Auditing

April 2008 Board Paper

Q1)Attempt any 3/5

(a)Write audit procedure for the verification of Bills Purchased in Banking company. (5) Ans. Depending on the number and volume of business transactions of a bank it is not possible for an auditor to perform detailed audit. Therefore it is necessary for him to rely on the system of internal control which should posses the following features: (1) Appropriate procedure for evaluating creditworthiness of borrowers and specification of authority for sanctioning loans and advances (2) Evidentiary material such as agreement in support of each loan and advance (3) Securing of adequate margins in respect of loans and advances as per directives of the RBI (4) Securing title or other proof in respect of securities mortgaged with the bank against loans and advances made by it and keeping the securities in joint custody of responsible officers (5) Regular inspection and valuation of securities (6) Appropriate accounting of increase/decrease in securities and their value (7) Regular review of operation of every account Bills Purchased and discounted: The banks discount the bills of exchange drawn or endorsed by customers. On maturity they recover the amount from the drawee or from the drawer or endorser. The auditor should physically verify the bills with the bank and see which of them have gone for collection. He should ascertain that there is accounting of all bills and that those are within the sanctioned limit. There should be scrutiny of overdue bills with reference to the possibility of recovery.

(b)Write short note on NPA(Non Performing Asset) and the norms of provisioning as per the R.B.I guidelines. (5) Ans. Money advanced by banks may be standard asset or non performing asset. A standard asset means an advance which does not pose any recovery problem or carry more than normal risk attached to banking business. A non performing asset (NPA) means an advance that is not a standard asset. On classification of an advance as NPA there must be proper provision against it. Income from NPA will receive recognition only on actual realization. Any term loan will become an NPA if interest or installment of principal sum is due for any 2 quarters even if there is no continuous default for 2 quarters during the year. However if there are defaults during the year but a subsequent regularization of the account by means of repayment of all overdue accounts through genuine sources before the balance sheet date it will not become NPA. It is necessary through that the account remains in order. In other words wiping out the overdue interest or installment of principal sum by any single entry in the account on or before the balance sheet date will make in NPA.

(c)State the procedure for verification of Commission in the course of audit of general Insurance company and write the records that should be verified. (5) Ans. The auditor should examine with reference to the receipts or the acknowledgements of the agents, the commission paid or payable on the direct business of the Insurance company. He should also scrutinize the monthly commission statements and verify whether or not commissions have been paid after deducting income tax on source. He should test check some of the calculations with reference to the insurance policies to ensure that the payments as per the rates prescribed. Provision for commission accrued but not paid should also be checked. Commission paid on reinsurance accepted and those received on reinsurance ceded should be examined with reference to reinsurance treaties or agreements, credit or debit notes and receipts.

(d)What are the basic principles governing and Audit. (SAP-1) (5) Ans. Audit: An audit is the independent examination of financial information of any entity whether profit-oriented or not and irrespective of its size or legal form when such an examination is conducted with a view to expressing an opinion thereon. Professional traits of an Auditor: Confidentiality: The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information o a third party without specific authority or unless there is a legal or professional duty to disclose.

Skills and Competence: The person having specialized skill and competence should conduct audit. The audit should be performed and the report prepared with due professional care by persons who have adequate training experience and competence in auditing. Audit Evidence: An auditor should obtain sufficient through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions therefrom on which to base his opinion on the financial information. Documentation: The auditor should document matters which are important in providing evidence that the audit was carried out in accordance with the basic principles. Auditing Conclusions and Reporting: The end result of the auditing is the audit report and conclusions. The auditor should review and assess the conclusions drawn from the audit evidence obtained and from his knowledge of business of the entity as the basis for the expressions of his opinion on the financial information. The audit evidence obtained should normally include: (1) Financial statements prepared on the basis of standard accounting practices (2) Compliance of relevant laws and regulations (3) Material facts adequately disclosed

(e)Write in brief the role of DCA (Department of Company Affairs) and SEBI particularly in case of listed company. (5) Ans. This is a declaration of mission values and standards and commitment to achieve excellence in the formulation and implementation of policies and procedures of Department of Company affairs for the benefit of the public, investors and corporate sector who are partners in progress. It Provides: (1) Legal framework for incorporation as well as proper and efficient functioning of companies (2) Redressal forums for grievances of investors, creditors and others (3) Prescribing the cost audit rules and ordering/approving the appointment of cost auditors in various industries (4) Ensuring compliance with the prescribed accounting standards under Companies Act (5) Interaction with professional bodies and business community for continuous feed back regarding general difficulties of corporate sector.

SEBI guidelines: (1) SEBI guidelines relate to first issue of new companies, first issue of existing companies, issue of convertible etc. These guidelines are in addition to other legal provisions in existence. SEBI has also introduced a code of advertisement for public issues for ensuring fair and truthful disclosures. Companies have to take the consent of SEBI before bringing its new issue in the market. (2) SEBI had started regulating Foreign Institutional Investors in pursuance of guidelines for investments issued in September 1992 (3) SEBI has prosecuted many company officials for delaying share transfers and for delay in refund of public issue money. This step gives protection to investors and avoids their exploitation through delayed payments (4) SEBI has issued guidelines to intermediaries in order to protect the interest of the investors and control unfair practices.

Q2
(a) Write the difference between Internal Audit and External Audit (Statutory audit) (7) Ans. Two broad categories namely external auditors and internal auditors exist. External auditors are the persons who practice the profession of accountancy having qualified in the professional examination and are external vis--vis the organization of which they audit the accounts. The internal auditors on the other hand may also be professionally qualified and are internal vis--vis the organization in which they are appointed to perform specific work. They are considered internal because their appointment is done by the management and the scope of work is also specified by it. They may be appointed either on a contract basis or as employees to undertake auditing of the books and records as a part of management control and appraisal system. The external auditors on the other hand are appointed by the owners of the organization say shareholders of the company and thus they are treated external to the organization in which they have been appointed. When and external auditor is appointed under a particular salute such auditor may be known as the statutory auditor. Their scope of work is determined by the statute under which they have been appointed. Another significant distinction between the internal and external auditor is that the former is not considered independent vis--vis the management of the organization while the latter is independent of the management of the organization which is responsible for the preparation of the books of account. Finally the scope of work of an internal auditor may extend even beyond the financial accounting and may include cost investigation inquires relating to losses and wastages production audit performance audit etc. It must be remembered that the basic foundation of any type of auditing , whether internal or external envisages that the auditor must be independent of the activity for which he is going to conduct an audit. Even though the internal auditor is an employee yet he must be independent to the extent practicable.

(b) Write in brief SEBI requirement on Corporate Governance and Describe the functions of Audit Committee. (7) Ans. Corporate Governance is adherence to certain norms with the objective of maximizing shareholder value while ensuring fairness to all shareholders. It is about creating an outperforming organization which leads to increased customer satisfaction and shareholder value. It primarily involves transparency full disclosure independent monitoring the state of affairs and being fair to all shareholders. Securities and Exchange Board of India(SEBI): The SEBI has appointed a committee. The recommendation of the committee has been adopted by the SEBI as the code of Corporate Governance.

Audit Committes The terminology for accountants defines an audit committee as a committee of directiors of a corporation whose specific responsibility is to review the annual financial statements before submission to the board of directors. Functions of Audit Committees: (1) To consider the appointment of the external auditor, the audit fee, and any questions of resignation or dismissal. (2) To discuss the nature and scope of the audit with the external auditor before the audit commences and ensure co-ordination where more than one audit firm is involved. (3) To review the half-yearly and annual financial statements before submission to the board focusing particularly on: Any changes in accounting policies and practices Major judgmental areas Significant adjustments resulting from the audit Appropriateness of the going concern assumption Compliance with accounting standards Compliance with requirements of law and if stock exchanges (4) To review the external auditors management letter and management response (5) To review the companys statement on internal control systems prior to endorsement by the board (6) To consider the major findings of internal investigations and managements response. (7) To consider other matters as decided by the board.

(c) Explain Contingent Liability and its disclosure as per the schedule- iii to the Banking Regulation Act 1949. (8) Ans. As per the guideline note issued by ICAI contingent liability means an obligation relating to an existing condition or situation which may arise in future depending on future events. It includes the following: (1) Uncalled liabilities on partly paid-up shares held by company as investment. (2) Arrears of dividend on cumulative preference shares (3) Estimated amounts of contracts remaining to be executed on capital account (4) Disputed liabilities on account of Income-Tax sales tax excise duty custom duty for which provision has not been made (5) Amount of any guarantee given by company on behalf of directors or other officers of the company workers claims not acknowledged as debts by company bills receivable discounted etc.

Note: Contingent liabilities are shown as a footnote to the balance sheet. These are not included in the total. Contingent liabilities may arise from forward exchange contracts, guarantees, letters of credit, or discounting and purchase of bills of exchange. The auditor should examine existing forward exchange contracts with brokers advices and ascertain that the net position of the bank in relation to any foreign currency has adequate coverage.

(d) Mention the special point that will receive the attention of bank auditor in verification of advance against Life insurance policies and advance against Government securities like NSC etc. (8)

Q3
(a)Write an audit verification checklist while auditing claims paid and claims provision transaction in Insurance company. (7) Ans. A general insurance company is required to disclose in the balance sheet the estimated liability in respect of outstanding claims whether due or intimated. The auditor has to check the following things while verifying claims paid: (1) Appropriate claim processing and payment procedures are established. (2) All payments for losses and loss adjustment expenses are approved by a responsible officer. (3) In case of large claims and claim payments an additional review is performed by a superior officer. (4) In case of material expenses between expected claim and actual claim the same are properly investigated. (5) There is numerical control over issued drafts and checks. (6) All settled cases are dually recovered as closed in a timely manner. (7) At the time of claims processing re-insurance taken is adequately considered.

In order to verify claims provisions the auditor has to take the following steps (1) The internal system should be studied to determine whether it ensures proper verification of facts before a claim is recorded in the claims register and whether proper claim file or docket is maintained containing the claim form, survey reports, sanction of the appropriate authority etc. (2) The estimated liability provided for in respect of claims due and intimated should be carefully scrutinized with reference to various documents in the claim files to examine whether provisions have been made for all unsettled claims as at the end. (3) The auditor has to verify that only those claims are paid or provided for in respect of which the company is legally liable. Major claims can be test-checked to see whether the risk was covered by the policy and the claim was actually due. (4) Claims pertaining to the year and settled after the close of the year but before the date of audit should be examined to judge the adequacy of the amount provided for in this regard. (5) Co-insurance arrangements should examine to verify that only that part of the claims is provided for in respect of which the company is legally liable.

(b)Explain the term Coinsurance and write short note on Incoming and Outgoing coinsurance. (7) Ans. Coinsurance is an arrangement where insurance is offered jointly with other insurance companies. The premium income normally comprises of premiums in respect of business exclusively transacted by the company itself and its share of premiums in respect of business transacted under the insurance company under audit is the leader, it should be verified whether only the companys own share of premium is shown as income. Where the company is not a leader the inward premium statements from coinsurers should be examined. The premium received during the year should be test checked with reference to counterfoils of receipts issued, agents premium accounts premium registers and inward premium statements from the coinsurers. Where the company is not the leader it will receive premium statements from other co-insurer. The auditor has to examine the co-insurance arrangements in order to verify that only that the part of the claims is provided for in respect of which the company is legally liable. Proper adjustments sould also be made for incoming and outgoing coinsurance. Incoming and Outgoing insurance: According to the sub section (4) of he IRDA Regulations, 2000, every insurer wanting to write inwards re-insurance business should have a precise underwriting policy. The decisions as regards to acceptance of re-insurance business to be taken should be taken by a person who is competent and has good knowledge and experience in this regard. The decisions in such case should be taken by the officer keeping in view the financial risk involved. As per regulations the insurer has to file a note o its underwriting policy and any changes therin from time to time to IRDA. Therefore the auditor should see that the Re-insurance Inward underwriting is as per the norms and guidelines prescribed by the regulation. He should also see that the reinsurance inward acceptances are in accordance with arrangements entered into with other company, the auditor should verify the policy for booking the accounts. The auditor should also verify that the company has received proper closing returns for premiums and claims. He should also examine whether the company has obtained outstanding claim figures and has also made adequate provisions for the same. The closing balance should be reconciled and the confirmation of balance should be obtained from all the companies.

(c)What are the provisions of Companies Act 1956 which ensures the Independence of auditors" with respect to appointment itself? (8) Ans. Independence implies that the judgment of a person is not subordinate to the wishes or directions of another person who might have engaged him or to his own self-interest. The need for independence in the work of the auditor is well established. If he is not independent of the management, his opinion would mean little to shareholders, prospective investors, bankers, government agencies, and others who are concerned with the financial statements of a company. An auditor must fulfill his obligations even when it means opposing or denying the wishes of those who have employed him, and who he know may cease to do so. It is a requirement unparalleled in any other field. The need for the auditors independence is also recognized in the CA act 1949, as well as in the Cost and Work Accountants Act 1959. For example clause 10 of Part I of the first schedule to the CA act prohibits except in certain cases the acceptance of contingent fees, i.e fees which are either based on a percentage of profits or are otherwise dependent on the findings or the results of employment. Similarly The following are the suggestions for ensuring greater independence of auditors. (1) Setting up of an independent audit committee comprising of non-executive directors of that company to deal with all audit related functions and to act as in insulator between the management and the auditors. (2) Peer review of auditors to monitor whether an auditor is maintaining proper standards. (3) Not allowing auditors to derive more than a certain percentage of their gross revenue from any one company/group of companies (4) Prohibition on persons to act as auditors of a company if they are related to directors they have common financial interests with them. (5) Prohibition on the auditor accepting goods services or undue hospitality from the client. (6) Rotation of auditors. (7) Dissociation with the audit where there is actual or threatened litigation with the client.

The Companies act 1956 has enacted specific provisions to give shape to this vital concept. Accordingly a person is disqualified to act as an auditor from being appointed as such if he is: (1) (2) (3) (4) An officer or employee of the company A partner or an employee of an officer or employee of the company Indebted to the company for a sum exceeding Rs.1000 A person holding any security of that company after a period of 1 year from the date of the commencement of the companies(Amendment) Act, 2000

(d) Enumerate the auditing Standard prescribed by the Institute of Chartered Accountants of India namely SAP-9 using the work of an expert and SAP Audit Materiality. (8) Ans. AAS-9 Using the work of an expert: The auditor while performing the audit work uses the work performed by the expert and takes into account the view of the expert while forming and expressing an opinion on the financial statements. Need to use the Work of an Expert: During the audit, the auditor may seek to obtain in conjunction with the client or independently, audit evidence in the form of reports, opinions, valuations and statements of an expert. Evaluating the Work of an Expert: (a) Professional qualification (b) Experience and reputation in related field (c) Independence and objectivity (d) Objectives and scope (e) Relationship with client (f) Source of data used by the expert (g) The assumptions and methods used for conclusion Effective date: AAS 9 became operative on or after April 1.1991

AAS-13--- Audit Materiality: Materiality: Information in financial statements, profit/loss statement or balance sheet is considered to be material if its misstatement, disclosure or non-disclosure could influence the economic decision of users of the financial information.

Objective: Objective is to establish standards on the concept of materiality and its relationship with audit risk. Effective date: AAS 13 became operative on or after April 1, 1996.

Q4 Attempt any 3/5

(a)A major part of the benefits paid by the insurer is the claims as far as Life Insurance companies are concerned, in context to the same write the notes on the audit procedure relating to the verification of the same and what are the records one has to check for the audit verification, (5) (b) Communicating the previous auditor- what are the provisions laid down by the ICAI in this regards. In what way this will be helpful to the incoming auditor? (5) (c) Why is it important for an auditor to remain independent? What are the provisions relating to the appointment of an auditor under Companies Act which ensures the independence? (5) Ans. Independence of auditor must not only exist in fact but should also appear to exist to all reasonable persons. Independence is a state of mind and personal character and an enlightened view of the professional duties involved. The Companies act 1956 has enacted specific provisions to give shape to this vital concept. Accordingly a person is disqualified to act as an auditor from being appointed as such if he is: (5) (6) (7) (8) An officer or employee of the company A partner or an employee of an officer or employee of the company Indebted to the company for a sum exceeding Rs.1000 A person holding any security of that company after a period of 1 year from the date of the commencement of the companies(Amendment) Act, 2000

(d) write short note on Audit and Investigation(Due diligence) (5) Ans. In lay terms due diligence is the effort made by ordinarily prudent or reasonable party to avoid harm to another party or himself. In finance, due diligence is the process is the process of research and analysis that takes place in advance of an acquisition, investment, business partnership or bank loan in order to determine the value of the subject of due diligence or whether there are any skeletons in the closet In addition to indentifying risks and implications of an investment, due diligence may include may include data on a companys solvency and assets. While due diligence is the responsibility one has to investigate and identify issues due care is doing something about the findings from due diligence. Due diligence can be classified into the following categories:

(1) (2) (3) (4) (5) (6) (7)

Commercial or Operational Due Diligence Financial Due Diligence Tax Due Diligence Information system Due Diligence Legal Due Diligence Environmental Due Diligence Personnel Due Diligence

(e) What is window dressing? Write short note on possible window dressing done by the bank officials as far as classification of advances are concerned, particularly to show the account is not NPA. (5) Ans. Window dressing means presenting the financial statements in order to show a rosy picture. The real value of assets and liabilities in the balance sheet is not reflected. Similarly the income and expenditure are also shown in a manner so that they do not reflect the real value of income and expenditure. Rules related to non-performing assets(NPAs): Money advanced by banks may be standard asset or non-performing asset. A standard asset means an advance which does not pose any recovery problem or carry more than normal risk attached to banking business. A non-performing asset (NPA) means an advance that is not a standard asset. On classification of an advance as NPA, there must be proper provision against it. Income from NPA will receive recognition only on actual realization. Any term loan will become an NPA if interest or installment of principal sum is due for any 2 quarters even if there is no continuous default for 2 quarters during the year. However if there are defaults during the year but a subsequent regularization of the account by means of repayment of all overdue accounts through genuine sources before the balance sheet date, it will not become NPA. It is necessary though that the account remains in order.