, that they have been subject to appropriate credit assessment procedures prior to the disbursement of funds. The auditor will typically find that limits for levels of exposures exist in respect of various transaction types. When performing tests of controls, the auditor considers whether these limits are being adhered to and whether positions in excess of these limits are reported to the appropriate level of management on a timely basis. 61. From an audit perspective, the proper functioning of a bank’s authorization controls is particularly important in respect of transactions entered into at or near the date of the financial statements. This is because aspects of the transaction have yet to be fulfilled, or there may be a lack of evidence with which to assess the value of the asset acquired or liability incurred. Examples of such transactions are commitments to purchase or sell specific securities after the period-end and loans, where principal and interest payments from the borrower have yet to be made. All transactions and other events are promptly recorded at the correct amount, in the appropriate accounts and in the proper accounting period so as to permit preparation of financial statements in accordance with accounting principles generally accepted in the Philippines. 62. In considering the internal controls that management use to ensure that all transactions and other events are properly recorded, the auditor takes into account a number of factors that are especially important in a banking environment. These include the following. Banks deal in large volumes of transactions that can individually or cumulatively involve large sums of money. Accordingly, the bank needs to have balancing and reconciliation procedures that are carried out within a time-frame that allows the detection of errors and discrepancies so that they can be investigated and corrected with minimal loss to the bank. Such procedures may be carried out hourly, daily, weekly, or monthly, depending on the volume and nature of the transaction, level of risk, and transactions settlement time-frame. The purpose of these reconciliations is often to ensure the completeness of transaction processing across highly  PAPS 1006 -29- complex integrated IT systems and the reconciliations themselves are normally automatically generated by these systems. Many of the transactions entered into by banks are subject to specialized accounting rules. Banks should have control procedures in place to ensure those rules are applied in the preparation of appropriate financial information for management and external reporting. Examples of such control procedures are those that result in the market revaluation of foreign exchange and security purchase and sale commitments so as to ensure that all unrealized profits and losses are recorded. Some of the transactions entered into by banks may not be required to be disclosed in the financial statements (for example, transactions that generally accepted accounting principles allow to be regarded as off balance sheet items). Accordingly, control procedures must be in place to ensure that such transactions are recorded and monitored in a manner that provides management with the required degree of control over them and that allows for the prompt determination of any change in their status that needs to result in the recording of a profit or loss. Banks are constantly developing new financial products and services. The auditor considers whether the necessary revisions are made in accounting procedures and related internal controls. End of day balances may reflect the volume of transactions processed through the systems or of the maximum exposure to loss during the course of a business day. This is particularly relevant in executing and processing foreign exchange and securities transactions. The assessment of controls in these areas takes into account the ability to maintain control during the period of maximum volumes or maximum financial exposure. The majority of banking transactions must be recorded in a manner that is capable of being verified both internally and by the bank’s customers and counterparties. The level of detail to be recorded and maintained on individual transactions must allow the bank’s management, transaction counterparties, and customers to verify the accuracy of the amounts and terms. An example of such a control is the continuous verification of foreign exchange trade tickets by having an employee not involved in the transaction match the tickets to incoming confirmations from counterparties. 63. The extensive use of IT and EFT systems has a significant effect on how the auditor evaluates a bank's accounting system and related internal controls. PSA 400, "Risk Assessments and Internal Control," PSA 401, "Auditing in a Computer Information Systems Environment," and PAPS 1008, "Risk Assessments and  PAPS 1006 -30- Internal Control-CIS Characteristics and Considerations," provide guidance on the IT aspects of such an evaluation, as do other PAPSs dealing with information technology. The audit procedures include an assessment of those controls that affect system development and modifications, system access and data entry, the security of communications networks, and contingency planning. Similar considerations apply to EFT operations within the bank. To the extent that EFT and other transaction systems are external to the bank, the auditor gives additional emphasis to the assessment of the integrity of pre-transaction supervisory controls and post-transaction confirmation and reconciliation procedures. Reports from the auditors of service organizations may be of use here, and PSA 402 gives guidance on the auditor's consideration of such reports. 64. A bank’s assets are often readily transferable, of high value and in a form that cannot be safeguarded solely by physical procedures. In order to ensure that access to assets is permitted only in accordance with management’s authorization, a bank generally uses controls such as the following. Passwords and joint access arrangements to limit IT and EFT system access to authorized employees. Segregation of the record-keeping and custody functions (including the use of computer generated transaction confirmation reports available immediately and only to the employee in charge of the record-keeping functions). Frequent third-party confirmation and reconciliation of asset positions by an independent employee. 65. The auditor considers whether each of these controls is operating effectively. However, given the materiality and transferability of the amounts involved, the auditor also ordinarily reviews the confirmation and reconciliation procedures that occur in connection with the preparation of the year-end financial statements and may carry out confirmation procedures himself. 66. The large amounts of assets handled by banks, the volumes of transactions undertaken, the potential for changes in the value of those assets due to fluctuations in market prices and the importance of confirming the continued operation of access and authorization controls necessitates the frequent operation of reconciliation controls. This is particularly important for: (a) assets in negotiable form, such as cash, bearer securities and assets in the form of deposit and security positions with other institutions where failure to detect errors and discrepancies quickly (which may mean daily where money market transactions are involved) could lead to an irrecoverable  PAPS 1006 -31- loss: reconciliation procedures used to achieve this control objective will ordinarily be based on physical counting and third party confirmation; (b) assets whose value is determined with reference to valuation models or external market prices, such as securities and foreign exchange contracts; and (c) assets held on behalf of clients. 67. In designing an audit plan to assess the effectiveness of a bank’s reconciliation controls, the auditor considers factors such as the following. Because of the number of accounts requiring reconciliation and the frequency with which these reconciliations need to be performed: o much of the audit effort is directed to the documentation, testing and evaluation of the reconciliation controls; and o the work of the internal auditor will also be similarly directed. The auditor therefore can ordinarily use the work of internal auditing. Since reconciliations are cumulative in their effect, most reconciliations can be satisfactorily audited at the year-end date, assuming that they are prepared as of that date, soon enough for the auditor to use and that the auditor is satisfied that the reconciliation control procedures are effective. In examining a reconciliation, the auditor considers whether items have not been improperly transferred to other accounts that are not subject to reconciliation and investigation at the same time. Examples of Controls 68. Appendix 2 to this Statement contains examples of controls over authorization, recording, access and reconciliation ordinarily found in the treasury and trading and lending operations of a bank. Inherent Limitations of Internal Control 69. PSA 400 "Risk Assessments and Internal Control" describes the procedures to be followed by the auditor in identifying, documenting and testing internal controls. In doing so, the auditor is aware of the inherent limitations of internal control. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedures. Irrespective of the assessed levels of inherent and control risks, the auditor performs some substantive procedures for material account balances and classes of transactions.  PAPS 1006 -32- Considering the Influence of Environmental Factors 70. In assessing the effectiveness of specific control procedures, the auditor considers the environment in which internal control operates. Some of the factors that may be considered include the following. The organizational structure of the bank and the manner in which it provides for the delegation of authority and responsibilities. The quality of management supervision. The extent and effectiveness of internal auditing. The extent and effectiveness of the risk management and compliance systems The skills, competence and integrity of key personnel. The nature and extent of inspection by supervisory authorities. Performing Substantive Procedures Introduction 71. As a result of the assessment of the level of inherent and control risks, the auditor determines the nature, timing and extent of the substantive tests to be performed on individual account balances and classes of transactions. In designing these substantive tests, the auditor considers the risks and factors that served to shape the bank’s systems of internal control. In addition, there are a number of audit considerations significant to these risk areas to which the auditor directs attention. These are discussed in subsequent paragraphs. 72. PSA 500, "Audit Evidence" lists the assertions embodied in the financial statements as: existence, rights and obligations, occurrence, completeness, valuation, measurement, and presentation and disclosure. Tests of the completeness assertion are particularly important in the audit of bank’s financial statements particularly in respect of liabilities. Much of the audit work on liabilities of other commercial entities can be carried out by substantive procedures on a reciprocal population. Banking transactions do not have the same type of regular trading cycle, and reciprocal populations are not always immediately in evidence. Large assets and liabilities can be created and realized very quickly and, if not captured by the systems, may be overlooked. Third party confirmations and the reliability of controls become important in these circumstances.  PAPS 1006 -33- Audit Procedures 73. To address the assertions discussed above, the auditor may perform the following procedures: (a) inspection; (b) observation; (c) inquiry and confirmation; (d) computation; and (e) analytical procedures. In the context of the audit of a bank’s financial statements, inspection, inquiry and confirmation, computation and analytical procedures require particular attention and are discussed in the following paragraphs. Inspection 74. Inspection consists of examining records, documents, or tangible assets. The auditor inspects in order to: be satisfied as to the physical existence of material negotiable assets that the bank holds; and obtain the necessary understanding of the terms and conditions of agreements (including master agreements) that are significant individually or in the aggregate in order to: o consider their enforceability; and o assess the appropriateness of the accounting treatment they have been given. 75. Examples of areas where inspection is used as an audit procedure are: securities; loan agreements; collateral; and commitment agreements, such as: o asset sales and repurchases o guarantees. 76. In carrying out inspection procedures, the auditor remains alert to the possibility that some of the assets the bank holds may be held on behalf of third parties rather than for the bank’s own benefit. The auditor considers whether adequate internal  PAPS 1006 -34- controls exist for the proper segregation of such assets from those that are the property of the bank and, where such assets are held, considers the implications for the financial statements. As noted in paragraph 58 the auditor is concerned with the existence of third party assets only to the extent that the bank’s failure to comply with its obligations may lead to the financial statements being materially misstated. Inquiry and confirmation 77. Inquiry consists of seeking information of knowledgeable persons inside or outside the entity. Confirmation consists of the response to an inquiry to corroborate information contained in the accounting records. The auditor inquires and confirms in order to: obtain evidence of the operation of internal controls; obtain evidence of the recognition by the bank’s customers and counterparties of amounts, terms and conditions of certain transactions; and obtain information not directly available from the bank’s accounting records. A bank has significant amounts of monetary assets and liabilities, and of off- balance-sheet commitments. External confirmation may be an effective method of determining the existence and completeness of the amounts of assets and liabilities disclosed in the financial statements. In deciding the nature and extent of external confirmation procedures that the auditor will perform, the auditor considers any external confirmation procedures undertaken by internal auditing. PSA 505, “External Confirmations” provides guidance on the external confirmation process. 78. Examples of areas for which the auditor may use confirmation are: Collateral. Verifying or obtaining independent confirmation of, the value of assets and liabilities that are not traded or are traded only on over-the-counter markets. Asset, liability and forward purchase and sale positions with customers and counterparties such as: o outstanding derivative transactions; o nostro and vostro account holders; o securities held by third parties; o loan accounts;  PAPS 1006 -35- o deposit accounts; o guarantees; and o letters of credit. Legal opinions on the validity of a bank’s claims. Computation 79. Computation consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations. In the context of the audit of a bank’s financial statements, computation is a useful procedure for checking the consistent application of valuation models. Analytical procedures 80. Analytical procedures consist of the analysis of significant ratios and trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts. PSA 520, “Analytical Procedures” provides guidance on the auditor’s use of this technique. 81. A bank invariably has individual assets (for example, loans and, possibly, investments) that are of such a size that the auditor considers them individually. However, for most items, analytical procedures may be effective for the following reasons: Ordinarily two of the most important elements in the determination of a bank’s earnings are interest income and interest expense. These have