Audit PDF

Dear Students, Auditing is the subject which is given a step motherly treatment by most of the students simply because it is a theoretical subject. The hard reality is that ultimately it claims many casualties. As we proceed with out course, you will be amazed when you realise that auditing is ac...

Dear Students, Auditing is the subject which is given a step motherly treatment by most of the students simply because it is a theoretical subject. The hard reality is that ultimately it claims many casualties. As we proceed with out course, you will be amazed when you realise that auditing is actually the most practical oriented subject in C.A. curriculum. You as students are going to have the rare opportunity to discuss the theoretical concepts in relation to the practical situations. It is this rare opportunity which will give you the chance of changing your entire attitude towards auditing. In order to know the exact scope of the subject, the syllabus is divided into many topics. Each topic has been created to comprehensively cover not only the concepts but also carefully selected examination questions which are a reflection of the past and a peep into the future. The coaching is well-planned, systematic, time bound and totally examination oriented. The coaching coupled with this study material is indeed your vehicle to success. I wish you a very happy study time. Best of Luck Prof. J. K. Shah Chartered Accountant  INDEX 01 1 Nature, Objective and Scope of Audit TO 15 16 2 Audit Strategy, Audit Planning and Audit Programme TO 28 29 3 Risk Assessment and Internal Control TO 75 76 4 Audit Evidence TO 139 140 5 Audit of Items of Financial Statements TO 178 179 6 Audit Documentation TO 186 187 7 Completion And Review TO 219 220 8 Audit Report TO 272 Special Features of Audit of Different Types 273 9 TO of Entities 321 322 10 Audit of Banks TO 353 354 11 Ethics and Terms of Audit Engagements TO 376  INTER CA - AUDIT 1 NATURE, OBJECTIVE AND SCOPE OF AUDIT 1. ORIGIN OF AUDITING  The word “audit” originates from Latin word “audire” meaning “to hear”.  In medieval times, auditors used to hear the accounts read out to them to check that employees were not careless and negligent.  Coming to more recent history, the first Auditor General of India was appointed in British India in 1860 having both accounting and auditing functions. Later on, office of Auditor General was given statutory recognition.  Presently, Comptroller and Auditor General of India is an independent constitutional authority responsible for auditing government receipts and expenditures.  The Institute of Chartered Accountants of India was established as a statutory body under an Act of Parliament in 1949 for regulating the profession of Chartered Accountancy in the country. 2. MEANING AND NATURE OF AUDITING “An audit is an independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon”. Note: (1) Independence, here, implies that the judgement of a person is not subordinate to the wishes or direction of another person who might have engaged him. (2) The purpose of audit is to express an opinion on the financial statements. Understand that preparation and presentation of financial statements of an entity is responsibility of management of entity. The auditor expresses an opinion on financial statements by means of written audit report. (3) In doing so, he has to see that financial statements would not mislead anybody by ensuring that: 1  INTER CA - AUDIT  the accounts have been drawn up with reference to entries in the books of account;  the entries in the books of account are adequately supported by sufficient and appropriate evidence;  none of the entries in the books of account has been omitted in the process of compilation;  the information conveyed by the statements is clear and unambiguous;  the financial statement amounts are properly classified, described and disclosed in conformity with accounting standards; and  the statement of accounts presents a true and fair picture of the operational results and of the assets and liabilities. 3. INTERDISCIPLINARY NATURE OF AUDITINGRELATIONSHIP WITH DIVERSE SUBJECTS Auditing and Accounting: Auditing reviews the financial statements which are nothing but a result of the overall accounting process. Auditing and Law: An auditor should have a good knowledge of business laws affecting the entity. Auditing and Economics: Auditor is expected to be familiar with the overall economic environment of the client. Auditing and Behavioural Science: Knowledge of human behaviour is essential for an auditor to effectively discharge his duties. Auditing and Statistics & Mathematics: Auditor is also expected to have the knowledge of statistical sampling for meaningful conclusions and mathematics for verification of inventories. Auditing and Data Processing: EDP auditing in itself is developing as a discipline in itself. Auditing and Financial Management : Auditor is expected to have knowledge about various financial techniques such as working capital management, funds flow, ratio analysis, capital budgeting etc. Auditing and Production: Good auditor is one who understands the client and his business functions such as production, cost system, marketing etc. 2  INTER CA - AUDIT 4. OBJECTIVES OF AUDIT In conducting audit of financial statements, objectives of auditor in accordance with SA-200 “Overall Objectives of the Independent auditor and the conduct of an audit in accordance with Standards on Auditing” are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and (b) To report on the financial statements, and communicate as required by the SAs, in accordance with the auditor’s findings. Note: (1) Reasonable assurance is to be distinguished from absolute assurance. Absolute assurance is a complete assurance or a guarantee that financial statements are free from material misstatements. However, reasonable assurance is not a complete guarantee. Although it is a high-level of assurance but it is not complete assurance. (2) Misstatements in financial statements can occur due to fraud or error or both. He has to see effect of misstatements on financial statements as a whole, in totality. 5. SCOPE OF AUDIT-WHAT IT INCLUDES  Scope refers to range or reach of something.  The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. The following points are included in scope of audit of financial statements: (1) Coverage of all aspects of entity Audit of financial statements should be organized adequately to cover all aspects of the entity relevant to the financial statements being audited. (2) Reliability and sufficiency of financial information The auditor should be reasonably satisfied that information contained in underlying accounting records and other source data (like bills, vouchers, 3  INTER CA - AUDIT documents etc.) is reliable and sufficient basis for preparation of financial statements. The auditor makes a judgment of reliability and sufficiency of financial information by (a) making a study and assessment of accounting systems and internal controls and (b) by carrying out appropriate tests, enquiries and procedures. (3) Proper disclosure of financial information The auditor should also decide whether relevant information is properly disclosed in the financial statements. He should also keep in mind applicable statutory requirements in this regard. It is done by ensuring that financial statements properly summarize transactions and events recorded therein and by considering the judgments made by management in preparation of financial statements. The auditor evaluates selection and consistent application of accounting policies by management; whether such a selection is proper and whether chosen policy has been applied consistently on a period-to-period basis. 5.1 What Scope does not include (1) Auditor is not expected to perform duties which fall outside domain of his competence. For example, physical condition of certain assets like that of sophisticated machinery cannot be determined by him. Similarly, it is not expected from an auditor to determine suitability and life of civil structures like buildings. These require different skillsets which may be performed by qualified engineers in their respective fields. (2) An auditor is not an expert in authentication of documents. The genuineness of documents cannot be authenticated by him because he is not an expert in this field. (3) An audit is not an official investigation into alleged wrong doing. He does not have any specific legal powers of search or recording statements 4  INTER CA - AUDIT of witness on oath which may be necessary for carrying out an official investigation. Audit is distinct from investigation. Investigation is a critical examination of the accounts with a special purpose. For example, if fraud is suspected and it is specifically called upon to check the accounts whether fraud really exists, it takes character of investigation. 6. INHERENT LIMITATIONS OF AUDIT The process of audit suffers from certain inbuilt limitations due to which an auditor cannot obtain an absolute assurance that financial statements are free from misstatement due to fraud or error. These fundamental limitations arise due to the following factors: (1) Nature of financial reporting Preparation of financial statements involves making many judgments by management. These judgments may involve subjective decisions or a degree of uncertainty. Therefore, auditor may not be able to obtain absolute assurance that financial statements are free from material misstatements due to frauds or errors. (2) Nature of Audit procedures  The auditor carries out his work by obtaining audit evidence through performance of audit procedures. However, there are practical and legal limitations on ability of auditor to obtain audit evidence. For example, an auditor does not test all transactions and balances. He forms his opinion only by testing samples. It is an example of practical limitation on auditor’s ability to obtain audit evidence.  Management may not provide complete information as requested by auditor.  The management may consist of dishonest and unscrupulous people and may be, itself, involved in fraud.  It is quite possible that entity may have entered into some transactions with related parties. Such transactions may be only paper transactions and may not have actually occurred. The auditor may not be aware of such related party relationships or audit procedures may not be able to detect probable wrong doings in such transactions. 5  INTER CA - AUDIT (3) Not in nature of investigation As already discussed, audit is not an official investigation. Hence, auditor cannot obtain absolute assurance that financial statements are free from material misstatements due to frauds or errors. (4) Timeliness of financial reporting and decrease in relevance of information over time The relevance of information decreases over time and auditor cannot verify each and every matter. Therefore, a balance has to be struck between reliability of information and cost of obtaining it. Consider, for example, an auditor who is conducting audit of a company since last two years. During these two years, he has sought detailed information from management of company regarding various matters. During his thirdyear stint, he chooses to rely upon some information obtained as part of audit procedures of second year. However, it could be possible that something new has happened and that information is not relevant. So, the information being relied upon by auditor is not timely and may have lost its reliability. (5) Future events Future events or conditions may affect an entity adversely. Adverse events may seriously affect ability of an entity to continue its business. The business may cease to exist in future due to change in market conditions, emergence of new business models or products or due to onset of some adverse events. 7. WHAT IS AN ENGAGEMENT? Engagement means an arrangement to do something. In the context of auditing, it means a formal agreement between auditor and client under which auditor agrees to provide auditing services. It takes the shape of engagement letter. 8.1. External audit engagements The purpose of external audit engagements is to enhance the degree of confidence of intended users of financial statements. Such engagements are also reasonable assurance engagements. For example, in India, companies are required to get their annual accounts audited by an external auditor. Even non-corporate entities may choose to have their accounts audited by an external auditor because of benefits of such an audit. 6  INTER CA - AUDIT 8. BENEFITS OF AUDIT-WHY AUDIT IS NEEDED?  Audited accounts provide high quality information. It gives confidence to users that information on which they are relying is qualitative and it is the outcome of an exercise carried out by following Auditing Standards recognized globally.  The financial statements are prepared by management consisting of directors. As shareholders are owners of the company, they need an independent mechanism so that financial information is qualitative and reliable. Hence, their interest is safeguarded by an audit.  An audit acts as a moral check on employees from committing frauds for the fear of being discovered by audit.  Audited financial statements are helpful to government authorities for determining tax liabilities.  Audited financial statements can be relied upon by lenders, bankers for making their credit decisions i.e. whether to lend or not to lend to a particular entity.  An audit may also detect fraud or error or both.  An audit reviews existence and operations of various controls operating in any entity. Hence, it is useful at pointing out deficiencies. 9. AUDIT- MANDATORY OR VOLUNTARY?  It is not necessary that audit is always legally mandatory. There are entities like companies who are compulsorily required to get their accounts audited under law. Even non-corporate entities may be compulsorily requiring audit of their accounts under tax laws. For example, in India, every person is required to get accounts audited if turnover crosses certain threshold limit under income tax law.  It is also possible that some entities like schools may be required to get their accounts audited for the purpose of obtaining grant or assistance from the Government.  Audit is not always mandatory. Many entities may get their accounts audited voluntarily because of benefits from the process of audit. Many such concerns have their internal rules requiring audit due to advantages flowing from an audit. 7  INTER CA - AUDIT 10. WHO APPOINTS AN AUDITOR?  Generally, an auditor is appointed by owners or in some cases by constitutional or government authorities in accordance with applicable laws and regulations. For example, in case of companies, auditor is appointed by members (shareholders) in Annual General Meeting (AGM).  However, in case of government companies in India, auditor is appointed by Comptroller and Auditor General of India (CAG), an independent constitutional authority. Note: Appointment of auditors is covered U/S 139 of Co-Act in Law syllabus. 11. TO WHOM REPORT IS SUBMITTED BY AN AUDITOR? The report is submitted to person making the appointment. In case of companies, these are shareholders- in case of a firm, to partners who have engaged him. 12. MEANING OF ASSURANCE ENGAGEMENT  “Assurance engagement” means an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.  It means that the practitioner gives an opinion about specific information due to which users of information are able to make confident decisions knowing well that chance of information being incorrect is diminished. 13. ELEMENTS OF ASSURANCE ENGAGEMENT 1. A three party relationship involving a practitioner, a responsible party, and intended users (i) A practitioner is a person who provides the assurance. The term practitioner is broader than auditor. Audit is related to historical information whereas practitioner may provide assurance not necessarily related to historical financial information. (ii) A responsible party is the party responsible for preparation of subject matter. (ii) Intended users are the persons for whom an assurance report is prepared These persons may use the report in making decisions. 8  INTER CA - AUDIT 2. An appropriate subject matter It refers to the information to be examined by the practitioner. For example, financial information contained in financial statements while conducting audit of financial statements. 3. Suitable criteria These refer to benchmarks used to evaluate the subject matter like standards, guidance, laws, rules and regulations. 4. Sufficient appropriate evidence “Sufficient” relates to quantity of evidence obtained by auditor. “Appropriate” relates to quality of evidence obtained by auditor. 5. A written assurance report in appropriate form A written report is provided containing conclusion that conveys the assurance about the subject matter. 13.1 Meaning of Review; Audit Vs. Review We have learnt that audit is a reasonable assurance engagement. It provides reasonable assurance. However, review is a limited assurance engagement. It provides lower level of assurance than audit. Further, review involves fewer procedures and gathers sufficient appropriate evidence on the basis of which limited conclusions can be drawn up. However, both “audit” and “review” are related to financial statements prepared on the basis of historical financial information. 13.2 Types of Assurance Engagements- Reasonable assurance engagement vs. Limited assurance engagement Reasonable assurance engagement Limited assurance engagement Reasonable assurance engagement Limited assurance engagement provides high level of assurance. provides lower level of assurance than reasonable assurance engagement. It performs elaborate and extensive It performs fewer procedures as procedures to obtain sufficient compared to reasonable assurance appropriate evidence. engagement. 9  INTER CA - AUDIT It draws reasonable conclusions on It involves obtaining sufficient the basis of sufficient appropriate appropriate evidence to draw limited evidence. conclusions. Example of reasonable assurance Example of limited assurance engagement is an audit engagement. engagement is review engagement.  Besides reasonable assurance engagements and limited assurance engagements, there is another kind of assurance which is related to matters other than historical financial information. Such an assurance may relate to prospective financial information and not to historical financial information. It may relate to providing assurance on internal controls in an entity.  “Prospective financial information” means financial information based on assumptions about events that may occur in the future and possible actions by an entity. It can be in the form of a forecast or projection or combination of both.  Prospective financial information relates to future events. While evidence may be available to support the assumptions on which the prospective financial information is based, such evidence is itself generally future- oriented. The auditor is, therefore, not in a position to express an opinion as to whether the results shown in the prospective financial information will be achieved.  Therefore, in such assurance engagements, practitioner provides a report assuring that nothing has come to practitioner’s attention to suggest that these assumptions do not provide a reasonable basis for the projection.  Hence, such type of assurance engagement provides only a “moderate” level of assurance. Assurance Engagements Reasonable Assurance Assurance Engagements dealing Limited Assurance Engagement with matters other than historical Engagement financial information Examination of prospective Audit Review financial information (like forecast) or assurance regarding operations of controls 10  INTER CA - AUDIT 14. QUALITIES OF AUDITOR  Tact, caution, firmness, good temper, integrity, discretion, industry, judgement, patience, clear headedness and reliability are some of qualities which an auditor should have. In short, all those personal qualities that go to make a good businessman contribute to the making of a good auditor.  In addition, he must have the shine of culture for attaining a great height.  He must have the highest degree of integrity backed by adequate independence.  The auditor, who holds a position of trust, must have the basic human qualities apart from the technical requirement of professional training and education.  He is called upon constantly to critically review financial statements and it is obviously useless for him to attempt that task unless his own knowledge is that of an expert.  An exhaustive knowledge of accounting in all its branches is the sine qua non of the practice of auditing. He must know thoroughly all accounting principles and techniques. 15. ENGAGEMENT AND QUALITY CONTROL STANDARDS: AN OVERVIEW The following Standards issued under authority of ICAI Council are collectively known as Engagement Standards: - 1. Standards on auditing (SAs) which apply in audit of historical financial information. 2. Standards on review engagements (SREs) which apply in review of historical financial information. 3. Standards on Assurance engagements (SAEs) which apply in assurance engagements other than audits and review of historical financial information. 4. Standards on Related Services (SRSs) which apply in agreed upon procedures to information, compilation engagements and other related service engagements. - No Assurance. 15.1 Standards on Auditing Some examples of Standards on Auditing are:  SA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with Standards on Auditing  SA 230 Audit Documentation  SA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment 11  INTER CA - AUDIT  SA 500 Audit Evidence  Revised SA 700 Forming an Opinion and Reporting on Financial Statements. 15.2 Standards on Review Engagements Examples of Standards on Review engagements are:  SRE 2400 (Revised) Engagements to Review Historical Financial Statements  SRE 2410 Review of Interim Financial Information Performed by the Independent Auditor of the Entity 15.3 Standards on Assurance Engagements Examples of Standards on Assurance Engagements are:  SAE 3400 The Examination of Prospective Financial Information  SAE 3420 Assurance Engagements to Report on the Compilation of Pro Forma Financial Information Included in a Prospectus 15.4 Standards on Related Services Examples of Standards on related services are:  SRS 4400 Engagements to perform agreed-upon procedures regarding financial information  SRS 4410 (Revised) Compilation engagements 15.5 Standards on Quality Control SQC 1 has been issued in this regard. It requires auditors/practitioners to establish system of quality control so that firm and its personnel comply with professional standards and regulatory & legal requirements and reports issued are appropriate. 15.6 Why are Standards needed?  Standards ensure carrying out of audit against established benchmarks at par with global practices.  Standards improve quality of financial reporting thereby helping users to make diligent decisions.  Standards promote uniformity as audit of financial statements is carried out following these Standards.  Standards equip professional accountants with professional knowledge and skill.  Standards ensure audit quality. 12  INTER CA - AUDIT 15.7 Duties in relation to Engagement and Quality Control Standards  It is the duty of professional accountants to see that Standards are followed in engagements undertaken by them. Ordinarily, these are to be followed by professional accountants. However, a situation may arise when a specific procedure as required in Standards would be ineffective in a particular engagement. In such a case, he is required to document how alternative procedures performed achieve the purpose of required procedure.  Also, reason for departure has also to be documented unless it is clear.  Further, his report should draw attention to such departures. It is also to be noted that a mere disclosure in the report does not absolve a professional accountant from complying with applicable Standards. 13  INTER CA - AUDIT 1 Lalji Bhai has purchased shares of a company listed on NSE. The audited financial statements of the company provide picture of healthy financial performance having robust turnover, low debt and good profits. On above basis, he is absolutely satisfied that money invested by him is safe and there is no chance of losing his money. Do audited results and audit reports of companies provide such assurance to investors like Lalji Bhai? Is thinking of Lalji Bhai correct? Ans. An audit does not provide assurance to investor in shares regarding safety of his money. Share prices of securities are affected by range of factors. An audit only provides reasonable assurance that financial statements are free from material misstatement whether due to fraud or error. Hence, thinking of Lalji Bhai is not correct. 2 Good deeds Limited is engaged in business of recycling of wastes from dumping grounds of municipal corporation of Indore to usable manure. It is, in this way, also, helping to make the city clean. During course of audit by Zoha & Zoha, a firm of auditors, it is observed by auditors that company has received a notice from Central Bench of National Green Tribunal for not following certain environmental regulations involving imposition of hefty monetary penalty on the company. The company is yet to reply to the notice. The auditors point out that same is not stated in notes to accounts in financial statements. The company points out that auditors are going beyond scope of their work. Does such a matter fall within scope of audit? Ans. Proper disclosure of financial information is well within scope of audit. 3 “Choosing of appropriate accounting policies in relation to accounting issues is responsibility of management”. Do you agree? Discuss duty of auditor, if any, in relation to accounting policies. Ans. Choosing of appropriate accounting policies is responsibility of management. The role of auditor lies in evaluating selection and consistent application of accounting policies by management- Refer to scope of audit- what it includes. 14  INTER CA - AUDIT 4 Assurance engagements are not restricted to audit of financial statements alone. Discuss. Ans. Refer to examples on assurance engagements. 5 An assurance engagement involves a three party relationship. Discuss meaning of three parties in such an engagement. Ans. Refer to elements of assurance engagement. 6 A Chartered Accountant is specifically asked to check accounts whether fraud exists. State with reasons whether it is an example of reasonable assurance engagement. Ans. It is not a reasonable assurance engagement. It is in nature of investigation. 7 An audit does not provide absolute assurance. Discuss how nature of audit procedures itself is one of the reasons due to which audit cannot provide absolute assurance. Ans. Refer to second point of inherent limitations of audit. 15  INTER CA - AUDIT 2 AUDIT STRATEGY, AUDIT PLANNING AND AUDIT PROGRAMME 1. AUDITOR’S RESPONSIBILITY TO PLAN AN AUDIT OF FINANCIAL STATEMENTS 1.1 Why Planning an audit is necessary? – Its Benefits Planning an audit is necessary to carry out it effectively in a timely manner. Besides ensuring compliance with professional standards, it helps in performing audit engagement effectively. Adequate planning benefits the audit of financial statements in several ways, including the following:- 1. Helping the auditor to devote appropriate attention to important areas of the audit. 2. Helping the auditor identify and resolve potential problems on a timely basis. 3. Helping the auditor properly organize and manage the audit engagement so that it is performed in an effective and efficient manner. 4. Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to respond to anticipated risks, and the proper assignment of work to them. 5. Facilitating the direction and supervision of engagement team members and the review of their work. 6. Assisting, where applicable, in coordination of work done by others such as experts 1.2 Nature of Audit Planning- A Continuous and iterative process (a) Planning is not a discrete phase of an audit, but rather a continual and iterative process that often begins shortly after (or in connection with) the completion of the previous audit and continues until the completion of the current audit engagement. (b) Planning, however, includes consideration of the timing of certain activities and audit procedures that need to be completed prior to the performance of further audit procedures. 16  INTER CA - AUDIT (c) For example, planning includes the need to consider, prior to the auditor’s identification and assessment of the risks of material misstatement, such matters as: - 1. The analytical procedures to be applied as risk assessment procedures. 2. Obtaining a general understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework. 3. The determination of materiality. 4. The involvement of experts. 5. The performance of other risk assessment procedures. 2. Planning Process- Elements of Planning The elements of planning can be categorized as under: (I) Preliminary engagement activities The auditor considers whether relationship with client should be continued and whether ethical requirements including independence continue to be complied with. It includes: - Preliminary engagement activities include the following: (A) Performing procedures regarding the Continuance of Client Relationships and Audit Engagements Matters such as integrity of principal owners and key management, competence of engagement team to perform the audit engagement and implications of matters that have arisen during current and previous audit engagement may need to be considered. (B) Evaluating compliance with ethical requirements including independence The engagement partner shall form a conclusion on compliance with independence requirements that apply to the audit engagement. In doing so, the engagement partner shall: (i) Obtain relevant information from the firm to identify and evaluate circumstances and relationships that create threats to independence (ii) Evaluate information on identified breaches, if any, of the firm’s independence policies and procedures to determine whether they create a threat to independence for the audit engagement and (iii) Take appropriate action to eliminate such threats or reduce them 17  INTER CA - AUDIT to an acceptable level by applying safeguards, or, if considered appropriate, to withdraw from the audit engagement, where withdrawal is permitted by law or regulation. The engagement partner shall promptly report to the firm any inability to resolve the matter for appropriate action. (C) Establishing an understanding of terms of engagement It is in the interests of both the entity and the auditor that the auditor sends an audit engagement letter before the commencement of the audit to help avoid misunderstandings with respect to the audit. (II) Planning activities Planning activities involve: (A) Establishing the overall audit strategy- Assistance for the auditor Overall audit strategy sets the scope, timing and direction of the audit, and guides the development of the more detailed audit plan. A.1 The process of establishing the overall audit strategy assists the auditor to determine, subject to the completion of the auditor’s risk assessment procedures, such matters as: - (i) The resources to deploy for specific audit areas, such as the use of appropriately experienced team members for high-risk areas or the involvement of experts on complex matters (ii) The amount of resources to allocate to specific audit areas, such as the number of team members assigned to observe the inventory count at material locations, the extent of review of other auditors’ work in the case of group audits, or the audit budget in hours to allocate to high risk areas (iii) When these resources are to be deployed, such as whether at an interim audit stage or at key cut-off dates (iv) How such resources are managed, directed and supervised, such as when team briefing and debriefing meetings are expected to be held, how engagement partner and manager reviews are expected to take place (for example, on-site or off-site), and whether to complete engagement quality control reviews 18  INTER CA - AUDIT A.2 Factors to be taken into consideration by auditor for establishing audit strategy (a) Identify the characteristics of the engagement that define its scope There are many characteristics of engagement defining its scope. Some of characteristics are as under:  Applicable financial reporting framework applicable to the entity  Nature of business segments to be audited including the need for specialized knowledge  Industry specific reporting requirements required by industry regulators  Expected use of audit evidence obtained in previous audits (b) Ascertain the reporting objectives of the engagement to plan the timing of the audit and the nature of the communications required. The ascertaining of reporting objectives of engagement helps the auditor to plan timing of different audit procedures and also nature of communications. Some of the instances are given under:  The entity’s timetable for reporting  Organization of meetings to discuss of nature, timing and extent of audit work with management  Discussion with management regarding the expected type and timing of reports to be issued including the auditor’s report  Discussion with management regarding the expected communications on the status of audit work throughout the engagement.  Expected nature and timing of communications among engagement team members. (c) Consider the factors that, in the auditor’s professional judgment, are significant in directing the engagement team’s efforts The auditor needs to direct efforts of engagement team towards matters that in his professional judgment are significant. Few examples are listed as under:  Volume of transactions which may determine whether it is more efficient for the auditor to rely on internal control 19  INTER CA - AUDIT  Significant industry developments such as changes in industry regulations and new reporting requirements.  Significant changes in the financial reporting framework, such as changes in accounting standards.  Other significant relevant developments, such as changes in the legal environment affecting the entity. (d) Consider the results of preliminary engagement activities and, where applicable, whether knowledge gained on other engagements performed by the engagement partner for the entity is relevant. Examples  Results of previous audits that involved evaluating the operating effectiveness of internal control, including the nature of identified deficiencies and action taken to address them. (e) Ascertain the nature, timing and extent of resources necessary to perform the engagement. (B) Development of Audit plan Once the overall audit strategy has been established, an audit plan can be developed to address the various matters identified in the overall audit strategy, taking into account the need to achieve the audit objectives through the efficient use of the auditor’s resources. SA-300 states that auditor shall develop an audit plan that shall include description of- (i) The nature, timing and extent of planned risk assessment procedures (ii) The nature, timing and extent of planned further audit procedures at assertion level (iii) Other planned audit procedures that are required to be carried out so that the engagement complies with SAs. 3. RELATIONSHIP BETWEEN AUDIT STRATEGY AND AUDIT PLAN (a) Audit strategy sets the broad overall approach to the audit whereas audit plan addresses the various matters identified in the overall audit strategy. (b) Audit strategy determines scope, timing and direction of audit. Audit plan describes how strategy is going to be implemented. 20  INTER CA - AUDIT (c) The audit plan is more detailed than the overall audit strategy that includes the nature, timing and extent of audit procedures to be performed by engagement team members. Planning for these audit procedures takes place over the course of the audit as the audit plan for the engagement develops. (d) Once the overall audit strategy has been established, an audit plan can be developed to address the various matters identified in the overall audit strategy, taking into account the need to achieve the audit objectives through the efficient use of the auditor’s resources. (e) The establishment of the overall audit strategy and the detailed audit plan are not necessarily discrete or sequential processes, but are closely inter-related since changes in one may result in consequential changes to the other. 4. CHANGES TO PLANNING DECISIONS DURING THE COURSE OF AUDIT As a result of unexpected events, changes in conditions, or the audit evidence obtained from the results of audit procedures, the auditor may need to modify the overall audit strategy and audit plan and thereby the resulting planned nature, timing and extent of further audit procedures, based on the revised consideration of assessed risks. 5. PLANNING SUPERVISION AND REVIEW OF WORK OF ENGAGEMENT TEAM MEMBERS The auditor shall plan the nature, timing and extent of direction and supervision of engagement team members and the review of their work. Which depend on many factors, including: - 1. The size and complexity of the entity. 2. The area of the audit. 3. The assessed risks of material misstatement 4. The capabilities and competence of the individual team members performing the audit work. 6. DOCUMENTATION (a) The documentation of the overall audit strategy is a record of the key decisions considered necessary to properly plan the audit and to communicate significant matters to the engagement team. (b) The documentation of the audit plan is a record of the planned nature, timing and extent of risk assessment procedures and further audit procedures at the assertion level in response to the assessed risks. 21  INTER CA - AUDIT (c) A record of the significant changes to the overall audit strategy and the audit plan, and resulting changes to the planned nature, timing and extent of audit procedures, explains why the significant changes were made, and the overall strategy and audit plan finally adopted for the audit. 7. AUDIT PROGRAMME An audit programme consists of a series of verification procedures to be applied to the financial statements and accounts of a given entity for the purpose of obtaining sufficient evidence to enable the auditor to express an informed opinion on financial statements. In other words, an audit programme is a detailed plan of applying the audit procedures in the given circumstances with instructions for the appropriate techniques to be adopted for accomplishing the audit objectives. 8.1 Evolving one audit programme- Not Practicable for All businesses Businesses vary in nature, size and composition; work which is suitable to one business may not be suitable to others; efficiency and operation of internal controls and the exact nature of the service to be rendered by the auditor are the other factors that vary from assignment to assignment. On account of such variations, evolving one audit programme applicable to all business under all circumstances is not practicable. 8.2 The Assistant to keep an open mind To start with, an auditor having regard to the nature, size and composition of the business and the dependability of the internal control and the given scope of work, should frame a programme which should aim at providing for a minimum essential work which may be termed as a standard programme. The assistant engaged in the job should be encouraged to keep an open mind beyond the programme given to him. 8.3 Periodic review of the audit programme There should be periodic review of the audit programme to assess whether the same continues to be adequate for obtaining requisite knowledge and evidence about the transactions. The utility of the audit programme can be retained and enhanced only by keeping the programme as also the client’s operations and internal control under periodic review so that inadequacies or redundancies of the programme may be removed. 22  INTER CA - AUDIT 8.4 Constructing an audit programme → The audit planning ideally commences at the conclusion of the previous year’s audit, and along with the related programme, it should be reconsidered for modification as the audit progresses. → While developing an audit programme, the auditor may conclude that relying on certain internal controls is an effective and efficient way to conduct his audit. However, the auditor may decide not to rely on internal controls when there are other more efficient ways of obtaining sufficient appropriate audit evidence. → Further, the auditor normally has flexibility in deciding when to perform audit procedures. However, in some cases, the auditor may have no discretion as to timing, for example, when observing the taking of inventories by client personnel or verifying the securities and cash balances at the year-end. → For the purpose of programme construction, the following points should be kept in mind: (1) Stay within the scope and limitation of the assignment. (2) Prepare a written audit programme setting forth the procedures that are needed to implement the audit plan. (3) Determine the evidence reasonably available and identify the best evidence for deriving the necessary satisfaction. (4) Apply only those steps and procedures which are useful in accomplishing the verification purpose in the specific situation. (5) Include the audit objectives for each area and sufficient details which serve as a set of instructions for the assistants involved in audit and help in controlling the proper execution of the work. (6) Consider all possibilities of error. (7) Co-ordinate the procedures to be applied to related items. 8.5 Audit Programme- Designed to provide audit evidence An auditor picks up evidence from a variety of fields and it is generally of the following broad types: (a) Documentary examination (b) Physical examination (c) Statements and explanation of management, officials and employees (d) Statements and explanations of third parties 23  INTER CA - AUDIT (e) Arithmetical calculations by the auditor (f) State of internal controls and internal checks (g) Inter-relationship of the various accounting data (h) Subsidiary and memorandum records (i) Minutes (j) Subsequent action by the client and by others 8.6 Advantages and disadvantages of an audit programme The advantages of an audit programme are: - (a) It provides the assistant carrying out the audit with total and clear set of instructions of the work generally to be done. (b) It is essential, particularly for major audits, to provide a total perspective of the work to be performed. (c) Selection of assistants for the jobs on the basis of capability becomes easier. (d) Without a written and pre-determined programme, work is necessarily to be carried out on the basis of some ‘mental’ plan. In such a situation there is always a danger of ignoring or overlooking certain books and records. (e) The assistants, by putting their signature on programme, accept the responsibility for the work carried out by them. (f) The principal can control the progress of the various audits in hand by examination of audit programmes initiated by the assistants deputed to the jobs for completed work. (g) It serves as a guide for audits to be carried out in the succeeding year. (h) A properly drawn up audit programme serves as evidence in the event of any charge of negligence being brought against the auditor. The disadvantages are: (a) The work may become mechanical and particular parts of the programme may be carried out without any understanding of the object of such parts in the whole audit scheme. (b) The programme often tends to become rigid and inflexible following set grooves; the business may change in its operation of conduct, but the old programme may still be carried on. Changes in staff or internal control may render precaution necessary at points different from those originally decided upon. 24  INTER CA - AUDIT (c) Inefficient assistants may take shelter behind the programme i.e., defend deficiencies in their work on the ground that no instruction in the matter is contained therein. (d) A hard and fast audit programme may kill the initiative of efficient and enterprising assistants. All these disadvantages may be eliminated by imaginative supervision of the work carried on by the assistants; the auditor must have a receptive attitude as regards the assistants; the assistants should be encouraged to observe matters objectively and bring significant matters to the notice of supervisor/principal. 25  INTER CA - AUDIT 1 The auditor T of Hand Fab Ltd is worried as to management of key resources to be employed to conduct audit. Required How the audit strategy would be helpful to the auditor? Ans. Refer - Establishing the overall audit strategy- Assistance for the auditor for solution. 2 MG & Co, a firm of auditors, having a standing of 30 years is appointed as a statutory auditor of company engaged in manufacturing of defence equipment. Due to opening of defence sector by government to private players in recent times, many new companies have entered the fray to manufacture sophisticated defence equipment. Considering technical and complex nature of operations, the auditors recognize that involvement of experts in the audit is required. Does consideration for involvement of experts by auditors fall in the domain of planning audit? Ans. Consideration for involvement of experts by auditors falls within domain of planning. While planning an audit, auditor would have to consider whether involvement of experts is necessary. In the stated case, company is involved in technical and complex operations. Therefore, while planning an audit, auditors would have to consider whether involvement of expert is necessary 3 CA Kartik is planning for audit of a company engaged in manufacturing of cosmetics. Considering nature of operations of the company, he had planned to include testing of controls of the company over purchases, sales and inventories. One fine day, he reaches the corporate office and asks for manuals and required documentation to ensure surprise element in testing. He had never shared with management his intention to carry out above procedures. Is approach of CA Kartik proper? Ans. In the case, CA Kartik has reached office of the company without sharing with management his intention to test the controls. The auditor may decide to discuss elements of planning with the entity’s management to facilitate the conduct and management of the audit engagement without compromising effectiveness of audit. Sharing details of visit to test controls does not compromise effectiveness of 26  INTER CA - AUDIT audit. It is for the better facilitation and conduct of audit. Therefore, approach of CA Kartik is not proper. 4 W, the auditor of SKM Ltd. asks its finance and audit head to prepare audit strategy for conducting audit of SKM Ltd. W also insists him to draw detailed audit procedures. On the request of auditor W completes audit strategy as well as audit procedures as prepared by finance head of the company. Subsequently, auditor realizes that effectiveness of the audit is compromised and it was his responsibility to prepare the overall audit strategy. Comment. Ans. Refer - Overall audit strategy and the audit plan- The auditor’s responsibility - Accordingly, approach of W was wrong and he should have prepared overall audit strategy and detailed audit procedures. 5 CA Mary, while planning audit of a company, feels that she would inquire from inhouse legal counsel of the company status of pending litigation matters against the company to identify and assess risks of material misstatements. Considering above description, are you able to identify said procedures? Where these identified procedures are included in planning in accordance with SA-300? Ans. These are planned risk assessment procedures to identify and assess risk of material misstatement. The objective of planned inquiry of inhouse legal counsel is to identify and assess risk of material misstatement. Such planned risk assessment procedures are included in audit plan in accordance with SA-300. 6 CA Shubhendu is statutory auditor of a social media company. Due to change in information technology regulations by government, it has become mandatory for such companies to constitute “grievance redressal mechanism” for users of social media platform of the company. Failure to comply with regulations can potentially lead to civil and criminal liabilities against the company. Is above factor to be considered by auditor while framing audit strategy? Ans. Changes in laws and regulations affecting the company is a factor to be considered while establishing overall audit strategy. There has been change in information technology regulations applicable to the company. Noncompliance of the same can have implications in form of civil and criminal liabilities. Such an important matter concerning changes in laws and regulations is to be considered by auditor while establishing overall audit strategy. 27  INTER CA - AUDIT 7 Rohit, undergoing practical training, is part of an engagement team conducting audit of a company engaged in manufacturing of paints. He has been provided with audit programme pertaining to sales. It lists out various items to be checked and verified by him including invoices, rate lists, posting in debtors accounts, correlation of invoices with e-way bills on sample basis etc. During verification, he notices that many e-way bills have been cancelled by the company within 24 hours of their generation in month of March. There is no specific instruction in audit programme in this regard. He keeps mum. Is attitude of Rohit proper? Ans. Attitude of Rohit is not proper. The assistants should observe matters objectively and bring significant matters to the notice of supervisor/principal. Reasons for cancellation of many e-way bills in month of March need to be looked into. Matter should be informed to engagement partner. 28  INTER CA - AUDIT 3 RISK ASSESSMENT AND INTERNAL CONTROL 1. AUDIT RISK Audit risk means the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. It means that an auditor expresses an unmodified opinion when financial statements are materially misstated. Audit risk is a function of the risks of material misstatement and detection risk. 1.1 Risks of material misstatement It simply means that there is a probability of frauds or errors in financial statements before audit. What is meant by misstatement? Misstatement refers to a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud. The risks of material misstatement may exist at two levels: (i) The overall financial statement level (ii) The assertion level for classes of transactions, account balances, and disclosures. Risks of material misstatement at the overall financial statement level refer to risks of material misstatement that relate pervasively to the financial statements as a whole and potentially affect many assertions. Risks of material misstatement at the assertion level are assessed in order to determine the nature, timing, and extent of further audit procedures necessary to obtain sufficient appropriate audit evidence. This evidence enables the auditor to express an opinion on the financial statements at an acceptably low level of audit risk. 29  INTER CA - AUDIT 1.2 Components of risk of material misstatement The risk of material misstatement at assertion level comprises of two components i.e., inherent risk and control risk. 1.2A Inherent risk Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements before consideration of any related controls Few examples An accounting standard provides guidance on some complex issue which might not be understood by the management. Therefore, recording of this issue in financial statements carries inherent risk of being misstated. There are large number of business failures in an industry. Therefore, assertions in financial statements of an entity operating in such an industry carry an inherent risk of being misstated. 1.2B Control risk Control risk is the risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control. Examples: A company has devised control that cash and cheque books should be kept in a locked safe and access is granted to authorized personnel only. There is risk that control is not being followed. An entity has devised a control that fire extinguishers and smoke detectors are in place and are in working condition at all times to reduce the risk of damage to inventories caused by fire. There is a risk that fire extinguishers in place are expired and are not being refilled. 30  INTER CA - AUDIT 1.3 Detection risk The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. Detection risk comprises sampling and non-sampling risk. Examples Sampling risk is the risk that the auditor’s conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure. It simply means that the sample was not representative of the population from which it was chosen. Non-sampling risk is the risk that the auditor reaches an erroneous conclusion for any reason not related to sampling risk. Like an auditor may reach an erroneous conclusion due to application to some inappropriate audit procedure. Examples Sizeable work-in-progress inventories are expected in financial statements of a company. However, auditor of the company does not devote time to attending inventory count. Instead, he chooses to rely upon alternative audit procedures. The auditor of a company has audited revenue of a company by taking a sample. However, there is a risk that sample of revenue is not representative of overall revenue. The auditor can only influence detection risk. Inherent risk and control risk belong to the entity and are influenced by the entity. Detection risk may be reduced by increasing area of checking, testing larger samples and by including competent and experienced persons in the engagement team. 1.4 Audit risk-What is not included? Audit risk is a technical term related to the process of auditing; it does not refer to the auditor’s business risks such as loss from litigation, adverse publicity, or other events arising in connection with the audit of financial statements. 31  INTER CA - AUDIT For purposes of the SAs, audit risk does not include the risk that the auditor might express an opinion that the financial statements are materially misstated when they are not. This risk is ordinarily insignificant. 1.5 Assessment of risks- A matter of professional Judgment The assessment of risks is a matter of professional judgment, rather than a matter capable of precise measurement. it is exercised by an auditor whose training, knowledge and experience have assisted in developing the necessary competencies to achieve reasonable judgments. 1.5.1 Combined Assessment of the Risk of Material Misstatement Standards on auditing do not ordinarily refer to inherent risk and control risk separately, but rather to a combined assessment of the “risks of material misstatement. The assessment of the risks of material misstatement may expressed in quantitative terms, such as in percentages, or in non-quantitative terms. It can be concluded from the above that: Audit risk = Risks of material misstatement x Detection risk it can also be shown as: Audit risk = Inherent risk x Control risk x Detection risk 1.6 Identifying and assessing the risk of material misstatement As per SA 315 “Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment”, the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. This will help the auditor to reduce the risk of material misstatement to an acceptably low level. 32  INTER CA - AUDIT The objective of the auditor as stated in SA 315 is to identify and assess the risks of material misstatement. (i) The auditor shall identify and assess the risks of material misstatement at: (a) the financial statement level (b) the assertion level for classes of transactions, account balances, and disclosures to provide a basis for designing and performing further audit procedures (ii) For the purpose of identifying and assessing the risks of material misstatement, the auditor shall: - (a) Identify risks throughout the process of obtaining an understanding of the entity and its environment, including relevant controls that relate to the risks, and by considering the classes of transactions, account balances, and disclosures in the financial statements (b) Assess the identified risks, and evaluate whether they relate more pervasively to the financial statements as a whole and potentially affect many assertions (c) Relate the identified risks to what can go wrong at the assertion level, taking account of relevant controls that the auditor intends to test and (d) Consider the likelihood of misstatement, including the possibility of multiple misstatements, and whether the potential misstatement is of a magnitude that could result in a material misstatement. 1.7 Risk Assessment Procedures The audit procedures performed to obtain an understanding of the entity and its environment, including the entity’s internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion level are defined as risk assessment procedures. What is included in risk assessment procedures? The risk assessment procedures shall include the following: (a) Inquiries of management and of others within the entity who in the auditor’s judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. (b) Analytical procedures. (c) Observation and inspection. 33  INTER CA - AUDIT Example: Inquiries directed toward internal audit personnel may provide information about internal audit procedures performed during the year relating to the design and effectiveness of the entity’s internal control Inquiries of employees involved in initiating, processing or recording complex or unusual transactions may help the auditor to evaluate the appropriateness of the selection and application of certain accounting policies. Inquiries directed toward in-house legal counsel may provide information about such matters as litigation, compliance with laws and regulations, knowledge of fraud or suspected fraud affecting the entity, Inquiries directed towards marketing or sales personnel may provide information about changes in the entity’s marketing strategies, sales trends, or contractual arrangements with its customers. Inquiries directed to the risk management function (or those performing such roles) may provide information about operational and regulatory risks that may affect financial reporting. Inquiries directed to information systems personnel may provide information about system changes, system or control failures, or other information system- related risks. (b) Analytical Procedures: Analytical procedures performed as risk assessment procedures may identify aspects of the entity of which the auditor was unaware and may assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks. Analytical procedures may help identify the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have audit implications. Unusual or unexpected relationships that are identified may assist the auditor in identifying risks of material misstatement, especially risks of material misstatement due to fraud. 34  INTER CA - AUDIT (c) Observation and Inspection: The entity’s operations. Documents (such as business plans and strategies), records, and internal control manuals. Reports prepared by management (such as quarterly management reports and interim financial statements) and those charged with governance (such as minutes of board of director’s meetings) The entity’s premises and plant facilities. 2. MATERIALITY 2.1 What is meant by materiality? SA 320 Materiality in Planning and Performing an Audit states that misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. Materiality is not always a matter of relative size. For example, a small amount lost by fraudulent practices of certain employees can indicate a serious flaw in the enterprise’s internal control system requiring immediate attention to avoid greater losses in future. 2.2 Materiality in Planning and performing an audit- Auditor’s responsibility The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. Financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of financial statements. Although financial reporting frameworks may discuss materiality in different terms, they generally explain that:  Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements; 35  INTER CA - AUDIT  Judgments about materiality are made in the light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both; and  Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered. Such a discussion, if present in the applicable financial reporting framework, provides a frame of reference to the auditor in determining materiality for the audit. If the applicable financial reporting framework does not include a discussion of the concept of materiality, the characteristics referred to above provide the auditor with such a frame of reference.  In planning the audit, the auditor makes judgments about the size of misstatements that will be considered material. These judgments provide a basis for: (a) Determining the nature, timing and extent of risk assessment procedures; (b) Identifying and assessing the risks of material misstatement; and (c) Determining the nature, timing and extent of further audit procedures.  The materiality determined when planning the audit does not necessarily establish an amount below which uncorrected misstatements, individually or in aggregate, will always be evaluated as immaterial. The circumstances related to some misstatements may cause the auditor to evaluate them as material even if they are below materiality.  The auditor has to apply his professional judgement in determining materiality, choosing appropriate benchmark and determining level of benchmark.  If there is any statutory requirement of disclosure, it is to be considered material irrespective of the value of amount. Examples are given below: As per Division I of schedule III of Companies Act, 2013, any item of income or xpenditure which exceeds one percent of the revenue from operations or ` 1,00,000, whichever is higher, needs to be disclosed separately. 36  INTER CA - AUDIT A company should disclose in notes to accounts, shares in the company held by each shareholder holding more than 5 per cent shares specifying the number of shares held as per requirements of Division I of Schedule III of Companies Act,2013. 2.3 Determination of materiality- a matter of professional judgment The auditor’s determination of materiality is a matter of professional judgment, and is affected by the auditor’s perception of the financial information needs of users of the financial statements. In this context, it is reasonable for the auditor to assume that users: (a) Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence; (b) Understand that financial statements are prepared, presented and audited to levels of materiality; (c) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events; and (d) Make reasonable economic decisions on the basis of the information in the financial statements. 2.4 Performance Materiality Performance materiality means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures. 2.5 Determining Materiality and Performance Materiality when Planning the Audit When establishing the overall audit strategy, the auditor shall determine materiality for the financial statements as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than the materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the 37  INTER CA - AUDIT financial statements, the auditor shall also determine the materiality level or levels to be applied to those particular classes of transactions, account balances or disclosures. 2.6 Use of Benchmarks in Determining Materiality for the Financial Statements as a Whole Determining materiality involves the exercise of professional judgment. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole. Factors that may affect the identification of an appropriate benchmark include the following:  The elements of the financial statements like assets, liabilities, equity, revenue, expenses  Whether there are items on which the attention of the users of the particular entity’s financial statements tends to be focused. For example, for the purpose of evaluating financial performance users may tend to focus on profit, revenue or net assets.  The nature of the entity, where the entity is at in its life cycle, and the industry and economic environment in which the entity operates, the entity’s ownership structure and the way it is financed. For example, If an entity is financed solely by debt rather than equity, users may put more emphasis on assets, and claims on them, than on the entity’s earnings;  The relative volatility of the benchmark. Note 1: Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value. Note 2: Profit before tax from continuing operations is often used for profit- oriented entities. When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues. 2.6.1 Chosen Benchmark – Relevant financial data In relation to the chosen benchmark, relevant financial data ordinarily includes:  Prior periods’ financial results and financial positions, 38  INTER CA - AUDIT  The period to-date financial results and financial position, and  Budgets or forecasts for the current period,  Adjusted for significant changes in the circumstances of the entity (for example, a significant business acquisition) and relevant changes of conditions in the industry or economic environment in which the entity operates. Consider, for example, that the auditor may consider 5% of profit before tax from continuing operations to be appropriate for a profit-oriented entity in a manufacturing industry, while the auditor may consider 1% of total revenue or total expenses to be appropriate for a not-for-profit entity. Higher or lower percentages, however, may be deemed appropriate in different circumstances. 2.6.2 Determining a percentage to be applied to a chosen benchmark involves the exercise of professional judgment. Consider, for example, that the auditor may consider 5% of profit before tax from continuing operations to be appropriate for a profit-oriented entity in a manufacturing industry, while the auditor may consider 1% of total revenue or total expenses to be appropriate for a not-for-profit entity. Higher or lower percentages, however, may be deemed appropriate in different circumstances. 2.7 Materiality Level or Levels for Particular Classes of Transactions, Account Balances or Disclosures Factors that may indicate the existence of one or more particular classes of transactions, account balances or disclosures for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements include the following: 1. Whether law, regulations or the applicable financial reporting framework affect users’ expectations regarding the measurement or disclosure of certain items like in case of related party transactions, and the remuneration of management and those charged with governance. 2. The key disclosures in relation to the industry in which the entity operates. For example, research and development costs for a pharmaceutical company. 39  INTER CA - AUDIT 3. Whether attention is focused on a particular aspect of the entity’s business that is separately disclosed in the financial statements like in case of newly acquired business. 2.8 Revision in Materiality level as the Audit Progresses Materiality for the financial statements as a whole (and, if applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures) may need to be revised as a result of a change in circumstances that occurred during the audit (for example, a decision to dispose of a major part of the entity’s business), new information, or a change in the auditor’s understanding of the entity and its operations as a result of performing further audit procedures. If during the audit it appears as though actual financial results are likely to be substantially different from the anticipated period end financial results that were used initially to determine materiality for the financial statements as a whole, the auditor revises that materiality. If the auditor concludes that a lower materiality for the financial statements as a whole (and, if applicable, materiality level or levels for particular classes of transactions, account balances or disclosures) than that initially determined is appropriate, the auditor shall determine whether it is necessary to revise performance materiality, and whether the nature, timing and extent of the further audit procedures remain appropriate. 2.9 Documenting the Materiality The audit documentation shall include the following amounts and the factors considered in their determination: (a) Materiality for the financial statements as a whole (b) If applicable, the materiality level or levels for particular classes of transactions, account balances or disclosures (c) Performance materiality and (d) Any revision of (a)-(c) as the audit progressed 2.10 Materiality and Audit Risk Materiality and Audit Risk are considered throughout the audit, in particular, when: 40  INTER CA - AUDIT (a) Identifying and assessing the risks of material misstatement; (b) Determining the nature, timing and extent of further audit procedures; & (c) Evaluating the effect of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report. 3. UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT SA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment states that the auditor shall obtain an understanding of the following: - (a) Relevant industry, regulatory, and other external factors including the applicable financial reporting framework Relevant industry factors include industry conditions such as the competitive environment, supplier and customer relationships, and technological developments. Examples of matters the auditor may consider include market and competition, whether entity is engaged in seasonal activities, product technology relating to the entity’s products. Examples of other external factors affecting the entity that the auditor may consider include the general economic conditions, interest rates and availability of financing, and inflation etc. (b) The nature of the entity, including: (i) its operations; (ii) its ownership and governance structures; (iii) the types of investments that the entity is making and plans to make, including investments in special-purpose entities; and (iv) the way that the entity is structured and how it is financed; to enable the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements. Examples of matters that the auditor may consider while obtaining understanding of nature of entity include: - Business operations such as nature of revenue sources, products or services, conduct of operations, location of production facilities, key customers and suppliers of goods and services 41  INTER CA - AUDIT Investment and investment activities such as capital investment activities and planned or recently executed acquisitions Financing and financing activities such as major subsidiaries, debt structure etc. Financial reporting such as accounting principles and revenue recognition practices (c) The entity’s selection and application of accounting policies, including the reasons for changes thereto (d) The entity’s objectives and strategies, and those related business risks that may result in risks of material misstatement. Examples of matters that the auditor may consider when obtaining an understanding of the entity’s objectives, strategies and related business risks that may result in a risk of material misstatement of the financial statements include: Industry developments (a potential related business risk might be, for example, that the entity does not have the personnel or expertise to deal with the changes in the industry). New products and services (a potential related business risk might be, for example, that there is increased product liability). Expansion of the business (a potential related business risk might be, for example, that the demand has not been accurately estimated). (e) The measurement and review of the entity’s financial performance Examples for measuring and reviewing financial performance which may be used by an auditor may include: Key performance indicators (financial and non-financial) and key ratios, trends and operating statistics. Period-on-period financial performance analyses. Budgets, forecasts, variance analyses, and departmental or other level performance reports. Credit rating agency reports 3.1 Why understanding the entity and its environment is significant? It helps the auditor in planning the audit and in identifying areas requiring special attention. 42  INTER CA - AUDIT 3.2 Understanding the entity-a continuous process It is a continuous, dynamic process of gathering, updating and analysing information throughout the audit. The understanding establishes a frame of reference within which the auditor plans the audit and exercises professional judgment throughout the audit, for example, when: Assessing risks of material misstatement of the financial statements Determining materiality in accordance with SA 320 Considering the appropriateness of the selection and application of accounting policies Identifying areas where special audit consideration may be necessary, for example, related party transactions, the appropriateness of management’s use of the going concern assumption, or considering the business purpose of transactions Developing expectations for use when performing analytical procedures Evaluating the sufficiency and appropriateness of audit evidence obtained such as the appropriateness of assumptions and of management’s oral andwritten representations. 4. INTERNAL CONTROL 4.1 Meaning of Internal Control As per SA-315, “Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment”, the internal control may be defined as “the process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to: (a) reliability of financial reporting, (b) effectiveness and efficiency of operations, (c) safeguarding of assets, and (d) compliance with applicable laws and regulations. 4.2 Benefits of Understanding of Internal Control An understanding of internal control assists the auditor in: (i) Identifying types of potential misstatements; (ii) Identifying factors that affect the risks of material misstatement, and (iii) Designing the nature, timing, and extent of further audit procedures. 43  INTER CA - AUDIT 4.3 Limitations of Internal Control (i) Internal control can provide only reasonable a