Adcanced Auditing and Professional Ethics Vol. 1

FINAL COURSE STUDY MATERIAL
PAPER 3
Advanced Auditing and

Professional Ethics
Volume – 1
BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA
This study material has been prepared by the faculty of the Board of Studies. The
objective of the study material is to provide teaching material to the students to enable
them to obtain knowledge and skills in the subject. Students should also supplement their
study by reference to the recommended text book(s). In case students need any
clarifications or have any suggestions to make for further improvement of the material
contained herein they may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful for
the students. However, the study material has not been specifically discussed by the
Council of the Institute or any of its Committees and the views expressed herein may not
be taken to necessarily represent the views of the Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this material.
© The Institute of Chartered Accountants of India
All rights reserved. No part of this book may be reproduced, stored in a retrieval system,
or transmitted, in any form, or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without prior permission, in writing, from the publisher.
Website : www.icai.org E-mail : bosnoida@icai.org
Published by Dr. T.P. Ghosh, Director of Studies, ICAI, C-1, Sector-1, NOIDA-201301
Typeset and designed at Board of Studies, The Institute of Chartered Accountants of India.
PREFACE
Auditing is an important area of core competency of the Chartered Accountancy profession.
Millions of investors, potential investors and other stakeholders of an organization repose faith
and confidence on the auditor’s report and the Indian Chartered Accountancy Profession has
aptly served the society and contributed for the national growth and development. This
became possible simply because of adherence to the strict norms of professional self-
discipline and pursuance of the global class auditing and assurance practices.
On the wake of many corporate failures in the USA, Sarbanes–Oxley Act was enacted which
encompasses newer ideas of internal control and Peer review apart from reinforcing old best
practices of auditing and assurance. Enhanced role of the auditors has also been perceived at
home in the context of implementing code of corporate governance and various fiscal
legislations.
Students of the Final level must appreciate these developments, understand and apply the
same even in their day to day work. Students should in the first instance focus on learning of
auditing concepts, procedures and techniques from the study material. The knowledge being
so derived may be related by the students to the practical work in the field of auditing which
they do as part of their training. Auditing is largely a practical and application oriented
discipline.
Students should learn the auditing concepts and techniques as also their intricacies purely for
the purposes of applying them in their audit work. The auditing knowledge inputs provided to
the students by the Institute through the study material and other publications and the
practical training inputs provided by the audit firms during the articleship training stage
compliment one another. Students should, as part of their articleship training, involve
themselves deeply in the professional audit work done by their principals, for the purpose of
getting an intense practical knowledge and learning skills in Auditing.
Here are few tips for examination preparation. Students must familiarise themselves with the
syllabus in detail. Since they are expected to exhibit “advanced knowledge”, it is absolutely
essential that they should be able to apply theoretical knowledge to diverse practical
situations. Therefore, students must study intensively AASs, Accounting Standards, relevant
provisions of the Companies Act, 1956, case laws, etc. A good knowledge of these would help
you to tackle practical-oriented questions in the examination. The Institute’s professional
pronouncements like Accounting Standards, Statements on Standard Auditing Practices and
Guidance Notes on various matters relating to Accountancy, Auditing and Taxation etc. are of
critical importance to CA Final students as they form the base of their knowledge and its
application to practical problems in the relevant subject areas. Students are expected to have
a good insight of the contents of the above publications for their immediate purpose of
examinations and also otherwise in their day to day work they are expected to make use of
them. Some of these publications have been incorporated at the appropriate places in the
study material. While reading through the chapters, you must take special note of various
pronouncements issued by the Institute. As a matter of practical convenience, all important
guidance notes and AASs have been covered at appropriate places. Some important guidance
notes have been covered in the Advanced Accounting study material as well. Students must
read monthly Journal “The Chartered Accountant” and the students’ newsletter “The Chartered
Accountant Student” regularly. The Institute’s monthly Journal “The Chartered Accountant” is a
valuable source of articles on topical interest, relevant notifications and clarifications by
Government of India, RBI, SEBI, etc., information on contemporary developments in
Accounting, Finance, Auditing and Corporate and Tax Laws, etc. Students, especially Final
students, should regularly keep in touch with the Journal to enrich their knowledge base,
relevant for examination and other purpose. “The Chartered Accountant Student”, the
students’ monthly newsletter, published by the Board is another regular channel of
communication with students which contributes to the fund of knowledge required of CA
students, through articles, case studies, reports, academic updates, announcements, etc.
Students may also refer to compilation of suggested answers of Final (Old) Course to the
extent these are relevant for the Final (New) Course. In addition, video CDs of various topics
will also be made available which students may listen. These CDs contain lectures of eminent
experts in the field of auditing.
This study material is divided into twenty three chapters covering in details principles of
Auditing, Audit and Assurance Standards issued by the ICAI , specific audit issues classified
by organizations like Company Audit , audit of Banks , Audit of General Insurance Business ,
Audit of Co-Operative Societies and Audit of Public Sector Undertakings, special audit issues
like audit under Fiscal Laws , role of auditor under clause 49 of the Listing Agreement , Audit
of Consolidated Financial Statements, Investigation and Due Diligence. In Chapter 21, the
latest concept of Peer Review has been explained in details, which are considered as an
important step towards maintenance and improvement of audit quality. In Chapter 22, relevant
aspects of the Sarbanes Oxley requirements are elaborated which will help the students to
appreciate the global trend in auditing and build up international perspective. Lastly, in
Chapter 23 Professional Ethics are dealt with which is regarded as a foundation to the audit
function, which is essentially developed on the foundation of ethical norms, which has so far
brought name and fame to the profession. All students of Final course should read this chapter
with sincerity and imbibe the norms explained. These norms should be the guiding force while
they will work as a chartered accountant.
This study material is developed by a team of experts comprising of CA. T.P.Ghosh, Director
of Studies, CA.Vikas Kumar, Executive Officer, Ms.Srishti Gupta and Ms.Ginni Aggarwal,
Management Trainees in the Board of Studies. Contributions are also made by
CA.K.S.Chauhan, Kanpur and CA.D.R.Sengupta, Kolkata. While preparing this material,
various publications of the ICAI are adopted appropriately. Moreover, a good portion of this
study material is taken from the Advanced Auditing study materials of the Final (Old) Course
prepared by Shri Vijay Kapoor, Director, ICAI. The Board of Studies acknowledges the
contributions made by all these faculty members.
We would welcome suggestions to make this study material more useful to the students. In
case of any doubt, students are welcome to write to the Director of Studies, The Institute of
Chartered Accountants of India, C-1, Sector-1, Noida-201 301.
SYLLABUS
PAPER 3 : ADVANCED AUDITING AND PROFESSIONAL ETHICS
(One Paper- Three hours - 100 marks)
Level of Knowledge: Advanced knowledge
Objectives:
(a) To gain expert knowledge of current auditing practices and procedures and apply them in
auditing engagements,
(b) To develop ability to solve cases relating to audit engagements.
Contents:
1. Auditing Standards, Statements and Guidance Notes
Auditing and Assurance Standards (AASs); Statements and Guidance Notes on Auditing
issued by the ICAI; Significant differences between Auditing and Assurance Standards
and International Standards on Auditing.
2. Audit strategy, planning and programming
Planning the flow of audit work; audit strategy, planning programme and importance of
supervision: review of audit notes and working papers; drafting of reports; principal’s
ultimate responsibility; extent of delegation; control over quality of audit work; reliance on
the work of other auditor, internal auditor or an expert.
3. Risk Assessment and Internal Control
Evaluation of internal control procedures; techniques including questionnaire, flowchart;
internal audit and external audit, coordination between the two.
4. Audit under computerized information system (CIS) environment
Special aspects of CIS Audit Environment, need for review of internal control especially
procedure controls and facility controls. Approach to audit in CIS Environment, use of
computers for internal and management audit purposes: audit tools, test packs,
computerized audit programmes; Special Aspects in Audit of E-Commerce Transaction.
5. Special audit techniques
(a) Selective verification; statistical sampling: Special audit procedures; physical
verification of assets, direct confirmation of debtors and creditors
(b) Analytical review procedures
(c) Risk-based auditing.
6. Audit of limited companies
Statutory requirements under the Companies Act 1956; Audit of branches: joint audits;
Dividends and divisible profits % financial, legal, and policy considerations.
7. Rights, duties, and liabilities of auditors; third party liability.
8. Audit reports; Qualifications, notes on accounts, distinction between notes and
qualifications, detailed observations by the statutory auditor to the management vis-a-vis
obligations of reporting to the members.
9. Audit Committee and Corporate Governance
10. Audit of Consolidated Financial Statements, Audit Reports and Certificates for Special
Purpose engagements; Certificates under the Payment of Bonus Act, import/export
control authorities, etc.; Specific services to non-audit clients; Certificate on Corporate
Governance.
11. Special features of audit of banks, insurance companies, co-operative societies and non-
banking financial companies.
12. Audit under Fiscal Laws, viz, Direct and Indirect Tax Laws.
13. Cost audit
14. Special audit assignments like audit of bank borrowers, audit of stock and commodity
exchange intermediaries and depositories; inspection of special entities like banks,
financial institutions, mutual funds, stock brokers.
15. Special features in audit of public sector companies. Directions of Comptroller and
Auditor General of India under Section 619; Concepts of propriety and efficiency audit.
16. Internal audit, management and operational audit Nature and purpose, organisation,
audit programme, behavioural problems; Internal Audit Standards issued by the ICAI;
Specific areas of management and operational audit involving review of internal control,
purchasing operations, manufacturing operations, selling and distribution, personnel
policies, systems and procedures. Aspects relating to concurrent audit.
17. Investigation and Due Diligence.
18. Concept of peer review
19. Salient features of Sarbanes – Oxley Act, 2002 with special reference to reporting on
internal control.
20. Professional Ethics
Code of Ethics with special reference to the relevant provisions of The Chartered
Accountants Act, 1949 and the Regulations thereunder.
VOLUME-1
ADVANCED AUDITING AND PROFESSIONAL ETHICS
CONTENTS
CHAPTER 1 : AUDITING STANDARDS, STATEMENTS AND GUIDANCE NOTES - AN

OVERVIEW
1.1 Introduction ................................................................................................... 1.1
1.2 Historical Retrospect ..................................................................................... 1.2
1.3 Auditing and Assurance Standards Board – Scope and Functions .................... 1.2
1.4 Framework of AASs and Guidance Notes on Related Services ........................ 1.4
1.5 Auditing Standards ........................................................................................ 1.6
1.6 Guidance Notes........................................................................................... 1.29
1.7 Guidance Note(S) on Related Services......................................................... 1.35
1.8 Authority Attached to the Documents issued by the Institute .......................... 1.35
CHAPTER 2: AUDIT STRATERGY, PLANNING AND PROGRAMMING

2.1 Commencing an Audit.................................................................................... 2.1
2.2 Formulating an Audit Programme ................................................................... 2.4
2.3 Designing Audit Strategy ............................................................................. 2.17
2.4 Using the work of an Expert ......................................................................... 2.20
2.5 Relying upon the work of Internal Auditor ..................................................... 2.23
2.6 Using the work of another Auditor ................................................................ 2.23
2.7 Principal’s ultimate Responsibility ................................................................ 2.23
2.8 Reliance on the Management or other Certificates by the Auditor .................. 2.24
2.9 Management Representations ...................................................................... 2.26
2.10 Drafting of Report ........................................................................................ 2.27
2.11 Control of Quality of Audit Work ................................................................... 2.28
CHAPTER 3: RISK ASSESSMENT AND INTERNAL CONTROL
3.1 Introduction ................................................................................................... 3.1
3.2 Internal Control System - Nature, Scope, Objective and Structure.................... 3.2
3.3 Components of Internal Control ...................................................................... 3.6
3.4 Review of the System of Internal Control ........................................................ 3.7
3.5 Methods of Recording .................................................................................... 3.9
3.6 Evaluation of Internal Control ....................................................................... 3.19
3.7 Internal Control and Risk Assessment .......................................................... 3.20
3.8 Internal control in Small Business Enterprises .............................................. 3.26
3.9 Reporting to clients on Internal Control Weaknesses ..................................... 3.26
CHAPTER 4: AUDIT UNDER COMPUTERISED INFORMATION SYSTEM (CIS)

ENVIRONMENT
4.1 Introduction ................................................................................................... 4.1
4.2 Scope of Audit in a CIS Environment .............................................................. 4.1
4.3 Impact of changes on Business Processes (for shifting from manual to electronic
medium)........................................................................................................ 4.3
4.4 Audit Approach in a CIS environment ............................................................. 4.3
4.5 Types of Computer Systems .......................................................................... 4.7
4.6 Effect of Computers on Internal Controls ...................................................... 4.12
4.7 Effects of Computers on Auditing ................................................................. 4.14
4.8 Internal controls in a CIS environment .......................................................... 4.15
4.9 Consideration of Control Attributes by the Auditors ....................................... 4.17
4.10 Internal control requirement under CIS Environment ..................................... 4.17
4.11 Approach to Auditing in a CIS Environment................................................... 4.19
4.12 Review of Checks and Controls in a CIS Environment ................................... 4.21
4.13 Auditors Involvement in the Clients System Development and Documentation
Control........................................................................................................ 4.28
4.14 Computer assisted audit techniques (CAATs) ............................................... 4.31
CHAPTER 5: SPECIAL AUDIT TECHNIQUES
5.1 Introduction ................................................................................................... 5.1
5.2 Statistical Sampling in Auditing .................................................................... 5.10
5.3 Audit of Fixed Assets ................................................................................... 5.18
5.4 Audit Risk ................................................................................................... 5.20
5.5 Risk-Based Audit ......................................................................................... 5.22
5.6 Materiality and Audit Risk ............................................................................ 5.24
CHAPTER 6: THE COMPANY AUDIT

6.1 Introduction ................................................................................................... 6.1
6.2 Appointment of Company Auditor ................................................................... 6.1
6.3 Remuneration.............................................................................................. 6.12
6.4 Functions, Duties and Rights of Auditors ...................................................... 6.19
6.5 Audit of Branches ........................................................................................ 6.26
6.6 Reliance on the Work and Report of the other Auditor ................................... 6.28
6.7 Joint Audit................................................................................................... 6.31
6.8 Gist of Important Circulars ........................................................................... 6.34
6.9 Compliance with Relevant Provisions of the Companies Act, 1956 ................. 6.39
6.10 Auditor’s Duty under Companies Act, 1956 ................................................... 6.45
6.11 Final Accounts Preparation and Presentation................................................ 6.51
6.12 Significance of True and Fair ....................................................................... 6.54
6.13 Divisible Profits, Dividends and Reserves ..................................................... 6.55
6.14 Depreciation................................................................................................ 6.77
CHAPTER 7: LIABILITIES OF AUDITORS

7.1 Nature of Auditor’s Liability ............................................................................ 7.1
7.2 Professional Negligence ................................................................................ 7.3
7.3 Cases Concerning the Civil Liability of Auditors for Negligence...................... 7.15
7.4 Civil Liabilities under the Companies Act ...................................................... 7.17
7.5 Criminal Liability under the Companies Act ................................................... 7.22
7.6 Cases Concerning the Misconduct of Auditors under the
Chartered Accountants Act .......................................................................... 7.25
7.7 Liabilities under Income Tax Act,1961 .......................................................... 7.27
CHAPTER 8: AUDIT REPORT

8.1 Auditor’s opinion ........................................................................................... 8.1
8.2 The Auditor’s Report on Financial Statements................................................. 8.4
8.3 Statement on Qualifications in the Auditor’s Report ....................................... 8.16
8.4 Distinction between Audit Report and Certificate ........................................... 8.32
8.5 Audit Reports and Certificates for Special Purposes ...................................... 8.35
8.6 Audit of Company Prospectuses................................................................... 8.38
8.7 Audit Reports/Certificates on Financial Information in Offer Documents ......... 8.41
8.8 Statement on the Companies (Auditor’s Report) Order, 2003 ......................... 8.54
CHAPTER 9: AUDIT COMMITTEE AND CORPORATE GOVERNANCE

9.1 Introduction ................................................................................................... 9.1
9.2 Definition of Corporate Governance................................................................ 9.2
9.3 Management’s Responsibility ......................................................................... 9.3
9.4 Audit Committee under Clause 49 .................................................................. 9.3
9.5 Functions of the Audit Committee................................................................... 9.6
9.6 Review of Information by Audit Committee...................................................... 9.6
9.7 Audit Committee Under Section 292 A of The Companies Act, 1956 ................ 9.7
9.8 Audit Committee – A Comparative .................................................................. 9.8
9.9 Role of Auditor in Audit Committee and Certification of
Compliance of Conditions of Corporate Governance...................................... 9.10
9.10 Disclosures ................................................................................................. 9.22
9.11 Report on Corporate Governance ................................................................. 9.23
9.12 Auditors’ Certificate ..................................................................................... 9.24
CHAPTER 10: AUDIT OF CONSOLIDATED FINANCIAL STATEMENTS
10.1 Introduction ................................................................................................. 10.1
10.2 Definitions................................................................................................... 10.2
10.3 Responsibility of Parent ............................................................................... 10.2
10.4 Responsibility of the Auditor of the Consolidated Financial Statements .......... 10.2
10.5 Audit Considerations ................................................................................... 10.3
10.6 Auditing the Consolidation ........................................................................... 10.5
10.7 Special Considerations ................................................................................ 10.7
10.8 Management Representations .....................................................................10.10
10.9 Reporting ...................................................................................................10.11
10.10 When the Parent’s Auditor is also the Auditor of its Subsidiaries...................10.11
10.11 When the Parent’s Auditor is not the Auditor of its Subsidiary (ies) ...............10.11
CHAPTER 11: AUDIT OF BANKS

11.1 Introduction ................................................................................................. 11.1
11.2 Special Features ......................................................................................... 11.2
11.3 Legal Framework......................................................................................... 11.3
11.4 Form and Content of Financial Statements ................................................... 11.3
11.5 Audit of Accounts ........................................................................................ 11.6
11.6 Internal Control in Certain Selected Areas ...................................................11.16
11.7 Verification of Assets and Balances.............................................................11.20
11.8 Capital Adequacy .......................................................................................11.70
11.9 Concurrent Audit ........................................................................................11.70
CHAPTER 12: AUDIT OF GENERAL INSURANCE COMPANIES

12.1 Introduction ................................................................................................. 12.1
12.2 Legal Framework......................................................................................... 12.2
12.3 Insurance Regulatory and Development Authority (IRDA) Act, 1999
and Regulations Framed there under............................................................ 12.5
12.4 Features of Accounting System of Insurance Companies............................... 12.5
12.5 Audit of Accounts .......................................................................................12.16
12.6 Specific Control Procedures related to General Insurance Business..............12.19
12.7 Audit Procedures ........................................................................................12.20
12.8 Items Relating to Balance Sheet .................................................................12.28
12.9 Reinsurance ...............................................................................................12.35
12.10 Co-Insurance .............................................................................................12.41
12.11 Solvency Margin .........................................................................................12.41
CHAPTER 13: AUDIT OF CO-OPERATIVE SOCIETIES

13.1 Introduction ................................................................................................. 13.1
13.2 Auditor and Management ............................................................................. 13.2
13.3 Special features of Co-operative Audit.......................................................... 13.7
13.4 Right and Duties of Co-operative Auditors .................................................... 13.9
13.5 Form of Audit Report ..................................................................................13.10
13.6 Audit, Inquiry and Inspection of Multi-State Co-operative Societies ...............13.11
CHAPTER 14: AUDIT OF NON-BANKING FINANCIAL COMPANIES

14.1 Introduction ................................................................................................. 14.1
14.2 Audit Procedure .......................................................................................... 14.2
14.3 Audit Check-List .......................................................................................... 14.6
14.4 Auditor’s duty .............................................................................................. 14.9
CHAPTER 15: AUDIT UNDER FISCAL LAWS

15.1 Introduction ................................................................................................. 15.1
15.2 Audit(s) Under the Income-Tax Act, 1961 ..................................................... 15.1
15.3 Tax Audit under section 44AB ...................................................................... 15.4
15.4 Audit Provisions under Vat Law ...................................................................15.53
CHAPTER 16: COST AUDIT
16.1 Concept of Cost Audit .................................................................................. 16.1
16.2 Types of Cost Audit ..................................................................................... 16.2
16.3 Advantages of Cost Audit............................................................................. 16.3
16.4 Functions of Cost Auditor............................................................................. 16.4
16.5 Programme of Cost Audit ............................................................................. 16.7
16.6 General Features of Cost Records ............................................................... 16.8
16.7 Cost Audit under the Companies Act ...........................................................16.15
16.8 Steps in Cost Audit .....................................................................................16.17
16.9 Right and Duties of Cost Auditor .................................................................16.22
CHAPTER 17: SPECIAL AUDIT ASSIGNMENTS

17.1 Audit of Members of Stock Exchanges ......................................................... 17.1
17.2 Functioning of Stock Exchanges................................................................... 17.2
17.3 Rolling Settlement ......................................................................................17.11
17.4 Derivatives .................................................................................................17.12
17.5 Circuit Filters of Circuit Breakers.................................................................17.13
17.6 Accounting for Stock Exchange Transactions...............................................17.14
17.7 Conduct of Audit.........................................................................................17.16
17.8 Auditor’s Report .........................................................................................17.23
17.9 Audit of Mutual Funds .................................................................................17.24
17.10 Audit of Depositories ..................................................................................17.27
17.11 Certification Pursuant to Companies (Acceptance of Deposit) Rules, 1975 ....17.28
17.12 Environmental Auditing ...............................................................................17.31
17.13 Energy Audit ..............................................................................................17.35
17.14 Audit of Accounts of Non-Corporate Entities (Bank Borrowers) .....................17.36
17.15 Audit of Depositories ..................................................................................17.40
Note: Chapters 18-23 of Advanced Auditing And Professional Ethics and Appendices I-III
are in Volume-2.
1
AUDITING STANDARDS, STATEMENTS AND GUIDANCE
NOTES – AN OVERVIEW
Introduction
1.1 The past decade has been one of unprecedented change in the global economy and
capital markets. Key aspects of the current business environment include a globalized, highly
competitive, expanding economy; explosive growth in the development and use of technology;
dramatic increases in new economy service- and technology-based businesses with
predominantly intangible assets; unparalleled expansion in the number of public entities; large
increases in the number of individuals who directly or indirectly own equity securities; and
unprecedented growth in the market value of those securities.
The expanded use of technology in both the operating and financial systems of companies
also has significantly affected the audit environment, forcing audit firms to recruit, train and
deploy a large number of information technology specialists to support their audit efforts. It
also has caused firms to reconsider their audit methods and techniques in an effort to harness
technology to improve audit efficiency and effectiveness.
In the changing environment, it is obvious that a professional accountant should to adhere to
standards and procedures laid down by the professional accountancy bodies of which he is a
member while discharging his duties in a responsible manner. In this direction, the role of a
professional accounting body is to lay down such standards and procedures with the aim of
providing guidance to members. The Institute of Chartered Accountants of India (ICAI) has
been formulating auditing and accounting standards for the guidance of its members on its
own volition in the larger interests of the society. In this chapter, we provide an overview of
auditing standards and guidance notes issued by the Institute from time to time. Though these
standards and guidance notes have been dealt at appropriate places, the main purpose is to
acquaint and inculcate appreciation on the part of students in a focused manner as to
significance of the standards in their day to day auditing activities. Towards the end of the
Chapter, the clarification issued by the Council of the Institute is also included, which would go
a long way in understanding as well as significance to the mandatory status of “Statements”
and “Standards”.
1.2 Advanced Auditing and Professional Ethics
Historical Retrospect
1.2 The Institute, since its inception, has been committed to research in the field of
accountancy. As early as in 1955, the Council set up the Research Committee. The Council
at that point of time felt the necessity to establish such a Committee to deal with the growing
complexities of the problems faced by membership at large and with a view to ensuring the
highest of traditions and technical competence in the discharge of the duties by chartered
accountants.
As back as in 1964, the Council published the “Statement on Auditing Practices” as prepared
by the Research Committee not only for the benefit of its members but also for others outside
the profession, who might be interested in this subject. It was hoped that this Statement
would provide valuable guidance in the performance of audits, particularly of companies. The
Council of the Institute fully realised that techniques of accounting and auditing had undergone
and were undergoing important changes. Since the members were expected to keep pace
with recent developments, this Statement attempted to set out practices which were generally
accepted in other countries and which the Council considered desirable in the light of
prevailing circumstances in India. The issuance of the Statement on Auditing Practices might
be considered as a path break as far as establishing sound auditing practices is concerned.
The Statement was further revised in 1968 and 1977.
Prior to establishment of the Auditing Practices Committee (APC), the Research Committee
issued the following Statements in Auditing:
♦ Statements on Qualifications in Auditor’s Report
♦ Statement on the Manufacturing and Other Companies (Auditor’s Report) Order,
1975/1988 (Issued under Section 227(4A) of the Companies Act, 1956)
♦ Statement on Responsibilities of Joint Auditors
♦ Statement on Payments to Auditors for Other Services
Auditing and Assurance Standards Board – Scope and Functions
1.3 The Following are the important points as regards scope and functions of Auditing and
Assurance Standards Board –
1.3.1 Setting up of AASB - The International Federation of Accountants (IFAC) came into
existence in 1977 and constituted International Auditing Practices Committee (IAPC) to
formulate International Auditing Guidelines. These guidelines were later on converted into
International Standards on Auditing (ISA). Considering the developments in the field of
auditing at international level, the need for issuing Standards and Guidance Notes in tandem
with international standards but conforming to national laws, customs, usages and business
environments was felt. With this objective, our Institute constituted the Auditing Practices
Committee (APC) on September 17, 1982, to spearhead the new framework of Statements on
Standard Auditing Practices (SAPs) and Guidance Notes (GNs) inter alia to replace various
chapters of the old omnibus Statement on Auditing Practices issued in 1964.
Auditing Standards, Statements and Guidance Notes – An Overview 1.3
In July, 2002, the Auditing Practices Committee has been converted into an Auditing and
Assurance Standards Board by the Council of the Institute, to be in line with the international
trend. A significant step has been taken aimed at bringing in the desired transparency in the
working of the Auditing and Assurance Standards Board, through participation of
representatives of various segments of the society and interest groups, such as, regulators,
industry and academics. The nomenclature of SAPs has also been changed to Auditing and
Assurance Standards (AASs).
1.3.2 Scope and Functions of AASB - The main function of the AASB is to review the existing
auditing practices in India and to develop Statements on Auditing and Assurance Standards
(AASs) so that these may be issued by the Council of the Institute. While formulating the
AASs, the AASB takes into consideration the ISAs issued by the IAPC, applicable laws,
customs, usages and business environment in India. The AASs are issued under the authority
of the Council of the Institute. The AASB also issues Guidance Notes on the issues arising
from the AASs wherever necessary. The AASB has also been entrusted with the
responsibility to review the AASs at periodical intervals.
1.3.3 Scope of AASs - The AASs apply whenever an independent audit is carried out; that is,
in the independent examination of financial information of any entity, whether profit oriented or
not, and irrespective of its size, or legal form (unless specified otherwise) when such an
examination is conducted with a view to expressing an opinion. The AASs may also have
application, as appropriate, to other related functions of auditors. Any limitation on the
applicability of a specific AAS is made clear in the introductory paragraph of the AAS.
1.3.4 Procedure for issuing AASs - Broadly, the following procedure is adopted for the
formulation of AASs:
♦ The AASB determines the broad areas in which the AASs need to be formulated and the
priority in regard to the selection thereof.
♦ In the preparation of AASs, the AASB is assisted by Study Groups constituted to
consider specific subjects. In the formation of Study Groups, provision is made for
participation of a cross-section of members of the Institute.
♦ On the basis of the work of the Study Groups, an exposure draft of the proposed AAS is
prepared by the Committee and issued for comments by members of the Institute.
♦ After taking into consideration the comments received, the draft of the proposed AAS is
finalised by the AASB and submitted to the Council of the Institute.
♦ The Council of the Institute considers the final draft of the proposed AAS, and, if
necessary, modifies the same in consultation with the AASB. The AAS is then issued
under the authority of the Council.
1.3.5 Compliance with the AASs - While discharging their attest function, it is the duty of the
members of the Institute to ensure that the AASs are followed in the audit of financial
information covered by their audit reports. If for any reason a member has not been able to
perform an audit in accordance with the AASs, his report should draw attention to the material
departures therefrom. Auditors are expected to follow AASs in the audits commencing on or
after the date specified in the Standard.
1.3.6 Linkage between AASs and Disciplinary Proceedings - The AASs (as well as other
statements on auditing) represent the generally accepted procedure(s) of audit. As such, a
member who does not perform his audit in accordance with these statements and fails to
disclose the material departures therefrom, becomes liable to the disciplinary proceedings of
the Institute under clause (9) of Part I of the Second Schedule to the Chartered Accountants
Act, 1949 which specifies that a member of the Institute shall be guilty of professional
misconduct if he “fails to invite attention to any material departure from the generally accepted
procedure of audit applicable to the circumstances”.
Framework of AASs and Guidance Notes on Related Services
1.4 Framework of Auditing and Assurance Standards and Guidance Notes on Related
Services issued recently distinguishes audits from related services. Related services comprise
reviews, agreed-upon procedures and compilations. As illustrated in the diagram below, audits
and reviews are designed to enable the auditor to provide high and moderate levels of
assurance respectively, such terms being used to indicate their comparative ranking.
Engagements to undertake agreed-upon procedures and compilations are not intended to
enable the auditor to express assurance.
Auditing _____Related Services_____
Nature of service Audit Review Agreed- Compilation
upon
Procedures
Comparative High, but Moderate No No

level of not absolute assurance assurance assurance
assurance assurance
provided by the
auditor
Report provided Positive Negative Factual Identificatio

assurance assurance findings of n of
on on procedures information
assertion(s) assertion(s) compiled
Assurance in the above context refers to the auditor's satisfaction as to the reliability of an
assertion being made by one party for use by another party. To provide such assurance, the
auditor assesses the evidence collected as a result of procedures conducted and expresses
a conclusion. The degree of satisfaction achieved and, therefore, the level of assurance
which may be provided is determined by the procedures performed and their results. In an
audit engagement, the auditor provides a high, but not absolute, level of assurance that the
information subject to audit is free of material misstatement expressed positively in the audit
report. In a review engagement, the auditor provides a moderate level of assurance that the
information subject to review is free of material misstatement. This is expressed in the form
of negative assurance. For agreed-upon procedures, auditor simply provides a report of the
factual findings, no assurance is expressed. Instead, users of the report draw their own
conclusions from the auditor's work. In a compilation engagement, although the users of the
compiled information derive some benefit from the involvement of a member of the Institute,
no assurance is expressed in the report. Objective of an audit is to enable the auditor to
express an opinion whether the financial statements are prepared, in all material respects, in
accordance with an identified financial reporting framework "give a true and fair view".
Absolute assurance in auditing is not attainable as a result of such factors as the need for
judgement, the use of test checks, the inherent limitations of any accounting and internal
control systems and the fact that most of the evidence available to the auditor is persuasive,
rather than conclusive, in nature. The objective of a review of financial statements is to
enable an auditor to state whether, on the basis of procedures which do not provide all the
evidence that would be required in an audit, anything has come to the auditor's attention that
causes the auditor to believe that the financial statements are not prepared, in all material
respects, in accordance with an identified financial reporting framework. While a review
involves the application of audit skills and techniques and the gathering of evidence, it does
not ordinarily involve on assessment of accounting and internal control systems, tests of
records and of responses to inquiries by obtaining corroborating evidence through inspection,
observation, confirmation and computation, the auditor attempts to become aware of all
significant matters, the procedures of a review make the achievement less likely than in an
audit engagement, thus the level of assurance provided in a review report is correspondingly
less than that given in an audit report. In an engagement to perform agreed-upon
procedures and auditor is engaged to carry out those procedures of an audit nature to which
the auditor and the entity and any appropriate third parties have agreed and to report on
factual findings. The report is restricted to those parties that have agreed to the procedures
to be performed since others, unaware of the reasons for the procedures, may misinterpret
the results. In a compilation engagement, a member of the Institute is engaged to use
accounting expertise as opposed to auditing expertise to collect, classify, and summaries
financial information. The procedures employed are not designed and do not enable the
member to express any assurance on the financial information. However, users derive some
benefit as a result of the member's involvement because the service has been performed
with due professional skill and care. An auditor is associated with financial information when
the auditor attaches a report to that information or consents to the use of the auditor's name
in a professional connection. If the auditor is not associated in this manner, third parties can
assume no responsibility of the auditor.
Auditing Standards
1.5 Till date, AASB has issued thirty four AASs. A brief summary of each AAS is given below:
1.5.1 AAS 1 : Basic Principles Governing an Audit - The Statement defines ‘audit’ as 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 express an opinion thereon. This Statement also describes the basic principles which
govern the auditor's professional responsibilities and which should be complied with whenever
an audit is carried out. These basic principles, as laid down by the Standard, are as follows:-
♦ Integrity, objectivity and independence
♦ Confidentiality
♦ Skills and competence
♦ Work performed by others
♦ Documentation
♦ Planning
♦ Audit evidence
♦ Accounting systems and internal controls
♦ Audit conclusions and reporting
Compliance with the aforestated basic principles requires the application of auditing
procedures and reporting practices appropriate to the particular circumstances.
This AAS became operative for all audits relating to accounting periods beginning on or after
April 1, 1985.
1.5.2 AAS 2 : Objective and Scope of the Audit of Financial Statements - This AAS describes
the overall objective and scope of the audit of general purpose financial statements of an
enterprise by an independent auditor. The Statement lays down that the objective of an audit
of financial statements, prepared within a framework of recognised accounting policies and
practices and relevant statutory requirements, if any, is to enable an auditor to express an
opinion on such financial statements. However, the auditor's opinion is in no way an
assurance as to the future viability of the enterprise or the efficiency or effectiveness with
which management has conducted the affairs of the enterprise. Besides, the Statement also
states that the scope of an audit of financial statements will be determined by the auditor
having regard to the terms of the engagement, the requirements of the relevant legislation and
the pronouncements of the Institute. However, the terms of engagement cannot restrict the
scope of an audit in relation to matters which are prescribed by statute or the pronouncements
of the Institute. The statement also requires the auditor to assess the reliability and
sufficiency of the information contained in the underlying accounting records and other source
data and also determine whether the relevant information is properly disclosed in the financial
statements.
The statement furthermore clarifies that due to pervasive rather than conclusive nature of
audit evidence, test nature and other inherent limitations of an audit, together with the
inherent limitations of any system of internal control, there is always an unavoidable risk that
some material misstatement might remain undiscovered. The auditor should also set out the
constraints on the scope of the audit, in his audit report.
This standard is operative for all audits relating to accounting periods beginning on or after
April 1, 1985.
1.5.3 AAS 3 : Documentation - The AAS deals with the working papers prepared or obtained
by the auditor and retained by him, in connection with the performance of his audit and the
advantages of maintaining working papers. The AAS, broadly, lays down that the working
papers should record the audit plan, the nature, timing and extent of audit procedures
performed, and the conclusion drawn from evidence obtained. The AAS divides working
papers into two categories – first, permanent audit files which are updated currently with
information of continuing importance to succeeding audits; and second, current audit files
which contain information relating primarily to the audit of a single period. The AAS also lays
down that working papers are the property of the auditor, however, the latter may at his
discretion make portions thereof or extracts therefrom available to his clients. The AAS also
prescribes the duration for which working papers are to be retained.
July 1, 1985.
1.5.4 AAS 4 (Revised) : The Auditor's Responsibility to Consider Fraud and Error in an Audit
of Financial Statement - The purpose of this AAS is to establish standards on the auditor's
responsibility to consider fraud and error in an audit of financial statements. While this AAS
focuses on the auditor's responsibilities with respect to fraud and error, the primary
responsibility for the prevention and detection of fraud and error rests with both those charged
with governance and the management of an entity. In this Standard, the term 'financial
information' encompasses 'financial statements'. In some circumstances, specific legislations
and regulations may require the auditor to undertake procedures additional to those set out in
this AAS. This AAS becomes operative for all audits relating to accounting periods
commencing on or after April 1, 2003.
♦ When planning and performing audit procedures and evaluating and reporting the
results thereof, the auditor should consider the risk of material misstatements in the
financial statements resulting from fraud or error.
♦ In planning the audit, the auditor should discuss with other members of the audit team,
the susceptibility of the entity to material misstatements in the financial statements
resulting from fraud or error.
♦ When planning the audit, the auditor should make inquiries of management:
• to obtain an understanding of:
¾ management's assessment of the risk that the financial statements may be

materially misstated as a result of fraud; and
¾ the accounting and internal control systems management has put in place to
address such risk;
• to obtain knowledge of management's understanding regarding the accounting and
internal control systems in place to prevent and detect error;
• to determine whether management is aware of any known fraud that has affected
the entity or suspected fraud that the entity is investigating; and
• to determine whether management has discovered any material errors.
♦ When assessing inherent risk and control risk in accordance with AAS 6 (Revised),
“Risk Assessments and Internal Control”, the auditor should consider how the financial
statements might be materially misstated as a result of fraud or error. In considering the
risk of material misstatement resulting from fraud, the auditor should consider whether
fraud risk factors are present that indicate the possibility of either fraudulent financial
reporting or misappropriation of assets.
♦ Based on the auditor's assessment of inherent and control risks (including the results of
any tests of controls), the auditor should design substantive procedures to reduce to an
acceptably low level the risk that misstatements resulting from fraud and error that are
material to the financial statements taken as a whole will not be detected. In designing
the substantive procedures, the auditor should address the fraud risk factors that the
auditor has identified as being present.
♦ When the auditor encounters circumstances that may indicate that there is a material
misstatement in the financial statements resulting from fraud or error, the auditor should
perform procedures to determine whether the financial statements are materially
misstated.
♦ When the auditor identifies a misstatement, the auditor should consider whether such a
misstatement may be indicative of fraud and if there is such an indication, the auditor
should consider the implications of the misstatement in relation to other aspects of the
audit, particularly the reliability of management representations.
♦ When the auditor confirms that, or is unable to conclude whether, the financial
statements are materially misstated as a result of fraud or error, the auditor should
consider the implications for the audit.
♦ The auditor should document fraud risk factors identified as being present during the
auditor's assessment process and document the auditor's response to any such factors.
If during the performance of the audit, fraud risk factors are identified that cause the
auditor to believe that additional audit procedures are necessary, the auditor should
document the presence of such risk factors and the auditor's response to them.
♦ When the auditor identifies a misstatement resulting from fraud, or a suspected fraud, or
error, the auditor should consider the auditor's responsibility to communicate that
information to management, those charged with governance and, in some
circumstances, when so required by the laws and regulations, to regulatory and
enforcement authorities also.
♦ If the auditor has identified a material misstatement resulting from error, the auditor
should communicate the misstatement to the appropriate level of management on a
timely basis, and consider the need to report it to those charged with governance.
♦ The auditor should inform those charged with governance of those uncorrected
misstatements aggregated by the auditor during the audit that were determined by
management to be immaterial, both individually and in the aggregate, to the financial
statements taken as a whole.
♦ If the auditor has:
• identified a fraud, whether or not it results in a material misstatement in the financial
statements; or
• obtained evidence that indicates that fraud may exist (even if the potential effect on
the financial statements would not be material);
♦ the auditor should communicate these matters to the appropriate level of management
on a timely basis, and consider the need to report such matters to those charged with
governance.
♦ If the auditor concludes that it is not possible to continue performing the audit as a result
of a misstatement resulting from fraud or suspected fraud, the auditor should:
• consider the professional and legal responsibilities applicable in the circumstances,
including whether there is a requirement for the auditor to report to the person or
persons who made the audit appointment or, in some cases, to regulatory
authorities;
• consider the possibility of withdrawing from the engagement; and
• if the auditor withdraws:
¾ discuss with the appropriate level of management and those charged with
governance, the auditor's withdrawal from the engagement and the reasons for the
withdrawal; and
¾ consider whether there is a professional or legal requirement to report to the
person or persons who made the audit appointment or, in some cases, to
regulatory authorities, the auditor's withdrawal from the engagement and the
reasons for the withdrawal.
1.5.5 AAS 5 : Audit Evidence - The AAS deals with the various aspects of `audit evidence' on
the basis of which the auditor expresses his opinion. The AAS lists the factors which may
affect the sufficiency and appropriateness of audit evidence. The AAS also deals with the
compliance and substantive procedures to be performed for obtaining assurance regarding
various assertions such as existence, effectiveness, continuity, completeness, valuation,
measurement etc., of assets/liabilities. The Statement, inter alia, prescribes the various
methods for obtaining audit evidence - inspection, observation, enquiry and confirmation,
computation and analytical review. The AAS also lays down general rules regarding the
extent of reliability of evidence having regard to source and nature of audit evidence.
This AAS is operative for all audits relating to accounting periods beginning on or after
January 1, 1989.
1.5.6 AAS 6 (Revised) : Risk Assessments and Internal Control - The purpose of this AAS is
to establish standards on the procedures to be followed to obtain an understanding of the
accounting and internal control systems and on audit risk and its components: inherent risk,
control risk and detection risk. This Standard becomes operative for all audit relating to
accounting periods beginning on or after April 1, 2002.
♦ The auditor should obtain an understanding of the accounting and internal control
systems sufficient to plan the audit and develop an effective audit approach. The
auditor should use professional judgement to assess audit risk and to design audit
procedures to ensure that it is reduced to an acceptably low level.
♦ In developing the overall audit plan, the auditor should assess inherent risk at the level
of financial statements. In developing the audit programme, the auditor should relate
such assessment to material account balances and classes of transactions at the level
of assertions made in the financial statements, or assume that inherent risk is high for
the assertion, taking into account factors relevant both to the financial statements as a
whole and to the specific assertions. When the auditor makes an assessment that the
inherent risk is not high, he should document the reasons for such assessment.
♦ The auditor should obtain an understanding of the accounting system sufficient to
identify and understand:
• major classes of transactions in the entity's operations;
• how such transactions are initiated;
• significant accounting records, supporting documents and specific accounts in the
financial statements; and
• the accounting and financial reporting process, from the initiation of significant
transactions and other events to their inclusion in the financial statements.
♦ The auditor should obtain an understanding of the control environment sufficient to

assess management's attitudes, awareness and actions regarding internal controls and
their importance in the entity.
♦ The auditor should obtain an understanding of the control procedures sufficient to
develop the audit plan.
♦ After obtaining an understanding of the accounting system and internal control system,
the auditor should make a preliminary assessment of control risk, at the assertion level,
for each material account balance or class of transactions.
♦ The preliminary assessment of control risk for a financial statement assertion should be
high unless the auditor:
• is able to identify internal controls relevant to the assertion which are likely to
prevent or detect and correct a material misstatement; and
• plans to perform tests of control to support the assessment.
♦ The auditor should document in the audit working papers, the understanding obtained of
the entity's accounting and internal control systems; and the assessment of control risk.
When control risk is assessed at less than high, the auditor would also document the
basis for the conclusions.
♦ The auditor should obtain audit evidence through tests of control to support any
assessment of control risk which is less than high. The lower the assessment of control
risk, the more evidence the auditor should obtain that accounting and internal control
systems are suitably designed and operating effectively.
♦ Based on the results of the tests of control, the auditor should evaluate whether the
internal controls are designed and operating as contemplated in the preliminary
assessment of control risk.
♦ Before relying on procedures performed in prior audits, the auditor should obtain audit
evidence which supports this reliance.
♦ The auditor should consider whether the internal controls were in use throughout the
period.
♦ Before the conclusion of the audit, based on the results of substantive procedures and
other audit evidence obtained by the auditor, the auditor should consider whether the
assessment of control risk is confirmed. In case of deviations from the prescribed
accounting and internal control systems, the auditor would make specific inquiries to
consider their implications. Where, on the basis of such inquiries, the auditor concludes
that the deviations are such that the preliminary assessment of control risk is not
supported, he would amend the same unless the audit evidence obtained from other
tests of control supports that assessment. Where the auditor concludes that the
assessed level of control risk needs to be revised, he would modify the nature, timing
and extent of his planned substantive procedures.
♦ The auditor should consider the assessed levels of inherent and control risks in
determining the nature, timing and extent of substantive procedures required to reduce
audit risk to an acceptably low level.
♦ Regardless of the assessed levels of inherent and control risks, the auditor should
perform some substantive procedures for material account balances and classes of
transactions.
♦ The higher the assessment of inherent and control risks, the more audit evidence the
auditor should obtain from the performance of substantive procedures. When the
auditor determines that detection risk regarding a financial statement assertion for a
material account balance or class of transactions cannot be reduced to an acceptable
level, the auditor should express a qualified opinion or a disclaimer of opinion as may be
appropriate.
♦ The auditor should make management aware, as soon as practical and at an
appropriate level of responsibility, of material weaknesses in the design or operation of
the accounting and internal control systems, which have come to the auditor's attention.
1.5.7 AAS 7 : Relying upon the Work of an Internal Auditor - This AAS deals with the
procedures which should be applied by the external auditor in assessing the work of an
internal auditor for the purpose of placing reliance upon that work. The AAS, inter alia, states
that, the external auditor should evaluate the internal audit function and also internal audit
work to the extent he considers that it will be relevant in determining the nature, timing and
extent of his compliance and substantive procedures. However, the report given by him is his
sole responsibility which is not in any way reduced because of the reliance he places on
internal auditor's work. The AAS also deals with scope and objectives of internal audit
function, aspects to be considered in general evaluation of internal audit function such as
organisational status, scope of functions, technical competence and due professional care,
specific evaluation of internal audit work, as also the coordination between the internal and the
external auditor.
April 1, 1989.
1.5.8 AAS 8 : Audit Planning - The purpose of this AAS is to amplify various principles
regarding `planning', i.e., the auditor should plan his work to enable him to conduct an
effective audit in an efficient and timely manner; that plans should be based on knowledge of
client's business; and that plans should cover, among other things, knowledge of client's
accounting systems, policies and internal control procedures, establishing the expected
degree of reliance to be placed on internal control; determining nature, timing and extent of
audit procedures; and, coordinating the work to be performed. The AAS also deals with the
factors to be considered in audit planning and development of audit plan, and acquiring the
knowledge of client's business, as also the timing for audit plan.
April 1, 1989.
1.5.9 AAS 9 : Using the Work of an Expert - Though an auditor is responsible for forming and
expressing his opinion on financial information, he is entitled to rely on the work performed by
others, provided he exercises adequate skill and care and is not aware of any reason to
believe that he should not have so relied. The auditor should obtain reasonable assurance
that work performed by other auditors/experts is adequate for his purpose. This AAS
discusses auditor's responsibility in relation to, and the procedures the auditor should consider
in using the work of an expert as audit evidence. The AAS also deals with factors to be
considered in determining the need to use an expert's work, evaluating skill, competence and
objectivity of the expert and his work. The AAS also lays down the considerations in referring
to an expert's work in the auditor's report.
April 1, 1991.
1.5.10 AAS 10 (Revised) : Using the Work of Another Auditor - This AAS discusses the
procedures to be applied in situations where an independent auditor reporting on the financial
statements of an entity, uses the work of an independent auditor with respect to the financial
statements of one or more divisions or branches included in the financial statement of the
entity. The Statement also discusses the principal auditor's responsibility in relation to his use
of the work of other auditor. This Standard becomes operative for all audit relating to
accounting periods beginning on or after April 1, 1995.
♦ When the principal auditor uses the work of another auditor, the principal auditor should
determine how the work of the other auditor will affect the audit.
♦ The auditor should consider whether the auditor's own participation is sufficient to be
able to act as the principal auditor.
♦ When planning to use the work of another auditor, the principal auditor should consider
the professional competence of the other auditor in the context of specific assignment if
the other auditor is not a member of the Institute of Chartered Accountants of India.
♦ The principal auditor should perform procedures to obtain sufficient appropriate audit
evidence, that the work of the other auditor is adequate for the principal auditor's
purposes, in the context of the specific assignment.
♦ The principal auditor should consider the significant findings of the other auditor.
♦ There should be sufficient liaison between the principal auditor and the other auditor.
♦ The other auditor, knowing the context in which his work is to be used by the principal
auditor, should co-ordinate with the principal auditor.
♦ When the principal auditor concludes, based on his procedures, that the work of the
other auditor cannot be used and the principal auditor has not been able to perform
sufficient additional procedures regarding the financial information of the component
audited by the other auditor, the principal auditor should express a qualified opinion or
disclaimer of opinion because there is a limitation on the scope of audit.
♦ When the principal auditor has to base his opinion on the financial information of the
entity as a whole relying upon the statements and reports of the other auditors, his
report should state clearly the division of responsibility for the financial information of
the entity by indicating the extent to which the financial information of components
audited by the other auditors have been included in the financial information of the
entity, e.g., the number of divisions/ branches/subsidiaries or other components audited
by other auditors.
1.5.11 AAS 11 : Representations by Management - This AAS establishes standards on the
use of management representations as audit evidence, the procedures to be applied in
evaluating and documenting management representations, and the action to be taken if
management refuses to provide appropriate representations. The AAS also deals with the
basic elements of a management representation letter, covering items like accounting policies,
fixed assets, capital commitments, investments, inventories, current assets and liabilities etc.
The AAS lays down, among other things, that in respect of management representation
relating to matters material to the financial statements, the auditor should seek corroborative
audit evidence from sources inside/outside the entity; evaluate whether the representations
appear to be reasonable and consistent with other audit evidence obtained; and consider
whether the individuals making the representations can be expected to be well-informed on
the matter.
The AAS became operative for all audits relating to accounting periods beginning on or after
April 1, 1995.
1.5.12 AAS 12 : Responsibility of Joint Auditors - This AAS deals with the professional
responsibilities which the auditors undertake in accepting appointments as joint auditors. The
AAS, inter alia, lays down that the joint auditors should, normally, by mutual discussion, divide
the audit work among themselves. The division of work among joint auditors as also the areas
of work to be covered by all of them should be adequately documented and preferably
communicated to the entity. The AAS also states that each joint auditor is responsible only for
the work allotted to him, whether or not he has prepared a separate report on the work
performed by him. The AAS describes the areas for which joint auditors are jointly and
severally responsible. As per the AAS, each joint auditor is entitled to assume that the other
joint auditors have carried out their part of the audit work in accordance with generally
accepted audit procedures. It also deals with the reporting responsibilities of the joint
auditors.
The AAS became effective for all audits relating to accounting periods commencing on or after
April 1, 1996.
1.5.13 AAS 13 : Audit Materiality - The AAS 13 establishes standards on the concept of
materiality and its relationship with audit risk. The AAS states that information is material if its
misstatement could influence the economic decisions of the users taken on the basis of the
financial information and that materiality depends on the size and nature of the items, judged
in the particular circumstances of its misstatements. Materiality should be considered by the
auditor in determining nature, timing and extent of his audit procedures and in evaluating the
effect of misstatements. The AAS also states that materiality should be considered both at
overall financial information level and in relation to individual account balances and classes of
transactions. Besides, there exists an inverse relationship between materiality and the degree
of audit risk. This AAS also deals with the factors influencing materiality, factors to be
considered relating to materiality and audit risk in evaluating audit evidence as also the duties
of an auditor when uncorrected misstatements approach materiality level.
The AAS became effective in respect of audits relating to accounting periods beginning on or
after April 1, 1996.
1.5.14 AAS 14 : Analytical Procedures - AAS 14 establishes standards on application of
analytical procedures during an audit. The AAS, inter alia, lays down that the auditor should
apply analytical procedures at the planning and overall review stages of the audit. The auditor
should apply analytical procedures at the planning stage to assist in understanding the
business and in identifying areas of potential risk and at or near the end of the audit to
corroborate conclusions formed during the audit of individual elements of financial statements
and to arrive at overall conclusion as to reasonableness of the financial statements. The AAS
also deals with advantages of performing analytical procedures, matters comprising analytical
procedures, factors to be considered when performing analytical procedures as substantive
procedures, and the factors influencing the extent of reliance that can be placed on results of
analytical procedures.
The AAS became operative for all audits relating to accounting periods beginning on or after
April 1, 1997.
1.5.15 AAS 15 : Audit Sampling - The AAS establishes standards on the design and
selection of an audit sample and evaluation of the sample results, and applies to both
statistical and non-statistical sampling methods. The AAS, inter alia, lays down that
performing audit procedures on samples and evaluating sampling results can provide
sufficient appropriate audit evidence. When designing an audit sample, the auditor should
consider the specific audit objectives, the population from which auditor wishes to draw
sample, the sample size, sampling risk, tolerable error and the expected error. The AAS also
extensively deals with each of the aforesaid items and illustrates the factors influencing
sample size for tests of control and those for substantive procedures.
The AAS became effective for all audits relating to accounting periods beginning on or after
April 1, 1998.
1.5.16 AAS 16 : Going Concern - This AAS, inter alia, states that when planning and
performing audit procedures and in evaluating the results thereof, the auditor should consider
the appropriateness of the going concern assumption underlying the preparation of financial
statements. When the going concern assumption becomes doubtful, the auditor should gather
sufficient appropriate audit evidence to attempt to resolve, to the auditors satisfaction, the said
doubt. The AAS also deals with the factors to be considered in evaluating the going concern
assumption; the procedures for evaluating the audit evidence regarding appropriateness of
going concern; the duties of the auditor and reporting requirements in case going concern
question is either not resolved or going concern assumption is considered inappropriate.
This AAS became effective for all audits relating to accounting periods beginning on or after
April 1, 1999.
1.5.17 AAS 17 : Quality Control for Audit Work - The AAS establishes standards on quality
control policies and procedures of an audit firm regarding audit work generally; and
procedures regarding the work delegated to assistants on an individual audit. At firm level,
the objectives of the quality control policies to be adopted by an audit firm normally include
professional requirements, skills and competence, assignment, delegations, consultation,
acceptance and intention of clients and monitoring. The AAS, inter alia, lays down that audit
firm should implement quality control policies and procedures designed to ensure that all
audits are conducted in accordance with AASs. At individual audit level, the AAS also deals
with aspects like providing direction and supervision to the assistants to whom work on
individual audits has been delegated, and also reviewing their performance.
The AAS became effective for all audits relating to accounting periods beginning on or after
April 1, 1999. Having regard to the importance of AAS for the auditor, this has been
discussed at length later in the Chapter.
1.5.18 AAS 18 : Audit of Accounting Estimates - The objective of this AAS is to establish
standards on the audit of accounting estimates contained in financial statements viz, the
auditor should obtain sufficient appropriate audit evidence regarding accounting estimates.
However, the AAS is not applicable to the examination of prospective financial information.
Since, accounting estimates are the responsibility of the management, the auditor needs to
obtain sufficient appropriate audit evidence as to whether and accounting estimate is
reasonable in the circumstances, and when required, appropriately disclosed in the financial
statements. According to the AAS, the auditor should follow either or all of the following
procedures to audit an accounting estimates:-
(A) Review and test the process used by management to develop the estimate; including
evaluation of date and evaluation of assumptions underlying the estimates; testing the
calculations involved in the estimate; comparison of estimates and actual results of prior
periods; and evaluation of the approval procedures of the management.
(B) Comparison of the management’s estimate with an independent estimate;
(C) Review of subsequent events which confirm the estimates.
The final assessment of reasonableness of an accounting estimates would be based on the
auditor’s knowledge of the client’s business and its consistency with other audit evidence
obtained during the audit. If the auditor is of the opinion that the accounting estimate
prepared by the management is significantly different from that assessed by him, he should
request the management to revise the same. If the management refuses to revise its
estimate, it would be considered as a misstatement and the auditor would need to consider its
effect on the financial statements. This AAS became operative for all audits commencing on
or after April 1, 2000.
1.5.19 AAS 19 : Subsequent Events - This AAS outlines the auditor’s responsibility in respect
of subsequent events; viz, the auditor should consider the effect of subsequent events on the
financial statements and on the auditor’s report. The AAS defines subsequent Events as
significant events occurring between the balance sheet date and the date of the auditor’s
report. The AAS also refers to Accounting Standard 4, “Contingencies & Events Occurring
After the Balance Sheet Date” for the purposes of “Subsequent Events”. The AAS requires
the auditor to obtain sufficient appropriate audit evidence that all “subsequent events”, have
been identified and adjusted/disclosed, where required, in the financial statements, by
employing the following procedures:-
♦ Review of management’s procedures to identify subsequent events.
♦ Reading of minutes of meetings of shareholders, board of directors etc.
♦ Reading the latest available interim financial information, budgets, forecasts etc.
♦ Inquiring the lawyers of the entity as to the litigations and claims.
♦ Inquiring management as to any subsequent events after the balance sheet date,
affecting the financial statements.
In case of subsequent events materially affecting the financial statements, the auditor would
consider whether such events have been properly accounted for in the financial statements.
Where the management does not account for such events, the auditor would need to express
a qualified or an adverse opinion as appropriate.
The AAS becomes operative for all audits commencing on or after 1st April, 2000.
1.5.20 AAS 20 : Knowledge of the Business - This AAS deals with the definition of the
knowledge of the business, its importance to the auditor and the audit staff, its relevance to
the audit; and how the auditor obtains and uses the knowledge. The auditor should have or
should obtain knowledge of the business efficient to identity and understand the events,
transactions and practices, which in his judgement might have a significant effect on the
financial statements or on examination or audit report. The auditor should be such knowledge
to assess inherent and control risks and to determine the nature, timing and extent of audit
procedures.
Auditor’s level of knowledge would include a general knowledge of the economy and the
industry within which the entity operates and a more particular knowledge of how the entity
operates. In case of a new engagement, the auditor would need to obtain a preliminary
knowledge of the industry and of nature of ownership/management and operations of the
entity. For continuing engagements, the auditor would need to update and reevaluate
information gathered previously and would also perform procedures designed to identify
significant changes that have taken place since the last audit. The AAS illustrates a number
of sources from which the knowledge can be obtained, viz., previous experience with
entity/industry, discussion with senior operating personnel of the entity, discussion with
internal auditors, review of internal audit reports, discussion with legal advisors etc.
The knowledge so obtained would assist the auditor in assessing risks and identifying
problems, planning and performing audit effectively and efficiently, evaluating audit evidence,
and providing better services to clients. The auditor should ensure that the audit staff should
obtain sufficient knowledge of the business. Effective use of knowledge requires the auditor to
consider its effect on the financial statements taken as a whole and also consider whether the
financials statement assertions are consistent with his knowledge of the business.
The AAS is operative for all audits commencing on or after 1st April, 2000.
1.5.21 AAS 21 : Consideration of Laws and Regulations in an Audit of Financial Statements -
The AAS lays down the standards in respect of the auditor’s responsibility regarding
consideration of laws and regulations in an audit of financial statements, viz., in planning and
performing audit procedures and in evaluating results thereof, the auditor should recognize
that non-compliance by the entity with laws and regulations may materially affect the financial
statements. The AAS, however, provides that:
(a) Whether an act constitutes non-compliance is a legal determination that is ordinarily
beyond the auditor’s professional competence, and is generally based on the advice of
an informed expert qualified to practice law but ultimately can only be decided by a court
of law.
(b) The responsibility of ensuring that the entity’s operations are carried out in accordance
with laws and regulations and that of prevention and detection of non-compliance is that
of the management.
(c) The auditor is not and cannot be held responsible for preventing non-compliance, and
audit, however, may act as a deterrent.
(d) The risk that some material misstatements of financial statements are not detected by
audit is higher in case of material misstatements resulting from non-compliance with laws
and regulations.
(e) The auditor should recognise that the audit may reveal conditions or events that would
lead to questioning the compliance with laws and regulations by the entity and should,
accordingly, plan and perform the audit.
After obtaining a general understanding of the legal and regulatory framework applicable to
the entity, and its compliance therewith, the auditor should perform procedures to identify the
instances the non-compliance affecting the financial statements. The auditor should also
obtain evidence regarding compliance with such laws and regulations which effect the
determination of material amounts and disclosures in financial statements.
The AAS requires the auditor to obtain written representations from management regarding
possible or actual non-compliance with laws and regulations whose affects should be
considered while preparing financial statements.
When the auditor becomes aware of information regarding a non-compliance, he should obtain
an understanding of the nature of the act, the circumstances in which it had occurred, and
sufficient other information to evaluate the possible effect on the financial statements. The
auditor should also document the findings and discuss them with management. When the
aforesaid information cannot be obtained, the auditor should consider the effect of lack of
evidence on his report.
The AAS also requires that the auditor should as soon as practicable communicate the non-
compliance to the appropriate level of management.
If the auditor concludes that the non-compliance materially affects the financial statements,
the auditor should express a qualified or an adverse opinion.
In case where the entity does not take remedial steps deemed necessary by the auditor, even
though the non-compliance is not material to the financial statements, the auditor must
withdraw from the engagement.
The AAS is operative for all audits commencing on or after 1st July, 2001.
1.5.22 AAS 22 : Initial Engagements - Opening Balances - This AAS establishes standards
regarding audit of opening balances in case of initial engagements, i.e., when the financial
statements are audited for the first time or when the financial statements for the preceding
period were audited by another auditor. The auditor should obtain sufficient For initial audit
engagements the auditor should obtain sufficient audit evidence that the closing balances of
the preceding period have been correctly brought forward to the current period; that the
opening balances do not contain misstatements that materially affect the financial statements
for the current period; also that appropriate accounting policies are consistently applied. The
auditor would also need to be satisfied regarding the following matters in respect of the
opening balances:
♦ Accounting policies followed by the entity;
♦ Nature of audit report of the preceding period - clean/ qualified etc.;
♦ Nature of opening balances and the risk of their misstatement in the current period;
♦ Materiality of opening balances relative to the financial statements for the current
period.
If the auditor is unable to obtain sufficient appropriate audit evidence concerning opening
balances, the auditor should express a qualified or a disclaimer of opinion, as appropriate.
If the opening balances contain misstatements which materially affect the financial statements
for the current period and the effect of the same is not properly accounted for and adequately
disclosed, the auditor should express qualified opinion or an adverse opinion, as adequate.
The AAS is effective for all audits commencing on or after 1st July, 2001.
1.5.23 AAS 23 : Related Parties - This AAS establishes standards on the auditor’s
responsibilities and audit procedures regarding related parties and transactions with such
parties. It requires that the auditor should perform audit procedures designed to obtain
sufficient appropriate audit evidence regarding the identification and disclosure by
management of related parties and the related party transactions that are material to the
financial statements. AAS requires that the auditor should review information provided by the
management of the entity identifying the names of all known related parties and should
perform the necessary procedures such as review of records, minutes books, income-tax
returns, relevant agreements, etc. to enable completeness of this information. AAS also
requires the auditor to satisfy himself that where the financial reporting framework requires
disclosure of related party relationships, such disclosure is adequate.
While auditing transactions with related parties, the auditor should review information provided
by directors and key management personnel of the entity identifying related party transactions
and should be alert for other material related party transactions. The auditor should also
consider the adequacy of control procedures over the authorisation and recording of related
party transactions. In examining the identified related party transactions, AAS requires that the
auditor should obtain sufficient appropriate audit evidence as to whether these transactions
have been properly recorded and disclosed. The auditor should obtain a written
representation from management concerning the completeness of information provided
regarding the identification of related parties; and the adequacy of related party disclosures in
the financial statements.
Finally, if the auditor is unable to obtain sufficient appropriate audit evidence concerning
related parties and transactions with such parties or concludes that their disclosure in the
financial statements is not adequate, the auditor should express a qualified opinion or a
disclaimer of opinion in the audit report, as may be appropriate.
Appendix to the AAS also gives an example of a management representation letter regarding
related parties. This AAS becomes operative for all audits related to accounting periods
beginning on or after 1st April, 2001.
1.5.24 AAS 24 : Audit Considerations Relating to Entities Using Service Organisations -
The purpose of this Standard is to establish standards for an auditor whose client uses a
service organisation. This AAS also describes the reports of the auditors of the service
organisation, which may be obtained, by the auditor of the client. This Standard becomes
operative for all audits related to accounting period beginning on or after April 1, 2003.
♦ The auditor should consider how a service organisation affects the client's accounting
and internal control systems so as to plan and develop an effective audit approach.
♦ While planning the audit, the auditor of the client should determine the significance of
the activities of the service organisation to the client and their relevance to the audit.
♦ If the auditor concludes that the activities of the service organisation are significant to
the entity and relevant to the audit, the auditor should obtain sufficient information to
understand the accounting and internal control systems of the service organisation and
to assess control risk at either the maximum, or a lower level if tests of control are
performed.
♦ When the auditor uses the report of a service organisation's auditor, the auditor of the
client should consider the professional competence of the other auditor in the context of
specific assignment if the other auditor is not a member of the Institute of Chartered
Accountants of India.
♦ When using a service organisation auditor's report, the auditor of the client should
consider the nature of and content of that report.

♦ The auditor should consider the scope of work performed by the service organisation's
auditor and should assess the usefulness and appropriateness of reports issued by the
service organisation's auditor.
♦ For those specific tests of control and results that are relevant, the auditor of the client
should consider whether the nature, timing and extent of such tests provide sufficient
appropriate audit evidence about the effectiveness of the accounting and internal control
systems to support the client auditor's assessed level of control risk.
♦ When the auditor of the client uses a report from the auditor of a service organisation,
no reference should be made in the client auditor's report to the service organisation's
auditor's report.
1.5.25 AAS 25 : Comparatives - This Auditing and Assurance Standard (AAS) establishes
standards on auditor's responsibilities regarding comparatives. This Standard becomes
operative for all audits relating to accounting period beginning on or after April 1, 2003.
♦ The auditor should determine whether the comparatives comply, in all material respects,
with the financial reporting framework relevant to the financial statements being audited.
♦ The auditor should obtain sufficient appropriate audit evidence that the corresponding
figures meet the requirements of the relevant financial reporting framework.
♦ When the comparatives are presented as corresponding figures, the auditor's report
should not specifically identify comparatives because the auditor's opinion is on the
current period financial statements as a whole, including the corresponding figures.
♦ When the auditor's report on the prior period, as previously issued, included a qualified
opinion, disclaimer of opinion, or adverse opinion and the matter which gave rise to the
modification in the audit report is:
• unresolved, and results in a modification of the auditor's report regarding the current
period figures, the auditor's report should also be modified regarding the
corresponding figures; or
• unresolved, but does not result in a modification of the auditor's report regarding the
current period figures, the auditor's report should be modified regarding the
corresponding figures.
♦ In such circumstances, the auditor should examine that:
• appropriate disclosures have been made; or
• if appropriate disclosures have not been made, the auditor should issue a modified
report on the current period financials modified with respect to the corresponding
figures included therein.
♦ When the prior period financial statements are not audited, the incoming auditor should
state in the auditor's report that the corresponding figures are unaudited.
1.5.26 AAS-26 : Terms of Audit Engagement - The purpose of this Auditing and Assurance
Standard (AAS) is to establish standards on agreeing the terms of the engagement with the
client; and the auditor's response to a request by a client to change the terms of an
engagement to one that provides a lower level of assurance. This Standard becomes
operative for all audits relating to accounting periods beginning on or after April 1, 2003.
♦ The auditor and the client should agree on the terms of the engagement.
♦ In the interest of both client and auditor, the auditor should send an engagement letter,
preferably before the commencement of the engagement, to help avoid any
misunderstandings with respect to the engagement.
♦ On recurring audits, the auditor should consider whether circumstances require the
terms of the engagement to be revised and whether there is a need to remind the client
of the existing terms of the engagement.
♦ An auditor who, before the completion of the engagement, is requested to change the
engagement to one which provides a lower level of assurance, should consider the
appropriateness of doing so.
♦ Where the terms of the engagement are changed, the auditor and the client should
agree on the new terms.
♦ The auditor should not agree to a change of engagement where there is no reasonable
justification for doing so.
♦ If the auditor is unable to agree to a change of the engagement and is not permitted to
continue the original engagement, the auditor should withdraw and consider whether
there is any obligation, either contractual or otherwise, to report the circumstances
necessitating the withdrawal to other parties, such as the board of directors or
shareholders.
1.5.27 AAS-27 : Communications of Audit Matters with those Charged with Governance -
The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on
communications of audit matters arising from the audit of financial statements between the
auditor and those charged with governance of an entity. These communications relate to audit
matters of governance interest as defined in this AAS. This AAS does not provide guidance
on communications by the auditor to parties outside the entity, for example, external
regulatory or supervisory agencies. This Auditing and Assurance Standard is effective for all
audits relating to accounting periods beginning on or after April 1, 2003.
♦ The auditor should communicate audit matters of governance interest arising from the
audit of financial statement with those charged with governance of an entity.
♦ The auditor should determine the relevant persons who are charged with governance
and with whom audit matters of governance interest are to be communicated.

♦ The auditor should consider audit matters of governance interest that arise from the
audit of financial statements and communicate them with those charged with
governance. Such matters may include:
♦ The auditor should communicate audit matters of governance interest on a timely basis.
♦ The auditor's communication with those charged with governance may be made orally or
in writing.
♦ When audit matters of governance interest are communicated orally, the auditor should
document in the working papers the matters communicated and any responses to those
matters.
♦ If the auditor considers that having regard to the facts and circumstances of the case a
modification of the auditor's report on financial statements is required, as described in
AAS 28, “The Auditor's Report in Financial Statements" communications between the
auditor and those charged with governance cannot be regarded as a substitute.
1.5.28 AAS-28 : The Auditor's Report on Financial Statements - The purpose of this Auditing
and Assurance Standard (AAS) is to establish standards on the form and content of the
auditor's report issued as a result of an audit performed by an auditor of the financial
statements of an entity. Much of the standards laid down by this AAS can be adapted to
auditor's reports on financial information other than financial statements. This Auditing and
Assurance Standard becomes operative for all audits relating to accounting periods beginning
on or after April 1, 2003.
♦ The auditor should review and assess the conclusions drawn from the audit evidence
obtained as the basis for the expression of an opinion on the financial statements.
♦ The auditor's report should contain a clear written expression of opinion on the financial
statements taken as a whole.
♦ The auditor's report should have an appropriate title.
♦ The auditor's report should be appropriately addressed as required by the
circumstances of the engagement and applicable laws and regulations.
♦ The auditor's report should identify the financial statements of the entity that have been
audited, including the date of and period covered by the financial statements.
♦ The report should include a statement that the financial statements are the responsibility
of the entity's management and a statement that the responsibility of the auditor is to
express an opinion on the financial statements based on the audit.
♦ The auditor's report should describe the audit as including:
• examining, on a test basis, evidence to support the amounts and disclosures in

financial statements;
• assessing the accounting principles used in the preparation of the financial
statements;
• assessing the significant estimates made by management in the preparation of the
• evaluating the overall financial statement presentation.
♦ The report should include a statement by the auditor that the audit provides a
reasonable basis for his opinion.
♦ The opinion paragraph of the auditor's report should clearly indicate the financial
reporting framework used to prepare the financial statements and state the auditor's
opinion as to whether the financial statements give a true and fair view in accordance
with that financial reporting framework and, where appropriate, whether the financial
statements comply with the statutory and regulatory requirements.
♦ The date of an auditor's report on the financial statements is the date on which the
auditor signs the report expressing an opinion on the financial statements.
♦ Since the auditor's responsibility is to report on the financial statements as prepared
and presented by management, the auditor should not date the report earlier than the
date on which the financial statements are signed or approved by management.
♦ The report should name specific location, which is ordinarily the city where the audit
report is signed.
♦ The report should be signed by the auditor in his personal name. Where the firm is
appointed as the auditor, the report should be signed in the personal name of the
auditor and in the name of the audit firm.
♦ An unqualified opinion should be expressed when the auditor concludes that the
financial statements give a true and fair view in accordance with the financial reporting
framework used for the preparation and presentation of the financial statements.
♦ The auditor should modify the auditor's report by adding a paragraph to highlight a
material matter regarding a going concern problem where the going concern question is
not resolved and adequate disclosures have been made in the financial statements.
♦ The auditor should consider modifying the auditor's report by adding a paragraph if
there is a significant uncertainty (other than going concern problem), the resolution of
which is dependent upon future events and which may significantly affect the financial
statements.
♦ A qualified opinion should be expressed when the auditor concludes that an unqualified
opinion cannot be expressed but that the effect of any disagreement with management
is not so material and pervasive as to require an adverse opinion, or limitation on scope
is not so material and pervasive as to require a disclaimer of opinion. A qualified opinion
should be expressed as being 'subject to' or 'except for' the effects of the matter to
which the qualification relates.
♦ A disclaimer of opinion should be expressed when the possible effect of a limitation on
scope is so material and pervasive that the auditor has not been able to obtain sufficient
appropriate audit evidence and is, accordingly, unable to express an opinion on the
financial statements.
♦ An adverse opinion should be expressed when the effect of a disagreement is so
material and pervasive to the financial statements that the auditor concludes that a
qualification of the report is not adequate to disclose the misleading or incomplete
nature of the financial statements.
♦ Whenever the auditor expresses an opinion that is other than unqualified, a clear
description of all the substantive reasons should be included in the report and, unless
impracticable, a quantification of the possible effect(s), individually and in aggregate, on
the financial statements should be mentioned in the auditor's report.
♦ When there is a limitation on the scope of the auditor's work that requires expression of
a qualified opinion or a disclaimer of opinion, the auditor's report should describe the
limitation and indicate the possible adjustments to the financial statements that might
have been determined to be necessary had the limitation not existed.
♦ The auditor may disagree with management about matters such as the acceptability of
accounting policies selected, the method of their application, or the adequacy of
disclosures in the financial statements. If such disagreements are material to the
financial statements, the auditor should express a qualified or an adverse opinion.
1.5.29 AAS-29 : Auditing in a Computer Information System Environment - The purpose of
this Auditing and Assurance Standard (AAS) is to establish standards on procedures to be
followed when an audit is conducted in a computer information systems (CIS) environment.
For the purposes of this AAS, a CIS environment exists when one or more computer(s) of any
type or size is (are) involved in the processing of financial information, including quantitative
data, of significance to the audit, whether those computers are operated by the entity or by a
third party. This Auditing and Assurance Standard (AAS) becomes operative for all audits
related to accounting periods beginning on or after April 1, 2003.
1.5.30 AAS-30 : External Confirmations - The purpose of this Auditing and Assurance
Standard (AAS) is to establish standards on the auditor's use of external confirmations as a
means of obtaining audit evidence.
External confirmation is the process of obtaining and evaluating audit evidence through a
direct communication from a third party in response to a request for information about a
particular item affecting assertions made by management in the financial statements. In

deciding to what extent to use external confirmations, the auditor considers the characteristics
of the environment in which the entity being audited operates and the practice of potential
respondents in dealing with requests for direct confirmation.
The process of external confirmations, ordinarily, consists of the following:
♦ Selecting the items for which confirmations are needed.
♦ Designing the form of the confirmation request.
♦ Communicating the confirmation request to the appropriate third party.
♦ Obtaining response from the third party.
♦ Evaluating the information or absence thereof.
This Auditing and Assurance Standard is effective for audits related to accounting periods
beginning on or after 1st April, 2003.
1.5.31 AAS-31 : Engagements to Compile Financial Information - The purpose of this Auditing
and Assurance Standard (AAS) is to establish Standards on professional responsibilities of an
accountant when an engagement to compile financial statements or other financial information
is undertaken and the form and content of the report to be issued in connection with such a
compilation so that the association of the name of the accountant with such financial
statements or financial information is not misconstrued by a user of those statements or
information as having been audited by him.
♦ In all circumstances when an accountant’s name is associated with financial information
compiled by him, the accountant should issue a report.
♦ The accountant should obtain an acknowledgement from management of it
responsibility for the accuracy and completeness of the underlying accounting data and
the complete disclosure of all material and relevant information.
♦ It is in the interest of both the accountant and the entity that the accountant sends an
engagement letter documenting the key terms of appointment. An engagement letter
confirms the accountant’s acceptance of the engagement and helps avoid
misunderstanding regarding matters such as the objective and scope of the engagement
and the extent of auditors responsibilities.
♦ The accountant should read the complied information and consider whether it appears
to be appropriate in form and free from obvious material misstatements.
♦ If the accountant becomes aware of material non-compliance with any applicable
Accounting Standard (s), the same should be brought to the attention of management
and, if the same is not rectified by the management, it should be included in the Notes
to Accounts and the compilation report of the accountant.
♦ The financial statements on other financial information compiled should be approved by
the client before the compilation report is signed by the accountant.

This Auditing and Assurance Standard is applicable to all compilation engagements beginning
on or after April 1, 204.
1.5.32 AAS-32 : Engagements to Perform Agreed-upon Procedures regarding Financial
Information - The purpose of this AAS is to establish standards and provide guidance on the
auditor’s professional responsibilities when an engagement to perform agreed-upon
procedures regarding financial information is undertaken and on the form and content of the
report that the auditor issues in connection with such an engagement.
♦ The objective of an agreed-upon procedures engagement is for the auditor to carry-out
procedures of an audit nature to which the auditor and the entity and any appropriate
third parties have agreed and to report on factual findings.
♦ The auditor should ensure with representatives of the entity and, ordinarily, other
specified parties who will receive copies of the report of factual findings, that there is a
clear understanding regarding the agreed procedures and the conditions of the
engagement.
♦ The auditor should carry out the procedures agreed-upon and use the evidence
obtained as the basis for the report of factual findings.
♦ The procedures applied in an engagement to perform agreed-upon procedures may
include:
• Inquiry and analysis
• Recomputation, Comparison and other clerical accuracy checks
• Observation
• Inspection
• Obtaining confirmations
♦ The report on an agreed-upon procedures engagement needs to describe the purpose
and the agreed-upon procedure of the engagement in sufficient detail to enable the
reader to understand the nature and the extent of the work performed. The report should
also clearly mention that no audit or review has been performed.
This Auditing and Assurance Standard is applicable to all agreed-upon procedures
engagements beginning on or after April 1, 2004.
1.5.33 AAS.33 : Engagements to Review Financial Statements - The purpose of this Auditing
and Assurance Standard (AAS) is to establish standards and provide guidance on the
auditor's1 professional responsibilities when an engagement to review financial statements is
1
As explained in the Framework of Statements on Standard Auditing Practices and Guidance Notes on
Related Services, the SAPs (now AASs) and Guidance Notes use the term "auditor" when describing both auditing and
undertaken and on the form and content of the report that the auditor issues in connection with
such a review. This AAS is directed towards the review of financial statements. However, it is
to be applied to the extent practicable to engagements to review financial or other related
information, for example, interim financial statements prepared by an entity pursuant to
Accounting Standard (AS) 25, Interim Financial Reporting.
The objective of a review of financial statements is to enable an auditor to state whether, on
the basis of procedures which do not provide all the evidence that would be required in an
audit, anything has come to the auditor's attention that causes the auditor to believe that the
financial statements are not prepared, in all material respects, in accordance with the financial
reporting framework used for the preparation and presentation of the financial statements2
(negative assurance).
1.5.34 AAS-34 : Audit Evidence - Additional Considerations for Specific Items - The purpose
of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's
responsibilities, audit procedures and provide additional guidance to that contained in AAS 5,
"Audit Evidence", with respect to certain specific financial statement amounts and other
disclosures. Application of the standards and guidance provided in this AAS will assist the
auditor in obtaining audit evidence with respect to the specific financial statement amounts
and other disclosures. The auditor should perform audit procedures designed to obtain
sufficient appropriate audit evidence during his attendance at physical inventory counting. The
auditor should carry out audit procedures in order to become aware of any litigation and
claims involving the entity which may have a material effect on the financial statements. The
auditor should perform audit procedures designed to obtain sufficient appropriate audit
evidence for valuation and disclosure of long term investments. When long-term investments
are material to the financial statements, the auditor should obtain sufficient appropriate audit
evidence regarding their valuation and disclosure. The auditor should perform audit
procedures designed to obtain sufficient appropriate audit evidence for appropriate disclosure
of segment information.
related services which may be performed. Such reference is not intended to imply that a person performing related
services need be the auditor of the entity's financial statements.
2
Paragraph 3- of Framework of Statements on Standard Auditing Practices" and Guidance Notes on
Related Services, issued by the Institute of Chartered Accountants of India, discusses the financial reporting framework.
The paragraph reads as under:
"Financial Reporting Framework
Financial statements are ordinarily prepared and presented annually and are directed towards the common information
needs of a wide range of users. Many of those users rely on financial statements as their major source of information
because they do not have the power to obtain additional information to meet their specific information needs. Thus,
financial statements need to be prepared in accordance with one, or a combination of:
(a) relevant statutory requirements, e.g., the Companies Act, 1956, for companies; (b) accounting standards issued by
the Institute of Chartered Accountants of India; and (c) other recognized accounting principles and practices. E.g., those
recommended in the Guidance Notes issued by the Institute of Chartered Accountants of India.”
(Students may note that the Framework of AASs and Guidance Notes on Related Services and
AAS 1 to AAS 34 are reproduced in Volume to the book)
Guidance Notes
1.6 Various technical committees of the Institute are involved in the task of issuing guidance
notes on topics relating to accounting and auditing for guidance of the members. Some of the
important topics in auditing on which guidance notes have been issued are discussed below:
1.6.1 Independence of Auditors - Professional integrity and independence is an essential
characteristic of any member of the accounting profession. A detailed note on this topic was
first published by the Council in 1968. In the light of the experience gained over a period of
years, this note was revised by the Council and published as a guidance note in 1975. The
revised Guidance Note contains essentially a discussion on relevant section of the Companies
Act, 1956, and the provisions of the Chartered Accountants Act, 1949 which aim at ensuring
independence of auditors.
1.6.2 Provision for proposed Dividend - Proposed dividend does not represent a liability nor
does it amount to a provision, pending the approval of the shareholders in General Meeting.
Since the meeting to approve the accounts would take place after the Balance Sheet date,
there could not be any liability in respect of the proposed dividend on the date of the Balance
Sheet. The Council is of the opinion that merely because the form requires proposed dividend
to be shown under “Current Liabilities and Provisions”, it does not mean that in fact the
proposal for the dividend becomes a liability or is necessarily a provision. However, forms of
accounts laid down under the Insurance Act, 1938 and the Banking Regulation Act, 1949, in
both of which it is not a requirement to show “proposed dividend” and it cannot be contended
that merely because proposed dividend is not shown in the accounts, that the accounts of
Insurance and Banking Companies do not disclose a ‘true and fair’ view.
Since, however, the form of Balance Sheet prescribed in Part 1 of Schedule VI requires
“proposed dividends” to be shown under “Provisions”, and since paragraph 3(xiv) of Part II of
the same Schedule requires the “proposed dividends” to be disclosed, the Council is of the
opinion that, though on correct accounting principles, the proposed dividend does not become
a liability for reasons mentioned above, the attention of the shareholders would have to be
drawn to the fact that no appropriation has been made for the proposed dividend, the amount
in respect of which should be specified.
The Council of the ICAI , therefore, recommends that the fact that provision for proposed
dividend has not been made should be disclosed by means of a note in the accounts and that
the auditor should refer to the note in his report and make his report subject thereto.
1.6.3 Auditing of Liquidators - Members of the profession are called upon to conduct the audit
of the accounts submitted by a Liquidator in a voluntary winding-up under Section 551. There
are no statutory provisions in regard to the manner of conducting such audit, nor is there any
statutory provision regarding the form in which the auditors' report is to be submitted after
such an audit under Section 551. The Research Committee has considered this question in all
its aspects and its recommendations in this connection are outlined below:
First, the professional skill and audit procedures to be applied in case of an audit under
Section 531 would be similar to those applied in the case of the normal audit of a company.
Secondly, there should be a fair measure of uniformity in the reports submitted by auditors
conducting an audit under Section 551 of the Companies Act, 1956. The Research Committee
recommends that the report of the auditor may be on the following lines:
(a) Whether he has obtained all the information and explanations, which to the best of his
knowledge and belief, were necessary for the purposes of his audit,
(b) Whether in his opinion, proper books of account as required by the Companies Act, 1956
and Companies (Court) Rules, 1959 have been kept by the Liquidator, so far as appears
from his examination of these books,
(c) Whether the Liquidator's Account relating to realisations and disbursements is in
agreement with the books and records produced before him,
(d) Whether in his opinion, and to the best of his information and according to the
explanations given to him, the Liquidator's Account including Annexure I (excepting items
included in I (a) in so far as they relate to estimates of the Liquidator and items 4, 5, 6
and 7), Annexure II, III, 1V and V, give the information required by the Companies Act,
1956, and the Companies (Court) Rules, 1059 in the manner so required and give a true
and correct view of the realisations and disbursements of the Liquidator.
Thirdly, “in order to establish a healthy convention, the Council recommends that, where a
chartered accountant acts as a liquidator, the statements of accounts to be filed under Section
551(1) of the Companies Act, 1956, should be audited by a qualified chartered accountant
other than the chartered accountant who is the liquidator of the company”.
1.6.4 Guidance Note on Section 293 A of the Companies Act and the Auditor - The Guidance
Note was first issued by the Company Law Committee in 1976 when, under Section 293A of
the Companies Act, 1956, companies were prohibited from making contributions to a political
party or for any political purpose. Since elaborate amendments were incorporated in Section
293A by the Companies (Amendment) Act, 1985, which came into force from May 24, 1985,
the Company Law Committee revised the existing Guidance Note in consonance with the
amended provisions in 1986.
1.6.5 Guidance Note on Auditor’s Report on Revised Accounts of Companies Before
Circulation to Shareholders – This Guidance Note considers the question of the manner in
which the auditor should report on accounts amended by the Board after approval and
authentication under section 215 of the Companies Act, 1956. This Guidance Note was
issued by the Council in December, 1979.
The Balance Sheet and the Profit and Loss Account of companies, approved by the Board of
Directors and authenticated on its behalf in terms of Section 215 of the Companies Act and
audited and reported upon by the statutory auditors are amended by the Companies for
various reasons, before circulation to the shareholders. In such cases, the amended accounts
are re-approved by the Boards of the Companies and statutory auditors are requested to make
a report once again on the amended accounts.
The Council recommends that members of the Institute, when called upon to issue a report on
the amended accounts for the same period consequent upon the revision of the Balance
Sheet and/or the Profit and Loss Account should ensure that unless all copies of the original
accounts and report are returned to the auditor, and adequate disclosure of the fact of the
revision on the accounts already approved by the Board and reported upon by the statutory
auditors appears as a specific Note on the amended accounts. In case the statutory auditor is
satisfied that the disclosure so made by the company in the Note on the accounts is adequate,
there may not be any further need for the auditor to refer to the revision of the Balance Sheet
and/or the Profit and Loss Account in his report. However, if the Notes to accounts do not
contain any note on the revision or if such a note is contained therein but not considered by
the statutory auditor as adequately comprehensive, it will be the duty of the statutory auditor to
refer to the fact of revision of the accounts in his report.
1.6.6 Guidance Note on Certificate to be Issued by the Auditor of a Company Pursuant to
Companies (Acceptance of Deposits) Rules, 1975 - Section 58A of the Companies Act, 1956,
contains certain restrictions on acceptance of deposits by companies. The rules framed in
1975 were amended in 1978 when a provision was made for certification by auditors of the
Return of Deposits to be filed by companies.
Rule 10(1) of the Companies (Acceptance of Deposits) Rules, 1975 as it stands after the
amendment referred to above requires, every company to which these rules apply shall, on or
before the 30th day of June of every year, file with the Registrar, a return in the form annexed
to these rules and furnishing the information contained therein as on 31st day of March of that
year, duly certified by the auditor of the Company. It follows, therefore, that every company to
which these rules apply shall prepare the return as on 31st March of every year, shall get the
return certified by the concerned auditor and shall submit the audited return to the Registrar of
Companies by 30th June.
It may be observed that neither the amended Rule 10 of the Companies (Acceptance of
Deposits) Rules, 1975 nor the form of return prescribed thereunder provides the manner in
which the auditor should certify the return. Even in the form of return, no space has been
provided for auditors' certificate. Consequently, no statutory guidance is available to the
auditor as regards the scope, manner and limitations inherent in this requirement of
certification.
This guidance note was issued by the Company Law Committee in 1979 for aiding the
members in correctly understanding the implications involved and for securing uniformity in
approach. For a detailed discussion refer to Chapter 17.
1.6.7 Guidance Note on Accountants’ Report on Profit Forecasts and/or Financial Forecasts -
Traditionally, the attest function performed by the members has been in relation to past
events. However, our growing and dynamic society seeks professional association in its
exercises relating to future events. A manifestation of this is the requirement of banks and
financial institutions regarding the preparation of projected cash flow and profitability
statements by intending borrowers for the purpose of making an appropriate appraisal of their
loan applications. These institutions placed a great reliance on such statements if they were
prepared or reviewed by chartered accountants. Research Committee issued this guidance
note in 1982 to provide guidance to members for preparation and review of profit and financial
forecasts for submission to banks and financial institutions.
1.6.8 Guidance Note on Audit Reports and Certificates for Special Purposes - The increasing
involvement of members in giving audit reports or certificates on special purpose statements
or other information prepared by an enterprise necessitated the need for guidance to the
auditor regarding various facets of such assignments including the form and contents of audit
reports and certificates for special purposes. In view of this, the Research Committee of the
Institute brought out this Guidance Note on Audit Reports and Certificates for Special
Purposes in 1984.
1.6.9 Guidance Note on Audit of Accounts of Members of Stock Exchanges - The provision
for audit of accounts of members of stock exchanges by chartered accountants was
introduced with effect from the financial year commencing April 1, 1984. The Research
Committee issued this guidance note explaining the implications of this new provision in 1984.
In response to the changes in the working of Stock Exchanges because of introduction of new
concepts, this guidance note was amended in 2002. Refer to Chapter 17 for a detailed
discussion.
1.6.10 Guidance Note on Tax Audit under Section 44AB of the Income-Tax Act - This
Guidance Note was first issued by the Taxation Committee in 1985 and was revised in 1989
and 1998. Recently when tax audit forms were revised, the Fiscal Laws Committee has
revised this guidance note in 1999. Refer to Chapter 15 for a detailed discussion.
1.6.11 Guidance Note on Audit of Accounts of Non-Corporate Entities (Bank Borrowers) - The
Professional Development Committee issued this guidance note in 1985 when RBI issued a
circular advising all scheduled banks to ensure that non-corporate borrowers enjoying
aggregate working capital credit limits of Rs.10 lakh or more from the banking system get their
accounts audited by chartered accountants in the prescribed manner. Refer to Chapter 17 for
a detailed discussion.
1.6.12 Guidance Note on Reports in Company Prospectuses - This Guidance Note was
issued by Company Law Committee in 1985. In order that the prospective investors in
companies may make their decisions on the basis of proper and adequate information, the
Companies Act, 1956, introduced stringent requirements which the companies were required
to comply with whenever they intended to offer shares or debentures for public subscription. It
was in this context that the requirements relating to issuance of prospectuses by companies
assumed importance. The legal formalities in this behalf sought to ensure that the information
which would be relevant for the investors to make investment decisions should be complete,
comprehensive and at the same time truthful. The requirements, inter alia, included certain
reports to be given by the chartered accountants about the companies to the investors. This
Guidance Note explains the manner of giving such reports given by our members.
1.6.13 Guidance Note on Audit of Abridged Financial Statements - The Companies
(Amendment) Act, 1988, brought about significant changes in Section 219 of the Companies
Act, 1956. By virtue of these amendments, a company listed on a recognised stock exchange
could send abridged balance sheet and abridged profit and loss account to its members, etc.
subject to certain conditions. The form of these abridged financial statements had been
prescribed by the Central Government. The Companies Act, 1956, did not specifically require
audit of abridged financial statements. The audit of abridged financial statements assured the
readers that the relevant information was properly disclosed in such statements and thus
lended a greater degree of credibility to them. Considering this, the AASB issued this
Guidance Note in 1990 which provides guidance to the members on issues relating to such
audit.
1.6.14 Guidance Note on Certification of Documents for Registration of Charges - The
Department of Company Affairs had directed the appropriate authorities to take the documents
relating to registration of a charge, on record, if such documents were duly certified as correct,
among others, by a chartered accountant in practice. This, in retrospect reflected the growing
faith in the competence of members of our profession. Since the procedure for registration of
charges involves a number of documents, the Corporate Laws Committee issued this
guidance note in 1994, with a view to provide guidance to the members, who may be called
upon to certify the relevant documents.
1.6.15 Guidance Note on Audit of Banks - The Institute had, in 1967, issued a study on audit
of banks. However, banking is a dynamic activity, which has constantly been undergoing a
change. In recent years, there has been a remarkable change in the nature, volume and
spread of transactions of banks. Apart from this, the non-traditional functions of banks, e.g.,
foreign exchange activities, merchant banking, portfolio management, investment, etc. have
acquired considerable importance during this period. Another significant development from
the auditors’ view point was the issuance, by the Reserve Bank of India, of detailed guidelines
regarding income recognition, asset classification, provisioning and other related matters. Yet
another development which affected the work of bank auditors was the revision of formats of
financial statements. Accordingly, in 1994, AASB issued this comprehensive guidance note
for the guidance of our members on, amongst others, these important issues. In 2001, a
thoroughly revised guidance note was issued by the Institute. Refer to Chapter 11 for a
detailed discussion.
1.6.16 Guidance Note on Audit Reports / Certificates on Financial Information in Offer
Documents - Investors’ confidence is an important pre-requisite for the sustained development
of capital markets to ensure economic development of a country. One of the confidence
building measures was the provision of detailed relevant information to the investors for taking
well-informed investment decisions. In this context, an offer document for corporate securities
is like a window through which the prospective investors get authentic details about the
prospects of a company. Recognising this, SEBI issued Guidelines for Disclosure and
Investors Protection which required, inter alia, more transparent, detailed, and dependable
offer documents which would promote investors confidence to maintain a conducive
investment atmosphere in Indian capital market. SEBI has also been issuing clarifications to
the aforesaid Guidelines with a view to, inter alia, enhancing the qualitative characteristics of
offer documents. Much of the information contained in an offer document is financial in
nature. To impart credibility to the financial information, Schedule II to the Companies Act,
1956, requires some important financial information to be contained in the auditor’s report and
the report of the accountant in Schedule II now has to be adjusted for amounts in respect of
the qualifications in the report of the auditor on annual accounts, previous year adjustments,
change in accounting policies, etc. so as to provide a uniform trend of profit in the statement of
profit to the prospective investors. The said clarifications also required additional financial
information to be disclosed in the offer document, e.g., accounting ratios. These new
requirements have increased the responsibility of the reporting auditors and accountants. The
Research Committee issued this Guidance Note in 1996.
1.6.17 Guidance Note on Revision of Audit Report - A revision of audit report may be
warranted in other instances involving reasons such as apparent mistakes, wrong information
about facts, subsequent discovery of facts existing at the date of the audit report, etc. The
nature and range of instances may vary from one enterprise to another depending upon facts
and circumstances. The Guidance Note on Revision of Audit Report provides guidance
regarding revision of the audit report if the same has been issued, in case the auditors
consider.
1.6.18 Guidance Notes on Audit of Items in Financial Statements - AASB has issued
guidance notes on audit of various items appearing in the financial statements from time to
time. These guidance notes explain the manner in which audit of records relating to these
items should be carried out. These guidance notes have been issued on the following topics:
♦ Fixed Assets
♦ Investments
♦ Inventories
♦ Debtors and Loans and Advances
♦ Cash and Bank Balances
♦ Miscellaneous Expenditure
♦ Liabilities
♦ Revenue
♦ Expenses
1.6.19 Guidance Note on Special Considerations in the Audit of Small Entities - The objective
of this Guidance Note is to describe the characteristics that are commonly found in small
entities and indicate how they might affect the application of AASs. This Guidance Note, thus,
includes:
(a) discussion of the characteristics of small entities; and
(b) guidance on the application of AASs to the audit of small entities;
1.6.20 Guidance Note on Audit of Consolidate Financial Statements - The Guidance Note on
Audit of Consolidate Financial Statements lays down the audit principles and procedures in
case an entity consolidates financial statements. Special consideration like permanent
consolidation adjustments current consolidation adjustments etc. and the reporting have also
been dealt with.
1.6.21 Guidance Note on Computer Assisted Audit Techniques - For Computerised

Information System (CIS) environment Computer Assisted Audit Techniques (CAATs) enjoy
wide acceptability on account of ease of use, reliability, cost and time effectiveness and
analytical capabilities. Recognising the developments in the field of technology and its impact
on the accounting profession in India, Auditing and Assurance Standards Board had issued
AAS 29. ‘Audit in Computer Information System Environment’. This Guidance Note is issued
as a sequel to that AAS. The Guidance Note deals with the concepts of CAATs and related
pertinent issues like what CAATs are, how to use, test and control them. This Guidance Note
applies to all uses of CAATs when a computer of any type or size is involved whether that
computer is operated by the entity or by a third party. Refer to Chapter 4 for a detailed
discussion.
Guidance Note(S) on Related Services
1.7 The framework for auditing and related services makes it clear that there can be different
layers of assurance depending upon the nature of services being performed by the chartered
accountant. Related Services comprise of Review engagements, Agreed upon Procedures
and Compilation Engagement. Reviews engagements involve providing moderate assurance
(or negative assurance) but other two services, viz., and compilation and agreed upon
procedures provide no assurance at all. The Institute has issued guidance notes covering
these aspects of related services in a comprehensive manner.
Authority Attached to the Documents Issued by the Institute
1.8 The Institute has, from time to time, issued ‘Statements’ and ‘Guidance Notes’ on a
number of matters. With the formation of the Accounting Standards Board and the Auditing
and Assurance Standards Board, Accounting Standards and Auditing and Assurance
Standards have also been issued. The level of authority attached to these documents and the
degree of compliance required in respect thereof has been explained by the Institute through
its various announcements issued from time to time.
1.8.1 Statements - The ‘statements’ have been issued with a view to securing compliance by
members on matters which in the opinion of the council of the institute are critical for the
proper discharge of their functions. ‘statements’ therefore are mandatory. Accordingly, while
discharging their attest function, it is the duty of the members of the institute.
(a) to examine whether ‘Statements’ relating to accounting matters are complied with in the
presentation of financial statements covered by their audit. In the event of any deviation
from such ‘Statements’, it is their duty to make adequate disclosures in their audit reports
so that the users of financial statements may be aware of such deviations; and
(b) to ensure that the ‘Statements’ relating to auditing matters, are followed in the audit of
financial information covered by their audit reports. If, for any reason, a member, has not
been able to perform an audit in accordance with such ‘Statements his report should
draw attention to the material departures there from.
A list of ‘Statements issued by the Institute which are in force is given below:
(i) Statement on Auditing practices.
(ii) Statement on Payments to Auditors for Other Services,

(iii) Statement on the Companies (Auditor’s Report) Order, 2003 (Issued under Section
227(4A) of the Companies Act, 1956).
(iv) Statement on Qualifications in Auditor’s Report.
(v) Statement on the Amendments to Schedule VI to the Companies Act.
1.8.2 Guidance Notes - ‘guidance notes’ are primarily designed to provide guidance to
members on matters which may arise in the course of their professional work and on which
they may desire assistance in resolving issues which may pose difficulty. Guidance notes are
recommendatory in nature. A member should ordinarily follow recommendations in a guidance
note relating to an auditing matter except where he is satisfied that in the circumstances of the
case, it may not be necessary to do so. Similarly, while discharging his attest function, a
member should examine whether the recommendations in a guidance note relating to an
accounting matter have been followed or not. If the same have not been followed, the member
should consider whether keeping in view the circumstances of the case, a disclosure in his
report is necessary.
1.8.3 Accounting Standards and Auditing and Assurance Standards - The ‘accounting
standards’ and ‘auditing and assurance standards’ establish standards which have to be
complied with to ensure that financial statements are prepared in accordance with generally
accepted accounting standards and that auditors carry out their audit in accordance with the
generally accepted auditing practices. They become mandatory on the dates specified in the
respective document or notified by the council.
There can be situations in which certain matters are covered both by a ‘Statement’ and by an
‘Accounting Standard’/ ‘Auditing and Assurance Standard. In such a situation, the ‘Statement’
prevails till the time the relevant ‘Accounting Standard’/ Auditing and Assurance Standard
becomes mandatory. Once an ‘Accounting Standard’/ ‘Auditing and Assurance Standard’
becomes mandatory, the concerned ‘Statement’ or the relevant part thereof automatically
stands withdrawn.
Auditing and Assurance Standards (AASs) establish standards, which have to be complied
with to ensure that auditors carry out their duties in accordance with the generally accepted
auditing practices. They become operative (i.e., mandatory) in respect of audit of all
enterprises on the dates specified in the respective AASs or notified by the Council. The
duties of the members of the Institute in relation to operative AASs are similar to those in
respect of ‘Statements’ relating to auditing matters, as described in paragraph 2 (b) above.
1.8.4 Accounting Standards - Accounting Standards are formulated by the Accounting
Standards Board and issued by the Council of the Institute. The Accounting Standards are
issued for use in the presentation of ‘general purpose financial statements’ which are issued to
the public by such ‘commercial, industrial or business enterprises’ as may be specified by the
Institute from time to time and subject to the attest function of its members. They become
mandatory on the dates specified in the respective Accounting Standards or notified by the
Council in this behalf.
(a) The term ‘General Purpose Financial Statements’ includes balance sheet, statement of
profit and loss and other statements and explanatory notes which form part thereof,
issued for the use of shareholders/members, creditors, employees and public at large.
(b) The reference to ‘commercial, industrial or business enterprises’ is in the context of the
nature of activities carried on by an enterprise rather than with reference to its objects.
The Accounting Standards apply in respect of commercial, industrial or business
activities of any enterprise, irrespective of whether it is profit oriented or is established for
charitable or religious purposes. Accounting Standards will not, however, apply to those
activities which are not of commercial, industrial or business nature (e.g. an activity of
collecting donations and giving them to flood affected people). The exclusion of an entity
from the applicability of the Accounting Standards is permissible only if no part of the
activity of entity is commercial, industrial or business in nature. In other words, even if a
very small proportion of the activities of an entity is considered to be commercial,
industrial or business in nature, then it can not claim exemption from the application of
Accounting Standards. In such a case the Accounting Standards will apply to all its
activities including those which are not commercial, industrial or business in nature.
The Companies Act, 1956, as well as many other statutes require that the financial statements
of an enterprise should give a true and fair view of its financial position and working results.
This requirement is implicit even in the absence of a specific statutory provision to this effect.
However, what constitutes ‘true and fair’ view has not been defined either in the Companies
Act, 1956, or in any other statute. The Accounting Standards (as well as other
pronouncements of the Institute on accounting matters) seek to describe the accounting
principles and the methods of applying these principles in the preparation and presentation of
financial statements so that they give a true and fair view.
The ‘Preface to the Statements of Accounting Standards’ issued by the Institute in 2004 states
(paragraphs 6.1 and 6.3):
“6.1 While discharging their attest function, it will be the duty of the members of the
Institute to examine whether the Accounting Standard is complied with in the
presentation of financial statements covered by their audit. In the event of any
deviation from the Accounting Standard, it will be their duty to make adequate
disclosures in their reports so that the users of such statements may be aware of
financial deviations.”
“6.3 Financial Statements can not be described as complying with the Accounting
Standards unless they comply with all the requirements of each applicable
standard.”
Once an Accounting Standard becomes mandatory, the duties of an auditor with respect to
such standard are the same as those specified at paragraph 2(a) above.
*Accounting Standards 4 and 5 were made mandatory in respect of accounting periods

commencing on or after 1.1.1987 for all commercial industrial or business enterprises.
Accounting Standards 1, 7, 8, 9 and 10 were initially made mandatory in respect of accounting
periods commencing on or after 1.4.1991 for companies governed by the Companies Act,
1956 as well as for other commercial, industrial or business enterprises except the following:
(a) Sole proprietory concerns/individuals (b) Partnership firms (c) Societies registered under
the Societies Registration Act (d) Trusts (e) Hindu undivided families (f) Associations of
persons.
Accounting Standards 1, 7, 8, 9 and 10 were made mandatory in respect of general purpose
financial statements of enterprises listed at (a) to (f) above, for accounting periods
commencing on or after 1.4.1993 where such statements were statutorily required to be
audited under any law. In this regard, the Council of the Institute has clarified that the
mandatory accounting standards also apply in respect of financial statements audited under
Section 44AB of the Income tax Act, 1961. Accordingly, members should examine compliance
with the mandatory accounting standards when conducting such audit. AS-6 was made
mandatory in respect of accounts for periods commencing on or after 1.4.1995. The remaining
Accounting Standards i.e. AS 11, 12, 13, 14 and 15 have been made mandatory with effect
from the dates specified in the standards themselves.
While discharging their attest function, the members of the Institute may keep the following in
mind with regard to mandatory Accounting Standards.
AS I - Disclosure of Accounting Policies - In the case of a company, members should
qualify their audit reports in case :
(a) accounting policies required to be disclosed under Schedule VI or any other provisions of
the Companies Act, 1956, have not been disclosed, or
(b) accounts have not been prepared on accrual basis, or
(c) the fundamental accounting assumption of going concern has not been followed and this
fact has not been disclosed in the financial statements, or
(d) proper disclosures regarding changes in the accounting policies have not been made.
Where a company has been given a specific exemption regarding any of the matters stated in
paragraph 16 above but the fact of such exemption has not been adequately disclosed in the
accounts, the member should mention the fact of exemption in his audit report without
necessarily making it a subject matter of audit qualification.
If accounting policies have not been disclosed at one place or if certain significant accounting
policies have not been disclosed, by a company on the ground that their disclosure is not
required under the Companies Act, 1956, the member should disclose the fact in his audit
report without necessarily making it a subject matter of audit qualification. Such a disclosure
*The Council has classified the enterprises for the purpose of applicability of Accounting Standards into three
Categories, viz. Level I, Level II and Level III. This scheme comes into effect in respect of accounting periods
commencing on or after 1-4-2004
would not constitute a reservation, qualification or adverse remark except where the auditor
has specifically made it a subject matter of audit qualification. Accordingly in the case of a
company, the Board of Directors need not provide information or explanation with regard to
such a disclosure (except where the same constitutes a qualification) in their report under sub-
section (3) of Section 217 of the Companies Act, 1956.
In the case of enterprises not governed by the Companies Act, 1956, the member should
examine the relevant statute and make suitable qualification in his audit report in case
adequate disclosures regarding accounting policies have not been made as per the statutory
requirements. Similarly, the member should examine if the fundamental accounting
assumptions have been followed in preparing the financial statements or not. In appropriate
cases, he should consider whether, keeping in view the requirements of the applicable laws, a
qualification in his report is necessary. In the event of non-compliance, by enterprises not
governed by the Companies Act, 1956, with the disclosure requirements of AS1 in situations
where the relevant statute does not require such disclosures to be made, the member should
make adequate disclosure in his audit report without necessarily making it a subject matter of
audit qualification.
Other Mandatory Accounting Standards - While making a qualification, the auditor should
follow the requirements of the ‘Statement on Qualifications in Auditor’s Report’ issued by the
Institute. Subject to this, non-compliance with any of the requirements of a mandatory
Accounting Standard other than AS 1 by any enterprise should be a subject matter of
qualification except that, to the extent that the disclosure requirements in the relevant
standard are in addition to the requirements of the Companies Act, 1956, or any other
applicable statute, the member should disclose the fact of non - compliance with such
disclosure requirements in his audit report without necessarily making it a subject matter of
audit qualifications.
Financial Statements Prepared on a Basis other than Accrual - With regard to the
fundamental accounting assumption of accrual, the Council of the Institute has made a
specific announcement that in respect of individuals/bodies covered by para AS I - Disclosure
of Accounting Policies above, the auditor should examine whether the financial statements
have been prepared on accrual basis. In cases where the statute governing the enterprise
requires the preparation and presentation of financial statements on accrual basis but the
financial statements have not been so prepared, the auditor should qualify his report. On the
other hand, where there is no statutory requirement for preparation and presentation of
financial statements on accrual basis, and the financial statements have been prepared on a
basis other than ‘accrual’, the auditor should describe in his audit report, the basis of
accounting followed, without necessarily making it a subject matter of a qualification. In such
a case the auditor should also examine whether those provisions of the accounting standards
which are applicable in the context of basis of accounting followed by the enterprise have
been complied with or not and consider making suitable disclosures/qualifications in his audit
report accordingly.
Manner of Making Qualification Disclosure in the Audit Report - In making a

qualification/disclosure in the audit report in respect of non-compliance with a Statement, AAS,
Accounting Standard or Guidance Note, the auditor should consider the materiality of the
relevant item. Thus, the auditor need not make qualification/disclosure in respect of items
which, in his judgement, are not material.
While making a qualification, the auditor should follow the requirements of the ‘Statement on
Qualifications in Auditor’s Report’ issued by the Institute.
A disclosure, which is not a subject matter of audit qualification, should be made in the
auditor’s report in a manner that it is clear to the reader that the disclosure does not constitute
an audit qualification. The paragraph containing the auditor’s opinion on true and fair view
should not include a reference to the paragraph containing the aforesaid disclosure.
Examples of Qualifications/Disclosures in the Audit Report - Given below are some
examples which illustrate the manner of making qualification/disclosure in the audit report. It
may be clarified that these examples are aimed only at illustrating the manner of making
qualifications/disclosures and are not intended in any way to be exhaustive.
Examples of Qualifications
(a) Where proper disclosures regarding changes in accounting policies have not been made
by a company.
"The profit and loss account and balance sheet comply with the accounting standards
referred to sub-section (3C) of Section 211 of the Companies Act, 1956, except
Accounting Standard (AS) 5, 'Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies', as the company has not disclosed in its accounts the
fact of change, from this year, in the method of providing depreciation on plant and
machinery from straight-line method to written-down value method, as also the effect of
this change. As a result of this change, the net profit for the year, the net block as well
as the reserves and surplus are lower by Rs. …. Each as compared to the position which
would have prevailed had this change not been made.
Subject to the above, we report that ……..".
(b) Where a manufacturing company has accounted for interest income on receipt basis and
not on time proportion basis.
referred to in sub-section (3C) of Section 211 of the Companies Act, 1956, except
Accounting Standard (AS) 9, 'Revenue Recognitions', as the company has followed the
policy of accounting for interest income on receipt basis rather than on time proportion
basis. As a result, the net profit for the year and the current assets are understated by
Rs…… each as compared to the position which would have prevailed if the company had
accounted for interest income on time proportion basis.
Subject to the above, we report that ….."
(c) Where an enterprise has capitalised financing costs related to certain fixed assets for
periods after such assets were ready to be put to use.
Accounting Standard (AS) 16, 'Borrowing Costs', as interest payable on borrowings
related to the acquisition of fixed assets has been capitalised for the periods after which
the assets were put to use. Consequently, the net profit for the year, the net block of
fixed assets and the reserves and surplus have been overstated by Rs….. each as
compared to the position which would have prevailed if the company had complied with
the requirements of AS 16.
Subject to the above, we report that ……"
Examples of Disclosures
(a) Where a company has not disclosed all significant accounting policies and has also not
disclosed the accounting policies at one place.
Accounting Standard (As) 1, 'Disclosure of Accounting Policies', as the company has
disclosed those accounting policies the disclosure of which is required by the Companies
Act, 1956. Other significant accounting policies, relating to treatment of research and
development costs have not been disclosed nor have all the policies been disclosed at
one place.
We report that ….."
(b) Where a partnership firm does not make adequate disclosures regarding the revaluation
of its fixed assets.
"During the year, the enterprise revalued its land and buildings. The revalued amounts of
land and buildings are adequately disclosed in the balance sheet. However, the method
adopted to compute the revalued amounts has not been disclosed, which is contrary to
Accounting Standard (AS) 10, 'Accounting for Fixed Assets' issued by the Institute of
Chartered Accountants of India.
We report that ……."
(c) Where a sole proprietary concern enterprise follows cash basis of accounting.
"It is the policy of the enterprise to prepare its financial statements on the cash receipts
and disbursements basis. On this basis revenue and the related assets are recognised
when received rather than when earned, and expenses are recognised when paid rather
than when the obligation is incurred.
In our opinion, the financial statements give a true and fair view of the assets and
liabilities arising from cash transactions of …….. at ……… and of the revenue collected
and expenses paid during the year then ended on the cash receipts and disbursements
basis as described in Note X."
Applicability of Accounting Standards to charitable and/or religious organisations - The

Accounting Standards Board has received a query as to whether the accounting standards
formulated by it are applicable to organisations whose objects are charitable or religious. The
Board has considered this query and its views in the matter are set forth in the following
paragraphs.
The Preface to the Statements of Accounting Standards states:
“The Institute will issue Accounting Standards for use in the presentation of the general
purpose financial statements issued to the public by such commercial, industrial or
business enterprises as may be specified by the Institute from time to time and subject to
the attest function of its members”.
The reference to commercial, industrial or business enterprises in the aforesaid paragraph is
in the context of the nature of activities carried on by an enterprise rather than with reference
to its objects. It is quite possible that an enterprise has charitable objects but it carries on,
either wholly or in part, activities of a commercial, industrial or business nature in furtherance
of its objects. The Board believes that Accounting Standards apply in respect of commercial,
industrial or business activities of any enterprise, irrespective of whether it is profit oriented or
is established for charitable or religious purposes. Accounting Standards will not, however,
apply to those activities which are not of a commercial, industrial or business nature. (e.g. an
activity of collecting donations and giving them to flood affected people).
It is also clarified that exclusion of an entity from the applicability of the Accounting Standards
would be permissible only if no part of the activity of such entity was commercial, industrial or
business in nature. For the removal of doubts, it is clarified that even if a very small
proportion of the activities of an entity was considered to be commercial, industrial or business
in nature, then it could not claim exemption from the application of Accounting Standards. The
Accounting standards would apply to all its activities including those which were not
commercial, industrial or business in nature.
2
AUDIT STRATEGY, PLANNING AND PROGRAMMING
Commencing an Audit
2.1 Auditing has been conceived of to provide a highly useful technical service to the economy
to know performances in financial and other appropriate terms in a reliable manner. It is
needless to say that multitudes of significant decisions in the economic society are taken
based on the financial information and, therefore, ensuring reliability of such information is an
imperative necessity. Any such important technical function as auditing requires a thorough
planning to avoid slips and omissions which may take place because of the complexity,
volume and technicality of the economic operations. AAS-1 on Basic Principles Governing an
Audit of Financial Statements states that audit planning is necessary to conduct an effective
audit in an efficient and timely manner. It has been stated that the audit plans should be based
on a knowledge of client’s business. AAS-8 issued by the Institute deals with ‘Audit Planning’.
According to this, plans should be made to cover, among other things:
(a) acquiring knowledge of the client’s accounting system, policies, and internal control
procedures;
(b) establishing the expected degree of reliance on internal control;
(c) determining and programming the nature, timing and extent of the audit of procedures to
be performed; and
(c) coordinating the work to be performed.
Planning in auditing encompasses developing an overall plan for the expected scope and
conduct of the audit and developing an audit programme showing the nature, timing and
extent of audit procedures. Planning is a continuous process and changes in conditions or
unexpected results of audit procedures may cause revisions of the overall plan as well as the
detailed audit programme. It is necessary to document reasons of significant changes in audit
planning. Careful and adequate audit planning is helpful in: (i) ensuring devotion of
appropriate attention to important areas of the audit, (ii) promptly identifying potential
problems, (iii) completing the work expeditiously, (iv) proper utilisation of assistants, and (v)
co-ordination of work done by other auditors and experts.
2.1.1 Before Engagement - Before an auditor accepts a new appointment, he should
communicate by a letter with the retiring auditor to see if there is any professional reason why
the appointment should be refused. Such communication is an ethical requirement as opposed

to a legal requirement, and it can also be seen as a matter of professional courtesy to the
previous holder of the post. The duty to communicate should be explained to the potential
client, from whom authority must be obtained before writing. If such authority is not
forthcoming or if the existing auditor is prevented from revealing anything of the client’s affairs,
then the appointment should not be accepted; for such would be a strong indication that
something is amiss. Normally the communication will be a routine matter, but occasionally
circumstances may reveal which could affect an acceptance decision. Such circumstances
may range from failure to pay fees, to dubious trading practices, and even to undue pressure
being placed upon auditors to comply with directors’ wishes concerning the accounts. The
requirement to communicate may be seen as one of the ways in which the profession seeks to
protect itself against this latter ever-present risk.
If the audit is that of a limited company, the scope of the work is defined by statute. But if the
client is a partnership or sole trader, then it will be very necessary to discuss the precise
scope of the work that is required, carefully distinguishing between audit and accountancy
work and any other services. The extent of any audit work must be precisely defined to
ensure that there are no misunderstandings as to the scope of work. And whatever may be
the type of audit, at this stage it will also be appropriate to discuss the basis for charging the
fee. These and other matters must be put in writing to safeguard the auditor in case of future
legal disputes, and this is the best achieved by an engagement letter as discussed below.
2.1.2 Audit Engagement Letter - AAS-26 deals with Terms of Audit Engagement. The
engagement letter has the following functions:
♦ To define the scope of the audit in the event that it is not defined by statute.
♦ To confirm any verbal agreements, including the basis on which fees will be charged.
♦ To confirm any other services which are to be provided, or to point out other services
which may possibly be of interest and value to the client.
♦ To emphasise that the directors are primarily responsible for producing ‘true and fair’
accounts.
♦ To explain in outline how the auditor will approach his task; this can assist considerably
in preventing future misunderstandings.
♦ To stress that the audit should not be relied upon necessarily to prevent or detect fraud
and error as this is not its main purpose; although it should also be stressed that normal
audit procedures can be expected to considerably reduce the likelihood of such
occurrences.
Many audit firms have standard engagement letters to cover different circumstances. Two
copies of the letter should be sent, one to be signed and returned by the client as
acknowledgement of and agreement to the terms contained therein.
2.1.3 Commencement procedures - Once a satisfactory reply has been received from the
retiring auditor, and the engagement has been documented in the form of an engagement
letter, the auditor can begin collecting the information necessary to commence his detailed
Audit Strategy, Planning and Programming 2. 3
work. This will include:

♦ A copy of the regulations (if any) of the client, e.g., Memorandum and Articles of
Association, or partnership agreement, or club rules, etc.
♦ Details as to the nature of the business.
♦ Details of physical location of factories, offices, shops, etc.
♦ An organisation chart of the client’s staff, with special emphasis on those employees with
whom the auditor is likely to have regular contact.
♦ An accounts manual, or other details as to the accounting system and the accounting
records of which it is composed.
♦ Copies of previous annual accounts.
♦ Details of the financial history of the company, noting whether it is listed or unlisted, and
whether it is director controlled.
♦ Names and addresses of the client’s advisers, including solicitors, stockbrokers, bankers
and management consultants.
♦ Copies of important documents, such as leases, debenture deeds and major contracts.
During the course of acquiring the information it can be extremely valuable to visit the client’s
various locations, and to meet the employees with whom the auditor is likely to have frequent
dealings. In this way a very valuable initial impression can be gained of the efficiency of the
company and of the sort of problems that may be encountered during the course of the audit.
2.1.4 Knowledge of the client’s business - As per AAS 8, the knowledge of the client’s
business is one of the critical element in formulating the audit programme. Having regard to
significance of this aspect, AAS 20 elaborates on this aspect.
The auditor needs to obtain a level of knowledge of the client’s business that will enable him
to identify the events, transactions and practices that, in his judgement, may have a significant
effect on the financial information. Among other things, the auditor can obtain such
knowledge from:
♦ The client’s annual reports to shareholders.
♦ Minutes of meetings of shareholders, Board of Directors and important committees.
♦ Internal financial management reports for current and previous periods, including
budgets, if any.
♦ The previous year’s audit working papers, and other relevant files.
♦ Firm personnel responsible for non-audit services to the client who may be able to
provide information on matters that may affect the audit.
♦ Discussions with the client.
♦ The client’s policy and procedures manual.
♦ Relevant publications of the Institute of Chartered Accountants of India and other

professional bodies, industry publications, trade journals, magazines, newspapers or text
books.
♦ Consideration of the state of the economy and its effect on the client’s business.
♦ Visits to the client’s premises and plant facilities.
With respect to the previous year’s audit working papers and other relevant files, the auditor
should pay particular attention to matters that require special consideration and whether they
might affect the work to be done in the current year.
Discussions with the client might include such subjects as:
♦ Changes in management, organisation structure and activities of the client.
♦ Current Government legislation, rules, regulations and directives affecting the client.
♦ Current business developments affecting the client.
♦ Existence of parties in whom directors or persons who are substantial owners of the
entity are interested and with whom transactions are likely.
♦ New or old premises and plant facilities.
♦ Recent or impending changes in technology, type of products or services and production
or distribution methods.
♦ Significant matters arising from previous year’s financial statements, audit report and
management letters, if any.
♦ Changes in accounting practices and procedures and in the system of internal control.
♦ Scope and timing of the examination.
♦ Assistance of client’s personnel in data preparation.
♦ Relevance of any work to be carried out by the client’s internal auditors.
Formulating an Audit Programme

2.2 In PCC study material, we have discussed audit programme generally so as to enable the
students to know the utility and nature of audit programmes. It is useful for students to know
how to plan an audit programme. The next step in planning is to prepare a written audit
programme setting forth the procedures that are needed to implement the overall plan of audit.
The programme, in addition, may contain audit objectives for each area and should have
sufficient detail to serve as a set of instructions to the assistants involved in the audit and as a
means to control the proper execution of work. It may be emphasised that a clear spelling out
of audit objectives for each area is important to link up the procedures with audit objectives
and to ensure a purposeful audit. For example, in the area of fixed assets, audit objectives
can be the following:
(i) Ascertaining their existence on the balance sheet date;
(ii) Confirming ownership;

(iii) Finding out encumbrances attaching the assets, if any;
(iv) Determining the valuations;
(v) Presentation of relevant information for a proper understanding of their nature value and
usefulness;
(vi) Proper categorisation of assets;
(vii) Generally ascertaining whether the assets are in good working order.
Procedures of verification for this purpose may include physical verification, review of working
papers, document verification including verification of loan documents, checking of provisions
for depreciation, review of accounting policy on fixed assets, verification of compliance with
legal requirements about disclosure and verification of jobs work performed by the assets.
This linkage in the mind of the assistants on job is imperative and without this the audit would
be just a mechanical performance. They should be able to identify the assertions made in the
Balance Sheet and Profit and Loss Account because that provides key to the auditor’s
selection of the procedures. The important matters which need to be considered in this regard
are:
(a) Nature of business in which the organisation is engaged.
(b) Overall plan prepared for the audit.
(c) System of internal control and accounting procedures.
(d) Size of the organisation and structure of its management.
(e) Information regarding the organisation of business.
(f) Accounting policies followed by the client.
(a) Nature of business in which the organisation is engaged - On his first appointment,
the auditor should examine in detail the financial and accounting organisation of the business
by visiting the client’s office; by observing different stages through which papers pass before
each transaction is authorised and recorded; the record that is kept and the titles of books in
which it is kept. In the case of an industrial concern, he must also visit the factory to acquaint
himself with the different processes of manufacture, the quantitative records maintained and
the manner in which statistics are compiled in respect of losses in process. He also must find
out the technical details of manufacture so that he can test check that the quantities of
materials shown to have been issued for various processes of manufacture are in consonance
with the technical formulae reported to him, and that losses in different processes are not
larger than those anticipated.
The nature of business carried on by the concern has a great relevance to different audit
procedures. The auditor, therefore, should draw up the programme of audit on a consideration
of the technical, financial and accounting set-up of the company. In addition, for his general
guidance, he must study the audit programme of different types of business to find out audit
procedures that are considered suitable under different conditions and circumstances. The
Institute of Chartered Accountants of India has brought out Technical Guides concerning audit
of specified industries, for example; sugar, textiles, type, advertising, etc. Students will do well
to read them to understand the several technical aspects to be gone into while undertaking the
audit of such industries. The nature and size of the business is a basic fact to be reckoned in
devising the audit procedures and in assessing the adequacy of the internal control in
recognition of this, the auditors are required to give their assessment of the internal controls in
relation to the nature and size of the company under the Companies (Auditor’s Report) Order,
2003.
(b) Overall plan - Overall plan for the audit programme should be drawn up to ensure a
systematic approach to the work. If in drawing the audit programme, any divergence from the
overall plan becomes necessary, first the overall plan should be modified after due
consideration and thereafter only the matter may be taken in the audit programme. The frame
provided by the overall plan should be strictly adhered to.
(c) System of internal control and accounting procedures - The existence of a system of
internal control is essential for every business organisation. It ensures that both financial and
statistical records are checked continuously; it also unearths errors, both of omission and of
commission. The auditor, in framing his opinion on financial statements needs reasonable
assurance that transactions are properly authorised and recorded in the accounting records
and that transactions have not been omitted. Internal control may contribute to the reasonable
assurance the auditor seeks. Therefore it has become an accepted audit practice to study
and evaluate internal control. The study and evaluation of internal control helps the auditor to
establish the reliance he can place on the internal control in determining the nature, timing an
extent of his substantive auditing procedures. The auditor also obtains an understanding of
the accounting system to identify points in processing of transaction and handling of assets
where errors or fraud may occur. When the auditor relies on internal control, it is at these
points that he must be satisfied that internal control procedures applied by the entity are
effective for his purpose.
In the context of our country, the study and evaluation of internal control has become a
standard audit procedure for the contribution it can make towards satisfactory discharge of
auditing responsibilities and also for the very nature of statutory duty cast on company
auditors. Maintenance of accurate and complete accounting records constitutes an integral
part of internal control. Under Section 227(3) of the Companies Act, an auditor has to report,
inter alia, whether proper books of account required by law have been maintained by the
company. Maintenance implies maintenance in a complete and accurate manner and it
requires a study and evaluation by the auditor. It amounts to a statutory requirement to study
and evaluate this aspect of internal control. Further, the CARO, 2003 issued under Section
227(4A) of the Companies Act directly requires the auditor to study and evaluate internal
control in specific areas.
Before commencing an audit, it is essential that the auditor should verify that proper records of
transactions entered into by the entity have been maintained and that accounting data
collected has been duly analysed. For the purpose, he should examine the procedures
followed for recording transactions. He should also verify that there exists a system of internal
control which guards against occurrence of mistakes and frauds. The verification of the system
of the internal control obtaining in the client’s office is thus the primary duty of the auditor. He
carries it out by examining the manner in which it operates and by application of procedural
checks and test checks to a number of transactions of different kinds recorded in the books.
The auditor’s examination of the system of internal control should have three features: review
and preliminary evaluation, testing of compliance and evaluation.
(i) Review and preliminary evaluation - The auditor should review the accounting system
and related internal control to gain an understanding of the flow of transactions and the
specific control procedures to be able to make a preliminary evaluation and identification
of these aspects of internal control on which it might be efficient and effective to rely in
conducting his audit. He should enquire whether the internal controls intended to be
relied upon were in use throughout the period for which accounts were made up. If
substantially different controls were in use at different times during the period, the auditor
should consider each of them separately. A break-down in internal controls for specific
portions of the period would necessitate a separate consideration of the nature, timing
and extent of audit procedures to be applied for that period. The review is made by
reference to documents i.e., manuals, job descriptions and flow charts and discussions
with related personnel of the client. It may be useful to trace a transaction through the
accounting system to assist in understanding that system and its related internal controls.
Different techniques such as narrative description, questionnaire and flow-chart are
available to the auditor to record information relating to internal control. Selection of the
particular technique is a matter of auditor’s own judgement the purpose of preliminary
evaluation is to identify the particular controls on which the auditor still intends to rely and
to test them through compliance procedures. The auditor may also decide not to rely on
any particular internal control.
(ii) Test of compliance - Compliance tests should be conducted by the auditor to gain
evidence that those internal controls on which he intends to rely operate generally as
identified by him and that they function effectively throughout the period of intended
reliance. Based on the results of his compliance procedure including observed
deviations, the auditor should evaluate whether the internal controls are adequate for his
purposes. If based on the results of compliance procedure, the auditor concludes that a
particular control cannot be substantially relied upon; he should ascertain whether there
exists another control that may satisfy his purpose. For example, if he finds that materials
are not regularly checked for quantity when received at the Receiving Section but Stock
Section carries out a quantity check before accepting the materials in stock, he may
prefer to rely on Stock Section checking for receipt of the materials as correct quantity,
provided further that the Stock Section records are properly and regularly maintained. If
he cannot find another supportive control procedure, he may have to modify the nature,
timing and extent of his substantive audit procedure. The compliance procedure normally
should be applied to transactions selected from those of the whole period under
examination. Compliance procedure is essentially a testing procedure. It demands that
important sections of the record of the concern or selected items of income and
expenditure of transactions should be examined “in depth” and by the application of
procedural tests to ensure that the transactions have been properly authorised,
evidenced and recorded. In certain cases, for purpose of verification, it is necessary to
observe the operation of the system by actual attendance, e.g., in the case of stock-
taking, payment of wages, etc. The examination in depth is a method whereby a few
selected transactions are traced through various stages from the origin to the conclusion:
at each stage, the record and the authority are examined and the operation of internal
check and delegation of authority considered. For example, to verify in depth a payment
to a creditor in respect of goods supplied, it will be necessary to examine the following
documents:
♦ The invoice and the statement of account received from the supplier.
♦ The evidence that goods have been entered in stock records.
♦ The goods received note and inspection certificate.
♦ A copy of the original order and the authority therefore.
The number of transactions selected for examination in depth, generally, can be reduced
as the intricacy of examination increases. For example, while examining payments to
creditors for goods supplied, the auditor, after he has verified all the acknowledgements
for payments, need examine only a proportion of these cases with the suppliers’ invoices
and statements and a still smaller proportions of the evidence that goods have been
recorded in the stock records and so on until a comparatively small proportion is verified
completely in depth. In addition, there are several other audit tests which can be applied
to strengthen the effectiveness of the system of internal control, e.g., procedural test. In
the case of a small concern, a large proportion of transactions should be selected for
examination in depth or application of procedural tests than is necessary in the case of a
large concern since the latter would normally have a more comprehensive system of
internal control. Further, in selecting items for examination as well as for deciding the
scope of tests, the auditor should consider to what extent the transactions under review
are material in relation to the affairs of the company as a whole. In addition to the annual
review of all procedures, it is desirable that each year the auditor makes an intensive
review of the accounting procedures relative to one main aspect of the activities of the
business, e.g., purchases, sales, payment of wages and salaries. In this way, it would be
possible for him to review the main aspects of the system of internal control over a period
of years.
(iii) Evaluation - It is essentially an objective process of application of auditor’s judgement to
determine whether all or any of the internal controls in the client’s organisation can be
relied upon in carrying out the audit. Based on the degree of reliance which may be full,
partial or none, the auditor will programme for the substantive verification of transactions
for expression of audit opinion. The results of compliance procedure directly provide the
basis for this evaluation and, in turn, basis to determine the nature, timing and extent of
the substantive audit procedure. In evaluating the auditor recognises that some
deviations from compliance may have occurred.
If the tests applied by the auditor reveal certain mistakes in accounting due to which
either some transactions have not been recorded or have been wrongly recorded, the
auditor should ascertain the nature and causes thereof. In case they are the result of
some inherent defect in the system of recording, their impact on the true and fair position
of the records should be assessed by extending the area selected for examination. For
example, if it is the duty of the sales manager to verify that various items of goods have
been correctly billed to customers and the examination of sales invoices that reveals
wrong rates have been applied in the case of one or two invoices, it should be assessed
whether the mistake are accidental or otherwise. If, however, there are many such
instances, the presumption would be that the sales manager had failed to discharge his
duty. If despite this, the auditor is satisfied that the magnitude of discrepancies or
irregularities is not sufficiently large to affect the true and fair character of the accounts of
the concern, he may decide to rely upon the control. In such a case, he needs only
report the result of his findings to the management with a recommendation that the
system of internal control be strengthened in such ways as he considers appropriate. If,
however, the auditor considers that the internal control is inadequate to such an extent
that reliance cannot be placed, he may have to extend his substantive audit procedure
significantly. If he is still not satisfied that the records are sufficiently reliable, he should
state in his report that books of account have not been properly kept.
In the end, the auditor should prepare a memorandum as regards the system of internal
control in operation, the test checks applied and matters observed on their application as
a general guide for drawing up the programme of audit. In specific terms he will identify
the controls which he has decided to rely upon, the controls which may be relied upon
only in conjunction with another control and the controls which cannot be relied upon
together with appropriate basis.
(d) Size of the organisation and structure of its management - An increase in the size of
the organisation enhances the complexity of the examination of its accounting records
specially when it has a number of branches, deals in several products or has a very large
turnover. With the increase in the size ordinarily the scope and extent of the system of internal
control also should increase but it may not be so in every case. It has been the experience
that while many small businesses have excellent controls, some of the large enterprises are
deficient in their operational controls. For example, the reports of the Comptroller and Auditor
General on audit of accounts of Public Enterprises show that some of them have a very poor
system of internal control. In such cases, the magnitude of the tasks of the auditor increases
considerably.
The structure of management of a concern is governed by law as well as its status in the
industry. For instance, management structure of a company is one contemplated by the
Companies Act. It is simple or elaborate, depending upon the position the company occupies
in the trade or industry in which it is engaged. For example, a company which is big and is
engaged in diverse trade or business, would have a large Board of Directors, a number of
whole-time directors and a team of qualified managers to attend to different aspects of the
business activity-technical, financial accounting, commercial, etc. On the other hand, a small
company may only have a managing director who attends to all the affairs of the company and
a small board of directors to guide its operations.
The structure of management of a co-operative society is the one contemplated by the Co-
operative Societies Act. Usually, its affairs are managed by persons who neither have had
formal training nor any commercial or administrative experience. Moreover, on account of the
limitation on shareholdings, no member of the managing committee has a sizeable investment.
Thus, self-interest which is an incentive to efficient management, is absent in a co-operative
enterprise. On that account the Co-operative Societies Act provides a detailed control over
the working of co-operative institutions by a Governmental agency (the Registrar).
It is also important for the auditor to examine the character of management for determining the
seat of power. If he is satisfied, it would not be necessary for him to examine each and every
decision taken by the management in so far as it affects the finances of the company. In the
alternative, it would be his duty to examine these matters in greater detail. For instance, in the
case of a concern in which powers and duties of the management are distributed among a
large number of persons and the work of each person is being effectively supervised by the
top management, by obtaining reports, etc., it may be sufficient for the auditor to carry out only
a balance sheet audit, provided the application of procedural tests shows that accounts are
properly maintained. On the other hand, in the case of a co- operative society or a proprietary
or partnership concern, it would be necessary for the auditor to examine the correctness and
validity of a large number of transactions entered into by them.
(e) Information as regards organisation of the business - To plan audit programme, it is
necessary that the auditor should obtain from his client information as regards the
undermentioned matters:
♦ Client’s history and business.
♦ Purpose and nature of engagement.
♦ Time schedule for the completion of audit.
Before accepting a new audit, the auditor should satisfy himself as to the desirability of being
associated with the job. If the concern is not known to him, he should enquire into its
standing, financial background, nature of business and other similar matters. As far as
practicable, he should also try to ascertain the reputation of the concern as also the honesty
and integrity of principal executive. On the basis of the enquiries made he should gather
information on the following points:
♦ Date of incorporation and commencement of business.
♦ The name of subsidiary companies or affiliates as well as the nature of business carried
on by each of them. The auditor should have information as regards work of all the
companies associated with the client through common ownership of capital or the
management.
♦ Details of products manufactured or services rendered and methods of their distribution.
♦ The status in the industry or in the geographical areas or among similar concerns
operating within the State.
♦ Location of plants and offices together with a description of activities at each location.
♦ The names of financial, technical and tax consultants working for the company.
♦ Names and designations of officers holding important positions in the administration of
the company, the duties of each officer being demarcated separately.
♦ The objective for which the audit is being conducted so that where necessary the auditor
may take the necessary precautions to see that he may not incur any liability for
negligence to a person or persons to whom these reports might be presented. This
matter has become of special importance since the decision in the case of Hedley Byrne
& Co. Ltd. vs. Heller and Partners Limited (an English case) and the case of Equity
Funding in the United States. If the engagement is in the nature of a tax audit, he must
plan to have all the pertinent facts recorded in his working paper. This he should do in all
other cases as well.
It is desirable that the auditor should know the date when the audit report shall be required.
This would depend on the purpose for which the auditor has been engaged. In case it is for
filing the income-tax return, the date by which the same is ordinarily required to be filed should
be ascertained. On the other hand, if the audit is for release of financial statements to the
shareholders for the annual meeting, the last date by which the notice should be issued should
be ascertained. This would indicate to him the last date by which the audit report should be
submitted. This information would be helpful to him in preparing a time schedule of his work
and that of his assistants so that the audit can be completed by the date the audit report would
be required. In drawing up the time schedule adequate provision should be made for
unforeseen complications and other delays. This time-schedule should separately show time
that a partner would be required to spend and that which the supervisor and senior assistants
and junior assistants would be required to spend. These, in turn must be coordinated with the
demands on them of other clients to attain an economical staff utilisation.
(f) Accounting and management policies - In view of the provisions under Clause (3) (xv)
of Part II of Schedule VI to the Companies Act, it is necessary for an auditor to know whether
there has been any change in the basis of accounting in order that he may report its effect to
the shareholders; also, the accounting principles require a disclosure of change in the basis of
accounting. On these considerations, on the first appointment it is necessary that the auditor
should review the financial statements of the past several years, audited by his predecessors
specially those of the immediately preceding previous year. This would reveal to him a great
deal of information regarding accounting and management policies which have been followed
in the past and whether these have been employed consistently. The policies affecting
accounts of business engaged in diverse trades differ; but they invariably deal with the
following matters:
(i) The method of maintaining the record of stocks, preparation of the closing inventory and
the basis of its valuation.
(ii) The basis adopted for making a provision for payment of bonus to staff.
(iii) Treatment to be accorded to research and development expenses.

(iv) Provision of depreciation in respect of assets, which strictly do not require to be
depreciated according to Sub-section (2) of Section 205 of the Companies Act, e.g.,
goodwill, development expenses, mining rights and leaseholds, etc.
(v) Provisions for gratuities payable to staff on retirement.
(vi) Provision for expenses on post sale services that would have to be rendered to
customers in respect of sales of various items of machinery or equipment.
(vii) Treatment to be accorded to items of deferred revenue expenditure.
(viii) Procedure for inclusion of expenses for arriving at cost of fixed assets.
In this regard, it is important to note that the Institute of Chartered Accountants of India has
always recommended that the auditor should critically examine the accounting policies
adopted by the management and test them for conformity with the accounting standards
recommended by the Institute, where available, or with any other authoritative statement. It
may also be noted that the Institute of Chartered Accountants of India has issued Accounting
Standard-1 and recommended disclosure of significant Accountants Policies. Similarly, the
vertical form of balance sheet introduced in the Schedule VI to the Companies Act requires
disclosure of Accounting Policies. The prime test should be that whether the treatment is
consistent with the basic principles of accounts. It may be noted that AS-1 in mandatory for all
corporate as well certain specified non-corporate entities. The Companies (Amendment) Act,
1999 has also made it obligatory on the part of companies to follow Accounting Standards
(Refer to Section 211).
2.2.1 Drawing up the audit programme - After the auditor has collected the aforementioned
information, he will be in a position to draw up the programme of audit. He can now decide
the areas to be covered by audit, also those to be covered in detail and those which should be
covered by the applications of the test checks. He will also be able to decide the specific audit
procedures which should be applied in each case. These procedures vary widely because of
the conditions under which each concern operates, its form of organisation, its nature of
business and the condition of its accounts. On this account, it is not practicable to draw up a
typical audit programme. When an auditor is appointed to audit the accounts of an entity for
the first time, the audit programme should be developed in three stages stated below:
(i) To begin with, a broad outline of the audit programme should be drawn up.
(ii) After the internal and accounting procedures have been reviewed, the details should be
filled up on a consideration of the deficiencies in the system of internal control.
(iii) After the detailed checking formality is over, the extent to which the special procedures
need to be applied should be determined, e.g., independent verification of balances of
debtors and creditors, physical inspection of fixed assets, personal inspection of various
items of stock included in closing inventories and testing their values. At times, special
procedures may have to be applied on a consideration of the nature of business e.g.
verification of provision for tax liability in case of a shipping company regarding freight
booked in different countries or for making a provision for unexpired liability in case of an
insurance company, etc.
At each subsequent engagement the programme should be reviewed and, if necessary,
modified on account of:
(i) experience gained during the previous audits;
(ii) important changes that have taken place in the business specially in the system of
internal control, accounting procedures or in the structure of management or of the scope
of business; and
(iii) evaluation of internal control made for the current year.
Given below are a few circumstances where in the audit programme would have to be suitably
altered:
(1) If the audit procedures were designed for a certain volume of turnover and subsequently
the volume has substantially increased. Also, when there have been significant changes
in the accounting organisation, procedures and personnel subsequent to the audit
procedures.
(2) Where during the course of an audit, it has been discovered that internal control
procedures were not as effective as assumed at the time the audit programme was
framed.
(3) Where there has been an extraordinary increase in the amount of book debts or that in
the value of stocks as compared to that in the previous year.
(4) When a suspicion is aroused during the course of audit or information has been received
that assets of the company have been misappropriated.
It may be noted that the audit plan and related programme should be reconsidered as the
audit progresses. Such re-consideration is based on the auditor’s review of internal control,
his preliminary evaluation thereof and the result of his compliance and substantive
procedures.
2.2.2 Development of an overall plan - Overall plan is basically intended to provide direction
for audit work programming and includes the determination of timing, manpower development
and co-ordination of work with the client, other auditors and other experts. The auditor should
consider the following matters in developing his overall plan for the expected scope and
conduct of the audit:
♦ Terms of his engagement and any statutory responsibilities
♦ Nature and timing of reports or other communication.
♦ Applicable legal or statutory requirements.
♦ Accounting policies adopted by the client and changes in those policies.
♦ Effect of new accounting or auditing pronouncements on the audit.
♦ Identification of significant audit areas.
♦ Setting of materiality levels for audit purposes.

♦ Conditions requiring special attention, such as the possibility of material error or fraud or
involvement of parties in whom directors or persons who are substantial owners of the
entity are interested and with whom transactions are likely.
♦ Degree of reliance he expects to be able to place on accounting system and internal
control.
♦ Possible rotation of emphasis on specific audit areas.
♦ Nature and extent of audit evidence to be obtained.
♦ Work of internal auditors and the extent of their involvement, if any, in the audit.
♦ Involvement of other auditors in the audit of subsidiaries or branches of the client.
♦ Involvement of experts.
♦ Allocation of work to be undertaken between joint auditors and the procedures for its
control and review.
♦ Establishing and co-ordinating staffing requirements;
Documentation of the overall planning on due consideration of the above should be done for
drawing a systematic, logical and an adequate audit programme. An illustration of
documentation of overall plan may be as under:
Plan dated 17.10.XX
1. Name and address of the client : Progressive Industries Ltd., 52, J. Bose Road,
Calcutta.
2. Nature of professional work : Annual audit under the provisions of Companies
Act, 19XX
3. Period for which the professional : Accounting year ending on 31st services required
March, XXXXY
4. Particulars of establishment of the : (i) Registered office and Head office client at the
client above address.
(ii) Factory at Tiljala.
(iii) Branches at Bombay, Madras, Delhi and
Kanpur (all the branches to be audited by
separate branch auditors).
5. Latest date within which the : 30th September, XXXX
company is to hold its annual
general meeting
6. Manner of audit agreed to with the : Interim checking up to 30.XX. to be completed by
client December, XYXX. and followed by an interim
report to the Board. Final audit to be completed
and report submitted by 5th August, 19XX.

7. Man hours required to completing : Interim audit for the first half-year involved 350
the audit in preceding year in two man hours and the final phase of audit involved
phases 450 man hours.
8. Assistants deputed in the previous : Mr. Jayanta –Senior
year Mr. Alokesh - Semi-Senior
Mr. Pulokesh - Articled Student
Mr. Bilkash – Inventory, cash
Mr. Raman - Security verification
Mr. Robin - alongwith the other three.
9. Partner-in-charge of the previous : Mr. T. Roychowdhury
year
10. Letter of appointment for 1994-95 : Received on 5.10.XXXX
11. Any non-statutory duty : Yes, Certification to Royalty statement and Export
statement besides reports to the Board on interim
verification
12. Any letter of engagement issued : Yes, dated on 12.10.XXXX.
13. Any change in the scope, volume : No significant change intimated/assessed.
or nature of work intimated, or
assessed
14. Assistants to be deputed for 1994- : Mr. Alokesh - Senior
95 Mr. Pulokesh - Semi-Senior
Mr. Rohin – Articled Student for interim checking.
Plan for final checking will be made later.
15. Number of man hours expected to : 320 man hours
be devoted in the interim checking
16. Is thorough evaluation of internal : No, It will be due next year. This year, apart from
control due this year? overall evaluation, indepth evaluation will be done
on payroll and transport.
17. Any change in the accounting : No, as per the discussion held on 15.10.XXXX
policies compared with the with the company management.
previous year
18. Any statement/ standard :
pronouncement/note issued by the -----
ICAI during the period that may
have a bearing on the present audit
19. Does any area of accounting : Yes, Payroll, Transport Discounts, Rebates,
require special attention in view of Reliefs on sales, consumption of raw materials.
the observations made on the

previous year’s accounts in the
audit report or in the working
papers?
20. Detailed audit or test audit : Normally test audit; verification of debtor’s
balance and value of inventory will be done by
adopting statistical sampling plan.
21. Whether inventory verification will : Yes, by arrangement with the client.
be witnessed Also, surprise verification of some of the selected
items should be done after the physical
verification by the management is over.
22. Whether cash and investment will : Yes, also surprise verification before year-end
be physically verified day.
23. How the fixed assets shall be : Documentary verification and scrutiny of physical
verified verification of working papers of the company.
24. How other areas to be examined/ : By reference to documents, vouchers,
verified confirmations, etc. as may be appropriate.
25. Associated party transaction : Officially confirmed list of associated parties
should be obtained and bonafides and
reasonableness of transactions ascertained.
26. How to establish materiality of : Bases provided by Schedule VI and the AAS-13.
transaction Partner-in-charge should be consulted where
consultation is required.
27. Is there only internal audit system : Yes, the internal auditor reports to the Managing
headed by a qualified internal Director.
auditor? If yes, to whom does the
internal auditor report?
28. Review of internal audit programme : Should be completed before drawing up detailed
and report/reports audit programme. Also, Areas of work sharing
should be discussed with the Internal Auditor at
that stage.
29. When, the reports of Branches : On 15.7.XXXX
auditor expected
30. Need for review of previous year’s : Yes, should be done in the light of points 16, 19,
audit programme 20, 21, 22, 25 and 28 by the Senior-in-charge and
shown to partner-in-charge.
31. Partner-in-charge of this year’s : Mr. T. Roychowdhury.
audit
Designing Audit Strategy

2.3 As stated earlier, audit planning is the process of gathering information and designing
audit strategies; the main output of audit planning is a tailored audit approach supported by
appropriate administrative arrangements. Audit strategy is concerned with designing
optimised audit approaches that seek to achieve the necessary audit assurance at the lowest
cost within the constraints of the information available. Audit procedures should be relevant to
the important assertions, and as cost effective as possible to perform. Audit strategy
generally involves the following steps:
(i) Obtaining knowledge of business.
(ii) Performing analytical procedures at initial stages.
(iii) Evaluating inherent risk.
(iv) Evaluating Internal Control system for strategy purpose.
(v) Formulating the strategy.
Let us deal with above stages step-wise:
(i) Obtaining Knowledge of Business - AAS-20 on, “Knowledge of Business” states that in
performing In performing an audit of financial statements, the auditor should have or
obtain knowledge of the business sufficient to enable the auditor to identify and
understand the events, transactions and practices that, in the auditor's judgment, may
have a significant effect on the financial statements or on the examination or audit report.
Knowledge of the business is a frame of reference within which the auditor exercises
professional judgment. Understanding the business and using this information
appropriately assists the auditor in:
♦ Assessing risks and identifying problems.
♦ Planning and performing the audit effectively and efficiently.
♦ Evaluating audit evidence.
♦ Providing better service to the client.
Finally, the auditor should ensure that the audit staff assigned to an audit engagement
obtain sufficient knowledge of the business to enable them to carry out the audit work
delegated to them. The auditor would also ensure that the audit staff understands the
need to be alert for additional information and the need to share that information with the
auditor and other audit staff.
To make effective use of knowledge about the business, the auditor should consider how
it affects the financial statements taken as a whole and whether the assertions in the
financial statements are consistent with the auditor's knowledge of the business.
(ii) Performing Analytical Procedures - AAS-14 on, “Analytical Procedures” states that the
auditor should apply analytical procedures at the planning and overall review stages of
the audit. Analytical procedures may also be applied at other stages.
The purpose of analytical procedures at the planning stage is attention-directing;

corroboration is not normally necessary at this stage beyond this stage beyond the
discussions that would usually take place with the client during the planning of the audit.
The use of analytical procedures during the planning stage requires the extensive use of
accounting and business knowledge and experience to assess the potential for material
misstatement in the financial statements as a whole, because the key aspect of the task
is to identify the relevant risk indicators and to interpret them properly. Furthermore,
analytical techniques applied during the planning stage are not generally as precise as
the analytical techniques at the substantive stage.
(iii) Evaluating Inherent Risk - To assess inherent risk, the auditor would use professional
judgement to evaluate numerous factors, having regard to his experience of the entity
from previous audit engagements of the entity, any controls established by management
to compensate for a high level of inherent risk, and his knowledge of any significant
changes which might have taken place since his last assessment. Examples of are such
factors are:
At the Level of Financial Statements:
♦ Management’s experience and knowledge and changes in management during the
period, for example, the inexperience of management may affect the preparation of
the financial statements of the entity.
♦ Unusual pressures on management, for example, circumstances that might
predispose management to misstate the financial statements, such as the industry
experiencing a large number of business failures or an entity that lacks sufficient
capital to continue operations.
♦ The nature of the entity’s business, for example, the potential for technological
obsolescence of its products and services, the complexity of its capital structure, the
significance of related parties and the number of locations and geographical spread
of its production facilities.
♦ Factors affecting the industry in which the entity operates, for example, economic
and competitive conditions as indicated by financial trends and ratios, and changes
in technology, consumer demand and accounting practices common to the industry.
At the level of Account Balance and Class of Transactions:
♦ Quality of the accounting system.
♦ Financial statements are likely to be susceptible to misstatement, for example,
accounts which required adjustment in the prior period or which involve a high
degree of estimation.
♦ The complexity of underlying transactions and other events which might require
using the work of an expert.
♦ The degree of judgement involved in determining account balances.
♦ Susceptibility of assets to loss or misappropriation, for example, assets which are

highly desirable and movable such as cash.
♦ The completion of unusual and complex transactions, particularly at or near period
end.
♦ Transactions not subjected to ordinary processing.
(iv) Evaluating Internal Control - The auditors’ assessment of the control environment is
crucial to the decision on whether to make an extended assessment of controls. This is
because a good control environment is conducive to the maintenance of a reliable
system of accounting and control procedures. For strategy purposes the auditor should
obtain a sufficient understanding of the control environment. The auditor needs an
understanding of the accounting systems, regardless of whether the audit strategy will
involve an extended assessment of internal accounting controls. This should be done by:
(a) documenting the extent to which the system is computerised; and
(b) preparing or updating overview flowcharts to record the files and transactions
relating to significant systems-derived account balances.
If there are significant computer systems, the auditor should obtain an understanding or
the IT controls so decide whether to make an extended assessment of monitoring
controls. Whether it is necessary to carry out any preliminary work for strategy purposes
to ascertain whether IT controls are likely to be satisfactory will depend on the auditor’s
previous knowledge about IT controls. For an existing audit, the objective will normally
be to carry out the minimum work necessary to update this previous understanding. If
more information is needed, or if the engagement is new or substantially changed, the
auditor should carry out an overview assessment of IT controls. However, even if auditor
has not carried out an overview assessment of the IT controls for strategy purposes, it
may be necessary to do so later, to help design and perform substantive tests and draw
conclusions on whether proper accounting records have been kept. Whether this work is
done before determining the strategy or subsequently as part of the fieldwork is a matter
of audit efficiency.
(v) Formulating the Strategy - The auditor should develop the strategy by:
(a) considering the results of gathering or updating information about the client; and
(b) making preliminary judgements about materiality, inherent risk and control
effectiveness. These will include identification of the system(s) the auditor
proposes to subject to an extended assessment of controls.
The initial assessment of the quality and complexity of the client’s systems will affect the
amount of the information the auditor needs to gather. Sometimes, on a new
engagement, the appropriate strategy may be obvious from a limited amount of
investigative work. In other cases, the necessary information gathering will be extensive.
The auditor should consider the following matters:
(a) For many existing clients, the majority of the information the auditor needs will
already exist in the prior year’s strategy and in the audit programme. Accordingly, it
will often be possible to restrict the work to updating existing knowledge,
considering whether there are any significant new or changed risks and confirming
that there are no new or substantially changed significant systems.
(b) On a new, large or complex engagement the auditor may be uncertain about the
extent of information that should be gathered. Accordingly, in such cases the
engagement partner, the engagement manager and the in-charge should consider
together their knowledge of the matters listed in the preceding paragraph before
undertaking further information gathering. This will ensure that the information-
gathering process is carried out in as efficient and effective a manner as possible.
(c) If the auditor determines that there have been significant changes to risks, systems
and other client circumstances, it may be necessary to gather extensive information
before determining the strategy. For example, more information would be required
for a client with an acquisition or a significant new system than for a client with a
stable, unchanging business and accounting environment.
(d) If the auditor has had substantial contact with the client in the current period it may
be possible to determine the strategy without gathering additional information.
Finally, audit strategy may be evolved after considering the following:
(a) The engagement objectives.
(b) The results of the business review, including major developments in the client’s
business and industry, significant operating results and financial arrangements.
(c) Preliminary judgements as to materiality.
(d) Identified inherent risks. The team should also consider the risk of fraud and, in
particular, any evidence of a high level of risk to the firm. They should take into
account the results of procedures for the acceptance and continuation of clients.
(e) The degree to which the team should carry out further assessment of controls as a
means of reducing substantive tests.
(f) The broad nature, extent and timing of substantive tests, or changes to the previous
year’s strategy for substantive testing.
(g) Main points relating to planning and controlling the audit or comments on the
adequacy of the existing arrangements.
Using the Work of an Expert

2.4 During the audit the auditor may seek to obtain, in conjunction with the client or
independently, audit evidence in the form of reports, opinions, valuations, and statements of
an expert.
Examples are:
♦ valuations of certain types of assets, for example, land and buildings, plant and
machinery, works of art, and precious stones.
♦ determination of quantities or physical condition of assets, for example, minerals stored
in stockpiles, mineral and petroleum reserves, and remaining useful life of plant and
machinery.
♦ determination of amounts using specialised techniques or methods, for example, an
actuarial valuation.
♦ the measurement of work completed and to be completed on contracts in progress for the
purpose of revenue recognition.
♦ legal opinions concerning interpretations of agreements, statutes, regulations,
notifications circulars, etc.
When determining whether to use the work of an expert or not, the auditor should consider:
♦ the materiality of the item being examined in relation to the financial information as a
whole.
♦ the nature and complexity of the item including the risk of error therein, and
♦ the other audit evidence available with respect to the item.
Skills and competence of the expert - When the auditor plans to use the expert’s work as
audit evidence, he should satisfy himself as to the expert’s skills and competence by
considering the expert’s:
♦ professional certification, licence or membership in an appropriate professional body.
♦ experience and reputation in the field in which the auditor is seeking evidence.
However, when the auditor uses the work of an expert employed by him, lie will not need to
inquire into his skills and competence.
Objectivity of the expert - The auditor should also consider the objectivity of the expert. The
risk that an expert’s objectivity will be impaired increases when the expert is:
♦ employed by the client, or
♦ related in some other manner to the client.
Accordingly, in these circumstances, the auditor should (after taking into account the factors
stated above) consider performing more extensive procedures than would otherwise have
been planned, or lie might consider engaging another expert.
Evaluating the work of an expert - When the auditor intends to use the work of an expert, he
should examine evidence to gain knowledge regarding the terms of the experts’ engagement
and such other matters as:
♦ the objectives and scope of the expert’s work,
♦ a general outline as to the specific items in the expert’s report,
♦ confidentiality of the client’s information used by the expert.

The auditor should seek reasonable assurance that the expert’s work constitutes appropriate
audit evidence in support of the financial information, by considering:
♦ the source data used,
♦ the assumptions and methods used and, if appropriate, their comparison with the prior
period, and
♦ the results of the expert’s work in the light of the auditor’s overall knowledge of the
business and of the results of his audit procedures.
♦ the auditor should also satisfy himself that the substance of the expert’s findings is
properly reflected in the financial information.
The auditor should consider whether the expert has used source data which are appropriate in
the circumstances. The procedures to be applied by the auditor should include:
♦ making inquiries of the expert to determine how he has satisfied himself that the source
data are sufficient, relevant and reliable, and
♦ conducting audit procedures on the data provided by the client to the expert to obtain
reasonable assurance that the data are appropriate.
The appropriateness and reasonableness of assumptions and methods used and their
application are the responsibility of the expert. The auditor does not have the same expertise
and, therefore, cannot always challenge the expert’s assumptions and methods. However, the
auditor should obtain an understanding of those assumptions and methods to determine that
they are reasonable, based on the auditor’s knowledge of the client’s business and on the
results of his audit procedures.
Normally, completion of the above procedures will provide the auditor with reasonable
assurance that he has obtained appropriate audit evidence in support of the financial
information. In exceptional cases where the work of an expert does not support the related
representations in the financial information, the auditor should attempt to resolve the
inconsistency by discussions with the client and the expert. Applying additional procedures,
including possibly engaging another expert, may also assist the auditor in resolving the
inconsistency.
If after performing these procedures, the auditor concludes that:
♦ the work of the expert is inconsistent with the information in the financial statements, or
that
♦ the work of the expert does not constitute sufficient appropriate audit evidence (e.g.
where the work of the expert involves highly technical matters or where, on grounds of
confidentiality, the expert refuses to make available to the auditor the source data used
by him, he should express a qualified opinion, a disclaimer of opinion or an adverse
opinion, as may be appropriate.
Reference to the Expert in the Auditor’s Report - When expressing an unqualified opinion,
the auditor should not refer to the work of an expert in his report. If, as a result of the work of
an expert, the auditor decides to express other than an unqualified opinion, it may in some
circumstances benefit the reader of his report if the auditor, in explaining the nature of his
reservation, refers to or describes the work of the expert. Where in doing so, the auditor
considers it appropriate to disclose the identity of the expert, he should obtain prior consent of
the expert for such disclosure if such consent has not ready been obtained.
Relying upon the Work of Internal Auditor

2.5 AAS-7 entitled ‘Relying upon the Work of an Internal Auditor’ deals with the procedure
which should be applied by the internal auditor for the purpose of placing reliance upon that
work. It should, however, be remembered that the external auditor has sole responsibility for
his report and for the determination of the nature, timing, extent of the auditing procedures but
much of the work of the internal audit function may be useful to him in his examination of the
financial information. The responsibility of the external auditor is not reduced by any means
because of the reliance placed upon the internal auditor’s work.
Using the Work of another Auditor

2.6 When the auditor uses work performed by other auditors, the auditor should obtain
reasonable assurance that such work is adequate for the purpose of the audit. Such a
situation may arise in case a company having branch or having different branch auditors or the
auditor is using the work of another independent auditor with respect to the financial statement
of one or more subsidiaries or associated companies. Generally when another auditor has
been appointed for the branch / division/ component, the principal auditor would be entitled to
rely upon the work of such auditor unless there are circumstances to indicate that he should
not rely. The procedure to be followed by the company auditor in relation to branch auditor is
outlined in Chapter on the Company Audit. It should however be noted that the aforesaid
instances do not cover cases where two or more auditors are appointed as joint auditors nor
does it deal with the auditor’s relationship with the predecessor auditor.
Principal’s Ultimate Responsibility

2.7 “When the auditor delegates work to assistants or uses work performed by other auditors
and experts, he will continue to be responsible for forming and expressing his opinion on the
financial information. However, he will be entitled to rely on work performed by others,
provided he exercises adequate skill and care and is not aware of any reason to believe that
he should not have so relied. In the case of any independent statutory appointment to perform
the work on which the auditor has to rely in forming his opinion, such as in the case of the
work of branch auditors appointed under the Companies Act, 1956 the auditor’s report should
expressly state the fact of such reliance.”
Reliance on the Management or other Certificates by the Auditor

2.8 It is customary for the company auditor to obtain certificates from the management
certifying the value of inventories, Provision for liabilities, the disclosure of contingent liabilities
etc. The object of this practice is to obtain information for which the management can be
specifically held responsible. However, possession of such certificates does not absolve the
auditor from carrying out a proper audit. Letter of representation obtained from the
management will not protect the auditor in a legal action for negligence if he has failed to
perform his duties according to the generally accepted auditing standards and procedures.
Thus, an auditor who fails to count cash, put to test the inventory figures, verify debtors and
liabilities according to the recognised practices, will derive little support from certificates of
directors or company officials certifying the accuracy of these items. At best certificates can
only act as the second line of defence for an auditor who has carried out his work with
reasonable care and skill.
Although the judgement in the Kingston Cotton Mill’s case held that there is no duty on the
auditor to take stock physically, that he may, in the absence of suspicious circumstances rely
upon the certificate of a responsible official has not been categorically overruled,
contemporary professional auditing practice requires a thorough investigation into the
adequacy or otherwise of the internal check system regarding the movement and periodic
counting of stocks with particular enquiry into deviations from the prescribed procedure.
Certain cases, decided long after the Kingston Cotton Mill’s case were quite forthright in
stating that a blind acceptance of certificate from the management by the auditor, without
putting the same to appropriate tests and intelligent scrutiny, does not amount to a proper
performance of duty. Mention may be made in this connection of the case of Thomas Gerrard
& Son (1967) and Colmer v Merrett Son & Street (1964). The development of the professional
practices mentioned above is the result of the timely notice taken by the accounting profession
of the gradual erosion of the dictum in the Kingston Cotton Mills case.
It is clear, therefore, that the request for a certificate and its receipt constitute no more than
the initial step in the auditor’s verification of the relevant item whereby he seeks to obtain from
those legally responsible, viz., the directors, the conscious acknowledgement of the amount at
which the item concerned is stated. It should, however, be noted that it would not be
considered proper for an auditor to seek or accept certificates from the management when the
subject-matter is such as is capable of direct verification by the auditor himself. For example,
cash in hand at the end of the year can be verified by the auditor himself and obtaining a
certificate without actually undertaking the verification will amount to a non-performance of
duty.
Notwithstanding anything stated above, the auditor can accept certificates from the director
and the officials under the following circumstances:
(1) The subject matter should not be capable of direct verification of the auditor and should
be one which is accepted to be beyond the competence of a professionally qualified
accountant.
(2) There exist proper records and “internal check” in the client’s system that can enable the
directors or the officials to prepare and issue the certificate. The auditor should review
such records and internal checks to ascertain their reliability,
(3) The certificate should be prima facie in agreement with the records maintained.
(4) The certificate should be put to common sense tests by the auditor.
During the course of an audit, an auditor may have to deal with certificates from outside
parties such as the company’s bankers, architects, agents, warehousemen, etc.
The bankers may certify the investments or securities held by them on behalf of the company,
the architect may certify the value of property held as security and an agent or distributor may
certify the value of property held as representatives of the company. The question of auditor’s
duty in such circumstances was discussed in Re. City Equitable Fire Insurance Co. Ltd. It was
held that a company’s brokers are not the proper people to have the custody of its securities,
however respectable and responsible those brokers may be. On the other hand, banks in the
ordinary course of business hold securities for their customers and, therefore, an auditor
would be justified in accepting the certificate of a respectable bank whilst verifying the
existence of the securities.
As a general rule, it may be stated that, before accepting and relying upon a certificate from a
third party, the auditor should satisfy himself that:
(a) the party issuing the certificate is reputable and trustworthy;
(b) the certificate relates to an item which is normally dealt with or held by such party;
(c) the auditor himself is not in a position to verify the item because of its technical nature or
because it would be too costly, cumbersome for him to do so.
(d) the certificate is prima facie reliable and reasonable; and reference to the third party is
available in the books and documents of the client as in possession of the concerned
goods, property and/or securities belonging to the client.
(iii) Not infrequently, during the course of an audit, local issues arise which have a bearing
on accounts. A chartered accountant is not necessarily competent to interpret law and,
therefore, it may be desirable for him to obtain legal advice from his own or his client’s
attorney or counsel. But before accepting a legal opinion, the auditor should satisfy himself
about the competence and impartiality of the lawyer. If a written opinion is sought, the auditor
should ensure that the case for opinion is properly drawn up so that all the relevant facts are
brought to the notice of the legal adviser. If a verbal opinion is being obtained, the auditor
should attend the conference at which the matter is to be discussed to make sure that the
facts are correctly presented.
Even if the legal opinion turns out to be erroneous the auditor cannot be held to be negligent
in the performance of his duties if he has acted honestly and in good faith and if the opinion
relied upon was prima facie reasonable. However, an auditor is under no compulsion to
accept a legal opinion, if he has reasons to believe that such opinion is erroneous or
inadequate.
Management Representations
2.9 Representations by management are the single most important source of audit evidence to
an auditor and, thus, have significant implication for an auditor to formulate his opinion on the
financial information. AAS-11 on “Representations by Management” expounds in detail to
establish standards on the use of management representations as audit evidence the
procedures to be applied in evaluating and documenting management representations, and
the action to be taken if management refuses to provide appropriate representations. AAS-9
emphasises that the auditor should obtain representations from management, where
considered appropriate. AAS 9 became operational for all audits relating to accounting period
beginning on or after April 1995.
Acknowledgement by Management of its Responsibility for the Financial Information -
The auditor should obtain evidence that management acknowledges its responsibility for the
appropriate preparation and presentation of financial information and that management has
approved the financial information.
Representation by Management as Audit Evidence - The auditor should exercise his
professional judgement in determining the matters on which he wishes to obtain
representations from management. Similarly, the matters on which the auditor wishes to
obtain such representations in writing should be determined by the auditor using his
professional judgement. However, representations should be obtained from management
invariably in writing on matters material to financial information, either individually or
collectively, when other sufficient appropriate audit evidence cannot reasonable be expected
to exist. During the course of an audit, management makes many representations to the
auditors either unsolicited or in response to specific enquiries. When such representations
relate to matters which are material to the financial information, the auditor should:
(a) seek corroborative audit evidence from sources inside or outside the entity;
(b) evaluate whether the representations made by management appear reasonable and
consistent with other audit evidence obtained, including other representations; and
(c) consider whether the individuals making the representations can be expected to be well-
informed on the matter.
Representations by management cannot be a substitute for other audit evidence that the
auditor could reasonably expect to be available. For example, a representation by
management as to the quantity, existence and cost of inventories is no substitute for adopting
normal audit procedures regarding verification and valuation of inventories. If the auditor is
unable to obtain sufficient appropriate audit evidence that he believes would be available
regarding a matter which has or may have a material effect on the financial information, this
will constitute a limitation on the scope of his examination even if he has obtained a
representation from management on the matter.
In certain instances such as where knowledge of the facts is confined to management or
where the matter is principally one of intention, a representation by management may be the
only audit evidence which can reasonably be expected to be available. For example, intention
of management to hold a specific investment for long-term appreciation.
If a representation by management is contradicted by other evidence, the auditor should

examine the circumstances and, when necessary, reconsider the reliability of other
representations made by management.
Documentation of Representations by Management - The auditor should document in his
working papers evidence of management’s representations. A written representation is better
audit evidence than an oral representation and can take the form of:
(a) a representation letter from management;
(b) a letter from the auditor outlining the auditor’s understanding of management’s
representations, duly acknowledged and confirmed by management;
(c) a duly authenticated copy of relevant minutes of meetings of the board of directors or
similar body.
Basic Elements of a Management Representation Letter -
(i) A management representation letter should be addressed to the auditor containing the
relevant information and be appropriately dated and signed.
(ii) A management representation letter would normally be dated the same date as the
auditor’s report on the financial information or a date prior thereto. However, in certain
circumstances, in respect to specific transactions or events, separate representation
letters may also be obtained during the course of audit.
(iii) A management representation letter should ordinarily be signed by the members of the
management who have primary responsibility for the entity and its financial aspects, e.g.,
managing director, finance director.
(iv) If management refuses to provide representations on any matter that the auditor
considers necessary, this will constitute a limitation on the scope of his examination. In
such circumstances, the auditor should evaluate any reliance he has placed on other
representations made by management during the course of his examination and consider
if the refusal may have any additional effect on his report.
(v) In case management is not willing to give in writing the representations made by it during
the course of audit, the auditor should himself prepare a letter in writing setting out his
understanding of management’s representations that have been made to him during the
course of audit and send it to the management with a request to acknowledgement and
confirm that his understanding of the representations is correct. If the manage refuses to
acknowledge or confirm the letter sent by the auditor, this will constitute a limitation on
the scope of his examination. In such circumstances, the auditor should evaluate any
reliance on those representations and consider if the refusal may have any additional
effect on his report.
Drafting of Report
2.10 AAS 28 establishes standards on the form and content of the auditor’s report issued as
a result of an audit performed by an auditor of the financial statements of an entity. The
auditor should review and assess the conclusions drawn from the audit evidence obtained as
the basis for the expression of an opinion on the financial statements. This review and
assessment involves considering whether the financial statements have been prepared in
accordance with an acceptable financial reporting framework applicable to the entity under
audit. It is also necessary to consider whether the financial statements comply with the
relevant statutory requirements.
The auditor’s report should contain a clear written expression of opinion on the financial
statements taken as a whole. The auditor’s report includes the following basic elements,
ordinarily, in the following layout:
(a) Title;
(b) Addressee;
(c) Opening or introductory paragraph;
(d) Scope paragraph (describing the nature of an audit);
(e) Opinion paragraph containing;
(f) Date of the report;
(g) Place of signature; and
(h) Auditor’s signature.
A measure of uniformity in the form and content of the auditor’s report is desirable because it
helps to promote the reader’s understanding of the auditor’s report and to identify unusual
circumstances when they occur. A statute governing the entity or a regulator may require the
auditor to include certain matters in the audit report or prescribe the form in which the auditor
should issue his report. For detail students may refer AAS 28 (The Auditor’s Report on
Financial Statements).
Control of Quality of Audit Work

2.11 AAS-1 on Basic Principles Governing an Audit of Financial Statements lists control of the
quality of work performed by others as one of the basic principles governing an audit. The
relevant parts are reproduced below:
When the auditor delegates work to assistants or uses work performed by other auditors and
experts, he will continue to be responsible for forming and expressing his opinion on the
financial information. However, he will be entitled to rely on work performed by others,
provided he exercises adequate skill and care and is not aware of any reason to believe that
he should not have so relied. In the case of any independent statutory appointment to perform
the work on which the auditor has to rely in forming his opinion, such as in the case of the
work of branch auditors appointed under the Companies Act, 1956 the auditor’s report should
expressly state the fact of such reliance. The auditor should carefully direct, supervise and
review the work delegated to assistants. The auditor should obtain reasonable assurance that
work performed by other auditors or experts is adequate for his purpose.
As is clear from the aforesaid principle, an auditor is required to control the audit work
delegated to assistants and work performed by other auditors and experts. Accordingly, the
procedure to be followed by a statutory auditor in controlling the quality of audit work
performed by assistants, the quality of work performed by experts, the question of relying
upon the work of the internal auditor and the assessment of work performed by others is
discussed in the following paragraphs:
2.11.1 Control of the quality of work-Audit staff - As stated earlier, as per the basic principles
governing an audit, the auditor is required to carefully direct, supervise and review the work
delegated to assistants. It may be noted that the nature and extent of a firm’s quality control
procedures depend on a number of factors such as the size and nature of its practice, its
geographic dispersion, its organisation and appropriate cost benefit considerations.
Accordingly, the procedures adopted by the individual firm will vary as will the extent of their
documentation. The audit staff includes all partners and professional staff of an audit firm and
other personnel, namely audit assistants involved in an individual audit other than the auditor.
The AAS lists the policies and procedures to be adopted by an audit firm to provide
reasonable assurances regarding the quality of audit work generally and procedures to be
adopted by an auditor to comply with this basic principle as it relates to the work delegated to
assistants in an individual audit. The controls suggested in the AAS all discussed in the
following paragraphs:
2.11.2 General quality controls - Quality controls are the policies and procedures adopted by a
firm to provide reasonable assurance that all audits done by the firm are being carried out in
accordance with the Basic Principles Governing an Audit, as set out in Auditing and
Assurance Standard (AAS) 1. An audit firm should adopt quality control policies that
incorporate the following objectives and should implement appropriate procedures that provide
reasonable assurance of achieving those objectives:
(a) Professional requirements - Personnel in the firm should adhere to the principles of
integrity, objectivity, independence and confidentiality. Firms should therefore frame
appropriate procedures to ensure compliance with this policy. For instance an important
procedure would be to communicate the firms policies relating to independence to
personnel at all levels within the firm.
(b) Skills and competence - The firm should be staffed by personnel who have attained and
who maintain the skills and competence required to enable them to fulfil their
responsibilities. Implementation of this policy would involve following proper recruitment
procedures designed to obtain appropriately qualified personnel and procedures to
maintain a high degree of skills through periodic staff training, continuing professional
educational programmes and dissemination of information relating to current
developments in professional/technical standards.
(c) Assignment - Audit work should be assigned to personnel who have the degree of
technical training and proficiency required in the circumstances. If, however, special skills
required for the conduct of an audit e.g. a good EDP background to evaluate controls
over computer programs are not available within the firm, then reliance will have to be
placed on work delegated to outside experts.
(d) Delegation - There is to be sufficient direction, supervision and review of work at all
levels to provide reasonable assurance that the work performed meets appropriate
standards of quality.
(e) Consultation - Whenever necessary, consultation within or outside the firm is to occur
with those who have appropriate expertise.
(f) Acceptance and retention of clients - An evaluation of prospective clients and a
review, on an ongoing basis, of existing clients is to be conducted. In making a decision
to accept or retain a client, the firm’s independence and ability to serve the client properly
are to be considered.
(g) Monitoring - The continued adequacy and operational effectiveness of quality control
policies and procedures is to be monitored.
A firm’s general quality control policies and procedures should be communicated to its
personnel in a manner that provides reasonable assurance that the policies and procedures
are understood. The form of communication would vary depending on the size of the firm and
the criticality of various policies and procedures and need not necessarily be documented in
all instances.
Special procedures should be developed to ensure that all personnel are kept fully aware of
the pronouncements of the Institute of Chartered Accountants of India, changes in the law and
appropriate notifications and clarifications issued by statutory authorities.
The firm should carry out an evaluation of a prospective client prior to acceptance and should
review, on an ongoing basis, the association with existing clients. In making a decision to
accept or continue with a client a firm should consider its own independence, its ability to
service a client properly, and the integrity of the client’s management.
In evaluating the firm’s ability to service the clients properly, consideration should be given to
the need for technical skills, knowledge of the industry and availability of suitable personnel.
In evaluating the integrity of the client’s management, consideration should be given to the
possibility of reviewing financial information available regarding the prospective client, such as
annual reports. Communication with the previous auditor may also provide significant
information or other similarly significant matters as also the predecessor’s understanding as to
the reason for the change in auditors.
2.11.3 Control on Individual Audits-
Delegation - Any delegation of work to assistants should be in a manner that provides
reasonable assurance that such work will be performed by persons having independence and
the degree of skills and competence required in the circumstances. Some of the factors which
need to be considered in this context are:
(i) Audit size and complexity
(ii) Personnel availability
(iii) Special expertise required

(iv) Timing of the work to be performed.
The auditor and assistants with supervisory responsibilities should consider the skills and
competence of assistants in performing the work that is delegated to them and in deciding on
the extent of direction, supervision and review appropriate in each situation.
Direction - Appropriate directions should be given to assistants to whom work is delegated.
Direction involves informing assistants of their responsibilities and the objectives of the
procedures they are to perform. It also involves informing them of matters, such as the nature
of the entity’s business and possible accounting or auditing problems that may affect title
nature, timing, and extent of audit procedures with which they are involved.
Supervision - Supervision is closely related to both direction and review and may involve
elements of both.
Personnel carrying out supervisory responsibilities should perform the following functions
during the performance of an audit.
(a) Monitor the progress of the work to determine that:
♦ assistants appear to have the necessary skills and competence to carry out their
assigned tasks:
♦ assistants appear to understand the audit directions; and
♦ the work is being carried out in accordance with the audit programme and other
planning documents.
(b) Become informed of significant accounting and auditing questions raised during the audit,
assess their significance and modify the audit programme where appropriate.
(c) Resolve any differences of professional judgement between personnel.
The use of standardized forms, checklist and questionnaires assist in the performance of audit
and supervision of audit work.
Review - The work performed by each assistant should be reviewed by personnel of equal or
higher competence to determine whether:
(a) the work has been performed in accordance with professional and firm standards and
specific policies and procedures adopted by the audit firm;
(b) the work performed and the results obtained have been adequately documented;
(c) all significant audit matters have been resolved; and
(d) the objectives of the audit procedures have been achieved and the conclusions
expressed are consistent with the results of the work performed and support the auditor’s
opinion on the financial information.
The following major review stages can often be identified in an audit:
(a) Review of the initial audit plan and the audit programme.
(b) Review of the study and evaluation of internal control, including compliance procedures,
and of the modifications, if any, made to the audit programme as a result thereof.
(c) Review of the documentation of the audit evidence obtained and the conclusions drawn
therefrom.
(d) Review of the financial information and proposed auditor’s report.
3
RISK ASSESSMENT AND INTERNAL CONTROL
Introduction
3.1 Audit risk means the risk that the auditor gives an inappropriate audit opinion when the
financial statement are materially misstated. Thus, it is the risk that the auditor may fail to
express an appropriate opinion in an audit assignment.
An auditor may consider audit risk both at overall level as well as at the level of individual
account balances or classes of transactions. This means that at overall level the auditor
applies their professional judgement to determine the extent of risk which he considers to be
an acceptable level. At account balance level, audit risk refers to the risk that error in
monetary terms exists beyond a tolerable error limit in the account balances or class of
transaction which the auditor fails to defect.
The Internal Control structure in an organization is referred to as the policies and procedures
established by the entity to provide reasonable assurance that the objectives are achieved.
The control structure in an organization basically has the following components:
1. Control Environment - Control environment covers the effect of various factors like
management attitude; awareness and actions for establishing, enhancing or mitigating the
effectiveness of specific policies and procedures.
2. Accounting System - Accounting system means the series of task and records of an entity
by which transactions are processed for maintaining financial records. Such system identifies,
assemble, analyze, calculate, classify, record, summarize and report transactions and other
events.
3. Control Procedure - Policies and procedures means those policies and procedures in
addition to the control environment and accounting systems which the management has
established to achieve the entity’s specific objectives.
In this regard, Auditing Assurance Standard No.1 : Basic Principles Governing an Audit also
specifies that management is responsible for maintaining an adequate accounting system
incorporating various internal controls to the extent that they are appropriate to the size and
nature of the business. There should be reasonable assurance for the auditor that the
accounting system is adequate and that all the accounting information required to be recorded
has in fact been recorded. Internal controls normally contribute to such assurance. The auditor
should gain an understanding of the accounting system and related internal controls and
should study and evaluate the operation of those internal controls upon which he wishes to
rely in determining the nature, timing and extent of other audit procedures. Where the auditor
concludes that he can rely on certain internal controls, he could reduce his substantive
procedures which otherwise may be required and may also differ as to the nature and timing.
Specific Requirement under Auditing and Assurance Standard Number - 6 Risk Assessment
and Internal Control." In AAS-6 (Revised ) - “Risk Assessment and Internal Control”
procedures to be followed to obtain an understanding of accounting and internal control
systems and on audit risk and its components has been explained. AAS-6 defines the system
of internal control as the plan of organization including methods and procedures adopted in
achieving management objectives, like:
(a) adherence to policies;
(b) safeguarding of assets;
(c) prevention and detection of fraud and error;
(d) accuracy and completeness of accounting records; and
(e) timely preparation of reliable financial information.
AAS-6 further states that the auditor should obtain an understanding of the accounting and
internal control system sufficient to plan the audit and develop an effective audit approach.
The auditor should use professional judgement to assess audit risk and to design audit
procedures to ensure that it is reduced to an acceptable low level.
Internal Control System - Nature, Scope, Objectives and Structure
3.2 The Following are the Nature, Scope, Objectives and Structure of an Internal Control
Audit:
Nature - A set of internally generated policies and procedures adopted by the management of
an enterprise is a prerequisite for an organisations efficient and effective performance. It is
thus, a primary responsibility of every management to create and maintain and adequate
system of internal control appropriate to the size and nature of the business entity.
AAS-6 defines the system of internal control as all the policies and procedures adopted by
the management of an entity to assist in achieving management’s objective of ensuring, as
far as practible, the orderly and efficient conduct of its business.
Scope - The scope of internal controls extends beyond mere accounting controls and
includes all administrative controls concerned with the decision - making process leading to
managements authorization of transaction, such controls include, production method,
time and motion study, pricing policies, quality control, work standard, budgetary control,
policy appraisal, quantitative controls etc. In an independent financial audit, the auditor is
primarily concerned with those policies and procedures having a bearing on the assertions
underlying the financial statements. These comprise primarily controls relating to
safeguarding of assets, prevention and detection of fraud and error, accuracy and
completeness of accounting records and timely preparation of reliable financial information.
Risk Assessment and Internal Control 3.3
Administrative controls, on the other hand, have only a remote relationship with financial
records and the auditor may evaluate only those administrative controls which have a
bearing on the reliability of the financial records.
Objectives - The objectives of internal control systems are determined by the management,
after considering the nature of business, scale operations, the extent of professionalism of
the management etc. AAS-6, identifies the following objectives of internal controls relating to
the accounting system:
(i) Transactions are executed through general or specific management authorization.
(ii) All transactions are promptly recorded in an appropriate manner to permit the
preparation of financial information and to maintain accountability of assets.
(iii) Assets and records are safeguarded from unauthorized access, use or disposition.
(iv) Assets are verified at reasonable intervals and appropriate action is taken with regard
to the discrepancies.
The basic accounting control objectives which are sought to be achieved by any accounting
control system are:
(a) whether all transactions are RECORDED;
(b) Whether recorded transactions are REAL;
(c) whether all recorded transactions are PROPERLY VALUED;
(d) whether all transactions are RECORDED TIMELY;
(e) whether all transactions are PROPERLY POSTED;
(f) whether all transactions are PROPERLY CLASSIFIED AND DISCLOSED;
(g) whether all transactions are PROPERLY SUMMARIZED;
If the response to all the above answer is positive, the auditor would be justified in limiting
his account balance tests considerably. In case of excellent companies it may also be
possible to rely on account balance with minimum of external tests, such as direct
confirmation, management representation etc,. Where in a system a particular control is
found to be deficient, audit attention can be focused on the areas where basic accounting
control objectives are not being adhered to. For example, if it found that sales transactions
are not being properly valued in accordance with the price list determined by the
management, the auditor would have to perform extensive searching tests on sales invoices
to assure himself that the recoverable amounts are correctly posted. He may also want to
expand his confirmation request at the year end to cover a large majority of debtors.
Limitations of Internal Control - An Internal Control system can provide only reasonable
assurance that the management’s objectives in establishing the system are achieved. That
is, no internal control system can provide absolute assurance that the control objectives are
achieved. This is due to the fact that any internal control system has certain internal
limitations. The limitations may arise due to:
(i) Controls have to be cost-effective.
(ii) Most controls address transaction of usual and routine nature. They fail in respect of
transactions of unusual nature.
(iii) The potential of human error remains in any system of control.
(iv) In any system of control, the possibility of circumvention of controls through collusion
between two or more persons might exist.
(v) A member of the management may himself override the controls.
(vi) Controls may not keep pace with changes in condition.
(vii) Management itself may manipulate transactions or accounting estimates.
The inherent limitation of internal control system requires the auditor to perform substantive
procedure to be able to express an opinion.
Structure - In order to achieve the objectives of internal controls, it is necessary to establish
adequate control policies and procedures. Most of these policies and procedures cover:
Segregation of duties - Transaction processing are allocated to different persons in such a
manner that no one person can carry through the completion of a transaction from start to
finish or the work of one person is made complimentary to the work of another person. The
purpose is to minimize the occurrence of fraud and errors and to detect them on a timely
basis, when they take place. The following functions are segregated -
(a) authorization of transactions;
(b) execution of transactions;
(c) physical custody of related assets; and
(d) maintenance of records and documents, while allocating duties, the considerations of
cost and efficacy should be kept in mind as there is a tendency to stretch the allocation
of tasks involved in a job to more persons than what is required resulting in cumbersome
procedures, over elaboration of records and unduly high cost of administration.
Apart from segregation of duties, periodic rotation of duties of personnel is also desirable.
The rotation of duties seeks to ensure that if a fraud and error is committed by a person, it
does not remain undetected for long. It also ensures that a person cannot develop vested
interest by holding a position for to long. Rotation of duties also ensures that each employee
keeps his work up to date. This also makes an employee to be careful because he is aware
that his performed tasks will be reviewed by others when duties are rotated.
Authorization of Transaction - Delegation of authority to different levels and to particular
persons are required to establish by the management for controlling the execution of
transaction in accordance with prescribed conditions. Authorization may be general or it may
be specific with reference to a single transaction. It is necessary to establish procedures
which provide assurance that authorizations are issued by persons acting within the scope of
their authority, and that the transactions conform to the terms of the authorizations. This
objective can be achieved by making independent comparison of transaction document with
general or specific authorizations, as the case may be.
Adequacy of Records and Documents - Accounting controls should ensure that -

(i) Transactions are executed in accordance with management’s general or specific
authorization.
(ii) Transactions and other events are promptly recorded at correct amounts.
(iii) Transactions should be classified in appropriate accounts and in the appropriate period
to which it relates.
(iv) Transaction should be recorded in a manner so as to facilitate preparation of financial
statements in accordance with applicable accounting standards, other accounting
policies and practices and relevant statutory requirements.
(v) Recording of transaction should facilitate maintaining accountability for assets
(vi) Assets and records are required to be protected from unauthorized access, use or
disposition.
(vii) Records of assets such as sufficient description of the assets (to facilitate identification)
its location should also be maintained so that the assets could be physically verified
periodically.
For prompt, accurate, complete and appropriate recording of accounting transaction, several
procedures are often established by the management. The assurance that transactions have
been properly recorded can also be obtained through a comparison of records with an
independent source of information which provides an indication of the execution of the
relevant transactions.
Accountability and Safeguarding of Assets - The process of accountability of assets
commences from acquisitions of assets its use and final disposal. Safeguarding of assets
requires appropriate maintenance of records, their periodic reconciliation with the related
assets. Assets like cash, inventories, investment scrips require frequent physical verification
with book records. The frequency of reconciliation would differ for different assets depending
upon their nature and amount. Assets which are considered sensitive or susceptible to error
need to be reconcile more frequently than others. For proper safeguarding of assets, only
authorized personnel should be given access to such asset. This not only means physical
access but also exercising control over processing of documents relating to authorization
for use and disposal of assets. It is essential to have effective controls over physical custody
of cash, inventories, investments and other fixed assets. In some cases, as per requirement,
special procedures regarding physical custody of assets may have to be designed by the
management.
Independent Checks - Independent verification of the control systems, designed and
implemented by the management, involves periodic or regular review by independent
persons to ascertain whether the control procedures are operating effectively or not. Such
process may be carried out by specially assigned staff under the banner of external audit.
Components of Internal Controls

3.3 The overall systems of inter control comprises of Administrative Control and Accounting
Controls, Internal Checks and Internal Audit are important constituents of Accounting
Controls.
Internal Check System - Internal check system implies organization of the overall system of
book-keeping and arrangement of Staff duties in such a way that no one person can carry
through a transaction and record every aspect thereof. It is a part of overall control system
and operates basically as a built-in-device as far as organization and job-allocation aspects
of the controls are concerned. The system provides existence of checks on the day to day
transactions which operate continuously as part of the routine system whereby the work of
each person is either proved independently or is made complimentary to the work of another.
The following are the objectives of the internal check system:
(i) To detect error and frauds with ease.
(ii) To avoid and minimize the possibility of commission of errors and fraud by any staff.
(iii) To increase the efficiency of the staff working within the organization.
(iv) To locate the responsibility area or the stages where actual fraud and error occurs.
(v) To protect the integrity of the business by ensuring that accounts are always subject to
proper scrutiny and check.
(vi) To prevent and avoid the misappropriation or embezzlement of cash and falsification of
accounts.
The effectiveness of an efficient system of internal check depends on the following
considerations -
(i) Clarity of Responsibility - The responsibility of different persons engaged in various
operations of business transactions should be properly identified. A well integrated
organizational chart depicting the names of responsible persons associated with specific
functions may help to fix up responsibility.
(ii) Division of Work - The segregation of work should be made in such a manner that the
free flow of work is not interrupted and also helps to determine that the work of one person is
complementary to the other. Then, it is suggested that rotation of different employees
through various components of job should be effectively implemented.
(iii) Standardization - The entire process of accounting should be standardized by creating
suitable policies commensurate with the nature of the business, so as to strengthen the
system of internal check.
(iv) Appraisal - Periodic review should be made of the chain of operations and work flow.
Such process may be carried out by preparing an audit flow chart.
The general condition pertaining to the internal check system may be summarized as under -
(i) no single person should have complete control over any important aspect of the
business operation. Every employee’s action should come under the review of another
person.
(ii) Staff duties should be rotated from time to time so that members do not perform the
same function for a considerable length of time.
(iii) Every member of the staff should be encouraged to go on leave at least once a year.
(iv) Persons having physical custody of assets must not be permitted to have access to the
books of accounts.
(v) There should exist an accounting control in respect of each class of assets, in addition,
there should be periodical inspection so as to establish their physical condition.
(vi) Mechanical devices should be used, where ever practicable to prevent loss or
misappropriation of cash.
(vii) Budgetary control should be exercised and wide deviations observed should be
reconciled.
(viii) For stock taking, at the close of the year, trading activities should, if possible be
suspended, and it should be done by staff belonging to several sections of the
organization.
(ix) The financial and administrative powers should be distributed very judiciously among
different officers and the manner in which those are actually exercised should be
reviewed periodically.
(x) Procedures should be laid down for periodical verification and testing of different sections
of accounting records to ensure that they are accurate.
The scope of statutory audit is limited by both time and cost. Therefore, it is increasingly being
recognized that for an audit to be effective especially in case of large organization, the
existence of a system of internal check is essential.
Internal Audit - Internal audit may be defined as, an independent appraisal function
established within an organization to examine and evaluate its activities as a service to the
organization. The scope of the internal audit is determined by the management. Internal
auditing includes a series of processes and techniques through which an organizations own
employees ascertain for the management, by means of on-the-job observation, whether
established management controls are adequate, and are effectively maintained; records and
reports financial, accounting and otherwise reflect actual operation and results accurately and
properly; each division, department or other units are carrying out the plans, policies and
procedures for which they are responsible.
For a detailed discussion on internal audit refer to Chapter 19.
Review of the System of Internal Controls

3.4 The review of the internal control system enables the auditor -
(i) to formulate his opinion as to the reliance he may place on the system itself i.e. whether
the system is such as would enable the management to produce a true and fair set of

(ii) to locate the areas of weakness in the system so that the audit programme and the
nature, timing and extent of substantive and compliance audit procedures can be
adjusted to meet the situation. For example, if the auditor is not satisfied with the control
system as regards debtors, he may decide to have a wider coverage for confirmation of
debtor’ balances. Normally, investments and cash are physically verified at the end of the
period and this routine is known to the client and his employees. In case the auditor
comes across a weakness in the control either he may provide in the programme for a
surprise cash count or investment verification on a day preceding or succeeding the
routine verification. In such a case, a surprise check will be more useful if it is
undertaken after the routine verification is over. Similarly if he is of the view that because
of weak controls the possibility of wrong billing to customers exists, be may extend the
programme for comparison of the invoices with the forwarding notes and for checking of
the extensions and castings of the invoices.
Deciding the point of time appropriate for undertaking the review of the internal controls
is a matter for individual judgement of the auditor. This decision can be taken on a
consideration of the size and complexity of the client’s operations. If the auditor, because
of his continuing relationship with his client, is already aware of the features and efficacy
of internal controls, he may just review the changes that have taken place in the
intervening period because of changes in the operations of the client. However, a
comprehensive review in such cases must be made at an interval of, say, 3 years.
Ordinarily, the review of internal controls should be undertaken as a distinct phase of
audit before finalisation of the audit programme. However, if the size of operations is
rather small, the review can be undertaken in conjunction with other audit procedures
and the programmes can be adjusted for any extension or elimination of checking.
When the auditor finds inadequacies or weaknesses in the internal control system, he
should advise his client about such inadequacies and weaknesses and the
consequences that may follow. It should be the duty of the auditor to see, in the course of
his audit, how far the inadequacies and weaknesses have been removed. He will take
this into account in preparing his audit report. It is a useful practice to note the following
after each function, set out in the audit programme -
(i) Any change in the system of internal control from that record in the appropriate
section of the internal control questionnaire.
(ii) Any further weakness noted in the internal control.
(iii) Any instance where the prescribed system or procedure has not been followed.
These should be considered in deciding whether any further modification in the audit
programme is called for. Also, these should be communicated to the client and confirmation
should be sought as regards changes in the system.
The review of internal control consists mainly of enquiries of personnel at various organisa-
tional levels within the enterprise together with reference to documentation such as
procedures, manuals, job description and flow-charts, to gain knowledge about the controls
which the auditor has identified as significant to his audit. The auditor may trace a few
transactions through the accounting system to assist in understanding that system and it is
related to internal controls. The auditor’s preliminary evaluation of internal controls should be
made on the assumption that the controls operate generally as described and that they
function effectively throughout the period of intended reliance. The purpose of the preliminary
evaluation is to identify the particular controls on which the auditor still intends to rely and to
test through compliance procedures. Different techniques are used to record information
relating to an internal control system. Selection of a particular technique is a matter for the
auditor’s judgement.
Methods of Recording
3.5 The following are the methods of recording:
3.5.1 Questionnaire - Because of the widespread experience that auditors possess about the
business operations in general and the knowledge about the appropriate control, most of the
auditing firms have developed their own standardised internal control questionnaire on a
generally applicable basis. In developing the standard questionnaire, endeavour is made to
make it as wide as possible so that all situations, generally found, are included therein but all
of these may not be applicable in a particular case. A questionnaire is a set of questions
framed in an organised manner, about each functional area, which has as purpose the
evaluation of the effectiveness of control and detection of its weakness if any. A questionnaire
usually consists of several separate sections devoted to areas such as purchases, sales,
debtors, creditors, wages, etc. The questionnaire is intended to be filled by the company
executives who are in charge of the various areas. However, this poses some practical
difficulties. The questionnaire is to travel from executives and, therefore, it may take a pretty
long time to be filled; also the questions may not be readily intelligible to busy executives and
there is a possibility of the questionnaire being misplaced while travelling from one table to
another. Having regard to these difficulties, it is now almost an accepted practice that the
auditor (or his representative) arranges meetings with the executives concerned and gets the
answers filled by each executive. Sometimes, the auditor himself may be required to fill the
answers. In such a case, he should ensure that the concerned executive has initiated the
answers as a token of his agreement therewith.
Questions are so framed as generally to dispense with the requirement of a detailed answer to
each question. For this purpose, often one general question is broken down into a number of
questions and sub-questions to enable the executive to provide a just ‘Yes’, ‘No’ or ‘Not
applicable’ form of reply. Questions are also framed in such a manner that generally a “No”
answer will effect weakness in the control system. This requires giving a positive power to the
question, keeping in view what the proper control should be. Consider the question ‘Are all
receipts recorded promptly and deposited in bank daily? If the answer to this is ‘Yes’, it fits
with the plan of good internal control. But if it is ‘No’ it indicates weakness in the system in as
much as the moneys received may not be recorded and may be defalcated because the
cashier has continued control over the amount for an uncertain period. However, this should
not be taken as an unbreakable rule. Questions may be framed also when a ‘Yes’ answer
would indicate weakness. The only thing that should be borne in mind is that the scheme of
questions should be consistent, sequential, logical, and if possible corroborative. Wherever it

is necessary, slightly detailed answers also may be asked for to bring clarity to the matter. In
the use of standardized internal control questionnaire, certain basic assumptions about
elements of good control are taken into account. These are -
(i) Certain procedures in general used by most business concerns are essential in achieving
reliable internal control. This is a time-tested assumption. Deposit into bank of the entire
receipts of a day or daily balancing of the cash book and ledgers or periodic
reconciliation with the control accounts are examples of widely used practices which are
considered good internal control practices. Besides, basic operations giving rise to these
practices exist in all businesses irrespective of their nature.
(ii) Organisations are such that permit an extensive division of duties and responsibilities.
The larger the organisation, the greater is the scope of such division.
(iii) Employees concerned with accounting function are not assigned any custodial function.
(iv) No single person is thrust with the responsibility of completing a transaction all by
himself.
(v) There should always be evidence to identify the person who has done the work whether
involving authorisation, implementation or checking.
(vi) The work performed by each one is expected to come under review of another in the
usual course of routine.
(vii) There is proper documentation and recording of the transactions.
The questionnaire serves the purpose of a record so far as the auditor is concerned about the
state of internal control as given to him officially. A question naturally arises as to whether it is
necessary to issue questionnaire for every year of the auditor’s engagement. For the first year
of engagements issue of questionnaire is necessary. For subsequent years, the auditor,
instead of issuing a questionnaire again, may request the client to confirm whether any
change in the nature and scope of business has taken place that necessitated a
corresponding change in the control system, or whether, even without a change in the nature
and scope of business, the control system has undergone a change. If there has been a
change, the auditor should take note of its and enter appropriate comments on the relevant
part of the questionnaire. However, it would be a good practice in the case of continuing
engagements to issue a questionnaire irrespective of any change, say, every third year. This
will obviate unnecessary trouble of filling the answers every time and to that extent the client’s
and the auditor’s own time will be saved. The rationale for issuance of a questionnaire every
three years, in the case of even no change, lies in altering the client as regards unnoticed and
unspectacular changes that might have taken place during the intervening period; also this will
make the client more control-conscious. Questionnaires can be prepared for various aspects
of the internal control system. A few sample questionnaires are given in Annexure 3.1.
3.5.2 Check List - It is a series of instructions or questions on internal control which the auditor
must follow or answer. When a particular instruction is carried out, the auditor initials the
space opposite the instruction. If it is in the form of a question the answer generally ‘Yes’, ‘No’
or ‘Not Applicable’ is entered opposite the question. A check list is more in the nature of a
reminder to the auditor about the matters to be checked for testing the internal control system.
While a questionnaire is basically a set of questions put to the client, a check list which may
be in a form of instructions, questions or just points to be checked may be meant for the
auditor’s own staff it is a set of instructions or points; it may be meant for the client if it is in the
form of questions. The question form of check list may even be meant for the auditor’s own
staff. For example, questions in the check list may be formed in the following manner (this is
an illustrative set of questions to be answered by the audit staff).
1. Have you checked that the cashier
(i) is not responsible for opening the incoming mails;
(ii) does not authorise any of the ledgers;
(iii) does not authorise any expenditure or receipt;
(iv) does not sign cheques;
(v) takes his annual leave regularly;
(vi) inks and balances the cash book everyday;
(vii) verifies physical cash balance with the book figure daily at the end of the day;
(viii) prepares monthly bank reconciliation statement;
(ix) holds no other funds or investment;
(x) holds no unnecessary balance in hand;
(xi) does not pay money without looking into compliance with proper procedure and due
authorisation; and
(xii) has tendered proper security or has executed a fidelity bond?
When the check list is in question form it is hardly different from a questionnaire. However,
generally questionnaire is a popular medium for the evaluation of the internal control system.
The basic distinction between internal control questionnaire and check list are as under:
1. The ICQ incorporates a large number of detailed questions but the check list generally
contains questions relating to the main control objective with the area under review.
2. ICQ, the weaknesses are highlighted by the ‘Yes’ while in the check list, it is indicated by
‘No’.
3. The significance of ‘No’ in an ICQ does indicate a weakness but the significance of that
weakness is not revealed automatically. However, in the check list, a specific statement
is required where an apparent weakness may prove to be material in relation to the
accounts as a whole.
3.5.3 Flow chart - The flow charting technique can also be resorted to for evaluation of the
internal control system. It is a graphic presentation of internal controls in the organisation and
is normally drawn up to show the controls in each section or sub-section. As distinct from a
narrative form, it provides the most concise and comprehensive way for reviewing the internal
controls and the evaluator’s findings. In a flow chart, narratives, though cannot perhaps be
totally banished are reduced to the minimum and by that process, it can successfully bring the
whole control structure, specially the essential parts thereof, in a condensed but wholly
meaningful manner. It gives a bird’s eye view of the system and is drawn up as a result of the
auditor’s review thereof. It should, however, not be understood that details are not reflected in
a flow chart. Every detail relevant from the control point of view and the details about how an
operation is performed can be included in the flow chart. Essentially a flow chart is a diagram
full with lines and symbols and, if judicious use of them can be made, it is probably the most
effective way of presenting the state of internal controls in the client’s organisation. A properly
drawn up flow chart can provide a neat visual picture of the whole activities of the section or
department involving flow of documents and activities. More specifically it can show -
(i) at what point a document is raised internally or received from external sources;
(ii) the number of copies in which a document is raised or received;
(iii) the intermediate stages set sequentially through which the document and the activity
pass;
(iv) distribution of the documents to various sections, department or operations;
(v) checking authorisation and matching at relevant stages;
(vi) filing of the documents; and
(vii) final disposal by sending out or destruction.
As a matter of fact a very sound knowledge of internal control requirements is imperative for,
adopting flow-charting technique for evaluation of internal controls; also it demands a highly
analytical mind to be able to see clearly the inter division of a job and the appropriate control
at relevant points.
It has been stated earlier that flow charts should be made section-wise or department-wise.
The suggestion has been made to ensure readability and intelligibility of the flow charts.
Drawing of a flow chart - A flow chart is normally a horizontal one in which documents and
activities are shown to flow horizontally from section to section and the concerned sections are
shown as the vertical column heads; in appropriate cases an individual also may be shown as
the vertical column head. Care should be taken to see that the first column head is devoted to
the section or the individual wherefrom a transaction originates and the placements of other
column heads should be in the order of the actual flow of the transaction. It has been started
earlier that a flow chart is a symbolic representation the flow of activity and related documents
through the section from origin to conclusion. These can be sales, purchases, wages,
production, etc. Each one of the main functions is to be linked with related functions for
making a complete course. Purchase is to be linked with sundry creditors and payments; sales
with sundry debtors and collections. By this process, a flow chart will become self contained,
complete and meaningful for evaluation of internal controls.
Generally, a questionnaire is also enclosed with a flow chart, incorporating questions, the
answers to which are to be looked into from the flow chart. This is an evaluation of the control
system through the process of flow charting. The internal control questionnaire contains ques-
tions; answers are available in the flow chart and they will reveal weakness, if any, in the
system. In fact, the questionnaire is a guide for the study of a control system through flow
charts.
We may examine the flow charting techniques for evaluation of internal controls on the sales
and debtors function. Let us assume that these are -
1. Order receiving function.
2. Despatch function.
3. Billing function.
4. Accounting in the debtors’ ledger.
5. Main accounting function.
6. Inventory recording function.
All these functions are carried out in distinct sections. As regards the Order Receiving
Section, let us further assume that the section receives orders:
(i) through mail;
(ii) by telephone; and
(iii) through the company’s salesmen.
Basing the receipts of orders of customers, the section raises internal “Sales advices”. These
sales advices are consecutively numbered (by reference to the last number on the order book)
and entered in the order book with the consecutive number, date, the party and other relevant
details. The orders received from customers are temporarily filed in the alphabetical order.
The sales advices are prepared in sets of four with a noting for the customer’s sales-tax
status. All the four copies are sent to the despatch section. The despatch section, after
despatch of the goods, sends back to the Order receiving Section the last copy of the sales
advice after entering thereon the date of despatch and the quantity despatched. Upon receipt
of the last copy, the Order receiving Section enters the date of dispatch and the quantity
despatched in the order book. If the quantity despatched is fulfillment of the quantity ordered,
the last copy of the sales invoices is annexed to customer’s order and filed in the customer’s
file. If, however, the order is only partly executed, the copy of the sales advice is kept in a
temporary file in numerical order. Periodically this file is checked to determine the unfulfilled
orders and, if stock is then available, the Section again initiates fresh sales advices in respect
of the unfulfilled part and all the processes, as in the case of original, are repeated. The last
copy of the original set is annexed to the customer’s order and kept in the customer’s file.
The salesmen use the same advice form as is being used by the order receiving section.
For the purpose of drawing a flow chart to incorporate the above narration it is useful to know -
1. the point for originating the flow of transaction.
2. the documents, internal and external, and the flow of the transaction, number of copies,
distribution flow and the details.
3. the books, if any, maintained and the details recorded there in and the source or sources
for the details.
4. that there exists an alternative possibility.
The flow chart for the above may be as under -
CHART 1
We can extend the activity flow now to the despatch section which is the logical second stage
of operation. The work and procedure content of the despatch section is assumed to be as
follows:
After the receipt of the sales advices in sets of four, the despatch section arranges despatch
of materials and put the date of despatch and the quantities despatched; the head of the
Section initials the advices. The last copy of the advice is sent back to the Order Receiving
Section. The first copy is sent as a packing slip with the goods, the second copy goes to the
Billing Department and the third copy accompanies the goods when delivered to the buyer
and, obtaining the buyer’s acknowledgement of the receipt of the goods therein, is received
back and filed date-wise. In case of goods not directly delivered to the buyers, i.e., when the
goods are sent either by rail, road or water transport, the copy constitutes the basis for raising
the relevant forwarding note on the basis of which R.R. etc., can be prepared.
The flow chart for the despatch section may be as follows -
CHART 2
This flow is taken to the Billing Section. The Section generally accumulates the second copy
of the Sales Advice for two or three days and prepares sales invoices in sets of four. The
pricing of the sales invoice is done by reference to the company’s current price list or the
catalogue. The number of the sales advice is entered on the corresponding invoice which is
pre-numbered, also, the number of the invoice is recorded on the copy of the sales advice
which is then filed alphabetically. The first copy of the invoice is sent to the customer while the
second, third and fourth copies are respectively sent to the sundry debtors’ ledger clerk, the
Stock Section and the Accounts Section. The Billing Section also is responsible for raising
credit notes on the basis of documents received. Credit notes are also prepared in sets of four
and are distributed in exactly the same way as invoices. The stocks of invoice and the credit
note forms remain in the Billing Section.
The Flow Chart for this Section is given below -
CHART 3
Now, in the order of the flow of activities, more sectional flow charts can be prepared to cover
the activities in the Accounts Section and the Stock Section and they together, when
sequentially assembled, will constitute the complete flow chart for the sales transactions and
sundry debtors recordings.
(These flow charts have been prepared on the basis of the approach and the symbols used in
the book “Analytical Auditing” by Skinner and Anderson. Students who desire to study the
subject of preparation of flow charts further may refer to Chapter 4 of that book.)
It is now left for us to see how these flow charts reveal the state of internal control. A close
look into flow charts will show the following:
(i) The advices are sent by salesmen; though prepared on the same sales advice form as is
prepared in the section, there is no check that all the advices sent by salesmen have
been received. This may entail loss of business because of non-receipt of sales advice.
(Refer to the flow chart for the Order Receiving Section).
(ii) The raising of sales advises on the basis of telephonic orders, irrespective of the party’s
standing and record of performance is risky from the business point of view. (Refer to the
flow chart for the Order Receiving Section).
(iii) There is no system of prior credit sanction to the parties; in consequence, there may be
despatch of goods to bad credit risks. (Refer to the flow chart for the Despatch Section).
(iv) There is no check that all the second copies of the sales advices sent by the Despatch
Section have been received by the Billing Section. The possibility of despatch not being,
billed exists, (Refer to the flow chart for the Despatch as well as the Billing Section.
(v) There is no check in respect of pricing, extension and addition on the invoice or the credit
notes. This may result in loss of revenue for wrong pricing or wrong calculation. (Refer to
the flow chart for Billing Section).
(vi) It is not clear whether the supporting documents are adequate for authorising the issue of
credit notes where there is a need for a greater caution. (Refer to the flow chart for Billing
Section).
So far we have seen the points of weaknesses that are evident from these flow charts. For a
clearer understanding of the flow chart as a medium for evaluating internal controls, the
following further points may be useful:
(a) There exists proper numerical control over orders booked (except the case for the
salemen’s orders).
(b) There is a permanent and continuous record of the orders booked in the form of order
book.
(c) There is a definite basis for raising sales advices.
(d) The order book record is always kept complete by entering the information about the
execution of the order and this keeps the information about the pending orders ready at
any moment.
(e) Partly executed orders are reviewed from time to time so that as soon as goods are
available, the same may be despatched to customers.
(f) The customer’s purchase order and the related sales advises are matched and kept
together in the customer’s file.
(g) The sales advices are initialed by the Despatch Section head as token of his having
satisfied himself about the correctness of the entries as regards the quantity despatched
and the date of despatch.
(h) Record of actual direct delivery is maintained through the copy of the sales advice
bearing the customer’s, acknowledgement of his having received the goods. Similarly,
the record of out station deliveries is kept in the copy of the forwarding note annexed to
the sales advice copy.
(i) Documents have as many copies as are necessary for ensuring proper flow and proper
control. There is no wastage through unnecessary copies nor any hold up because of
inadequacy of copies.
(j) There are supporting documents for raising invoices and credit notes.
(k) The distribution of invoices and credit notes is such as would enable the recording of
billing at the relevant centres independent of each other.
(l) There is control over the number of invoices and credit notes by pre-numbering.
Thus, by flow charting has an auditor can very clearly see the interrelationships of the
activities and flows and how they are integrated from stage to stage. However, the
auditor has to be careful about the readability and intelligibility of the chart. Identification
of all individual functions in a section is also highly relevant for preparation of the flow
chart. The smaller the segment, the better is the possibility of quick comprehension.
Naturally, the auditor should try to see each section as the natural assembly of distinct
and identified components.
Evaluation of Internal Control

3.6 The auditor, in forming his opinion on financial information, needs reasonable assurance
that transactions are properly authorised and recorded in the accounting records and that
transactions have not been omitted. Internal controls, even if fairly simple, may contribute to
the reasonable assurance the auditor seeks. The auditor’s objective in studying and evaluating
internal controls is to establish the reliance he can place thereon in determining the nature,
timing and extent of his substantive auditing procedures.
Compliance procedures are tests designed to obtain reasonable assurance that those internal
controls on which audit reliance is to be placed are in effect. These procedures include tests
requiring inspection of documents supporting transactions to gain evidence that controls have
operated properly (for example, verifying that the document has been authorised) and
enquiries about the observation of controls which leave no audit trial (for example, determining
who actually performs each function trial not merely who is supposed to perform it).
The auditor should review the accounting system and related internal controls to gain an
understanding of the flow of transactions and the specific control procedures to be able to
make a preliminary evaluation and identification of those internal controls on which it might be
effective and efficient to rely in conducting his audit. The purpose of preliminary evaluation is
to identify the particular controls on which the auditor intends to rely and to test through
compliance procedures. It should be remembered that preliminary evaluation of the internal
control is made on the assumptions that the controls operates generally as described and that
they function effectively throughout the period of intended reliance.
Compliance procedures should be conducted by the auditor to gain evidence that those
internal controls on which he intends to rely operate generally as identified by him and that
they function effectively throughout the period of intended reliance. The concept of effective
operation recognises that some deviations from prescribed controls may have occurred.
Deviations from prescribed controls may be caused by such factors as changes in key
personnel, significant seasonal fluctuations in volume of transactions and human error. The
auditor should make specific enquiries concerning these matters, particularly as to the timing
of staff changes in key control functions. He should then ensure that his compliance
procedures appropriately cover such a period of change or fluctuation.
Based on the results of his compliance procedures, the auditor should evaluate whether the
internal controls are adequate for his purposes. If based on the results of the compliance
procedures, the auditor concludes that it is not appropriate to rely on a particular internal
control to the degree previously contemplated, he should ascertain whether there is another
control which would satisfy his purpose and on which he might rely (after applying appropriate
compliance procedures). Alternatively, he may modify the nature, timing or extent of his
substantive audit procedures.
The auditor’s compliance procedures normally should be applied to transactions selected from
those of the entire period under examination. When, however, a shorter period is initially
tested, the auditor needs to consider what is necessary to provide reasonable assurance as to
the reliability of the accounting records for the whole period. The auditor’s judgement as to
the nature, timing and extent of compliance or substantive procedures to be applied to
transactions occurring in the remaining period will be affected by such factors as the following-
(a) the results of the procedures already conducted;
(b) the responses to enquiries as to whether the internal control system is still operating in
the same manner as when studied and evaluated;
(c) the length of the remaining period
(d) the nature and amount of transactions or balances involved;
(e) the auditor’s evaluation of internal control environment, especially supervisory controls;
and
(f) the substantive procedures which the auditor intends to carry out irrespective of the
adequacy of internal controls.
The aforesaid study and discussion to give an overall idea of the control plan as it is and may
be considered as the first step of evaluation. This is followed by a process which enables the
auditor to know the specific control, its appropriateness and weakness of redundancy in the
context of the specific operation. This process is essentially a question and answer exercise.
For this, the auditor should have sufficient knowledge and experience about what should be
the appropriate and exact control in the given circumstances for the specific operation.
Accordingly, he frames questions for the answers to which will provide him insight into the
effectiveness or otherwise of the given controls. This question- answer exercise can be
undertaken either by framing a questionnaire or a check list.
Internal Control and Risk Assessment

3.7 The auditor should obtain an understanding of the control environment sufficient to
assess management's attitudes, awareness and actions regarding internal controls and their
importance in the entity. Such an understanding would also help the auditor to make a
preliminary assessment of the adequacy of the accounting and internal control systems as a
basis for the preparation of the financial statements, and of the likely nature, timing and extent
of audit procedures.
The auditor should obtain an understanding of the control procedures sufficient to develop the
audit plan. In obtaining this understanding, the auditor would consider knowledge about the
presence or absence of control procedures obtained from the understanding of the control
environment and accounting system in determining whether any additional understanding of
control procedures is necessary. Because control procedures are integrated with the control
environment and the accounting system, as the auditor obtains an understanding of the
control environment and the accounting system, some knowledge about control procedures is
also likely to be obtained, for example, in obtaining an understanding of the accounting system
pertaining to cash, the auditor ordinarily becomes aware of whether bank accounts are
reconciled regularly. Ordinarily, development of the overall audit plan does not require an
understanding of control procedures for every financial statement assertion in each account
balance and transaction class.
3.7.1 Control Risk -
Preliminary Assessment of Control Risk - After obtaining an understanding of the
accounting system and internal control system, the auditor should make a preliminary
assessment of control risk, at the assertion level, for each material account balance or class of
transactions.
The preliminary assessment of control risk is the process of evaluating the likely effectiveness
of an entity's accounting and internal control systems in preventing or detecting and correcting
material misstatements. The preliminary assessment of control risk is based on the
assumption that the controls operate generally as described and that they operate effectively
throughout the period of intended reliance. There will always be some control risk because of
the inherent limitations of any accounting and internal control system.
The auditor ordinarily assesses control risk at a high level for some or all assertions when:
(a) the entity's accounting and internal control systems are not effective; or
(b) evaluating the effectiveness of the entity's accounting and internal control systems would
not be efficient.
In the above circumstances, the auditor would obtain sufficient appropriate audit evidence
from substantive procedures and from any audit work carried out in the preparation of financial
statements.
The preliminary assessment of control risk for a financial statement assertion should be high
unless the auditor:
(a) is able to identify internal controls relevant to the assertion which are likely to prevent or
detect and correct a material misstatement; and
(b) plans to perform tests of control to support the assessment.
Documentation of Understanding and Assessment of Control Risk - The auditor should
document in the audit working papers:
(a) the understanding obtained of the entity's accounting and internal control systems; and
(b) the assessment of control risk.

When control risk is assessed at less than high, the auditor would also document the basis for
the conclusions.
Different techniques may be used to document information relating to accounting and internal
control systems. Selection of a particular technique is a matter for the auditor's judgement.
Common techniques, used alone or in combination, are narrative descriptions, questionnaires,
check lists and flow charts. The form and extent of this documentation is influenced by the
size and complexity of the entity and the nature of the entity's accounting and internal control
systems. Generally, the more complex the entity's accounting and internal control systems
and the more extensive the auditor's procedures, the more extensive the auditor's
documentation will need to be.
Tests of Control - Tests of control are performed to obtain audit evidence about the
effectiveness of the:
(a) design of the accounting and internal control systems, that is, whether they are suitably
designed to prevent or detect and correct material misstatements; and
(b) operation of the internal controls throughout the period.
Tests of control include tests of elements of the control environment where strengths in the
control environment are used by auditors to reduce control risk.
Some of the procedures performed to obtain the understanding of the accounting and internal
control systems may not have been specifically planned as tests of control but may provide
audit evidence about the effectiveness of the design and operation of internal controls relevant
to certain assertions and, consequently, serve as tests of control. For example, in obtaining
the understanding of the accounting and internal control systems pertaining to cash, the
auditor may have obtained audit evidence about the effectiveness of the bank reconciliation
process through inquiry and observation.
When the auditor concludes that procedures performed to obtain the understanding of the
accounting and internal control systems also provide audit evidence about the suitability of
design and operating effectiveness of policies and procedures relevant to a particular financial
statement assertion, the auditor may use that audit evidence, provided it is sufficient to
support a control risk assessment at less than a high level.
Tests of control may include:
♦ Inspection of documents supporting transactions and other events to gain audit evidence
that internal controls have operated properly, for example, verifying that a transaction has
been authorised.
♦ Inquiries about, and observation of, internal controls which leave no audit trail, for
example, determining who actually performs each function and not merely who is
supposed to perform it.
♦ Re-performance of internal controls, for example, reconciliation of bank accounts, to
ensure they were correctly performed by the entity.
♦ Testing of internal control operating on specific computerised applications or over the

overall information technology function, for example, access or program change controls.
The auditor should obtain audit evidence through tests of control to support any assessment of
control risk which is less than high. The lower the assessment of control risk, the more
evidence the auditor should obtain that accounting and internal control systems are suitably
designed and operating effectively.
When obtaining audit evidence about the effective operation of internal controls, the auditor
considers how they were applied, the consistency with which they were applied during the
period and by whom they were applied. The concept of effective operation recognises that
some deviations may have occurred. Deviations from prescribed controls may be caused by
such factors as changes in key personnel, significant seasonal fluctuations in volume of
transactions and human error. When deviations are detected the auditor makes specific
inquiries regarding these matters, particularly, the timing of staff changes in key internal
control functions. The auditor then ensures that the tests of control appropriately cover such a
period of change or fluctuation.
In a computer information systems environment, the objectives of tests of control do not
change from those in a manual environment; however, some audit procedures may change.
The auditor may find it necessary, or may prefer, to use computer-assisted audit techniques.
The use of such techniques, for example, file interrogation tools or audit test data, may be
appropriate when the accounting and internal control systems provide no visible evidence
documenting the performance of internal controls which are programmed into a computerised
accounting system.
Based on the results of the tests of control, the auditor should evaluate whether the internal
controls are designed and operating as contemplated in the preliminary assessment of control
risk. The evaluation of deviations may result in the auditor concluding that the assessed level
of control risk needs to be revised. In such cases, the auditor would modify the nature, timing
and extent of planned substantive procedures.
Quality and Timeliness of Audit Evidence - Certain types of audit evidence obtained by the
auditor are more reliable than others. Ordinarily, the auditor's observation provides more
reliable audit evidence than merely making inquiries, for example, the auditor might obtain
audit evidence about the proper segregation of duties by observing the individual who applies
a control procedure or by making inquiries of appropriate personnel. However, audit evidence
obtained by some tests of control, such as observation, pertains only to the point in time at
which the procedure was applied. The auditor may decide, therefore, to supplement these
procedures with other tests of control capable of providing audit evidence about other periods
of time.
In determining the appropriate audit evidence to support a conclusion about control risk, the
auditor may consider the audit evidence obtained in prior audits. In a continuing engagement,
the auditor will be aware of the accounting and internal control systems through work carried
out previously but will need to update the knowledge gained and consider the need to obtain
further audit evidence of any changes in control. Before relying on procedures performed in
prior audits, the auditor should obtain audit evidence which supports this reliance. The auditor
would obtain audit evidence as to the nature, timing and extent of any changes in the entity's
accounting and internal control systems since such procedures were performed and assess
their impact on the auditor's intended reliance. The longer the time elapsed since the
performance of such procedures the less assurance that may result.
The auditor should consider whether the internal controls were in use throughout the period. If
substantially different controls were used at different times during the period, the auditor would
consider each separately. A breakdown in internal controls for a specific portion of the period
requires separate consideration of the nature, timing and extent of the audit procedures to be
applied to the transactions and other events of that period.
The auditor may decide to perform some tests of control during an interim visit in advance of
the period end. However, the auditor cannot rely on the results of such tests without
considering the need to obtain further audit evidence relating to the remainder of the period.
Factors to be considered include:
♦ The results of the interim tests.
♦ The length of the remaining period.
♦ Whether any changes have occurred in the accounting and internal control systems
during the remaining period.
♦ The nature and amount of the transactions and other events and the balances involved.
♦ The control environment, especially supervisory controls.
♦ The nature, timing and extent of substantive procedures which the auditor plans to carry
out.
Final Assessment of Control Risk - Before the conclusion of the audit, based on the results
of substantive procedures and other audit evidence obtained by the auditor, the auditor should
consider whether the assessment of control risk is confirmed. In case of deviations from the
prescribed accounting and internal control systems, the auditor would make specific inquiries
to consider their implications. Where, on the basis of such inquiries, the auditor concludes that
the deviations are such that the preliminary assessment of control risk is not supported, he
would amend the same unless the audit evidence obtained from other tests of control supports
that assessment. Where the auditor concludes that the assessed level of control risk needs to
be revised, he would modify the nature, timing and extent of his planned substantive
procedures.
3.7.2 Relationship between the Assessments of Inherent and Control Risk - Management
often reacts to inherent risk situations by designing accounting and internal control systems to
prevent or detect and correct misstatements and therefore, in many cases, inherent risk and
control risk are highly interrelated. In such situations, if the auditor attempts to assess
inherent and control risks separately, there is a possibility of inappropriate risk assessment.
As a result, audit risk may be more appropriately determined in such situations by making a
combined assessment.
3.7.3 Detection Risk - The level of detection risk relates directly to the auditor's substantive
procedures. The auditor's control risk assessment, together with the inherent risk assessment,
influences the nature, timing and extent of substantive procedures to be performed to reduce
detection risk, and therefore audit risk, to an acceptably low level. Some detection risk would
always be present even if an auditor were to examine 100 percent of the account balances or
class of transactions because, for example, most audit evidence is persuasive rather than
conclusive.
The auditor should consider the assessed levels of inherent and control risks in determining
the nature, timing and extent of substantive procedures required to reduce audit risk to an
acceptably low level. In this regard the auditor would consider:
(a) the nature of substantive procedures, for example, using tests directed toward
independent parties outside the entity rather than tests directed toward parties or
documentation within the entity, or using tests of details for a particular audit objective in
addition to analytical procedures;
(b) the timing of substantive procedures, for example, performing them at period end rather
than at an earlier date; and
(c) the extent of substantive procedures, for example, using a larger sample size.
There is an inverse relationship between detection risk and the combined level of
inherent and control risks. For example, when inherent and control risks are high,
acceptable detection risk needs to be low to reduce audit risk to an acceptably low level.
On the other hand, when inherent and control risks are low, an auditor can accept a
higher detection risk and still reduce audit risk to an acceptably low level. Refer to the
Appendix to this AAS for an illustration of the interrelationship of the components of audit
risk.
While tests of control and substantive procedures are distinguishable as to their purpose, the
results of either type of procedure may contribute to the purpose of the other. Misstatements
discovered in conducting substantive procedures may cause the auditor to modify the previous
assessment of control risk. Refer to the Appendix to this AAS for an illustration of the
interrelationship of the components of audit risk.
The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the
need for the auditor to perform any substantive procedures. Regardless of the assessed
levels of inherent and control risks, the auditor should perform some substantive procedures
for material account balances and classes of transactions.
The auditor's assessment of the components of audit risk may change during the course of an
audit, for example, information may come to the auditor's attention when performing
substantive procedures that differs significantly from the information on which the auditor
originally assessed inherent and control risks. In such cases, the auditor would modify the
planned substantive procedures based on a revision of the assessed levels of inherent and
control risks.
The higher the assessment of inherent and control risks, the more audit evidence the auditor
should obtain from the performance of substantive procedures. When both inherent and
control risks are assessed as high, the auditor needs to consider whether substantive
procedures can provide sufficient appropriate audit evidence to reduce detection risk, and
therefore audit risk, to an acceptably low level. When the auditor determines that detection
risk regarding a financial statement assertion for a material account balance or class of
transactions cannot be reduced to an acceptable level, the auditor should express a qualified
opinion or a disclaimer of opinion as may be appropriate.
Internal Control in Small Business Enterprises

3.8 The auditor needs to obtain the same degree of assurance in order to give an unqualified
opinion on the financial statements of both small and large entities. However many controls
which would be relevant to large entities are not practical in small business. For example, in a
small business, accounting procedures may be performed by a few persons. These persons
may have both operating and custodial responsibilities and segregation of functions may be
missing or severely limited. Inadequate segregation of duties may, in some cases, be offset
by supervisory controls exercised by the owner. This supervisory function by the owner
becomes possible because of the fact that he has direct personal knowledge of the business
and involvement in the business transactions. In circumstances where segregation of duties is
limited and the evidence of supervisory controls is lacking the evidence necessary to support
the auditor’s opinion on the financial information may have to be obtained largely through
substantive procedures.
Reporting to Clients on Internal Control Weaknesses

3.9 During the course of audit work, the audit may notice material weaknesses in the internal
control system. Material weaknesses are defined as absence of adequate controls on flow of
transactions that increases the possibility of errors and frauds in the financial statements of
the entity. For example, if monthly age-wise analysis of debtors is not performed then it may
result in inadequate provisioning of bad debts for the fiscal year under audit.
The auditor should communicate such material weaknesses to the management or the audit
committee, if any, on a timely basis. This communication should be, preferably, in writing
through a letter of weakness or management letter. Important points with regard to such a
letter are as follows:
(a) The letter lists down the area of weaknesses in the system and offers suggestions for
improvement.
(b) It should clearly indicate that it discusses only weaknesses which have come to the
attention of the auditor as a result of his audit and that his examination has not been
designed to determine the adequacy of internal control for management.
(c) This letter serves as a valuable reference document for management for the purpose of
revising the system and insisting on its strict implementation.
(d) The letter may also serve to minimize legal liability in the event of a major defalcation or
other loss resulting from a weakness in internal control.
It should be appreciated that by writing a letter to the management about the weaknesses in
the system, the auditor is not absolved from his duty to report the shortcomings in the
accounts by way of qualification where the defects have not been corrected to the auditor’s
satisfaction weighing the materiality of weaknesses and their impact, if considered necessary.
The practice of the issue of letter of weaknesses has a great merit in relieving the auditor
from liability in case serious frauds or losses have occurred, which probably would not have
taken place had the client taken due note of the auditor’s points in the letter of weakness. In
the case Re S.P. Catterson & Ltd. (1937, 81, Act L.R. 62), the auditor was acquitted of the
charge of negligence for employee’s fraud in view of the fact that he had already informed the
client about the unsatisfactory state in the specific areas of accounts and had suggested
improvements which were not acted upon by the management.
Self-examination Questions
1. Indicate which of the following are administrative controls:
(a) Attendance record of employees.
(b) Purchase requisition.
(c) Stock control account.
(d) Invitation for quotations.
(e) Inspection of goods received as to quality.
(f) Fire insurance of the factory.
(g) Indemnity Bond.
(h) Bank reconciliation.
(i) Budget.
(j) Observation of the disbursement of wages.
2. Explain three important elements of internal controls?
3. Read the following and state whether proper controls exist or not. In case answer is
negative, state the reason:
(i) Raw jute purchased by a jute mill is weighed on trolleys and the jute purchase
officer who is present at the time of weighment signs the weighment record.
(ii) Post Office Savings Bank Certificates, being investments, are lodged with the
banker for sale custody and collection when due. The company also maintains a
register showing details of the certificates, their dates of maturity, etc. in view of the
fact that the certificates are numerous the company official reviews the register on a
half-yearly basis and advises the bank to collect the matured ones.
(iii) As a matter of routine, a budget is prepared well in advance in respect of each

financial year. The annual budget is broken down to quarterly budgets for facilitating
review. At the expiry of each quarter a thorough reconciliation is made between the
budgeted figures and the actuals.
(iv) The cashier, being a highly reliable person, is discouraged from taking periodic
leave; he is compensated by extra payment.
(v) Annual stock-taking is carried out by employees drawn from various sections-but
not a single one from the stock section.
(vi) Wages sheets are prepared in the time section.
(vii) Before finalising any sales tender, the sales manager sends the tenders to the
costing section for proper product or job costing.
(viii) Cheques up to Rs. 1,000 are signed by the accountant and those in excess are
jointly signed by the finance manager and the accountant.
(ix) The cashier is under instruction to carry cash in hand just enough to meet next
day’s requirements. Excess requirement of the day, if any, is met by borrowing from
the executive director.
(x) The moment bank balance falls below a certain level, the bank is under a standing
instruction to transfer securities lodged with it for safe custody to the pledge account
of a requisite amount and raise the balance to certain level. After the inflow of cash
into the account, the bank is to re-transfer the securities.
4. State the reasons for the following procedural requirements, all of help to strengthen
internal control:
(a) The gateman of a cinema house is required to tear each ticket presented for
admission into two and hand over the stub to the patron.
(b) After the chief accountant signs the disbursement cheques, they are listed and the
supporting data are retained in the Accounts Department but the cheques are
passed on to the Mailing Department for onward transmission.
(c) The copy of the “Goods Received Note” passed on to the quality inspector for
Quality Report does not contain the name and particulars of the supplier.
(d) Department Attendance Registers are maintained in the factory even though the
workers while entering the factory are to punch their respective clock-cards.
(e) In a bank no director, officer or employee is entitled to act on behalf of a customer
in relation with any transaction with the bank.
(f) The driver of each vehicle is to maintain a log book showing details of trips and
petrol purchased. The log-book is presented to the Office Manager once a week for
his verification.
5. Comment on the following questions in a questionnaire prepared by an audit firm.

(i) What is the nature of business?
(ii) Is there a case that more than one fund is under the charge of a single employee?
(iii) Is cash given against I.O.Us.?
(iv) Do you have a daily physical verification of petty cash and postage stock?
(v) Do you keep -inventory of table stationery?
(vi) Is there a typists’ pool in your organisation?
(vii) What are the thrusts in your advertisement campaign?
(viii) Who looks after your investments?
(ix) Are payers required to sign vouchers for all disbursements?
(x) Do you obtain clearance from the Credit Control Department in each and every
case, before supplies are made on credit?
6. Prepare a flow chart in respect of the function of the Sales Ledger Clerk?
7. Tick the items given below that can be known by a study of the organisation chart of
concern:
(a) Scope of the business
(b) Accountability.
(c) Line and staff functions.
(d) Job division.
(e) Internal check.
(f) Accounting records.
(g) Inter-relationship of the functionaries.
(h) Exercise of authority.
(i) Personnel policy.
(j) Accounting policies.
(k) Authority for exceeding limits.
(l) Clerical distribution.
Answer to the Self-examination Questions

1. (a), (e), (f), (o)
2. (i) Job division
(ii) Separation of recording and custodial functions.
(iii) Internal auditing.
3. (i) No; because the jute purchase officer, who is directly in touch with supplying
parties, has opportunity of causing wrong weights being recorded at the cost of the
mill.
(ii) No; there is a gap of six months in between two reviews and there will be loss of
interest in respect of certificates maturing in the intervening period.
(iv) No; opportunity for a second person to look into details about what the cashier has
been doing.
(v) No; provides no opportunity manipulation.
(vi) No; it involves the company into avoidable borrowings and provides opportunities
for wrong payments to the executive director instead the estimation of the next
day’s requirement should be made a little more liberally, taking into account the past
experience about excess requirement.
(vii) No; it provides uncontrolled latitude to the bank to convert company’s securities
meant, for safe custody into security for funds borrowed.
4. (a) The pass collected by the gate man can be checked against total sale of ticket as
per the counterfoils of ticket books. Any presentation of unauthorised tickets will be
known; also the patrons will carry with them the evidence of their authorised entry
into the exhibition hall by retaining the stub.
(b) It provides an independent record with the Accounts Department about daily issue
and actual forwarding of cheques.
(c) The quality inspector should not know the supplying party in the interest of an
objective quality inspection.
(d) It records actual attendance to the work and also helps to keep check on wastage of
time in reaching his work spot.
(e) It avoids conflict of interest.
(f) It enables exercise of control over trips and consumption of control; also
unauthorised trips or excessive consumption of petrol may be known at an early
date.
5. Items (i) to (iv) and (viii) to (x) are all right.
(v) From materiality point of view the question is not relevant.
(vi) Normally, an auditor is not concerned with the typing organisation of the client.
(vii) Not of any direct relevance from the point of view of accounting control.
7. (b), (d), (c), (g), (h).
Annexure I
Sample Internal Control Questionnaire
I. Investments
(i) Segregation and rotation of duties: Is there a proper segregation of duties? Are the following
functions relating to investments segregated?
(a) Authorization of transactions relating to investments.
(b) Execution of transactions.
(c) Recording of transactions.
(d) Physical custody of investment scrips.
(ii) Are the duties of various persons relating to investments rotated periodically?
Authorization of Transactions
(i) Are the authorities for acquisition, disposal and other decisions relating to investments clearly laid
down? Are the limits on authorities of managers at various levels clearly defined?
(ii) Are the procedures for acquisition, disposal, etc., of investments?
(iii) Are the relevant legal provisions duly considered in taking decisions regarding acquisition/disposal of
investments? (For example, in the case of insurance companies, there are restrictions regarding the
nature of investments that can be acquired. Similarly, in the case of other companies, the law lays down
conditions which have to be followed if investments exceed prescribed limits.)
(iv) Are the transactions of acquisition/ disposal of investments in the form of shares, debentures, etc.,
required to be executed only through brokers who are members of recognized stock exchanges? Are
there any limits on exposure with each broker (e.g., there may be a limit on the total value of transactions
outstanding with a broker at any point of time)? Do these limits appear reasonable?
Maintenance of Records and Documents
(i) Are all transactions relating to investments recorded properly and promptly? Is there an investment
register (or other appropriate record) wherein particulars relating to investments are recorded? Are the
records sufficiently detained to facilitate identification of investments and determination of their cost? In
particulars, whether the records show, in respect of each investment, the nature of investment, or cum
interest, due dates of interests or the likely dates of the receipt of the dividends, financial year of the
enterprise in which the investment has been made, date of maturity (in the case of debentures and
similar investments), purchased price and incidental costs (brokerage, stamp fee, etc.)?
(ii) Are all accretions to investments (i.e., bonus shares, right shares, etc?) Properly recorded? Similarly
are changes in the nature of investments (e.g. conversion of debentures into equity shares) properly
recorded?
(iii) Do the records include particulars of significance developments relating to investments, e.g., Right
offers, bonus announcements, options for conversion, warrants, etc.? For e.g., do the records show
whether rights were offered and whether they were subscribed or soled or otherwise renounced?
(iv) Is a proper record maintained in respect of scrips belonging to third parties which are in the
possession of the enterprise ( e.g., as security for loans granted)? Are there adequate procedures to
ensure that the scrips belonging to third parties can be readily identified?
(v) Are proper records maintained in respect of investments which have been sent for registration of
transfer, splitting-up or similar purposes? Does the enterprise keep a photo copy ( or other detailed
record) of all transfer deeds and investment certificates sent for registration of transfer, split, etc., So
that the necessary details are available even if the original documents are lost?
(vi) Is the validity of transfer deeds accompanying the investment scrips acquired by the enterprise
checked? Is it ensured that the investments scrips along with the transfer deeds are lodged with the
company / transfer agent within the validity period?
(vii) Is immediate action taken in case of bad deliveries, i.e., where the company / transfer agent returns
the documents without affecting the transfer due to certain defects?
Accountability for and Safeguarding of Investments
(i) Are all investments held in the name of the enterprise? Are the circumstances in which investments
may not be held in the name of the enterprise clearly specified? Are the authorities for approving the
acquisition or holding of investments in the name of other persons clearly laid down? Are adequate
measures taken to safeguard the interests of the enterprise in such cases?
(ii) Are investment scrips kept under lock and key in the custody of a responsible official? Are there
adequate safeguard against theft, fire, etc?
(iii) Are there any special safeguards against misappropriation of investment scrips which are
accompanied by blank transfer deeds? (In blank transfer deeds, the name of the transferee is not filled
in. They are, therefore, particularly prone to misappropriation. Special safeguards in respect of
investment scrips accompanied by blank transfer deeds include dual custody, separate storage of
transfer deeds and related scrips, etc.)
(iv) Are investment scrips kept with third parties only in appropriate cases (e.g., as security for loan
from a bank ) and under proper authorization? In such cases, is there a system of obtaining certificates
from the third parties periodically? Do the certificates contain sufficient details of investments held by
the third parties? Is there a system whereby a periodic review is made to ensure that all such
investments in the hands of third parties are safe?
(v) Is there a system of periodic physical verification of the scrips? Are the differences between the
results of physical verification and the book records analyze? Is there a proper follow-up on all
discrepancies noticed on physical verification?
Independent Checks
(i) Is there a regular internal audit of transactions relating to investments, including a review of the rates
at which the various transactions have been effected? Does the internal audit examine whether the
rates conform to the prevalent market rates? In case of divergence, does the internal audit specifically
examine the authorization for the relevant transactions and the reasons for not effecting the
transactions at market rates?
(ii) Is there an independent review of compliance with rules and regulations governing investments? Is
there also a review of compliance with conditions attached to certain investments which restrict the
right of ownership/disposal of investments (for e.g., certain shares allotted to promoters cannot be sold
by them for a certain period)?
II. Inventories
Segregation and Rotation of Duties
(i) Are the duties relating to inventories properly segregated? As far as possible, the persons
responsible for handling physical inventories should not be assigned any duties relating to purchasing,
billing or accounting.
(ii) Are the duties of various persons relating to inventories rotated periodically?
Authorization of Purchases, Receipts and Issues

(i) Have the authorities for purchases, receipt of goods and their issuance from stores been clearly laid
down?
(ii) Are issues from stores made only against proper requisition notes or Challans approved by
authorized managers?
(iii) Are transfers of inventory items from one department to another made only after obtaining the
approval of authorized managers?
(i) Is there a proper documentation of receipt of goods from suppliers as well as issue of goods from
the factory?
(ii) Is there a proper documentation of transfer of inventory items from one department to another?
(iii) Is there a perpetual inventory system whereby receipts and issues are recorded in the inventory
records as soon as they take place?
(iv) Are perpetual inventory records reconciled periodically with financial records / cost accounting
records?
(v) Does the enterprise have a proper cost accounting system for determining the cost of work-in-
process and finished goods?
(vi) Are overhead absorption rates properly determined in the light of current experience?
(vii) Are actual costs compared with standard and / or budgeted costs and the variance analyze and
properly adjusted?
(viii) Are proper records maintained in respect of waste, scrap, returnable containers and by-products?
(ix) Are proper records maintained in respect of inventories belonging to the enterprise but lying with
third parties such as public warehouses, consignees, sub- contractors, goods sent to customers on
approval, etc.?
(x) Are proper records maintained in respect of stocks belonging to third parties which are in the
possession of the enterprise, e.g., for processing?
(xi) Are there adequate cut-off procedures to ensure that:
(a) goods purchased but not yet received are included in the inventories, purchases are debited and a
liability is created from the same, and
(b) goods sold but not yet despatched are excluded from inventories, sales are credited and the
amount of sundry debtors is suitably adjusted?
Accountability for, and safeguarding of, inventories
Storage
(ii) Is the storage of various items of inventories methodical? Does it protect them against damage,
deterioration, etc?
(ii) Is the access to areas where inventories are stored , restricted? Are there suitable safeguards to
ensure that inventory item cannot be taken out of the stores without proper authorization?
Insurance
(i) Have different items of inventories been insured against fire, theft, riots, etc.?
(ii) Is the insurance cover adequate? Is it reviewed periodically?
(iii) Is insurance premium paid up- to-date?

(iv) Are the insurance policies / cover notes kept in proper custody?
Physical Stock Taking
(i) What is the system of stock taking - continuous, annual or both?
(ii) How effective is the system of continuous / annual stock taking? In this regard the following
aspects may be specifically examined.
(a) Is there a well laid down procedure for stock taking?
(b) Are persons responsible for stock taking independent of the stores personnel?
(c) Are there written instructions for stock taking, particularly regarding proper identification and
counting of stocks and for recording the quantities and the condition of the stocks? Are these
instructions proper?
(iii) Are stocks belonging to third parties which are in the possession of the enterprise physically
segregated from the stocks of the enterprise, or otherwise properly identified during the course of
physical stock taking? Are confirmations regarding the quantity and quality obtained from third
parties, in respect of stocks held on their behalf, on a regular basis during the year as also at the
year-end?
(iv) Are physical verification sheets checked for arithmetical accuracy and internal consistency by a
person other than the person who prepares them?
(v) Are variations between stocks as per physical stock taking and stock records as per the books
investigated and adjusted in the stock records and financial accounts with proper authorization?
Inventories held by third parties
Are stocks held with third parties physically verified periodically by the third party or by the enterprise?
Are certificates obtained from the holders of the stocks regarding the quantity and quality of the stocks
on a regular basis during the year as well as at the year-end?
Independent Checks
Is there an internal audit of inventories?
III. Fixed Assets
A. Segregation and rotation of duties
(i) Is there a proper segregation of various duties relating to fixed assets? As far as possible, the
following duties should be assigned to different persons.
(a) Authorizations of acquisitions and disposals.
(b) Execution of transactions relating to acquisitions and disposals.
(c) Recording of transactions.
(d) Physical custody of items.
(ii) Are duties of various persons relating to fixed assets rotated periodically?
B. Authorization of acquisitions, Transfer and Disposal
(i) Is there an effective system of capital budgeting with well laid down procedures? The following aspects
are particularly important in this regard.
(a Are proposals for capital expenditure invited from various departments of the enterprise well-in-time?
(b) Are the proposals received in a properly laid down format which provides for complete details
about the financial, commercial and technical aspects of a proposal?
(c) Are the proposals for capital expenditure scrutinized by a committee consisting of senior managers
and then a composite budget put up to the top management or governing body for approval?
(d) Is the approved budget communicated in writing to various departments including the purchase
department and the accounts department?
(ii) Is prior written authorization of a manager at a sufficiently senior level required for incurring capital
expenditure for items included in the budget?
(iii) Is there a well laid down procedure for acquisition of items of fixed assets? Does the procedure
provide for adequate controls, particularly with regard to invitation of quotations, selection of suppliers,
and approval of prizes, payment terms and other terms of the purchase contract including technical
specifications and delivery schedule? Are there sufficient safeguard to ensure timely delivery /
construction of fixed assets, such as provision for penalty in case of delayed delivery, etc.?
(iv) Where purchases are made on the basis of competitive bids, is there a requirement for
documenting the reasons for making purchases otherwise than at the lowest price?
(v) Are controls over receipts of items of fixed assets effective? In particular are the technical
specifications of the items received verified with the purchase order before accepting them? In case
any items are rejected, are debit notes raised promptly?
(vi) Is there a periodic comparison of capital expenditure incurred with the capital budget? In cases
where the amounts actually expended indicate the likelihood of cost over-runs, are supplementary
budgets prepared and got approved from competent authority?
(vii) Is there a system of obtaining prior approval of a senior manager in case of transfer of fixed
assets (e.g., from one department or unit to another department or unit)?
(viii) Are there adequate controls over disposal of fixed assets, especially with regard to the following?
(a) Are fixed assets scrapped or retired from use only on written authorization of a senior manager?
(b) Are limits prescribed on the authority of the specified managers to scrap or retire fixed assets?
(c) Are there proper controls over disposal of fixed assets, particularly with regard to invitation of
quotations, approval of prices, etc.?
(d) Is there a proper documentation of the disposal of fixed assets?
(i) Does the enterprise maintain proper records of all fixed assets? Do the records contain details of
such fully depreciated assets also which are in use or are kept for disposal? Are the records kept up-
to-date and reconcile periodically with financial accounts? Do the records contain such particulars as
date of purchase, supplier’s name, identification number, details of cost, location, estimated life,
estimated residual value, rate of depreciation, accumulated depreciation till date and where applicable,
measurement of impairment loss on assets?
(ii) Is a proper record maintained in respect of fixed assets given by the enterprise on lease and of
assets owned by others but used by the enterprise?
(iii) Where applicable, does the enterprise maintain proper records of intangible assets?
(iv) Does the system ensure that all disposals are recorded in the books of account promptly?
(v) Is a register containing particulars of title deeds of land and buildings maintained? Are the title
deeds kept in safe custody? Are these deeds periodically verified?

Where such deeds have been lodged as security against loans, are certificates of lodgment obtained
periodically from banks financial institutions or other parties with whom the title deeds have been
lodged?
(vi) Are registration books of vehicles maintained properly and verified periodically?
(vii) Does the enterprise maintain detailed records of projects under construction? Are job numbers
assigned to each such project? Is there a proper system for identifying the direct expenditure incurred
on each project ( e.g., Cost of materials and stores, wages ) and for allocation or apportionment of
overheads to various projects? Is a separate account maintained in the ledger to monitor the actual
amounts expended on each projects?
(viii) Is the basis of allocating expenditure between capital and revenue proper?
Accountability for and safeguarding of, Fixed Assets
(ii) Is there a system whereby each item of fixed assets is given an identification number indicating its
location, use, etc.? Is the identification number marked on the item in such a manner that it cannot be
removed easily?
(ii) Are there adequate safeguards to protect the items of fixed assets from theft, fire, etc., Such as
restricting access to items of fixed assets to authorized personnel and use of devices like locks,
burglar alarms, etc.?
(iii) Are the items of fixed assets properly insured? In this regard, the following aspects are particularly
important.
(a) Is the insurance cover against fire, flood, theft and other losses adequate?
(b) Is the adequacy of insurance cover reviewed periodically?
(c) Are insurance policies renewed on a timely basis?
(d) Are values of items of fixed assets determined properly for the purpose of insurance? Do insurance
policies cover replacement values of fixed assets? Is the system of determining replacement values
proper?
(e) In case certain assets are left uninsured, is it on the basis of a conscious decision by an authorized
manager? Is such a decision properly recorded?
(f) In case the enterprise resorts to self-insurance, is there a proper system whereby adequate funds
are allocated to the self-insurance fund? Does the past experience indicate that the self-insurance
fund is adequate to take care of the various kinds of possible losses?
(iv) Are fixed assets verified periodically on the basis of a well laid down written procedure?
(v) Does the verification procedure extend to fixed assets with third parties? In case it is not possible
to physically verify the fixed assets with third parties, is there a procedure for obtaining confirmation
from such third parties?
(vi) Is there a proper follow-up on discrepancies between the book records and the results of physical
verification? Are these discrepancies investigated and responsibilities fixed? Are fixed asset records
and financial accounts adjusted, with proper approval of a senior manager, to take cognizance of the
discrepancies noticed on physical verification?
(vii) Is there a system of identifying and reporting damaged, obsolete and idle fixed assets? Is there an
adequate follow-up on such fixed assets? Are the fixed asset records and financial accounts adjusted,
with the approval of a senior manager, to recognize the fall in the value of fixed assets due to damage
obsolescence or idleness?
Independent Checks
Is there an internal audit of fixed assets? Is the internal audit work relating to fixed assets properly
planed and executed?
IV. Sales
Processing Orders and Dispatching Goods
(i) Are standard price lists maintained? Is a special sanction from a senior manager required in the
case of sales at prices lower than the standard prices?
(ii) Does the system of allowing quantity rebates and discounts provide for adequate controls? In
particular, is there a clear cut policy for allowing such rebates and discounts? Are the authorities of
various managers in this regard clearly laid down and are they reasonable?
(iii) Are special sanctions required in case of sales to affiliate companies or individuals, or other
enterprises in which the managerial personnel or senior employees are interested?
(iv) Is there a well-defined policy for making sales to employees at concessional prices? Does it lay
down any limits in this regard?
(v) Is there a timely preparation of a written sale order on receipt of an order from a customer?
(vi) Are sale orders pre-numbered? Is a lack of continuity in sale order numbers duly enquired into?
(vii) Is there a proper authorisation of credit, price, quantity and other important terms of the sale
order?
(viii) Is there a system of fixing credit limits for regular customers? Are these limits approved by a
senior manager as per the credit policy determined by the top management? Are these limits reviewed
periodically in the light of the experience in dealing with the customer?
(ix) Is credit limit of the customer concerned checked before sanctioning the credit on the sale order? Is
up-to-date information on the extent of credit already extended to the customer readily available for this
purpose?
(x) Is a copy of each sale order sent to the despatch department and to the accounts department?
(xi) Is a despatch document, e.g., A goods outward Challans, prepared at the time the goods are
despatched to the customer? Is it matched with the bill of lading or the railway receipt/ transporter’s
receipt?
(xii) Are despatch documents pre-numbered and missing document numbers duly enquired into?
(xiii) Is there a system of checking each consignment of goods leaving the premises with the related
despatch document?
(xiv) Is a copy of the despatch document, i.e., Goods outward Challans/gate pass sent to the customer
and to the accounts department?
(xv) Is an acknowledgment of receipt of goods obtained from the customer or from his agent on the
copy of the despatch document?
Billing Customers and Recording Sales
(i) Is there a system of preparing sale invoices immediately on receipt of despatch documents?
(ii) Do the sale invoices contain all the relevant details including the name of the customer, description
and quantity of goods sold, sale price, freight, insurance, sales tax and other charges as well as other
major terms of the sale?

(iii) Are the sale invoices properly checked (particularly for prices, calculation and terms of payment)
and authorised before despatch? Are the particulars such as the name of the customer, quantity, etc.,
As appearing in the copies of the sale orders, gate pass/other despatch document, and the railway
receipt/transporter’s receipt/bill of lading compared with those in the invoices to ensure that proper
amounts have been billed to appropriate customers.
(iv) Is the original invoice sent to the customer immediately and entries made in the accounting
records on a timely basis?
(v) Are sale invoices pre-numbered and entered sequentially in the sale summary sheet or the sale
book? Is a lack of continuity in sale invoice numbers duly enquired into?
(vi) Are copies of sale order, despatch document, railway receipt/transporter’s receipt/ bill of lading
attached with the relevant invoice?
Follow-up on Sales after-sale Service
(i) What is the nature of after-sale service rendered by the enterprise?
(ii) Does the enterprise maintain adequate records (e.g., Customer cards) of after- sale service
provided to each customer? Does the format of the record provide for a clear distinction between
customers being serviced under warranty period and those under maintenance contracts?
(iii) Are the service engineers required to fill up a form describing the services rendered/ parts
replaced on each visit? Is the form required to be signed by the customer?
(iv) Are cases of major replacements reviewed by a senior official?
(v) Are service engineers authorised to collect cash and issue provisional receipts to customers in the
case of chargeable parts? In such a case, are they required to deposit the cash so collected the same
day along with copies of provisional receipts? Are the provisional receipts pre-numbered? Are missing
receipt numbers duly enquired into?
(vi) Is the customer sent a final invoice/receipt for the services rendered and/or for the parts replaced?
(vii) Are invoices entered into the customer cards immediately?
(viii) Is there a periodic comparison of the cost of parts replaced free of charge with the budgeted
figures? Are any unusual fluctuations duly investigated?
Sale returns
(i) Does the system relating to sale returns prescribe limits on the authority of managers at various
levels to accept return of goods? (These limits may be in terms of value of the goods returned and the
period during which they are returned.)
(ii) Are the returned goods accepted only after they have been properly inspected for their quantity and
quality?
(iii) Is an inward return note prepared promptly against each sale return, indicating the quantity and
specifications of the goods received back?
(iv) Are the inward returned notes per-numbered? Are missing note numbers duly enquired into?
(v) Are returned goods sent to the stores immediately? Are inward return notes entered promptly in
inventory records?
(vi) Is a credit note prepared on the basis of the inward return note? It is properly checked with
reference to the relevant inward return note before it is approved and sent to the customer? Are
appropriate entries made in the books of account promptly?

(vii) Is there a proper control over the issue of credit notes specially with regard to the authority for
issuing the same?
(viii) Are credit notes pre-numbered? Are missing credit note numbers duly enquired into?
(ix) Is the sale commission paid in respect of goods returned recovered through an appropriate debit
note?
(x) Are sale returns analyzed with reference to the reasons? Are appropriate follow-up steps taken?
Claims by Customers
(i) Are all claims ( for shortfall in quantity, or for poor quality, or for delay in delivery and similar other
reasons) approved by an authorized manager? Is the approval granted only after a proper examination
of the matter?
(i) Is a credit note sent to the customer in respect of each approved claim? Are appropriate entries
made in the books of accounts promptly?
Import Entitlements
Are adequate records maintained in respect of import entitlements against export of goods? Are the
entitlements properly utilized?
Overall Controls
(i) Is there a proper segregation of duties in the various segments of the total sales cycle? Have the
duties relating to sales been so allocated that different persons are entrusted the functions of (a)
authorization of sales (b) execution of sale transactions, (c) recording of sales, and (d)
custody of goods? Are the duties of various persons relating to sales rotated periodically?
(ii) Are there adequate cut-off procedures in relation to sales?
(iii) Are there adequate cut-off procedures in relation to sale returns?
(iv) Is there an internal audit of the entire sales cycle?
(v) Is there a system of sending monthly statements of accounts to regular customer? Are the
discrepancies intimated by customers in their response and are they properly dealt with?
V. Purchases
Processing Purchase Orders
(i) What is the organization of the purchase function? Are purchases centralized or decentralized?
(ii) Does the purchase procedure provide for preparation of written purchase requisitions by authorized
personnel? Are these prepared in a standard format? Does the format require furnishing of sufficient
details about quantity required, technical specifications, delivery schedule, etc.?
(iii) Have the authorities regarding sanctioning of purchases been clearly laid down? Is the distribution
of authorities proper? Have limits been prescribed within which purchases can be sanctioned by each
authority?
(iv) Is a list of approved suppliers maintained for each major item? Is the list updated regularly? Does
it contain appropriate remarks in respect of suppliers who fail to comply with the terms of purchase
orders? Are purchases made from approved suppliers only?
(v) Are tender / quotations invited from more than one supplier (usually three or more) on the basis of
a clear cut specification of the item required?
(vi) Have any long-term purchase contracts been entered into with the suppliers? Are the stipulations
regarding price, specification of goods, etc., in such contracts clear and unambiguous?
(vii) Where tenders / competitive quotations are invited, it is ensured that no supplier gets an undue
advantage? For example, are quotations opened at one time by a senior officer and in the presence of
the representatives of the suppliers? In case negotiations are carried on after the opening of the
tenders / quotations, is an equal opportunity given to all the short-listed suppliers?
(viii) Is a special authorization required in case the lowest quotation is not accepted?
(ix) What is the system of approving prices and other terms and conditions in case purchase are not
made on the basis of competitive quotations, e.g., Emergency purchases or purchases involving small
amounts? Is the system reasonable?
(x) In case a price variation clause or variation in terms of delivery, insurance, etc. Is to be included in
the purchase order / agreement, does it require prior approval of prescribed authorities?
(xi) Are specific approvals required for the following?
(a) Purchases from entities or individuals which are affiliates of the enterprise, e.g., Holding company,
subsidiaries, associates, joint ventures, organizations in which managerial personnel (e.g., Directors,
senior managers) are interested, etc. In case the law governing the enterprise (e.g., Companies Act,
1956, in the case of a company) lays down certain requirements in respect of such purchases, does
the system ensure compliance with such requirements? Is there a system by which all managerial
personnel up to a certain level are required to disclose their interest in various organizations?
(b) Purchase of abnormally large value.
(c) Entering into long-term purchase contracts, the purchases under which are likely to involve a large
amount over a period of time.
(xii) Are purchase orders pre-numbered? Are unused forms kept in proper custody? Are missing
numbers duly enquired into?
(xiii) Are purchase orders sufficiently detailed and precise so as to leave no scope for
misunderstanding? (For this purpose, a purchase order should clearly mention the name of the
supplier, the description of the goods ordered their quantity, price as well as other terms and
conditions relating to delivery, freight, payment, etc.)
(xiv) Is a copy of purchase order required to be signed by the supplier signifying his acceptance of the
terms of the order? In appropriate cases (e.g., For long-term purchase contracts or contracts involving
large amounts), are formal purchase agreements entered into with the suppliers?
(xv) Are copies of each purchase order / agreement forwarded to the goods receiving department and
the accounts department?
(xvi) Is there a periodic review of purchase orders which remain partly or fully unexecuted beyond the
due dates?
Receiving Goods
(i) Are all goods and suppliers received only in the receiving department? Where goods can also be
received by others, e.g., User departments / customers / sub-contractors, is there a procedure for
obtaining confirmation about he quantity and quality of the goods received?
(ii) Is every receipt of materials supported by a goods received note? Are the goods received notes pre-
numbered? Are missing goods received duly enquired into?
(iii) Is there a procedure for verifying the quantities of materials at the time of receipt through counting
weighing / measurement?
(iv) Is the quality of the materials checked on receipt? Are the specifications of materials received
matched with those in the purchase order? Are proper laboratories or other analyses conducted in
appropriate cases?
(v) In case of shortage of quantity or variations from specifications given in the purchase order, does the
receiving department reject the materials? In such a case, is an outward return note prepared, indicating
the quantity and specifications of goods to be returned? Are the goods returned promptly and an
acknowledgment of return of goods obtained from the supplier? Where materials are accepted despite
shortage or variations from specifications, is the shortage in quantity or the nature of qualitative
defects/variations from specifications mentioned on the challan sent to the supplier as well as on the
goods received note?
(vi) Does the receiving department send a copy of each goods received note containing its remarks
regarding the quantity and quality of the materials received to the following?
(a) Accounts department.
(b) Purchase department.
(c) Stores or the department to which the materials received are sent.
(vii) Are the materials received sent to the stores or to the requisitioning department promptly?
Recording Purchases
(i) Are the suppliers invoices received directly in the accounts department where they are matched
with the purchase order, the goods received note and the record of advance payments (where
applicable)?
(ii) Are all invoices checked thoroughly to ensure that the terms and conditions of the relevant
purchase orders / agreements have been complied with?
(iii) Are invoices checked for arithmetical accuracy? Does the person responsible for such checking
initial the invoice?
(iv) Are all invoices entered promptly in the purchase book?
(v) In case of variation of quantity or quality of materials received vis-a-vis those specified in the
purchase order, or in case in non-compliance with other terms and conditions of the purchase order,
are debit notes raised promptly against the suppliers concerned, on the basis of the observations of
the receiving department / examination of the suppliers! Invoices? Similarly, are debit notes raised
promptly against the suppliers concerned for goods returned, on the basis of the copies of the outward
return notes?
(vi) Are debit notes pre-numbered? Are missing numbers duly enquired into?
(vii) Is there a proper control over the issue of debit notes specially with regard to the authority for
issuing the same?
(viii) Are debit notes recorded promptly in the books of account?
(ix) Is each invoice given a running serial number? Is the serial number as marked on an invoice also
marked on the supporting documents attached to the invoice such as purchase order, goods received
note, etc.?
(x) Is it ensured that duplicate invoices are accepted only with proper authorization and only in such
cases where the original invoices were not received? Are duplicate invoices prominently marked
duplicate and attached with the supporting documents regarding the relevant purchase?
(xi) Where the accounts department has received a written intimation from the purchase department that
the supplier has supplied the goods to the representatives / customers / sub-contractors of the
enterprise, is a proper entry made in the books of account recognizing the purchase ( even though the
goods have not been physically received in the stores)?
(xii) Are advance against purchases made only as per the terms of the purchase order and with proper
authority?
(xiii) Are all advances for purchases reviewed periodically and followed up properly?
(xiv) Is there a system of periodic reconciliation of the goods paid for as per financial accounts with the
goods received as per stores record?
Overall Controls
(i) Is there a proper segregation of duties in the various segments of the total purchase cycle? Have the
duties relating to purchases been so allocated that different persons are entrusted the functions of (a)
authorization of purchases, (b) execution of purchase transactions, (c) recording of purchases, and (d)
custody of goods? Are the duties of various persons relating to purchases rotated periodically?
(ii) Are the adequate cut-off procedures in relation to purchases? (These procedures seek to ensure that
the purchase of a preceding or a subsequent accounting period are not included in the purchases of the
current period, and vice versa. For example, an enterprise may have a system whereby the goods
receiving department is required to intimate to the accounts section the serial number of the last goods
received note issued on the last day of the Accounting year. Another example of cut-off procedures is
the use of new goods received note books from the commencement of a new accounting year, the old
books being handed over to an authorized officer. Similarly, appropriate cut-off procedures are
required to identify goods in which property has passed to the enterprise but which have not been
received by the end of the accounting year.)
(iii) Are the adequate cut-off procedures in relation to purchase returns?
(iv) Is there an internal audit of the entire purchase cycle?
(v) Is there a system of sending monthly statements of account to suppliers? Are the discrepancies
intimated by suppliers in their responses properly dealt with?
4
AUDIT UNDER COMPUTERISED INFORMATION
SYSTEM (CIS) ENVIRONMENT
Introduction
4.1 Information Technology throughout the world has revolutionized and dramatically changed
the manner in which the business is conducted today. Computerization has a significant effect
on organization control, flow of document information processing and so on. Auditing in a CIS
environment even though has not changed the fundamental nature of auditing, it has definitely
caused substantial changes in the method of evidence collection and evaluation. This also
requires auditors to become knowledge about computer environment (Hardware, software
etc.) and keep pace with rapidly changing technology, even to the extent of using
sophisticated Audit software. Students are advised to study the technical issue relating to
Information Technology from the study material of paper 6.
Scope of Audit in a CIS Environment
4.2 Impact of computerisation on audit approach needs consideration of the following factors:
(1) High speed - In a CIS environment information can be generated very quickly. Even
complex reports in specific report format can be generated for audit purposes without much
loss of time. This cuts down the time enabling the auditor to extend their analytical review for
under coverage with high speed of operation, the Auditor can expand their substantive
procedures for collection of more evidence in support of their judgement.
(2) Low clerical error - Computerised operation being a systematic and sequential
programmed course of action the changes of commission of error is considerably reduced.
Clerical error is highly minimised.
(3) Concentration of duties - In a manual environment the auditor needs to deploy separate
individuals for carrying out the verification process. In a CIS environment, the traditional
approach does not apply in many cases, as computer programs perform more than one set of
activities at a time thereby concentrating the duties of several personnel involved in the work.
(4) Shifting of internal control base -
(i) Application systems development control - Systems development control should be
designed to provide reasonable assurance that they are developed in an authorised and
efficient manner, to establish control, over:
a) testing, conversion, implementation, and documentation of new revised system.

b) changes to application system.
c) access to system documentation.
d) acquisition of application system from third parties.
(ii) Systems software control - Systems software controls are designed to provide
reasonable assurance that system software is acquired or developed in an authorised
and efficient manner including:
a) authorisation, approval testing, implementation and documentation of new system
software systems software modifications.
b) putting restriction of access to system software and documentation to authorised
personnel.
(5) Disappearance of manual reasonableness - The shift from traditional manual information
processing environment to computerised information systems environment needs a detailed
analysis of the physical system for transformation into a logical platform. In creating such
logical models many stages required under manual operations are either deleted or managed
to create a focused computer system. In such creative effort, the manual reasonableness may
be missing.
(6) Impact of poor system - If system analysis and designs falls short of expected standard
of performance, a computerised information system environment may do more harm to
integrated business operation than good. Thus, care has to be taken in adopting manual
operations switch-over to computerised operations for ensuring performance quality
standards.
(7) Exception reporting - This is a part of Management information system. Exception
Reporting is a departure from straight reporting of all variables. Here the value of a variable is
only reported if it lies outside some pre-determined normal range. This form of reporting and
analysis is familiar to the accountant. The main strength of exception reporting lies in its
recognition that to be effective information must be selectivity provided.
(8) Man-machine interface / human-computer interaction - Man-machine interface ensures
maximum effectiveness of the information system. Organisation concentrated on presenting
information that is required by the user and to present that information in the most uncluttered
way. It is required to determine what information was necessary to achieve through a careful
analysis of the job or task for which the user needed the information.
Human-computer interaction is a discipline concerned with the design, evaluation and
implementation of interactive computing systems for human use and with the study of the
major phenomena, surrounding them. The approach is user centered and integrates
knowledge from a wide range of disciplines.
Audit under Computerised Information System (CIS) Environment 4.3
Impact of Changes on Business Processes (For Shifting From Manual To Electronic

Medium)
4.3 The effect of changes on accounting process may be stated as under:
A. Primary Changes
(1) Process of recording transactions - The process of recording transaction undergoes a
major change when accounting process are computerised under CIS environment, the order of
recording transaction from basic document to prime books and finally to principal book may
not be followed strictly in sequential from as is observed in manual system. In many cases all
the three processes Prime book of Entry →Ledger →Final accounts (Balance Sheet and
Profit and Loss Account) are carried on simultaneously.
(2) From of accounting records - Mechanisation often results in the abandonment in whole
or in part of the primary records. Punch card installation or electronic data processor changes
the form of both intermediate and ultimate records much more radically than manual records.
(3) Use of loose-leaf stationeries - Bound hand written records as used in manual
accounting processes are replaced by loose-leaf machine written records in electronic
medium. In a computerised information system, magnetic tapes, floppy disks, diskettes, print-
outs replace the traditional records. This necessarily require proper control over such records
to prevent their unauthorised us, destruction or substitution.
(4) Use of accounting code – In computerised information systems, alpha-numeric codes are
extensively used to represent names and description. The accountants as well as the Auditors
has to get themselves familiarised with the use of such codes which initially may pose
considerable problems in understanding the various transactions.
(5) Absence of link between transaction - In a computerised information system
environment, there may be an inadequacy or even total absence of cross-reference between
the basic documents, primary records and the principal records. This create special problems
for the auditors. The auditors may find it difficult to trace a transaction from start to finish there
by having a doubt in their mind as to loss of audit trials.
B. Recent Changes
The growth and development in the field of information technology is a fast paced one and
unless the auditors are alert to such developments and take pre- emptive action in upgrading
their knowledge, they may find difficulty in coping with such advancement.
Following are a few instance of the recent changes which the may need to be addressed in
discharging their responsibilities in such environment:
(1) Mainframes are substituted by mini/micro users.
(2) There is a shift from proprietary operating system to more universal ones like UNIX,
LINUX, Programming in 'C' etc.
(3) Relational Date Base Management (RDBMS) are increasingly being used.
(4) The methodology adopted for systems development is becoming crucial and CASE
(Computer Aided Software Engineering) tools are being used by many organisation.
(5) End user computing is on the increase resulting in decentralized data processing.
(6) The need for data communication and networking is increasing.
(7) Common business documents are getting replaced by paperless electronic data interface
(EDI).
(8) Conventional data entry giving way to scanner, digitized image processes, voice
recognition system etc.
The Impact of all such change on auditing may be summarised as:
(a) widespread end-user computing may result in unintentional errors creeping into
systems owing to inept handling. Also coordinated program modification may not be
possible.
(b) improper use of decision support system can have serious repercussion. Also their
underlying assumption must be clearly documented.
(c) Usage of sophisticated audit software would be a necessity.
(d) Auditors non-participation at System Development Life Cycle State (SDLC) pose
considerable problem in understanding the operational controls.
(e) Data communication and net working would introduce new audit risk.
(f) The move toward paperless EDI would eliminate much of the traditional audit trail
radically changing the nature of audit trails.
Audit Approach in a CIS Environment
4.4 Based on The knowledge and expertise of Auditors in handling computerised data, the
audit approach in a CIS environment could be either:
A. A Black-box approach i.e., Auditing around the computer, or
B. A White-box approach i.e., Auditing through the computer.
A. The Black Box Approach
Client Input CPU Client Output
Auditing Around The Computer
Compare with
Client Output
Auditor's
Predetermined Output
In the Black box approach or Auditing around the computer, the Auditor concentrates on input
and output and ignores the specifics of how computer process the data or transactions. If input
matches the output, the auditor assumes that the processing of transaction/data must have
been correct.
In testing, say, Payroll Application, the auditor might first examine selected time cards for
hours worked and employee earning cards for rates and then trace these to the payroll
summary output and finally compare hours, rates and extensions. The comparison of inputs
and outputs may be done manually with the assistance of the computer. The computer
assisted approach has the advantage of permitting the auditor to make more comparisons
than would be possible, if done manually.
Auditing around the computer has the advantage of ease of comprehension as the tracing of
documents to output does not require any in-depth study of application program.
A major disadvantage, however, is that the auditor not having directly tested the control,
cannot make assertions about the underlying process. Moreover, in some of the more complex
computer systems intermediate printout may not be available for making the needed
comparisons.
B. The White Box Approach
Auditor’s
Input CPU Client Output
Auditing Through The Computer
Compare with
Client Output
Predetermined Output
The processes and controls surrounding the subject are not only subject to audit but also the
processing controls operating over this process are investigated. In order to help the auditor to
gain access to these processes computer Audit software may be used. These packages may
typically contain:
(a) interactive enquiry facilities to interrogate files.
(b) facilities to analyze computer security logs for unusual usage of the computer.
(c) the ability to compare source and object (compiled) program codes in order to detect
dissimilarities.
(d) the facility to execute and observe the computer treatment of "live transaction" by moving
through the processing as it occurs. e) the generation of test data.
f) the generation of aids showing the logs of application programs. The actual controls and
the higher level control will be evaluated and then subjected to compliance testing and, if
necessary, substantive testing before an audit report is produced.
It is obvious, that to follow this approach the auditor needs to have sufficient knowledge of
computers to plan, direct-supervise and review the work performed.
The areas covered in an audit will concentrate on the following controls:
(1) Input controls,
(2) Processing control,
(3) Storage control,
(4) Output control and
(5) Data transmission control.
The auditor will also need to be satisfied that there are adequate controls over the prevention
of unauthorised access to the computer and the computerised database. The auditors task will
also involve consideration of the separation of functions between staff involves in transaction
processing and the computerised system and ensuring that adequate supervision of personnel
is administered.
The process of auditing is not a straight forward flow of work from start to finish to be
completed by satisfying oneself against a standard checklist or a list of questions. It involves
exposure, experiences and application of knowledge and expertise to differing circumstances.
No two information system is same. From the view point of analysis of computerised
information system, the auditors need not only have adequacy on knowledge regarding
information requirement and computer data security they must also get exposed to system
analysis and design so as to facilitate post implementation audit.
Types of Computer Systems
4.5 There is large variety of computer systems applicable to accounting and other type of
information processing. The nature and type of system affect the various types of controls for
its efficient and effective functioning Computer System may be broadly classified as under:
A) System configuration, and
B) Processing systems.
A. Systems configuration
System configuration may be classified as:
(1) Large system computers - In large system computers, the processing task of multiple
user is performed on a single centralised computer, i.e., all inputs move directly from the
terminal to central processors and after processing goes back to users from central
processors. All the terminals in these systems were called 'dumb terminals' as these terminals
were not capable of processing data on their own and casually serve only as input/output
terminals. With time, these systems have become more efficient and sophisticated. In many
instances dumb terminals have given way to intelligent terminals i.e., allowing data processing
at local levels.
(2) Stand alone personal computers - A stand alone system is one that is not connected to
or does not communicate with another computer system. Computing is done by an individual
at a time. All input data and its processing takes place on the machine itself. Many small
business rely on personal computers for all their accounting functions.
(3) Network computing system - A network is a group of interconnected system sharing
services and interacting by a shared communication links. All networks have something to
share, a transmission medium and rules for communication. Network share hardware and
software resources. Hardware resources include:
(a) Client Server - A server in a network is dedicated to perform specific tasks to support
other computers on the network. Common types of servers are:
(b) File Server - File servers are the network applications that store, retrieve and move data.
(c) Data base server - Most of the data base are client server based. Database servers
provide a powerful facility to process data.
(d) Message Server - They provide a variety of communication methods which takes the
form of graphics, digitized audio/video etc.,
(e) Print Server - Print server manages print services on the network.
Software resource sharing provides a facility to share information in the organisation.
The networks can also be classified on the basis of areas covered. Software resources
include:
(1) Local area network - In a local area network (LAN), two or more computers located within
a small well-defined area such as room, office or campus are connected through cables. One
of the computers acts as the server, it stores the program and data files centrally. These
programs and data files can be accessed by the other computers forming part of the LAN. LAN
provide the additional advantage of sharing programs, data and physical resources like hard
disks peripherals.
(2) Wide area network - Networks that employ public telecommunications facilities to provide
users with access to the resources of centrally located computers. A WAN uses the public
switched telephone network, high speed fibre optic cable, ratio links or the internet. When a
LAN extend in the metropolitan area using the WAN technology, it is called Metropolitan Area
Network (MAN).
WAN uses modem to connect computers over telephone lines (PSTN) PSTN system transfer
analog signals. Therefore, public telephone system are not appropriate to connect computers.
Modems are used to convert analog signals into digital and vice versa.
(3) Distributed data processing - The term has been used to cover many varities of
computer system. It consists of hardware located at least two geographically distinct sites
connected electronically by telecommunications where processing / data storage occur at two
or more than one sites. The main computer and the decentralised units communicate via
communication links. A more integrated connection occur with 'cooperative processing where
processing is handled by two cooperating geographically distinct processors. One processor
send the output of its processing to another for completion. The system becomes more
complex, where operating system of both machines are different. Cooperative operating
system may be required under such situation.
(4) Electronic data interchange (EDI) - EDI can be defined as:
The transfer of electronic data from one organisations computer system to another's, the data
being structured in a commonly agreed format so that it is directly usable by the receiving
organisation computer system.
EDI may be introduced where a group of organisations wish to ensure that electronic
transactions are passed between one another. EDI groups require EDI services in order to
effect the data exchanges. These are often provided by a third party in more than merely the
transmission of the data. By providing these services the third party adds value to the data
transmission and is thus called value added network (VAN). The following benefits accrue
under EDI systems.
a) The speed with which an inter-organisational transaction is processed is minimised.
b) the paperwork involved in transaction processing is eliminated.
c) the costs of transaction processing are reduced, as much of the need for human
interpretation and processing is removed.
d) reduced human involvement reduces error.
B. Processing system
Transaction processing systems include:
(1) Batch processing - Under batch processing a large volume of homologous transactions
are aggregated and processed periodically. There are four steps in batch processing.
(a) Occurrence of transaction - The occurrence of business events is recorded in the source
document.
(b) Recorded in a Transaction file - A batch of source is periodically transferred to the data
entry operator to extract information from the source document and enter it into the computer
format. Data entry is usually done off line. The computerised format is the transaction file to be
processed in the system. Once the data entry is done, the records entered are confirmed with
the source document. Once the records are checked, the source documents are stored
separately for future reference.
(c) Updation of Master file - After all the data is entered in the system and it is processed
and summarised, the master files are updated.
(d) Generation of output - After processing and master file updation, the report, as required
are periodically generated.
Batch processing system are used for processing large volumes of repetitive transactions
where control considerations and efficient utilisation of computing capacity are important.
(2) On Line Processing System - One line processing refers to processing of individual
transactions as they occur from their point of origin as opposed to accumulating them into
batches. This is possible by direct access devices such as magnetic disk and number of
terminals connected to and controlled by a central processors. In this way, various
departments in a company can be connected to the processor by cables.
Apart from transaction processing and file updating, inquires are also handled by the on-line
processing system. On-line processing ensures that the records are in a updated status at any
time whereas this is not so with batch processing, but the fact remains that online processing
is costly.
(3) Interactive Processing - Under this processing mode, a continuous dialogue exists
between the user and the computer. It is also called 'transaction driven' processing as
transactions dealt with completely on an individual basis through all the relevant processing
operations before dealing with the next transaction occur and enquiries to be dealt with on an
immediate response basis.
(4) On-line real time processing - The term ' Real Time' refers to the technique of updating
files with transaction data immediately after the occurrence of the event. Real time system are
basically on-line system with one speciality in enquiry processing. The response of the system
to the enquiry itself is used to control the activity. The response of a real time system is one
type of feed back control system. The response time would naturally differ from one activity to
another. Real time system usually operates in multi-programming and multi-processing. This
increases both availability and reliability of the system. CPU's in real time systems should
possess the capability of 'Program Interrupts'. These are temporary stoppage of halts in the
execution of a program so that more urgent message can be handled on priority. Some
computer systems are dedicated to real time operations and others are designed to operate in
both batch and real time modes so that they can also serve as stand by units to each other.
(5) Time Sharing - A time-sharing allows access to a CPU and files through many remote
terminals. Multiprogramming is the method of implementing time shared operations. In
transaction processing, time sharing occurs when a computer processes transactions of more
than one entity.
(6) Service Bureau - A service bureau is a company that processes transaction for other
entities. Such units may handle the computer processing for small companies that singly do
not have sufficient transactions to justify the acquisition of a computer.
Advanced processing system further includes:
(a) Decision Support System - A Decision Support System (DSS) can be defined as a
system that solving provided tools to managers to assist them in soloing semi-structured and
an unstructured problem. A DSS is not intended to make decisions for managers, but rather to
provide managers with a set of capabilities that enables them to generate the information that
is required by them for decision making. In other words, a DSS supports the human decision
making process, rather then providing a means to replace it.
The decision-support system are characterised by:

(i) they support semi-structured or unstructured decision making
(ii) they are flexible enough to respond to the changing needs of decision makers, and,
(iii) they are easy to operate.
A decision-support system has 4 basic components:
(i) The Users – represent managers at any given level of authority in the organisation.
(ii) Data bases – contains both routine and non-routine data from both internal and external
sources.
(iii) Planning Language – include general purpose planning language like spread
sheets/special purpose planning languages, SAS, SPSS, Minilab etc;
(iv) Model Base – Model base is the 'Brain' of the decision support system because it
perform data manipulations and computations with the data provided by the user and
data base.
(b) Expert System - An expert system a computerised information system that allows non-
experts to make decision comparable to that of an expert. Expert system are used for complex
or ill structured tasks that require experience and special knowledge in specific subject areas.
As expert system typically contains
(i) Knowledge Base - This includes data, knowledge, relationships, rules of thumb to and
decision rules used by experts to solve a particular type of problem. A knowledge base is
the computer equivalent of all the knowledge and insight that an expert or a group of
experts develop through years of experience in their field.
(ii) Inference Engine - This program contain the logic and reasoning mechanisms that
stimulate the expert system logic process and deliver advice. It uses data obtained from
both the knowledge base and the user to make associations and inference, forms its
conclusion and recommends a course of action.
(iii) Use interface - This program allows the user to design, create, update, use and
communicate with the expert system.
(iv) Explanation Facility - This facility provides the user with an explanation of the logic the
expert system use to arrive.
(v) Knowledge acquisition Facility – Building a knowledge base (also called knowledge
engineering), involves both a human expert and a know ledge engineer. The knowledge
engineer is responsible for extracting an individuals expertise and using the knowledge
acquisition facility to enter into the knowledge base.
(7) Integrated File System - These systems update many files simultaneously as transaction
is processed. Processing of a sales order updates the accounts receivable control accounts
and the related subsidiary ledger is also updated and the sales control and sales details are
also posted as the sales order is processed.
Integrated data base system contains a set of interrelated master files that are integrated in
order to reduce data redundancy. The software used to control input processing and output is
referred to as Data Based Management System (DBMS) which handles the storage, retrieval,
updating and maintenance of the data in the data base.
Integrated files are most commonly associated with OLRT (on-line real time) system and pose
the greatest challenge to the Auditor's. Controls within these systems are harder to test and
assess due to the danger of file destruction.
Files may be physically stored on disk in the following way:
'Sequentially' records are physically ordered by some field (e.g., employee number).
'Randomly' records are stored at a physical address computed by an algorithm working on a
field value.
'Indexed' records are physically stored randomly with a sequentially ordered index field (e.g.
by customer) and a pointer to the physical location of each record.
'Indexed Sequential' records are physically stored sequentially ordered by some field
together with an index which provides access by some possibly other field.
If files are required to be processed sequentially, then they may be stored sequentially. The
sequential update of an employee master file by time sheet data is an example. However, if
individuals records are required to be accessed from time to time by some field e.g. employee
name, then one of the other storage method may be used.
Effect of Computers on Internal Controls
4.6 nternal control system include separation of duties, delegation of authority and
responsibility, a system of authorisation, adequate documents and records, physical control
over assets and records, management supervision, independent checks on performance and
periodic reconciliation of assets with records. In CIS environment, all these components must
exist but computers affects the implementation of these internal control in many ways. Some
of the effects are as under:
(1) Separation of Duties - In a manual system, different persons are responsible for carrying
out function like initiating, recording of transaction, safeguarding of assets, does not always
apply in a computer system. For example, in a computer system, a program may carryout
reconciliation of vendor invoice against a receipt document and also prepare a cheque
payable to a creditors. Such operation through a program will be considered as incompatible
functions in a manual system.
In minicomputer and microcomputer environments, separation of incompatible function could
be even more difficult. Some such forms, allows, users to change programs and data entry
without providing a record of these changes. Thus, it becomes difficult to determine whether
incompatible function have been performed by system users.
(2) Delegation Of Authority And Responsibility - A structured authority and responsibility is
an essential control within manual and computer environment. In a computer system however,
a clean line of authority and responsibility might be difficult to establish because some
resources are shared among multiple users. For instance, one objective of using a data base
management system is to provide multiple users with access to the same data, thereby
reducing the control problems that arise with maintaining redundant data, when multiple users
have access to the same data and the integrity of the data is somehow violated, it is not
always easy to trace who is responsible for corrupting the data and who is responsible for
identifying and correcting the error. Some organisation identified a single user as the owner of
the data.
(3) Competent And Trustworthy Personnel - Skilled, competent, well-trained and
experienced in formation system personnel have been in short supply. Since substantial power
is often vested in the person responsible for the computer information system
development, implementation, operation and maintenance within the organisation, competent
and trustworthy personnel is very much in demand. Unfortunately, the non availability of
competent personnel, forced many organisation to compromise on their choice of staff.
Moreover, it is not always easy for organisation to assess the competence and integrity of
their system staff. High turnover among those staff has been the norm. Some information
systems personnel lack a well developed sense of ethics and some enjoy in subverting
controls.
(4) System Of Authorisation - Management authorisation of transaction may be either:
a) general authorisation to establish policies for the organisation,
b) specific authorisation applying to individual transactions. In manual system, auditors
evaluate the adequacy of procedures for authorisation by examining the work of
employees. In a computer system, authorisation procedures often are embedded within a
computer program. In a computer system, it is also more difficult to assess whether the
authority assigned to individual persons is constant with managements policies. Thus, in
evaluating the adequacy of authorisation procedures, auditors have to examine not only
the work of employees but also the varacity of the programme processing.
(5) Adequate Documents And Records - In a manual system, adequate documents and
records are required to provide an audit trail of activities within the system. In computer
system, document support might not be necessary to initiate, execute and records some
transaction. The task of a visible audit trail is not a problem for auditors, provided the systems
have been designed to maintain a record of all events and that they are easily accessible. In
well-designed computer systems, audit trails are more extensive than those maintained in
manual systems unfortunately not all computer systems are well designed. This creates a
serious control problem.
(6) Physical Control Over Assets And Records - Physical access to assets and records is
critical in both manual systems and computer system. In a computer system the information
system assets and records may be concentrated at a single site. The concentration of
information systems assets and record also increases the losses that can arise from computer
abuse or disaster. If the organisation does not have another suitable backup, it might be
unable to continue operations.
(7) Adequate Management Supervision - In a computer system, supervision of employee

might have to be carried out remotely. Supervisory controls must be built into the computer
system to compensate for the controls that usually can be exercised through observation and
in inquiring computer system also make the activities of employees less visible to
management. Because many activities are electronically controlled managers must
periodically access the audit trial of employee activities and examine it for unauthorised
actions.
(8) Independent Checks On Performance - Checks by an independent person help to detect
any errors or irregularities. In a computer system, if a program code is authorised accurate,
and complete the system will always follow the laid down procedures in absence of other type
of failures like hardware or systems software failure. Thus, independent checks on the
performance of programs often have little value. Instead, the control emphasis shifts to
ensuring the veracity of programme code. Auditors, must now evaluate the controls
established for program development, modification operation and maintenance.
(9) Comparing Recorded Accountability With Assets - In a manual system, independent
staff prepare the basic data used for comparison purposes. In a computer system software is
used to prepare this data. If unauthorised modifications occur to the program or the data files
that the program uses, an irregularity might not be discovered, because traditional separation
of duties no longer applies to the data being prepared for comparison purposes.
Effects of Computers on Auditing
4.7 The objective of auditing, do not undergo a sea change in a CIS environment. Auditor
must provide a competent, independent opinion as to whether the financial statements records
and report a true and fair view of the state of affairs of an entity. However, computer systems
have affected how auditors need to collect and evaluate evidence. These aspects are
discussed below:
(1) Changes to Evidence Collection - Collecting evidence on the reliability of a computer
system is often more complex than collecting evidence on the reliability of a manual system.
Auditors have to face a diverse and complex range of internal control technology that did not
exist in manual system, like:
a) accurate and complete operations of a disk drive may require a set of hardware controls
not required in manual system,
b) system development control include procedures for testing programs that again are not
necessary in manual control.
Since, Hardware and Software develop quite rapidly, understanding the control technology is
not easy. With increasing use of data communication for data transfer, research is focussed
an cryptographic controls to project the privacy of data. Unless auditor's keep up with these
developments, it will become difficult to evaluate the reliability of communication network
competently.
The continuing and rapid development of control technology also makes it more difficult for
auditors to collect evidence on the reliability of controls. Even collection of audit evidence
through manual means is not possible. Hence, auditors have to run through computer system
themselves if they are to collect the necessary evidence. Though generalized audit softwares
are available the development of these tools cannot be relied upon due to lack of information.
Often auditors are forced to compromise in some way when performing the evidence collection
(2) Changes to Evidence Evaluation - With increasing complexity of computer systems and
control technology, it is becoming more and more difficult for the auditors to evaluate the
consequences of strength and weaknesses of control mechanism for placing overall reliability
on the system.
Auditors need to understand:
a) whether a control is functioning reliably or multi functioning,
b) traceability of control strength and weakness through the system. In a shared data
environment a single input transaction may update multiple data item used by diverse,
physically disparate user, which may be difficult to understand.
Consequences of errors in a computer system is a serious matter as errors in computer
system tend to be deterministic, i.e., an erroneous program will always execute data
incorrectly. Moreover, the errors are generated at high speed and the cost and effort to correct
and rerun program may be high. Errors in computer program can involve extensive redesign
and reprogramming. Thus, internal controls that ensure high quality computer systems should
be designed implemented and operated upon. The auditors must ensure that these control are
sufficient to maintain assets safeguarding, data integrity, system effectiveness and system
efficiency and that they are in position and functioning.
Internal Controls in a CIS Environment
4.8 Internal control is an essential prerequisite for efficient and effective management of any
organisation. Basically, they are the policies and procedure adopted by a management to
achieve the entity's specific objectives like, physical verification of assets, periodic review and
reconciliation of accounts, specific control on computer generated data etc.
An internal control is a CIS system depends on the same principal as that of manual system.
Thus, the plan of organisation, delegation of powers, system authorisation, distribution of
duties etc., are determined on similar consideration as in a manual system. However, in a CIS
environment, due to difference in approach there is various other types of controls which are
quite specific to CIS environment.
In setting up an internal control system in a CIS environment, the overall CIS operation need
to be broken down into defined subsystem and controls established accordingly, addressing
each function separately so that auditors can place reliance on them. The basic components
that can be identified in a CIS environment are:
♦ Hardware (CPU, Monitor, Printers etc.)
♦ Software (Operating system, application programs, Data base management system etc.)
♦ People (Data entry operator, CIS organisation, end users)
♦ Transmission media
Once components have been identified, auditors must evaluate their reliability with respect to
each type of error or irregularity that might occur.
The reliability of a component is a function of the controls that act on the component. A control
is stated to be a set of activities designed to prevent, detect or correct errors or irregularities
that affect the reliability of the components. The set of all control activities performed in a
system constitutes the control subsystem within a system. Its function is to establish execute
modify and maintain control activities so that the reliability of the system in maintained at an
acceptable level. In a computer system many different types of controls are used to enhance
component reliability. Major classes of control that the auditor must evaluate are:
(1) Authenticity Controls - Authenticity control are exercised to verify the identify of the
individuals or process involved in a system (e.g. password control, personal identification
numbers, digital signatures)
(2) Accuracy Control - Accuracy control ensure the correctness of data and processes in a
system (e.g. program validation cheek that a numeric field contains only numeric, overflow
checks, control totals, hash total etc.)
(3) Completeness Control - Completeness control attempt to ensure that no data is missing
and that all processing is carried through to its proper conclusion. (e.g. program validation
check, sequence check etc.)
(4) Redundancy Control - Redundancy controls attempts to ensure that a data is processed
only once. (e.g. batch cancellation stamp, circulating error files etc.)
(5) Privacy Controls - Privacy controls ensure that data is protected from inadvertent or
unauthorised disclosure. (e.g. cryptograph, data compaction, inference control etc.)
(6) Audit Trail Controls - Audit trail control ensure traceability of all events occurred in a
system. This record is needed to answer queries, fulfil statutory requirements, minimise
irregularities, detect the consequences of error etc. The accounting audit trail shows the
source and nature of data and process that update the database. The operations audit trail
maintains a record of attempted or actual resource consumption within a system.
(7) Existence Controls - Existence controls attempt to ensure the ongoing avail ability of all
system resources (e.g., database dump and logs for recovery purposes duplicate hardware,
preventive maintenance, check point and restart control)
(8) Asset Safeguarding Controls - Asset safeguarding control attempt to ensure that all
resources within a system are protected from destruction or corruption (e.g. physical barriers,
libraries etc.)
(9) Effectiveness Controls - Effectiveness control attempt to ensure that systems achieve
their goals. (e.g. monitoring of user satisfaction, post audits, periodic cost benefit analysis
etc.)
(10) Efficiency Controls - Efficiency controls attempt to ensure that a system uses minimum
resources to achieve its goals.
Consideration of Control Attributes by the Auditors

4.9 In evaluating the effects of a control, the auditor needs to assess the reliability by
considering the various attributes of a control. Some of the attributes are:
(1) whether the control is in place and is functioning as desired.
(2) generality versus specificity of the control with respect to the various types of errors and
irregularities that might occur.
General control inhibit the effect of a wide variety of errors and irregularities as they are
more robust to change controls in the application sub-system which tend to be specific
control because component in these sub-system execute activities having less variety.
(3) Whether the control acts to prevent, detect or correct errors.
The auditor focuses here on
i) Preventive controls: Controls which stop errors or irregularities from occurring.
ii) Detective controls: Controls which identify errors and irregularities after they occur.
iii) Corrective controls: Controls which remove the effects of errors and irregularities
after they have been identified.
Auditors expect to see a higher density of preventive controls at the early stages of
processing or conversely they expect to see more detective and corrective controls later
in system processing.
(4) the number of components used to execute the control.
Multi-component controls are more complex and more error prone but they are usually
used to handle complex errors and irregularities.
Internal Control Requirement Under CIS Environment
4.10 The requirement of internal control under CIS environment may cover the following
aspects:
(1) Organisation And Management Control - Controls are designed to establish an
organisational frame work for CIS activities including:
a) Policies and procedures relating to control functions.
b) Appropriate segregation of incompatible functions.
(2) Application System Development and Maintenance Control - Control are designed to
provide reasonable assurance that systems are developed and maintained in an authorised
and efficient manner, to establish control over:
a) testing, conversion, implementation and documentation of new revised system.
b) changes made to application system.
c) access to system documentation.
d) acquisition of application system from third parties.
(3) Computer Operation Controls - Designed to control the operation of the system and to
provide reasonable assurance that:
a) the systems are used for authorised purposes only.
b) access to computer operation is restricted to authorised personnel.
c) only authorised programs are to be used.
d) processing errors are detected and corrected.
(4) System Software Control - Controls are designed to provide reasonable assurance that
system software is acquired or developed in an authorised and efficient manner including:
a) authorisation, approval, testing, implementation and documentation of new system
software and system software modification.
b) restriction of access to system software and documentation to authorised personnel.
(5) Data Entry And Program Control - Designed to provide assurance:
a) an authorisation structure is established over transaction being entered into the system.
b) access to data and program is restricted to authorised personnel.
(6) Control Over Input - Control are designed to provide reasonable assurance that:
a) transactions are properly authorised before being processed by the computer.
b) transactions are accuratelyconverted into machine readable from and recorded in
the computer data files.
c) transaction are not lost, added, duplicated or improperly changed.
d) incorrect transactions are rejected, corrected and if necessary, resubmitted on a timely
basis.
(7) Control Over Processing and Computer Data Files - Controls are designed to provide
reasonable assurance that:
a) transactions including system generated transactions are properly processed by the
computer.
b) transaction are not lost, added duplicated or improperly changed.
c) processing errors are identified and corrected on a timely basis.
(8) Control Over Output - Designed to provide reasonable assurance that
a) results of processing are accurate.
b) access to output is restricted to authorised personnel.
c) output is provided to appropriate authorised personnel on a timely basis.
(9) Other Safeguards - Other safeguards include:
a) Offsite back-up of data and program.
b) Recovery procedures for use in the event of theft, loss or intentional or accidental
destruction.
c) Provision of offsite processing in the event of disaster.
Approach to Auditing in a CIS Environment
4.11 The institute of Chartered Accountants of India has come out with Auditing Assurance
Standard 29 - Auditing in a computer Information System Environment, which emphasis that
the overall objective and scope of an audit do not change in a CIS environment. However, the
use a computer changes the processing, storage, retrieval and communication of financial
information and may affect the accounting and internal control systems employed by the
entity.
The standard requires the auditor to consider the effect of the factor like, (a) the extent of use
of computers for preparing accounting information( c) efficacy of internal control over input,
processing, analysis and reporting undertaken in the CIS installation and ( c) the impact of
computerisation on the audit trail that could otherwise be expected to exist in a manual
system.
The standard provides for the following:
(1) Skill and Competence - The standard provides that an auditor should have sufficient
knowledge of the computer information systems to plan, direct, supervise control and review
the work performed. The sufficiency of knowledge would depend on the nature and extent of
the CIS environment. The auditor should consider whether any specialized CIS skills are
needed in the conduct of the audit. If the answer is in affirmative the auditor would seek the
assistance of an expert possessing such skills.
(2) Planning - In regard to planning, the standard specifies that, the auditor should obtain an
understanding of the significance and complexity of the CIS activities and the availability of the
data for use in the audit.
The auditor should also obtain an understanding of the accounting and internal control system
in terms of AAS - 6 ( Revised ) to plan the audit and to determine the nature, timing and the
extent of the audit procedures.
Auditors understanding the process would include -
a) The computer information systems infrastructure ( hardware, operating system (s) and
application software used by the entity, including changes therein since last audit, if any )
b) The significance and complexity of computerized processing in each significant
accounting application, Significance relates to materiality of the financial statement
assertions affected by the computerized processing.
c) Determination of the organizational structure of the client; CIS activities and the extent of
concentration or distribution of computer processing throughout the entity, particularly, as
they may affect segregation of duties.
d) The auditor needs to determine extent of availability of data by reference to source
documents, computer files and other evidential matters. Computer information systems
may generate reports that might be useful in performing substantive tests (particularly
analytical procedures). The potential for use of CAATS may permit increased efficiency in
the performance of audit procedures, or may enable the auditor to economically apply
certain procedures to the entire population of transactions.
(3) Risk - When the computer information systems are significant the auditor should assess
whether it may influence the assessment of inherent and control risks.
The nature of the risks and the ICS in CIS environment include the following:
(a) Lack of Transaction Trails - Some computer information systems are designed so that a
complete transaction trail that is useful for audit purposes might exist for only a short period of
time or only in computer readable form. Where a complex application system performs a large
number of processing steps, there may not be a complete trail. Accordingly errors embedded
in an application’s program logic may be difficult to detect on a timely basis by manual
procedures.
(b) Uniform processing of Transactions - Computer programs processing transactions
uniformly, virtually eliminating the occurrence of clerical errors. However, if programming error
exists all transactions will be processed incorrectly.
(c) Lack of Segregation of functions - Many controls become concentrated in a CIS
environment allowing data processing of incompatible functions.
(d) Potential for errors and Irregularities - The potential for human error in the
development, maintenance and execution of computer information systems may be greater
than in manual systems, because of the level of detail inherent in these activities. Also, the
potential for individuals to gain unauthorized access to data or to alter data without visible
evidence may be greater in CIS environment than in manual systems.
(e) Initiation or Execution of Transactions - In a CIS process certain types of transactions
are triggered internally by the system, the authorization for which may not be documented as
in manual system. In such cases, management; authorization of these transactions may be
implicit.
(f) Dependence of Other Controls over Computer Processing - Certain manual control
procedures are dependent on computer generated reports and outputs for their effectiveness.
In term, the effectiveness and consistency of transaction processing controls are dependent
on the effectiveness of general computer information systems controls.
(g) Increased management Supervision - Computer information can offer management a
variety of analytical tools that can enhance the effectiveness of the entire internal control
structure.
(h) Use of Computer - Assisted Audit Techniques - The Auditor may apply general or
specialized computer audit techniques and tools in the execution of audit tests.
While evaluating the reliability of the accounting and internal control systems, the auditor
would consider whether these systems:
(i) Ensure that authorized, correct and complete data is made available for processing;
(ii) Provide for timely detection and correction of errors.

(iii) Ensure that the case of interruption in the work of the CIS environment due to power,
mechanical or processing failures, the system restarts without distorting the complection
of the entries and records;
(iv) Ensure that accuracy and completeness of output;
(v) Provide adequate data security against fire and other calamities, wrong processing,
frauds etc.,
(vi) Prevent unauthorized amendments to the program;
(vii) Provide for safe custody of source code of application software and data files.
(4) Risk Assessment - The auditor in accordance with AAS-6 " Risk Assessment and Internal
Controls ”, should make an assessment of inherent and control risk for material financial
statement assertions.
Risk may result from deficiencies in,
(a) Program development and maintenance,
(b) System software support;
(c) Operations
(d) Physical CIS security;
(e) Control over access to specialized utility programs;
These deficiencies would tend to have a negative impact on all application systems that are
processed through the computer.
Risk may also increase the potential for errors or fraudulent activities in;
(a) Specific applications.
(b) Specific data base or master files, or
(c) Specific processing activities.
As new CIS technologies are emerging for data processing and Clients are adopting the same
for building complex computer systems, these may increase risk which needs further
consideration
(5) Documentation - The Auditor should document the audit plan, the nature, timing and
extent of audit procedures performed and the conclusions drawn from the evidence obtained.
In an audit in CIS environment, some of the audit evidence may be in electronic form. The
auditor should satisfy himself that such evidence is adequately and safely stored and is
retrievable in its entirety as and when required.
Review of Checks and Controls in a CIS Environment
4.12 General controls in a CIS environment falls under the three basic control approaches as
seen under manual system, i.e. Feedback, feed-forward and preventive control. Apart from the
three - fold categorization computer based information system also required different controls,
though the emphasis is on preventive controls, Controls are present over many aspects of the
computer system and its surrounding social environment. They operate over data moving into,
through and out of the computer to ensure correct, complete and reliable processing and
storage. There are other controls present over staff, staff involvement with the computer and
access to data. Further controls are effective at preventing deterioration or collapse of the
entire computing function.
Erroneous data processing by a computer system is likely to be the result of incorrect data
input. This is the major point at which the human interfaces with the machine and it is here
where important controls are placed.
4.12.1 Review Process -
(1) Organization Structure / Control - CIS function in an organization need to be so
organized that different groups are formed to perform different duties in a large CIS
installation. Some of the typical function that must be performed by select group includes:
(a) Data Administrator - Generates the data requirements of the users of information system
services: formulates data policies, plans the evaluation of the Corporate data bases, maintains
data documentation.
(b) Database Administrator - Responsible for the operational efficiency of corporate
database, assist users to use database better.
(c) System Analyst - Manages information requirement for new and existing applications,
designs information systems architectures to meet these requirements, facilitates
implementation of information systems, writes procedures and users documentation.
(d) System Programmers - Maintains and enhances operating systems software, network
software, library software, and utility software, provides when unusual systems failure occurs.
(e) Application Programmer - Designs programs to meet information requirements, codes,
tests and debugs programs documents programs, modify program to remove errors, improve
efficiency.
(f) Operation Specialist - Plans and control day-to-day operations, monitors and improves
operational efficiency along with capacity planning.
(g) Librarian - Maintains library of magnetic media and documentation.
Auditors should be concerned about two matters:
i) Responsibilities of each job position must be clear; and incumbents must fully understand
their duties, authority and responsibilities.
ii) The jobs performed within the information system function should maintain separation of
duties to the extent possible. Without separation of duties, errors and irregularities might
remain undetected.
(2) Documentation Control - Systems and programs as well as modifications, must be
adequately documented and properly approved before being used: Documentation ordinarily
assumes the following form:
a) A system flowchart;
b) A program flowchart;
c) Program change;
d) Operator instructions;
e) Program description (explaining the purpose for each part of the program)
Adequate documentation evidencing approval of changes minimises the probability of
unauthorized system and program changes that could result in loss of control and decreased
reliability of financial data.
(3) Access Control - Access controls are usually aimed at for preventing unauthorized
access. The controls may seek to prevent persons who are authorised for access from
accessing restricted data and program, as well as preventing unauthorized persons from
gaining access to the system as a whole.
(a) Segregation Controls
♦ Access to program documentation should be limited to those persons who require it in
the performance of their duties.
♦ Access to data files and programs should be limited to those individuals authorized to
process data.
♦ Access to computer hardware should be limited to authorized individuals ( e.g. Computer
operators).
(b) Limited Physical Access to the computer Facility
♦ The physical facilities that hold the computer equipment, files and documentation should
have controls to limit access only to authorized individuals.
♦ Types of controls may include, (a) using a guard, (b) automated key cards, (c ) manual
key locks, (d) new access devices like, fingerprints, palm prints, or other biometric
devices.
(c) Visitor entry Logs - Entry logs should be uses to determine and documents those who
have had access to the area.
(d)Hardware and Software access controls - Access control software like ‘user
identification’ may be used. User identification is a frequently used control and is a
combination of a unique identification code and a confidential password.
(e) Call back - It is a specialized form of user identification in which the user dials the system,
identifies him and is disconnected from the system. Then, either an individual manually finds
the authorized telephone number or the system automatically finds the authorized telephone
number of the individual and finally the user is called back.
(f) Encryption - In encryption data is encoded when stored in computer files / and or
before transmission to or from remote locations. This coding protects data because to use the
data unauthorized users must not only obtain access, but must also decrypt the data i.e.,
decode it from encoded form.

(g) Computer Application Controls - Programmed application controls apply to specific
application rather than multiple applications.
These controls operate to assure the proper input and processing of data. The input steps
converts human readable data into computer readable form. All CIS application are classified
under 3 heads: Input, Processing and output.
(4) Input Controls - Input into the CIS system should be properly authorized and approved.
The system should verify all significant data fields used to record information i.e., Should
perform editing of the data. Conversion of data into machine readable form should be
controlled and verified for accuracy.
For validation of input controls, the following procedure can be applied:
(a) Pre-printed form - All constant information be printed on a source document. For
example, if only limited number of responses to a question is considered appropriate then
preprint the responses and have the user tick or circle the correct responses deleting those
that are inappropriate.
(b) Check Digit - Errors made in transcribing and keying data can have serious
consequences. One control used to guard against these types of errors is a ‘Check Digit’.
A Check Digit is a redundant digit (s) added to a code that enables the accuracy of other
characters in the code to be checked. The check digit can act as a prefix or suffix character or
it can be placed somewhere in the middle of the code. When the code is entered, a program
recalculates the check digit to determine whether the entered check digit and the calculated
check digit are the same. If they are the same, the code is most likely to be correct.
Calculation Of Check Digit
A simple way is to add the digits in a number and assign the result as a suffix.
Example: The number is 2148 the check digit is
2+1+4+8=15 i.e., 5 (dropping tens digit ). The code is 21485
However, this does not protect transposition error, like 2814. The incorrect code will still
produce the correct check digit.
This problem can be overcome by Module -11 test ; The Calculation steps are as under:
- The desired number = 2148.
- Make weighed average = 2x5 + 1x4 + 4x3 + 8x2 =42
- Divide by Modules 11 = 42/11 -3 with remainder 9
- Subtract the remainder from the modules = 11-9 =2 (check digit)
- Check digit is added as a suffix = 21482.
The check digit can be recalculated for verification as under:
- The encoded number = 21482
- Weighted average = (2x1)+(8x2)+(4x3)+(1x4)+(2x5) = 44.

- Division by the modules = 44/11 = 4 with no remainder.
If the remainder is zero, there is a high probability that the code is correct.
(c) Completeness Totals - To input data erroneously is one type error. To leave out or lose
data completely is another type of error against which controls are provided.
(i) Batch Control Totals - The transactions are collected together in batches of say, 50
transactions. A total of all the data value of some important field is made. For example, if a
batch of invoices is to be inputed a total of all the invoices amounts might be calculated
manually. The control total is then compared with a computer generated control total, after
input of batch transaction. A difference indicates either a lost transaction or the input of an
incorrect invoice total. The method is not foot proof as compensating errors is possible.
(ii) Batch Hash Total - The idea is similar to control totals except that Hash totals are
meaningless totals prepared purely for control purposes. The total of all customer account
numbers in a batch is meaningless but may be used for control by comparing it with computer
generated hash totals.
(iii) Batch Record Totals - Account is taken of the number of transactions and this is
compared with the record count produced by the computer at the end of the batch.
(iv) Sequence Checks - Documents may be pre-numbered sequentially before entry and at
a later stage the computer will perform a sequence check and display any missing number.
(d) Reasonableness Checks - These are sophisticated forms of limit checks. An example
might be a check on an electricity meter reading. The check might consists of subtracting the
last reading recorded from the current reading and comparing this with the average usage for
that quarter. If the reading differs by a given percentage then it is investigated before
processing.
(e) Field Checks - The following types of field checks may be applied:
(i) Missing data / blank - Is there any missing data in the field? If a code should contain 2
hyphens, though they might be in a variable position, can only one be detected? Does the field
contain blanks when data always should be present.
(ii) Alphabetic / Numeric - Does a field that should contain only alphabetic or numeric
contain alphanumeric characters?
(iii) Range - Does the data for a field fall within its allowable value range?
(iv) Master Reference - If the master file can be referenced at the same time input data is
read, is there a master file match for the key field?
(v) Size - If variable - length fields are used and a set of permissible sizes is defined does the
field delimiter show the field to be one of these valid sizes?
(vi) Format Mask - Data entered into a field might have to conform to a particular format, like
‘yy mm dd’
(f) Record Checks - The following types of record checks can be applied:
(i) Reasonableness - Even though a field value might pass a range check, the contents of
another field might determine what is a reasonable value for the field.
(ii) Valid-Sign-Numeric - The content of one field might determine which sign is valid for a
numeric field.
(iii) Size - If Variable - length records are used, the size of the record is a function of the
sizes of the variable length fields or the sizes of fields that optionally might be omitted from the
record. The permissible size of the fixed and variable - length records also might depend on a
field indicating the record type.
(g) File Checks - In file checks, validation control examines whether the characteristics of a
file used during data entry are matching with the stated characteristics of the file. For example
if auditors validate some of the characteristic of data that is keyed into an application system
against a master file, they can check whether they are using the latest version of the master
file.
(5) Processing Controls - When input has been accepted by the computer, it usually is
processed through multiple steps. Processing controls are essential to ensure the integrity of
data. Almost all of the controls mentioned under input may also be incorporated during
processing stage.
Processing validation checks primarily ensure that computation performed on numeric fields
are authorized, accurate, and complete. The following validation checks may be indicated in
this regard.
(i) Overflow - Overflow can occur if a field used for computation is not initiated to zero at
start. Some error in computation occurs, or unexpected high values occur.
(ii) Range - An allowable value range can apply to a field.
(iii) Sign Test - The contents of one record type field might determine which sign is valid for
a numeric field.
(iv) Cross – Footing - Separate control totals can be developed for related fields and cross
footed at the end of a run.
(v) Run-to-Run Control - In a tape based system, the processing of transaction file may
involve several runs, for instance, a tape based order processing system might have a
transaction tape that is used to update first a stock master file, then a sales ledger followed by
a general ledger, various control totals may be passed from one run to the next as a check on
completeness of processing.
(6) Recording Control - Recording controls enable records to be kept free of errors and
transactions details that are input into the system.
(a) Error Log - This is particularly important in batch entry and batch processing system.
Many of the accuracy checks can only be carried to during run time processing. It is important
that a detected error does not bring the run to a halt, on discovery, the erroneous transaction
is written to a error log file, which is examined at the end of processing. The errors can then
be corrected or investigated with the relevant department before being input and processed.
(b) Transaction Log - The transaction log provides a record of all transactions entered into
the system as well as storing transaction details such as the transaction reference number,
the date, the account number, the type of transaction the amount and the debit and credit
references. The transaction will be "Stamped” with details of input. These typically include
input time, input date, input day, terminal number and user number. It is used for multi-access
main frame systems accounting transactions. The transaction log can form the basis of an
audit trail and may be printed out for investigation during an audit.
(7) Storage Control - These controls ensure the accurate and continuing and reliable storage
of data. Data is a vital resource for an organization and is the heart of CIS activities. Special
care must be taken to ensure the integrity of the database or file system. The controls are
particularly accidental erasure of files and the precision of back-up and recovery facilities.
The following checks may be considered:
(a) Physical Protection Against Erasure - Magnetic tape files have rings that may be
inserted if the files are to be written or erased. Read only files have the ring removed. The
controls in respect of floppy disks have a plastic lever, which is switched for read only
purposes.
(b) External Label - These are attached to tape reels or disk packs to identify the contents.
(c) Magnetic Labels - These consists of magnetic machine readable information encoded on
the storage medium identifying its contents. File header labels appear at the start of a file and
identify the file by name, give the date of last update and other information. This is checked by
a software prior to file up dating. Trailer labels at the end of files often contain controls that are
checked against those calculated during file processing.
(d) File Back - up Routines - Copies are held of important files for security purposes. As
the process of providing back-up often involves a computer operation in which one file is used
to produce another, a fault in this process would have disastrous results; if both the master
and the back-up were lost.
(e) Database Back - up routines - The contents of a data base held on a direct access
storage device (DASD) such as magnetic disk are periodically dumped on to a back-up file.
The back-up is usually a tape which is then stored together with the transaction log tape of all
transactions occurring between the last and the current dump. If a fault in database, such as
disk crash, happens afterwards the state of the data base can be recreated using the dumped
data base tape, the stored transaction and the current log of transactions occurring between
the dump and the crash point.
(f) Cryptographic Storage - Data is commonly written to files in a way that uses standard
coding like ASCII or EBCDIC. It can be interpreted easily by unauthorized reader gaining
access to the file. If the data is confidential or sensitive then it may be scrambled prior to
storage and described on reading.
The security process involves the conversion of the plain text message or data into cipher text
by the use of an encryption algorithm and an encryption key. The opposite process, uses a
description key to reproduce the plain text or message. If the encryption and decryption key
are identical the entire procedure is called Symmetric Cryptograph, otherwise, it is known as
asymmetric cryptograph.
(8) Output Control - Output control ensures that the results of data processing are accurate,
complete and are directed to authorize recipient. The auditor should examine whether audit
trail relating to output was provided and the date and time when the output was so provided.
This would enable the auditor to identify the consequences of any errors discovered in the
output.
Auditors Involvement In The Clients System Development And Documentation Control
4.13 Auditors both external and internal, may be consulted while designing appropriate
controls over the development of computerized system within an enterprise. Such association
may help the auditors in suggesting appropriate trails in post implementation audit.
The major functions may be elaborated as under:
Analysis of the system involves identification understanding and critically examining the
system and its inter-related parts (sub-system). For the purpose of achieving the goals
(objectives) set for the CIS as a whole, through modification, changed inter-relationship of
components, deleting or merging or separating or break-up of component. They may also
involve upgrading the system as a whole.
The Methodology involves:
(A) Identification of the system (setting system boundary ), the system objectives, the system
components, and
(B) Understanding the role and inter-relationships of elements with other elements of the
same system.
Through this identification and understanding process the capability (or background) to
analyze and compare various alternatives regarding components and system functioning is
generated.
In order to develop a Computerized Information System it is necessary to pass through a
number of distinct stages. These stages (as shown in the schematic) are completed in
sequence. The process cannot progress from one stage to the next until it has completed all
the required work of the stage. In order to ensure that a stage is satisfactorily and some
deliverable is produced at the stage end, generally, this is a piece of documentary evidence
on the work carried out. This is known as the ‘exit criteria for the stage’.
System Development Life Cycle Stage
A. Stages and Objectives → Deliverable output
B. Systems Investigation and Feasibility Report →Feasibility Report.
C. System Analysis →Logical Model Of The System
D. System Design → The Intended System Design In Broad Outline.
E. Detailed Design →A Detailed Physical Specification Of The System
F. Implementation →The New System With Documentation Procedure

G. Changeover →The New System With Documentation Procedure
H. Evaluation and Maintenance →Evaluation Report.
It is common for some of the tasks carried out during a stage of the process to be initially
unsatisfactory.
This should come to light when the exit criteria are considered. The relevant tasks will need to
be redone before exit from the stage can be made. Although slooping within a stage is quite
common but once a stage has been left it should not be necessary to return to it from a later
stage.
The benefits of this staged approach are:
(1) Sub-division of a complex, lengthy project into discrete chunks of time, makes the project
more manageable and thereby promotes better project control.
(2) Although different parts of a project may develop independently during a stage, the parts
of the project reaches the same point of development at the end of the stage. This
promotes coordination between the various components of large projects.
(3) The deliverables being documentation provide a historical trace of the development of
the project. At the end of each stage the output documentation provides an initial input
into the subsequent stage.
(4) The document deliverables are designed to be communication tools between analyst,
programmers, users and management. This promote easy assessment of the nature of
the work completed during the stage.
(5) The stages are designed to the ‘natural’ division points in the development of the project.
(6) The stage allows a creeping commitment to expenditure during the project.
Project Stages
(A) Determination of Scope and Objective - Before an analyst can attempt to undertake a
reasonable systems investigation, analysis and design, there must be some indication given of
the agreed overall scope of the project. The documentation provided on this acts as the
analysts initial terms of reference.
(B) System Investigation and Feasibility Study - The output of this stage is a report on the
feasibility of a technical solution to the problems or opportunities mentioned in the statement
of scope and objectives in stage A. The solution will be present in broad outlines.
(C) System Analysis - Provided that the project has been given the ago ahead as a result of
the feasibility study, the next task for the analyst is to build a logical model of the existing
system. This will be partly based on information gathered from the existing system during the
stage of system investigation and partly on new information.
The purpose of this stage is to involve a decomposition of the functions of the system into
their logical constituents and the production of a logical model of the process and data flows
necessary to perform these through data flow diagram.

(D) System Design - Once the analysis is complete the analyst has a good idea of what is
logically required of the new system. There will be a number of ways that this logical model
can be incorporated into a physical design. The analyst will suggest two or three design
alternatives to management together with their implication.
Management will then decide amongst them.
(E) Detailed Design - Detailed physical specifications need to be made so that the system
can be purchased / build and installed. There are a number of distinct areas that must be
considered. These areas can be summarized as:
A) Software, D) Schedule for Implementation.
B) Hardware E) Security
C) Data Storage F) User Machine Interface
The Systems Specifications is a highly detailed set of documents covering every aspect of the
system.
(F) Implementation - During implementations the system as specified is physically created.
The hardware is purchased and installed. The programs are written and tested individually.
The database or file structure is created and historic data from the old system is loaded.
Particular attention will be paid to security features surrounding the conversion of existing
files, whether manual or computer based on the new system.
(G) Changeover - Changeover is that time during which the old system is replaced by the
newly designed computer system. This period may be short if, at the time the new system
starts, running the old system is discarded. Alternative method of changeover exists. The old
system can be run in parallel with the new.
(H) Evaluation and Maintenance - At this time, the system is running and in continual
system use. It should be delivering the benefit for which it was designed and installed. Any
initial problem in running will be rectified. Throughout the remainder of the useful life of the
system it will have to be maintained if it is to provide a proper service.
The maintenance will involve hardware and software. It is normal to transfer the maintenance
of the hardware to the manufacturer of the equipment or some specialist third party
organization. The software need to be maintained as well. This will involve corrective actions
for errors in program that become apparent after an extended period of use. Programs may
also be altered to enable the machines to run with greater technical efficiency.
It is customary, to produce an evaluation report on the system after it has been functioning for
some time. This will be drawn up after the system has settled into its normal daily functioning.
The report will compare the actual system with the objectives required to be designed.
Shortcomings, if any, are identified and corrective actions are taken.
Computer Assisted Audit Techniques (CAATs)

4.14 The overall objectives and scope of an audit do not change when an audit is conducted in
a Computer Information Systems (CIS) environment. The application of auditing procedures
may, however, require the auditor to consider techniques known as Computer Assisted Audit
Techniques (CAATs) that use the computer as an audit tool for enhancing the effectiveness
and efficiency of audit procedures. CAATs are computer programs and data that the auditor
uses as part of the audit procedures to process data of audit significance, contained in an
entity’s information systems.
Uses of CAATs - CAATs may be used in performing various auditing procedures, including
the following:
♦ tests of details of transactions and balances, for example, the use of audit software for
recalculating interest or the extraction of invoices over a certain value from computer
records;
♦ analytical procedures, for example, identifying inconsistencies or significant fluctuations;
♦ tests of general controls, for example, testing the set-up or configuration of the operating
system or access procedures to the program libraries or by using code comparison
software to check that the version of the program in use is the version approved by
management ;
♦ sampling programs to extract data for audit testing;
♦ tests of application controls, for example, testing the functioning of a programmed
control; and
♦ reperforming calculations performed by the entity’s accounting systems.
Audit Software - CAATs allow the auditor to give access to data without dependence on the
client, test the reliability of client software, and perform audit tests more efficiently. caats may
consist of package programs, purpose-written programs, utility programs or system
management program. a brief description of the programs commonly used is given below.
♦ Package Programs are generalized computer programs designed to perform data
processing functions, such as reading data, selecting and analyzing information,
performing calculations, creating data files and reporting in a format specified by the
auditor.
♦ Purpose-Written Programs perform audit tasks in specific circumstances. These
programs may be developed by the auditor, the entity being audited or an outside
programmer hired by the auditor. In some cases, the auditor may use an entity’s existing
programs in their original or modified state because it may be more efficient than
developing independent programs.
♦ Utility Programs are used by an entity to perform common data processing functions,
such as sorting, creating and printing files. These programs are generally not designed
for audit purposes, and therefore may not contain features such as automatic record
counts or control totals.
♦ System Management Programs are enhanced productivity tools that are typically part of
a sophisticated operating systems environment, for example, data retrieval software or
code comparison software. As with utility programs these tools are not specifically
designed for auditing use and their use requires additional care.
Considerations in the Use of Caats - When planning an audit, the auditor may consider an
appropriate combination of manual and computer assisted audit techniques. in determining
whether to use caats, the factors to consider include:
♦ the IT knowledge, expertise and experience of the audit team;
♦ the availability of CAATs and suitable computer facilities and data;
♦ the impracticability of manual tests;
♦ effectiveness and efficiency; and
♦ time constraints.
Before using caats the auditor considers the controls incorporated in the design of the entity’s
computer systems to which caat would be applied in order to determine whether, and if so,
how, caats should be used.
It Knowledge, Expertise And Experience Of The Audit Team : Auditing and Assurance
Standard (AAS) 29, “auditing in a computer information systems environment” deals with the
level of skill and competence the audit team needs to conduct an audit in a cis environment. it
provides guidance when an auditor delegates work to assistants with cis skills or when the
auditor uses work performed by other auditors or experts with such skills. specifically, the
audit team should have sufficient knowledge to plan, execute and use the results of the
particular caat adopted. the level of knowledge required depends on “availability of caats” and
“suitable computer facilities”.
Availability of CAATS and Suitable Computer Facilities - The auditor considers the
availability of caats, suitable computer facilities and the necessary computer-based
information systems and data. The auditor may plan to use other computer facilities when the
use of caats on an entity’s computer is uneconomical or impractical, for example, because of
an incompatibility between the auditor’s package program and entity’s computer. Additionally,
the auditor may elect to use their own facilities, such as pcs or laptops. The cooperation of the
entity’s personnel may be required to provide processing facilities at a convenient time, to
assist with activities such as loading and running of CAAT on the entity’s system, and to
provide copies of data files in the format required by the auditor.
♦ Impracticability of Manual Tests - Some audit procedures may not be possible to
perform manually because they rely on complex processing (for example, advanced
statistical analysis) or involve amounts of data that would overwhelm any manual
procedure. In addition, many computer information systems perform tasks for which no
hard copy evidence is available and, therefore, it may be impracticable for the auditor to
perform tests manually. The lack of hard copy evidence may occur at different stages in
the business cycle.
Effectiveness and Efficiency - The effectiveness and efficiency of auditing procedures may
be improved by using CAATs to obtain and evaluate audit evidence. CAATs are often an
efficient means of testing a large number of transactions or controls over large populations by:
♦ analyzing and selecting samples from a large volume of transactions;
♦ applying analytical procedures; and
♦ performing substantive procedures.
Matters relating to efficiency that an auditor might consider include:
♦ the time taken to plan, design, execute and evaluate CAAT;
♦ technical review and assistance hours;
♦ designing and printing of forms (for example, confirmations); and
♦ availability of computer resources
In evaluating the effectiveness and efficiency of CAAT, the auditor considers the continuing
use of CAAT application. The initial planning, design and development of CAAT will usually
benefit audits in subsequent periods.
Time Constraints
Certain data, such as transaction details, are often kept for a short time and may not be
available in machine-readable form by the time auditor wants them. Thus, the auditor will need
to make arrangements for the retention of data required, or may need to alter the timing of the
work that requires such data.
Where the time available to perform an audit is limited, the auditor may plan to use CAAT
because its use will meet the auditor’s time requirement better than other possible procedures.
Using CAATs -The major steps to be undertaken by the auditor in the application of CAAT are
to:
(a) set the objective of CAAT application;
(b) determine the content and accessibility of the entity’s files;
(c) identify the specific files or databases to be examined;
(d) understand the relationship between the data tables where a database is to be
examined;
(e) define the specific tests or procedures and related transactions and balances affected;
(f) define the output requirements;
(g) arrange with the user and IT departments, if appropriate, for copies of the relevant files
or database tables to be made at the appropriate cut off date and time;
(h) identify the personnel who may participate in the design and application of CAAT;
(i) refine the estimates of costs and benefits;
(j) ensure that the use of CAAT is properly controlled;
(k) arrange the administrative activities, including the necessary skills and computer
facilities;
(l) reconcile data to be used for CAAT with the accounting and other records;
(m) execute CAAT application;
(n) evaluate the results;
(o) document CAATs to be used including objectives, high level flowcharts and run
instructions; and
(p) assess the effect of changes to the programs/system on the use of CAAT.
Testing CAAT - The auditor should obtain reasonable assurance of the integrity, reliability,
usefulness, and security of CAAT through appropriate planning, design, testing, processing
and review of documentation. This should be done before reliance is placed upon CAAT. The
nature, timing and extent of testing is dependent on the commercial availability and stability of
CAAT.
Controlling CAAT Application - The specific procedures necessary to control the use of
CAAT depend on the particular application. In establishing control, the auditor considers the
need to:
(a) approve specifications and conduct a review of the work to be performed by CAAT;
(b) review the entity’s general controls that may contribute to the integrity of CAAT, for
example, controls over program changes and access to computer files. When such
controls cannot be relied on to ensure the integrity of CAAT, the auditor may consider
processing CAAT application at another suitable computer facility; and
(c) ensure appropriate integration of the output by the auditor into the audit process.
Procedures carried out by the auditor to control CAATs applications may include:
(a) participating in the design and testing of CAAT;
(b) checking, if applicable, the coding of the program to ensure that it conforms with the
detailed program specifications;
(c) asking the entity’s staff to review the operating system instructions to ensure that the
software will run in the entity’s computer installation;
(d) running the audit software on small test files before running it on the main data files;
(e) checking whether the correct files were used, for example, by checking external
evidence, such as control totals maintained by the user, and that those files were
complete;
(f) obtaining evidence that the audit software functioned as planned, for example, by
reviewing output and control information; and
(g) establishing appropriate security measures to safeguard the integrity and confidentiality
of the data.
When the auditor intends to perform audit procedures concurrently with online processing, the
auditor reviews those procedures with appropriate client personnel and obtains approval
before conducting the tests to help avoid the inadvertent corruption of client records.
To ensure appropriate control procedures, the presence of the auditor is not necessarily
required at the computer facility during the running of CAAT. It may, however, provide
practical advantages, such as being able to control distribution of the output and ensuring the
timely correction of errors, for example, if the wrong input file were to be used.
Audit procedures to control test data applications may include:
♦ controlling the sequence of submissions of test data where it spans several processing
cycles;
♦ performing test runs containing small amounts of test data before submitting the main
audit test data;
♦ predicting the results of the test data and comparing it with the actual test data output, for
the individual transactions and in total;
♦ confirming that the current version of the programs was used to process the test data;
and
♦ testing whether the programs used to process the test data were the programs the entity
used throughout the applicable audit period.
When using CAAT, the auditor may require the cooperation of entity staff with extensive
knowledge of the computer installation. In such circumstances, the auditor considers whether
the staff improperly influenced the results of CAAT.
1. Define and give an example of general controls, application controls and user controls.
2. Differentiate between auditing around and through the computer.
3. Differentiate between batch processing and online real time processing.
4. What is an EDI system.
5. Why are systems and programs documentation important to effective internal control.
6. Explain the following checks and controls
Control total Check digit
Hash total Reasonableness check
Sequence check Transaction log
7. Why auditors might prefer to review general control before reviewing application
controls?
8. Why auditors prefer to apply a combination of techniques in directly testing computer
controls.
9. Identify the advantages and disadvantages of each of the following: Test data approach.
ITF approach.
10. Parallel simulation is though to be an automated version of auditing around the computer.
Explain why?
11. What is the impact of IT on the audit procedures.
12. Why the adequacy of controls in a sophisticated computerized environment more
important than in a computerized system that maintains hard copy evidence.
Annexure
I. Stand-Alone Personal Computers (Pcs)
Stand-Alone PCs
01. “PCs” are economical yet powerful self-contained general purpose computers consisting typically
of a processor, memory, video display unit, data storage unit, keyboard and connections for a
printer and communications. Programs and data are stored on removable or non-removable
storage media.
02. PC’s can be used to process accounting transactions and produce reports that are essential to
the preparation of financial statements. The PC may constitute the entire computer-based
information system or merely a part of it.
03. Generally, IT environments in which PCs are used are different from other IT environments.
Certain controls and securities, measures that are used for large computer systems may not be
practicable in PC. On the other hand, certain types of control procedures need to be emphasised
due to the characteristics of PC and the environments in which they are used.
PC Configurations
04. A PC can be used in various configurations. These include
(a) a stand-alone workstation operated by a single user or a number of users at different times;
(b) a workstation which is part of a local area network of PCs; and
(c) a workstation connected to a central computer.
05. The stand-alone workstation can be operated by single user or a number of users at different
times accessing the same or different programs. The programs and data are stored in the PC or
in close proximity and, generally, data are entered manually through the keyboard. The user of
the stand-alone workstation who process generally, data are entered manually through the
keyboard. The user of the stand-alone workstation who processes accounting applications may
be knowledgeable about programming and typically performs a number of functions, i.e., entering
data, operating application programs and, in some cases, writing the computer program
themselves. This programming may include the use of third-party software packages to develop
electronic spreadsheets or database applications.
06. A local area network is an arrangement where two or more PCs are linked together through the
use of special software and communication lines. Typically, one of the PCs will act as the file
server which manages the network. A local area network allows the sharing of resources such as
storage facilities and printers. Multiple users, for example, can have access to information, data
and programs stored in shared files. A local area network may be referred to as distributed
system.
07. PCs can be linked to central computers and used as part of such systems, for example, as an
intelligent on line workstation part of a distributed accounting system. Such an arrangement may
be reffered to as an on-line system. A PC can act as an intelligent terminal because of its logic,
transmission, storage and basic computing capabilities.
08. Since control considerations and the characteristics of the hardware and software are different
when a PC is linked to other computers, such environments are described in other Guidance
Statements. However, to the extent that a micro computer which is linked to another computer
can also be used as a stand-alone workstation, the information in this statement is relevant.
Characteristics of PCs
09. Although PCs provide the user with substantial computing capabilities, they are small enough to
be transportable, are relatively inexpensive and can be placed in operation quickly. Users with
basic computer skills can learn to operate a PC easily since many operating system software and
application programs are “user-friendly” and contain step-by-step instructions. Another
characteristic is that operating system software, which is generally supplied by the PC
manufacturer, is less comprehensive than that found in larger computer environments; e.g., it
may not contain as many control and security features, such as password controls.
10. Software for a wide range of PC applications can be purchased from third-party vendors to
perform, e.g., general ledger accounting, accounts receivable, production and inventory, control.
Such software packages are typically used without modification of the programs. Users can also
develop other applications with the use of generic software packages, such as electronic
spreadsheets or database, purchased from third-party vendors.
11. The operating system software, application programs and data can be stored and retrieved from
removable storage media, including diskettes, cartridges and removable hard disks. Such storage
media, owing to its small size and portability, is subject to accidental erasure, physical damage,
misplacement or theft, particularly by persons unfamiliar with such media or by unauthorised
users. Software, programs and data can also be stored on hard disks that are not removable.
Internal Control in PC Environments
12. Generally the IT environment in which PCs are used is less structured than a centrally-controlled
IT environment. In the former application programs can be developed relatively quickly by users
possessing only basic data processing skills. In such cases, the controls over the system
development process for example, adequate documentation and operations, for example, access
control procedures, which are essential to the effective control of a large computer environment,
may not be viewed by the developer, the user or management as being as important or cost-
effective in a PC environment. However, because the data are being processed on a computer,
users of such data may tend to place unwarranted reliance on the financial information stored or
generated by a PC. Since PCs are oriented to individual end-users, the degree of accuracy and
dependability of financial information produced will depend upon the internal controls prescribed
by management and adopted by the user. For example, when there are several users of a single
PC, without appropriate controls, programs and data stored on non-removable storage media by
one user may be susceptible to unauthorised access, use, alteration or theft by other users.
13. In a typical PC environment, the distinction between general IT controls and IT application
controls may not be easily ascertained.
Management Authorisation for Operating PCs
14. Management can contribute to the effective operation of stand-alone PCs by prescribing and
enforcing policies for their control and use. Management’s policy statement may include:
(a) management responsibilities;
(b) instructions on PC use;
(c) training requirements;

(d) authorisation for access to programs and data;
(e) policies to prevention authorised copying of programs and data
(f) security, back-up and storage requirements;
(g) application development and documentation standards;
(h) standards of report format and report distribution controls;
(i) personal usage policies;
(j) data integrity standards;
(k) responsibility, for programs, data and error correction; and
(l) Appropriate segregation of duties.
Physical Security – Equipment
15. Because of their physical characteristics, PCs are susceptible to theft, physical damage,
unauthorised access or misuse. This may result in the loss of information stored in the PC, for
example, financial data vital to the information system.
16. One method of physical security is to restrict access to PCs when not in use by using door locks
or other security protection during non-business hours. Additional physical security over PCs can
be established, for example, by:
(a) locking the PC in a protective cabinet or shell;
(b) using an alarm system that is activated any time the PC is disconnected or moved from its
location;
(c) fastening the PC to a table; or
(d) installing locking mechanism to control access to the on/off switch may not prevent PC theft,
but may be effective in controlling unauthorised use.
Physical Security – Removable and Non-Removable Media
17. Programs and data used on a PC can be stored on removable storage media or non-removable
storage media. Diskettes and cartridges can be removed physically from the PC, while hard disks
are normally sealed in the PC or in a stand-alone unit attached to the PC. When a PC is used by
many individuals, users may develop a casual attitude toward the storage of the application
diskettes or cartridges for which they are responsible. As a result, critical diskettes or cartridges
may be misplaced, altered without authorisation or destroyed.
18. Control over removable storage media can be established by placing responsibility for such media
under personnel whose responsibilities include duties of software Custodians or librarians.
Control can be further strengthened when a program and data file check-in and check-out system
is used and designated storage locations are locked. Such control procedures help ensure that
removable storage media are not lost, misplaced or given to unauthorised personnel. Physical
control over non-removable storage media is probably the best established with locking devices.
19. Depending on the nature of the program and data files, it is appropriate to keep current copies of
diskettes, cartridges and hard disks in a fire-proof container, either onsite, offsite or both. This
applies equally to operating system and utility software and backup copies of hard disks.
Program and Data Security
20. When PCs are accessible to many users, there is a risk that programs and data may be altered
without authorisation.
21. Because PC operating system software may not contain many control and security features, there
are several control procedure which can be built into the application programs to help ensure that
data are processed and read as authorised and that accidental destruction of data is prevented.
These techniques, which limit access to programs and data to authorised personnel, include:
(a) segregating data into files organised under separate file directories;
(b) using hidden files and secret file names;
(c) employing passwords; and
(d) using cryptography.
22 The use of a file directory allows the user to segregate information is removable and non-
removable storage media. For critical and sensitive information, this technique can be
supplemented by assigning secret file names and “hiding” the files.
23. When PCs are used by multiple users, an effective control procedure is the use of passwords,’
which determine the degree of access granted to a user. The password is assigned and
monitored by an employee who is independent of the specific system to which the password
applies. Password software can be developed by the entity, but in instances it will be purchased.
In either case, control procedures can be strengthened by installing software that has a low
likelihood of being thwarted by users.
24. Cryptography can provide an effective control for protecting confidential or sensitive programs
and information from unauthorised access and modification by users. It is general used when
sensitive data are transmitted over communication lines, but it can also be used on intimation
processed by a PC. Cryptography is the process of programs transforming programs information
into an unintelligible form. Incryption and dycryption of data require the use of special programs
and a code key known only to those users to whom the programs or information is restricted.
25. Directories and hidden files, user authentication software and cryptography can be used for PCs
that have both removable and non-removable storage media. For PCs that have removable
storage media, an effective means of program and data security is to remove diskettes and
cartridges from the PC and place them in custody of the users responsible for the data or the file
librarians.
26. An additional access control for confidential or sensitive information; stored on non-removable
storage media is to copy the information diskette or cartridge and delete the files on the non-
removable storage media. Control over the diskette or cartridge can then be established in the
same manner as over other sensitive or confidential data stored in diskettes or cartridges. The
user should be aware that many software programs include in “erase” or “delete” function, but that
such a function may not actually clear erased or deleted files from the hard disk. Such functions
may merely clear the file name from the hard disk directory. Programs and data are in fact
removed from the hard disk only when new data are written over the old files or when special
utility programs are used to clear the files.

Software and Data Integrity
27. PCs are oriented to end-users for development of application programs, entry and processing of
data and generation of reports. The degree of accuracy and dependability of financial information
produced will depend on the internal controls prescribed by management and adopted by users,
as well as on controls included in the application programs. Software and data integrity controls
may ensure that processed information is free of errors and that software is not susceptible to
unauthorised manipulation, i.e., that authorised data are processed in the prescribed manner.
28. Data integrity can be strengthened by incorporating control procedures such as format and range
checks and cross checks of results. A review of purchased software may determine whether it
contains appropriate error checking error trapping facilities. For user developed software,
including electronic spreadsheet templates and database applications, management may specify
in writing the procedures for developing and who processes the data may be expected to
demonstrate that appropriate data were used and that calculations and other data handling
operations were performed properly. The end-user could use this information to validate the
results of the application.
29. Adequate written documentation of applications that are processed on the PC can strengthen
software and data integrity controls further. Such documentation may include step-by-step
instruction, a description of reports prepared, source of data processed, a description of individual
reports, files and other specifications, such as calculations.
30. If the same accounting application is used at various locations, application software integrity and
consistency may be improved when application programs are developed and maintained at one
place rather than by each user dispersed throughout an entity.
Hardware, Software and Data Back-Up
31. Back-up refers to plans made by the entity to obtain access to comparable hardware, software
and data in the event of their failure, loss or destruction. In a PC environment, users are normally
responsible for processing, including identifying important programs and data files to be copied
periodically and stored at a location away from the micro-computers. It is particularly important to
establish back-up procedures for users to perform on a regular basis. Purchased software
packages from third-party vendors generally come with a back-up copy or with a provision to
make a back-up copy.
The Effect of PCs on the Internal Control Structure
32. The effect of PCs on the information system and the associated risks will generally depend on:
(a) the extent to which the PC is being used to process transactions;
(b) the type and significance of financial transactions being processed; and
(c) the nature of files and programs utilised in the applications.
33. The characteristics of PC systems, described earlier in the statement, illustrate some of the
considerations in designing cost effective control procedures for stand-alone PCs. A summary of
some of the key considerations and their effects on general IT application controls is described
below.
General IT Controls - Segregation of Duties

34. In a PC environment, it is common for users to be able to perform two or or more of the following
functions in the information system:
(a) initiating and authorising source documents;
(b) entering data into the system;
(c) operating the computer;
(d) changing programs and data files;
(f) using or distributing output; and
(g) modifying the operating systems
35. In other IT environments, such functions would normally be segregated through appropriate
general IT controls. This lack of segregation of functions in a PC environment may;
(a) allow errors to go undetected; and
(b) permit the perpetration and concealment of fraud.
IT Application Controls
36. The existence and use of a appropriate access controls over software, hardware and data files,
combined with controls over input, processing and output of data may, in coordination with
management policies, compensate for some of the weaknesses in general IT controls in PC
environments. Effective controls may include:
(a) a system of transaction logs and batch balancing;
(b) direct supervision; and
(c) reconciliation of record counts or cash totals.
37. Control may be established by an independent function which would normally :
(a) receive all data for processing;
(b) ensure that all data are authorised and recorded;
(c) follow up all errors detected during processing;
(d) verify the proper distribution of output; and
(e) restrict physical access to application programs and data files.
The Effect of a PC Environment on Audit Procedures

38. In a PC environment, it may not be practicable or cost effective for management to implement
sufficient controls to reduce the risks of undetected errors to a minimum level. Thus, the auditor
may often assume that control risk is high in such systems.
39. In this situation, the auditor may find it more cost-effective, after obtaining an understanding of
the control environment and flow of transactions, not to make a review of general IT controls or IT
application controls, but to concentrate the audit efforts on substantive tests at or near the end of
the year. This may entail more physical examination and confirmation of assets, more tests of
details, larger sample sizes and greater use of computer-assisted audit techniques, where
appropriate.
40. Computer-assisted audit techniques may include the use of client software’ (database, electronic
spreadsheet or utility software) which has been subjected to review by the auditor, or the use of
the auditor’s own software programs. Such software may be used by the auditor, for example, to
add transactions or balances in the data files for comparison with control records or ledger
account balances, to select accounts or transactions for detail testing or confirmation or to
examine databases for unusual items.
41. In certain circumstances, however, the auditor may decide to take a different approach. These
circumstances may include PC systems that process a large number of transactions when it
would be cost effective to perform audit work on the data at a preliminary date. For example, an
entity processing a large number of sales transactions on a stand-alone PC may establish control
procedures which reduce control risk; the auditor may decide, on the basis of a preliminary
review of controls, to develop an audit approach which includes testing of those controls on which
he intends to rely.
42. The following are examples of control procedures that an auditor may consider when assessing
control risk in relation to stand-alone PCs;
(a) Segregation of duties and balancing procedures:
(i) segregation of functions as listed in paragraph 36;
(ii) rotation of duties among employees;
(iii) reconciliation of system balances to general ledger control accounts; and
(iv) periodic review by management of the processing schedule and reports which identify
individuals that used the system.
(b) Access to the PC and its files:
(i) placement of the PC within sight of the individual responsible for controlling access
to it;
(ii) the use of key locks on the computer and terminals;

(iii) the use of passwords for access to the PCs programs and data files; and
(iv) restriction on the use of utility programs.
(c) Use of third-party software:
(i) review of application software prior to purchasing, including functions, capacity and
controls;
(ii) adequate testing of the software and the modifications to it prior to use; and
(iii) ongoing assessment of adequacy of the software to meet user requirements.

II Auditing Guidance Statement: On-Line Computer Systems

01. The purpose of this guidance (issued by the IASC) describe the effects of an on-line computer
system on the internal control structure and on audit procedures.
On-line Computer Systems:
02. Computer systems that enable users to access data and programs directly through terminal
devices are referred to as on-line computer systems. Such systems may be based on mainframe
computers, minicomputers or PCs structured in a network environment.
03. On-line systems allow users to initiate various functions directly. Such functions include:
(a) entering transactions, for example, sales transactions in a retail store, cash withdrawals in a
bank and shipment of goods in a plant;
(b) making, inquiries, for example, current customer account or balance information;
(c) requesting reports, for example, a list of inventory items with negative ‘on hand’ quantities;
and
(d) updating master files, for example, setting up new customer accounts and changing general
ledger codes.
04. Many different types of terminal devices may be used in on-line computer systems. The functions
performed by these terminal devices vary widely depending on their logic, transmission, storage
and basic computer capabilities. Types of terminal devices include:
(a) General Purpose Terminals, such as:
(i) basic keyboard and screen - used for entering data without any validation within the
terminal and for displaying from the computer system on the screen. For example, in
entering a sales order, the product code is validated by the main computer and the
result of the validation is displayed on the terminal screen;
(ii) intelligent terminal - used for the functions of the basic keyboard and screen with the
additional functions of validating data within the terminal, maintaining transaction logs
and performing other local processing. In the above sales order example, the correct
number of characters in the product code is verified by the intelligent terminal and
existence of the product code master file is verified by the main computer;
(iii) PC - used for all of the functions of an intelligent terminal with additional local
processing and storage capabilities. Continuing the above example, all verification of
the product code may be performed on the PC.
(b) Special Purpose Terminals, such as:
(i) point of sale devices-used to record sales transactions they occur and to transmit
them to the main computer on-line cash registers and optical scanners used in the
retail trade are typical point of sale devices :
(ii) automated teller machines - used to initiate, validate, record, transmit and complete
various banking transactions. Depending on the design of the system, certain of these
functions are performed by the automated teller machine and others are performed
on-line by the main computer.
05. Terminal devices may be located either locally or at remote sites. Local terminal devices are
connected directly to the computer through cables, whereas remote terminal devices require the
use of telecommunications to link them to the computer. Terminal devices may be used by many
users, for different purposes, in different locations, all at the same time. Users may be within the
entity or outside, such as customers or suppliers. In such cases application software and data are
kept on-line to meet the needs of the users. These systems also require other software, such as
access control software which monitors on-line terminal devices.
06. In addition to the users of these systems, programmers may use the online capabilities through
terminal devices to develop new programs and maintain existing programs. Computer supplier
personnel may also have on-line access to provide maintenance and support services.
Types of On-line Computer Systems
07. On-line computer systems may be classified according to how information is entered into the
system; how it is processed and when the results are available to the user. For purposes of this
statement, on-line computer systems functions are classified as follows:
(a) On-line/Real Time Processing.
(b) On-Line/Batch Processing.
(c) On-Line/Memo Update (and Subsequent Processing).
(d) On-Line/Enquiry.
(e) On-Line Downloading/Uploading Processing.
On-Line/Real Time Processing
08. In an on-line/real time processing system, individual transactions are entered at terminal devices,
validated and used to update related computer files immediately. An example is cash receipts
which are applied directly to customers’ accounts. The results of such processing are then
available immediately for inquiries or reports.
On-Line/Batch Processing
09. In a system with on-line input and batch processing, individual transactions are entered at a
terminal device, subjected to certain validation checks and added to a transaction file that
contains other transactions entered during the period. Later, during a subsequent processing
cycle the transaction file may be validated further and then used to update the relevant master
file. For example, journal entries may be entered and master file being updated on a monthly
basis. Inquiries of, or reports generated from, the master file will not include transactions entered
subsequent to the last master file update.
On-Line/Memo Update (and Subsequent Processing)
10. On-line input with memo update processing, also known as shadow, update, combines on-
line/real time processing and on-line/batch processing. Individual transactions immediately update a
memo file containing information which has been extracted from the most recent version of the master
file. Inquiries are made from this memo file. These same transactions are added to a transaction file
for subsequent validation and updating of the master file on a batch basis. For example, the withdrawal
of cash through an automated teller machine, where the withdrawal is checked against the customer’s
balance on the memo file, is immediately posted to the customer’s account on that file to reduce the
balance by the amount of the withdrawal. From the user’s perspective, this system will seem no
different than on-line/real time processing since the results of data that are entered are available
immediately, even though the transactions have not been subjected to complete validation prior to the
master file update.
On-Line/Inquiry
11. On-line inquiry restricts users at terminal devices to making inquiries of master files. In such
systems, the master files are updated by other systems, usually on a batch basis. For example,
the user may inquire of the credit status of a particular customer, prior to accepting an order from
that customer.
On-Line Downloading/Uploading Processing
12. On-line downloading refers to the transfer of data from a master file to an intelligent terminal
device for further processing by the user. For example, data at the head office representing
transactions of a branch may be downloaded to a terminal device at the branch for further
processing and preparation of branch financial reports. The results of this processing and other
locally processed data may be uploaded to the head office computer.
Characteristics of On-line Computer Systems
13. The characteristics of on-line computer systems may apply to a number of the types of on-line
systems discussed in the previous section. The most significant characteristics relate to on-line
data entry and validation, on-line access to the system by users, possible lack of visible
transaction trail and potential programmer access to the system. The particular characteristics of
a specific on-line system will depend on the design of that system.
14. When data are entered on-line, they are usually subject to immediate validation checks. Data
failing this validation would not be accepted and a message may be displayed on the terminal
screen, providing the user with the ability to correct the data and re-enter the valid data
immediately. For example, if the user enters an invalid inventory part number, an error message
will be displayed enabling the user to re-enter a valid part number.
15. Users may have on-line access to the system that enables them to perform various functions,
e.g., to enter transactions and to read, change or delete programs and data files through the
terminal devices. Unlimited access to all of these functions in a particular application is
undesirable because it provides the user with the potential ability to make unauthorised changes
to the data and programs. The extent of this access will depend upon such things as the design of
the particular application and the implementation of software designed to control access to the
system.
16 An on-line computer system may be designed in a way that does not provide supporting
documents for all transactions entered into the system. However, the system may provide details
of the transactions on request or through the use of transaction logs or other means. Illustrations
of these types of systems include orders received by a telephone operator who enters them on-
line without written purchase orders, and cash withdrawals through the use of automated teller
machines.
17. Programmers may have on-line access to the system that enables them to develop new programs
and modify existing programs. Unrestricted acess provides the programmer with the potential to
make unauthorised changes to programs and obtain unauthorised access to other parts of the
system. The extent of this access depends on the requirements of the system. For example, in
some systems, programmers may have access only to programs maintained in a separate
program development and maintenance library; whereas, in emergency situations which require
changes to programs that are maintained on-line, programmers may be authorised to change the
operational programs. In such cases, formal control procedurs would be followed subsequent to
the emergency situation to ensure appropriate authorisation and documentation of the changes.
Internal Control in an on-line Computer System
18. Certain general IT controls are particularly important to on-line processing. These include:
(a) access controls-procedures designed to restrict access to programs and data. Specifically,
such procedures are designed to prevent or detect:
(i) unauthorised access to on-line terminal devices, programs and data;
(ii) entry of unauthorised transactions-
(iii) unauthorised changes to data files;
(iv) use of operational computer programs by unauthorised personnel; and
(v) use of computer programs that have not been authorised.
These access control procedures include the use of passwords and specialised access-
control software such as on-line monitors that maintain control over menus, authorisation
tables, passwords, files and programs that users are permitted to access the procedures
also include physical controls such as the use of key locks on terminal devices:
(b) controls over passwords - procedures for the assignment and maintenance of passwords to
restrict access to authorised users;
(c) system development and maintenance controls-additional procedures to ensure that
controls essential to on-line applications such as passwords, access controls, on-line data
validation and recovery procedures, are included in the system during its development and
maintenance;
(d) programming controls - procedures designed to prevent or detect improper changes to
computer programs which are accessed through on-line terminal devices. Access may be
restricted by controls such as the use of separate operational and program development
libraries and the use of specialised program library software. It is important for on-line
changes to programs to be adequately documented;
(e) transaction logs - reports which are designed to create an audit trail for each on-line
transaction. Such reports often document the source of a transaction (terminal, time and
user) as well as the transaction’s details.
19. Certain IT application controls are particularly important to on-line processing. These include :
(a) pre-processing authorisation - permission to initiate a transaction, such as the use of a
bank card together with a personal identification number before making a cash withdrawal
through an automated teller machine;
(b) terminal device edit, reasonableness and other validation tests - programmed routines that
check the input data and processing results for completeness, accuracy and
reasonableness. These routines may be performed on an intelligent terminal device or on
the central computer;
(c) cut-off procedures - the procedures which ensure that transaction are processed in the
proper accounting period. These are particularly necessary in systems which have a
continuous flow or transactions. For example, in on-line systems where sales order and
shipments are being recorded through the use of on-line terminal devices in various
locations, there is a need to coordinate the actual shipment of goods, inventory relief and
invoice processing;
(d) file controls - procedures which ensure that the correct data files are used for on-line
processing;
(e) master file controls - changes to master files are controlled by procedures similar to those
used for controlling other input transaction data. However, since master file data may have
a pervasive effect on processing results, more stringent enforcement of these control-
procedures may be necessary;
(f) balancing - the process of establishing control totals over data being submitted for
processing through the on-line terminal devices and comparing the control totals during
and after processing to ensure that complete and accurate data are transferred to each
processing phase.
Effect of On-Line Computer Systems on the Internal Control Structure
20. The effect of an on-line computer system on the information system and the associated risks will
generally depend on:
(a) the extent to which the oil-line system is being used to process transactions;
(b) the type and significance of financial transactions being processed; and
(c) the nature of files and programs utilised in the applications.
21. Risk of fraud or error in on-line systems may be reduced in the following circumstances:
(a) if on-line data entry is performed at or near the point where transactions originate, there is
less risk that the transactions will not be recorded;
(b) if invalid transactions are corrected and re-entered immediately, there is less risk that such
transactions will not be corrected and re-submitted on a timely basis;
(c) if data entry is performed on-line by individuals who understand the nature of the
transactions involved, the data entry process may be less prone to errors than when it is
performed by, individuals unfamiliar with the nature of the transactions;
(d) if transactions are processed immediately on-line, there is less risk that they will be
processed in the wrong an accounting period.
22 Risk of fraud or error in on-line computer systems may be increased for the following reasons:
(a) if on-line terminal devices are located throughout the entity, the opportunity for unauthorised
use of a terminal device and the entry of unauthorised transactions may increase;
(b) on-line terminal devices may provide the opportunity for unauthorised uses such as:
(i) modification of previously entered transactions or balances;
(ii) modification of computer programs; and
(iii) access to data and programs from remote locations;
(c) if on-line processing is interrupted for any reason, for example, due to faulty
telecommunications, there may be a greater chance that transactions or files may be lost
and that recovery may not be accurate and complete;
(d) on-line access to data and programs through telecommunications may provide greater
opportunity for access to data and programs by unauthorised persons.
23. On-line computer systems may also have an effect on control procedures. The characteristics of
on-line computer systems, as described earlier in this statement, illustrate some of the
considerations influencing the effectiveness of controls in on-line computer systems. Such
characteristics may have the following consequences:
(a) there may not be source documents for every input transaction;
(b) results of processing may be highly summarised; for example only totals from individual
on-line data entry devices can traced to subsequent processing;
(c) the on-line computer system may not be designed to provide printed reports; for example,
edit reports may be replaced by edit messages displayed on a terminal device screen.
Effect of On-Line Computer Systems on Audit Procedure
24. The following matters are of particular importance to the auditor in an on-line computer system:
(a) authorisation, completeness and accuracy of on-line transactions
(b) integrity of records and processing, due to on-line access to the system by many users and
programmers;
(c) changes in the performance of audit procedures including the use of CAAT’s due to matters
such as:
(i) the need for auditors with technical skills in on computer systems;
(ii) the effect of the on-line computer system on the timing of auditing procedures;
(iii) the lack of visible transaction trails;
(iv) procedures carried out during the audit planning stage (see paragraph 25);
(v) audit procedures performed concurrently with on-line processing (see paragraph 26);
and
(vi) procedures performed after processing has taken place (see paragraph 27).
25. Procedures carried out during the planning stage may include:
(a) the participation on the audit team of individuals with technical proficiency in on-line
computer systems and related controls;
(b) preliminary determination during the risk assessment process impact of the system on the
audit procedures. A well designed and controlled on-line system will affect the auditor’s
assessment of control risk and influence the nature, timing and extent of audit procedures.
26. Audit procedures performed concurrently with on-line processing include compliance testing of
the controls over the on-line applications. For example, this may be by means of entering test
transactions through the on-line terminal services or by the use of audit software. These tests
may be used by the auditor either to confirm his understanding of the system or to test controls
such as passwords and other access controls. The auditor would be advised to review such tests
with appropriate client personnel and to obtain approval prior to conducting the tests in order to
avoid inadvertent corruption of client records.
27. Procedures performed after processing has taken place may include:
(a) compliance testing of controls over transactions logged by the on-line system for
authorisation, completeness and accuracy;
(b) substantive tests of transactions and of processing results rather than tests of controls,
where the former may be more cost effective or where the system is not well-designed or
controlled;
(c) re-processing transactions as either a compliance or substantive procedure.
28. The characteristics of on-line computer systems may make it more effective for the auditor to perform a
pre-implementation review of new on-line accounting applications than to review the applications after
installation. This pre-implementation review may provide the auditor with an opportunity to request
additional functions, such as detailed transaction listings, or controls within the application design. It
may also provide the auditor with sufficient time to develop and test audit procedures in advance of
their use.
III Auditing Guidance Statement: Database Systems
Introduction
01 The purpose of this note (issued by the IASC) is to describe the effects of a database system on
the internal control structure and on audit procedures.
Database Systems
02. Database systems are comprised principally of two essential components, the database and the
database management system (DBMS). Database systems interact with other hardware and
software aspects of the overall computer system.
03. A database is a collection of data that is shared and used by a number different users for different
purposes. Each user may not necessarily be aware of all the data stored in the database or of the
ways that the data may be used for multiple purposes. Generally, individual users are aware only
of the data that they use and may view the data as computer files utilised by their applications.
04. The software that is used to create, maintain and operate the database is referred to as DBMS
software. Together with the operating system, the DBMS facilitates the physical storage of the
data, maintains the interrelationships among the data, and makes the data available to application
programs. Usually, the DBMS software is supplied by a commercial vendor.
05. Database systems may reside on any type of computer system, including a PC system. In some
PC environments, database systems are used by a single user. Such systems are not considered
to be databases for the purposes of this Statement. The contents of this Statement, however, are
applicable to all multiple user environments.
Database System Characteristics
06. Database systems are distinguished by two important characteristics data sharing and data
independence. These characteristics require the use of a data dictionary (paragraph 10) and the
establishment of a database administration function (paragraphs 10-14).
Data Sharing
07. A database is composed of data which are set up with defined relationships and are organised in
a manner that permits many users to use the data in different application programs. Individual
applications share the data in the database for different purposes. For example, an inventory item
unit cost maintained by the database may be used by one application program to produce a cost
of sales report and by another application program to prepare an inventory valuation.
Data Indepedence From Application Programs
08. Because of the need for data sharing, there is a need for data independence from application
programs. This is achieved by the DBMS recording the data once for use by various application
programs. In non-database systems, separate data files are maintained for each application and
similar data used by several applications may be repeated on several different files. In a database
system, however, a single file of data (or database) is used by many applications, with data
redundancy kept to a minimum.
09. DBMS’s differ in the degree of data independence they provide. The degree of data
independence is related to the ease with which personnel can accomplish changes to application
programs or to the database. True data independence is achieved when the structure of data in
the database can be changed without affecting the application programs, and vice versa.
Data Dictionary
10. A significant implication of data sharing and data independence is the potential for the recording
of data only once for use in several applications. Because various application programs need to
access this data, a software facility is required to keep track of the location of the data in the
database. This software within the DBMS is known as a data dictionary. It also serves as a tool
to maintain standardised documentation and definitions of the database environment and
application systems.
Database Administration
11. The use of the same data by various application programs emphasises the importance of
centralised coordination of the use and definition of data and the maintenance of its integrity,
security, accuracy and completeness. Coordination is usually performed, by a group of individuals

whose responsibility is typically referred to as ‘database administration”. The individual who
heads this function may be referred to as the “database administrator”. The database
administrator is responsible generally for the definition, structure, security, operational control and
efficiency of databases, including the definition of the rules by which data are accessed and
stored.
12. Database administration tasks may also be performed by individuals who are not part of a
centralised database administration group. Where the tasks of database administration are not
centralised, but are distributed among existing organisational units, the different tasks still need to
be coordinated.
13. Database administration tasks typically include:
(a) defining the database structure - determining how data are defined, stored and accessed by
users of the database in order to ensure that all their requirements are met on a timely
basis;
(b) maintaining data integrity, security and completeness - developing, implementing and
enforcing the rules for data integrity, completeness and access. Responsibilities include:
(i) defining who may access data and how the access is accomplished, i.e. through
passwords and authorisation tables;
(ii) preventing the inclusion of incomplete or invalid data;
(iii) detecting the absence of data;
(iv) securing the database from unauthorised access and destruction; and
(v) arranging total recovery in the event of a loss;
(c) coordinating computer operations related to the database-assigning responsibility physical
computer resources and monitoring their use relative to the operation of the database;
(d) monitoring system performance - developing performance measurements to monitor the
integrity of the data and the ability of the database to respond to the needs of users;
(e) providing administrative support - coordinating and liaising with the vendor of the DBMS;
assessing new releases issued by the vendor of the DBMS and the extent of their impact on
the entity, installing new releases and ensuring that appropriate internal education is
provided.
14. In some applications, more than one database may be used. In these circumstances, the tasks of
the database administration group will need to ensure that:
(a) adequate linkage exists between databases;
(b) coordination of functions is maintained; and
(c) data contained in different databases are consistent.
Internal Control in a Database Environment
15. Generally, internal control in a database environment requires effective controls over the
database, the DBMS and the applications. The effectiveness of internal controls depends to a
great extent on the nature of the database administration tasks, described in paragraphs 11-14
and how they are performed.
16. Due to data sharing, data independence and other characteristics of database systems, general
EDP controls normally have a greater influence that, EDP application controls on database
systems. General EDP controls over the database, the DBMS and the activities of the database
administration function have a pervasive effect on application processing. The general EDP
controls of particular importance in a database environment can be classified into the following
groups:
(a) standard approach for development and maintenance of application programs;
(b) data ownership;
(c) access to the database; and
(d) segregation of duties.
Standard Approach for Development and Maintenance of Application Programs
17. Since data are shared by many users, control may be enhanced when a standard approach is
used for developing each new application program and for application program modification. This
includes following a formalised, step-by-step approach that requires adherence by all individuals
developing or modifying an application program. It also includes performing an analysis of the
effect of new and existing transactions on the database each time a modification is required. The
resulting analysis would indicate the effects of the changes on the security and integrity of the
database. Implementing a standard approach to develop and modify application programs is a
technique that can help improve the accuracy, integrity and completeness of the database.
Data Ownership
18. In a database environment, where many individuals may use program, to input and modify data, a
clear and definite assignment of responsibility is required from the database administrator for the
accuracy and integrity of each item of data. A single data owner should be assigned
responsibility for defining access and security rules, such as who can use the data (access) and
what functions they can perform (security). Assigning specific responsibility for data ownership
helps to ensure the integrity of the database. For example, the credit manager may be the
designated “owner” of a customer’s credit limit and would therefore be responsible for determining
the authorised users of that information. If several individuals are able to make decisions affecting
the accuracy and integrity of given data, the likelihood increases of the data becoming corrupted
or improperly used.
Access to the Database
19. User access to the database can be restricted through the use of passwords. These restrictions
apply to individuals, terminal devices and programs. For passwords to be effective, adequate
procedures are required for changing passwords, maintaining secrecy of passwords and
reviewing and investigating attempted security violations. Relating passwords to defined terminal
devices, programs and data helps to ensure that only authorised users and programs can access,
amend or delete data. For example, the credit manager may give salesmen authority to refer to a
customer’s credit limit, whereas a warehouse clerk may not have such authorisation.
20. Users access to the various elements of the database may be further controlled through the use
of authorisation tables. Improper implementation of access procedures can result in unauthorised
access to the data in the database.
Segregation of Duties
21. Responsibilities for performing the various activities required to design, implement and operate a
database are divided among technical, design, administrative and user personnel. Their duties
include system design, database design, administration and operation. Maintaining adequate
segregation of these duties is necessary to ensure the completeness, integrity and accuracy of
the database. For example, those persons responsible for modifying personnel database
programs should not be the same persons who are authorised to change individual pay rates in
the database.
The Effect of Databases on the Internal Control Structure
22. The effect of a database system on the information system and the associated risks will generally
depend on:
(a) the extent to which databases are being used by accounting applications;
(b) the type and significance of financial transactions being processed;,
(c) the nature of the database, the DBMS (including the data dictionary), the database
administration tasks and type applications (e.g. batch or on-line update); and
(d) the general EDP controls which are particularly important in a database environment.
23. Database systems typically provide the opportunity for greater reliability of data than non-
database systems. This can result in reduced risk of fraud or error in the accounting system fraud
or error in the accounting system where databases are used. following factors, combined with
adequate controls, contribute to this, improved reliability of data:
(a) improved consistency of data is achieved because data are recorded and updated only once,
rather than in non-database systems, where the same data are stored in several files and
update., at different times and by different programs;
(b) integrity of data will be improved by effective use of facilities included in the DBMS, such as
recovery/restart routines, generalised edit find validation routines, and security and control
features;
(c) other functions available with the DBMS can facilitate control, and audit procedures. These
functions include report generators which may be used to create balancing reports, and
query languages, which may be used to identify inconsistencies in the data.
24. Alternatively, risk of fraud or error may be increased if database systems are used without
adequate controls. In a typical non-database environment, controls exercised by individual users
may compensate for weaknesses in general EDP controls. However, in a database system, this
may not be possible, as inadequate database administration controls cannot always be
compensated for by the individual users. For example, accounts receivable personnel cannot
effectively control accounts receivable data if other personnel are not restricted from modifying
accounts receivable balances in the database.
The Effect of Databases on Audit Procedures

25. Audit procedures in a database environment will be affected principal by the extent to which the
data in the database are used by the accounting system. Where significant accounting
applications use a common database, the auditor may find it cost-effective to utilise some of the
procedures in the following paragraphs.
26. In order to obtain an understanding of the database control environment and the flow of
transactions, the auditor may consider the effect of the following on audit risk in planning the
audit.
(a) the DBMS and the significant accounting applications using the database;
(b) the standards and procedures for development and maintenance of application programs
using the database;
(c) the database administration function;
(d) job descriptions, standards and procedures for those individual responsible for technical
support, design, administration and operation of the database;
(e) the procedures used to ensure the integrity, security and completeness of the financial
information contained in the database and
(f) the availability of audit facilities within the DBMS.
27. During the risk assessment process, in assessing control risk related to the use of databases in
the information system, the auditor may consider how the controls described in paragraphs 17-21
are used in the system. The auditor would perform tests of control to support an assessment to
control risk that is less than high.
28. Where the auditor decides to perform compliance or substantive test related to the database
system, audit procedures may include using the functions of the DBMS (see paragraph 23) to :
(a) generate test data;
(b) provide an audit trail;
(c) check the integrity of the database;
(d) job descriptions, standards and procedures for those individual responsible for technical
support, design, administration and operation of the database;
(e) obtain information necessary for the audit.
When using the facilities of the DBMS, the auditor will need to obtain reasonable -assurance
regarding their correct functioning.
29. Where the auditor assesses control risk as less than high in relation to the database system, he
would consider whether performing additional substantive tests on all significant accounting
applications which use the database would achieve his audit objective, as inadequate database
administration controls cannot always be compensated for by the individual users.
30. The characteristics of database systems may make it more effective for the auditor to perform a
pre-implementation review of new accounting applications rather than to review the applications
after installation. This pre-implementation review may provide the auditor with an opportunity to
request additional functions, such as built-in audit routines, or controls within the application
design. It may also provide the auditor with sufficient time to develop and test the audit
procedures in advance of their use.
5
SPECIAL AUDIT TECHNIQUES
Introduction
5.1 Normally, an audit programme specifies the techniques to be employed in the specific
case by relating the techniques to the respective areas of accounting. Chapter 3 of the
Professional Competence Course Study Material contains various techniques generally
employed for auditing the books of account. For example, the techniques of posting, checking
and casting all related to the subsidiary books of account and the principal books of account.
Vouching will be in respect of all the transactions whether appearing in the cash book or in
any journal. The confirmation technique is appropriate in relation to personal accounts
balances, bank balances or securities lodged with others. In this Chapter, we shall deal with
some of these techniques in greater detail.
5.1.1 Confirmation - AAS 5 (Audit Evidence) defines confirmation as a method of collecting
audit evidence which consists of the response to an inquiry to corroborate information
contained in the accounting records. It may be interesting to note that the AICPA included
direct confirmation of sundry debtors in its Auditing Standards after the decision of Mckesson
and Robbins. Same procedure is applicable in case of creditors as well. For example, the
auditor requests confirmation of receivable by direct communication with debtors. The
Guidance Note on Audit of Sundry Debtors, Loans and Advances issued by the Institute of
Chartered Accountants of India has recommended that balances outstanding against debtors
and as loan and advances should be confirmed by a procedure of communication with the
parties. The Guidance Note provides the following:
The checking of the debtors’ ledger balances does not merely involve a comparison of the
balances in the ledger with those shown in the schedule. Each account should be scrutinised
in order to do the ‘aging’ of the debtors. The debtors’ schedule should have appropriate
columns to indicate the period over which each account is outstanding. The auditors must not
assume that any balance which is confirmed is necessarily realisable. Where debts are written
off, the auditor should satisfy himself whether the write off was based on appropriate
considerations of the relevant facts. Debts often include claims made against insurance
companies, shipping companies, railways, etc. and the auditor should ascertain that the claims
are realisable. Correspondence should be seen in all major cases in order to ascertain
whether the claims have been acknowledged and whether there is a reasonable possibility of
their being realised. If it appears that they are not collectible, they should be shown as
doubtful. These recommendations can be applied to creditors as well. Based on the above
recommendations an outline of a confirmation procedure may be as under:
1. The confirmatory letters should be sent out within a period of 15 to 21 days of the end of
the year, even when the audit is taken up much later in respect of balances either as at
the date of the Balance Sheet or as at another selected date before the close of the year.
2. If the number of balances is large, letters may be issued only in respect of major debtors
and creditors, selected according to some system. Having selected the accounts, the
balances wherein are to be confirmed, the client should be requested to prepare
statements of account showing the position of the balances as at the date of
confirmation. A nil balance account should also be included.
3. The statements of account prepared by the client should be compared by the auditor with
the balances of debtors and creditors. Therefore, he should maintain control over them
until they are posted.
4. Either each statement of account should contain a request for confirmation of the balance
shown therein or it should be forwarded with a separate letter by the auditor or the client,
as may have been mutually agreed upon, The letter or the statement should show the
address of the auditor to which the statements of account after the confirmation are to be
returned. A stamped envelope containing the auditor’s name and address should be
enclosed.
5. Letters or statements should be posted under the supervision of the auditor.
6. In cases where replies are not received within a reasonable time, a reminder should be
sent out by the auditor. Letters received back undelivered should be sent again at the
correct address.
7. On receipt of replies from the parties, it should be verified that either the balances have
been confirmed or the amounts confirmed can be satisfactorily reconciled with the
balances shown by the books of account of the client. The client should be requested to
prepare reconciliation statements where necessary.
8. In every case, where a reconciliation statement has been prepared, it should be verified
that the difference in the amount confirmed and that shown by the books of account is
not the result of an omission to credit any amount received from the party or failure to
debit him with any amount of sales or to credit him with the value of goods received with
a view to suppressing or inflating profit.
9. If the difference is the result of some dispute or claim for allowance or return, etc. not
afforded to a party, it should be confirmed that there exists a provision equal to the
difference which ultimately may have to be credited to him.
Direct confirmation procedure may be performed both for sundry creditors and sundry debtors.
Special precautions in respect of creditors to be taken are as under:
(i) The Creditors’ ledger trial balance should be extracted by the client and agreed with the
Control Account, if any, before balances are selected for confirmation.
Special Audit Techniques 5.3
(ii) The provision made for the amount payable in respect of goods received within the last
week of the close of the year should be verified by comparing entries in the Goods
Inward Register with the Purchase Journal.
(iii) A certificate should be obtained from the client that all the liabilities which have accrued
up to the date of the Balance Sheet have been taken into account.
Special precautions in respect of sundry debtors to be taken are as under:
(i) The Debtors’ ledger trial balance should be extracted by the client and agreed with the
Control Account, if any, before balances are selected for confirmation.
(ii) The adjustment of sales made at the close of the year should be verified by comparing
the entries in the Goods Outward Register for two weeks before the close of the year with
these in the Sales Journal.
(iii) The accounts to be verified by direct confirmation should be settled on the basis of
internal control procedures.
5.1.2 Inquiry – AAS 5 mentions inquiry as one of the methods of collecting audit evidence by
seeking appropriate information from knowledgeable persons inside or outside the entity.
Inquiries may range from formal written inquiries addressed to third parties to informal oral
inquiries addressed to persons inside the entity. Responses to inquiries may provide the
auditor with information which he did not previously possess or may not provide him with
corroborative evidence. The need for inquiry may arise at every stage of auditing. Wherever
any transaction or entry is not readily understandable or its effects are not readily apparent,
the auditor should not hesitate to make enquiry from the appropriate official of the client.
Apart from this, students should remember that the auditor of a company has to make a
statement in his report on whether he has obtained all the information and explanations that
he considered necessary for his audit. This requirement suggests that inquiry is one of the
processes of the whole scheme of auditing and, accordingly, the Companies Act, 1956 has
given certain powers to the auditor in Section 227(1) and has cast certain duties on company
officials in Section 221. Besides, Section 227(IA) of the Companies Act, 1956 casts upon the
auditor a specific duty to inquire into certain specified transactions. How the auditor is
expected to perform the duty of enquiry as contained in Section 227(lA) is given in Chapter
“Audit Report”.
5.1.3 Observation - According to AAS 5, observation consists of witnessing a process being
performed by others. For example, the auditor may observe the counting of inventories by the
client personnel or the performance of internal control procedures that leave no audit trail.
5.1.4 Analytical Review Procedures - Analytical review procedures may be defined as
substantive tests of financial information made by a study of comparisons and relationship
among data. Analytical procedures include comparison of financial information with:
♦ comparable information for a prior period or periods,
♦ anticipated results, such as budgets or forecasts, and
♦ similar industry information, such as a comparison of the entity’s ratio of sales to accounts
receivable with industry averages or with other entities of comparable size in the same
industry.
Essentially these procedures ensure that the various items making up the financial statements
are consistent with:
(a) Each other (for example, the relationship between debtors and sales, or current assets
and current liabilities).
(b) Known trends.
(c) The auditor’s knowledge of the business.
The auditor should ask the following questions:
(a) What data, ratios and statistics exist which are of significance for the business?
(b) What should they be compared with (i.e., what yard-stick)?
(c) Are there any variations between (a) and (b) which the auditors would expect to occur?
Analytical procedures also include study of relationships:
♦ among elements of financial information that would be expected to conform to a
predictable pattern based on the entity’s experience, such as a study of gross margin
percentages, and
♦ between financial information and relevant non-financial information, such as a study of
payroll costs to number of employees.
Various methods may be used in performing the above procedures. These range from simple
comparisons to complex analyses using advanced statistical techniques. Analytical
procedures may be applied to consolidated financial information, financial information of
components (such as subsidiaries, divisions or segments), and individual elements of financial
information. The choice of procedure, methods and level of application is a matter of
professional judgment.
The following table summarizes the position:
Types of data, ratios etc. Comparison with

Financial data (e.g., items in annual (i) Corresponding previous period.
statements, management accounts, budgets, (ii) Budgets and forecasts (if available).
etc.)
Non-financial data (e.g., production and (i) Entries in accounting records.
employment statistics) (ii) Other financial data.
Ratios and percentages (developed from (i) Preceding period.
financial and non- financial data; for example (ii) Budgets and forecasts.
inventory turnover ratio)
(iii) Industry Statistics.
Analytical procedures are used for the following purposes:

(a) To assist the auditor in planning the nature, timing and extent of other auditing
procedures.
(b) As a substantive test to obtain evidential matter about particular assertions related to
account balances or classes of transactions.
(c) As an overall review of the financial information in the final review stage of the audit.
Analytical procedures should be applied to some extent for the purposes referred to in (a) and
(c) above for all audits of financial statements. In addition, in some cases, analytical
procedures can be more effective or efficient than tests of details in reducing detection risk for
specific financial statement assertions.
Analytical procedures in planning the audit - In the planning stage, analytical procedures
assist the auditor in understanding the client’s business and in identifying areas of potential
risk by indicating aspects of and developments in the entity’s business of which he was
previously unaware. This information will assist the auditor in determining the nature, timing
and extent of his other audit procedures. Analytical procedures in planning the audit use both
financial data and non-financial information, such as number of employees, square feet of
selling space, volume of goods produced and similar information.
Analytical procedures used as substantive tests - The auditor’s reliance on substantive
tests to reduce detection risk relating to specific financial assertions may be derived from the
tests of details, from analytical information procedures, or from a combination of both. The
decision about which procedure or procedures to use to achieve a particular audit objective is
based on the auditor’s judgement about the expected effectiveness and efficiency of the
available procedures. The auditor will normally inquire of management as to the availability,
and reliability of information needed to apply analytical procedures and the results of any such
procedures performed by the client. The auditor may find that it is efficient to use analytical
data prepared by the client, provided he is satisfied that such data are properly prepared.
When the auditor intends to perform analytical procedures, he should consider the following:
♦ The objective of the analytical procedures, and the extent to which he may be able to rely
on their results.
♦ The nature of the entity - for example, analytical procedures may be more effective when
applied to financial information on individual sections of a business operation or to
financial statements of components of diversified entities, than when applied to the
financial statements of the entity as a whole.
♦ The availability of information, either financial such as budgets or forecasts or non-
financial such as the number of units produced or sold.
♦ The reliability of the information available - for example, experience may indicate that
budgets are prepared with insufficient care.
♦ The relevance of the information available - for example, budgets may have been
established as goals to be achieved rather than expected results.
♦ The comparability of the information available - for example, broad industry data may not
be comparable to that of an entity that produces and sells specialized products.
♦ The knowledge gained by the auditor during previous examinations, together with his
understanding of the effectiveness of internal controls and the types of problems that in
preceding periods have given rise to accounting adjustments.
The auditor should consider the need for testing the controls over the preparation of non-
financial information, if any, used in applying analytical procedures. When such controls are
adequate, the auditor will have greater confidence in the reliability of the non-financial
information and, therefore, he will have a greater degree of assurance as to the results of his
analytical procedures. The controls over non-financial information can often be tested in
conjunction with compliance procedures performed in the study and evaluation of the
accounting system and related internal controls. For example, an entity in establishing
internal controls over the processing of sales invoices may include controls over the recording
of unit sales in conjunction with his compliance procedures to test the controls over the
processing of sales invoices.
Extent of reliance on analytical procedures - The application of analytical procedures is
based on the expectation that relationships among data exist and continue in the absence of
known conditions to the contrary. The presence of these relationships provides audit evidence
as to the completeness, accuracy and validity of the data produced by the accounting system.
However, reliance to be placed on the results of analytical procedures will depend on the
auditor’s assessment of the risk that the analytical procedures may identify relationships as
expected when, in fact, a material misstatement exists. The extent of reliance that the auditor
places on the results of analytical procedures depends on the following factors:
♦ Materiality of the items involved in relation to the financial information taken as a whole
(e.g. when inventory balances are significant to the financial information, the auditor does
not rely only on analytical procedures in forming his conclusions). On the other hand, he
may rely solely on analytical procedures for certain expense items when they are not
individually significant to the financial information taken as a whole and there is an
absence of unexpected fluctuations.
♦ Other audit procedures directed toward the same audit objectives, for example, other
procedures performed by the auditor in reviewing the collectability of accounts receivable,
such as the review of subsequent cash receipts, might confirm or dispel questions raised
from the application of analytical procedures to an aging of customers’ accounts.
♦ Accuracy with which the expected results of analytical procedures can be predicted, for
example, the auditor will normally expect greater consistency in comparing gross profit
margins from one period with another than in comparing discretionary expenses, such as
research or advertising.
♦ Evaluation of internal controls, for example, if the auditor has concluded that internal
controls over sales order processing are weak, he may have to rely more on the tests of
details of transactions and balances than on analytical procedures in drawing his
conclusion on sales.
This technique has been discussed at the PCC level. However in view of importance of this
technique in the context of growing complexities, diversities and volumes of business, it
requires a more detailed treatment in the specific area of ratio analysis and related matters. It
should be appreciated that an audit programme will be realistic only after the auditor has
modified in the light of his experience of the changes and of the state of internal controls
operating in the organisation. If the auditor can perceive some of the imperatives under which
the management operates and the relationship of the business with the economy and
environment, he would be able to make the audit programme far more objective. Conflict of
interests, inflation, inter-company relations, scarcity conditions, captive market, control by the
State, etc. are some of the forces that condition a company’s working and management
approach to a large extent.
The auditor normally performs an audit by placing reliance on the internal control system. A
company’s control system may provide for a maximum holding of a particular raw material but
if the raw material is a controlled commodity and the supply is irregular, it is obvious that the
internal control rule about the maximum or minimum holding of the raw material is of no use to
the management which is concerned with the running of the business. As and when the
company is allotted a quota or permit for that material irrespective of any consideration, the
management will avail of the same. Besides the management will not mind even to procure
such material from the open market at a price different from the controlled price, if the
materials are needed. For goods to be imported it is often the practice to ask for and obtain
an import license for a quantity far larger than is reasonably needed simply to avoid the
procedural red tape involved in obtaining a license. Internal control systems, howsoever
good, will be of no use in such cases.
It should also be understood that significant non-routine transactions are entered into
sometimes in complete disregard of the laid down rules of control. The internal control system
may be good as far as the transactions that have been recorded. But if certain transactions
are omitted altogether, the internal control system may not be in a position to reveal anything
about them. An auditor should always bear in mind these limitations of the control system.
These limitations have made it even more important for the auditor to supplement his routine
audit programme, by overall tests which are based on judgment of what is reasonable. Ratio
analysis is an audit approach that helps the auditor to make an overall assessment of the data
by reference to attendant factors.
Relevance of Ratio and Trend Analysis - Ratio analysis is an important supplement to the
audit process which has the merit of bringing to focus the abnormalities, deviations and
unexpected variations. A ratio measures the relative magnitude of two related factors. It does
not have any significance of its own except to provide material for further analysis,
interpretation and conclusion. It is a means to objectively assess or diagnose the financial
health of a business. The auditor can take a broad view of the data under audit by adopting
ratio analysis. He can assess whether the data is reasonable, valid and consistent. Through
the process of ratio analysis, any abnormal relationship between two related matters is most
likely to be disclosed. It, however, presupposes certain amount of knowledge on the part of
the auditor about what should be the reasonable relationship. This may be acquired by the
auditor from his knowledge and experience gained elsewhere or from the knowledge of the
past relationships. In addition, if there exists certain known relationship, the matter becomes
simpler. For example, if the rate of Provident Fund contribution is 10% of the basic pay and
dearness allowance, either set of the data can be proved by the other having regard to the
given relationship. If the auditor finds the Provident Fund contribution to be of the order of say
6% of the total of basic pay after dearness allowance, this immediately alerts him that some
abnormal feature exists, though he should not hasten to the conclusion that it is an error.
There may be circumstances, e.g., newly appointed employees are not entitled to the
Provident Fund benefit for certain period or there may be some retired persons re-employed
who are not entitled to any provident fund benefit.
Therefore, it may be said that ratio analysis makes it possible for the auditor to locate problem
areas which can thereafter be subjected to scrutiny for confirming that the problem really
exists or it is manifestation of some real abnormality that business has experienced during the
period covered by the audit. This may help also in forestalling an approaching danger before it
has done much damage. It is felt that if, at the audit planning stage, the data are subjected to
ratio analysis; the auditor would be in a position to plan his audit programme more
purposefully. He will be able to devote an appropriate amount of time and effort in areas
where abnormalities have been detected. The analysis of ratios and relationships has two
phases:
1. The determination and measurement of changes and interrelationships in data.
2. The scrutiny, explanation and evaluation of the changes and their significance in light of
the circumstances.
It has been stated earlier that data must be inter-related for any effective ratio analysis. Apart
from this, certain businesses have their own features. A business with high sales volume at a
low margin of profit is expected to have a high inventory turnover ratio. If the ratio is low, it
will be a pointer for further probe. Similarly, a business offering cash discount for prompt
settlement of accounts will have a high debtors’ turnover ratio. A business dealing with a
widely needed scarce material will in most cases have customer’s advances against supply
rather than any debtors’ balances. On the other hand, in a business where Government is the
principal buyer, it is the general nature that the margin of profit is high and the debtors
outstanding quite large. For the auditor to properly understand the implications of ratios, such
background knowledge is essential.
Also, the auditor is expected to possess the knowledge of normal relationship between related
variables in the business he is auditing so that he can discern deviation from the normal and
assess significant variation in the relationship. This knowledge can be derived from either a
comparison with the concerned business’s past corresponding data or by reference to
readymade data available about the industry from some official source or by comparing the
data with the corresponding data found in another company engaged in the same line of
industry in similar circumstances.
The external data are generally considered to be objective and independent in character.
These, however, should be used with discretion. The basis and method of compilation, the
period covered and the source and author of the data are some of the considerations needed
before they are used for comparisons. In India, the Reserve Bank of India Bulletin, the
Bombay Stock Exchange Directory, the Calcutta Stock Exchange Directory, Kothari’s
Economic and Industrial Guide are some of the publications that contain reliable financial
information about companies, individually or as a class. However, they should not be
considered as a readymade material for comparison because the manner of compilation, the
circumstances, etc., may be dissimilar. Subject to review of these data for adjustment these
may be used for comparison.
Most of the ratios known to us from our study of Advanced Accounting can be used by the
auditor in evaluating different aspects of the financial health of a concern. However, the
auditor should be experienced and skillful enough to know what ratio is appropriate for his
purpose, what they would reveal and how to relate matters; also, what can be expected as a
result of particular ratio. For example, to know whether the concern’s cost of sales bears the
normal relation to sales, the auditor may compute gross profit ratio. Now if the gross profit
ratio shows any abnormality, depending upon the abnormality, further inference may be drawn
for verification and confirmation. If the gross profit ratio is higher than normal, the possibilities
that immediately should strike one are: (i) sales overstated, (ii) stock overstated or over
valued, (iii) purchases understated, (iv) wages and other costs understated, etc. Now the
auditor, having localised the problem areas, can check them extensively to find out whether
the doubts are true or certain abnormal situations did prevail that accounts for the distortion.
It is also natural for the auditor to expect the ratio of gross profit to net profit to be up in such
circumstances unless explained by other abnormal factors working in the opposite direction.
For example, the selling and distribution cost or interest on borrowings might have gone up
significantly to eat up the excess margin of gross profit. Take another example: suppose the
turnover ratio (Sales/Capital) shows a considerable improvement over the last year and there
is no concurrent increase in the solvency or liquidity ratios. The auditor should inquire why it
is so. It is quite possible that the company has evolved a better system of financial
management. It is also possible that (i) sales have been inflated or (ii) the credit policy was
defective to result into huge accumulation of debtors or (iii) there had been defalcation of
sales proceeds. There are certain quantitative ratios which may be particularly helpful to the
auditor, e.g., the ratio between the main raw material consumed to total production may prove
both the figures. Auditors can use a number of other quantitative ratios like ratio of man hours
to production to verify the accuracy of figures in the Profit and Loss Account and the Balance
Sheet. It would thus be seen that by working out ratios, the auditor can identify areas where
detailed enquiries are called for. Like, a physician, he examines symptoms, analyses them
and works out a diagnosis. Such a procedure may prove immensely helpful when used as a
supplementing technique to the normal vouch and post audit.
Ratio analysis can be of great use for overall checks. It is to be expected that figures of sales
will change together with changes in purchases, wages, expenses, etc. But the mutual
relationship of most related figures can change only because of extraordinary circumstances,
favourable or adverse. Working out the relationship of ratios, therefore, and comparing them
with the previous years, corresponding ratios serve to establish the apparent reasonableness
of the figures. To the extent reasonableness is established, the auditor may feel to be on a
firm ground when he issues his report. Of course, it should be noted that ratios are one of the
ways of application of overall tests.
A good approach is to study the trends. Trend analysis is of course mainly resorted to in
investigations. However, it may, be developed as a useful audit tool also to locate areas
showing abnormalities. If trends of sales and purchases are studied over a reasonable period
say 5 years - any distortion in their relations will be apparent. Similarly, trend of cost of
production can be studied along with the trend of the major components of cost. Even the
trend of significant ratios can be studied by the auditor over a number of years either by
plotting them on a graph paper or by setting them chronologically. The objective of
comparison of absolute figures by reference to the corresponding figures of the previous year
has been stated by the Government in the context of the requirement in the Schedule VI to the
Companies Act, as follows:
“The intention of displaying the figures relating to the previous year is to facilitate the
comparative study of the items in the Balance Sheet and Profit and Loss Account, so that the
significance of the figures for the current year can be more readily appreciated and
understood”.
These all highlight one fact: those relevant ratios may be of great value for proper financial
analysis and this may bring out the problem areas on which the auditor is directly interested.
Students are referred to Study Material in Advanced Accounting.
Investigating unusual fluctuations and Items - When analytical procedures identify unusual
fluctuations and items, that is, relationships that are unexpected or inconsistent with evidence
obtained from other sources, the auditor should investigate them. The investigation usually
begins with inquiries of management and the auditor should:
♦ Corroborate management’s responses - for example, by comparing them with his
knowledge of the business and other evidence obtained during the course of the audit.
♦ Consider the need to apply other audit procedures based upon the results of such
inquiries.
Further investigation, by means of audit procedures designed to produce a satisfactory
conclusion, would be required if management is unable to provide an explanation or if the
explanation is not considered adequate.
Analytical procedures used in the overall review - In forming his overall conclusion that the
financial information as a whole is consistent with his knowledge of the entity’s business and
relevant economic conditions, the auditor should perform analytical procedures at or near the
end of the audit. The conclusions drawn from the results of such procedures are intended to
corroborate conclusions formed during the audit on individual elements of financial information
and assist in arriving at the overall conclusion as to the reasonableness of the financial
information. However, they may also identify areas requiring further procedures.
Statistical Sampling in Auditing
5.2 According to AAS-5 on ‘Audit Evidence”,
“The audit evidence should, in total, enable the auditor to form an opinion on the financial
information. In forming such an opinion, the auditor does not normally examine all of the
information that is available to him because he can reach a conclusion about an account
balance, class of transactions or a control by way of judgmental or statistical sampling

procedures”.
Statistical sampling technique is increasingly becoming popular with the auditors. Statistical
sampling in auditing stands for the technique of forming an opinion about a group of items on
the basis of an examination of a few of the items. It may be recalled that test checking
technique is one of the accepted auditing techniques, which most of the professional bodies of
the world, including the Institute of Chartered Accountants of India have recommended for use
by the members on a proper consideration of facts and applicability. We have also seen the
shortcomings of the test check technique as a basis for forming informed opinion about the
accounts under audit. Statistical sampling technique may be considered as a refined
application of the test check technique which has all the advantages of the latter with the
shortcomings removed. The greatest merit of statistical sampling technique lies in its being
based on the statistical theory of probability. It is however, not as simplistic as the test
checks.
On the basis of the audit carried out, an auditor is required to give a report containing his
opinion, about truth and fairness of the accounting statements. In expressing his opinion the
auditor never guarantees absolute accuracy of the accounting statements; but he takes a risk
of being challenged about the validity of his opinion. Even after a complete checking, he
cannot be sure that the accounts and the resulting accounting statements are absolutely free
from error, manipulation, fraud or mistake. However, the opinion that he expresses,
represents his overall assessment of the truth and fairness of the accounting statement based
on his satisfaction that he has applied all professional skill at his command to see that no
material error or fraud exists to distort the true and fair view of the accounting statements.
When he checks only a part of the total accounting data in lieu of checking of all the data, it is
obvious that the degree of satisfaction obtainable from the latter would not be available;
however, a small loss of the degree of satisfaction will be more than compensated by the
considerable savings in time and costs for having checked only a fraction of the total data. It
is again true that bigger the sample, the greater would be the satisfaction, but from a practical
consideration the minimum requisite sample size, if determined statistically will be adequate to
express an opinion about the overall truth and fairness of the total data within a reasonable
range of precision and with reasonable confidence.
It is important to recognize that certain testing procedures do not come within the definition of
sampling. Tests performed on 100% of the items within a population do not involve sampling.
Likewise the technique of selecting all items within a population which have a particular
significance (e.g., all items over a certain amount) does not qualify as sampling with respect to
the portion of the population examined nor with respect to the population as a whole, since the
items were not selected from the total population on a basis that was expected to be
representative. Such items might imply some characteristic of the remaining portion of the
population but would not be the basis for a valid conclusion about the remaining portion of the
population.
5.2.1 Design of the sample and its evaluation - In designing an audit sample, the auditor has
to consider the following -
Audit objectives - The auditor should first consider the specific audit objectives to be
achieved to enable him to determine the audit procedure or combination of procedures which
is likely to be the best to achieve those objectives. In addition, when audit sampling is
appropriate, the nature of the audit evidence sought and possible error conditions or other
characteristics relating to that evidence will assist the auditor in defining what constitutes an
error and what population should be used for sampling. For example, when performing
compliance tests of a company’s purchasing procedures, the auditor will be concerned with
matters such as whether an invoice was clerically checked and properly approved. On the
other hand, when performing substantive tests of invoices processed during the period, the
auditor will be concerned with matters such as the proper reflection of the monetary amounts
of such invoices in the financial information.
Population - The population is the entire set of data from which the auditor wishes to sample
in order to reach a conclusion. The auditor determine that the population from which he draws
the sample is appropriate for the specific audit objective. For example, if the auditor’s
objective were to test for overstatement of accounts receivable, his population could be
defined as the accounts receivable trial balance. On the other hand, if he was testing for
understatement of accounts payable, his population would not be the accounts payable trial
balance but could be subsequent disbursements, unfair invoices, unmatched receiving reports
or other populations that would provide evidence of understatement of accounts payable. The
individual items that make up the population are known as sampling units. The population can
be divided into sampling units in a variety of ways. For example, if the auditor’s objective is to
test the validity of the entity’s accounts receivable, he could define the sampling unit for
confirmation purposes as either customer balances or individual customer invoices. The
auditor should define the sampling unit in order to obtain an efficient and effective sample to
achieve the particular audit objective. Further regarding population, it should be noted:
(a) ‘Population’, or ‘field’, or ‘universe’ (i.e. the total number of items potentially subject to
scrutiny within a defined area, must be sufficiently large.
(b) The system which produces the records to be tested must be sufficiently reliable.
(c) All items within a particular population must be homogeneous, i.e. they must all fall within
the same ‘category’.
(d) Items within the population must be both (i) identifiable; and (ii) accessible.
Such selection should therefore be entirely random, and for this purpose random number
tables are often used. The difficulty often arises, however, that the items within the population
are themselves not identifiable in a way which enables such random selection to take place.
Petty cash vouchers, for example, are rarely preprinted with a sequential numbering series
and randomness will thus have to be ensured in some other way; it will hardly be practical for
the auditor himself to set about entering the numbers on the vouchers.
Confidence level - The reliability referred to is usually termed the confidence level. More
precisely, in an auditing context, it is the mathematical probability that the error rate in the
sample will not differ from the error rate in the population by more than a stated amount.
Confidence level is conveniently expressed as a percentage. Thus, when we speak of a
confidence level of 90% we mean that there are 90 chances that the item would fall within the
confidence intervals of about 90 to 100, against 10 chances, i.e. the risk we take, that it will
not (once again, at a specified level of precision). The confidence level is therefore seen to be
complementary to risk.
Precision - The precision may be defined with which we can describe the attributes of a given
population. For example, our sample may be chosen such that the errors in the population can
be proved to be within 5 percent of the monetary value. But how precise do we require this
percentage to be? The bigger our sample, clearly the more precise we can be, but we can
never be completely precise for the same reasons as we can never be 100 percent confident.
The degree of precision required will depend on the materiality of the items in question. For
example, if Rs. 3,000 of errors in a sales ledger population of Rs. 100,000 would be
considered to be just not material, then 3 percent would be our precision limits. From this you
will deduce that confidence level and precision limits are essentially inter-related, and the two
combined would determine the quality of testing. The auditor’s assessment of the following
factors will primarily be responsible for selecting total limit:
(i) Evaluation of the functioning of the system of internal control in the area under
examination.
(ii) Materiality of the amounts involved.
5.2.2 Defining error - The auditor must determine the significance of potential error as it will
determine the way in which tests should be conducted. Tolerable error is the maximum error in
the population that the auditor would be willing to accept and still conclude that the result from
the sample has achieved his audit objective. Tolerable error is considered during the planning
stage and is related to the auditor’s preliminary judgement about materiality. The smaller the
tolerable error, the larger the sample size the auditor will require. Further, we must determine
the significance of potential errors, for this will in turn determine the way in which we conduct
our tests. For example, in compliance testing any error will be significant irrespective of its
monetary value, because any failure of internal control procedures reduces the reliance that
we can place on those procedures. Hence tests of detail will have to be extended. It is not the
size of the error that is significant in these circumstances, but its nature, (indeed there may be
no monetarily quantifiable misstatement at all e.g. a payroll may not have been check cast, but
it may still be correct). With substantive testing, on the other hand, we are interested in
discovering whether there is material misstatement, so in this situation it is purely the amount
of the error that is relevant.
5.2.3 Sample size - When determining the sample size, the auditor should consider sampling
risk, the tolerable error, and the expected error. Examples of some factors affecting sample
size are contained in Tables 1 and 2.
5.2.4 Sampling risk - Sampling risk arises from the possibility that the auditor’s conclusion,
based on a sample, may be different from the conclusion that would be reached if the entire
population were subjected to the same audit procedure. The auditor is faced with sampling
risk in both tests of control and substantive procedures as follows:
(a) Tests of Control

(i) Risk of Under Reliance: the risk that, although the sample result does not support the
auditor’s assessment of control risk, the actual compliance rate would support such an
assessment.
(ii) Risk of Over Reliance: the risk that, although the sample result supports the auditor’s
assessment to control risk, the actual compliance rate would not support such an
assessment.
(b) Substantive Procedures
(i) Risk of Incorrect Rejection: the risk that, although the sample result support the
conclusion that a recorded account balance or class of transactions is materially mis-
stated, in fact it is not materially mis-stated.
(ii) Risk of Incorrect Acceptance: the risk that, although the sample result supports the
conclusion that a recorded account balance or class of transactions is not materially mis-
stated in fact it is materially mis-stated.
The risk of under reliance and the risk of incorrect rejection affect audit efficiency as they
would ordinarily lead to additional work being performed by the auditor, or the entity, which
would establish that the initial conclusions were incorrect. The risk of over reliance and the
risk of incorrect acceptance affect audit effectiveness and are more likely to lead to an
erroneous opinion on the financial statements than either the risk of under reliance or the risk
of incorrect rejection.
Sample size is affected by the level of sampling risk the auditor is willing to accept from the
results of the sample. The lower the risk the auditor is willing to accept, the greater the
sample size will need to be.
5.2.5 Tolerable error - Tolerable error is the maximum error in the population that the auditor
would be willing to accept and still conclude that the result from the sample has achieved the
audit objective. Tolerable error is considered during the planning stage and, for substantive
procedures, is related to the auditor’s judgement about materiality. The smaller the tolerable
error, the greater the sample size will need to be.
In tests of control, the tolerable error is the maximum rate of deviation from a prescribed
control procedure that at the auditor would be willing to accept, based on the preliminary
assessment of control risk, in substantive procedures, the tolerable error is the maximum
monetary error in an account balance or class of transactions that the auditor would be willing
to accept so that when the results of all audit procedures are considered, the auditor is able to
conclude, with reasonable assurance, that the financial statements are not materially mis-
stated.
5.2.6 Expected error - If the auditor expects error to be present in the population, a larger
sample than when no error is expected ordinarily needs to be examined to conclude that the
actual error in the population is not greater than the planned tolerable error. Smaller sample
size are justified when the population is expected to be error free. In determining the expected
error in a population, the auditor would consider such matter as error levels identified in
previous audits, changes in the entity’s procedures, and evidence available from other
procedures.
Statistical sampling procedures - There are many different types of statistical sampling
plans, but whatever type is used, procedures for conducting a test will be as follows:
(a) decide on the relevant confidence level and precision limits;
(b) calculate the sample size using an appropriate formula or tables designed for the
purpose;
(c) select the sample using random methods:
(d) carry out the necessary tests;
(e) appraise the results.
The most common types of plans adopted by auditors are: Acceptance sampling (with
discovery sampling a variation) or Estimation sampling, which may be used to determine:
(a) population variables, or
(b) population attributes.
Selection with the aid of the computer - The auditor may use a computer to render
considerable assistance in the performance of statistical sampling tests, employing the
following methods:
(a) Interval sampling - The computer is programmed to select every nth item stored on
magnetic tape, and the items so selected can be copied on to a separate tape and
printed out in the form required by the auditor.
(b) Random number selection - The technique of random number selection can be
computerised, the random numbers being stored on tape or generated by the computer
separately for each application.
(c) Random Interval selection - The dangers of selecting a biased example by the use of a
uniform interval can be avoided through the use of random variation of the interval
between successive items. Random intervals are selected from random number tables
maintained on magnetic tape, or produced by means of a random number generator
program.
While applying statistical sampling, it should be remembered that materiality is one of the
major considerations to decide whether or not a sample should be selected. For instance in
case of certain enterprises like real estate builders, agents, merchant houses, etc. the total
number of transactions may be relatively very small and hence are not appropriate for the
selection of a sample. Even in case of major enterprises, there are certain items which are so
significant that the records relating to them should be scrutinized by the auditor at new item by
item basis. For example, the year end closing entries in the journal may be manipulated and,
therefore, each entry must be carefully examined and authenticated by the auditor. In actual
practice many firms of Chartered Accountants have found limited use of statistical sampling
than anticipated by them. The various reasons which may be attributed to this state of affairs
are as under:
(i) Audit has never been a mathematical discipline,
(ii) Designing and sampling schemes properly take unduly long time.
(iii) To draw valid conclusions on the basis of statistical sampling, all members of the audit
team should have an excellent grasp of the statistical principles involved,
5.2.7 Selection of the sample - The auditor should select sample items in such a way that the
sample can be expected to be representative of the population. This requires that all items in
the population have an opportunity of being selected. While there are a number of selection
methods, three methods commonly used are -
Random selection, ensures that all items in the population have an equal chance of selection,
for example by use of random number tables.
Systematic selection, involves selecting items using a constant interval between selections,
the first interval having a random start. The interval might be based on certain number of
items (for example, every 20th voucher number) or on monetary totals (for example, every
Rs.1,000 increase in the cumulative value of the population). When using systematic
selection, the auditor would need to determine that the population is not structured in such a
manner that the sampling interval corresponds with a particular pattern in the population. For
example, if in a population of branch sales, a particular branch’s sales occur only as every
100th item and the sampling interval selected is 50, the result would be that the auditor would
have selected all or none of the sales of that particular branch.
Haphazard selection, may be an acceptable alternative to random selection, provided the
auditor attempts to draw a representative sample from the entire population with no intention
to either include or exclude specific units. When the auditor uses this method, care needs to
be taken to guard against making a selection that is biased, for example, towards items which
are easily located, as they may not be representative.
5.2.8 Analysis of errors in the sample - In analysing the errors detected in the sample, the
auditor will first with a view to evaluating the sample results, the auditor should analyse any
errors detected, project such errors and reasons the sampling risk need to determine that an
item in question is in fact an error. In designing the sample, the auditor will have defined those
conditions that constitute an error by reference to the audit objectives. For example, in a
substantive procedure relating to the recording of accounts receivable, a mis-posting between
customer accounts does not affect the total accounts receivable. Therefore, it may be
inappropriate to consider this an error in evaluating the sample results of this particular
procedure, even though it may have an effect on other areas of the audit such as the
assessment of doubtful accounts.
When the expected audit evidence regarding a specific sample item cannot be obtained, the
auditor may be able to obtain sufficient appropriate audit evidence through performing
alternative procedures, For example, if a positive account receivable confirmation has been
requested and no reply was received, the auditor may be able to obtain sufficient appropriate
audit evidence that the receivables is valid by reviewing subsequent payments from the
customer. If the auditor does not, or is unable to, perform satisfactory alternative procedures,
or if the procedures performed do not enable the auditor to obtain sufficient appropriate audit
evidence the item would be treated as an error.
The auditor would also consider the qualitative aspects of the errors. These include the
nature and cause of the error and the possible effect of the error on other phases of the audit.
In analysing the errors discovered, the auditor may observe that many have a common
feature, for example, type of transaction, location, product line, or period of time. In such
circumstances, the auditor may decide to identify all items in the population which possess the
common feature, thereby producing a sub-population, and extent audit procedures in this
area. The auditor would then perform a separate analysis based on the items examined for
each sub-population.
5.2.9 Projection of errors - The auditor projects the error results of the sample to the
population from which the sample was selected. There are several acceptable methods of
projecting error results. However, in all the cases, the method of projection will need to be
consistent with the method used to select the sampling unit. When projecting error results, the
auditor needs to keep in mind the qualitative aspects of the errors found. When the population
has been divided into sub-population, the projection of errors is done separately for each sub-
population and the results are combined.
5.2.10 Reassessing Sampling Risk - The auditor needs to consider whether errors in the
population might exceed the tolerable error. To accomplish this, the auditor compares the
projected population error to the tolerable error taking into account the results of other audit
procedures relevant to the specific control or financial statement assertion. The projected
population error used for this comparison in the case of substantive procedures is net of
adjustments made by the entity. When the projected error exceeds tolerable error, the auditor
reassesses the sampling risk and if that risk is unacceptable, would consider extending the
audit procedure or performing alternative audit procedures.
Table 1: Examples of Factors influencing Sample Size for Tests of Control
Conditions leading to...
Factor Smaller Sample Size Larger Sample Size
Assessment of control risk Higher Preliminary Lower preliminary
assessment of control risk assessment of control risk
Tolerable error Higher acceptable rate of Lower acceptable rate of
deviation deviation
Allowable risk of over Higher risk of over reliance Lower risk of over reliance
reliance
Expected error or deviation Lower expected rate of Higher expected rate of
deviation in population deviation in population (1)
Number of items in Virtually no effect on sample
population size unless population is
small.
(1) High expected deviation rates ordinarily warrant little, if any, reduction of control risk and
therefore, tests of controls might be omitted.
Table 2: Examples of Factor influencing Sample Size for Substantive Procedures

Conditions leading to …..
Factor Smaller Sample Size Larger Sample Size
Assessment of control risk Lower control risk Higher control risk
Reduction in detection risk Greater use of other Reduced use of other
because of other substantive substantive tests substantive tests
tests related to the same
financial statement
assertions
Tolerable error Smaller measure of Tolerable Large measure of tolerable
error error
Expected error Smaller errors or lower Large errors or higher
frequency frequency
Population value Smaller monetary Larger monetary significance
significance to the financial to the financial statements
statements.
Number of items in Virtually no effect on sample
population size unless population is
small
Acceptable level of detection Higher acceptable level of Lower acceptable level of
risk detection risk detection risk
Stratification Stratification of the No stratification of the
population, if appropriate population
Audit of Fixed Assets

5.3 The Guidance Note on Audit of Fixed Assets issued by the ICAI recommends that the
verification of fixed assets consists of examination of related records and physical verification.
The auditor should normally verify the records with reference to the documentary evidence
and by evaluation of internal controls.
The verification of records would include verifying the opening balances of the existing fixed
assets from records such as the Schedule of fixed assets, ledger or register balances to
acquisition of new fixed assets should be verified with reference to supporting documents such
as orders, invoices, receiving reports and title deeds. Self-constructed fixed assets and
capital work-in-progress should be verified with reference to the supporting documents such
as contractors’ bills, work orders and independent confirmation of the work performed from
other parties. When fixed assets have been written off or fully depreciated in the year of
acquisition, the auditor should examine whether these were recorded in the fixed assets
register before being written off or depreciated. In respect of retirement of fixed assets, the
auditor should examine whether retirements were properly authorised, whether depreciation
accounts have been properly adjusted, whether the sale proceeds, if any, have been
accounted for and the resulting gains or losses, if material, have been properly adjusted and
disclosed in the profit and loss account. In case the asset has impaired the auditor must
ensure that the asset has met the criteria as specified in AS 28, “impairment of Assets”.
Further, if conditions so warrants the reversal norms of impairment loss are duly complied
with.
The ownership of assets like land the buildings should be verified by examining title deeds. In
case the title deeds are held by other persons such as bankers or solicitors, independent
conformation should be obtained directly by the auditor through a request signed by the client.
Physical verification of fixed assets is primarily a responsibility of the management. The
management is required to carry out physical verification of fixed assets at appropriate
intervals in order to ensure that they are in existence. However, the auditor should satisfy
himself that such verification was done by the management wherever possible and by
examining the relevant working papers. The auditor should also examine whether the method
of verification was reasonable in the circumstances relating to each asset. The
reasonableness of the frequency of verification should also be examined by the auditor in the
circumstances of each case. The auditor should test check the books records of fixed assets
with the physical verification reports. He should examine whether discrepancies noticed on
physical verification have been properly dealt with.
The auditor should see that the fixed assets have been valued and disclosed as per the
requirements of law and generally accepted accounting principles. The auditor should test
check the calculations of depreciation and the total depreciation arrived at should be
compared with that of the preceding years to identify reasons for variations. He should
particularly examine whether the depreciation charge is adequate keeping in view the
generally accepted basis of accounting for depreciation. The Institute has also recommended
that the company should provide deprecation so as to write off the asset over its normal
working life. The company may provide depreciation at higher rate than the rates prescribed
under Schedule XIV to the Companies Act, 1956, if it feels that the normal working life of the
asset is low. However, if the company feels that the normal working life of the assets is much
higher, it cannot provide depreciation at the rates lower than the rate prescribed by the
Schedule XIV to the Companies Act, 1956. In such a case the rates given in Schedule XIV
should be followed.
Re-valuation of fixed assets implies re-statement of their books values on the basis of
systematic scientific appraisal which would include ascertainment of working condition of each
unit of fixed assets. It would also include making technical estimates of future working life and
the possibility of obsolescence. Such an appraisal is usually made by independent and
qualified persons such as engineers, architects, etc. To the extent possible, the auditor
should examine these appraisal. As long as the appraisal appears reasonable and based on
adequate facts, he is entitled to accept the revaluation made by the experts.
Audit Risk
5.4 Students may recall that according to AAS-2, on “Objective and scope of Financial
Statements”, there is unavoidable risk that even some material misstatements may remain
undiscovered due to the test nature and other inherent limitations of any system of internal
control. AAS-5 on “Audit Evidence” also makes it clear that an auditor’s judgement as to what
is sufficient and appropriate audit evidence is affected by the degree of risk of misstatement.
Therefore, it becomes significant that an auditor is aware of risks which are inherent in any
audit with reference to materiality of transactions involved and accordingly test and evaluate
internal control systems so as to assess the extent of risk. In the following paragraphs, first of
all various facts of audit risks are discussed followed by relationship between materiality and
audit risk. Following this, the procedure to be adopted by an auditor to assess risk in the
internal control system is elaborated.
Low-risk areas are those which require the application of routine “nuts and bolts” audit
procedures in the ordinary course of vouching, casting, checking, etc., at both compliance and
substantive stages, usually occupying up to 80% of all audit effort. High-risk areas are those
which should be the primary concern of partners and senior managers, and will include such
matters as:
(a) adequacy of provisions;
(b) full disclosure of liabilities, including contingent liabilities;
(c) interpretation of AASs and company legislation;
(d) post–balance sheet review of subsequent events;
(e) analytical reviews on draft financial statements;
(f) implications of tax legislation;
(g) detecting overstatement of assets, e.g. by capitalising expenditure;
(h) identifying high-value items and ‘error-prone’ conditions, and
(i) drafting the audit report itself.
Concept of audit risk - Audit risk is the risk that an auditor may give an inappropriate opinion
on financial information that is materially misstated. For example, an auditor may give an
unqualified opinion on financial statements without knowing that they are materially misstated.
Such risk may exist at overall level or while verifying various transactions and balance-sheet
items.
1. Audit risk at the financial statement level - Audit risk is considered at the financial
statement level during the audit planning process. At this time, the auditor should
undertake an overall audit risk assessment based on his knowledge of the client’s
business, industry, management, control environment and operations. Such an
assessment provides preliminary information about the general approach to the
engagement, the auditor’s staffing needs and the framework within which materiality and
audit risk assessments can be made at the individual account balance or class of
transactions level. As part of this overall risk assessment, the auditor should consider
whether there is potential for pervasive problems, for example, liquidity or going concern
problems.
2. Audit risk at the account balance and class of transactions level - The majority of
audit procedures are directed to, and carried out at the account balance and class of
transactions level. Accordingly, audit risk should be considered by the auditor at this level
taking into account the results of the overall audit risk assessment made at the financial
statement level. To assess inherent risk, the auditor uses professional judgement to
evaluate numerous factors, examples of which are:
At the financial statement level:
♦ the integrity of management;
♦ management experience, knowledge and changes during the period (e.g. the in ex-
perience of management may affect the preparation of the financial statements of the
entity);
♦ unusual pressures on management (e.g. circumstances that might predispose
management to mis-state the financial statements, such as an entity in an industry
experiencing a large number of business failures or an entity that lacks sufficient capital to
continue operations);
♦ the nature of the entity’s business (e.g. its technological obsolescence of products and
services, complex capital structure, significance of related parties, and the number of
locations and geographical spread of its production facilities); factors affecting the
industry in which the entity operates (e.g. economic and competitive conditions, and
changes in technology, accounting practices common to the industry and, if available,
financial trends and ratios);
At the Account balance and class of transaction level:
♦ financial statement of accounts likely to be susceptible to misstatement (e.g. a financial
statement of account which required adjustment in the previous period);
♦ the complexity of underlying transactions which might require the use of the work of an
expert;
♦ the amount of judgement involved in determining account balances;
♦ susceptibility of assets to loss or misappropriation;
♦ the completion of unusual and complex transactions, particularly at or near year end; and
♦ transactions not subjected to the normal processing mode.
Assessment of audit risk by reference to its components - The paragraphs that follow
provide guidance directed to the assessment of audit risk at both the overall and the account
balance and class of transactions level. Three components of audit risk are:
♦ inherent risk (risk that material errors will occur);
♦ control risk (risk that the client’s system of internal control will not prevent or correct such
errors); and
♦ detection risk (risk that any remaining material errors will not be detected by the auditor).
The nature of each of these types of risk and their interrelationship is discussed below:
Inherent risk - is the susceptibility of an account balance or class of transactions to
misstatement that could be material, individually or when aggregated with mis-statements in
other balances or classes, assuming that there were no related internal controls. It is a
function of the entity’s business and its environment and the nature of the account balance or
class of transactions. For example, accounts involving a high degree of management
judgement, or that are difficult to compute, such as a complex accounting estimate, or that
involve highly desirable and movable assets, such as jewellery, or that are particularly
susceptible to changes in consumer demand or technology that could affect their value, will
involve more inherent risk than other accounts.
Control risk - is the risk that misstatement that could occur in an account balance or class of
transactions and that could be material, individually or when aggregated with mis-statements
in other balances or classes, will not be prevented or detected on a timely basis by the system
of internal control. There will always be some control risk because of the intrinsic limitation of
any system of internal control. To assess control risk, the auditor should consider the
adequacy of control design, as well as test adherence to control procedures. In the absence
of such an assessment, the auditor should assume that control risk is high.
Detection risk - is the risk that an auditor’s procedures will not detect a misstatement that
exists in an account balance or class of transactions that could be material, individually or
when aggregated with misstatements in other balances or classes. The level of detection risk
relates directly to the auditor’s procedures. Some detection, risk would always be present
even if an auditor were to examine 100 percent of the account balance or class of transaction
because, for example, the auditor may select an inappropriate audit procedure, misapply an
appropriate audit procedure or misinterpret the audit results.
Interrelationship of the components of audit risk - Inherent and control risks differ from
detection risk in that they exist independently of an audit of financial information. Inherent and
control risks are functions of the entity’s business and its environment and the nature of the
account balances or classes of transactions, regardless of whether an audit is conducted.
Even though inherent and control risks cannot be controlled by the auditor, the auditor can
assess them and design his substantive procedures to produce an acceptable level of
detection risk, thereby reducing audit risk to an acceptably low level.
Risk-Based Audit
5.5 Audit should be risk-based or focused on areas of greatest risk to the achievement of the
audited entity’s objectives. Risk-based audit (RBA) is an approach to audit that analyzes audit
risks, sets materiality thresholds based on audit risk analysis and develops audit programmes
that allocate a larger portion of audit resources to high-risk areas.
The auditor does not normally need to perform specific audit procedures on all areas of audit.
He only needs to design audit programmes and procedures on areas earlier identified as
major risks that could result in the financial statements being materially misstated. RBA is an
essential element of financial audit- both in the attest audit of the financial statements and in
the audit of financial systems and transactions including evaluation of internal controls. It
focuses primarily on the identification and assessment of the financial statement misstatement
risks and provides a framework to reduce the impact to the financial statement of these
identified risks to an acceptable level before rendering an opinion on the financial statements.
It also provides indicators of risks as a basis of opportunity for improvement of auditee risk
management and control processes. This affords an opportunity to the auditee to improve its
operations from recommendations on risks that do not have a current impact on the financial
statements but impact the audited entity’s operational strategies and performance over the
longer term.
In the context of performance audit, it is the risk to delivery of an activity or scheme or
programme of the entity with economy, efficiency and effectiveness. Awareness of areas that
puts the programme or resources at risk from the point of view of economy, efficiency and
effectiveness helps focus audit attention on them. The risk analysis provides a framework for
assurance in performance auditing.
5.5.1 Audit risk analysis - The auditor should perform an analysis of the audit risks that impact
on the auditee before undertaking specific audit procedures. Risk assessment is a subjective
process. It is part of the professional judgment of the auditor and of the particular
circumstances. In Para 5.4 ‘audit risk’ has been explained in details. It is the risk that the
auditor may unknowingly fail to appropriately modify his opinion on financial statements that
are materially misstated.
Audit risks are brought about by error and fraud:
♦ Error is an unintentional mistake resulting from omission, as when legitimate transactions
and/or balances are excluded from the financial statements; or by commission, as when
erroneous transactions and/or balances are included in the financial statements.
♦ Fraud is an intentional misstatement in the accounting records or supporting documents
from which the financial statements are prepared. It is intended to deceive financial
statement users or to conceal misappropriations.
The auditor has the responsibility to plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatements, whether
caused by error or fraud.
An error risk may arise from an error in principle, estimate, critical information processing,
financial reporting process or disclosure.
Fraud risk involves manipulation, falsification of accounting records, or misrepresentation in
the financial statements of events, transactions or other significant information, or
misapplication of accounting principles or misappropriation of funds.
5.5.2 General Steps in the Conduct of RBA - RBA consists of four main phases starting with
the identification and prioritization of risks, to the determination of residual risk, reduction of
residual risk to acceptable level and the reporting to auditee of audit results. These are
achieved through the following:
♦ Understand auditee operations to identify and prioritize risks
♦ Assess auditee management strategies and controls to determine residual audit risk
♦ Manage residual risk to reduce it to acceptable level
♦ Inform auditee of audit results through appropriate report
Understanding auditee operations involves processes for reviewing and understanding the
audited organization’s risk management processes for its strategies, framework of operations,
operational performance and information process framework, in order to identify and prioritize
the error and fraud risks that impact the audit of financial statements. The environment in
which the auditee operates, the information required to monitor changes in the environment,
and the process or activities integral to the audited entity’s success in meeting its objectives
are the key factors to an understanding of agency risks. Likewise, a performance review of the
audited entity’s delivery of service by comparing expectations against actual results may also
aid in understanding agency operations.
Assessment of management risk strategies and controls is the determination as to how
controls within the auditee are designed. The role of internal audit in promoting a sound
accounting system and internal control is recognized, thus the SAI should evaluate the
effectiveness of internal audit to determine the extent to which reliance can be placed upon it
in the conduct of substantive tests.
Management of residual risk requires the design and execution of a risk reduction approach
that is efficient and effective to bring down residual audit risk to an acceptable level. This
includes the design and execution of necessary audit procedures and substantive testing to
obtain evidence in support of transactions and balances. More resources should be allocated
to areas of high audit risks, which were earlier known through the analytical procedures
undertaken.
The results of audit shall be communicated by the auditor to the audited entity. The auditor
must immediately communicate to the auditee reportable conditions that have been observed
even before completion of the audit, such as weaknesses in the internal control system,
deficiencies in the design and operation of internal controls that affect the organization’s ability
to record, process, summarize and report financial data.
Materiality and Audit Risk
5.6 The concise Oxford Dictionary defines the term “material” as “important or essential.
Whatever is important or essential in a given auditing situation would automatically be
material. It is a relative term and what may be material in one set of circumstances may not
be so in another. The concept of materiality is fundamental to the process of aggregation,
classification and presentation of accounting information. Questions of materiality arise in
various circumstances. The Statement on Auditing Practices issued by the Institute of
Chartered Accountants of India states that the recommendations contained therein apply
primarily to items which are material and significant in relation to the affairs of a company.
Items of little or no significance may be dealt with as may be found expedient, as it is neither
desirable nor necessary that members should devote their time and energies in the pursuit of
matters of a trivial nature. However, freedom to deal expediently with non- material items
should not extend to a group of items whose cumulative effect on the accounts may be
material or significant.
The auditor has to keep this in view while examining the truth and fairness of the statements
of account. The auditor has to satisfy himself that the statements exhibit a true and fair state
of affairs having regard to all material aspects. At various places of Part II of Schedule VI to
the Companies Act reference is made to materiality and the same is also a matter of
importance in relation to items in the balance sheet.
It is clear from the above that the concept of materiality is fundamental to the accounting
process, right from the stage of aggregation to preparation of the annual accounts. The Profit
and Loss Account and the Balance Sheet of a company with a view to disclosing a true and
fair state of affairs, are to be drawn up in accordance with the form and disclosure
requirements prescribed in the Schedule VI to the Companies Act. The concept of materiality
has implicit as well as explicit recognition in the requirements contained in Schedule VI: As
regard implicit recognition, the very items which have been identified for a distinct disclosure
both in Part I and Part II of Schedule VI, are based on materiality consideration Viewed from
legislative angle, for example, disclosure of remuneration paid to the auditor. Explicit
reference to materiality exists at a number of places in Part II of Schedule VI and that requires
due consideration and judgement at the time of preparation of the profit and loss account by a
company. Clause 2 (b) of Part II of Schedule VI requires the disclosures of every material
feature including credits or receipts and debits or expenses in respect of non-recurring
transactions or transactions of an exceptional nature. Some more specific instances of
mention of the materiality consideration in Part II of Schedule VI are as follows:
(1) Aggregate if material, of any amounts set aside to reserves, aggregate, if material of any
amounts withdrawn from such reserves, aggregate, if material of the amount set aside to
provisions made for meeting specific liabilities and aggregate if material, of the amounts
withdrawn from such provisions are required to be disclosed.
(2) Profits or Losses in respect of transactions of a kind not usually undertaken by the
company, should be disclosed, if material in amount.
(3) Amount, if material, by which any items shown in the Profit and Loss Account are
affected by any change in the basis of accounting should be disclosed.
However, what is material has not been defined by the statute. Even though the statute has
not defined the concept of materiality, in a way, we can say that it has provided some sort of
guidance in this matter in specific circumstances. For example, Part II of Schedule VI requires
the following disclosures.
(1) Any item under which expenses exceed 1 per cent of the total revenue of the company or
Rs. 5,000 whichever is higher should be shown as a separate and distinct item.
(2) All those items of raw materials which in value individually account for 10 per cent or
more of the total value of the raw material consumed shall be shown as separate and
distinct items with quantities thereof in the break-up. Likewise, in giving the break-up of
purchases. stocks and turnover, items like spare parts and accessories should be shown
as separate and distinct items if their value as individual items account for 10 percent or
more of the total value of purchases, stock or turn over.
The following are some of the specific requirements in the form of balance sheet based on
materiality consideration implicit in the very process of prescribing the format in Part I of
Schedule VI.
1. Loans from Directors should be shown separately.
2. Nature of interest, if any, of any director with the bankers or other officers of the company
at any time during the year should be disclosed by way of a note.
3. The maximum amount due by directors or other officers of the company at any time
during the year should be disclosed by way of a note.
Further, wherever there is a change in the basis of accounting, the effect thereof, even if it is
small, must be disclosed, it being a material factor for assessing the causes of the change in
the profitability of the company.
AAS-13 on “Audit Materiality” requires that the auditor should consider materiality and its
relationship with audit risk when conducting an audit. According to it, information is material if
its misstatement (i.e., omission or erroneous statement) could influence the economic
decisions of users taken on the basis of the financial information. Materiality depends on the
size and nature of the item, judged in the particular circumstances of its misstatement. Thus,
materiality provides a threshold or cut-off point rather than being a primary qualitative
characteristic which the information must have if it is to be useful. It stresses that the
assessment of what is material is a matter of professional judgement.
The concept of materiality recognises that some matters, either individually or in the
aggregate, are relatively important for true and fair presentation of financial information in
conformity with recognized accounting policies and practices. The auditor considers
materiality at both the overall financial information level and in relation to individual account
balances and classes of transactions. Materiality may also be influenced by other
considerations, such as the legal and regulatory requirements, non-compliance with which
may have a significant bearing on the financial information, and considerations relating to
individual account balances and relationships. This process may result in different levels of
materiality depending on the matter being audited. Although the auditor ordinarily establishes
an acceptable materiality level to detect quantitatively material misstatements, both the
amount (quantity) and nature (quality) of misstatements need to be considered. An example
of a qualitative misstatement would be the inadequate or improper description of an
accounting policy when it is likely that a user of the financial statements would be misled by
the description.
The auditor needs to consider the possibility of misstatements of relatively small amounts that,
cumulatively, could have a material effect on the financial information. For example, an error in
a month-end (or other periodic) procedure could be an indication of a potential material
misstatement if that error is repeated each month or each period, as the case may be.
5.6.1 Relationship between Materiality and Audit Risk - when planning the audit, the auditor
considers what would make the financial information materially misstated. The auditor’s
preliminary assessment of materiality, related to specific account balances and classes of
transactions, helps the auditor decide such questions as what items to examine and whether
to use sampling and analytical procedures. This enables the auditor to select audit procedures
that, in combination, can be expected to support the audit opinion at an acceptably low degree
of audit risk.
There is an inverse relationship between materiality and the degree of audit risk, that is, the
higher the materiality level, the lower the audit risk and vice versa. For example, the risk that a
particular account balance or class of transactions could be misstated by an extremely large
amount might be very low, but the risk that it could be misstated by an extremely small amount
might be very high. The auditor takes the inverse relationship between materiality and audit
risk into account when determining the nature, timing and extent of audit procedures. For
example, if, after planning for specific audit procedures, the auditor determines that the
acceptable materiality level is lower, audit risk is increased. The auditor would compensate for
this by either:
(a) reducing the assessed degree of control risk, where this is possible, and supporting the
reduced degree by carrying out extended or additional tests of control; or
(b) reducing detection risk by modifying the nature, timing and extent of planned substantive
procedures.
5.6.2 Materiality and Audit Risk in Evaluating Audit Evidence - The auditor’s assessment of
materiality and audit risk may be different at the time of initially planning the engagement from
that at the time of evaluating the results of his audit procedures. This could be because of a
change in circumstances or a change in the auditor’s knowledge as a result of the audit. For
example, if the audit is planned prior to period end, the auditor will anticipate the results of
operations and the financial position. If actual results of operations and financial position are
substantially different, the assessment of materiality and audit risk may also change.
Additionally, the auditor may, in planning the audit work, intentionally set the acceptable cut off
level for verifying individual transactions at a lower level than is intended to be used to
evaluate the results of the audit. This may be done to cover a larger number of items and
thereby reduce the likelihood of undiscovered misstatements and to provide the auditor with
the margin of safety when evaluating the effect of misstatements discovered during the audit.
In forming his opinion on the financial information, the auditor should consider whether the
effect of aggregate uncorrected misstatements on the financial information is material.
Qualitative considerations also influence an auditor in reaching a conclusion as to whether the
misstatements are material.
The aggregate of uncorrected misstatements comprises:
(a) specific misstatements identified by the auditor, including the net effect of uncorrected
misstatements identified during the audit of previous periods; and
(b) the auditor’s best estimate of other misstatements which cannot be specifically identified
(that is, projected errors).
When the auditor tests an account balance or class of transactions by an analytical procedure,
he ordinarily would not specifically identify misstatements but would only obtain an indication
of whether misstatements might exist in the balance or class and possibly its approximate
magnitude. If the analytical procedure indicates that misstatements might exist, but not its
approximate amount, the auditor ordinarily would have to employ other procedures to enable
him to estimate the aggregate misstatement in the balance or class.
When an auditor uses audit sampling to test an account balance or class of transactions, he
projects the amount of known misstatements identified by him in his sample to the items in the
balance or class from which his sample was selected. That projected misstatement, along with
the results of other substantive tests, contributes to the auditor’s assessment of aggregate
misstatement in the balance or class.
If the aggregate of the uncorrected misstatements that the auditor has identified approaches
the materiality level, or if auditor determines that the aggregate of uncorrected misstatements
causes the financial information to be materially misstated, he should consider requesting the
management to adjust the financial information or extending his audit procedures. In any
event, the management may want to adjust the financial information for known misstatements.
The adjustment of financial information may involve, for example, application of appropriate
accounting principles, other adjustments in amounts, or the addition of appropriate disclosure
of inadequately disclosed matters. If the management refuses to adjust the financial
information and the results of extended audit procedures do not enable the auditor to conclude
that the aggregate of uncorrected misstatements is not material, the auditor should express a
qualified or adverse opinion, as appropriate.
5.6.3 Responsibility of Management - Management may decide to adjust the financial
statements for some, or all, of the mis-statements the auditor brings to its attention. In
evaluating whether the financial statements give a true and fair view (or “are presented fairly”),
the auditor should take into account the aggregate of all uncorrected misstatements, including
those involving estimates. The aggregation of mis-statements should include the auditor’s the
best estimate of the total misstatements in the account balances or classes of transactions
examined, not just the misstatements that he identified. If the aggregate uncorrected
misstatements exceed the final assessment of materiality for the financial information, account
balances or classes of transactions, the auditor should, after performing additional work if
needed, request management to correct the material mis-statement and, if management
refuses, issue a qualified or adverse opinion.
6
THE COMPANY AUDIT
Introduction
6.1 The shareholders of the company are the real owners of the Company. They invest their
money in the company. However the management of the company lies in the hands of the
directors. Generally the shareholders do not have the skills required to understand the financial
statements. Thus audit of account of company has been made compulsory in order to protect the
interest of the shareholders. Audit of accounts ensures that the statements of account are properly
drawn up and they disclose all the requisite information. Auditor must also ensure that the
company has not violated any of the provisions contained in the companies Act, 1956. Although
compliance with the relevant provisions of the companies Act, 1956 is the responsibility of the
directors and officers of the company, nevertheless the auditor must make a report to the
shareholders where non compliance results in affecting the accounts materially.
Appointment of Company Auditor
6.2 The following are the important considerations regarding the appointment of the company
auditor :
6.2.1 Who can be Auditor - Section 226 of the Companies Act, 1956 deals with the
qualification of company auditors. It intends to ensure that the auditors are independent of the
companies they audit. A body corporate can not be appointed as an auditor because it has a
limited liability. Clause (b) of sub-section (3) of Section 226 of the Act disqualifies an officer or
employee of the company from being appointed as its auditor. According to a clarification of
the Department of Company Affairs the legal position is as follows:
“Where the chartered accountant is employed whole-time, he is an employee of the
company. In other cases, generally speaking there would appear to be only a
contract for service and not a contract of service between the company and
chartered accountant, In Dhrangadhra Chemicals Works v. State of Saurashtra
(1957 S.CA, p. 216) the Supreme Court has laid down that the prima facie test for
determination of the relationship between master and servant is the existence of the
right in the master to supervise and control the work done by the servant not only in
matter of directing that work the servant is to do, but also the manner in which he
shall do his work, or to borrow the words of Lord Uthwatt, the proper test is whether
or not the hirer had authority to control the manner of execution of the act in
question. Applying this test in any case, where the chartered accountant is
consulted only professionally on income tax matters by a company, he can not be
said to be an officer or employee of the company.
“A Chartered Accountant’s main business is to render professional service for
reward like a lawyer or a doctor. Where such service is rendered professionally and
not as an officer or employee of the company, a chartered accountant is not
disqualified under Section 226(3)(b) of the Companies act, 1956".
It is, however, clear that there is no prohibition on a relative of a director or a partner of such
relative to be appointed as an auditor. The provisions of Section 297(1) would also not apply
to the appointment of such a person as an auditor because an audit is in the nature of
rendering personal service obtained not on the basis of the lowest tender but on account of
professional expertise irrespective of cost involved. However, the appointment of an auditor
who is a relative of a director or a firm of auditors in which a director of the company or his
relative is a partner would be an office of profit under Section 314 requiring the consent of the
company by a special resolution, if the total monthly remuneration exceeds prescribed limits
(Section 314). Prior consent of the company and approval of Central Government (Company
Law Board) would also be required in appropriate cases. Moreover, a chartered accountant in
practice shall be deemed to be guilty of professional misconduct under the Chartered
Accountants Act, 1949 if he expresses his opinion on the financial statements of any
enterprise, in which he, his firm or a partner in his firm or any of his relatives have a
substantial interest, unless he discloses the interest also in his report. The term “relatives” is
to be construed with reference to Section 6 of the Companies Act. Similarly, the expression
“substantial interest” is to have the same meaning as is assigned thereto under Explanation 3
to Section 13 of the Income Tax Act, 1961. Further, clause (d) of sub-section (3) of Section
226 of the Act states that a person indebted to the company for an amount exceeding Rs.
1,000 or a person who, has given any guarantee or provide any security in connection with the
indebtedness of any third person to the company for an amount exceeding Rs. 1,000 is not
qualified for appointment as an auditor. Some special situations are discussed below:
(a) In this context, a question may come up as to whether such indebtedness would arise in
cases where, in accordance with the terms of appointment by a client, the auditor
recovers his fees on a progressive basis as and when a part of the work is done without
waiting for the completion of the whole job. According to the Research Committee of the
Institute “a question often arises as to whether indebtedness arises in cases where in
accordance with the terms of his engagement by a client (e.g. resolution passed by the
general meeting) the auditor recovers his fees on a progressive basis as and when a part
of work is done without waiting for the completion of the whole job. In these
circumstances, where in accordance with such terms, the auditor recovers his fees on a
progressive basis, he cannot be said to be indebted to the company at any stage.”
The Company Audit 6. 3
(b) A question of indebtedness may also be raised where an auditor of a company

purchases goods or services from the company audited by him. In such a case, if the
amount outstanding exceeds Rs. 1,000, irrespective of the nature of the purchase or
period of credit allowed to other customers, the provisions concerning disqualification of
auditors as contained in Section 226(3)(d) will be attracted.
(c) Another question which arises for consideration is whether a partner is disqualified from
appointment as auditor when the firm of which he is a partner is indebted to the company
in excess of the limit prescribed and whether the firm is disqualified from appointment as
auditor when a partner of the firm is indebted in excess of the prescribed limit. In both
cases disqualification will apply because when a firm is appointed as an auditor, each
partner is deemed to be so appointed and when a firm is indebted each partner is
deemed to be indebted.
(d) There may also be situations in which, though the appointment is made in the individual
name of a partner, the work is in fact carried out by the firm and the fees are credited to
the account of the firm. In such situations, the firm will be deemed to be acting as auditor
and the disqualification will be attracted in the case of indebtedness either of firm or a
partner.
Section 226(3) has been amended by the Companies (Amendment) Act, 2000 whereby a
person holding any security carrying voting rights after a period of one year from December
13, 2000 shall be disqualified from being appointed as auditor of the company. The aim of the
provision is to curb possible insider trading on the part of auditors.
6.2.2 Reappointment of Auditors - The Companies Act, 1956 stipulates that the office of an
auditor in a company is a continuing one and, therefore, has laid down that an auditor shall
hold office from the conclusion of the annual general meeting in which he is appointed till the
conclusion of the next annual general meeting. Except in cases of appointment of the first
auditor, appointment or filling of casual vacancies in the office of the auditor, companies are
required to appoint the auditor or auditors in the annual general meeting as a routine feature.
The appointment is subject to the following conditions:
(i) The auditor proposed to be appointed or re-appointed must possess the qualifications
prescribed under Section 226 of the Companies Act, i.e., he must be a Chartered
Accountant (holding Certificate of Practice) within the meaning of the Chartered
Accountants Act, 1949 or a Restricted State Auditor [Section 226(l) & (2)].
(ii) A firm of Chartered Accountants whereof all the partners practising in India are qualified
for appointment may also be appointed as the auditor in its firm name [Section 226(l)].
(iii) The proposed auditor does not suffer from the disqualifications enumerated in sub-
sections (3) and (4) of Section 226 of the Companies Act.
(iv) In the case of re-appointment of the retiring auditor, it should be ensured that:
(a) he has not given notice to the company in writing of his unwillingness to be re-ap-
pointed;
(b) no resolution has been passed at the annual general meeting appointing somebody
else instead of the retiring auditor or providing expressly that the retiring auditor
shall not be reappointed;
(c) no notice of the intended resolution to appoint some other person or persons in
place of retiring auditor was received by the company that could not be proceeded
with due to death, incapacity or disqualification of other person or persons [Section
224(2)].
(d) a written certificate has been obtained from the proposed auditor to the effect that
the appointment or re-appointment, if made, will be in accordance with the limits
specified in sub-section (1B) of Section 224.
Appointment in a general meeting of the company means appointment by the shareholders of
the company. Upon an auditor being appointed in the annual general meeting, the company is
to give intimation thereof to the concerned auditor within seven days of the appointment,
whether it is a case of a new auditor being appointed or the retiring auditor being re-
appointed. The auditor, in his turn, upon receipt of the intimation from the company about his
‘appointment’ is required to send a written communication to the concerned Registrar of
Companies within 30 days of the receipt of the intimation stating whether he has accepted or
declined the appointment.
It should also be noted that the auditors shall hold office until conclusion of the next annual
general meeting meaning thereby that the non-holding of the next annual general meeting or
its adjournment without considering the business of appointment or re-appointment of
auditors, shall in no way affect the factual conclusion of the next annual general meeting of
the company. Notionally, it cannot be presumed that the auditor’s term expires on the date on
which the annual general meeting ought to have been held. A detailed clarification has been
issued by the Department of Company Affairs in this regard according to which:
“The tenure of an auditor is laid down in Section 224(l); it is from the conclusion of
the annual general meeting to the conclusion of the next annual general meeting
and cannot therefore, be for any particular year or financial year as such. The duty
of the auditor is laid down in Section 227(2), whereunder the auditor in office has to
audit every balance sheet and profit and loss account and every other document in
it or annexed to it which is laid before the general meeting held during his tenure of
office. In view of the provisions in Section 224(l), there can only be one annual
general meeting held during the tenure of office of any particular auditor. That also
shows that the auditor’s appointment is not related to any particular balance sheet
or profit and loss account or to any particular financial year.
“In the above context the Board decided that the tenure of an auditor appointed under
Section 224 of the Companies Act will continue upto the factual conclusion of the next
general meeting held by the company.”
6.2.3 Defective appointment - Where the appointment of a person as the auditor in the
annual general meeting is void ab initio, it appears that the provision of Section 224(3) will be
attracted and the appointment of the auditor can be made by the Central Government.
Filling of a casual vacancy - A casual vacancy in the office of the auditor can be filled by the
Board of Directors, provided such vacancy has not been caused by the resignation of the
auditor. In the case of a casual vacancy arising on account of resignation, only the company
in general meeting can fill the vacancy. The expression ‘casual vacancy’ has not been defined
in the Act. Taking its natural meaning, it stands for the vacancy created by the auditor ceasing
to act after he was validly appointed and the appointment was accepted. This may arise due
to a variety of reasons which include death, resignation, disqualification, dissolution of the firm
of auditors, etc. The provision to require filling of casual vacancy caused by the resignation of
the auditor by the annual general meeting is in consonance with the principle of auditor’s
independence. This process may bring out facts regarding the auditor’s resignation to the
notice and scrutiny of the shareholders. Any abuse of authority or financial impropriety by the
management, that might have contributed to the resignation, will be known. If the resigning
auditor could be found to be conscientious and honest the general meeting may even request
him to reconsider his decision and take appropriate steps to cure the evils, if any, in the
management. The auditor appointed to a casual vacancy shall hold office till the conclusion of
the next general meeting. However, it should be noted that a casual vacancy does not arise in
the office of auditors on the expiry of one year of their appointment if the annual general
meeting is not held in time. According to the Annual Report of the Institute of Chartered
Accountants of India for the year ended 31 March, 1971:
“A case of an alleged unjustified removal of auditors was reported to the Council where
the existing auditors were removed and new auditors were appointed by the board of
directors before holding the annual general meeting, on the footing that a casual vacancy
in the office of the auditors of the company had occurred on the expiry of the period of
one year, even though no annual general meeting was held. On a review of the facts
and circumstances of the case reported, it was held that the change of auditors sought to
be made in the circumstances was not justified and in the Council’s opinion the
appointment sought to be made of the new auditors was not valid, since no vacancy had
arisen in the office of the auditors. The Council felt that the existing auditor continued to
be the statutory auditor until the conclusion of the next annual general meeting. The
decision was communicated both to existing auditors and new auditors who were also
informed that accepting the appointment in such circumstances would not be proper.”
6.2.4 Appointment of Auditor by Central Government - Where, at the annual general
meeting, no auditors are appointed or re-appointed, the Central Government may appoint a
person to fill the vacancy. It is the duty of the company to give notice of the fact that no
auditor was appointed in the annual general meeting to the Central Government within 7 days
of the annual general meeting. In case of any default to give notice to the Central
Government, the company and every officer in default shall be punishable with Fine that may
extend to Rs. 5000.
6.2.5 Ceiling on Audits - It has been mentioned earlier that before appointment is given to
any auditor, the company must obtain a certificate from him to the effect that the appointment,
if made, will not result in an excess holding of company audit assignments by the auditor
concerned over the limit laid down in Section 224(1B). Section 224(1B) of the Companies Act
as amended by Companies (Amendment) Act, 1988 provides that no company or its Board of
Directors shall appoint or re-appoint any person who is in full time employment elsewhere or
firm as its auditor if such firm or person is, at the date of such appointment or re-appointment,
holding appointment as auditor of the specified number of companies. Specified number has
been defined to mean 20 company audits subject to a further limit of 10 company audits in
respect of companies having paid up capital of Rs. 25 lakhs or more. Further it provides that in
the case of a firm of auditors, specified number of companies shall be construed as the
number of companies specified for every partner of the firm who is not in full-time employment
elsewhere.
(Note: It may be noted that the intention of the Central Government in amending this section
was to plug the loophole whereby chartered accountants in full-time employment could not be
considered for the purpose of conducting company audits. However, the amended section
tends to suggest that an individual chartered accountant in full time employment practising as
a sole proprietor can audit 20 companies while a chartered accountant practising as a sole-
proprietor not in full-time employment elsewhere can audit unlimited number of companies).
The limit of 20 company audits is per person. In the case of an auditing firm having 3 partners,
the overall ceiling will be 3 ×20 = 60 company audits of which not more than 30 should be in
companies having paid-up capital of Rs. 25 lakh or more. Sometimes a single chartered
accountant can be a partner or proprietor in a number of auditing firms. In such a case, all the
firms in which he is a partner or proprietor will be together entitled to 20 company audits on his
account, subject to the sub- ceiling of 10 large company audits. How they allocate the 20
audits between themselves is their affair. Explanation II after sub-section (1C) of Section 224
further amplifies the manner of identifying the audit units for calculating the specified number.
Under this explanation, when an auditor is appointed to audit even a part of company’s
accounts, the part will be considered as a unit of audit for the purpose of calculation of the
ceiling. Often one comes across what is known as joint audit when two or more auditors are
appointed to audit the accounts of a company. Each of the joint auditors is considered an
auditor for the purpose; any joint audit held by an auditor will be included as one audit unit for
the purpose of calculating ceiling. However, appointment as a branch auditor will not be
counted. The question arises whether the audits of branches of Indian companies and the
audits of Indian business accounts of foreign companies which have established their place of
business in India and are doing business in India are to be taken into account for computing
the limit of 20 companies as laid down in Explanation I of sub-section (1C) of Section 224 of
this Act. The Department of Company Affairs clarified that “the branch auditor of Indian
companies, appointed under Section 228 of the Act, audits the accounts of the particular
branch only for which he is appointed and forwards his report to the auditor appointed under
Section 224 of the Act and hence he cannot be equated with the company auditor appointed
under Section 224 who has to report to the annual general meeting on the, account of the
company as a whole including the branches audited by branch auditor. The words “any part of
which” appearing in Explanation II cannot have any reference to branch audit which as noted
above does not fit into the context of Section 224. The said words relate to the antecedent
number and not companies in so far as they are of any material significance to the context.
Hence, the branch audits are not to be included while calculating the specified number of 20
units.”
As regards the audit of the accounts of foreign companies, the Department is of the view that
they are outside the scope of Section 224 since the definition of company under Section 3 of
the Act does not include a foreign company. Hence the audit of the accounts of foreign
companies is also not to be included within the specified number of 20 as laid down in
explanation I to sub-section (1C) of Section 224 of the Act. A point has been raised as to
whether companies limited by guarantee are to be included in reckoning “specified” number of
auditors within the meaning of Explanation I to sub-section (1B) and (1C). This has been
examined and the Department is of the view that such companies as having no share capital
are to be excluded from the reckoning.
The Companies (Amendment) Act, 2000 has also amended Section 224(1B) dealing with
ceiling on company audits. Pursuant to this amendment, the private companies will be
excluded while computing the ceiling limit of 20 companies, as the case may be.
Consequently, the auditor can accept audit of any number of private companies subject to the
overall limits laid down by guidelines of the Institute. The guidelines finalised by the Council
are reproduced below:
“No.1-CA(7)/53/2001: In exercise of the powers conferred by clause (ii) of Part II of the
Second Schedule to the Chartered Accountants Act, 1949, the Council of the Institute of
Chartered Accountants of India hereby specifies that a member of the Institute in practice shall
be deemed to be guilty of professional misconduct, if he holds at any time appointment of
more than the “specified number of audit assignments of the companies under Section 224
and /or Section 228 of the Companies Act, 1956”.
Provided that in the case of a firm of chartered accountants in practice, the specified number
of audit assignments shall be construed as the specified number of audit assignments for
every partner of the firm.
Provided further that where any partner of the firm of chartered accountants in practice is also
a partner of any other firm or firms of chartered accountants in practice, the number of audit
assignments which may be taken for all the firms together in relation to such partner shall not
exceed the specified number of audit assignments in the aggregate.

Provided further that where any partner of a firm or firms of chartered accountants in practice
accepts one or more audit assignments in his individual capacity, or in the name of his
proprietary firm, the total number of such assignment which may be accepted by all firms in
relation to such chartered accountant and by him shall not exceed the specified number of
audit assignments in the aggregate.
Explanation:
1. For the above purpose, the specified number of audit assignments means :
(a) in the case of a chartered accountant in practice or a proprietary firm of chartered
accountant, thirty audit assignments whether in respect of private companies or
other companies.
(b) in the case of a firm of chartered accountants in practice, thirty audit assignments
per partner in the firm, whether in respect of private companies or other companies.
Provided that out of such specified number of audit assignments, the number of audit
assignments of public companies each of which has a paid-up share capital of rupees
twenty-five lakhs or more, shall not exceed ten.
2. In computing the specified number of audit assignments:
(a) the number of such assignments, which he or any partner of his firm has accepted
whether singly or in combination with any other chartered accountant in practice or
firm of such chartered accountants, shall be taken into account.
(b) the audit of the head office and branch offices of a company by one chartered
accountant or firm of such chartered accountants in practice shall be regarded as
one audit assignment.
(c) the audit of one or more branches of the same company by one chartered
accountant in practice or by firm of chartered accountants in practice in which he is
a partner shall be construed as one audit assignment only.
(d) the number of partners of a firm on the date of acceptance of audit assignment shall
be taken into account.
(e) a chartered accountant in full time employment elsewhere shall not be taken into
account
3. This notification shall come into force from the date of its publication in the Official
Gazette.
4. A chartered accountant in practice as well as firm of chartered accountants in practice
shall maintain a record of the audit assignments accepted by him or by the firm of
chartered accountants, or by any of the partner of the firm in his individual name or as a
partner of any other firm as far as possible, in the following manner:
S.No Name of the Registration Date of Date of Date on which

company/Audit Number Appointment Acceptance Form 23-B
Assignment filled with
Registrar of
Companies
1 2 3 4 5 6
6.2.6 Auditor not to be appointed except with the approval of the company by a Special
Resolution - Section 224A provides for appointment of auditors in certain cases only by a
special resolution. It should be remembered that normally an auditor can be appointed or re-
appointed by an ordinary resolution. However, in terms of Section 224A, a company in which
not less than 25% of the subscribed capital is held by (i) a public financial institution or a
government company or the Central Government or any State Government, or (ii) any financial
or other institution established by any Provincial or State Act in which a State Government
holds not less than 51% of the subscribed share capital, or (iii) a nationalised bank or an
insurance company carrying on general insurance business, or (iv) any combination of the
above categories, shall appoint or re-appoint an auditor in the annual general meeting only by
passing a special resolution. In case the aforesaid company omits or fails to pass a special
resolution in the annual general meeting to appoint an auditor or auditors it shall be deemed
that no auditor or auditors have been appointed, and thereupon the Central Government’s
power to appoint the auditors pursuant to Section 224(3) will become exercisable. In
determining whether the appointment calls for a special resolution or not the measuring
yardstick is the proportion of the subscribed capital held by the various categories mentioned
above. If any of them singly or several of them jointly held 25% of the subscribed capital of
the company as on the day of the closing of the register of members before the annual general
meeting of the company will be covered by the provisions of Section 224A and, consequently,
the appointment of the auditor can only be made by passing a special resolution. It should be
noted that subscribed capital includes preference share capital also. In this case a doubt has
been expressed in some quarters about the material date for considering the 25% holding - as
to whether it should be the date of passing of the special resolution. The Department of
Company Affairs has clarified that “material date is the date of the annual general meeting at
which the resolution is required to be passed. Moreover, since generally articles of
association of companies provide for closure of the register of members before the general
meeting during a period not exceeding thirty days at any one time, it is unlikely that the
position regarding shareholding in the company will be different between the date of issue of
notice and date of the general meeting. In exceptional cases, however, where a change in the
shareholding pattern in the company has taken place between the date of issue of notice of
the general meeting and the date of actual passing of this resolution regarding appointment of
auditor, the company may either (i) adjourn the meeting to another date, and later issue the
required notice in accordance with law, and thereafter, pass a special resolution required to be
passed under Section 224A of the Act; or (ii) omit or pass over the item on the agenda
regarding appointment of auditor.
In the event of the company adopting the procedure at (ii) above, the situation would then be
covered by Sub-section (2) of Section 224A of the Act. It has also been clarified by the
Department that irrespective of the circumstances in which a nationalised bank is holding
shares (whether beneficially or as security for loan advanced to constituents), if the name of
the bank is entered in the register of members of the company as holder of shares, such
holding of shares will have to be taken into account for the purposes of Section 224A of the
Act.
6.2.7 Appointment of Auditor of a Government Company - A Government company has been
defined in Section 617 of the Companies Act as “any company in which not less than 51% of
the paid-up share capital is held by the Central Government or by any State Government or
governments or partly by the Central Government and partly by one or more State
Governments, and includes a company which is a subsidiary of a Government company as
thus defined.” In respect of any Government company appointment of auditor is governed by
the provisions of Section 619 of the Companies Act, 1956. According to this Section, the
auditor of a Government company shall be appointed or re-appointed by the Comptroller and
Auditor General of India. However, the appointment will be subject to the ceiling discussed
above.
The aforesaid provisions applicable to the appointment of auditors of Government companies
also apply to another category of companies even though they are not Government
companies. This provision is contained in Section 619B of the Companies Act (in force on and
from 1.2.1975). If, in a company, not less than 51% of the paid up share capital is held by:
(a) the Central Government and one or more Government companies;
(b) any State Government, or Governments and one or more Government companies;
(c) the Central Government, and one or more State Governments and one or more
Government companies;
(d) the Central Government, one or more corporations owned or controlled by the Central
Government;
(e) the Central Government, one or more State Governments and one or more corporations
owned or controlled by the Central Government;
(f) one or more corporations owned or controlled by the Central Government or the State
Governments;
(g) more than one Government company or by combination of above.
The auditor of such a company shall be appointed by the Comptroller and Auditor General of
India.
According to the clarification issued by the Department, Nationalised Banks, General
Insurance Corporation of India and Industrial Development Bank of India are
corporations/institutions owned or controlled by the Central Government within the meaning of
Section 619B. But co-operative institutions, Industrial Credit and Investment Corporation of
India, Unit Trust of India and Industrial Finance Corporation are not covered under Section
619B. However, the aforesaid list of corporations is only illustrative and not exhaustive.
It should be noted that the provision of Section 224A which requires a special resolution for
the appointment of auditor and Section 619B have made the acceptance of the position of
auditor in a company somewhat difficult. Before acceptance of the appointment given by any
company on the strength of an ordinary resolution an auditor should specifically satisfy himself
that the company is not covered by either Section 224A or Section 619B which require
compliance with special procedure. Otherwise, he may find the appointment to be a nullity.
6.2.8 Auditor appointed at an Annual General Meeting failing to accept appointment - Can
the Board of Directors be authorised by the General Meeting to appoint auditors in the event
of auditors, appointed at annual general meeting, fail to accept the appointment? For knowing
the correct legal procedure that should be followed in such a case, the Research Committee of
the Institute had posed the following query to its Counsel:
(1) A company appointed auditors for the current year by a resolution passed in the Annual
General Meeting as under:
“Resolved that Shri X (Chartered Accountant) be re-appointed as auditor for the current
year on the overall remuneration of Rs...............only.”
“Resolved further that Shri Y (Chartered Accountant) be and hereby re-appointed as a
joint auditor for the current year on an overall remuneration of Rs......... only. Further
resolved that in the event of both or either of the auditors declining the assignments,
the Board may fill up the vacancy at their own discretion.”
(2) The Board of Directors, subsequently, passed a resolution as under:
“Resolved that in the event of any of the Auditors declining to accept the assignment,
Shri Z should be appointed as joint auditor.”
(3) The last para of the resolution of the General Meeting and the resolution itself of the
Board of Directors, were intended to meet a contingency of the appointments being
declined by any or both of the auditors appointed by the General Meeting, since the
remuneration fixed by the General Meeting was less than that proposed by the retiring
auditors, and as such there was a possibility of the appointments being rejected by the
auditors on that account.
(4) Y declined to accept the assignment and Z was called upon to intimate his willingness
or otherwise to accept the assignment pursuant to the resolution of the Board of
Directors.
The Counsel’s opinion was sought on the following points:
(a) Whether the vacancy caused by Y declining to accept the appointment constituted a
casual vacancy under Sub-section 6 (a) of Section 224 or due to resignation of an
auditor; and
(b) Was the appointment of Z, made by the Board of Directors in place of Y, valid?
The Counsel was of the opinion that the Board of Directors could appoint an auditor only
under the circumstances completed under Sub-section 5 and under Sub-section 6(a) of
Section 224. Further that, in the specific case referred to him for opinion, the refusal of Y to
accept the appointment as joint auditor did not create a vacancy either casual or by
resignation since Y’s appointment had not become effective. Further, the appointment of
auditor having been made by shareholders, sub-section (3) could not be invoked. Thus, Z
could only be appointed by shareholders at a general meeting.
6.2.9 When appointment is made to fill up a vacancy caused by resignation of the previous
Auditor - An auditor, before accepting the appointment in place of an auditor or who has
resigned, should verify that the resolution appointing him as the auditor at the general meeting
was duly moved and approved by the share holders. In addition, he should refer to the
resignation submitted by the previous auditor and also communicate with him so as to
ascertain: (i) the circumstances which led up to his resignation; and (ii) whether there existed
any circumstances on account of which he should not accept the appointment. He should also
see whether the requirements of Section 224 (6) in respect of such an appointment have been
complied with.
[Notes: (1) Though there is no provision in the Act for an auditor ceasing to hold office on
becoming bankrupt or insane, it will not be possible for a person of unsound mind or an
undischarged insolvent to hold such office, as he will not under Sections 8 and 10 of the
Chartered Accountants Act, 1949 have his name on the Register of Chartered Accountants.
(2) In the case of appointment of an auditor to act jointly with an existing auditor, the
procedure would be similar to that where the existing auditor is being removed (as discussed
hereinafter). In practice, however, compliance with the formalities would not give rise to any
difficulties, since the existing auditor’s consent to the proposal, it is expected, will have been
secured in advance. (3) Students should also refer to the Guidance Note on Compliance with
provisions of Sections 224 and 225 of the Companies Act in the context of Clause 9 of Part I
of the First Schedule to the C.A. Act as reproduced in the Code of Ethics.]
Remuneration
6.3 Under Section 224(8) of the Act, it is fixed:
(a) in case of an auditor appointed by the Board or the Central Government, may be fixed by
the Board or the Central Government as the case may be; and
(b) subject to clause (a) above, shall be fixed by the company in General meeting or in such
manner as the company in general meeting may determine. For this purpose, the
expression “remuneration” should be deemed to include any sums paid by company in
respect of the auditor’s expenses.
Students may note that the Act does not require that the remuneration should be fixed at the
same meeting of the company at which the appointment is made. It may, therefore, be fixed
at a subsequent meeting. Where a retiring auditor has been re-appointed, his remuneration in
the absence of any resolution fixing a different remuneration, is considered to be the amount
already fixed, in respect of the previous appointment. Where, in addition to the normal audit,
the auditor is also required to undertake the writing up of the books, to prepare the annual
accounts of the company and do the income-tax or secretarial work, he is entitled to receive
remuneration in addition to the normal fee for the audit. Such additional remuneration is a
matter of arrangement with the directors. But any remuneration paid as fees, expenses or
otherwise for such service must be disclosed in the Profit & Loss Account. The remuneration
paid to the auditor is required to be shown in the Profit & Loss Account separately:
(a) as auditor;
(b) as adviser or in any other capacity in respect of:
(i) taxation;
(ii) company law matters;
(iii) management service; and
(c) in any other manner.
The Council of the Institute of Chartered Accountants of India in the ‘Statement on Payment to
Auditors for other Services’ has recommended that the fees paid to the auditors for other
services rendered should be disclosed in the profit and loss account of the companies under
the following heads in order to give precise and correct information to shareholders and others
who read the accounts:
(i) tax representation;
(ii) company law matters;
(iii) management services;
(iv) internal auditing;
(v) other services.
In case of joint audit, if other services were rendered by one of the joint auditors or in case of
a company having a branch, the other services were rendered by the branch auditor, a
disclosure should be made accordingly.
Section 224(8)(aa) has been inserted whereby it is provided that, in the case of an auditor
appointed under section 619 by the Comptroller and Auditor General of India, the
remuneration shall be fixed by the company in a general meeting or in such manner as the
company in general meeting may determine. Earlier this power was vested in the Central
Government.
6.3.1 Rendering other services - One often finds that statutory auditors of the companies are
called upon to render other services to the client like tax consultancy, internal audit,
management consultancy, etc. The issues arising out of this practice have been considered
by the Institute of Chartered Accountants of India. The views of the Institute in this regard are
given below:
The payments for other services which are statutory required on the face of the published
accounts of a company represent perfectly legitimate payments for services rendered by the
auditors to the company which services the company needs and from which the benefit
derived by the company and the shareholders at large is more than commensurate with the
cost thereof. The very fact that the law requires specific disclosure of the payment for other
services shows that the Parliament did contemplate rendering of such services and did not
consider anything “prima facie” wrong about them. The other services which might be usefully
rendered by an auditor of a company against payment of additional fees may comprise the
following:
(a) Taxation Representations before the tax authorities and tax planning and advisory
services.
(b) Management Services which may include advice on the installation of a costing or
budgetary control system, management information system, selection of Senior Per-
sonnel in the Finance Department, etc.
(c) Company Law Services which include giving advice in relation to compliance with the
various provisions and procedures under the Companies Act.
(d) Investigation of accounts for various purposes, e.g., in case of purchase of business,
suspected fraud, etc.
(e) Advice in connection with amalgamation and merger, scheme of reconstruction and
reorganisation, etc.
(f) Valuation of shares of limited companies for various purposes.
(g) Issue of certificates as required by the Government and other authorities for various
specific purposes, for example,
(i) Certificates required by the Reserve Bank of India for exchange control purposes.
(ii) Certificates of gross profit and available surplus under the Payment of Bonus Act.
(iii) Certificate for consumption for raw materials, production, exports, etc. required by
the Joint Chief Controller of Imports,
(iv) Certificates at the specific request of lending institutions, both national and
international.
(v) Certificates based on verification of financial records to various Government, public
and other authorities.
(h) Special assignments required by a company for its own benefit, for example, a surplus
verification of cash or inventories or surprise visit to branches under special cir-
cumstances.
(i) Review of systems and procedures and of the internal controls, particularly, in relation to
cash transactions, purchases made by the company, inventories’ sale effected by the
company, etc. Such a review is followed by recommendation for internal control for the
benefit of the company.
(j) Audits of ancillary institutions of the company like the Employee’s provident fund, etc., in
respect of which usually the fees are paid by the company itself.
From the above illustrative list of the various services rendered by the auditors for which
additional fees are paid, it will be appreciated that it is only normal and natural for a company
to need such services and to pay for them. The next question is whether there is anything
wrong in such services rendered by the company’s auditors if they are competent to render
them. This question may be viewed from the angle of the benefit of the company and the
shareholders, on the one hand, and its effect on the independence of the auditor, on the other.
Sometimes, it may be desirable that the services are rendered by the company’s own auditor
who is expected to have overall knowledge of the accounts and the financial affairs of the
company and, also from the point of view of ensuring effectiveness of the work, fairness of the
opinion expressed on the certificate issued and also the benefit to the company as well as its
shareholders, this is desirable. It is emphasized that the other services rendered are also
those which are considered essential and beneficial to the company by the management and
they would normally have to be rendered by a professional accountant or other similar agency.
If the services are not rendered by the company’s own auditor, they will have to be rendered
by some other Chartered Accountant or by some other similar agency. The company’s auditor
with his overall knowledge of the affairs of the company would be in a much better position to
render such services compared to others. The cost of other services to the company when
rendered by its own auditor may also be comparatively less because he would need to expend
less direct time on the job than a person who has not audited the accounts. He can draw
upon the work already performed in the course of the audit where as another person may
need to follow certain procedures which have already been covered by the statutory auditor.
It is usually a matter of advantage to the company and the Income Tax Department if the tax
representation of the company is handled by its own auditor. The intimate knowledge which
the auditor possesses of the company’s business affairs and accounts is of material help in
the representation before the tax authorities. Chances of errors and accidental misstatements
or omissions are reduced and the tax officers are then able to complete the assessments more
expeditiously and with a greater degree of confidence. The work done by the auditor in
rendering other services may enable him to get a greater insight into the accounts and affairs
of the company, which would enable him to carry out a more effective and more purposeful
audit. For example, an auditor who has been engaged for rendering managements services to
the company by way of a review of the systems and procedures and the internal control
systems of the company would acquire valuable additional knowledge which would certainly
help to perform a more efficient audit. It may also be clarified that there is no compulsion on
the company to engage its own auditors for rendering other services. If the company so
chooses it can engage the services of any other person. It is for the management of the
company to judge as to which course would be in the best interest of the company. If the
management, for valid reasons, concludes that it can have more efficient and less expensive
services from its own auditor, there seems to be no justifiable reason why it should be
deprived of such services. In recent time, there has been a growing appreciation in business
and industrial circles of the constructive and effective assistance that a chartered accountant
can render to the management in various fields. This has opened up new horizons particularly
for the young members in the profession who are in a very good position to develop these new
skills and to use them to the advantage of every one concerned. An analysis published in the
press suggested that it is the bigger firms who derive most benefit from rendering other
services. In fact, most young entrants to the profession who, in their early career, would have
comparatively fewer clients, do render varied services to their clients with mutual advantage
without sacrificing public interest. Many young and promising members of the profession are
trained to render management services, taxation and company law services, etc. to their
clients. Any unreasonable restriction on company auditors in the matter of rendering other
services would unjustifiably hit this young generation whom the Institute considers its pillars of
strength. Such a restriction would retard professional development and would at the same
time not be in the interests of the company and its shareholders nor in the public interest.
The Institute, of course, is quite mindful of the utmost necessity of ensuring high standard of
independence and integrity by its members in the performance of their duties as company
auditor. From time to time, the Council of the Institute has issued recommendations to its
members with this object in view. For Example, a Notification issued by the Council lays down
that a statutory auditor cannot act as a cost auditor. The Council has also advised its
members to refrain from expressing professional opinion on financial statements of a company
in which he or his relatives are substantially interested. The Council has also advised the
members to be always on guard and not to accept any professional assignment under such
circumstances that his independence may be affected. However, the Institute does not
consider that there is anything inherently improper in the auditor receiving an additional fee for
services rendered under such circumstances that his independence is not likely to be
adversely affected. It is not proper to suggest that mere receipt of fees for such services is
likely to taint the auditor’s conscience or that such payment of other fees which under
statutory requirements are disclosed on the face of the accounts are made with an untoward
or ulterior motive. There is no doubt that an auditor should not seek favour from his client
company nor should he has a financial interest in the company if he has to maintain his
independence and authority. However, the rendering of useful professional service in
consideration of a fees is not a matter of favour nor does it amount to have a financial interest
in the company. It would, therefore, be entirely incorrect to suggest that a company’s auditor
compromises his independence or obtains an undue advantage or interest in the company
merely by accepting an engagement for rendering other professional services to his client on
payment of specific fees for such services.
It may also be stated that the Institute has provided enough safeguard for ensuring proper
performance of duties by its members. A very strict disciplinary control is maintained by the
Institute and action is quickly taken by the Disciplinary Committee against erring members. In
disciplinary matters the standard maintained by the Institute is so high that there has been not
a single case where the High Court has enhanced the punishment suggested by the Institute
for an erring member. In most of the cases the High Court has reduced the punishment. It
may also be pointed out that a practising Chartered Accountant is precluded from engaging in
business or activities which are not directly within the scope of his profession. Thus, the other
services rendered by a company’s auditor are only such services which are directly within the
scope of the accountancy profession. Therefore, there is hardly any possibility of any misuse
or abuse if other professional services are rendered by the auditor.
The Council issued this note in the hope that it would clarify the matter with regard to the
payment of fees to auditors in ‘other capacity’. Such services and such payments are perfectly
legal and perfectly within the code of conduct and ethics of the professional. There need not
be any misgiving in this matter nor any apprehension that by such payments the public interest
of the generality of the shareholders is compromised. While the Council of the Institute will
continue to exercise the utmost vigilance in order to ensure the highest standards of
independence and discipline, it would be a mistake to stand in the way of normal professional
development, where such development does, not compromise the auditor’s independence or
authority. In fact, the Council actively encourages diversification in the professional services
rendered by the members of the profession so that new horizons and more avenues of useful
and constructive work may open up for the young entrants to the profession. This approach is
in keeping with the profession’s desire to play its proper role in the affairs of the nation by
contributing its utmost for developing the natural resources of the country, increasing the
national wealth and improving the standards of the millions of our countrymen.
6.3.2 Recommendations regarding disclosures for payments to auditors for other services -
By Notification No. 455 dated 27, April 1974, the Government amended the requirements of
Part II of Schedule VI to the Companies Act, 1956 as a result of which, the fees paid to
auditors, whether as fees, expenses or otherwise, for services rendered as auditor and adviser
or in any other capacity in respect of taxation matters, company law matters, management
service and in any other manner are required to be disclosed separately. Even prior to the
issuance of the aforesaid Notification, the Council had recommended disclosure of the break-
down of the fees paid to the auditor in other capacity under certain heads. Whilst the break-
down required by the aforesaid Notification is somewhat narrower than the break-down earlier
recommended by the Council, in the interest of better and fuller disclosure, the Council
recommended that such disclosure, in respect of fees paid to the auditor in other capacity
should continue to be under the following head:
(i) for taxation matters;
(ii) for company law matters;
(iii) for management services;
(iv) for internal audit; and
(v) for other services.
It may happen that the fees paid to the auditor in other capacity may have been fixed or
settled in a composite manner in respect to more than one head. In such a case, it is
recommended that the composite amount may be disclosed describing that it was fixed as
such for the specified matters.
A question arises as to whether, if a company pays fee or remuneration to one of the partners
of a firm which is acting as its auditor, separate disclosure is required in respect of the fee or
remuneration so paid. The Council is of the view that the requirement as to the separate
disclosure of fees paid in other capacity should be more properly construed in the context of
the spirit behind such requirement and, accordingly, recommends that even in the aforesaid
case separate disclosure should be made in respect of fees paid by the company to the
partner of the firm which is its auditor.
Sometimes, the company may pay fees in other capacity to one out of several firms of joint
auditors. In such a case, in the interest of proper disclosure, it may be indicated that the fee is
paid to one of the joint auditors specifying the name of such auditor to whom the fee is paid.
Likewise a company may pay fee to its branch auditor appointed under Section 228 of the
Companies Act, 1956 for services rendered in other capacity. In such a case also while
disclosing the fee paid in other capacity the fact that it was paid to a branch auditor may be
specified. It may be noted that according to the Institute of Chartered Accountants of India,
there does not arise a situation of conflict, legal or ethical, when the statutory auditor renders
other services, e.g., tax advice, management consultancy etc. to the client at the same time.
6.3.3 Management Consultancy and Other Services - A member of the Institute in practice
shall be deemed to be guilty of professional misconduct, if he accepts the appointment as
statutory auditor of Public Sector Undertaking(s)/Government Company(ies)/Listed
Company(ies) and other Public Company(ies) having turnover of Rs. 50 crore or more in a
year and accepts any other work(s) or assignment(s) or service(s) ,in regard to the same
Undertaking(s)/Company(ies) on a remuneration which in total exceeds the fee payable for
carrying out the statutory audit of the same Undertaking/Company.
Provided that in case appointing authority(ies)/regulatory body(ies) specify(ies) more stringent
condition(s)/restriction(s), the same shall apply instead of the conditions/restrictions specified
in this Notification.
Explanation:
1. The above restrictions shall apply in respect of fees for other work(s) or service(s) or
assignment(s) payable to the statutory auditors and their associate concern(s) put
together;
2. For the above purpose,
♦ the term “other work(s)" or "service(s)" or "assignment(s)" shall include Management
Consultancy and all other professional services permitted by the Council pursuant to
Section 2(2)(iv) of the Chartered Accountants Act, 1949 but shall not include:
(i) audit under any other statute;
(ii) certification work required to be done by the statutory auditors; and
(iii) any representation before an authority
♦ the term "associate concern" means any corporate body or partnership firm which
renders the Management Consultancy and all other professional services permitted by
the Council wherein the proprietor and/ or partner(s) of the statutory auditor firm and/ or
their "relative(s)" is/are Director / s or partner / s and/or jointly or severally hold"
substantial interest" in the said corporate body or partnership;
♦ the terms "relative" and "substantial interest" shall have the same meaning as are
assigned under Appendix (10) to the Chartered Accountants Regulations, 1988.
3. In regard to taking up other work(s) or service(s) or assignment(s) of the
undertaking/company referred to above, it shall be open to such associate concern or
corporate body to render such work(s) or service(s) or assignment(s) so long as
aggregate remuneration for such other work(s) or service(s) or assignment(s) payable to
the statutory auditor I s together with fees payable to its associate concern(s) or
corporate body(ies) do/does not exceed the aggregate of fee payable for carrying out the
statutory audit.
4. This notification shall apply for any appointment(s) on or after 1st April, 2002.
Functions, Duties and Rights of Auditors

6.4 The following are the functions, duties and rights of auditors:
6.4.1 Functions of an Auditor under the Companies Act, 1956 - The primary function of an
auditor is to report on different types of financial statements prepared in a variety of situations
mentioned below:
(i) Reporting on Balance Sheet and Profit & Loss Account - It is the primary duty of the
auditor of a company to make a report to the shareholders on the accounts examined by him
and on every Balance Sheet and Profit & Loss Account as well as any other document
declared by the Act to be part of and annexed to the Balance Sheet or Profit & Loss Account,
which are laid before the company in general meeting during his tenure of office. The report
should state whether, in his opinion and to the best of his information and according to the
explanations given to him, the said accounts give the information required by the Act in the
manner so required and give a true and fair view:
(a) in the case of balance sheet, of the state of the company’s affairs as at the end of its
financial year; and
(b) in the case of the profit and loss account the amount of profit or loss during the financial
year.
The matters which should be dealt with by the auditor in his report are set out in detail in sub-
section (3) of section 227. Also, the auditor is to inquire and, if necessary, to report on the
matters Specified in Section 227 (1A).
Power of Government to amplify the scope of audit - By the Companies (Amendment) Act
1965, sub-section (4A) has been added to section 227 empowering the Central Government to
direct, by a general or a special order, that in case of any class or description of companies,
as may be specified in the order, the auditor’s report should also include a statement on such
matters as may be specified therein. It is a general power which authorises the Government
to extend the scope of audit in case of a particular class of companies. Exercising this power
the Government of India issued the Manufacturing and other Companies (Auditor’s Report)
Order 1975. This Order was applicable to the following categories of companies:
(a) Manufacturing, mining or processing;
(b) Supplying and rendering services;
(c) Trading; and
(d) Financing, investment, chit fund, nidhi or mutual benefit companies.
The 1975 Order was replaced by the 1988 Order which came into force w.e.f. November 1,
1988. The 1988 Order has been further substituted by the Companies (Auditor’s Report)
Order, 2003.
(ii) Report to be set out in the Prospectus - Section 60 (3) of the Companies Act 1958,
contemplates three circumstances under which it is necessary for a Chartered Accountant to
report on the statements of account, operating results and assets and liabilities of a going
company which issues a prospectus. Part II or Schedule II to the set contains the reports to be
included in prospectus.
(iii) Certification of Statutory Report - Every public company limited by shares and every
company limited by guarantee and having share capital must prepare a statutory report for
being placed before the shareholders in accordance with section 165. It should be certified by
the auditor of the company, in so far as the report relates to the shares allotted by the
company, cash received in respect of such shares and payments of the company. A deemed
public company will not be required to hold statutory meeting or issue statutory report if a
period of 6 months has expired after incorporation at the time, it is so deemed.
(iv) “Special Audit” (Section 233 A) - It is an audit procedure alternative to investigation
when the Central Government is authorised to adopt in the under mentioned circumstances:
(a) when the affairs of the company are not being managed in accordance with sound
business principles or prudent commercial practices; or
(b) when it is being managed in a manner likely to cause serious injury or damage to the
interest of the trade, industry or business to which it pertains; or
(c) when the financial position of the company is such as would endanger its solvency.
The procedure is a short cut to an investigation and is simpler. It is therefore preferred in
cases where, instead of a detailed roving enquiry, information is required on certain specific
points. The Central Government is authorised to determine the scope of such an examination
so that it may be able to obtain such information as it may require to prove or disprove any
suspicion that it may have, either on the basis of any information in its possession or those
aroused from a perusal of the statements of account. To conduct such an audit, the Central
Government may appoint a person who is a Chartered Accountant, whether or not he is the
auditor of the company. The special auditor for purposes of carrying on the audit is invested
with the same powers and has the same duties as the statutory auditor except for the fact,
instead of making a report to the company; he has to report to the Central Government.
The Government on receipt of the report, may take such action on it as it considers necessary
but, if it fails to do so within a period of four months from the date of the receipt of the report,
the Government is required to send to the company either a copy or the relevant extract of the
report with its comments thereon and require the company either to circulate the copy or the
extract among the members or have them read before the members at the next General
Meeting.
(v) Report on the Accounts prepared on voluntarily winding-up - When, on company
being put to voluntary winding-up, the directors of the company make a declaration of
solvency, it should be accompanied by a copy of the report of the auditors of the company on
the Profit and Loss Account of the company for the period commencing from the date up to
which the last such account was prepared and ending on the latest practicable date,
immediately before the declaration is made, as well as, the Balance Sheet of the company on
last mentioned date embodying the statement of the company’s assets and liabilities as at that
date (section 488).
(vi) Report on the Accounts of Liquidators - When a company is being wound up by the
Court, its liquidator, at such times as may be prescribed by the Court, but not less than twice
at year, present to the Court an account of amounts received and paid by him. It is obligatory
for the Court to have the accounts audited (Section 462). Furthermore, in the case of a
company, which is being wound voluntarily under the supervision of the Court or by the Court,
unless the liquidation is concluded within one year of its commencement, the liquidator must
file a statement of receipts and payments in the prescribed form, duly audited:
(a) in the case of a winding-up by or subject to the supervision of the Court, in the Court; and
(b) in the case of voluntary winding -up, with the Registrar (section 551).
But such an audit is not necessary in a case where the provisions of section 462 are
applicable.
(vii) Other Duties of the Company Auditor - The auditor can be called upon to carry out the
undermentioned duties:
(a) To assist the Inspector appointed by the Central Government either on the application of
the members or on a report by the Registrar of Companies under section 235 of the Act,
in the investigation of the affairs of the company. Such a duty extends to all persons who
were employed as auditors whether as statutory or as internal auditors [section 240 (1)
(b)].
(b) To assist Government in the prosecution of directors, provided the auditor is not himself
involved in pursuance of the Inspector’s report under section 241 of the Act, [section 242
(1)].
(c) To give such reasonable assistance as is necessary in cases where prosecution has
been instituted against delinquent officers and members of the company in the capacity
of an officer of the company [section 545 (7)].
(d) In the event of his being engaged in the formation of a company, to make a declaration
that all the requirements of the Act have been complied with [section 33 (2)].
6.4.2 Nature of duties of a Company Auditor - Though in sub-sections 1A, (2), (3), (4) and
4A of section 227, the duties of the auditor are set out in some detail, the Act does not
prescribe the procedures that should be followed for the examination of books of account or
verification of assets and liabilities included in the Balance Sheet of a company. Neither does
the Act define the scope of such an examination (except requiring verification of propriety of
certain transactions stated in sub-section (lA) of Section 227 or looking into the matters
specified in the Companies (Auditor’s Report) Order 2003, nor does it suggest the attitude of
mind with which the task should be approached. It is because these are matters in regard to
which members, it is expected, would be guided by informed opinion in the profession;
especially the statements issued by professional bodies, or by the pronouncements of learned
judges in cases concerning the duties and responsibilities of auditors, under different
conditions and circumstances.
Generally, it is the duty of the auditor to examine the company’s books of account to ascertain
that they do, in fact, truly and fairly record the transactions entered into by the company, and
to verify that the statements of account, drawn up on the basis of the books, truly and fairly
reflect the financial position disclosed by them. The scope and depth of checking of the entries
in the books for the verification of the statement of account is, to a large extent, a matter which
the auditor must determine himself on taking into account the conditions of the record in the
books, existence of the system of internal control and the character of the management. If the
books of account do not contain a complete record of the transactions, or are kept in a manner
that either the amount of the revenue receipts, or that of expenditure, or the values of assets
or the amounts of liabilities cannot be properly ascertained he must report the fact to the
shareholders. [Subsection (4) of Section 227]. However, the report should be qualified in this
regard only after the auditor has verified the condition of the records.
The directors are responsible for maintenance of accounts and for financial control of the
affairs of the company. Under section 209 of the Companies Act, they are responsible for
ensuring the maintenance of adequate records and the preparation of annual accounts
showing a true and fair view of the state of affairs of the company. They are also responsible
for safeguarding the assets of the company. If they fail to exercise the requisite degree of
supervision, they cannot plead in defence that the auditor had not drawn their attention to the
dangers to which the assets were exposed.
It is a primary duty of the auditor to verify the books of account presented to him for audit and
to report on the final statements of account. However, he does not guarantee or certify them
as a result, after the audit has been completed, if a fraud is discovered, the auditor would not
be liable for any breach of duty or negligence, for any failure to perform his duties
competently, provided he had conducted the audit with due care and skill in consonance with
professional standards.
It is expected, however, that the auditor would not accept the financial position of the company
as shown by books of account, before making a thorough enquiry so as to satisfy himself that
the books of account in fact show the true position and it is properly reflected in the
statements of account reported upon by him. The compliance with the accounting standards is
also required to be ensured by the auditor.
Often, a question is asked that if the internal check is found by the auditor to be inadequate,
should he extend his examination to trace down any fraud or would it be enough if he merely
reports that the internal check is inadequate. The informed opinion in the profession in this
regard is that, it being the duty of the auditor to report any loss or defalcation resulting from
the non-existence of internal check, he must extend his examination, if circumstances so
warrant, but he need not imagine the spectre of a loss which might have been suffered where
in fact, no loss has occurred.
Another duty of the auditor is to see that the Balance Sheet of the company is drawn up in the
form contained in the of Schedule VI to the Companies Act; also, that the Profit and Loss
Account contains all the information required to be disclosed according to the Part II of the
same Schedule.
The Companies (Amendment) Act, 2000 has further amplified the duties of an auditor under
the Companies Act, 1956 by introducing additional reporting requirements under clauses (e)
and (f) of Section 227(3) of the Act where by the auditor shall state his observations having
adverse effects on functioning of company in thick type or italics [clause (e)] and ascertain
whether any Director of the Company suffers any disqualification under section 274 (1)(g)
[clause (f)]. The Institute has issued a Guidance Note on Section 227(3)(e) and (f) of the
Companies Act, 1956 explaining in detail the manner of reporting by the auditor.
The Companies (Second Amendment) Act, 2002 has added Clause (g) in section 227(3),
whereby the auditor’s report shall have to state whether the cess payable u/s 441A has been
paid and if not, the details of the amount of cess not so paid. Section 441A provides for levy
and collection of cess on turnover or gross receipt of companies.
Cess on Companies - A cess on companies will be levied for purpose of rehabilitation or
revival of sick industrial companies. The provisions are made in sections 441A to 441F, which
are placed in part relating to winding up of company by Tribunal.
Section 441A(1) provides that there shall be levied and collected, for the purposes of
rehabilitation or revival or protection of assets of the sick industrial company, a levy by way of
cess. It shall not be less than 0.005% and not more than 0.1% on the value of annual turnover
of every company or its annual gross receipt, whichever is more as the Central Government
may, from time to time, specify by notification in the Official Gazette.
Every company shall pay to the Central Government the cess referred to in section 441A(1)
within three months from the close of every financial year. [Section 441A(2)]. Every company
shall furnish, in such form as may be prescribed, to the Central Government and the Tribunal
the details of its turnover and gross receipts with payment of cess. [section 441A(3)]. The
Central Government may, be rules made in this behalf, specify the manner in which the cess
shall be paid u/s 441A(2) [section 441A(4)].
Can the scope of the audit be restricted - Though the scope of an audit cannot be restricted
(Newton v. Birmingham Small Arms & Co.) it has been held in Pendleburys Ltd. v. Ellis Green
and Co. that where the directors of a private company are its sole shareholders and the
auditor has reported to the directors that he has not been able to satisfactorily examine the
entries in the company’s cash book, in view of inadequacy of the system of recording entries,
he cannot be held guilty of negligence for not having qualified his report to the shareholders.
The decision, though good law at the time it was delivered, may not now provide protection to
auditors in similar circumstances, if a third party is aggrieved.
Auditor’s Report - An audit report should be clear, specific and complete, in order that
anyone who has an occasion to read it may know exactly what is wrong with the company. An
Auditor who gives the shareholders “the means of information” in respect of company’s
financial position, does so, at his peril and runs the serious risk of being held judicially to have
failed to discharge his duty (Lindley L.J in Re London and General Bank).
True and Fair - By the substitution of these words in the report which an auditor makes on the
statements of account of a company for the words “true and correct” by the Companies Act,
1956, the scope of the responsibility of the auditor has been widened. The statements of
account, as a result should not only correspond with the entries as contained in the books of
account but should also present a true and fair view of financial position of the company. This
demands:
(a) that the statements must disclose all material facts affecting the profits made, losses
incurred, the valuation of assets possessed or liabilities owned by the company. For
example, if there has been a loss of some stocks of raw-material by fire, which were not
insured, or certain amounts have had to be paid on account of losses suffered in the
past, in respect of which no provision existed in the books of account, these facts should
be disclosed separately and, if material, commented upon;
(b) that all unusual, exceptional or non-recurring items of income and expenditure must be
disclosed separately;
(c) that the propriety of transactions specified in sub-section (1A) of Section 227, where any
one of these has been entered into, should be examined;
(d) that the statements of account should neither over or understate the financial position of
the company;
(e) that events, subsequent to the close of the year, which enable the auditor to determine in
a better way the profits or the financial position of the company, as at the close of the
year, must be taken into account;
(f) that the statements of account should be drawn up in conformity with the accepted
standards of accounting principles consistently applied from year to year; and
(g) that the accounts should comply with the requirements as to the disclosure contained in
Schedule VI to the Companies Act, 1956.
In the context of ascertainment of true and fair view and drafting of the audit report, it is
necessary that students also acquaint themselves with the requirement of the Accounting
Standards issued by the Accounting Standards Board of the Institute of Chartered
Accountants of India. While discharging their attest functions it will be ‘the duty of the
members of the Institute to ensure that the Accounting Standards are implemented in the
presentation of financial statements covered by their audit reports. In the event of any
deviation from the standards, it will be also their duty to make adequate course in their reports
so that the users of such statements may be aware of such deviations. Now it is incumbent
upon the management of a company to ensure whether the financial statements have
complied with the accounting should are not in terms of section 211 of the Companies Act,
1956.
6.4.3 Rights of an Auditor - These are set out in detail in Sections 227(l) and 231.
The right of access to the “books of account” and “vouchers” must be construed as a right to
inspect all the books of account and records kept whether in compliance with the statutory
provision or for financial purpose at a reasonable time, either with or without notice. Section
227 casts a duty specifically on the officers and other persons associated with the
management of the company to furnish any particulars or information required by the company
or auditor for being included in the Final Accounts or in any documents to be annexed thereto.
The auditor’s power to obtain information and explanation is indeed very wide and, in case any
information is refused, the auditor may report to the members that he has not been able to
obtain all the information or the explanations he required. It is the duty of the management to
balance and agree the books and prepare the final statements of account. Until this has been
done, the auditor normally should not start the audit. If a person other than the statutory
auditor has been appointed to audit the accounts of a branch or branches, it would be the duty
of the branch auditor to forward his report to the statutory auditor before he makes the
accounts of the company.
Audit of Accounts governed by Special Acts - The duties and responsibilities of an auditor
in case of companies which are governed by a special Act, is much the same as in case of
others except to the extent that these have been modified by the provisions contained in the
relevant special Act.
Accordingly, sub-section (6) of section 211 of the Companies Act provides that the final
accounts of companies governed by a special Act, and drawn up according to requirements
thereof, would not be considered as not disclosing a true and fair view on the ground that they
do not disclose information not requiring disclosure under the special Act.
Audit of Branches
6.5 The following are the points regarding audit of branches:
6.5.1 Relevant provisions of Companies Act, 1956 - In accordance with the principle of
independent professional audit of the company accounts, the Companies Act, 1956 in Section
228 has provided for the audit of accounts of branches. Section 2(9) of the Companies Act,
1956 defines a branch office as:
(i) any establishment described as a branch by the company;
(ii) any establishment carrying on either the same or substantially the same activity as that
carried on by the head office of the company; or
(iii) any establishment engaged in any production, processing or manufacturing but does not
include any establishment specified in any order made by the Central Government under
Section 8.
Under Section 8, the Central Government has the power to declare any establishment
falling under (i) or (ii) above as not a branch office in relation to the company owning it.
Section 228 of the Companies Act, 1956 provides that where a company has a branch
office, the accounts of that office shall be audited either by the company’s auditor
appointed under Section 224 or by another auditor possessing qualifications prescribed
under Section 226. In the case of a branch situated outside India, any of the above or an
accountant qualified to act as auditor in the country concerned can be appointed as the
branch auditor. The scheme of Section 228 presumes that normally the company auditor
shall be appointed as the branch auditor. However a company may decide to have the
branch accounts audited by a person other than the company auditor in a general meeting.
In such a situation, the company is required to appoint the branch auditor from out of the
eligible categories in the same meeting or it is to authorize the Board of Directors to
appoint one in consultation with the company’s auditor appointed under Section 224.
6.5.2 Branch Auditor Appointment and Powers - In the opinion of the Institute of Chartered
Accountants of India, the appointment of branch auditors in consultation with the company’s
statutory auditor should not be taken to mean that the statutory auditor is in any way taking
responsibility in respect of the work done by the branch auditor. The provision regarding
consultation with the statutory auditor only implies that the statutory auditor should be satisfied
that prima facie, he is not aware of any reason why the proposed auditor should not be
appointed as branch auditor. For example, where an auditor or a partner of his has been the
subject matter of adverse disciplinary proceedings under the Chartered Accountants Act and
the statutory auditor knows it, it may well be necessary for the statutory auditor to bring this to
the notice of the Board of Directors.
The branch auditor shall have the same powers and duties in respect of the audit of the
branch accounts as the company auditor has in relation to the company accounts. The
powers that the company auditor enjoys in relation to branch accounts are the rights (i) to
have access at all times to the books of accounts and vouchers of the branch, (ii) to visit the
branch, and (iii) to obtain information and explanation considered necessary for the audit of
the branch accounts. But the branch auditor, unlike the company auditor, will not have the
right to attend the general meeting of the company or to receive the notice and other related
communications in connection with the general meeting. The branch auditor is required to
prepare a report on the accounts of the branch office examined by him and forward the same
to the company’s auditor. It is obvious that when the company auditor himself is the auditor for
the branch accounts, there cannot be any question of any report being made on the branch
accounts audited. He as the auditor for the company, is under a duty to make a report on the
consolidated accounts in accordance with Section 227(2) of the Companies Act.
The branch auditor shall receive such remuneration as may be fixed for him by the general
meeting appointing him or by the Board of Directors, if so authorised by the general meeting.
Also, he is to hold office subject to the terms and conditions specified by the appointing body.
Naturally it is reasonable to presume that the branch auditor will not necessarily hold office for
the same statutory period as is held by the statutory auditor under Section 224.
6.5.3 Exemption of Branches from audit requirements in certain situations - Though
independent professional scrutiny of the branch accounts is the principle in providing audit,
the legislature, having regard to the element of materiality and other considerations, has
provided that under certain circumstances the accounts of the branch may not be audited
[Section 228(4)]. The Companies (Branch Audit Exemption) Rules, 1961 have been issued to
provide for the exemptions; under the above Rules a branch of a company carrying on
manufacturing, processing or trading activity accounting for average quantum of activity not
exceeding higher of Rs. 2 lakhs or 2% of the average total turnover of the company shall be
exempt from the purview of compulsory audit of branch accounts. Quantum of activity means
the highest out of the following:
(i) the aggregate value of the goods or articles produced, manufactured or processed, or
(ii) the aggregate value of the goods or articles sold and of services rendered, or
(iii) the amount of the expenditure, whether of a revenue or a capital nature, incurred by a
branch office during a financial year.
The average of the quantum of activity is to be computed by including the activities for the
three years immediately preceding the year in respect of which the question of exemption is
to be determined. In case the company did not exist for all the three years referred to
above, the number of years in which the company actually existed will constitute the base of
computing the average. It should be noticed that the question of exemption is to be
considered every year by reference to the yardstick given above. The exemption discussed
above is mandatory in nature, if the condition about the quantum of activity is met. There
may be exemption also on other grounds. But these exemptions are discretionary, subject to
the satisfaction of the Central Government. The grounds on which exemption may be
granted by the Central Government are the following:
(i) If there are satisfactory arrangements for the scrutiny and check at regular intervals of
the accounts of the branch office of a company, not carrying on manufacturing or
processing or trading activities, by a person who is competent to scrutinise and check the
accounts.
(ii) If arrangements are made for the audit of the accounts of the branch office by a person
possessing the qualifications necessary for appointment as a branch auditor, even
though such person is an employee of the company.
(iii) If a branch auditor is not likely to be available at a reasonable cost, having regard to the
nature and quantum of activity carried on at the branch or having regard to any other
reason.
(iv) If for any other reason, the Central Government is satisfied that exemption may be
granted.
The company auditor in his report is to make a mention about exemption from audit granted to
any of the branches of the company under the Companies (Branch Audit Exemption) Rules,
1961.
Reliance on the Work and Report of the Other Auditor

6.6 Occasionally, an auditor may be called upon to report on financial statements, part of
which has been audited by other auditor or auditors. This phenomenon is particularly present
where the accounts of subsidiaries, audited by other auditors, are consolidated with the
holding company’s accounts also where branch accounts audited by other auditors are
merged in the head- office account, this problem arises. In our country, consolidation of the
subsidiaries accounts with the holding company’s accounts is not a legal requirement.
However, listed companies are required to get their accounts consolidated as per the SEBI’s
requirement. In that connection, companies are required to comply with the requirements of
AS-21. Under the Companies Act, 1956 branch accounts may be audited by auditor different
from the company auditor provided of course he holds the requisite qualification. The Institute
of Chartered Accountants of India has come out with an Auditing and Assurance Standard
(AAS) 10 - “Using the Work of another Auditor”.
6.6.1 Company’s Auditor in relation to Branch Accounts, Branch Audit and Branch Auditor -
When the company’s auditor himself is the auditor for the branch accounts, he treats the
whole company as an audit unit and ensures that the branch accounts have been properly
incorporated in the main office accounts. There remains no question of any separate report on
the branch accounts for consideration. Also there is no question of any separate and distinct
right to visit the branch or to have access to the books, accounts and vouchers. When the
branch accounts are audited by a person other than the company’s auditor it is necessary to
define the position of the company auditor in relation to branch accounts and branch auditor.
The Companies Act, under Section 228(2), has given a right to the company’s auditor to visit
the branch and to have access to the books, accounts and vouchers maintained at branch
even when the branch audit is conducted by a person other than the company’s auditor. Also,
the Companies (Branch Audit Exemption) Rules, 1961 has retained this right for the
company’s auditor in respect of branches granted exemption from audit this is a right given to
the company auditor and not a duty cast on him. If in his own assessment of the situation, he
considers it necessary for the proper audit of the accounts of the company, he may visit the
branch and may have access to the books, accounts and vouchers maintained there; but it is
not compulsory that he must visit the branch or branches.
As regards foreign branch of a banking company, however it is sufficient if the company’s
auditor is allowed access to the copies and extracts from the books and accounts of the
branch as have been transmitted to the principal office of India. Under Section 228(3)(c), the
company’s auditor is required to deal with the branch audit report received from the branch
auditor, in preparing his own report. The manner in which to deal with the report is left to him.
This requirement is supplemental to the main duty cast on him under Section 227(3)(c) to
state in his report whether the branch audit report has been forwarded to him and how he has
dealt with the same. It is clear that the law has left the question of how to deal with branch
audit report to the company auditor and only requires him to state in his report how he has
dealt with the same. In other words, full freedom of judgement has been given to the company
auditor to decide the prima facie relevance and impact of the branch audit report on the total
company accounts. Certain matters may appear material and important in the limited context
of the operations of the branch but may be considered not much significant in the setting of
the total company accounts. He, therefore, may incorporate the points, if any, made in the
branch audit report if he considers the same relevant in making the consolidated accounts true
and fair. He, at his discretion may drop any or all the qualifications made in the branch audit
report. However, if the branch audit report contains qualifications on matters specially
required to be disclosed in the company accounts, pursuant to the Schedule VI requirements,
then it is obvious that the company auditor is left with no choice but to incorporate them in his
own report after confirming the accuracy of the report, if he so feels. For example, if the
branch audit report contains a qualification about non-disclosure of loans granted by the
branch to a firm of which a partner is the subsidiary of the company, the auditor has to include
it in his report unless he has reasons to doubt the veracity of the branch audit report itself.
It should be understood that this discretion allowed to the company auditor is highly sensible.
Since the company auditor is to report upon the combined accounts of the main office and the
branches, it is he who can judge the requirements of true and fair in an overall context, having
regard to materiality, accounting principles and the requirements of disclosure. For example, if
depreciation on the fixed assets of the branch has not been charged in the branch accounts,
no doubt the branch accounts will not show a true and fair view and it will be quite legitimate
for the branch auditor to qualify his report on that point. But if the company auditor can satisfy
himself that such charge of depreciation has been in fact made in the head office books, he
will not retain the branch auditor’s qualification in his report. It should also be understood that
discretion is simultaneously a very big responsibility on the company auditor. If he omits any of
the qualifications appearing in the branch audit report, without sufficient consideration, he and
not the branch auditor will be responsible for the omission.
It seems that in a situation where the branch audit is being conducted by a person other than
the company auditor the law has recognised a degree of overlapping responsibility. The legal
opinion obtained by the Institute of Chartered Accountants of India and published in the
“Opinion regarding certain provisions of the Companies Act, 1956”, in this context, holds the
view that the company’s auditor has a certain measure of responsibility in respect of the
accounts and papers of the branch. This is shown by the fact that he has a right to visit the
branch and has access to the papers and documents of the branch. He is in substance in
overall supervision as the company’s auditor and, in that capacity, he has to make disclosure
of anything in regard to the branch which he thinks is not in order and which has come to his
notice.
The Auditing and Assurance Standards Board of the Institute of Chartered Accountants of
India in their Auditing and Assurance Standard entitled “Using The Work of Another Auditor”
(AAS 10) has reviewed the relationship between the statutory auditor and the branch auditor
and has come to a conclusion that the statutory auditors would not be responsible for work
entrusted to branch auditors except in circumstances which should have aroused his
suspicion, about the achievability of work performed by the branch auditor.
The statutory auditor would normally be entitled to rely upon the work of the branch auditor
unless there are special circumstances to make it essential for him to visit the branch and / or
to examine the books of account and other records of the said branch. When using the work of
the branch auditor, the statutory auditor should ordinarily advise the branch auditor of the use
that is to be made of his work and report. He should make sufficient arrangements for the
coordination of their efforts at the planning stage of his audit. He should advise the branch
auditor of the significant accounting, auditing and reporting requirements and obtain
representation as to compliance with them. Ascertain from the other auditor any limitation on
the scope of his work imposed by the terms of engagement. The statutory auditor should also
consider the significant audit findings of the other auditor.
The statutory auditor is not required to evaluate the professional competence or independence
of the branch auditor, except in situations which create doubt about the professional
competence or independence of the other auditor. Where the statutory auditor’s report is other
than unqualified, the principal auditor should also document how he has dealt with the
qualifications or adverse remarks contained in the branch auditor’s report in framing his own
report. There should be sufficient liaison between the principal auditor and the branch auditor.
For this purpose, the principal auditor may find it necessary to issue a written communication
to the branch auditor.
The branch auditor, knowing the context in which his work is to be used by the principal
auditor, should cooperate with him and assist him actively, for example, by bringing to the
principal auditor’s immediate attention any significant findings requiring to be dealt with at
entity level, adhering to the time table for audit of the branches, etc. He should ensure
compliance with the relevant statutory requirements. Similarly, the principal auditor should
advise the other auditor of any matters that come to his attention that he thinks may have an
important bearing on the branch auditor’s work. If the branch auditor qualifies his report, the
principal auditor should consider whether the subject of the qualification is of such nature and
significance, in relation to the financial statements of the entity on which the principal auditor
is reporting, that it requires a qualification in his report.
The principal auditor would not be responsible in respect of the work entrusted to the branch
auditors, except in circumstances which should have aroused his suspicion about the
reliability of the work performed by the branch auditors. When the principal auditor has to base
his opinion on the financial statements of the entity as a whole relying upon the statements
and reports of the other auditors, his report should state clearly the division of responsibility
for the financial statements of the entity by indicating the extent to which the financial
statements of branches audited by the other auditors have been included in the financial
statements of the entity, e.g., the number of branches / divisions audited by other auditors.
Joint Audit
6.7 The practice of appointing Chartered Accountants as joint auditors is quite widespread
in big companies and corporations. With a view to providing a clear idea of the professional
responsibility undertaken by the joint auditors, the Institute of Chartered Accountants of India
had issued a statement on the Responsibility of Joint Auditors which now stands withdrawn
with the issuance of AAS 12 on “Responsibility of Joint Auditors” w.e.f. April, 1996. Basic
principles laid down in AAS 12 are discussed in following paragraphs:
Division of Work - Where joint auditors are appointed, they should, by mutual discussion,
divide the audit work among themselves. The division of work would usually be in terms of
audit of identifiable units or specified areas. In some cases, due to the nature of the business
of the entity under audit, such a division of work may not be possible. In such situations, the
division of work may be with reference to items of assets or liabilities or income or expenditure
or with reference to periods of time. Certain areas of work, owing to their importance or owing
to the nature of the work involved, would often not be divided and would be covered by all the
joint auditors. The division of work among joint auditors as well as the areas of work to be
covered by all of them should be adequately documented and preferably communicated to the
entity.
Coordination - Where, in the course of his work, a joint auditor comes across matters which
are relevant to the areas of responsibility of other joint auditors and which deserve their
attention, or which require disclosure or require discussion with, or application of judgement
by, other joint auditors, he should communicate the same to all the other joint auditors in
writing. Thus should be done by the submission of a report or note prior to the finalisation of
the audit.
Relationship among joint auditors - In respect of audit work divided among the joint
auditors, each joint auditor is responsible only for the work allocated to him, whether or not he
has prepared as separate report on the work performed by him. On the other hand, all the
joint auditors are jointly and severally responsible:
(a) in respect of the audit work which is not divided among the joint auditors and is carried
out by all of them;
(b) in respect of decisions taken by all the joint auditors concerning the nature, timing or
extent of the audit procedures to be performed by any of the joint auditors. It may,
however, be clarified that all the joint auditors are responsible only in respect of the
appropriateness of the decisions concerning the nature, timing or extent of the audit
procedures agreed upon among them; proper execution of these audit procedures is the
separate and specific responsibility of the joint auditor concerned;
(c) in respect of matters which are brought to the notice of the joint auditors by any one of
them and on which there is an agreement among the joint auditors;
(d) for examining that the financial statements of the entity comply with the disclosure
requirements of the relevant statute; and
(e) for ensuring that the audit report complies with the requirements of the relevant statute.
If any matters of the nature referred above are brought to the attention of the entity or other
joint auditors by an auditor after the audit report has been submitted, the other joint auditors
would not be responsible for those matters. Subject to paragraph (b) above, it is the
responsibility of each joint auditor to determine the nature, timing and extent of audit
procedures to be applied in relation to the area of work allocated to him; The issues such as
appropriateness of using test checks or sampling should be decided by each joint auditor in
relation to his own area of work. This responsibility is not shared by the other joint auditors.
Thus, it is the separate and specific responsibility of each joint auditor to study and evaluate
the prevailing system of internal control relating to the work allocated to him. Similarly, the
nature, timing and extent of the enquiries to be made in the course of audit as well as the
other audit procedures to be applied are solely the responsibility of each joint auditor.
In the case of audit of a large entity with several branches, including those required to be
audited by branch auditors, the branch audit reports/returns may be required to be scrutinised
by different joint auditors in accordance with the allocation of work. In such cases, it is the
specific and separate responsibility of each joint auditor to review the audit reports/returns of
the divisions/branches allocated to him and to ensure that they are properly incorporated into
the accounts of the entity. In respect of the branches which do not fall within any divisions or
zones which are separately assigned to the various joint auditors, they may agree among
themselves as regards the division of work relating to the review of such branch returns. It is
also the separate and specific responsibility of each joint auditor to exercise his judgement
with regard to the necessity of visiting such divisions/branches in respect of which the work is
allocated to him.
A significant part of the audit work involves obtaining and evaluating information and
explanations from the management. This responsibility is shared by all the joint auditors
unless they agree upon a specific pattern of distribution of this responsibility. In cases where
specific responsibility of each joint auditor to obtain appropriate information and explanations
from the management in respect of such divisions/zones/units and to evaluate the information
and explanations so obtained by him. Each joint auditor is entitled to assume that the other
joint auditors have carried out their part of the audit work in accordance with the generally
accepted audit procedures. It is not necessary for a joint auditor to review the work performed
by other joint auditors or perform any tests in order to ascertain whether the work has actually
been performed in such a manner. Each joint auditor is entitled to rely upon the other joint
auditors for bringing to his notice accounting principles or any material error noticed in the
course of the audit. Where separate financial statements of a division/branch are audited by
one of the joint auditors, the other joint auditors are entitled to proceed on the basis that such
financial statements comply with all the legal and professional requirements regarding the
disclosures to be made and present a true and fair view of the state of affairs and of the
working results of the division/branch concerned, subject to such observations as may be
communicated by the joint auditor concerned.
Reporting Responsibilities - Normally, the joint auditors are able to arrive at an agreed
report. However, where the joint auditors are in disagreement with regard to any matters to be
covered by the report, each one of them should express his own opinion through a separate
report. A joint auditor is not bound by the view of the majority of the joint auditors regarding
matters to be covered in the report and should express his opinion in a separate report in case
of a disagreement.
For the purpose of computation of the number of company audits held by an auditor pursuant
to the ceiling rule introduced in the Companies Act, 1956 each joint auditorship in a company
will be counted as one unit.
Gist of Important Circulars

6.8 A gist of some important circulars issued from time to time by the Company Law
Department is given below:
Another meeting to be held by directors for considering reservation, qualification,
etc., made in auditor’s report - In case the auditors’ remarks are not available to the board
at the time of its consideration and authentication of the balance-sheet and profit and loss
account under Section 215(3), the board has to meet once again to consider the
reservations, qualifications made in auditor’s report and give their explanations to the said
remarks in terms of Section 217(3) - Source: Letter No. 8/22(215)/76-CL-V, dated 16-8-
1978.
Need for appointment of independent auditors - Where due to near relationship of an
auditor with managing or a whole-time director, the independence of an auditor is likely to
be jeopardised, he shall use his good sense, and acting in the best traditions of the
profession, refrain from accepting the appointment - Source: The Chartered Accountant,
Vol. XII, Part XI, May, 1964 issue.
Statutory auditor cannot be internal auditor - If the statutory auditor of the company is
also the internal auditor, it will not be possible for him to give an independent and objective
report under-Section 227. As such a statutory auditor of a company cannot also be its
internal auditor - Source: Circular No. 29/76(1)/[76-CL-V], dated 27-8-1976 as corrected by
Circular No. 5/[77(1)/1/76-CL- V], dated 8-4-1977.
Statutory auditor cannot undertake work of writing books of account - The acceptance
of the book-keeping work by the statutory auditor is likely to place the statutory auditor in a
rather vulnerable position in the matter of free expression of his professional opinion as an
auditor on the annual accounts of the company. Such practice deserves to be discouraged -
Source: Extract from Seventh Annual Report on Working and administration of Companies
Act, 1956 - Year ended 31st March, 1963.
Retiring auditor can be deemed to be reappointed or automatically appointed at
annual general meeting- It is not correct to say that in the absence of the resolution to the
effect that that retiring auditors shall not be reappointed, the retiring auditors shall stand
reappointed as auditors of the company. Where auditors are not appointed or reappointed in
accordance with the provisions of the Act including section 224(2), as read with sections
225, 190 and 224(3) relating to the Government’s power to appoint auditors becomes
attracted in the matter - Source: Circular No. 5/72, dated 21-2-1972.
Continuation of tenure of auditor up to factual conclusion of next annual general
meeting - Where no annual general meeting is held, the tenure of an auditor appointed
under section 224 will continue up to the factual conclusion of the next annual general
meeting held by the company - Source: Clarification issued by Department of Company
Affairs.
Signing of Form 23B by auditors in firm’s name without disclosing identity of
signatory - The intimation in token of acceptance or refusal to accept the appointment is
only a ministerial act which can be performed by a duly authorised person on behalf of the
auditor’s firm. It is, however, necessary that the identity of person who signs Form No. 23B,
whether he be a partner or a clerk of the firm, must be disclosed as such, as it will not be
enough if the form is signed only in the firm’s name, without disclosing the identity of the
signatory since the firm has no locus standi of its own in the eye of law - Source: Letter No.
7/26/76-IGC, dated 31-10-1977.
Requirement of sending certificate by auditors to Registrar - The intimation for the
appointment or reappointment of a person or firm as the auditor under sub-section (1C) of
Section 224 does not provide for prescribing any form for furnishing the said intimation to
the Registrar - Source: Circular No. 20/75[35/3/75-CL-III], dated 22-9-1975.
Guarantee companies are not to be counted in reckoning specified number of audits -
Such companies as have no share capital, i.e. guarantee companies, are to be excluded
from the reckoning of ‘specified’ number of companies within the meaning of Explanation 1
to sub-sections (1B) and (1C) - Source: Letter No. 8/12(224)/74-CL.-V, dated 28-9-1974.
Branch audits of Indian companies and audit of Indian business accounts of foreign
companies not to be included while calculating specified number of audits - The
branch auditor of the Indian Companies appointed under section 228 audits the accounts of
the particular branch only for which he is appointed and forwards his report to the auditor
appointed under section 224 and, hence, he cannot be equated with the company’s auditors
appointed under section 224. Hence, the branch audits are not to be included while
calculating the specified number of 20 audits. The audit of the accounts of companies is
also not to be included within the specified number of 20 as laid down under Explanation I to
sub-section (1C) of Section 224 - Source: Circular No. 21/75(35/3/75-CL-III), dated
24- 9-1975.
Central Government’s power to appoint auditors exercisable only where auditors are
not appointed in annual general meeting - It is only where an auditor is not appointed at
an annual general meeting that the Central Government can exercise the powers under
section 224(3) - Source: Letter No. 35/13/74-CL-III, dated 21-11-1974.
Material date for appointment or reappointment of auditor is date of annual general
meeting at which special resolution is required to be passed - The material date for the
appointment or reappointment of an auditor is the date of the annual general meeting at
which the special resolution is required to be passed. Moreover, since generally, articles of
association of companies provide for closure of the register of members before general
meeting during period not exceeding thirty days at any one time, it is unlikely that the
position regard shareholding in the company will be different between the date of issue of
notice and date of the general meeting.
In exceptional cases, however, where a change in the shareholding pattern in the company
has taken place, between the date of issue of notice of the general meeting and the actual
passing of this resolution regarding appointment of auditor, the company may either:
(i) adjourn the meeting to another date, and later issue the required notice in accordance
with the law and thereafter pass the special resolution required to be passed under
section 224A, or
(ii) omit or pass over the item on the agenda regarding appointment of auditor.
In the event of the company adopting the procedure at (ii) above, the situation would be
then covered by sub-section (2) of section 224A-Source: Circular No. 2/76(1/176-CL-V),
dated 5-6-1976.
Interpretation of expression “other than retiring” as occurring in section 225(1) -
Passing of a resolution in the annual general meeting appointing another person as an
auditor of the company without mentioning the words ‘instead of him is quite sufficient and
valid’ under Section 224(2)(c) and similarly a special notice proposing to move a resolution
to appoint a new person as an auditor of the company without mentioning the words ‘in
place of retiring auditor’ is sufficient compliance under section 225(l) - Source: Circular No.
22/76(35/4/76 - CL-III), dated 26- 7-1976.
Service of copy of special notice to retiring auditors to be effected by registered post-
The copy of the special notice under Section 225(2) should be sent to the retiring auditors
by the registered AD post-Source: Circular No. 2/81(1/1/81-CL- V), and 8/20(225)/81-CL-
(V), dated 17-10-1981.
Consequence of non-forwarding of notice to retiring auditors - The effect of non-
forwarding of notice under Section 225(2) to the retiring auditors will make the resolution for
appointing or removing auditors illegal and ineffective - Source: Circular No. 35/6/68-CL-III,
dated 18-11-1969.
Proprietary firm, whether qualifies for appointment as auditor - A company must
appoint the proprietor of the proprietary firm by his name in his individual capacity as its
auditor and the auditor’s report will have to be signed by the proprietor himself in his own
name - Source: Circular No. 8/1229/56-PR, dated 20-3-1957.
Where chartered accountant renders services professionally and not as an officer
company, he is not disqualified under section 226(3)(b) - A chartered accountant’s main
business is to render professional service for reward like a lawyer or a doctor. Where such
service is rendered professionally and not as an officer or employee of the company’ a
chartered accountant is not disqualified under section 226(3)(b) - Source: Circular Letter No.
8/1/57-PR, dated 11-7-1957.
Section 215 not contravened where audit of final accounts is completed before
approval of balance sheet by board of directors of company - The Company Law Board
does not consider that there is any contravention of section 215 in a case where the audit of
the final accounts is completed before the approval of the balance sheet by the board of
directors of the company - Source: Letter No. 8/13(215)/65-CL- V, dated 29-9-1996.
Instances of lapses on part of auditors - The auditors will not be fulfilling their duties if
they have given clean certificate on the company accounts audited by them without looking
into matters which were clearly relevant to a ‘true and fair’ view of the affairs of the
companies concerned. It would not be a proper discharge of their responsibilities of auditors
were not to disclose the infringements of the provisions of the Companies Act or those of
the other important laws, much less to draw company’s attention to inadequate depreciation,
to under- or over-valuation of current assets like stock-in-trade, to improper allocation of
reserves, to improper classification of debts and loans, etc. Source: Extract from Third
Annual Report on Working and Administration of Companies Act, 1956 Year ended
31-3-1959.
Statutory auditor is to refer to branch audit only when branch accounts are audited by
a person other than himself - The company’s auditor need refer in his report to the branch
audit only when the branch accounts are audited by a person other than himself - Source:
Letter No. 8/46(1)/61 -PR, dated 9-5-1961.
Followance of procedure of section 225 for appointment of branch auditor - The term
‘auditor’ mentioned in section 225 means statutory auditor. It would be preferable if
companies followed the procedure laid down in section 225, in all cases, including that for
appointment of branch auditor - Source: Extract from Minutes of Meeting of Bombay
Chambers’ Company Law Sub-Committee with Secretary, Department of Company Law
Administration, held on 2-6-1961.
Branch audit can be conducted at head office without visiting branches - For the
auditor of the branch accounts there is no compulsion to visit branches, but here again it is
a matter for the auditors to decide - Source: Letter No. 8/16(1)/61-PR, dated 9-5-1961.
Place of manufacture can be deemed to be branch office for purposes of carrying out
audit - The place of manufacture, for the purpose of carrying out an audit, shall be regarded
as a branch office and should be audited as such under Section 228 unless it is exempted
from audit under the Companies (Branch Audit Exemption) Rules, 1961. As regards any
accounts or other papers relating to this branch office kept at the head office, it is for the
concerned auditor to decide about the procedure he should follow - Source: Letter No.
8/16(1)/61-PR, dated 9-5-1961.
Copy of branch audit report could be sent to the board of directors simultaneously
with transmission of original branch audit report to statutory auditor - There can be no
administrative objections to a copy of the branch audit report being sent to the board of
directors simultaneously with the direct transmission of the original branch audit report to
the statutory auditor - Source: Letter No. I0(1)-CL-VI/61, dated 27-4-1961.
Interpretation of definition of “accounts” as occurring in Section 228 (3)(c) - The
‘accounts’ maintained in the branch office would necessarily depend largely on type of
businesses carried on in branch. However, two requirements, in addition to the other
requirements of Section 227 that might be applicable to any particular branch that have to
be complied with, are namely, the auditors should certify that (a) proper books of account
have been kept a branch; and (b) that the accounts or returns of the branch show a true and
fair view of working of the branch - Source: Extract from Fifth Annual Report on Working and
Administration of Companies Act, 1956 - Year ended 31st March, 1961.
The revised guiding principles on which applications of banking companies for exemption
from branch audit be dealt with, were formulated keeping in view the fact that the accounts
of the branches of banking companies are generally inspected regularly by their trained
inspectors, and the further- fact that many banks have a large number of branch offices
spread throughout the country - Source: Extract from Sixth Annual Report on Working and
Administration of Companies Act, 1956 - Year ended 31st March, 1962.
Signing of auditors’ report in firm’s name - The partner concerned shall invariably sign in
his own hand for and on behalf of the firm appointed to audit a company’s accounts, and
this is what is required by the provisions of the Act - Source: Circular No. 26/72 (F. No.
14/12/72- CL- V), dated 29- 7-1972.
Appointment of a chartered accountant who is not in practice - There is no
inconsistency between the provisions of the Chartered Accountants Act and section 233A
whereby the Central Government has been empowered to appoint a chartered accountant
who is not in practice for the special audit of a company - Source: Letter No. 8/16(1)/1,
dated 9-5-1961.
Appointment of cost auditors in firm’s name - Whether cost audit report could be
signed by merely affixing firm’s name - In cases where a firm of cost auditors is approved
for appointment under sub-section (2) of section 233B, the cost audit report shall be signed
by any one of the partners of the firm responsible for the conduct of cost audit in his own
hand, for and on behalf of the firm, which has been approved for appointment as cost
auditors of the company. In any case, the report should not be signed by merely affixing the
firm’s name - Source: Letter No. 52/409/60-CLB, dated 24-8-1984.
Whether appointment of cost auditor as internal auditor permissible - The cost auditor
should not be the internal auditor of a company for the period for which he is conducting the
cost audit - Source: Circular No. 1/83, dated 20-1-1983.
Whether cost auditor is under legal obligation to make disclosure of full details in his
cost audit report - The duties of the cost accountants appointed to conduct an audit of cost
accounts of the company flow directly from the above provisions and as such they should in
strict compliance therewith ensure that full and complete details in respect of the accounts of
the company are furnished in their reports. Any request that certain details may not be
disclosed in the report (on any ground whatsoever) should be inconsistent with the object and
purpose of the Cost Audit Report Rules and the requirements there under. The cost auditors
should, if necessary, bring such instances to the notices of Government by a specific note in
their reports - Source: Circular No. 3/83, dated 18-3-1983.
Compliance with Relevant Provisions of the Companies Act, 1956

6.9 One of the fundamental duties of the auditor is to verify that the statements of account
are properly drawn up and they disclose all the required information. In the process, he must
also ascertain that the company has not violated any of the provisions contained in the
Companies Act, 1956. Since the auditor is not associated with day-to-day management of the
company, compliance with the relevant provisions of the Companies Act, 1956 is the
responsibility of the directors and officers of the company. Nevertheless, where non-
compliance results in affecting the accounts materially, the auditor must make a report to the
shareholders. He can properly discharge such onerous duty only if he is aware of the duties of
the management prescribed by the Companies Act, 1956.
The Companies Act, 1956 lays down detailed provisions regarding various matters and casts
an obligation upon directors and officers of the company to carry out the requirements of the
law. Generally speaking, it is the duty of the directors and the management to ensure that the
provisions of the Companies Act, 1956 have been complied with. However, where non-
compliance with the provisions of the Companies Act, 1956 has a bearing upon the accounts
and transactions of the company, the auditor would in the normal course of his inquiry become
aware of the breaches of the Act and may have an obligation to bring this to the attention of
the shareholders. A brief list of some of the important sections of the Companies Act, 1956 is
given below:
Section
4. Explains the meaning of Holding Company and Subsidiary Company.
10FA. Dissolution of Company Law Board.
10FB-10FP Contribution of National Company Law Tribunal.
10FQ-10GF Appellate Tribunal.
13. This Section prescribes requirements with respect to the Memorandum of
Association.
31. Alteration of Articles of Association of a company; by special resolution.
43A. This Section described the circumstances under which a private company would
become a public company under the Act. This section has been amended by
Companies (Amendment) Act, 2000.
49. This Section requires that the investments of a company are held in its own
name, except as otherwise permitted by it and the auditor should see that its
provisions have been complied with.
58A. This Section read with Rules framed thereunder regulates acceptance and
renewal of deposits by certain classes of companies.
58AA. Small Depositors.
60A. Concept of Shelf Prospectus.
60B. Concept of information memorandum and red herring prospectus introduced.
62. Civil liabilities for misstatements in prospectus.
63. Criminal liabilities for misstatements in the prospectus.
68B. Initial offer of securities to be in dematerialised form in certain cases.
69. This Section prohibits any allotment of shares unless the minimum subscription
stated in the prospectus has been received in cash. It also provides that all
monies received from applicants for shares shall be kept deposited in a
scheduled bank for the period specified in sub-section (4).
71. Effect of irregular allotment.
73. This Section deals with allotment of shares and debentures to be dealt in on a
recognised stock exchange.
75. This Section deals with the return of allotment.
76. This Section deals with underwriting commission and brokerage. Attention is
invited to sub-section (4A) which prohibits the payment of commission in certain
circumstances.
77. This Section prohibits a company from purchasing its own shares or giving a
loan or guarantee in order to facilitate the purchase of its shares except under
certain circumstances and it should be seen that no loans are made in
contravention of its provisions.
77A,77AA These Sections deals with buy back of shares by the company.
& 77B.
78. This Section deals with the application of securities premium amounts received.
It should be seen that these provisions are complied with.
79. If a company has made an issue of shares at a discount it should be seen that
the provisions of this Section have been complied with.
79A. This Section deals with Issue of sweat equity shares by a company.
80. This Section deals with the terms and conditions on which redeemable
preference shares may be issued.
80A. Redemption of irredeemable preference shares.
81. This Section gives the existing equity shareholders of a public company the right
to be offered any shares subsequently issued subject to certain limitations and
conditions. Where any shares are issued by a company, it should be seen that
the provisions of Section 81 have been complied with
86. New issues of share capital to be only of two kinds: The concept of equity share
capital with differential voting rights introduced.
93. Deals with the payment of dividend in proportion to the amount paid up under
certain circumstances.
94. Deals with the alteration of share capital.
94A. This Section provides for the increase in share capital under orders of the
Central Government relating to conversion of debentures or loans into share
capital.
100 & 102. These Sections deal with the reduction of share capital under a court’s order.
108. Transfer not to be registered except on production of instrument of transfer.
109. Transfer by a legal representative.
109 A & Nomination of shares/Transmission of shares.
109 B.
117A/117B Creation of Debenture Trust Deed, Appointment and duties of debenture

& 117C. trustees and liability of company to create security and debenture redemption
reserve.
143. Company’s Register of charges.
149. This Section lays down certain restrictions on public companies in regard to
commencement of business including new business.
152A. Register and Index of beneficial owners
165. Statutory Meeting and Statutory Report.
192A. Passing of resolutions by postal ballot.
197A. Company not to appoint more or employ certain different categories of
managerial personnel at the same time.
198. This Section deals with overall managerial remuneration and minimum
remuneration to managerial personnel. Any breach of this section should be
brought to the attention of the shareholders.
199. This Section provides that the commission or other remuneration payable to any
officer or employee of the company (other than a director, or manager) if fixed at
a percentage of the company’s net profits, should be calculated on the net profits
as set out in Sections 349, 350 & 351.
200. This Section prohibits payment by a company to its officers and employees
remuneration free of tax calculated with reference to the tax payable by the
employee.
204. This Section deals with restrictions on appointment of a firm or body corporate to
an office or place of profit under a company for a term exceeding five years at a
time.
205. This Section deals with payment of dividends only out of profits after providing
for depreciation, etc. The Section further requires compulsory transfer of profits
to reserve and regulates excess transfers in accordance with the Rules. Concept
of interim dividend introduced.
205A. This Section deals with transfer of unpaid dividends to a separate Unpaid
Dividend Account in a Scheduled Bank. Rules framed under this Section regulate
the utilisation of past reserves for declaration of dividends.
205C. Establishment of Investor Education and Protection Fund.
208. If a company has paid interest on its share capital it should be ascertained that
the provisions of this Section have been complied with.
209. This Section provides for the keeping of proper books of account by a company.
It should be noted that the auditor is specifically required to report if proper
books of account are not kept. Attention is invited to the provisions of Section
541, and in particular to sub-section (2)(b). Attention is also invited to the rules
issued from time to time by the Central Government under sub-section (1)(d) of
Section 209, which prescribe the requirements for maintenance of cost records
by certain classes of companies. Section 209(3) requires keeping books on
accrual basis of accounting.
210. This Section deals with annual accounts and balance sheet of a company. It
includes provisions regarding the accounts to be laid before the annual general
meeting of the company, definition of the term “financial year” etc.
210A. This Section requires constitution of National Advisory Committee on Accounting
Standards.
211. This Section, together with Schedule VI to the Act, deals with the form and
contents of the Balance Sheet and Profit and Loss Account. Compliance with
accounting standards has been made mandatory.
215. The auditor should ascertain that the account have been properly authenticated
as required by this Section before he signs the report on the accounts.
216. This Section requires Profit and Loss Account to be annexed and Auditor’s
Report to be attached to the Balance Sheet.
217(2AA). Board's Report to include Director's Responsibility Statement.
222. This Section provides that any document to be annexed or required to be
annexed to company’s account shall not include Board’s report.
224, 225
& 226 These Sections deal with the appointment, removal, remuneration, qualification,
etc. of the auditors. Before consenting to act as an auditor he should certify that
the number of companies of which he is the auditor is within the limits specified
in Section 224 (lB).
224A. Section 224A requires appointment of auditors by a special resolution under
certain circumstances.
227. It deals with power and duties of an auditor. The auditor is required to report to
the shareholders in the terms set out in this Section. Attention is invited to the
Statement on Section 227(lA) issued by the Institute. Attention is also invited to
the orders issued by the Government titled Companies (Auditor’s Report) Order
2003, pursuant to sub-section (4A) and the Statement issued by the Institute
under this order. Compliance with the accounting standards referred to in sub-
section (3C) of Section 211, should be opined by the auditor. Clauses (e) and (f)
also added to sub-section (3) of section 227.
228. This Section deals with the audit of the accounts of a company. It should be
seen that the provisions of the Section read with the Companies (Branch Audit
Exemption) Rules 1961 have been complied with.
229. This Section deals with signing of audit report by the auditor.
233A. This Section deals with the power of the Central Government to direct special
audit in certain cases.
233B. This Section deals with the power of the Central Government to direct audit of
cost accounts in certain cases.
268& 269. These Sections deal with appointment, re-appointment and variation etc.,
relating to Managing Directors, and Wholetime Directors.
292A. Audit Committees.
293. Restriction on the Powers of a Board.
293A & These Sections prescribe certain limitations in respect of donation to charitable
293B. organisations, political parties, National Defence Fund etc.
295. This Section prohibits, except under certain conditions, loans to directors etc.,
and other persons connected with them. If any loans are given in contravention
of this Section, the auditor should report the matter.
296. This Section deals with application of Section 295 to book debts in certain cases.
297. This Section deals with contacts between a company and its director or his
relative, a firm in which the director or relative is a partner, any other partner in
such a firm or a private company of which the director is a member or director.
The auditor should see that the provisions of this Section have been complied
with where transactions with such parties have come to his attention. The
auditor should enquire whether the company has observed the terms and
conditions stipulated by the Central Government in its approval wherever
applicable.
299 & 301. These Sections deal with the Register of contracts, companies and firms in
which directors are interested.
309. 310 & These Sections deal with remuneration of directors. Wherever applicable, the
311. terms and conditions of the orders of the Central Government should be looked
into.
314. This Section requires a special resolution of the shareholders for the
appointment of a director and/or his relative to an office of profit under the
Company. In respect of monthly remuneration exceeding specified amount

approval of the Central Government is also necessary vide sub-section (1B). If
any such appointment has been made, it should be seen that the provisions of
this Section have been prima facie complied with. “Office or place of profit” is
defined in sub-section (3).
317. This Section deals with the terms of office of a managing director.
318 & 319. These Sections deal with compensation to directors for loss of office.
349. This Section deals with the manner of computing the profits for the purposes of
determining the remuneration of various classes of managerial personnel.
350. Ascertainment of depreciation.
372A. This Section deals with Inter-corporate loans and investments.
417 & 418. These Sections make provision regarding the treatment of security deposits of
employees and company’s provident fund schemes.
424A-424L Revival and Rehabilitation of Sick Industrial Companies (Second Amendment,
Companies Act)
591. This Section deals with foreign companies. Where prima facie the provisions of
sub-section (2) are attracted, the company should comply with the rules which
may be framed under this Section. The auditor should enquire into the
compliance with such of the Sections as have a bearing on his role as auditor.
594. This Section deals with the accounts of foreign companies.
619. This Section deals with special provisions relating to Government companies.
619B. This Section extends the applicability of Section 619 to non-government
companies under certain circumstances. The auditor shall enquire from the
company whether the conditions are prima facie attracted.
Auditor’s Duty Under Companies Act, 1956

6.10 The following are the duty of an auditor under companies act 1956:
(i) Register of mortgages and charges - Every company under Section 143 is required to
keep a Register of charges to enter therein all the charges specifically affecting the property of
the company as well as the floating charges on the undertaking or on the property of the
company. The particulars of each property charged that should be entered in the register are:
(a) a short description of the property; (b) the amount of charge: and (c) the names of the
persons entitled to exercise the charge. This register should be examined by the auditor to
ascertain whether any of the assets belonging to the company except bearer securities, is
subject to charge, and, if so, its nature. Section 143(2) of the Companies Act, 1956, lays down
that if any officer of a company knowingly omits, or willfully authorises or permits the
ommission of any entry required to be made in pursuance of Section 143(l), he may be
punishable with fine which may extend to five hundred rupees.

(ii) Register of contracts with companies and firms in which the directors are
interested - This Register is maintained pursuant to sub-section (1) of Section 301. It contains
a record of particulars of contracts or arrangements that attract the provisions of Sections 297
and 299; dates of Board meetings at which contracts were approved and that of the names of
directors who voted for or against the proposal. The names of firms and bodies corporate in
which the Directors are interested, of which a notice has been given by the directors under
sub-section 297(2)(c) are also entered in it.
The provisions of Section 297 are not applicable to; (a) contracts or arrangements for the sale
or purchase or supply of goods, materials or services, if the value or cost thereof in any year
does not exceed Rs. 5000; and (b) contracts, etc., by banking companies for the collection of
bills in the ordinary course of business, and transactions of banking and insurance companies
in the ordinary course of business with any director, relative, partner, etc., referred to in
Section 297(2) (c).
It is the duty of the auditor to examine the Register to find out whether transactions of
purchase or sale of goods in which a director or directors were interested were entered into
under the sanction of the Board and the directors concerned had disclosed their interest.
(iii) Register of investment or loan made, guarantee given or security provided in
relation to any body corporate - In pursuance of sub-section (5) (a) of Section 372A, every
company shall keep a register showing the following particulars in respect of every investment
or loan made, guarantee given or security provided by it in relation to any body corporate
under sub-section (1), namely:
(i) the name of the body corporate; (ii) the amount, terms and purpose of the investment or
loan or security or guarantee; (iii) the date on which the investment or loan has been made;
and (iv) the date on which the guarantee has been given or security has been provided in
connection with a loan.
The particulars of investment, loan, guarantee or security referred to in clause (a) shall be
entered chronologically in the register aforesaid within seven days of the making of such
investment or loan, or the giving of such guarantee or the provision of such security.
The register referred to in sub-section (5) shall be kept at the registered office of the company
concerned shall be open to inspection at such office and extracts may be taken therefrom and
copies thereof may be required, by any member of the company to the same extent, in the
same manner on payment of the same fees as in the case of the register of members of the
company; and the provisions of Section 163 shall apply accordingly.
(iv) Register of investments held in the names of Nominees - Normally, a company is
expected to hold investments in its own name [Section 49]. But where under sub-sections (2),
(3), (4) and (5) of Section 49, investments have been made in the names of nominees, a
register must be kept and the following particulars recorded therein:
(a) the nature, value and such other particulars as may be necessary to identify the shares
or securities.
(b) the name of the person or the bank in whose name or custody the shares or securities
are standing.
The auditor should examine the register during the course of inspection of securities.
(v) Register of directors, managing director, manager and secretary - Under the
provisions of Section 303 of the Companies Act, it is obligatory for a company to maintain a
record, in a register, of the names and addresses and that of other particulars relevant for the
administration of the Act in respect of all the officers aforementioned. Under sub-section (2) of
the aforesaid Section, any change in the officers or any of the particulars of an officer must be
incorporated in the register and notified to the Registrar of Companies within 30 days of the
change taking place. Particulars of original appointment also should be notified to the
Registrar within 30 days of appointment.
The auditor should refer to this register to find out the names of persons who had held
different offices during the year under audit to confirm that various transactions entered into by
the company have been authorised by a competent person.
(vi) Register of shareholding of directors and manager - It contains a record of the
particulars of shares and debentures of the company, as well as those of similar securities in
the capital of any other body corporate, which is a subsidiary or holding company or subsidiary
of the company’s holding company held by a director or which lie in trust with him or of which
he has any right to become the holder whether on payment or not. This register is being
maintained pursuant to the requirement under Section 307.
Where the auditor carries out a share transfer audit, he should see that the purchase and sale
of shares by the directors are properly recorded in the register. But in the course of regular
audit, he is not expected to check the accuracy of entries in the register.
(vii) Managerial Remuneration - Disclosure in the accounts is made. Elaborate provisions
are contained under Clause (4) of Part II of Schedule VI to the Companies Act in the matter of
disclosure of remuneration paid during the financial year to the group of persons commonly
referred to as managerial personnel. The information required to be disclosed is:
(a) Remuneration paid or payable for the financial year to the directors (including managing
directors, or managers).
(b) Other allowances or commission including guarantee commission (details are to be
given).
(c) Any other perquisites or benefits in cash or kind (stating approximate money value where
practicable).
(d) Pensions, gratuities, payment from Provident Fund in excess of own contribution and
interest thereon, compensation for loss of office, consideration in connection with
retirement from office, separately.
A note showing the computation of net profits in accordance with Section 349 of the Act with
relevant details of calculation of the commission payable by way of such profits the directors
(including managing directors or managers) should be given.
Personal expenses of directors - All payments to directors by way of remuneration or
perquisites whether in the case of a public or private company are required to be authorised
both in accordance with the provisions of the Companies Act and Articles of Association of the
company. In some cases, depending upon the provisions contained in the Articles, the
remuneration may require sanction of the shareholders either by an ordinary or special
resolution while, in other cases, it may require only approval of the Directors. In the case of
public companies and private companies which are subsidiaries of public companies, sanction
of the Government is also necessary. If the terms of appointment of a director include payment
of expenses of personal nature then such expenses can be incurred by the company. Where,
however, the contract with the director or the conditions of employment does not contain any
provision for payment of expenses of a personal nature, then there is no warrant for incurring
or reimbursement of such expenses by the company and if such expenses are paid the auditor
should disclose the fact in his report, as also in the accounts. Attention in this regard is invited
to Section 227(IA)(e) of the Companies Act.
(viii) Employees’ Securities (Section 417) - All moneys or securities deposited by the
employees of a company in pursuance to their contract of service must be kept deposited by
the company with a Scheduled Bank or in Post Office Saving Bank Account; or in the State
Bank of India within 15 days of receipt; also such moneys or securities must not be used for
any purpose except for purpose is agreed to in the contract of service.
(ix) Employees’ Provident Fund (Section 418) - All moneys contributed to a Provident Fund
constituted by a company for its employees, together with interest accrued thereon shall have
to be deposited in a:
(i) Post Office Saving Bank account, or
(ii) Special Account to be opened in the State Bank of India or a Scheduled Bank, or
(iii) shall be invested in the securities referred to in clauses (a) to (e) of Section 20 of the
Indian Trusts Act, 1882
The term contribution referred to above means contribution both by the employee and the
employer. The deposit is to be made within 45 days of the date of the contribution or of the
receipt of or accrual of the interest.
(x) Inter-Corporate Loans and Investments (Section 372A) - 372A (1) No company shall,
directly or indirectly:
(a) make any loan to any other body corporate;
(b) give any guarantee, or provide security, in connection with a loan made by any other
person to, or to any other person by, any body corporate; and
(c) acquire, by way of subscription, purchase or otherwise the securities of any other body
corporate, exceeding sixty per cent, of its paid-up share capital and free reserves, or
hundred per cent of its free reserves, whichever is more:
Provided that where the aggregate of the loans and investments so far made, the amounts for
which guarantee or security so far provided to or in all other bodies corporate, along with the
investment, loan, guarantee or security proposed to be made or given by the Board, exceeds
the aforesaid limits, no investment or loan shall be made or guarantee shall be given or
security shall be provided unless previously authorised by a special resolution passed in a
general meeting:
Provided further that the Board may give guarantee, without being previously authorised by a
special resolution, if,
(a) a resolution is passed in the meeting of the Board authorising to give guarantee in
accordance with the provisions of this section;
(b) there exists exceptional circumstances which prevent the company from obtaining
previous authorisation by a special resolution passed in a general meeting for giving a
guarantee; and
(c) the resolution of the Board under clause (a) is confirmed within twelve months, in a
general meeting of the company or the annual general meeting held immediately after
passing of the Board resolution, whichever is earlier:
Provided also that the notice of such resolution shall indicate clearly the specific limits,
the particulars of the body corporate in which the investment is proposed to be made or
loan or security or guarantee to be given, the purpose of the investment, loan or security
or guarantee, specific sources of funding and such other details.
(2) No loan or investment shall be made or guarantee or security given by the company
unless the resolution sanctioning it is passed at a meeting of the Board with the consent
of all the directors present at the meeting and the prior approval of the public financial
institution referred to in Section 4A, where any term loan is subsisting, is obtained:
Provided that prior approval of a public financial institution shall not be required where
the aggregate of the loans and investments so far made, the amounts for which
guarantee or security so far provided to or in all other bodies corporate, along with the
investments, loans, guarantee or security proposed to be made or given does not exceed
the limit of sixty per cent, specified in sub-section (1), if there is no default in repayment
of loan instalments or payment of interest thereon as per the terms and conditions of
such loan to the public financial institution.
(3) No loan to any body corporate shall be made at a rate of interest lower than the
prevailing bank rate, being the standard rate made public under Section 49 of the
Reserve Bank of India Act, 1934.

(4) No company, which has defaulted in complying with the provision of Section 58A, shall,
directly or indirectly:
(a) make any loan to any body corporate; (b) give any guarantee, or provide security, in
connection with a loan made by any other person to, or to any other person by, any
body corporate; and (c) acquire, by way of subscription, purchase or otherwise the
securities of any other body corporate, till such default is subsisting.
(5) (a) Every company shall keep a register showing the following particulars in respect of
every investment or loan made, guarantee given or security provided by it in relation
to any body corporate under sub-section (1), namely :
(i) the name of the body corporate;
(ii) the amount, terms and purpose of the investment or loan or security or
guarantee;
(iii) the date on which the investment or loan has been made; and (iv) the date on
which the guarantee has been given or security has been provided in
connection with a loan.
(b) The particulars of investment, loan, guarantee or security referred to in clause (a)
shall be entered chronologically in the register aforesaid within seven days of the
making of such investment or loan, or the giving of such guarantee or the provision
of such security.
(6) The register referred to in sub-section (5) shall be kept at the registered office of the
company concerned and (a) shall be open to inspection at such office; and (b) extracts
may be taken therefrom and copies thereof may be required, by any member of the
company to the same extent, in the same manner, and on payment of the same fees as
in the case of the register of members of the company; and the provisions of Section 163
shall apply accordingly.
(7) The Central Government may prescribe guidelines for the purposes of this section.
(8) Nothing contained in this section shall apply
(a) to any loan made, any guarantee given or any security provided or any investment
made by,
(i) a banking company or an insurance company, or a housing finance company
in the ordinary course of its business, or a company established with the
object of financing industrial enterprises, or of providing infrastructural
facilities;
(ii) a company whose principle business is the acquisition of shares, stock,
debentures or other securities;
(iii) a private company, unless it is a subsidiary of a public company;

(b) to investment made in shares allotted in pursuance of clause (a) of sub-section (1)
of Section 81.
(c) to any loan made by a holding company to its wholly owned subsidiary;
(d) to any guarantee given or any security provided by a holding company in respect of
loan made to its wholly owned subsidiary; or
(e) to acquisition by a holding company, by way of subscription, purchases or
otherwise, the securities of its wholly owned subsidiary.
(9) If default is made in complying with the provisions of this section, other than sub -section
(5), the company and every officer of the company who is in default shall be punishable
with imprisonment which may extend to two years or with fine which may extend to fifty
thousand rupees:
Provided that where any such loan or any loan in connection with which any such
guarantee or security has been given, or provided by the company, has been repaid in
full, no punishment by way of imprisonment shall be imposed under this sub-section, and
where such loan has been repaid in part, the maximum punishment which may be
imposed under this sub-section by way of imprisonment shall be appropriately reduced:
Provided further that all persons who are knowingly parties to any such contravention
shall be liable, jointly and severally, to the company for the repayment of the loan or for
making good the same which the company may have been called upon to pay by virtue of
the guarantee given or the securities provided by such company.
(10) If default is made in complying with the provisions of sub-section (5), the company and
every officer of the company who is in default shall be punishable with fine which may
extend to five thousand rupees and also with a further fine which may extend to five
hundred rupees for every day after the first day during which the default continuous.
Explanation: For the purposes of this section, (a) “loan” includes debentures or any deposit of
money made by one company with another company, not being a banking company; (b) “free
reserves” means those reserves which, as per latest audited balance sheet of the company,
are free for distribution as dividend and shall include balance to the credit of the securities
premium account but shall not include share application money.
Final Accounts Preparation and Presentation

6.11 Statutory Requirements - Section 211 governs the form and contents of the Balance
Sheet and the Profit and Loss Account. The provisions thereunder, however, are not
applicable to an insurance or banking company or a company engaged in the generation or
supply of electricity or to any other class of companies for which a form of balance sheet and
profit and loss account has been specified in or under the Act governing such class of
companies. The provisions that companies, other than those aforementioned, should comply
with are:
(a) That every balance sheet of a company should give a true and fair view of the state of
affairs of the company as at the lend of financial year and should be in the form set out in
Part I of Schedule VI or as near thereto as circumstances admit or such other form as
may be approved by the Central Government either generally or in any particular case;
while preparing the balance sheet, due regard should be had as far as may be to the
general instructions for the preparation of balance sheets under heading “Notes” at the
end of the Part I; and
(b) That every profit and loss account of a company should give a true and fair view of the
profit or loss of the company for the financial year and should comply with the
requirements of Part II of Schedule VI, so far as they are applicable thereto.
The Central Government is authorised under sub-section (3) to exempt, by a notification in the
Official Gazette, any class of companies from compliance with any of the requirements in
Schedule VI if, in its opinion, it is necessary to grant the exemption in the public interest. The
exemption may be granted unconditionally or subject to such conditions as may be specified in
the notification. The Central Government also may, on the application of or with the consent
of the Board of Directors of the company by order modify in relation to that company any of
the requirements of the Act as to the matters to be stated in the company’s balance sheet or
profit and loss account for the purpose of adopting them to the circumstances of the company.
Thus in order that the statements of account of a company may exhibit a true and fair view of
the state of affairs of a company, it is necessary:
(i) that the information required by law (as specified in Schedule VI to the Act) should be
disclosed; and
(ii) that the same to be displayed in the manner required.
The Companies (Amendment) Act, 1999 has inserted following sub-sections in Section 211
namely:
(3A) Every profit and loss account and balance sheet of the company shall comply with the
accounting standards.
(3B) Where the profit and loss account and the balance sheet of the company do not comply
with the accounting standards, such companies shall disclose in its profit and loss account
and balance sheet, the following, namely: (a) the deviation from the accounting standards; (b)
the reasons for such deviation; and (c) the financial effect, if any, arising due to such
deviation.
(3C) For the purposes of this section, the expression “accounting standards” means the
standards of accounting recommended by the Institute of Chartered Accountants of India
constituted under the Chartered Accountants Act, 1949, as may be prescribed by the Central
Government in consultation with the National Advisory Committee on Accounting Standards
established under sub-section (1) of Section 210A:
Provided that the Standards of accounting specified by the Institute of Chartered Accountants
of India shall be deemed to be the Accounting Standards until the Accounting Standards are
prescribed by the Central Government under this sub-section.
Constitution of National Advisory Committee on Accounting Standards - The Central
Government may, by notification in the official Gazettee, constitute an Advisory Committee to
be called the National Advisory Committee to be called the National Advisory Committee on
Accounting Standards (hereafter in this section referred to as the “Advisory Committee”) to
advise the Central Government on the formulation and laying down of accounting policies and
accounting standards for adoption by companies or class of companies under this Act.
Form of the Balance Sheet - Now a days, the shares in companies are held by a wide
variety of persons, a majority of whom are not conversant with the principles of accounting
or with the form in which the final statements of accounts are drawn up. As a result, there
have been complaints from several quarters that the traditional form in which the balance
sheet of a company is drawn up, known as the “T” form, is not satisfactory, for it does not
disclose clearly whether the value of the equity of the share holders has increased or
decreased and, if so, by what amount. On this ground, it has been suggested that instead,
the balance sheet should be drawn up in the columnar form. [Students are invited to see
the published accounts of any big company]. The Balance Sheet of a company shall be
either in horizontal form or vertical form. Some of the advantages of final statements of
account being drawn in a columnar form are as under:
(i) When the final accounts are drawn up in this form, the financial position of the company
can be readily comprehended by a layman.
(ii) The profit and loss account discloses clearly the amount of trading or non-trading profit
earned during the year,that brought forward from the previous year, and the
appropriations out of the total profits recommended by the Board of Directors.
(iii) The Balance Sheet discloses the amount of debt and shareholders’ equity. It further
discloses the position of assets held against them segregated into fixed assets and
working capital.
(iv) The form is capable of presenting together comparative figures of a number of years.
(v) The relationship between the various balances (ratios) can be easily worked out.
Schedule VI –
Part I of Schedule VI contains the form in which the Balance Sheet of a company should be
drawn up, and states the information as regards different assets and liabilities which should be
disclosed therein. At the end of the form, there are general instructions which should be
followed in the preparation of the Balance Sheet. This part has again two sub-parts (IA) and
(IB). The former gives the form of balance sheet in traditional horizontal form while the latter
introduced in late 1978, provides the vertical form of the balance sheet. This vertical form can
be used by companies without the necessity of any permission.
Part II of the Schedule contains provisions as regards information relating to items of income
and expenditure which should be disclosed in the Profit & Loss Account. But no form has
been prescribed for Profit & Loss Account. Companies are therefore free to adopt a form they
consider suitable according to their own requirements, provided of course, all the disclosures
required by this part are made.
Part III of the Schedule contains definitions of the expressions ‘Provision’, ‘Reserve’, ‘Capital
Reserve’, ‘Liability’ and ‘Quoted Investment’. It further provides that in the case of a provision
of liability which, in the opinion of directors, is in excess should be treated as a reserve and
not as a provision.
Part VI of the Schedule VI contains an abstract of the financial statements and general
business profile of the company.
Significance of True and Fair

6.12 The words “true and fair” are not defined in the Companies Act, 1956 except in so far as
sub-section (5) of Section 211 of the Companies Act states that the balance sheet and profit
and loss account of a company shall be deemed as not disclosing a true and fair view of the
state of affairs of the company in case any matter which is required to be disclosed by the
provisions contained in Schedule VI or by virtue of a notification issued under sub-section (3)
or an order under sub-section (4) is not disclosed.
From the foregoing provision, it could be construed that so long as the statements of accounts
are drawn up in conformity with the provisions contained in Schedule VI they would be
deemed to disclose a ‘true and fair’ view of the state of affairs of the company (except in case
of companies governed by special Acts).
The foregoing view is broadly correct in as much as, when the balance sheet of a company is
drawn up in the form prescribed in Schedule VI to the Companies Act, 1956 and the profit and
loss account discloses all the information required by several provisions contained in part II of
Schedule VI, the statements of account disclose all material facts which must be considered
for studying the profitability of the company and its financial position.
Where, however, the auditor is of the opinion that the information disclosed does not show the
correct financial position of the company; he should disclose further information, for example,
the current position of trade investments if their market value is below cost.
It will be important to understand here the role played by the Accounting Standards published
under the authority of the Council of the Institute of Chartered Accountants of India and other
authoritative publications. As per section 211 (3A), it is obligatory upon companies to comply
with accounting standards laid down by the Institute of Chartered Accountants of India
[Section 211(3A)].
The Companies Act, 1956 apart from prescribing the disclosure requirements in Schedule VI
and by way of notes to the Profit and Loss Account, does not dwell upon the accounting
practices that should be followed in order to generate the information required to be disclosed.
The Institute’s Accounting Standards have therefore been formulated with a view to harmonise
the diverse accounting policies and practices. It is clear that these standards cannot deal with
all nuances of accounting practices. They concentrate on basic matters. They apply only to
items which are material. While discharging their attest functions, it will be the duty of the
members of the Institute to ensure that the Accounting Standards are implemented in the
presentation of financial statements covered by their audit reports. The compliance of the
practices recommended by the Accounting Standard in prime facie and predominant
evidence in deciding whether the accounts represent a true and fair view.
Divisible Profits, Dividends and Reserves

6.13 Profit is the central theme for almost all business activities. Decision about the future of
the business, i.e., whether to close down, expand or modify largely depend on the trend of
profits or losses; investors’ interest in a business is also dependent upon the yield that they
get. For all these, determination of correct profit is obviously important and, no wonder, it is
a matter to which accountants attach great importance. The auditor must necessarily have
regard to generally accepted accounting practices, legal provisions and judicial
pronouncements in carrying out his duties. Should more profit be distributed than is
permissible, because of a wrong process of computation, it may be treated as paying a
dividend out of capital which is legally not permissible unless the company is being wound
up. Apart from legal consequences, the management of the business would be depleting
capital of the company which may have dangerous results.
Reserves can be created only when there is profit; some reserves can also be utilised to
pay dividends. Apart from the specific law governing creation and maintenance of
reserves in certain cases, the articles of association of companies generally contain
provisions in this respect. In addition, accepted accounting practices suggest situations,
where, even in the absence of any specific law, reserves should be maintained. Despite
the existence of accounting principles, judicial rulings and legal requirements controversy
in these respects cannot be considered to have come to an end. For example, though
professional bodies as well as law have tried to distinguish revenue reserves from capital
reserves, still there is large scope of disagreement on whether capital reserves are
distributable. It is imperative that there should be a clear idea about profit, distributable
profit, dividend and reserves. The auditor should, within the broad framework of available
guidelines, exercise his own judgement in each case.
A special note in this connection should be taken for depreciation and valuation of stocks, the
two major elements influencing the correct determination of profit or loss. These two are
related to the valuation of assets of the business which directly and significantly affect the
figure of profit or loss. One should be aware of the various possibilities in this regard.
6.13.1 Concept of profit - Like the term “value” in Economics, accountants have used the
word ‘profit’ for many years without assigning a definite meaning to it. This state of affairs has
given rise to much uninformed criticism of accountants and their work; added to this is the
difficulty an economist and an accountant differ as to computation of profit of a business.
Economist’s concept - Profit is the increase the value of total net assets of a business
over a period of time after making an allowance for any withdrawal or introduction of
capital. This is known as the “Increased Net Worth Theory of Profit”. It is ascertained by
determining the market value on the two accounting dates of all the assets reduced by the
amount of liabilities incurred. The increase or reduction in the net worth is the profit or
loss for the intervening period.
Accountant’s concept - To an accountant, profit is the margin between operating income and
associated expenses as related to a given period of time. Nevertheless, he is conscious of the
fact that a business is a continuing operation and its wheels do not cease to grind, as is
assumed for the purpose of preparing the periodical statements of account. So, while he
agrees that these should be prepared in order that proprietors may have periodical reports of
the stewardship, he is conscious of their limitations. It is on this account that he is continually
striving to perfect his method to evaluate the expenditure which has not resulted in an income
so that, on its exclusion the accounts may become more accurate and meaningful.
In this regard some of the ideas which have dominated the thinking of accountants in the past
are: the necessity of preserving the monetary value of the proprietary capital originally
contributed, the unpredictable nature of the future course of events and sale as an essential
step to the emergence of profit. These ideas in due course have developed into a completed
fabric of generally “accepted accounting practices” which are stated below:
(i) The book value of fixed assets should be assessed at their historical cost regardless of
their market price.
(ii) The book value of current assets should be based on their cost or net realisable value
whichever is lower.
(iii) A mere rise in market value is not a profit, but if the asset is a current asset, decline in its
market value is a loss.
(iv) No profits are earned unless the product is sold and cash is received or an enforceable
obligation against a debtor is created.
(v) In general, underestimation of prospective revenue (i.e., conservatism) is

commendable: overstatement is not permissible. This is based on the dictum:
anticipate no profits, provide for all losses. No a day, concept of procedure is
gaining importance over the conservatism.
(vi) In general, known expenditure or loss even though not incurred should be provided for.
(vii) Consistency of accounting policy adopted from year to year should be ensured as far as
practicable.
On a consideration of the aforementioned practices it would appear that if any of them are
disregarded, the accuracy of profits disclosed by the statements of account would be vitiated
and elements of guess work and uncertainty would creep in.
6.13.2 Valuation of assets - The question of determination of profits is inextricably bound up

with the valuation of assets. Therefore, when the basis of valuation is altered or a wrong
basis is adopted, it affects the amount of profit or loss disclosed by the Profit and Loss
Account. Some of the significant factors which affect the determination of profit are: rate of
depreciation of fixed assets, the practice adopted for writing off fictitious assets such as
preliminary expenses, the manner in which expenditure on research is adjusted in the
accounts, valuation of stock-in-trade, provision for bad and doubtful debts, etc. The different
bases on which assets are valued are briefly explained below to show that the method
conventionally followed for the determination of profits does not necessarily give profit which
have been actually earned. This is because a lot of estimation enters in determining the value
of assets and liabilities:
(i) Fixed assets - The charge for depreciation is always approximate. There are several
elements of estimation involved in its computation, e.g., the life of the asset, its residual scrap,
value of obsolescence, etc. Further, the charge for depreciation is made merely to amortize
the original cost. It may or may not at the end of its useful life, result in accumulating enough
liquid resources to replace the asset on account of the increase which may have taken place
in the replacement cost.
(ii) Intangible assets - Accounting theory so far has not sufficiently developed to prescribe
a uniform method of valuation of intangible assets like goodwill, patent rights, technical know -
how, etc. This class of assets is thus treated differently by different industries; sometimes
even in the same industry their treatment at different units is not the same.
(iii) Deferred revenue expenditure and other fictitious assets - Again there is no unifor-
mity of treatment of these items. Successful companies write off their preliminary expenses or
development expenses, etc. immediately. Less successful ones write them off over a period
of years, the argument being that such initial expenditure also benefits future years. The likely
issuance of Accounting Standard on “Intangible Assets”, would provide the necessary
guidance.
(iv) Stock-valuation - There are several senses in which the words “cost” and “net realisable
value” may be construed. The rule that profit must only be taken into account when realised by
sale is again responsible for some distortion. Its application logically to companies doing long-
term construction contracts may involve a great fluctuation in profits from year to year. AS-2
issued by the Institute deals with uniform approach and practice as regards valuation and
presentation of inventories.
Judicial rulings on ascertainment of profits - The fact of the three cases given below
should be studied carefully:
In Re. Spanish Prospecting Co. Ltd. (1911), the company had contracted to pay a certain
salary to some of its staff subject to the condition that they shall not be entitled to draw their
salary “except only out of profits” if any, arising from the business of the company. The salary
was cumulative. Any arrears were to be payable out of future profits. The company dealt in
shares and securities. The company went into liquidation and some of the securities held were
sold by the liquidator. It was contended that the proceeds should be credited to the Profit and
Loss Account (their book value was nil) in order to enable the staff to receive their arrears to
salary. This contention was rejected at first but was upheld by the Court of Appeal. This case
establishes the fundamental nature of profit (impliedly the economist’s profit).
In Re. Crabtree Thomas vs. Crabtree (1912), the testator left his business to be carried on by
trustees and to pay thereof to his wife while she lived and on her death, to a residuary legatee.
The trustee charged in the accounts depreciation on machinery. It was contended on behalf of
the life tenant that the profits before charging depreciation were paid to her. But it was ruled
out on the ground that depreciation must be charged on the assets of a business to arrive at
the amount of profit.
Edwards vs. Saunton Hotel Co. Ltd. (1942), a director of the company was to be paid by way
of remuneration 20% of the profit “available” for distribution each year. It was held that
depreciation on assets calculated on the straight line, method must be deducted from the
surplus to arrive at the amount of profit, 20% whereof was payable to the director, but the
income tax payable by the company was not to be deducted.
6.13.3 Depreciation under Section 205 of the Companies Act, 1956 - Section 205 prohibits a
company from declaring dividend out of its profits before providing for depreciation in the
manner laid down in the section. The said section, as amended by the Companies
(Amendment) Act, 1988, reads as under:
“Section 205, Dividend to be paid only out of profits -
(1) No dividend shall be declared or paid by a company for any financial year except out of
the profits of company for that year arrived at after providing for depreciation in
accordance with the provisions of sub-section (2) or out of the profits of the company for
any previous financial year or years arrived at after providing for depreciation in
accordance with those provisions and remaining undistributed or out of both or out of
moneys provided by the Central Government or a State Government for the payment of
dividend in pursuance of a guarantee given by that Government.
Provided that:
(a) if the company has not provided for depreciation for any previous financial year or
years which falls or fall after the commencement of the Companies (Amendment)
Act, 1960 it will, before declaring or paying dividend for any financial year provide
for such depreciation out of the profits of that financial year or out of the profits of
any other previous financial year or years;
(b) if the company has incurred any loss in any previous financial year or years, which
falls or fall after the commencement of the Companies (Amendment) Act, 1960,
then, the amount of the loss or an amount which is equal to the amount provided for
depreciation for that year or those years whichever is less, shall be set off against
the profits of the company for the year for which dividend is proposed to be declared
or paid or against the profits of the company for any previous financial year or
years, arrived at in both cases after providing for depreciation in accordance with
the provisions of sub-section (2) or against both;
(c) the Central Government may, if it thinks necessary to do so in the public interest,
allow any company to declare or pay dividend for any financial year out of the profits
of the company for that year or any previous financial year or years without
providing for depreciation:
Provided further that it will not be necessary for a company to provide for depreciation as
aforesaid where dividend for any financial year is declared or paid out of the profits of any
previous financial year or years which falls or fall before the commencement of the Companies
(Amendment) Act, 1960.
(1A) The Board of directors may declare interim dividend and the amount of dividend including
interim dividend shall be deposited in a separate bank account within five days from the date
of declaration of such dividend.
(1B) The amount of dividend including interim dividend so deposited under sub-section (1A)
shall be used for payment of interim dividend.
(1C) The provisions contained in sections 205, 205A, 205C, 206, 206A and 207 shall, as far
as may be, also apply to any interim dividend.
(2) For the purpose of sub-section (1), depreciation shall be provided either:
(a) to the extent specified in Section 350; or
(b) in respect of each item of depreciable asset, for such an amount as is arrived at by
dividing ninety five per cent of the original cost thereof to the company by the
specified period in respect of such asset; or
(c) on any other basis approved by the Central Government which has the effect of
writing off by way of depreciation ninety five per cent of the original cost to the
company of each such depreciable asset on the expiry of the specified period; or
(d) as regards any other depreciable asset for which no rate of depreciation has been
laid down by this Act or any rules made thereunder; or such basis as may be
approved by the Central Government by any general order published in the Official
Gazette or by any special order in any particular case:
Provided that where depreciation is provided for in the manner laid down in clause (b) or
clause (c), then, in the event of the depreciable asset being sold, discarded, demolished or
destroyed the written down values thereof at the end of the financial year in which the asset is
sold, discarded, demolished or destroyed, shall be written off in accordance with the provision
to Section 350.
(2A) Notwithstanding anything contained in sub-section (1), on and from the commencement
of the Companies (Amendment) Act, 1974, no dividend shall be declared or paid by a
company for any financial year out of the profits of the company for that year arrived at after
providing for depreciation in accordance with the provisions of sub-section (2), except after the
transfer to the reserves of the company of such percentage of its profits for that year, not
exceeding ten per cent, as may be prescribed:
Provided that nothing in this sub-section shall be deemed to prohibit the voluntary transfer by
a company of a higher percentage of its profits to reserves in accordance with such rules as
may be made by the Central Government in this behalf.
(2B) A company which fails to comply with the provisions of Section 80A shall not, so long as
such failure continues, declare any dividend on its equity shares.
(3) No dividend shall be payable except in cash:
Provided that nothing in this sub-section shall be deemed to prohibit the capitalization or
profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or
paying up any amount, for the time being unpaid, on any shares held by the members of
the company.
(4) Nothing in this section shall be deemed to affect in any manner the operation of section
208.
(5) For the purposes of this section:
(a) “specified period” in respect of any depreciable asset shall mean the number of
years at the end of which at least ninety-five per cent of the original cost of that
asset to the company will have been provided for by way of depreciation if
depreciation were to be calculated in accordance with the provisions of section 350;
(b) any dividend payable in cash may be paid by cheque or warrant sent through the
post directed to the registered address of the shareholder entitled to the payment of
the dividend, or in the case of joint shareholders to the registered address of that
one of the joint shareholders which is first named on the register of members, or to
such person and to such address as the shareholders or the joint shareholders may
in writing direct.
Ascertainment of depreciation Section 350 - The amount of depreciation to be deducted in
pursuance of clause (k) of sub-section (4) of Section 349 shall be the amount of depreciation
assets as shown by the books of the company at the end of the financial year expiring at the
commencement of this Act or immediately thereafter and at the end of each subsequent
financial year at the rate specified in Schedule XIV.
The Companies (Amendment) Act, 2000 w.e.f. 13.12.2000 amended section 350 and deleted
the words, “the amount calculated with reference to the written down value of the assets" by
the words, "the amount of depreciation assets". Therefore depreciation in future would be with
reference to books of account and which may be on SLM basis.
Provided that if any asset is sold, discarded, demolished a destroyed for any reason before
depreciation of such asset has been provided for in full, the excess if any of the written down
value of such asset over its sale proceeds or, as the case may be, its scrap value, shall be
written off in the financial year in which the asset is sold, discarded, demolished or destroyed.
6.13.4 Law relating to dividends -
Sources of dividends - The Companies Act, 1956 lays down the law relating to distribution of
profits by making certain provisions under Section 205, Accordingly dividend cannot be
declared or paid by a company for any financial year except:
(a) out of profits of the company for the year arrived at after providing for depreciation in
accordance with the provisions of Section 205(2), or
(b) out of the undistributed profits or the company for any previous financial year or years
arrived at after providing for depreciation in the manner aforementioned and remaining
undistributed, or
(c) out of the balances of profit mentioned in (a) and (b) above; or
(d) out of moneys provided by the Central Government or a State Government for payment
of a dividend pursuant to the guarantee given by the Government.
Dividends out of current profits -Transfer to reserves - In terms of Section 205(2A) of the
Companies Act, no company is permitted to declare or pay dividend for any financial year out
of the profits of that year without first transferring to reserve so much percentage of profits of
the year as is prescribed under the Companies (Transfer of Profits to Reserve) Rules, 1975.
The percentage of profits required to be transferred to reserves have been related to the rate
of dividend proposed for the year and are given hereunder:
Rate of dividend Percentage of profit required to be

transferred to reserves
Upto 10% Nil
Exceeding 10% but not exceeding 12.5% Not less than 2.5% of the current profits.
Exceeding 12.5% but not exceeding 15% Not less than 5% of the current profits.
Exceeding 15% but not exceeding 20% Not less than 7.5% of the current profits.
Exceeding 20% Not less than 10% of the current profits.
(i) Arrears of depreciation mentioned in Section 205(1) should also be provided in

determining the profit for the purpose of transfer to reserves.
(ii) The profit should be after tax for the above purpose.
(iii) The profit for the above purpose should be determined after debit for Statutory
Development Reserve.
(iv) The rates of dividend mentioned in the table above relate to the rates of equity dividend
and the portion of dividend in excess of the fixed rate of dividend in respect of the
participating preference shares.
(v) The transfer to reserve contemplated in Section 205(2A) does not include any transfer to
Development Rebate Reserve, Capital or any special reserve. The reserves
contemplated are only the “free reserve”.
(vi) A company is absolutely free to transfer to reserves a higher percentage than is indicated
in the slabs in the table above, provided the rate of transfer does not exceed 10%. In
other words, when the rate of dividend proposed is between “exceeding 10% but not
exceeding 12.5%” the corresponding rate for transfer to reserve is 2.5% of the current
profits. The company would be free to transfer to reserve any percentage from 2.5% to
10%. The ceiling at 10% for transfer to reserve is in accordance with the provision of
Section 205(2A) which requires the transfer “not exceeding 10%”.
(vii) Companies are free to carry the residual profit, irrespective of the amount, after dividend
and transfer to reserves, in the Profit and Loss Account.
Transfer to reserves exceeding 10% Conditions - The aforesaid requirement of transferring
profits to reserve, subject to a ceiling of 10% is not a ban on a higher transfer. A company
can transfer to reserve a percentage, of profits higher than 10%. For doing that it must comply
with further conditions laid down in the Companies (Transfer of Profits to Reserves) Rules,
1975. If the company wishes to transfer a higher percentage and is also contemplating
declaration of dividend it is to ensure a rate of dividend for the year equal to the average rate
of dividend declared in respect of the immediately preceding three years. In a case where
bonus shares have also been issued in the financial year in which the dividend is declared, or
in the three years immediately preceding the financial year, a minimum distribution sufficient
for the maintenance of dividends to shareholders at an amount equal to the average amount
(quantum) of dividend declared over the three years immediately preceding the financial years
is to be ensured. However, if the net profit after tax for the year is lower at least 20%
compared to the average net profit after tax at the immediately two preceding years, the
company will not be required to ensure the maintenance of the average amount/rate of
dividend mentioned earlier.
Where no dividend is declared the amount proposed to be transferred to its reserves from the
current profits shall have to be lower than the average amount of the dividends declared over
the immediately proceeding three financial years.
Dividends out of past profits - Also, companies are henceforth [i.e., after coming into force
of the Companies (Amendment) Act, 1974] forbidden from declaring dividends out of past
profits kept in reserves unless declaration conforms to the rules prescribed for the purpose by
the Central Government or Central Government’s prior approval is obtained in case such rules
are not complied with [Section 205A(3)].
The rules titled “Companies (Declaration of Dividend out of Reserves) Rules, 1975” provided
that in the event of inadequacy or absence of profits in any year, dividend may be declared by
a company for that year out of the accumulated profits earned by it in previous years and
transferred by it to the reserves, subject to the conditions that:
(i) the rate of the dividend declared shall not exceed the average of the rates at which
dividend was declared by it in the five years immediately preceding that year or ten per
cent of its paid-up capital, whichever is less;
(ii) the total amount to be drawn from the accumulated profits earned in previous year and
transferred to the reserve shall not exceed an amount equal to one-tenth of the sum of its
paid-up capital and free reserves and the amount so drawn shall, first be utilised to set
off the losses incurred in the year before any dividend in respect of preference or equity
shares is declared, and
(iii) the balance of reserves after such withdrawal shall not fall below 15% of its paid-up
share capital.
Illustration
(a) Give your views together with reasons on the following proposals:
(i) A company had profit after depreciation and tax of Rs. 17,00,000 for the year 2002-
03.
In arriving at this profit a deduction was made of Rs.3,00,000 in respect of the
reserve created on account of Shipping Reserve. The company has proposed a
rate of dividend @15% on its equity capital of Rs.6,00,000 and 10% on the
preference capital of Rs. 6,00,000. The company also proposes to transfer to
reserves 10% of the current profit.
(ii) The rates of equity dividend declared and paid by a company are as follows:
2001-2002 15%
2000-2001 12%
1999-2000 12%
The company has earned sufficient profit after tax in 2002-03 and wishes to
propose a dividend on equity shares at 11% of the current profits and transfer to
Reserved 20%. The company has not issued any bonus shares during the last few
years. The post-tax profit in 2002-03 is higher than the corresponding profit of
each of the previous three years.
(iii) Will it make any difference if the company under (ii) above proposed a rate of equity
dividend @ 20%?
(iv) Will it make any difference if the amounts of net profits after tax of the company
under (ii) above are as follows?
Rs.
2002-2003 10,00,000
2001-2002 17,00,000
2000-2001 15,00,000
1999-2000 18,00,000
(v) A company’s profits after tax for several years and equity dividends are given
below:
Years Net profit Rate of equity Amount of
after tax (Rs.) dividend dividend (Rs).
2002-2003 10,00,000 8% (proposed) 8,00,000
2001-2002 17,00,000 14% (paid) 14,00,000
2000-2001 15,00,000 12% (paid) 9,60,000
1999-2000 16,00,000 10% (paid) 8,00,000
The company wishes to transfer to reserves Rs. 2,00,000 of the current profits. It issued
bonus shares during 2001-02.
(b) A company has earned a total sum of Rs. 85 lakhs during the years from 1997-98 to
2001-02. The company has neither declared any dividend nor transferred any amount to
the reserves during these years and kept the amount in the Profit & Loss Account. Now
the company proposes to appropriate a part of this amount for making payment of
dividend for the years 2002-03 in which it has earned a profit of Rs. 18 lakhs. The Board
proposes a payment of dividend of Rs. 25 lakhs. Advise the company.
Solution
(a) (i) All the proposals of the company are legally valid. Profit of Rs. 17,00,000 after tax
and depreciation is the profit contemplated in Section 205(2A) of the Companies Act
as clarified by the Company Law Board. Reserve on account of shipping reserve of
Rs. 3,00,000 is an item of prior deduction for determination of the figure of Rs.
17,00,000 on this account. Since the company is proposing a transfer to reserve of
10% of the current profit, there is no problem before the company for declaration of
dividend. Under Section 205(2A) of the Companies Act, a transfer not exceeding
10% of the current profits to reserve is required and the question of voluntary higher
transfer will arise only if the rate of transfer is higher than 10%. The Companies
(Transfer of Profit to Reserve) Rules, 1975 issued under Section 205(2A) of the
Companies Act provide for a transfer to reserve of “not less than 5% of the current
profits” in respect of the dividend rate exceeding 12.5% but not exceeding 15%.
Thereafter transfer to reserve of 5% more up to 10% is valid. As per the
clarification of the Company Law Board, fixed preference dividend is not to be
considered in Section 205(2A) of Companies Act.
(ii) The proposal is not legally sustainable.
It is a case of voluntary transfer to reserves at a percentage higher than 10% under
Section 205(2A) of Companies Act. Any voluntary transfer of profits of a percentage
higher than 10% to reserve can be made only when the company complies with the
requirements laid down by the Companies (Transfer of Profits to Reserve) Rules.
When a company declares a dividend and wishes to transfer profit to reserve at a
percentage higher than 10%, it is incumbent on it to at least maintain the average
rate of dividend declared by the company in respect of the immediately preceding
three years. In the present case the average rate of dividend works out to 13%.
The dividend proposed in 2002-03, viz. 11% is less than this rate and, therefore the
company cannot make a transfer of a higher percentage reserves than 10%. It
should also be noted that the company’s post-tax profit is not less than the average
post-tax profit for the last two years and no bonus shares have been issued by the
company during 2002-03 or in the preceding three years which would have
permitted transfer to reserves higher than 10% with a reduced rate of dividend.
(iii) Yes, the company’s proposal to transfer to reserves @ 20% would be in order in
view of the fact that the current year’s rate of proposed dividend is higher than the
average rate of dividend for the preceding three years.
(iv) Yes, the company’s post-tax profit for the year is less than the average post-tax
profit of the company for the preceding two years by more than 20%. The post-tax
profit for the year is Rs.10,00,000 whereas the average post tax profit, taking 2001-
2002 and 2000-2001 figure into account is Rs.16,00,000; the former is less than the
latter by about 37.5%. Since the current year’s post-tax profits is less by 37.5% than
the average post-tax profit referred to above, the company is free to make voluntary
transfer to reserves at more than 10% without being required to maintain the rate of
dividend, as per the Companies (Transfer of Profits to Reserve) Rule, 1975.
Therefore, the company’s proposal to pay dividend @11% and transfer to reserve
@20% would be valid propositions.
(v) The proposal is in conformity with law. The company has issued bonus shares
within the preceding three years and therefore, it is required to maintain the amount
of dividend for 2002-03 at least at the level of the average of the amounts paid
during the preceding three years. The average aforesaid works out to Rs.
10,53,333. The current year’s proposed amount, Rs. 8,00,000 is less than the
aforesaid average figure. Therefore, on the first-count the company can not make
transfer of Rs. 2 lakhs to reserves. However, compared to the average of
corresponding profits to the preceding two years, the profit is 2002-03 is lower by
more than 20%; therefore, the company is allowed to pay a lower dividend. Because
of this overriding situation the company is not obliged to maintain the average
amount of dividend as contemplated in a situation where bonus shares have been

issued.
(b) Assuming that the profits arrived at are after providing for depreciation in accordance
with the provisions of Section, 205 (2) of the Companies Act, 1956 the company must
comply with Section 205(2A) of the Companies Act before it can appropriate Rs.18 lakhs
profit pertaining to the year 2002-03 and the balance amount of profit from the past
accumulated profits.
In terms of Section 205(2A) of the Companies Act, no company is permitted to declare or pay
dividend for any financial year out of the profits of that year without first transferring to reserve
so much percentage of profit of the year as is prescribed under the Companies (Transfer of
Profit to Reserve) Rule, 1975. The percentages of profits required to be transferred to
reserves have been related to the rate of dividend proposed for the year and are given earlier:
According to Section 205A(3) of the Companies Act a company is forbidden from declaring
dividends out of the accumulated profits earned by the company in previous years and
transferred by it to the reserves, unless such declaration conforms to the rules prescribed by
the Central Government. In as much as the given company has not transferred the profit of
1997-98 to 2001-02 amounting to Rs. 85 lakhs to reserves, the rules made under Section
205A(3) viz., “Companies (Declaration of Dividend out of Reserves) Rules, 1975” has no
application. Accordingly, the company can freely appropriate past profits towards any
insufficiency in the current year. Profit for the purpose of payment of dividend. On an overall
basis it may be advised that the company can appropriate any part of Rs. 85 lakhs for
payment of dividend in the current year and also it can utilise the profit of Rs. 18 lakhs for the
current year for payment of dividend on compliance with the requirement of Section 205(2A).
Restrictions on dividends when debentures not redeemed - When debentures are not
redeemed, following restrictions apply on declaration of dividend: (a) Company can declare
dividend out of general reserves, only if residual profits after transfer to DRR are adequate (b)
In case of new companies, distribution of dividends shall be only with approval of debenture
trustees and lead financial institution (c). In case of existing companies, prior permission of
lead financial institution will be required if dividend proposed is over 20% or as per loan
agreement or if the company does not comply with conditions of financial institutions regarding
interest and DSCR (debt service coverage ratio).
Amendments relating to payments of Dividends - As per Section 2(14A), dividend has
been defined to include interim dividend also.
Newly inserted sub-section (1A) of section 205 provides that board of directors may declare
interim dividend and the amount of dividend including interim dividend should be deposited in
a separate bank account within five days from the declaration of such dividend.
A question that arises here is whether the company should transfer profits to reserves and
provide depreciation for the whole year before declaring interim dividend.
Based on section 2(14A), read with section 205(1C), it can be concluded that since interim
dividend is also dividend, companies should provide for depreciation as required by section
205 and comply with the Companies (Transfer of Profits to Reserves) Rules, 1975 before
declaration of interim dividend. The company has to provide estimated depreciation for the full
year before declaring interim dividend. If the company does not transfer any profit to reserves,
it has to be contended with an interim dividend not exceeding 10 per cent of the paid-up
capital.
Distribution of Capital Profit - First we should distinguish the three concepts: Capital profit,
Capital Reserve and Capital Receipts.
Capital Profit - The term Capital profit means these profit which arise from transactions which
do not fall within the normal activities of the business. For example a trading company sells
part of its fixed assets at a price which is higher then the original cost of these assets. Since
the company deals in merchandise, the sale of assets, therefore, does from part of its normal
course of business, hence the resultant surplus from the sale of fixed assets would be capital
profit. Strictly Speaking, the Companies Act, 1956 does not make any distinction between
capital profits and other profit. Therefore, any profit realized on sale of fixed or on disposal of
investments, may be distributed by way dividends. Following two conditions must be satisfied
before capital profit distributed:
(i) The surplus is realized, i.e., it is not merely a book entry, like revaluation reserve.
(ii) Such surplus remains after evaluation of the whole of the assets and liabilities has been
fairly taken.
Capital Reserve - Defined as per part-III of Schedule VI to the Companies Act, 1956 does
not include any amount regarded as free for distribution through profit and loss account. That
means the amount in capital reserve can not be used for distribution of dividend.
Capital Receipts - By their nature can not be distributed by way of dividend. Examples of
capital receipt include share premium amounts transferred to capital redemption reserve on
redemption of preference shares, and profit on re-issue of forfeited shares.
As a result, we have gone over to what is sometimes called the ‘balance sheet surplus’
approach: the company’s cumulative position, involving past years as well as the current year,
has to be considered, and dividends can be paid only if justified by the picture as a whole.
Special rules apply to public companies and to investment companies. A public company must
allow for any excess of unrealised losses over unrealised profits on the capital account - i.e.
provision must be made for any unrealised revaluation deficit (Section 264). An investment
company (defined in Section 266) may make a distribution out of the surplus on revenue
account only (i.e. not including even realised capital profits, but at the same time not being
bound to take account of unrealised or realised capital losses), provided that it assets are not
reduced to less than one and a half times its liabilities (Section 265).
The position in our country, regulated more by convention than by any law as regards
unrealised capital profits, is that the same can be applied for writing off past capital losses. As
regards the application of revaluation reserve to write off past revenue loses, the position is to
clear. It seems having regard to the provisions of Section 205 of the Companies Act, that
revaluation reserve should not be applied to write off past revenue losses because that will
facilitate a distribution of dividend without being required to earn a revenue surplus for the
purpose. Such profits however, can not be applied in issuing bonus shares as per the Bonus
Issue Guidelines issued by the Securities and Exchange Board of India (SEBI) nor in paying
up debentures or loan stock or calls on partly paid shares.
The Institute has also issued a guidance note on availability of Revaluation Reserve for issue
of bonus shares, which makes it clear that bonus shares cannot be issued by capitalisation of
revaluation reserve. If any company (including a private or a closely held public Co.) utilises
the revaluation reserve for issue of bonus shares, the statutory auditor of the company should
qualify his audit report (vide November ’94, the Chartered Accountant, p. 681). Also refer to
Accounting Material)
Previous losses - Though companies do write off capital losses, both unrealised and
realised, and either in the year in which they occur or in convenient instalments out of revenue
profits, it is not obligatory for them to do so.
Appropriation out of the amount available for distribution as dividend

Although the whole of the amount standing to the credit of the Profit & Loss Account, provided
it represents revenue profits or capital profits which are available for distribution on the
conditions aforementioned is distributable as dividend, it is often necessary to make
appropriations out of the same on various grounds to arrive at the amount which may be
distributed as a dividend. Some of these grounds are the following:
(a) For credit to General Reserve - If any part of the profits has been utilized for meeting a
capital expenditure or is invested in book debts or stocks, it should not be available for
distribution as a dividend. On this account, the amount so invested as well as that
proposed to be further invested similarly must be credited to the General Reserve
Account. Otherwise, the amount proposed to be distributed will be in excess of the
account actually available for distribution in cash or securities readily convertible into
cash. It would give rise to an anomalous position, the company having stocks which it
cannot sell or books debts it cannot realise, on account of which it will not be able to pay
dividends within the time allowed (30 days) which shall result in the management being
penalized (Section 207). The Articles of Association of a company may also require that
a part of the profit should be credited to the general reserve before any dividend is
distributed. In all such cases it would be necessary for the directors to appropriate proper
amounts out of profits to comply with the legal necessity.
(b) Amortisation of a debt - At times a company, while raising a loan, may undertake that it
would create a fund out of its profits for its payment. For example, the Debenture Trust
Deed in respect of a debenture issue made by a company may stipulate that a fixed
percentage of profits will be credited annually to the Debenture Redemption Reserve
Fund. In such a case, the amount of such an appropriation for credit to the Fund would
be a prior appropriation of the profits.
(c) Provision for preferential payments - If a company has issued preference capital, there
must be provision to pay the dividend on preference shares at the stipulated rate before
any dividend is paid on equity shares. Moreover, if the shares are cumulative, a provision
for all the arrears of dividend payable thereon must be first made.
In addition the directors in any year may decide to appropriate a part of the profits
considered extraordinary or excessive to the credit of a Dividend Equalization Reserve so
as not to raise the rate of dividend distributed beyond what the company could be
expected to maintain in the future.
Legal Decisions - The question of divisible profits has been the subject of several legal
decisions. Most of these decisions were arrived at on the basis that unless required by the
Articles of Association, profits earned could be distributed as dividends before providing for
depreciation or writing off past losses. After the amendment of Section 205 in 1960, however,
these decisions have little applicability.
Application of the principle laid down in the case of Lee vs. Neuchatel Asphalte Co. Ltd. (An
English case decided in 1889). It has been considered above that there is necessity for
provision of depreciation on assets under the provisions contained under Section 205 of the
Companies Act. However, on the basis of provisions contained in clause (d) sub-section (2) of
Section 205 it could be held that in respect of any asset for which no rate of depreciation has
been laid down by the Income tax Act or has been prescribed by the Central Government
depreciation need not be provided. On this basis, it could be argued that no depreciation need
be provided in respect of goodwill, leaseholds and other similar wasting assets.
It could, therefore, be argued that the principle laid down by the decision in the above
mentioned case is still applicable in this country. But, if a company decides to follow this
procedure, it would be necessary for it to retain assets sufficient to pay its debts. For if this is
not done, it would be a fraud on creditors. It is the position of law propounded in another
English Case Verner vs. Generals and Commercial Investment Trust Ltd [1894 2 Ch. 239].
Another view in this matter can be that regardless of the fact that the Central Government has
not notified any rate in respect of an asset for which no rate has been prescribed under the
Income tax Rules, there is an obligation to provide depreciation on every asset on the ground
that it is sound accounting practice. In support of this view it has been pointed out that the
Institute of Chartered Accountants in England and Wales had recommended to its members as
early as January 1945, that depreciation must be provided not only on building, plant and
machinery, etc., but also on leaseholds, patents, mines and other similar assets; also that the
Company Law Department of the Government of India has clarified by a notification that in its
opinion a company is obliged to provide depreciation on the wasting assets before it can
declare dividends, even though no depreciation is allowable in respect of these assets under
the Income tax Act.
The accounting opinion being in favour of provision of depreciation in respect of every asset,
the absence of an order under Section 205(2)(d) specifying the rates at which depreciation
should be charged on wasting assets, it is argued, cannot be interpreted to support the legal
principle emerging out of the English cases, aforementioned. The Central Government has
refrained from issuing the notification presumably on this ground.
It may be noted that with the issuance of accounting standards, the situations described in the
preceding paras do not exist any more. In fact, compliance with accounting standards even as
per provisions of the Companies Act, 1956 would necessitate provisions of depreciation.
Dividend policy and related financial considerations - Normally an auditor, in the

discharge of his duties is not concerned with the policy about dividends. He is merely
concerned with the legality and actual payment of the dividend. The basis of legality is
provided by the Companies Act, 1956 and the related Articles of Association. However,
sometimes auditors are consulted in the matter of deciding upon the quantum of dividend that
can be distributed by a company. Apart from this, Chartered Accountants as such also act as
consultants to various companies on a number of matters, including dividend. The basic
decision about the dividend is that of the management; the shareholders do not have the
authority to enhance the sum proposed by the directors unless the articles allow such a
procedure. On the other hand, the management, because of its very thorough and intimate
knowledge of the financial state of affairs of the company and of the business environment, is
considered to be the best equipped to deal with the matter.
Dividend is a phenomenon involved with the question of financial management of the
company, rationality or feelings of the shareholders and other allied factors; it is therefore very
difficult to lay down any definite policy in this regard. However, as a guiding rule a broad frame
of policy has often been adopted by companies for guidance in deciding each year the
quantum of dividend having regard to the specific situations faced by the company in the
concerned year or situations that are in offing. In deciding upon a policy of dividend the
financial considerations generally get the place of prominence, though the aspects of
shareholders’ aspirations are also taken into consideration. A balance is generally struck to
bring about compromise and adjustment between these without unduly impairing the financial
state of the company. In this context, it should be appreciated that the amount of the profit
available as dividend has competing claimants. It is a source of finance so far as the company
is concerned. This can often be very profitably employed to finance expansion or
diversification or for setting right the adverse working capital or liquidity position.
As a general proposition the following are determinants of dividend policy:
1. Nature of earnings.
2. Re-investment alternative.
3. Dividends and liquidity.
4. Dividends and working capital.
5. Dividends and new capital requirements.
6. Dividends and market value of shares.
7. Tax brackets of shareholders.
8. Stability of dividend.
Payment of dividends
(1) Dividends once declared become the liability of the company and must be paid within 30
days of the date of declaration. Any failure to do so attracts a penalty for the various
persons associated with the management [Section 207].
(2) Dividends are not payable except in cash or by a warrant. It is permissible, however, for
payment to be made by a cheque.
But the profits or reserves can be capitalised for purpose of issuing fully paid bonus
shares subject to the guidelines issued by the SEBI also they may be applied for paying
up any amount for the time being unpaid on any share held by the members of the
company Section 205(3), surplus obtained on revaluation of asset cannot be applied for
the issue of bonus shares.
(3) Dividends can be paid either to the registered holder of a share or to his order or to his
banker. But in respect of a share warrant, the payment can be made only to the bearer or
his banker.
(4) According to the provisions contained in Clause 85 of Table A, though a dividend can be
declared only in a general meeting, the amount thereof must not exceed the amount
recommended for distribution by the Board of Directors. Dividend is payable in proportion
to the amount paid up or credited as paid up on shares, if so authorised by the Articles of
Association (Section 93). If nothing has been paid on any of the shares, dividend may be
declared and paid according to the nominal amount of shares. In the case of a fresh
issue of capital the holders unless precluded by the terms of issue, are entitled to receive
dividends along with the holders of shares already issued. Unless the foregoing
regulation has been excluded or modified by the articles, the same will be deemed as a
part thereof.
Section 205A states that where, after the commencement of the Companies (Amendment) Act,
1974 a dividend has been declared by a company but has not been paid or claimed within 30
days from the date of the declaration, to any shareholder entitled to the payment of dividend,
the company shall within seven days from the date of expiry of the said period of 30 days,
transfer the total amount of dividend which remains unpaid or unclaimed within the said period
of 30 days to a special account to be opened by the company in this behalf in any scheduled
bank, to be called “Unpaid Dividend Account of........... Company Limited./Company (Private)
Limited. The expression “dividend which remains unpaid” means any dividend the warrant in
respect thereof has not been encashed or which has otherwise not been paid or claimed.
The dividends that have remained unpaid upto 1.2.1975 shall also have to be transferred to
the above mentioned account within six months from 1.2.1975. It is obligatory for the company
to pay interest at the rate of 12% for the benefit of the shareholders concerned on any amount
of unpaid dividend which has not been transferred to the aforesaid account with the scheduled
bank.
Any money which has been transferred to unpaid dividend account of a company and which
remains unpaid or unclaimed for a period of seven years from the date of such transfer, the
amount shall be transferred by the company to the Fund established under sub- section (1) of
Section 205C. When unclaimed dividends are transferred to the Fund, the company must
furnish to such authority or committee as the Central Government may appoint, a statement in
the prescribed form setting forth in respect of all sums included in such transfer: (i) the nature
of sum; (ii) the name and last known addresses of the rightful recipients; (iii) the amount to
which each person is entitled; (iv) the nature of his claim thereof; and (v) such other
particulars as may be prescribed.
The company shall be entitled to a receipt from the authority or committee under sub-section
(4) of Section 205C for any money transferred to it to the Fund and such a receipt shall be an
effectual discharge of the company in respect there of [sub-section (7)]
205C. Establishment of Investor Education and Protection Fund –

(1) The Central Government shall establish a fund to the called the Investor Education and
Protection Fund (hereafter in this section referred to as the “Fund”).
(2) There shall be credited to the Fund the following amounts, namely:
(a) amounts in the unpaid dividend accounts of companies;
(b) the application moneys received by companies for allotment of any securities and
due for refund;
(c) matured deposits with companies;
(d) matured debentures with companies;
(e) the interest accrued on the amounts referred to in clauses (a) to (d);
(f) grants and donations given to the Fund by the Central Government. State
Governments, companies or any other institutions for the purposes of the Fund; and
(g) the interest or other income received out of the investments made from the Fund;
Provided that no such amounts referred to in clauses (a) to (d) shall form part of the Fund
unless such amounts have remained unclaimed and unpaid for a period of seven years
from the date they became due for payment.
Explanation: For the removal of doubts, it is hereby declared that no claims shall lie
against the Fund or the company in respect of individual amounts which were unclaimed
and unpaid for a period of seven years from the dates that they first became due for
payment and no payment shall be made in respect of any such claims.
(3) The Fund shall be utilised for promotion of investor awareness and protection of the
interests of investors in accordance with such rules as may be prescribed.
(4) The Central Government shall, by notification in the Official Gazette specify an authority
or committee, with such members as the Central Government may appoint, to administer
the Fund, and maintain separate accounts and other relevant records in relation to the
Fund in such from as may be prescribed in consultation with the Comptroller and Auditor
General of India.
(5) It shall be competent for the authority or committee appointed under sub-section (4) to
spend moneys out of the Fund for carrying out the objects for which the Fund has been
established.]
The Companies (Amendment) Act, 1988, added a new Section 206A according to which
payment of dividend and allotment of bonus and right shares to the transferee to be held in
abeyance till the title to shares is decided. This Section requires that where any instrument of
transfer of shares has been delivered to the company for registration and the transfer of such
shares has not been registered by the company, it shall transfer the dividend in relation to
such shares to the special account referred to in Section 205A unless the company is
authorised by the registered holder of such shares in writing to pay such dividend to the
transferee specified in such instrument of transfer. Further the company shall also keep in
abeyance in relation to such shares any offer of right shares and any issue of fully paid up
bonus shares.
The auditor may take the following steps to ensure that the dividend has been paid only out of
profits:
(a) Check whether dividend was declared out of profits arrived at after providing for
depreciation.
(b) If no depreciation was provided, ensure that approval was obtained from the Central
Government before declaring dividend [Section 205(1)(c)].
(c) Check whether:
(i) the depreciation was provided according to provisions of Section 205(2).
(ii) the minimum prescribed amount had been transferred to reserves according to the
Companies (Transfer of Profits to Reserves) Rules, 1975, before declaring any
dividend.
(iii) conditions governing transfer of higher percentage complied with.
(iv) a board resolution recommending dividend was passed.
(v) register of members was closed as per the provisions of Section 154.
(vi) the dividend was declared only in the annual general meeting.
(vii) dividend has been paid in the prescribed manner within 30 days of time to the
registered holder or to their order (Section 207).
(viii) Amount of dividend deposited in a separate bank account within five days from the
date of declaration of dividend.
(ix) permission of Reserve Bank of India was obtained for payment to non-resident
shareholders before the dividend was remitted to them.
(x) intimation sent to stock exchange, in case of listed company.
(xi) there were any complaints regarding non-payment or delay in payment of dividend?
If, so, whether corrective action was taken.
Documents Involved - 1. Annual Report, 2. Dividend payment Register, 3. Dividend warrant,
4. Minutes of Board/General Meeting, 5. Form 1 of the Unpaid Dividend Rules, etc., 6.
Reserve Bank of India’s Receipt/Approval, 7. Correspondence with Central Government, 8.
Register of Members, 9. Unpaid Dividend Account/Register, 10. Notice of Closure for Register
of members.
Interim Dividend - The definition of term dividend has been modified to include interim
dividend also. Prior to amendment in the Companies Act, 1956, the interim dividend could be
declared by the Board of Directors only if there was an authorisation in the Articles of
Association to do so. However, the same has to be regularised at the general meeting
because interim dividend was a dividend paid by the directors any time between two annual
general meeting. A mere resolution of the directors resolving to pay a certain amount as
interim dividend did not create a debt enforceable against the company for it was always open
to the directors to rescind the resolution before payment of the dividend as decided in the
leading case PNB Ltd. vs. Union of India. It was further held that an interim dividend
announced by the Board of Directors would not, unlike a final dividend declared by the
company at the annual general meeting, created a debt as the Board may subsequently
rescind the resolution and cancel the announcement. The distinction between interim and
final dividend was that unlike interim dividend, a final dividend once declared by the company
in general meeting was a debt and created an enforceable obligation.
However, with the commencement of the Companies (Amendment) Act, 2000 w.e.f. December
13, 2000, interim dividend stands at par with the final dividend. Therefore, all aforesaid
requirements applicable in case of final dividend would also apply to interim dividend.
As stated earlier, section 205A has been amended to provided for interim dividend as well.
Payment of dividend and the Income tax Act - Payment of dividends by a company though
basically governed by the provisions of the Companies Act, has to reckon with a number of
provisions contained in the Income tax Act, having direct or indirect relevance to the
determination of the amount of dividend. The Companies Act, 1956 has prescribed the
manner of determination of the amount of dividend in Section 205. In particular it requires
provision for depreciation, setting off of past losses and transfer to reserves of a prescribed
percentage of the profits. It also provides for the circumstances under which dividend can be
paid out of past profits. The manner of payment of the dividend is also provided for in the
Companies Act. It may be mentioned that any deviation from these provisions will render the
dividend illegal. The payment of dividend is a corporate phenomenon based on accounting,
financial and legal considerations. The accounting and legal considerations are highly related.
In determining the accounting profit, as indicated above a number of provisions from the
Income tax Act have got to be considered. For example, distributable profit of a company gets
conditioned by the requirements to create and retain reserves e.g. investment allowance
reserves. It may be pointed out that any departure from the provisions of the Income tax Act
will not make the payment of dividend illegal but may increase the tax liability of the company.
Should all fictitious assets be written off before distribution of dividends? - The
Accounting Standards Board of ICAI has issued a guidance note on terms used in financial
statements where the term ‘fictitious asset’ has been described as an item grouped under
assets in a balance sheet which has no real value. The guidance note cites the example of
the debit balance of the profit and loss statement. We can also give other examples like, (1)
Goodwill recorded at a particular figure whereas the company may have no goodwill at all in
the ordinary commercial sense, (2) Patents appearing in the balance sheet which in fact are
useless.
There is no mandatory rule in accounting or any legal requirement that fictitious assets must
be written off before declaration of dividend. In this connection if it may be noted that in
Schedule VI, Part I in the asset side certain items are included under the heading
‘Miscellaneous Expenditure’. They represent certain fictitious assets. However, there is no
instruction in Schedule VI or anywhere in the Companies Act including Section 205 to first
write off such miscellaneous items of expenditure. The Statement of Auditing Practices issued
by the ICAI opines that only those items of expenditure which can properly be deferred should
final a place under the head ‘Miscellaneous Expenditure’. Part I of Schedule VI also requires
disclosure under the head Miscellaneous Expenditure of the amounts to the extent not written
off. These professional and statutory requirements imply that these items need not be fully
written off but to the extent they are capable of being deferred can be included under the head
‘Miscellaneous Expenditure’. This is more in the nature of preferable practice but is not
mandatory in its nature. Accordingly it may be said that though writing off of fictitious assets
on a proper accounting consideration is desirable, it is not mandatory. However, the following
points must be noted in this regard:
If there exists debit balance in the profit and loss account, depreciation, if any, contained
therein should first be set off before declaration of dividend out of current profits. Similarly, if
capital profit is sought to be distributed as dividend, all fictitious assets must be first written
off. This is for the reason that one of the conditions for use of capital profits for dividend
purposes is a complete revaluation of all assets and liabilities which should result in a surplus.
In the case of Verner vs. The General Commercial In vestment Trust Ltd., it was held that a
company may pay dividends if it is solvent and is acting within its articles that distribution of
dividend is permissible if there exists revenue surplus even though some portion of the value
of the assets disclosed in the balance sheet may turn out to be fictitious.
6.13.5 Reserves - The term ‘reserves’ is not defined in Part III of Schedule VI except
negatively, in the sense that the profits retained in the business not having any of the
attributes of a ‘provision’ are to be treated as reserves; also provisions in excess of the
amount considered necessary for the purposes, than were originally made are to be
considered as reserve. It is thus evident that the provisions are a charge against profits while
reserves are an appropriation of profits. Also, provisions that prove to be in excess of
amounts required or having been made liberally, are in addition thereto, are reserves. Such a
distinction is essential for disclosing in the balance sheet the amount by which the equity of
the shareholders has increased with the accumulation of undistributed profits. The distribution
is carried further by segregating the reserve which is made up of fortuitous gains,
unconnected with business activity (e.g., appreciation in values of fixed assets, receipts on
account of share premiums), from those appropriated out of profits for credit to revenue
reserve; the first is described as a capital reserve and the second merely as a reserve. The
Companies Act does not specify the categories of accretions to the shareholders funds which
are to be credited to the Capital Reserve, except indirectly by providing that the amounts,
which in the opinion of directors can not be distributed as a dividend through the Profit and
Loss Account are to be credited to such a reserve. The language of the provision appears to
suggest that directors are vested with an unrestricted right to decide which of the amounts to
be credited to the Capital Reserve subject only to provisions of the Act as regards certain
funds not being available for distribution as dividend. But, it is not so, for they cannot violate
the accepted principles of accountancy which determine whether or not an item of income is
capital or revenue. It may also be remembered that an appropriation once made can be
revoked. Therefore, if subsequently conditions arise, which show that amounts appropriated
earlier to the Capital Reserve are distributable as dividends, directors can alter their earlier
decision.
The following are examples of amounts retained in the business that are credited to one
reserve account or another:
(1) Securities Premium Account (Capital Reserve).
(2) Capital Redemption Reserve Account created in pursuance of provision contained in
Section 80 of the Companies Act (Capital Reserve).
(3) Profit on reissue of forfeited share (Capital Reserve).
(4) Amounts retained for equalisation of dividends (Revenue Reserve).
(5) General Reserve built up for the future developments of business (Revenue Reserve).
Attention of the students is drawn to the provisions of Section 205(A) of the Companies Act,
discussed earlier, about restrictions in the utilisation of past profit kept: in reserves for
dividend purposes.
6.13.6 Deferred Taxation - It is a common experience that the profit or loss as per the Profit
and Loss Account will be different from the income ultimately assessed to income tax. It is
also generally different from the income shown in the tax-return submitted to tax authorities’.
Consequently the taxation liability that is provided for in the accounts does not bear any direct
relationship to the profit disclosed and readers of such account are left to guess the reasons.
For instance, income tax should be treated on the same footing as is done in case of other
expenses i.e., accounted for on accrual basis. From a management point of view income tax
is an item of expense rather than an appropriation of pre-tax profit. AS-22 on “Accounting for
Taxes on Income” now requires that tax should be treated as an expense. Students are
advised to go through AS-22 on “Accounting for Taxable Income”.
6.13.7 Non-provision of proposed dividend - It has been noticed that a large number of
companies do not provide for the proposed dividend but either carry forward the balance on
the Profit and Loss Account or transfer an amount to the general reserve and charge the
dividend to the profit and loss account or to the reserve when payment is made. The Council
of the Institute of Chartered Accountants of India has considered the issues involved and is of
the view that proposed dividend does not represent a liability, nor does it amount to a
provision, pending the approval of the shareholders in the general meeting. The Council is
further of the opinion that merely because the form, as given in the Schedule VI of the
Companies Act, requires proposed dividend to be shown under “Current Liabilities and
Provisions” it does not mean that in fact the proposal for the dividend becomes a liability or is
necessarily a provision. The form of accounts laid down under the Insurance Act, 1938 and
the Banking Regulation Act, 1949 do not require proposed dividends to be shown in respective
balance sheets, and this does not impair the true and fair view of such balance sheets. Since,
however the form of the balance sheet prescribed under Schedule VI, Part I-A requires,
“proposed dividends” to be shown under Provisions at paragraph 3(XIV) of Part II of the same
Schedule requires the “proposed dividends” to be disclosed, the Council is of the opinion that
though on correct accounting principles, the proposed dividend does not become a liability,
the attention of the shareholders would have to be drawn to the fact that no appropriation has
been made for the proposed dividend, the amount in respect of which should be specified.
The Council, therefore, has recommended that the fact that the provision for proposed
dividend has not been made should be disclosed by means of a note in the accounts and that
the auditor should refer to the note in his report and make his report subject thereto.
6.13.8 Non-provision of tax in the accounts - The Council of the Institute of Chartered
Accountants of India has taken note of the fact that there is a practice prevalent whereby
companies do not make provision for tax even when such a liability is anticipated. It has
expressed the view that on an overall consideration of the relevant provisions of law, non-
provision for tax (where a liability is anticipated’ would amount to contravention of the
provisions of Sections 209 and 211 of the Companies Act. Accordingly, it is necessary for the
auditor to qualify his report and such qualification should bring out the manner in which the
accounts do not disclose a “true and fair” view of the state of affairs of the company and the
profit or loss of the company. An example of the manner in which the report on the balance
sheet and the Profit and Loss Account may be qualified in this respect is given below:
“The company has not provided for taxation in respect of its profits and the
estimated aggregate amount of taxation not so provided for is Rs ............ including
Rs. ............. for the Year ended on ..............To the extent of such non-provision for
the year, the profits of the Company for the financial year under report have been
overstated and to the extent of such aggregate non provision, the reserves of the
company appearing in the said balance sheet have been over-stated and the
current liabilities and provisions appearing in the said balance sheet have been
understated”.
Depreciation
6.14 There are different methods for charging depreciation:
6.14.1 Method of providing for depreciation - Section 205(2) of the Companies Act, 1956 lays
down the following alternatives for providing the depreciation:
(a) To the extent specified in Section 350 - Section 350 provides that the amount of
depreciation should be the amount of depreciation shown as per books of account.
(b) Straight line method - Alternatively depreciation may be calculated by dividing 95% of
the original cost of the asset to the company by its specified period. According to Section
205(5)(a), specified period of any depreciable asset is “the number of years at the end of
which at least 95% of the original cost of that asset to the company will have been provided for
by way of depreciation if depreciation were to be calculated in accordance with the provision
of Section 350”. Schedule XIV to the Companies Act also provides the straight line
depreciation rates in respect of various categories of assets. These rates have the effect of
writing-off 95% of the original cost of an asset on straight line basis over the same period in
which the aforesaid percentage of the original cost would be written off if depreciation were
provided on writing down value basis.
(c) Any other basis - Depreciation can also be charged on any other basis provided it has
effect of writing-off 95% of the original cost of the asset on the specified period and it is
writing-off 95% of the original cost of the asset on the expiry of the specified period and it is
approved by the Central Government.
In respect of depreciable assets for which no rate has been prescribed under Schedule XIV to
the Companies Act, depreciation is to be provided on a basis approved by the Central
Government.
Schedule XIV to the Companies Act, 1956 - Schedule XIV which has been inserted by the
Companies (Amendment) Act, 1988 and as altered by GSR 756(E), Ministry of Law, Justice
and Company Affairs, Department of Company Affairs specifies depreciation rates both on the
written down value basis and the straight line basis. The SLM rates of depreciation have been
worked out by dividing 95% of the original cost of an asset by its specified period. For
example, in the case of factory buildings (for which the WDV depreciation rate prescribed in
Schedule XIV is 10%), the specified life is 28.43 years. Thus the corresponding SLM rates for
the factory buildings would be 3.34% (i.e. 95/by 28.43) per annum.
The WDV rates prescribed in Schedule XIV are relevant in the context of Section 350 which
can also be followed by a company for providing depreciation under Section 205 for the
purpose of declaration or payment of dividends. The straightline method of depreciation
permitted under Section 205 is one of the bases for charging depreciation. As straight line
depreciation rates have been specified in Schedule XIV to the Companies Act, there would be
no need for a company to calculate these rates.
Schedule XIV also provides separate depreciation rates for single shift, double shift and triple
shift working. This has set at rest the controversy that whether or not depreciation has to be
provided on multiple shift working. Schedule XIV provides rate of depreciation for extra shift
working for only certain categories of plant and machinery. It also list 23 items of plant and
machinery falling within the general category in respect of which no extra shift depreciation is
allowed. The rates of depreciation prescribed in Schedule XIV for various categories of
depreciable assets implicitly recopied that the rates of depreciation represent true commercial
depreciation.
It has been specifically provided that in case any addition is made to any asset during the
financial year, depreciation should be calculated on prorata basis from the date of such
addition. Similarly where an asset is sold, discarded, demolished or destroyed during the
financial year, depreciation should be provided upto the date on which the asset is sold,
discarded, demolished or destroyed.
The Companies (Amendment) Act, 1988, provided that Schedule XIV shall be deemed to have
been inserted in the principal Act from 2nd April, 1987. The amendments to Section 205 and
Section 350 have been notified to come into force from 15th June, 1988.
1. The Directors of A Ltd., a manufacturing company having a capital of Rs. 8,00,000 has
advanced a loan of Rs. 2 lakhs to B Ltd. The Managing Director of the two companies is
one and the same person. Has the investment been validly made? Would it have any
difference if B Ltd. was private company?
2. (a) Mr. Z a chartered accountant is often consulted by Directors of Y Ltd. on specific
financial problems. A suffered a loss on the shares held by him X Ltd. A sues Mr Z.
Will A succeed?
(b) Shri C.A., the auditor of X Ltd., wishes to visit Pune branch of the company. The
company says that the visit is unnecessary since the branch has been audited by a
chartered accountant. Is the company’s contention valid ?
(c) A company wishes to issue debentures on the condition that these would be
redeemed only when the free reserves accumulate to 25% of the paid up capital.
Can the company do so?
3. Examine the following acts and state which of them you consider to be in violation of the
provisions of the Companies Act, mentioning the provisions that have been violated.
(i) The auditor’s report of a company contained significant qualifications; the Board’s
report circulated amongst the shareholders did not contain any reference to the
auditor’s qualifications.
(ii) It is usual practice of a manufacturing company to hold shares in the name of its
banker which is a nationalised bank. It is contended that this facilitates speedy
transfers.
(iii) A subscriber to the memorandum paid no money towards the shares agreed to be
taken by him. His name, however, is found in the Register of members maintained
by the company.
(iv) While conducting a share capital audit, it was noticed that some of the shares were
transferred pursuant to transfer deeds submitted to the company which did not bear
any endorsement.
(v) In a general meeting of a company which has the President of India as a
shareholder, Mr. Z, the Secretary of the Deptt. of Industries, attended and exercised
voting powers on behalf of the President.
(vi) Mr. Gower has been appointed as the Office Master of a Jute Mill at a salary of
Rs.2,500 p.m. Mr. Gower happens to be the maternal uncle of Mr. Sylvester, a
director of the Mill.
(vii) Mr. S, a Director of a public company, is being appointed as retainer in Z Pvt. Ltd.,
a subsidiary of the company, at a remuneration of Rs. 250.
(viii) Mr. K.P.M, a director of X Ltd., which is a subsidiary to Y Ltd., has been appointed
by U Ltd., as the Chief Accountant at a monthly salary of Rs. 3,200.
(ix) A Pvt. Ltd. company composed of two shareholders entered into contract with a
public limited company for supply of certain materials against cash consideration;
the rates quoted were absolutely competitive. The members of the Private Ltd.
company happened to be the wife & son of Mr. Z, a director of the other company.
No sanction of the Board was sought for this contract.
(x) Certain shares were issued to a creditor of the company in settlement of his claims.
A portion of the claim so settled was overdue while for the balance the normal credit
period was not over, The company, in its published accounts, has shown the issue
as issue for cash consideration.
Answers to Question
1: No
2: (a) No (b) No (c) No
3: The actions that are in violation of the provision of the Companies Act:
(i) 217 (iii) 108, (x) Extent of shares issued against claims not due can not be so
described Section 227(IA).
7
LIABILITIES OF AUDITORS
Nature of Auditor’s Liability

7.1 A member of the accounting profession, when he is in practice, offers to perform a
larger variety of professional services, only a few of which have been mentioned above; he
also holds himself out to the public as an accountant qualified to undertake these
assignments. When, therefore, he is appointed under a statute or under an agreement to
carry out some professional work it is to be presumed that he shall carry them out
completely and with the care and diligence expected of a member of the profession. In view,
however, of the fact that the standards of competence may vary from individual to individual
and also the concept of the function of an audit and that of its technique, may from time to
time undergo change, the auditor is expected to discharge his duties according to “generally
accepted auditing standards” obtaining at the time when the professional work is carried out.
The implications of a professional engagement have been explained in the case Lanphire v.
Phipos (1838) & Case & P. 475 cited in “Professional Negligence” by J.P.Eddy, as follows:
“Every person who enters into a learned profession undertakes to bring to the
exercise of it a reasonable degree of care and skill. He does not undertake, if he
is an attorney, that at all events he shall gain his case, nor does a surgeon
undertake that he will perform a cure; nor does he undertake to use the highest
degree of skill. There may be persons who have a higher education and greater
advantages than he has; but he undertakes to bring a fair, reasonable and
competent degree of skill.”
To the same effect are the undermentioned observations in Cooly’s “Torts” an outstanding
American Authority (cited in “Accountant’s Legal Responsibility’ by Saul Levy):
“In all these employment’s where peculiar skill is requisite, when one offers his
services, he is understood as holding himself out to the public as possessing the
degree of skill company possessed by others in the same employment and if his
pretentions are unfounded, he commits a species of fraud upon every man who
employs him in reliance on his public profession. But no man, whether skilled or
unskilled undertakes that the task he assumes shall be performed successfully
and without fault or error; he undertakes for good faith and integrity, but not for
infallibility, he is liable to his employer for negligence, bad faith or dishonesty, but
not losses consequent upon mere errors of judgement.”
Either absence of the requisite skill or failure to exercise reasonable skill can give rise to an
action for damage for professional negligence.
7.1.1 Taking assistance in the discharge of his duties - It is a well accepted legal principle
that duties under a contract can be assigned only in cases where it does not make any
difference to the person to whom the obligation is owed, which of the two persons
discharges it. But contracts involving personal skill, or other personal qualifications normally
cannot be assigned. It, therefore, follows that the work of an auditor being of a personal
character, it must be performed either by him or by his persons under his supervision since
he himself remains finally responsible. Only to ensure that this scheme shall be adhered to
in all cases, clause (13) of Part I of First Schedule to the Chartered Accountants Act, 1949
makes it obligatory that reports on financial statements would be signed either by the
member or his partner.
An auditor who, in the discharge of his professional obligations had relied on the report or
statement of his, subsequently found to be false, cannot be held liable in a criminal action
brought against him (Rex. v. Hinds Musgrave Stevens).
This is, however, no bar to assistance being taken in the performance of a duty or engage-
ment. It is, therefore, quite common for the auditors to engage persons some of whom are
professionally qualified, while others are not, to assist them in their work. The principals,
however, are expected to guide and supervise their work and are personally responsible for
any dereliction of duty or absence of care or skill in performance of an audit or any other
professional engagement. They cannot ordinarily shift any part of this liability to their
employees.
Such legal position is clearly borne by the following extracts from the judgements in two
celebrated cases:
(1) In Henry Squire (Cash Chemists) Ltd. v. Ball Baker & Co.: “The principal must not
excuse himself for his clerk’s negligence by saying that he employed a clerk.”
(2) In the Superintendent of Police v. M. Rajamany : “No auditor can escape from personal
liability by taking shelter under the misconduct of his own employees.”
The decision in the Rajamany’s case also places a limitation on the extent to which an
auditor may delegate his duties to his assistants:
“Callousness and irresponsible abdication of his (auditor’s) work can never be
regarded as anything but misconduct . An auditor who does not personally look
into the accounts but merely delegated it to his assistants cannot be said to be
acting with due skill and care.’
Despite the fact the principal is responsible for the misdemeanour and misdeeds of his
employees, in order that such of them as are qualified may discharge their duties, which are
Liabilities of Auditors 7.3
assigned to them with adequate skill and care, the Council has issued the following
notification in the exercise of powers vested in it by Part II of Schedule II to the Act :
“In exercise of the powers conferred by Clause (ii) of Part II of the Second
schedule to the Chartered Accountants Act, 1949, the Council of the Institute of
Chartered Accountants of India is pleased to specify that a member of the
Institute, whether in practice or not, who is employed by a Chartered Accountant
in practice or by a firm of such Chartered Accountants, shall be deemed to be
guilty of professional misconduct, if he is grossly negligent in the conduct of his
duties.”
In the absence of this clause, only the Chartered Accountant who had signed the report
would be liable and it would not be possible to reach the employee chartered accountant on
grounds of misconduct. The above Notification safeguards the interest of members who
engage Chartered Accountants and issue reports on the basis of the work carried on by
them.
The Council has also issued a Notification bearing No.1-CA (7)/65 November, 1965,
reproduced below:
“No 1-CA (7)/65: In exercise of the powers conferred by Clause (ii) of Part II of the
Second Schedule to the Chartered Accountants Act, 1949, the Council of the
Institute of Chartered Accountant of India specifies that a member of the Institute
who is an employee shall be deemed to be guilty of misconduct if he is wilfully
and grossly negligent in the conduct of his duties as such employee.”
This Notification is much wider in scope than the previous Notification issued on 12th
November, 1960 in as much as it applied not only to a member in service with a Chartered
Accountant in practice or a firm of Chartered Accountants but also to those in service with a
commercial, industrial, or Government concern. This Notification was issued because the
Council felt the need to create public confidence in such members since they had certain
responsibilities as members of the Institute as against other employees who were not
members.
7.1.2 Basis of liability - The liability for professional negligence may arise either under a
statute or an agreement; the liability may be civil or criminal, disciplinary action for
professional misconduct under section 21 of the Chartered Accountants Act can also be
taken against a Chartered Accountant for failure to discharge his professional duties
competently or diligently.
Professional Negligence
7.2 Negligence, which is culpable, generally consists of undermentioned three elements:
(a) existence of duty or responsibility owed by one party to another to perform some act
with certain degree of care and competence;
(b) occurrence of a breach of such duty; and
(c) loss or detriment, being suffered by the party to whom the duty was owed as a result of
negligence.
In this context, professional negligence would constitute failure to perform duties according
to “accepted professional standards”, resulting in some loss or damage to a party to whom
the duty is owed.
(A) To whom is the duty owed? - A professional man is deemed to have been negligent
only when he owed a duty to a person or persons and he had failed to perform or had
performed it negligently. If a loss had been suffered by a client through the action of the
auditor, his liability would be determined on the basis of the contract of engagement
according to which the auditor had undertaken to provide service. When a loss has been
suffered by a third party who is not privy to the arrangement between the clients and the
auditor for determining whether he is liable, it is necessary to find out whether the auditor
owed any duty to him. This will be apparent from the summary of legal decisions discussed
hereinafter.
The financial statements, on which the auditors report, are designed to serve the needs of a
variety of users, particularly owners and creditors. There are users who have direct
economic interest in the concerned business enterprise like the owners, creditors and
suppliers, potential owners, management, taxation authorities, employees and customers.
There are also others who have indirect interests like financial analysts and advisers, stock
exchanges, lawyers, regulatory authorities, financial press, trade associations and labour
unions . Usually, these parties are not in priority with the auditor. Under what
circumstances should these parties not in privity with the auditor be allowed to recover from
the auditor losses that they incur as a result of the auditor’s dereliction of duty? The
solution seems difficult. To hold a negligent auditor liable “in an indeterminate amount for an
indeterminate time to an indeterminate class” will be stretching the limit too far. We cannot
at the same time brush aside the whole concept of auditors’ liability to those parties with
whom he has no privity of contract. If responsibility is to be imposed where specific users
are identified, then to what extent will it be imposed and what criteria will be used to
determine the specific user to whom the auditor should be responsible? Liability imposed
should have some relation to the responsibility reasonably assumed and the fees charged.
The evolution of law in this regard varies widely in England and the United States. So far as
our country is concerned, we should say that much headway has not been made. Hence, it
will be highly instructive to analyse the situation under the following three heads:
(1) English Scene.
(2) American Scene.
(3) Indian Scene.
English scene - The general rule in England is that only parties to a contract may enforce
the rights under the contract.
In Winberbottom v. Wright (10M & W 109,152 Eng. 402 Ex. 1842) it was held that an injured
passenger, who was not a party to a contract to maintain a stage coach, could not sue on
the contract. Learned Judge observed as follows:
“There is no privity of contract between these parties, and if the plaintiff can sue,
every passenger, or even any person passing along the road who was injured by
the upsetting of the coach, might bring a similar action. Unless we continue the
operation of such contracts as this to the parties who entered into them, the most
absurd and outrageous consequences, to which I can see no limit, would ensue.”
In 1883, however, the suppliers of a scaffold for the painting of a ship was held liable to the
painter even in the absence of privity of contract. Lord Esher observed as follows:
“Whenever one person is by circumstances placed in such a position with regard
to another that every one of ordinary sense who did think would at once recognise
that if he did not use ordinary care and skill in his own conduct with regard to
those circumstances he would cause danger of injury to the person or property of
the other, a duty arises to use ordinary care and skill to avoid such danger.” The
formula is very broad and could justify auditor’s liability to users of financial
statements having direct or indirect economic interests.
In Derry v. Peek (1889) 14 A. C 337, it was held that there is no liability to third parties for
negligent language that resulted only in pecuniary loss, although liability to third parties
could be established if the negligent misrepresentation resulted in loss of life, limb or health.
It was held that a false statement made through carelessness and without reasonable
ground for believing it to be true could be evidence of fraud. However, if it was made in the
honest belief that it was true, it was not fraudulent and could not render the person liable in
deceit. However, this decision was the subject of great controversy.
English courts continued to follow Derry v. Peek until 1963. During this period there was no
liability to third parties for negligent misrepresentation except when a special duty to be
careful was imposed by contract a fiduciary relationship or likelihood of physical damage to
person or property.
Thus, Lord Esher in Le Lievre v. Gould (1893) LQ.B. 491 (C.A.) that an architect who
negligently gave certificates of progress for the construction of a building was not liable to a
lender for losses incurred in relying on the certificates. He said:
“But the law of England does not go to that extent; it does not consider that what
man writes on paper is like a gun or other dangerous instruments, and unless he
intended to deceive, the law does not, in the absence of contract, hold him
responsible for drawing his certificates carelessly.”
Direct case on an Accountant’s liability to third parties - The question of Accountant’s
liability to third parties directly came up for consideration in England in the case of Candler
v. Crane Christmas & Co. The fact to the case were that a firm of accountants had been
engaged by a company to prepare the company’s accounts. The accountants knew that the
statements of account would be shown to third parties. Relying on the statements of account
reported upon by the accountants, the plaintiff had invested money in the company and it
was lost. The statements in question had been prepared negligently but there was no fraud.
Cohen and Asquith L.J. (Denning, LJ. dissenting), held that a false statement made
carelessly, as contrasted with one fraudulently made by one person to another, though
acted on by that other to his detriment was not action in the able absence of any contractual
or fiduciary relationship between the parties Lord Denning, however, dissented, and said:
“ .................... the Accountant, who certifies the accounts of his client is always
called upon to express his personal opinion whether the accounts exhibit a true
and correct view of his client’s affairs; and he is required to do this not so much
for the satisfaction of his own client but more for the guidance of shareholders,
investors, revenue authorities, and others who may have to rely on the accounts
in serious matters of business. If we should decide this case in favour of the
Accountants there will be no reason why Accountants should ever verify the word
of the man in a one man company, because there will be no one to complain
about it. The one man who gives them wrong information will not complain if they
do not verify it. He wanted their backing for misleading information he gives them
and he can only get it if they accept his word without verification. It is just what
he wants so as to gain his own ends. And the persons who are misled cannot
complain because the accountants owe no duty to them. If such be the law, I
think it is to be regretted, for it means that the accountant’s certificate which
should be a safeguard, becomes a share for those who rely on it. I do not myself
think it is the law. In my opinion Accountants owe a duty of care only to their own
clients; but also to those who they know will rely on their accounts in the
transactions for which these accounts are prepared.”
A turning point - Hedley Byrne & Co. Ltd. v. Heller & Partners Ltd. (1963) All E.R. 575:
(1964). I Camp L.J., 14, the House of Lords. In the case, the subject of liability to third
parties for negligence of a professional person has been comprehensively reviewed. The
House of Lords unanimously overruled the majority decision in Candler v. Crane, Christmas
& Co. and upheld Lord Denning’s dissenting opinion in that case. Though the Hedley Byrne
case did not directly concern an Accountant, the principle laid down in the case is applicable
to Accountants. Therefore, the following extracts from the headnotes are reproduced :
“If, in the ordinary course of business or professional affairs, a person seeks
information or advice from another, who is not under contractual or fiduciary
obligation to give the information or advice, in circumstances in which a
reasonable person may, so asked, would know that he was being trusted, or that
his skill or judgement was being relied on, and the person asked chooses to give
the information or advice without clearly so qualifying his answer as to show that
he does not accept responsibility, then the person replying accepts a legal duty to
exercise such a care as the circumstances require in making his reply; and for
failure to exercise that care an action for negligence will lie if damage result.”
The Council of the English Institute has taken legal advice on the question of accountants’
liability for negligence in the light of the decision aforementioned. It has issued a statement
“Professional liability of accountants and auditors” in November, 1983.
In the context of accountant’s liability to third parties recently, the House of Lords in
England decided that there is no immunity from third party liability to an accountant unless
he is acting judicially. In this case the auditors of a company valued certain shares of the
company as per the agreement between the parties selling and buying the shares. It was
later established that the valuation was a gross undervaluation. Negligence was alleged
against the auditors. The contention of the auditors that using as arbitrators. One of the
Judges Lord Kilbrandon, held that even if the auditors had acted as arbitrators, they could
not claim immunity in negligence. Immunity stemmed from the origin of the appointments
and not from the way the duties were performed (Arenson v. Casson, Beckman Rutley &
Co. The Times. 12th November, 1975).
However for recent cases have suggested a break away from the Hedley Byrne ‘special
relationship principle’-Jeb Fasteners Ltd. v. Marks, Bloom and (1981), and Twomax Ltd,.
and Goode v. Dickson, Mcfarlane and Robinson (1982).
Jeb Fasteners - In 1975, Marks, Bloom and Co., the defending firm of auditor reported on
the annual financial statements of B.G. fasteners Ltd. for the year ended 31 October, 1974.
Stock had been valued at net realisable value of £2. instead of at cost of £11,000 resulting
in overstated income and balance sheet figure. The auditors were aware of the company’s
liquidity problems, and had discussions with Jeb Fasteners, the plantiffs, at the time of
takeover negotiations.
Jeb Fasteners subsequently purchased the company, but the takeover was not a success.
Consequently Jeb sued the auditors on the grounds that they were made into purchasing
the company by the mis-stated financial statement, and that the auditors had a duty of care
to persons whom they could have reasonably foreseen would rely on their audit report.
Justice Woolf ruled that such a duty of care did exist, but the auditors escaped liability on
the grounds that the alleged negligence was not the cause of the loss. The judge ruled that
the primary purpose of the takeover appeared to be the acquisition of the services of the
two B.G. directors, and that a purchase would probably have taken place on the same basis
even had the true financial position been known.
Justice Woolf applied a ‘reasonable foresight’ test, as opposed to the ‘special relationship
test of Hedley Byrne. This was based on a judgement by Lord Woolf force in the 1977 case
of Anns v. London Borough of Merton, in which it was hold that : ‘First, one has to ask
whether, as between the alleged wrongdoer and person who has suffered damage there is a
sufficient relationship of neighbourhood such that, in the reasonable contemplation of the
former, carelessness on his part may be likely to cause damage to the latter, in which case
a prima facie duty of care arises.
‘Second, if the first question is answered affirmatively, it is necessary to consider whether
there are any considerations which ought to negate, or reduce or limit the scope of the duty
of the class of person to whom it is owed or the danger to which any breach of it may give
rise.’
In Jeb Fasteners, Justice Woolf ruled that the auditors were aware of the liquidity problems
of B.G. and that financial assistance would become necessary and that a takeover was
certainly one method which, was within the contemplation of Mr. Marks (the auditor).
Consequently, the judge decided that the events leading to the takeover of B.G. were
foreseeable, although it agreed by all parties that at the time of the audit Marks, Bloom and
Co. were not aware of reliance by the plaintiffs or even of the fact that a takeover was
contemplated.
The Court of Appeal agreed that there was a lack of causal connection between the
auditor’s negligence and Jeb’s loss. It further stated that it was not necessary for it to
decide on the extent of liability to confirm in favour of the defendant.
Accordingly, Justice Woolf’s ruling has some authority but leaves the extent of third party
liability still unconfirmed.
Twomax Ltd. - Twomax Ltd and Goode v. Dickson, McFarlane and Robinson was a 1982
case decided in Scotland (where the law of negligence is the same as in England). Twomax
Ltd. acquired a controlling interest in Kintyre Knitware Ltd. of which Dickson, Mcfarlane and
Robinson were the auditors. Twomax and joint plaintiffs Gordon and Goode, stated that they
had relied on the audit opinion of Dickson et al. in purchasing their respective interest in
Kintyre. There were various mistakes in the audited financials, particularly those for 1973,
and had they been aware of the true position, the plaintiffs claimed they would not have
been interested in the company. The auditors did not attend the stock take and this
contributed towards their being regarded as negligent.
Lord Steward relied on the Jeb case, and decided that although the auditors were not aware
of the specific intention of the plaintiffs, they were aware of the fact that Kintyre needed
capital. This made the situation foreseeable, and the judge accordingly ruled in favour of
the plaintiffs.
Although the extent of liability is still by no means certain, it would appear unwise for an
auditor or accountant to rely on Hedley Byrne to restrict his liability. It would appear safest
to assume that negligently prepared or audited financial statements can result in liability to
clients and third parties alike.
A usual argument against the extension of liability to third parties is that company law
requires the auditor to report to the existing shareholders, for the purposes of stewardship
only. And that the accounts have not necessarily been prepared with others in mind. This
latter is not a powerful argument, for it is hard to imagine a situation where accounts which
are true and fair to members will be sufficiently misleading to others to provide the basis of
a claim for negligence. Financial loss to creditors or other third parties will normally only
occur as a result of the auditor’s default, if the auditors have made some very significant
‘goof.’ And auditor’s, insurers should be well able to cover this risk, which could otherwise
unfairly result in individuals bearing the loss.
On the other hand, it can be strongly argued that if the company law wants auditors to
report to creditors, and others, it should clearly say so. And tort should not be used as a
backdoor approach for creating such a liability; although on grounds of equity one can
question whether the auditor should in fact be held responsible for the financial loss of every
potential investor and every creditor who seeks to rely on his report. In the words of
Cardozo in the famous American case of the Ultramares Corporation v. Touche,”............. it
would be wrong for accountants to be exposed ‘to liability in an indeterminate amount for an
indeterminate time to an indeterminate class’. The amounts involved could indeed be
almost infinite, and the fact of reliance very difficult to prove projectively (herein would lie
the auditors’ the greatest safeguard). Furthermore, it is the directors who should really take
primary responsibility for loss through misleading accounts. Yes so often they are ‘men of
straw’ so there is no point in pursuing them; the auditors, with their insurance cover, will
prove a much better bet. But should we have to entirely bear this heavy burden, via our
insurance premiums, whereas directors can often escape with a suspended jail
sentence........ and their illgotten spoils? Perhaps directors should also carry a mandatory
indeminity insurance, as a requirement of holding office.
CAPARO Industries V. Touche Ross - M/s. Touche Ross, a firm of accountants had
appealed to the House of Lords from a decision of the Court of Appeal which held that
auditors could be sued by an investing shareholder for inaccuracy in accounts or misleading
accounts by which a pre-tax profit should have been shown as a loss. On the facts, it was
alleged that CAPARO would not have bid for the takeover of Fidelity, a public company, if
the true accounts were known.
The House of Lords opined that in advising his clients, the professional owed a duty to
exercise the standard of skill and care appropriate to his professional status. He would be
liable to contract and tort for losses his client might suffer from breach of the duty. The
House of Lords observed that where a statement was put into general circulation and might
forcibly be relied on by strangers for anyone of a variety of different purposes which the
makers of the statement had no specific reason to anticipate, the duty to use care did not
exist. The auditors owed no duty of care to the members of the public who relied on the
accounts in deciding to buy shares. It was difficult to visualise a situation in which individual
shareholders could claim to have sustained loss in respect of existing shareholdings
referable to auditors’ negligence which could not be recouped by the company. A purchaser
of additional shares stood in the public to whom the auditors owed no duty. It was also held
that the purpose of the auditor’s certificate was to provide those entitled to the report with in
information to enable them to exercise their proprietary powers. It was not for individual
speculation with a view to profit. The purpose of annual accounts so far as members are
concerned, was to enable them to question past management, to exercise voting rights and
to influence future policy management.
The learned judges disclosed that for a duty to exist the following conditions must be
satisfied:
(i) the defendant would need to be fully aware of the nature of the transaction the plaintiff
had in mind;
(ii) he must know that his advice or information would be directly or indirectly communi-
cated to the plaintiff; and
(iii) he must know that the plaintiff was likely to rely on the advice or information in deciding
on the transaction that he had in mind.
It is interesting to note that Touche Ross, the auditors in the case, made an out of court
settlement with Caparo of £1.35m in July, 1994 to avoid any further legal action. They
denied any negligence, a position they have maintained throughout the case.
In Al Saudi Bank and others v Clark Pixley and another (1990), the Caparo principles were
applied and, because the auditor had not directly sent a copy of the audited statements to a
bank about to grant a loan to his client, and had not been aware that the statements had
been distributed, the relationship to the client was not deemed to be sufficiently close. The
fact that a potential lender could foreseeably come to possess statements was not enough
to create the necessary relationship.
Subsequent to the Caparo case, three more cases have endorsed its doctrine. They are
James Mc Naughton Paper Group Ltd v Hicks Anderson and Co (1991), where a duty of
care was denied again because, it applied to shareholders as a class not as individuals;
Berg Sons and Co and others v, Adams and others (1992), which showed that the auditor’s
work had been performed only to satisfy the statutory audit requirement and no more, and
could not support a duty of care to a finance house that had discounted Berg’s bills; and
Goloo and others v Bright Grahame and Murray (1993) which would not extend the classes
of persons to whom the accountant might be liable and which reinforced the view that it
must be proved that an auditor’s negligence must be the “effective and dominant cause” of
loss for a liability to exist.
Clearly these recent cases have upheld the principles established in the Caparo judgement.
Only one case, Morgan Crucible Co PLC v Hill Samuel and Co Ltd (1991) has threatened to
dilute the effects of the Caparo decision. The facts of the case work that company taking
over another, relying on information provided by the auditor of the target company, as in
Caparo. Since the directors of the target company circularised all their shareholders
forecasting a sizeable increase in pre-tax profits, supported by a letter from the auditors and
the auditors’ opinion was issued after the takeover had commenced, and thus the plaintiff
was not relying solely on the accounts but also on these further representations. Thus, it
was held the auditor had a duty of care in that, whereas in the Caparo case the audited
accounts had been drafted for one purpose but had been relied upon for a different purpose,
in this case, the opinion had been relied upon for the purpose for which it was issued. The
degree of proximity was such that the defendant could well be liable. The case was settled
out of court. Similarly in Columbia Coffee and Tea Party Ltd v. Churchill and others (1992),
the Court held that a third party investor was owed a duty of care on the basis of an
assumption of responsibility flowing from statements in the defendant’s auditor manual
which brought a potential purchaser of shares within the ambit of persons to whom a duty of
care was owed. In Possfund v. Diamond (1996), it is being argued that a duty of care is
assumed and owed to these investors who (as intended) rely on the contents of the
prospectus in making subsequent purchases.
American Scene - The common law liability of the auditor to third parties is important in any
discussion of the auditor’s legal liability. A third party may be defined as an individual who is
not in privity with the parties to a contract. From a legal stand-point, there are two classes of
third parties: (1) a primary beneficiary and (2) other beneficiaries, A primary beneficiary is
anyone identified to the auditor by name prior to the audit who is to be the primary recipient
of the auditor’s report. For example, if at the time the engagement letter is signed, the client
informs the auditor that the report is to be used to obtain a loan at the city national bank, the
bank becomes a primary beneficiary. In contrast, other beneficiaries are unnamed third
parties, such as creditors, stockholders, and potential investors.
The auditor is liable to all third parties for gross negligence and fraud under tort law. In
contrast, the auditor’s liability for ordinary negligence has traditionally been different
between the two classes of third parties.
Liability to Primary Beneficiaries - The privity of contract doctrine extends to the primary
beneficiary of the auditor’s work. The landmark case, Ultramares Corp. v. Touche (now
deloitte and Touche), and its major findings are as follows.
In essence, Ultramares upheld the privity of contract doctrine under which third parties cannot
sue auditors for ordinary negligence. However, judge Cardozo’s decision extended to primary
beneficiaries the rights of one in privity of contract. Hence, Ultramares as a primary
beneficiary could sue and recover for losses suffered because of the auditor’s ordinary
negligence.
The defendant auditors, Touch, failed to discover fictitious transactions that overstated assets
and stockholders equity by $700,000 in the audit of Fred Stern & Co. On receiving the audited
financial statements, Ultramares loaned Stern large sums of money that Stern was unable to
repay because it was actually insolvent. Ultramares sued the CPA firm for negligence and
fraud.
The court found the auditors guilty of negligence but ruled that accountants should not be
liable to any third party for negligence except to a primary beneficiary.
An analysis of the decision reveals several significant environmental factors that are
particularly interesting in view of the current legal environment. First, the judge recognized that
extending liability for ordinary negligence to any third part might discourage individuals from
entering the accounting profession, thus depriving society of a valuable service. Second, he
feared the impact that a broader encroachment on the privity doctrine might have on other
professionals such as lawyers and doctors. Third, the decision reaffirmed the auditor’s liability
to any third party for gross negligence or fraud.
Liability to Other Beneficiaries - The Ultramares decision remained virtually unchallenged

for 37 years, and it still is followed today in many jurisdictions. However, since 1968, several
court decisions have served to extend the auditor’s liability for ordinary negligence beyond the
privity of contract doctrine.
A Foreseen Class - The first shift away from Ultramares occurred in the form of judicial
acceptance of the specifically foreseen class concept. This concept is explained as follow:
If the client informs the CPA that the audit report is to be used to obtain a bank loan, all banks
are foreseen parties, but trade creditors and potential stockholders would not be part of the
foreseen class. The liability is limited to losses suffered through reliance on the information in
a transaction known by the auditor or a similar transaction. In the above instance, this means
that the accountant would not be liable if the audit report was used by a bank to invest capital
in the client’s business in exchange for common stock instead of granting a loan.
The foreseen class concept does not extend to all present and future investors, stockholders,
or creditors. Court decisions have not required that the injured party be specifically identified,
but the class of persons to which the party belonged had to be limited and known at the time
the auditor provided the information.
Foreseeable Parties - Individuals or entities whom the auditor either knew or should have
known would rely on the audit report in making business and investment decisions are
foreseeable parties. Ths concept extends the auditor’s duty of due care to any foreseeable
party who suffers a pecuniary loss from relying on the auditor’s representation. Foreseeable
parties include all creditors’, Stock holders and present and future investors. Foreseeability is
used extensively by the courts in cases involving physical injury. For example, foreseeablility
is almost universally used in product liability cases when the manufacturer’s negligence
causes the physical injury. This concept was first applied in an audit negligence case in the
early 1980s. Rusch Factors Inc v. Levin (1968)
Cases Illustrating Liability to Other Beneficiaries - The leading cases that extended the
accountant’s liability for ordinary negligence to foreseen parties and to foreseeable parties are
as follows:
In Rush Factors Inc. vs. Levin (1968), The plaintiff had asked the defendant accountant to
audit the financial statements of a corporation seeking a loan. The certified statements
indicated that the potential borrower was solvent when, in fact, it was insolvent. Rush Factors
sued the auditor for damages resulting from its reliance on negligent and fraudulent
misrepresentations in the financial statements. The defendant asked for dismissal on the basis
of lack of privity of contract.
The court ruled in favour of the plaintiff. While the decision could have been decided on the
basis of the primary benefit rule set forth in ultramares, the court instead said.
The accountant should be liable in negligence for careless financial misrepresentation relied
upon by actually foreseen and limited classes of persons. In this case, the defendant knew
that his certification was to be used for potential financial of the ….. corporation (emphasis
added).
The Indian Scene - Commissioner of Income Tax v. G.M. Dandekar : This is the only
decision on the auditor’s liability to a third party by an Indian Court. The facts of the case
are: Mr. Dandekar had been engaged by Messrs A. Mohamad & Co., Madras and had
prepared the statements of account and Income-tax Return on the basis of account
produced to him. During the course of assessment, it was discovered that Messrs.
Mohamad & Co. had maintained two sets of account- regular Day Books and ledgers for the
open market transactions and a separate book for the black market transactions. While the
former contained detailed entries, relative to daily transactions, the latter contained only
consolidated entries, made at the end of the week of the transactions of that week. At the
end of the financial year, all the weekly entries in the separate sets of books of account
were to called up and were entered in the regular books of account. Mr. Dandekar had
examined only the regular books of account of the assessee and prepared the statements of
account and the Income-tax Return on the basis of these units. All the statements were
signed by him and there was also endorsement at the foot of the Balance Sheet that it had
been verified and found to be correct. Mr. Dandekar had forwarded the statements of
account to the Income-Tax Officer and, while doing so had stated particulars of books of
account that he had examined.
On examination, the statements of account having been found to be wrong, the Income-tax
department took up the matter against Mr. Dandekar and filed a complaint with the Institute
of Chartered Accountants of India. When the matter was subsequently considered by the
Madras High Court it was held that “he (Mr. Dandekar) was under an obligation to perform
auditing with due skill and diligence; if he did that; it would be difficult to see what further
obligations he had in the matter and in the favour of whom. The Accountant is under a duty
to prepare and resent correct statements of account of the assessee and he should, of
course, neither suggest or assist in the preparations of false accounts. But, he is under no
duty to investigate whether the accounts prepared by the assesses are correct or not. The
charge is that he owed a duty to the Department to himself investigate the truth and
correctness of the accounts of the assessee and not merely to act as their Post Office in
transmitting them. We do not agree that the respondent is under any such duty to the
Department and, therefore, no question of negligence arises.”
In view of the English decision (Hedley Byrne’s Case) mentioned earlier, the decision in this
case may any more be considered to be good law. For, very likely, the Indian Courts may
hereafter follow the decision in the Hedley Byrne case and hold that the auditor is
responsible to all those persons for negligence who had relied on a financial accounts or
statement prepared by him which is incorrect, if he knows or ought to have known that it has
been prepared for a particular person or class of persons or may be relied on by the person,
or class of persons in that particular connection.
The effect of the Hedley Byrne decision is that some one possessed of a special skill may,
quite irrespective of a contract, be considered to have undertaken to apply that skill for the
assistance of another person and thereby to have accepted a duty of care to that person. A
negligent though honest, misrepresentation which causes financial loss to another may thus,
in certain circumstances, give rise to an action for damages at the suit of a person with
whom no contract exists.
This doctrine is of particular concern to practising accountants, an important part of whose
work consists of preparing, examining or expressing an opinion on financial statements of
various kinds which may be relied on by persons other than those for whom they were
originally intended; the implications should not be overlooked by any accountant who knows
that his professional skill, exercised in an independent capacity, whether gratuitously or not,
will be relied on by others.
(B) Breach of Duty or Negligence - To charge a professional man with breach of duty or
negligence, it is necessary to prove that there has been a deviation from the standard of
care which he was expected to exercise in the performance of his duties. A professional
man does not guarantee the success of his professional effort. Nevertheless he is expected
to posses a certain amount of knowledge and experience and he must exercise a
reasonable degree of care and skill for the performance of duties. If there is any default or
failure in the conduct of an audit or in carrying out any other engagement judged by
professional standards the person responsible, therefore, would be guilty of negligence.
The auditor being an expert, skilled in the techniques of accounting and auditing, is
expected that he would be in possession of certain standards of knowledge and experience.
He also must exercise the same degree of prudence, skill and care, as any other
professional person, in similar circumstances, would be expected to do. In other words, he
must carry out the audit according to ‘accepted professional standards’ (the implications of
these words are explained hereafter) and having regard to all facts known to him about the
financial solvency of the client.
The auditor, however, is not expected to be a detective nor is he required to approach his
work with a suspicious or pre-conceived notion that there is something wrong. He is a
watch dog but not a ‘blood hound’. However, if there is any thing that excites suspicion in
him, he should delve deep into the matter. But, in the absence thereof, he is only required
to be reasonably cautious and careful.
In the case of non-company audit, where a detailed audit is not required the scope and
extent of routine checking that must be carried out is determined, on a consideration of the
nature of engagement. Nevertheless, it is expected that the auditor would carry out the
checking of accounts and verification of statements according to ‘standard audit practices’.
For example, the auditor who verifies the books of account of client by the application of test
checks, in a case where a complete audit should have been carried out, would be held guilty
of professional negligence if subsequently it is found that a mistake or fraud had remained
undetected which would have been unearthed if a detailed audit had been carried out. On
this account, where a detailed audit has been carried out, on the ground that it was not
agreed upon, the fact should be brought to the notice of the client by the nature of checking
carried out being stated in the report and area of accounts which have been covered being
specified.
Likewise, under the general principles of law, the auditors have been called upon to pay
compensation to their clients for the losses suffered by them through their negligence. Only
in one case, i.e. Armitage v. Brewer and Knott, the auditors were held responsible for the
amount of defalcations which arose subsequent to their failure to detect frauds in an earlier
period.
Cases Concerning the Civil Liability Of Auditors For Negligence

7.3 In the series of cases considered below, action was brought against the auditors for
damages sustained through defalcation of employees or otherwise which, it has been
alleged would have been discovered by the auditors, if they had carried out their duties with
the required degree of care and skill. The plaintiffs in some cases were individuals or
partners and in the other companies but action was not brought under misfeasance
proceedings of the Companies Act. It may be observed that in general the defence was that
the frauds were such that reasonable diligence and careful audit would have failed to reveal
them or they were caused by lack of efficiency of the management, or in its supervision over
the accounts.
1. London Oil Storage Co. v. Seear Hasulk & Co. (1904): In this case, the auditors were
charged with negligence for failure to discover the misappropriation of the petty cash
balance, which was shown by the petty cash book at 799 but in fact was only 30. The
auditor was found guilty of negligence in not verifying the petty cash balance as part of
the audit; but the damages awarded were limited to £5.5 sh. on the ground that the
damages suffered were not due to the conduct of the auditor but that of directors who
were guilty of gross negligence in allowing the balance in the hands of the Petty Cashier
to increase to such a large amount.
2. Arthur E. Green & Co. v. The Central Advance and Discount Co. Ltd. (1901): The
auditors in this case had accepted the schedule of bad debts supplied to them by the
Managing Director although it was inaccurate and they were far from satisfied with it.
Despite the fact, they had failed to qualify their report. The claim filed by the liquidator of
the company against the auditors for negligence therefore, succeeded.
3. Pendleburys Ltd. v. Eills Green & Co. (1936): The charge in this case was that due to
failure on the part of the auditor to verify the amount recorded and received for cash
sales, the fraud of the cashier had not been discovered. But the charge did not succeed
since the auditors have repeatedly brought the lack of internal check on ‘cash receipts to
the attention of the three directors who were the only shareholders and debenture
holders of the company. In the course of judgement, the learned judge observed:
“He (the auditor) is there to see that the shareholders get a true
representation of the finances of the company as disclosed by its books, this
he must do with reasonable care, but in considering whether or not he has
displayed reasonable care one must apply rules of common sense. There is
all the world of difference between a company which has a large body of
shareholders numbering say, six or seven hundred and a company which has
only three shareholders; all of whom happen to be the sole directors and the
sole debenture holders............ Where the interests of a small company are

confined to a very few persons and there are no outside people because all
the interests in the company are held by the directors themselves, if the
auditor has, in fact, reported to the directors, what more could he be
expected to do?”.
4. Leads Estate and Investment Society Ltd. v. Shepherd (1887): In this case action was
brought by the liquidators against the auditors not under misfeasance proceedings, but
under a civil action for the recovery for amounts paid as dividend out of capital. In
examining the balance sheet, the auditor had not considered the provision in the
Articles and the balance sheet was not properly drawn up. In the course of the
judgement, the learned judge observed that it was the duty of the auditor in auditing
the accounts of the company not to confine himself to verifying the arithmetical
accuracy of the balance sheet, but to enquire into its substantial accuracy, and to
ascertain that it contained the particulars specified in the Articles of Association, and
was properly drawn up so as to contain a true and correct representation of the
company’s affairs. The auditor was found negligent by the Court.
5. Artmitage v. Brewer & Knot (1942) ACTC (P 836): In this case, action was brought by
Mr. Joseph Armitage for alleged negligence in auditing the plaintiff’s books by reason
of which defalcations aggregating to £1440 were not detected. The defalcations
consisted in fraudulent alterations of time sheets and petty cash vouchers.
The plaintiff had arranged with the auditor that they would vouch all payments with the
receipts entered in the Petty Cash Account, check calculations and additions of wages
sheets, check totals of wages sheets into wages book and check weekly totals with other
detailed provisions.
Such a detailed audit had been called for since the plaintiff wanted protection against his
staff. A special fee was demanded and paid for this work. But it transpired after the audit
had been in progress for some two and half years, that the cashier of the plaintiff, by
altering systematically figures on vouchers of petty cash and making fraudulent entries on
time sheets, had misappropriated a large sum of money. During the course of the hearing, it
transpired that the auditors had not examined the books of account with sufficient care as a
result whereof the frauds committed by the cashier had remained undetected Mr. Justice
Talbot, during the course of his judgement, observed that “Accountants undertaking duties
of that kind could not be heard to excuse themselves on the ground that this or that was
small matter.” The auditors were held guilty of negligence and a damage of £1259 was
awarded against them.
6. Tri-Sure India Ltd. v. A.F. Ferguson & Co.: Tri-Sure India Limited issued a prospectus of
February 75 inviting public to subscribe its share. The prospectus contained, inter alia, the
report of the auditors (the defendants) on the accounts of the company for the year 1973-74
which showed that there was an abnormal rise in the rate of profits for the year 1973-74.
The public issue was over-subscribed and the company proceeded to allot the shares as per
the term of the issue. An investigation later revealed that sales figures for 1973-74 had
been manipulated by a whole time director of the company with the active co-operation of
other top officials of the company. On discovery of this, the company offered to refund all
moneys which were subscribed by the allottees and also proceeded to sue the auditors for
damages of Rs. 63.85 lakhs. The company alleged that the auditors failed to examine and
ascertain any satisfactory explanation for steep increase in the rate of gross and net profits.
The other charges levelled against the auditors were (i) whether the consumption of raw
material was commensurate with the sharp increase in sales/production; (ii) the reasons for
disproportionate ratio of the total debts due by trade debtors to turnover as compared to the
previous years; (iii) the reason for material variation in the ratio of the value of stock on
hand to the cost of turnover for the year 1972-73 and for the year 1973-74; (iv) whether
there was any change in the prices of prime raw material; (v) whether there was any
improvement/deterioration in the usage of material; (vi) whether the company had got new
customers and/or there was any change in the terms of credit to customers; and (vii)
whether the production for the year was adequate to support the volume of sales and
closing stock for the year.
The Court held that the plaintiffs were not able to prove that the auditors were negligent in
the performance of their duties. The suit was, therefore, dismissed.
Regarding the duties of the auditor, the Court held that “the auditor is required to employ
reasonable skill and care, but he is not required to begin with suspicion and to proceed in
the manner of trying to detect a fraud or a lie, unless some information has reached which
excites suspicion or ought to excite suspicion in a professional man of reasonable
competence. An auditor’s duty is to see what the state of the company’s affairs actually is,
and whether it is reflected truly in the accounts of the company, upon which the balance
sheet and the profit and loss account are based, but he is not required to perform the
functions of a detective. What is reasonable care and skill must depend upon the
circumstances of each case. Where there is nothing to excite suspicion and there is an
atmosphere of complete confidence, based on the record of continued success in financial
matters, less care and less scrutiny may be considered reasonable.” Thus, the judgment
has re-emphasised that an auditor need not proceed with suspicion unless the cir-
cumstances are such as to arouse suspicion or ought to arouse suspicion in a professional
man of reasonable competence. The practice of resorting to selective verification where
internal controls are found to be satisfactory by an auditor has also been upheld in his
judgement.
Civil Liabilities under the Companies Act
7.4 A civil action against the auditor may either take the form of claim for damages on
account of negligence or that of misfeasance proceeding for breach of trust or duty:
(a) Damages for negligence - Under section 62 for making an untrue statement in the
report (as an expert forming a part of the prospectus).
Action in this case can be brought by a person who has sustained a loss or damage as a
result of subscription to the shares or debentures, on the faith of the prospectus containing
an untrue statement.
It may be noted that the term “expert” under section 58(2) includes, among others, an
accountant and “any other person whose profession gives authority to a statement made by
him.” Also that under Section 55 of the Act a statement may be considered to be untrue, not
only because it is so but also if it is misleading in the form and context in which it is
included.
The liability would arise if the written consent of the auditor to the issue of the prospectus,
including the report purporting to have been made by him as an “expert” has been obtained.
The action, however, would not succeed if the auditor is able to prove:
(a) that after he had given his consent in writing, the same was withdrawn before any copy
of the prospectus was delivered for registration; or
(b) that after registration of the prospectus but before any allotment was made thereunder,
he, on realising that the statement was untrue, had withdrawn his consent in writing
and had given reasonable public notice of the withdrawal and of the reasons therefore;
or
(c) that he was competent to make the statement and that on reasonable ground he
believed and had continued to believe up to the time of allotment of shares or
debentures that the statement was true.
Liability also arises in the circumstances where some loss or damage has been suffered by
a client or a third party, due to professional negligence of the auditor. Some of these have
been illustrated above by the decision in cases on civil liability of auditor due to professional
negligence.
(b) Liability for misfeasance - The term “misfeasance” implies a breach of trust or duty.
The auditor of a company would be guilty of misfeasance if he has been guilty of any breach
of trust of negligence in the performance of his duties which has resulted in some loss or
damage to the company or its property.
A few cases in which action has been brought the auditors against under misfeasance
provisions of the Companies Act are summarised below:
1. In Re: The London and General Bank, (1895),held - The auditor who does not report,
to the shareholders the facts of the case, when the balance sheet is not properly drawn up,
is guilty of misfeasance.
The charge against the auditor in this case was that though he had submitted a detailed
report to the directors, as regards loans and overdrafts granted to customers, in respect of
which the security lodged was wholly insufficient and had expressed his misgivings as
regards recovery/ of interest on these accounts, included in the Profit and Loss Account, he
had neither disclosed the position to the shareholders nor he had made any reference to the
report which he had laid before the directors. The words in his report, “the value of assets
as shown on the Balance Sheet is dependent upon realisation etc.” did not contain any
warning to shareholders and the mere presence of these words was not enough to excite
suspicion. The Court observed that the duty of the auditor was to convey information and
not to arouse enquiry and held that the auditor, by way of damages, was liable to refund the
amount of the second dividend (declared in 1892) on the ground that he was aware of the
critical position of the affairs and thus had acted negligently in not reporting the facts to the
shareholders although he had reported them to directors. As regards the first dividend
(declared in 1891), the auditor was not held liable, as it was of the opinion that the evidence
was not sufficiently strong to establish a case of misfeasance against him, though he was
guilty of an error of judgement.
2. In Re: Kingston Cotton Mills Co. Ltd. (1896), held - That it is not the duty of the auditor to
take stock and that he is not guilty of negligence if the certificate of a responsible official is
accepted in the absence of suspicious circumstances.
In this case, the profits of the company had been inflated fictitiously by the deliberate
manipulation of the quantities and values of stock-in-trade. The auditors had certified the
balance sheet on the basis of the certificate of the manager as to the correctness of the
stock-in-trade without checking the stock in detail and this fact was shown on the fact of the
balance sheet. Lopes L.J. exonerating the auditors of the charge of negligence, in the
course of judgement, made remarks to the following effect :
It is the duty of an auditor to bring to bear on the work he has to perform the skill, care and
caution which a reasonably competent, careful and cautious auditor ordinarily would use.
What is reasonable skill, care and caution is a matter which must be judged on
consideration of the special circumstances of each case. An auditor is not bound to act as a
detective, or as had been said to approach his work with suspicion or with a foregone
conclusion that there is something wrong. ‘He is a watch dog, but not a blood hound’. He is
entitled to rely on the representation made to him by the tried servants of the company in
whom confidence has been placed by the company, believing them to be honest and
truthful. He must, however, take reasonable care to find that the representations made by
them are not palpably false. If any matter is observed which is calculated to excite
suspicion, he should probe it to the bottom, but in the absence of anything of that kind he is
only bound to be reasonable, cautious and careful.
3. The Irish Woolen Co. Limited v. Tyson and others (1900) Act L.R. 23,held - That an
auditor is liable for any damages sustained by a company by reasons of falsification of
accounts which might have been discovered by the exercise of reasonable care and skill in
the performance of the audit.
In this case, under a special agreement with the company, the auditor was required to
conduct a monthly audit, despite the fact, the profit disclosed by the profit & loss account
was found to have been inflated by the suppression of certain purchase invoices
outstanding at the date of the balance sheet though the goods received in respect thereof
had been included in the closing stock. The learned judge hearing the case found that the
suppression of invoices would have been detected if the auditor had called for the creditors’
statements of account on the basis of which payment had been ordered, in the period
subsequent to the audit, and had compared them with ledger balance; also, if the entries in
the ledger accounts were checked with relevant invoices, it would have been discovered
that these had not been posted on the true dates. On these facts, he concluded that if due
care and skill had been exercised, the suppression of the invoices would have been
discovered and held the auditor liable for the damages which the company had suffered due
to understatement of liability in the Balance Sheet.
4. In Re : Republic of Bolivia Exploration Syndicate Ltd. (1913),held - That the auditors of a
company in liquidation may be held liable for failure to detect ultra vires payments, but only
in extreme cases will the liability be fully enforced.
In this case, a claim was brought against the auditor to make good certain payments which
were held to be wrong and ultra vires, though the payments had not been made by the
company in consequence of any report or audit by the auditors. It was contended that they
had failed in their duty in passing the accounts without drawing attention to such payments
and that in consequence the Balance Sheet did not show the true financial position, a fact
which had put the company to loss.
5. In Re : City Equitable Fire Insurance Co. Ltd., held - That an auditor is not justified in
omitting to make personal inspection of securities that are in the custody of a person or a
company with whom it is not proper that they should be left.
In this case, an action had been brought by the Official Receiver as liquidator of the
company against the directors and auditors for damages arising out of misfeasance. The
chairman of the company was also the senior partner in the firm of Ellis & Co., the
company’s stock brokers who, at all material times, were heavily indebted to the company.
The principal charge against the auditors was that they had failed to detect and report to the
shareholders that a number of company’s securities, which were in the custody of Ellis &
Co. were being pledged by the firm to its customers. The auditor had relied on the
certificate of Ellis & Co. that these securities were held by them. The master of Rolls, on a
consideration of the evidence led in this case, showed that it was customary for the auditor
to obtain certificate from banks in respect of securities lodged with them and that the
certificates were not accepted from brokers. He made the following obiter dicta which is of
great significance to auditors.
“I think he (the auditor) must take a certificate from a person who is in the habit of dealing
with, and holding securities, and who he, on reasonable grounds, rightly believes to the
exercise of the best judgement a trustworthy person to give such a certificate.”
6. In Re: Westminster Road Construction and Engineering Co. Ltd. (1932),held- That when
there is time lag between the incurring of a liability and receipt of bills and at the time of
audit, sufficient time had not elapsed for the invoices relating to such a liability to have been
received it was the duty of auditor to make specific enquiries as to the existence of such
liabilities. He also must check the valuation of the work in progress at which it is included in
the Balance Sheet.
In this case, action had been brought against the auditor by the liquidator of the company in
respect of payment of dividend when there were in fact no profits of which it could be paid.
Negligence was alleged in respect of over valuation of work in progress, omission of
liabilities, etc. The Court held that the auditor was liable to refund to the company the
amount of dividend wrongly declared, with interest and costs.
7. In Re: S.P. Catterson and Sons Ltd. (1947), held - That the primary responsibility for the
accountant of a company is of those who are in control of the company i.e. the directors.
In the case, an application had been made by the liquidator that the auditor of the company
had been negligent in the performance of his duty and thus was liable to compensate the
company in respect of amounts misappropriated by an employee of the company, which had
become irrecoverable. Though the fact that the defalcation had occurred was accepted, the
auditor contended that he had drawn the attention of the directors to the weakness of the
system of recording cash and credit sales and had recommended its alteration;
notwithstanding this, the system had been continued. Also, that the directors had failed to
check adequately the cash records, at the time money was duly handed over, day to day, by
the manager.
8. In Re: Continental Vending Machine Corporation (1970) An American Case - This is a
significant case in as much as it seeks to provide guidelines for the exercise of auditor’s
judgement and discretion where conclusive accounting and auditing principles are not
available to guide the auditor. In this case, the auditor was held guilty of not having reported
a known fact. The President of the Continental Vending Machine Corporation caused the
diversion of a substantial sum of money of the Corporation to his benefit by canalising it
through an associated concern the audit of which was conducted by another. A substantial
part of the security for this accommodation consisted of securities of the Continental
Vending Co., itself. This was not reported and since the amount advanced by this company
became irrecoverable, the auditors were held guilty of gross negligence.
The judgement is significant for what it says about the weight the law will attach to the
standards of accounting profession and for what it says about obligations of an auditor over
and above those imposed by the standards themselves. The test that the Court applied was
not whether the balance sheet was in accordance with generally accepted accounting
principles but whether the balance sheet fairly represented the financial position.
The Court held that though in ordinary case disposition of funds advanced by the client to its
affiliates need not be disclosed by the auditor, such a disclosure becomes necessary in
cases of : (i) looting; (ii) known dishonesty by a high official; (iii) corporation being operated
to a material extent for the private benefit of its President; and (iv) dishonest diversion of
funds. Thus the Court laid down a special rule for disclosure and emphasised that an
auditor’s approach should not necessarily be limited to the mere compliance with the
accepted standards but should primarily be governed by the objective to establish an honest
and fair representation of financial facts.
Damages must be suffered - In the various cases considered, it will be observed that when
an auditor has been found guilty of professional negligence and a loss has been suffered,
the Courts have held that the amount of loss should be made good by the auditor. For
instance, in the case of Leeds Estate Building and Investment Co. Ltd. v. Shephered, under
a civil action by the liquidator, the auditor was held liable to make good, jointly with
directors, the dividend paid out of capital.
Where, however, the loss has been occasioned through negligence of directors, the fault of
the auditor in failing to verify the asset has been considered to be only technical and only
nominal penalty has been imposed. For instance, in the case of London Oil Storage Co.
Ltd. v. Seear Husluck and Co.£5. 5sh was awarded as damages against the auditor,
although the loss was much more, on the ground that professional negligence had not
occasioned the loss. In the case of Artmitage v. Brewer and Knot, the auditors were held
responsible even for the amount of defalcations which has taken place subsequent to their
failure to detect fraud with regard to petty cash in an earlier period. It is the only case in
which the principle of consequential damages has been applied to audit claims, i.e. if an
auditor omits to detect a defalcation by an employee and, in the following year, before there
is a chance of any further audit, the employee emboldened by the non-detection of the
defalcation, embezzles a larger sum, the auditor would be liable both for the original loss
which he had failed to detect and the subsequent loss suffered by the employer.
Apart from the liability for professional negligence, in the discharge of duties an auditor also
may be penalised under section 233 of the Companies Act for failure to comply with any of
the provisions contained in sections 221 and 229. He incurs such a liability as auditor of the
company. The punishment in this case is fine which may extend to Rs. 1,000/-.
Criminal Liability under the Companies Act
7.5 The circumstances in which an auditor can be prosecuted under the Companies Act, and
the penalties to which he may be subjected are briefly stated below:
(i) Under section 63 an auditor is criminally liable for making any misstatement (untrue
statement in a prospectus) and can be sentenced to a term of imprisonment extending to
two years or a fine of Rs. 50,000 or to both. But he can be so charged only if he has
authorised the issuance of the prospectus. The charge may also fail if he is able to prove
that the statement complained of is either immaterial or that he had reasonable ground to
believe, and in fact he did believe up to the time of issue of the prospectus, that the
statement was true.
(ii) Under section 628 an auditor is liable for criminal prosecution, if he in any return,
certificate, balance sheet, prospectus, statement or other document required by or for the
purpose of the Act, makes a statement (a) which is false in any material particular
knowing it to be false; or (b) which omits any material fact knowing it to be material. If
convicted, he can be punished with imprisonment for a term extending to two years and
also with a fine.
This section, presumably, is applicable only to false statements which are not specifically
punishable under any section of the Act. It penalises the making of a false statement in any
document required by or for the purposes of complying with the provisions of the Act.
7.5.1 Cases in which an auditor has been held to have incurred criminal liability -
1. Dambell Banking Co. Ltd. (1900) - The directors and auditors, in the case, were
prosecuted under section 221 of the Criminal Code of 1872 which is similar to Section 227
of the Companies Act, 1956, for having joined in the issue of false balance sheets, knowing
them to be false in material particulars, and with the intent to deceive and defraud
shareholders of the company. From the facts provided, it was clear that the accounts were
not only false but materially false; letters from the auditors to the managers showed that
they (the auditors) thought that overdrafts were bad although taken in as good. They had
told the managers that they held strong’ views about the overdraft, but did not state those
views in their certificates to the shareholders. The jury found all the defendants (including
the auditors) guilty, and they were sentenced to various terms of imprisonment.
2. Farrow’s Bank Ltd. (1921) - In this case, there had been a considerable writing up of
assets, obviously to show profits available for dividends. In one case a piece of property
that cost £5,500 was written up to £7,80,000. The auditor was in the company’s regular
employment as its accountant and was convicted on various charges of conspiracy and
fraud in connection with the published accounts of the bank, and sentenced to 12 months’
imprisonment.
3. Rex v. Lord Kylsant and Another (1931) - (Known as the Royal Mail Steam Packet
Company’s Case) This was a criminal prosecution in which Lord Kylsant who was Chairman
of the Board of Directors of Royal Mail Steam Packet Company was charged on two counts
(a) of publishing an annual report for 1926, which he knew to be false in a material
particulars and that the said report concealed from the shareholders the true position of the
company, with intent to deceive the shareholders; and (b) of publishing an annual report for
the year 1927, which he knew to be false in a material particular, with intent to deceive the
shareholders Mr. H.J.Morland the auditor, was charged with aiding and abetting Lord
Kylsant to commit these offences. Both the accused were acquitted of respective charges,
though Lord Kylsant was found guilty and convicted on a separate charge of publishing false
prospectus for the issue of fresh debenture stock.
The facts of the case briefly were that the Profit and Loss Account for the year 1926
showed, ‘Balance for the year, including dividends on shares in allied and other companies,
adjustment of taxation reserves, less depreciation of fleet £4,30,212. Actually this apparent
surplus had been arrived at on including undisclosed credits of £5,50,000 from excess Profit
Duty, £2,75,000 from Income tax Reserve and £25,776 from investment Profit. If this was
not done there would have been a considerable deficit. In 1927, with practically identical
wording, a surplus of £2,24,907 was raised to £4,37,293 by similar credits totalling
£2,12,386. It must be added that almost the entire amounts of these credits had no relation
to the trading of the respective years 1926 and 1927. The contention of the crown was that
such item, in the accounts conveyed “a deliberate false representation to the shareholders
that the company was making a trading profit when, in fact, it was making a trading loss.”
The company, in fact, had been drawing upon its secret or hidden reserves from 1921 to
1927. The adjustment of these special credits enabled the company to pay its debenture
interest, and dividends on both the preference and ordinary stocks.
N.B. The decision in the case has been principally responsible for the change in the
phraseology of the auditor’s report from ‘true and correct’ to ‘true and fair’ requiring a fuller
disclosure of any non-trading income or that not belonging to the year, adjusted in the Profit
and Loss Account.
4. Official Liquidator Karachi Bank v. The Directors, etc. of Karachi Bank Ltd. (1932) - The
directors of the Bank made a statement in the balance sheet that the profit earned by the
bank in 1927 amounted to Rs. 15,608. The amount of profit had been arrived at on taking
credit for a sum of Rs.45,214, an amount held in suspense for bad or doubtful items of
interest. It was held that the official Liquidator should prosecute the managing directors,
manager and the auditors for an offence under section 232 of the Indian Companies Act,
1913 (now section 628) of the Act.
Wild J.C. said “What the Directors of the bank have done is to show a cash profit for the
year by adding in a sum which is due, no doubt, but was never paid and was never likely to
be paid. The balance sheet, therefore, contains a false statement and a very material one
and I am unable to see how it can be argued that it was not intended to be misled.”
5. Rex v. Hinds Musgrave and Steven (1950) - This was a prosecution of Mr. A.E.P.
Hinds and Mr. J.L. Musgrave, two directors and of Mr. Cenneth Forbes Steven (of Singleton
Fabian and Co.) the auditor of Richard Critical and Co. Ltd. an engineering concern,
connection with a prospectus issued by the company inviting applications for shares. The
case was brought in England under Section 12(l) of the Prevention of Fraud (Investment)
Act (1930), almost similar to Section 68 of the Companies Act, 1956.
Two of the aforenamed directors and the auditors were charged with inducing people to
apply for shares in the company by recklessly making misleading statements in the
prospectus. Other charges, which did not involve the auditor, were made against the two
Directors. The auditor was prosecuted on the basis of the auditor’s report set out in the
prospectus. The charge against the auditor was in respect of inclusion of a sum of £39,746,
in assets. It, in fact represented “expenditure in connection with development and
expansion of export trade of newly formed subsidiary and associated companies carried
forward.” The contention of the prosecution was that this item, together with the figure of
profit for the year 1946, when the expenditure was actually incurred, was a misleading
statement and that the two directors and the auditor were guilty of making it recklessly. The
auditor, Mr. Steven was acquitted so also was Mr. Musgrave, one of the directors, on this
charge but Mr. Hinds, the other director was convicted.
In the course of summing up Mr. Justice Humphries said:
“It seems to me a very serious matter for your consideration whether you can possibly say
that Mr. Steven handed that matter over to his partner and Us partner having in fact made
tests and satisfied himself at the time as an honourable man, as an accountant, and a
careful accountant that the document was right can you say that Mr. Steven was reckless in
accepting Mr. Morton’s (the partner’s ) explanation. This is the one thing that is said to be
against him. There is plenty of evidence that in others parts he took meticulous care in
trying to ascertain whether the books of this company were reliable or whether they were
not. But on this particular point his evidence is relied upon Mr. Morton.”
Cases Concerning the Misconduct of Auditors under the Chartered Accountants Act
7.6 The code of conduct for an auditor should be taken into consideration and the different
circumstances under which disciplinary action can be taken against a member; the
decisions in a number of cases can be referred to. It being important, however for students
to understand what constitutes ‘gross negligence’ in terms of Clauses 5 to 8 of Part I of the
Second Schedule to the Chartered Accountants Act, two decisions by Indian Courts which
have become legal classics, are considered below:
Deputy Secretary of the Government of India, Ministry of Finance v. S. N. Dass Gupta - In
this case, action was brought against Shri S.N. Dass Gupta, a member of the Institute, in
respect of alleged negligence in the audit of accounts of Aryan Bank Limited, for the years
1942 to 1944. It was alleged that the bank had resorted to manipulation of accounts on an
extensive scale. One of the charges was that in 1944 the bank has shown in its Fixed
Deposit Ledger certain large sums as having been received on fixed deposit from certain
concerns in which the Managing Director was interested but the Cash Book of the bank did
not show any corresponding entries on the relevant dates. Another charge was that though
the auditor had certain doubts as regard loans advanced against fixed deposits, he had not
stated the position clearly. It was also alleged that on a certain date in 1944 the Cash Book
showed a cash balance of Rs. 5,00,000 although the actual balance on the date was a little
over Rs. 1,000. The auditor in defence submitted that he had not verified the cash balance
in hand and had mentioned this fact in his Special Report. The learned judge in this regard
observed:
“If an auditor does not do what it is his duty to do, it is no defence for him to say in
disciplinary proceedings started under Chartered Accountants Act that he had told
the shareholder that he had not done it. The lapse is constituted by his failure to
verify a duty without which an audit is meaningless and it is not excused by giving
information of the omission to the shareholders. Authorities both legal and
professional are unanimous that in a bank audit the cash balance claimed by the
management must be verified by the auditor because otherwise the management
might remove the greater part of the funds and show them falsely as lying in hand
in cash and thereby relieve themselves of the necessity of making up accounts
showing the disposition of money. In the matter of cash the auditor is not entitled
to rely on the certificate of the manager of accepted integrity, according to the
principles laid down in the case Re: City Equitable Fire Insurance Co.”
In the matter of the second charge against the auditor that though he had some doubts and
misgivings as regards certain losses which might be suffered by the bank due to certain
overdrafts accounts proving to be irrecoverable, he had failed to qualify the report in certain
terms indicating the true position of the debits and, instead, had made some cryptic remarks
about them in his special report. The learned judge observed, “Either he knew that some of
the debts were bad and some of the so called secured loans were not genuine, but he did
not wish to inform the shareholders of that fact but wanted at the same time to provide for
his own safety and, therefore, he inserted certain cryptic remarks in his Special Report; or
he was careless and neglected to give the shareholders the information which it was his
duty to give.”
It was held that the respondent has committed a grave wrong and in consequence he was
suspended from the membership of the institute for two years.
The learned judge in his judgement also made the following observation as regards the
duties of auditor and methods they should follow for discharging them satisfactorily:
(a) Ascertaining reporting, not only whether the balance sheet exhibits a true and fair state
of affairs of the company, as shown by the books of the company, but also whether the
books of the company themselves exhibit a true and fair state of the company’s affairs.
If any matter has been kept out of the books, with the result that the auditor did not have
access to it, he is not responsible for its non disclosure to the shareholders. In this regard
the dictum, pronounced by Rigby L.J. in the case Re : London & General Bank, that the
words as shown by the books of the company, contained, in the report which the auditors
make on the statements of account relieve them the responsibility as regards disclosure
of the affairs of the company kept out of the books can be followed.
(b) Verifying not merely the arithmetical accuracy of the statements of account but also their
substantial accuracy by confirming that they include all the particulars requiring
disclosure by the Articles or the Companies Act and otherwise represents true and fair
state of affairs of the company.
(c) Checking the accounts and verifying the financial statements with reasonable care and
skill. For the purpose, the auditor may properly rely on the statements of the director-in-
charge or the Mg. Director but only if he is satisfied that the representations made by him
appear to be an honest and truthful. All matters which are capable of direct verification
should generally be verified directly. But matters which require investigation rather than
checking may be verified on the basis of representation of officers of accepted
competence and integrity provided there is nothing unusual in the accounts.
(d) Examining the books of the company and obtaining such information or explanation
which he considers necessary but not with suspicious mind or by proceeding in a manner
he would adopt for detecting a fraud or a lie subject, however, to the fact that he is not in
possession of any information which excites suspicion or ought to excite suspicion of a
professional man of reasonable competence.
(e) Verifying the existence of assets and liabilities.
(f) Making a report to the shareholders as would give them information and not merely
means of information, in order that the shareholders may judge the position of the
company for themselves. If the auditor is not satisfied as to the accuracy of entries in the
balance sheet or they are such that, if disclosed, they would show the balance sheet in a
different way, these facts must be conveyed to the shareholders.
Controller of Insurance vs H. C. Das - In this case, action was brought against Messers
H.C. Dass & Co. by the Central Government in the matter of audit of accounts of Bhagya
Laxmi Insurance Limited. The auditors had audited the accounts of the company from 1936
until 1951 and had issued the certificate required under Regulations 7(c) and 7(d) of Part I
of the First Schedule to the Insurance Act, 1938. On the appointment of the administrator
subsequently under Section 52A of the Insurance Act, a number of irregularities were
discovered. The principal defence of the auditor in respect of the charges was that he had
relied on statements of the management in regard to matters included in the statements
certified by him. During the course of the judgement, the learned judge made the following
observation:
“As has been said, an auditor is not only blood hound, but he is not also an insurer. He
does not certify the absolute accuracy of the accounts which he audits and approves of, but
only says that he has taken all possible care and exercised reasonable skill and having
done so has arrived at the conclusions which are recorded in his certificate. But if, as we
find to our regret to have been the position here, an auditor does nothing at all in the way of
scrutinising the books of the company, but only relies upon statements made to him by the
management, as his own case find it impossible to hold that he exercised any skill or care of
any kind.......
“An auditor who construes his duty to shareholders or policy holders too narrowly and who
passes and approves of whatever is stated to him by the management of the corn any
whose accounts he audits does not serve the shareholders with the loyalty or efficiency
expected of him and constitutes, instead of a source of security to the shareholders, a
positive danger to them.”
The auditor was held guilty of gross negligence.
Liabilities Under Income Tax Act 1961
7.7 In connection with proceedings under the Income Tax Act 1961, a Chartered Accountant
often acts as the authorised representative of his clients and attends before an Income Tax
Authority or the appelate tribunal. His liabilities under the Income Tax Act of 1961 are as
below:
(i) Under Section 288 - A person who has been convicted of any offence connected with
any Income Tax proceeding or on whom a penalty has been imposed under the said Act
(except under clause (ii) of sub section (1) of Section 271) is disqualified from representing
an assesses. The Chief Commissioner/Commissioner of Income Tax has been given powers
to determine the period of such disqualification of a person.
A Chartered Accountant found guilty of professional misconduct in his professional capacity
by the Council of the Institute of Chartered Accountants of India, can not act as an
authorised representative (for any matter within the definition of a member in practice) for
such time that the order of the Council disqualifies him from practising.
(ii) Under Section 278 - Any person who acts or induces, in any manner another person
to make and deliver to the Income Tax Authorities a false account, statement, or
declaration, relating to any income chargeable to tax which he knows to be false or does not
believe to be true.
(iii) Under Rule 12A of the Income Tax Rules - Under this rule a Chartered Accountant
who as an authorised representative has prepared the return filed by the assessee, has to
furnish to the Assessing Officer, the particulars of accounts, statements and other
documents supplied to him by the assessee for the preparation of the return.
Where the Chartered Accountant has conducted an examination of such records, he has
also to submit a report on the scope and results of such examination. The report to be
submitted will be a statement within the meaning of Section 277 of the Income Tax Act.
Thus if this report contains any information which is false and which the Chartered
Accountant either knows or believes to be false or untrue, he would be liable to rigorous
imprisonment which may extend to seven years and to a fine.
8
AUDIT REPORT
Auditor’s opinion
8.1 At the end of every audit, the auditor issues a report. The report is the medium of
communication of the auditor’s expert views on the financial statements and it has a significant
bearing on the credibility of such statements. By expressing views in the report, the auditor
takes upon himself a great responsibility because a large number of people are likely to put
reliance on the financial statements. Therefore, he is necessarily to be careful, clear and
objective in the matter of preparation of the report. The report should also be as simple as the
circumstances permit.
It is necessary to emphasise that an auditor’s report is directly linked with the task entrusted to
him. Accordingly, he is to report within the terms of his appointment as agreed upon by him
and the client. In case of statutory appointments, often the duties to be performed by the
auditor and matters to be reported upon are specified by the concerned legislation. In case of
a non-statutory appointment, it is the agreement, written or otherwise, between the auditor and
the client that determines the scope of the auditor’s work and consequently, the scope of the
report. The auditor in his interest should endeavour to get the terms of appointment reduced in
writing so that possibilities of ambiguities or different interpretations of the terms can be
eliminated. This is imperative to avoid disputes on the contents of the report.
The auditor’s task is basically verificatory in nature: that is why auditing is called an “attest”
function. He is to verify the books of account and the resulting statements and state his
findings in the report. Naturally, the report will have a fact paragraph and an opinion
paragraph, besides other matters considered necessary by the auditor. It must be appreciated
that what is sought from an auditor is his informed opinion about the credibility of the financial
statements which summarise the year’s transactions. An opinion can be formed by a process
of examination. Verification and evaluation are the steps that provide the very basis of the
opinion to be expressed. Consequently, where an auditor finds that a reference to certain facts
is necessary in the report in order to render his opinion meaningful, he should state such facts
in the report. In this context, students may refer to sub-sections (2) and (3) of Section 227 of
the Companies Act, 1956 which provide for, inter alia, a few factual statements to be made by
the auditor. The facts should be stated as they are and any attempt to interpret them should
be avoided and they should be distinguished from the opinion part of the report.
The report, to be self-contained, should also devote a part to the scope and limitations, if any,
of the work done and the examination carried out in a broad manner. The scope of part is as
important as the opinion part because the opinion is very much conditioned by the scope of
the work and the examination carried out. If the scope of the work was limited by the client,
obviously the opinion will be subject to the limitations and is likely to be different from what it
would have been if the auditor had the authority to check and verify whatever he considered
necessary. The misunderstanding about the scope of the work and the nature of the work to
be performed in the past, provided grounds for much litigation and, therefore, it is necessary
that a reference is made in the audit report itself about the scope and nature of the work
performed. This has another positive aspect if the scope and nature are spelt out in the report,
the readers of the report will be in a position to assess the implications of the opinion more
clearly, and can be expected to exercise their judgement on how far to act on the basis of the
opinion expressed. For example, if in a report on the accounts of a partnership firm it is stated
that the stock records were not subject to audit, then naturally the opinion ultimately
expressed cannot be taken to be the opinion based on a complete audit including the audit of
the stock records. The recitation of the scope of the audit has the advantage of limiting and
defining the responsibility assumed by the auditor.
8.1.1 Significance of the nature of audit examination - The nature of the audit examination
carried out also has a very great bearing on the value of the audit opinion. AASs issued by the
AASB constitute auditing standards within which framework the auditor carries out his
responsibility. However, under the requirement contained in Section 227 of the Companies
Act, 1956, the auditor in our country is required to state certain facts like whether he has
obtained all the information and explanations considered necessary by him and whether the
balance sheet and the profit and loss account are in agreement with the books of account. The
requirement simultaneously serves the purpose of indicating to a limited extent, the nature of
examination carried out. In the audit report of partnerships and sole traders, often we come
across reports stating that the audit has been carried out by reference to the “books of
account and the vouchers produced” This is a very significant statement highlighting the
nature of audit carried out; it will suggest proper evidence collection and arithmetic agreement.
How significant is the disclosure of nature of examination carried out can be appreciated from
the famous case of Deputy Secretary to the Govt. of India, Ministry of Finance v. S.N. Das
Gupta. In this case, apparently to disown responsibility, the auditor indicated that he had not
carried out certain procedures. This ultimately resulted in his being charged with professional
misconduct and being found guilty. The statement in the report that he had not carried out
certain procedures suggested the nature of examination actually carried out by him and that
established the meaninglessness of the opinion.
8.1.2 Significance of obtaining information and explanation from the management - Section
227 (3) of the Companies Act, 1956 casts a duty on the auditor to state whether the
information and explanations considered necessary by him for the purpose of his audit has
been obtained. This is a significant requirement in as much as recognition is accorded to the
process of obtaining information as part of the whole auditing process. The auditors cannot
be expected to know all the technicalities and the complexities of the business deals; also the
relevant papers and documents to explain the transactions may not be really available to the
Audit Report 8.3
auditor and, even if they are available they may still need to be explained so that one can
clearly understand the impact of the transactions on the accounts. The management of the
company, which actually enters into transactions on behalf of the company is expected to
have thoroughly understood the implications of all material transactions, and therefore
auditors have been given the right to ask for information and explanations from the
management. In this connection, students should refer to the provision of Section 221 of the
Companies Act, 1956 in which the officers of the company have been made responsible to
provide information to the auditor on matters pertaining to the payments, in particular. It has to
state that his opinion on true and fair character of the balance sheet and the profit and loss
account is based on the information received. Therefore, if any vital information is deliberately
withheld from the auditor in the ordinary course of audit, and he had no means to know the
existence of such information, in case the accounts turn to be wrong for that reason, the
auditor should not be held guilty or negligent. If, however, the auditor has means to know of
the existence of such vital information but he ignored it, he would be held guilty on that
account.
The information and explanations made available to the auditor by the management should be
relied upon when the auditor is satisfied that they are prima facie reliable, having regard to the
circumstances. Where some basic documentary evidence is available, the auditor should insist
on its production before him. He, however, should not reject the information and explanations
as fabricated unless he has noticed something suspicious about them. The auditor should also
see whether the information and explanations made available to him have come from the
company’s records or they have been specially formulated. If they have been specially
formulated the auditor should exercise a little more care to examine them for any apparent
unreasonableness or inconsistency. However, no information and explanations should be
accepted as reliable without subjecting that a scrutiny, based on available evidence and
common sense.
Apart from the scope, fact and opinion parts of an audit report, it would not be uncommon to
find a part devoted to recommendations. If an auditor feels that certain improvements in the
accounting control or in the records are called for, it is very much within his rights to make in
the report or in a separate report suggestions for improvements. In fact, the auditor’s report is
greatly valued on account of objectivity, the overall view that an auditor is able to take of the
business and his intimate knowledge of the internal organisations. Students may recall that an
auditor may write “letter of weaknesses” to communicate weaknesses in the internal control
system to the management.
8.1.3 Nature of Auditor’s Opinion- About the opinion which is the central focus of an auditor’s
report, the auditor has to be highly discreet in using words and phrases. He should also make
it obvious by prefixing the expression “in my opinion” to the opinion part of the report. Thereby
he will be able to draw a line between facts and opinion. If the auditor is satisfied that the
statements of account under report correctly summarise the year’s transactions and are
truthfully and fairly presented, he will issue an opinion that will lend credibility to the financial
statements. On the other hand, if the auditor is not satisfied about the proper presentation of
facts in the accounting statements or is of the opinion that inappropriate classification,
aggregation, etc. have been used or important information has been withheld, he cannot issue
an unqualified opinion. He may qualify or express reservation about the truth and fairness of
the accounting statement either on an overall basis or as to the aspects specified in the report.
This will put the readers of his report on guard and the auditor will remain protected to the
extent he has qualified, from allegation of professional misconduct or negligence against him.
In the course of audit, he takes care to see whether the financial statements are prepared and
presented in accordance with the principles of accounting; also he checks whether
consistency in accordance with the principles has been maintained. In case he finds the
accounting principles are not being followed properly and consistently, he qualifies the report.
It is also a presumption in our country that the accounting statements contain relevant
informative disclosures unless an exception is made. Clauses (5), (6), (8), and (9) of Part I,
Second Schedule to the Chartered Accountants Act, 1949 have a direct bearing on the reports
of the chartered accountants in India. A chartered accountant in practice shall be deemed to
be guilty of professional misconduct, if he:
1. fails to disclose a material fact known to him which is not disclosed in financial statement
but disclosure of which is necessary to make the financial statement not misleading;
2. fails to report a material misstatement known to him to appear in a financial statement
with which he is concerned in a professional capacity;
3. fails to obtain sufficient information to warrant the expression of an opinion or his
exceptions are sufficiently material to negate the expression of an opinion; and
4. fails to invite attention to any material departure from the generally accepted procedure
of audit applicable to the circumstances.
An act of a chartered accountant in practice in India falling under the aforesaid clauses, can
result in his being held to have committed a professional misconduct. The very fact that these
acts are not considered as desirable professional practices has its own effect of indirectly
setting standards of reporting for the chartered accountants in India.
The Auditor’s Report on Financial Statements

8.2 The purpose of this Auditing and Assurance Standard (AAS) is to establish standards
on the form and content of the auditor’s report issued as a result of an audit performed by an
auditor of the financial statements of a n entity. The standard replies that auditor’s report
should contain a clear written expression of opinion on the financial statements taken as a
whole. With a view to express an opinion, the auditor should review and assess the
conclusion drawn from the audit evidence obtained. The review and assessment involves
considering whether the financial statements have been prepared in accordance with an
acceptable financial reporting framework applicable to the entity under audit. It is also
necessary to consider whether the financial statements comply with the relevant statutory
requirements. In the following paragraph the requirements as laid down in AAS 28 are
elaborated.
8.2.1 Basic Elements of the Auditor’s Report - The auditor’s report includes the following
basic elements, ordinarily, in the following layout:
(a) Title;
Audit Report 8.5
(b) Addressee;
(c) Opening or introductory paragraph
(i) identification of the financial statements audited;
(ii) a statement of the responsibility of the entity’s management and the responsibility of
the auditor;
(d) Scope paragraph (describing the nature of an audit)
(i) a reference to the auditing standards generally accepted in India;
(ii) a description of the work performed by the auditor;
(e) Opinion paragraph containing
(i) a reference to the financial reporting framework used to prepare the financial
statements; and
(ii) an expression of opinion on the financial statements;
(f) Date of the report;
(g) Place of signature; and
(h) Auditor’s signature.
A measure of uniformity in the form and content of the auditor’s report is desirable because it
helps to promote the reader’s understanding of the auditor’s report and to identify unusual
circumstances when they occur.
Title -The auditor’s report should have an appropriate title. It may be appropriate to use the
term “Auditor’s Report” in the title to distinguish the auditor’s report from reports that might be
issued by others, such as by the officers of the entity, the board of directors, or from the
reports of others.
Addressee- The auditor’s report should be appropriately addressed as required by the
circumstances of the engagement and applicable laws and regulations. Ordinarily, the
auditor’s report is addressed to the authority appointing the auditor.
Opening or Introductory Paragraph - The auditor’s report should identify the financial
statements of the entity that have been audited, including the date of and period covered by
the financial statements. The report should include a statement that the financial statements
are the responsibility of the entity’s management and a statement that the responsibility of the
auditor is to express an opinion on the financial statements based on the audit. Financial
statements are the representations of management. The preparation of such statements
requires management to make significant accounting estimates and judgments, as well as to
determine the appropriate accounting principles and methods used in preparation of the
financial statements. This determination will be made in the context of the financial reporting
framework that management chooses, or is required to use. In contrast, the auditor’s
responsibility is to audit these financial statements in order to express an opinion thereon.
Scope Paragraph - The auditor’s report should describe the scope of the audit by stating that
the audit was conducted in accordance with auditing standards generally accepted in India.
“Scope” refers to the auditor’s ability to perform audit procedures deemed necessary in the
circumstances. Auditing and Assurance Standard (AAS) 2, “Objective and Scope of the Audit
of Financial Statements”, with regard to the determination of the “scope” states (paragraph 5):
“The scope of an audit of financial statements will be determined by the auditor
having regard to the terms of the engagement, the requirements of relevant
legislation and the pronouncements of the Institute. The terms of engagement
cannot, however, restrict the scope of an audit in relation to matters which are
prescribed by legislation or by the pronouncements of the Institute.”
The Auditing and Assurance Standards issued by the Institute of Chartered Accountants of
India establish the auditing standards generally accepted in India. The report should include a
statement that the audit was planned and performed to obtain reasonable assurance whether
the financial statements are free of material misstatement. The auditor’s report should
describe the audit as including:
(a) examining, on a test basis, evidence to support the amounts and disclosures in financial
statements;
(b) assessing the accounting principles used in the preparation of the financial statements;
(c) assessing the significant estimates made by management in the preparation of the
(d) evaluating the overall financial statement presentation.
The report should include a statement by the auditor that the audit provides a reasonable
basis for his opinion.
Opinion Paragraph - The opinion paragraph of the auditor’s report should clearly indicate the
financial reporting framework used to prepare the financial statements and state the auditor’s
opinion as to whether the financial statements give a true and fair view in accordance with that
financial reporting framework and, where appropriate, whether the financial statements comply
with the statutory requirements. The term used to express the auditor’s opinion, “give a true
and fair view”, indicates, amongst other things, that the auditor considers only those matters
that are material to the financial statements.
Date of Report - The date of an auditor’s report on the financial statements is the date on
which the auditor signs the report expressing an opinion on the financial statements. The date
of report informs the reader that the auditor has considered the effect on the financial
statements and on the report of the events and transactions of which the auditor became
aware and that occurred up to that date. Since the auditor’s responsibility is to report on the
financial statements as prepared and presented by management, the auditor should not date
the report earlier than the date on which the financial statements are signed or approved by
management.
Place of Signature - The report should name specific location, which is ordinarily the city
where the audit report is signed.
Audit Report 8.7
Auditor’s Signature- The report should be signed by the auditor in his personal name.
Where the firm is appointed as the auditor, the report should be signed in the personal name
of the auditor and in the name of the audit firm. The partner/proprietor signing the audit report
should also mention the membership number assigned by the Institute of Chartered
8.2.2 The Auditor’s Report - An unqualified opinion should be expressed when the auditor
concludes that the financial statements give a true and fair view in accordance with the
financial reporting framework used for the preparation and presentation of the financial
statements. An unqualified opinion indicates, implicitly, that any changes in the accounting
principles or in the method of their application, and the effects thereof, have been properly
determined and disclosed in the financial statements. An unqualified opinion also indicates
that-
(a) the financial statements have been prepared using the generally accepted accounting
principles, which have been consistently applied;
(b) the financial statements comply with relevant statutory requirements and regulations; and
(c) there is adequate disclosure of all material matters relevant to the proper presentation of
the financial information, subject to statutory requirements, where applicable.
8.2.3 Modified Report - An auditor’s report is considered to be modified when it includes:
(a) Matters That Do Not Affect the Auditor’s Opinion
♦ emphasis of matter
(b) Matters That Do Affect the Auditor’s Opinion
♦ qualified opinion
♦ disclaimer of opinion
♦ adverse opinion
Uniformity in the form and content of each type of modified report will enhance the user’s
understanding of such reports. Accordingly, this AAS includes suggested wordings to express
an unqualified opinion as well as examples of modifying phrases for use when issuing
modified reports.
Matters That Do Not Affect the Auditor’s Opinion

In certain circumstances, an auditor’s report may be modified by adding an emphasis of matter
paragraph to highlight a matter affecting the financial statements which is included in a note to
the financial statements that more extensively discusses the matter. The addition of such an
emphasis of matter paragraph does not affect the auditor’s opinion. The paragraph would
preferably be included preceding the opinion paragraph and would ordinarily refer to the fact
that the auditor’s opinion is not qualified in this respect.
The auditor should modify the auditor’s report by adding a paragraph to highlight a material
matter regarding a going concern problem where the going concern question is not resolved
and adequate disclosures have been made in the financial statements.

The auditor should consider modifying the auditor’s report by adding a paragraph if there is a
significant uncertainty (other than going concern problem), the resolution of which is
dependent upon future events and which may affect the financial statements. An uncertainty is
a matter whose outcome depends on future actions or events not under the direct control of
the entity but that may affect the financial statements.
An illustration of an emphasis of matter paragraph for a significant uncertainty in an auditor’s
report is as follows:
“Without qualifying our opinion, we draw attention to Note X of Schedule …… to the
financial statements. The entity is the defendant in a lawsuit alleging infringement
of certain patent rights and claiming royalties and punitive damages. The entity has
filed a counter action, and preliminary hearings and discovery proceedings on both
actions are in progress. The ultimate outcome of the matter cannot presently be
determined, and no provision for any liability that may result has been made in the
In our opinion ……….. –
An illustration of an emphasis of matter paragraph relating to going concern is set
out in AAS 16, “Going Concern.”
The addition of a paragraph emphasising a going concern problem or significant uncertainty is
ordinarily adequate to meet the auditor’s reporting responsibilities regarding such matters.
However, in extreme cases, such as situations involving multiple uncertainties that are
significant to the financial statements, the auditor may consider it appropriate to express a
disclaimer of opinion instead of adding an emphasis of matter paragraph.
Matters that Do Affect the Auditor’s Opinion

An auditor may not be able to express an unqualified opinion when either of the following
circumstances exists and, in the auditor’s judgment, the effect of the matter is or may be
material to the financial statements:
(a) there is a limitation on the scope of the auditor’s work; or
(b) there is a disagreement with management regarding the acceptability of the accounting
policies selected, the method of their application or the adequacy of financial statement
disclosures.
The circumstances described in (a) could lead to a qualified opinion or a disclaimer of opinion.
The circumstances described in (b) could lead to a qualified opinion or an adverse opinion.
A qualified opinion should be expressed when the auditor concludes that an unqualified
opinion cannot be expressed but that the effect of any disagreement with management is not
so material and pervasive as to require an adverse opinion, or limitation on scope is not so
material and pervasive as to require a disclaimer of opinion. A qualified opinion should be
expressed as being ‘subject to’ or ‘except for’ the effects of the matter to which the
Audit Report 8.9
qualification relates.
A disclaimer of opinion should be expressed when the possible effect of a limitation on scope
is so material and pervasive that the auditor has not been able to obtain sufficient appropriate
audit evidence and is, accordingly, unable to express an opinion on the financial statements.
An adverse opinion should be expressed when the effect of a disagreement is so material and
pervasive to the financial statements that the auditor concludes that a qualification of the
report is not adequate to disclose the misleading or incomplete nature of the financial
statements.
Whenever the auditor expresses an opinion that is other than unqualified, a clear description
of all the substantive reasons should be included in the report and, unless impracticable, a
quantification of the possible effect(s), individually and in aggregate, on the financial
statements should be mentioned in the auditor’s report. In circumstances where it is not
practicable to quantify the effect of modifications made in the audit report accurately, the
auditor may do so on the basis of estimates made by the management after carrying out such
audit tests as are possible and clearly indicate the fact that the figures are based on
management estimates. Ordinarily, this information would be set out in a separate paragraph
preceding the opinion or disclaimer of opinion and may include a reference to a more
extensive discussion, if any, in a note to the financial statements.
8.2.4 Circumstances That May Result in Other Than an Unqualified Opinion -
Limitation on Scope
A limitation on the scope of the auditor’s work may sometimes be imposed by the entity, for
example, when the terms of the engagement specify that the auditor will not carry out an audit
procedure that the auditor believes is necessary. However, when the limitation in the terms of
a proposed engagement is such that the auditor believes the need to express a disclaimer of
opinion exists; the auditor should ordinarily not accept such a limited engagement as an audit
engagement, unless required by statute. Also, a statutory auditor should not accept such an
audit engagement when the limitation infringes on the auditor’s statutory duties.
A scope limitation may be imposed by circumstances, for example, when the timing of the
auditor’s appointment is such that the auditor is unable to observe the counting of physical
inventories. It may also arise when, in the opinion of the auditor, the entity’s accounting
records are inadequate or when the auditor is unable to carry out an audit procedure believed
to be desirable. In these circumstances, the auditor would attempt to carry out reasonable
alternative procedures to obtain sufficient appropriate audit evidence to support an unqualified
opinion.
When there is a limitation on the scope of the auditor’s work that requires expression of a
qualified opinion or a disclaimer of opinion, the auditor’s report should describe the limitation
and indicate the possible adjustments to the financial statements that might have been
determined to be necessary had the limitation not existed.
Disagreement with Management

The auditor may disagree with management about matters such as the acceptability of
accounting policies selected, the method of their application, or the adequacy of disclosures in
the financial statements. If such disagreements are material to the financial statements, the
auditor should express a qualified or an adverse opinion.
Illustrations of these matters are set out below:
Disagreement on Accounting Policies-Inappropriate Accounting Method—Qualified Opinion
“We have audited ……... (introductory paragraph).
We conducted our audit in accordance with .………. (scope paragraph).
As stated in Note X of Schedule ……. to the financial statements, no depreciation has been
provided for the period in the financial statements. This is contrary to Accounting Standard
(AS) 6 on “Depreciation Accounting”, issued by the Institute of Chartered Accountants of India
and the accounting policy being followed by the entity according to which depreciation is
provided on straight line basis. Had this accounting policy been followed, the provision for
depreciation for the period would have been Rs............. This short provisioning for
depreciation has resulted into the profit for the year, fixed assets and reserves and surplus
being overstated by Rs……….
8.2.5 Signature on Audit Report - The report is to be signed by the maker of the report.
Normally, a chartered accountant in practice signs the report in the name he is registered as a
practitioner. If he is an individual, it may be his individual name or the firm name of which he is
the sole proprietor. For those who practise as a partnership, it is usual for them to sign in the
firm name. Under Section 229 of the Companies Act, 1956 only the person appointed as
auditor of the company or, where a firm is so appointed, only a partner in the firm practising in
India, may sign the auditor’s report or sign or authenticate any other document of the company
required by law to be signed or authenticated by the auditor.
It is obvious that the person appointed makes the report; otherwise the very essence of the
appointment of a particular man or firm will be lost. In a profession, the particular skill and
reputation of the practitioner counts considerably and if anybody else is allowed to make the
report on behalf of the person appointed, then this confidence in the person will cease to be a
factor. This has other implications also from the point of view of professional responsibility; it
will create an unusual legal situation. It has also implications from the standpoint of the
practitioner. If in respect of appointments held by him, the reports are made by others,
gradually the goodwill of the practitioner will end and the clients may shift to the person
actually making the report.
In the case of practice as a partnership firm, any of the partners can sign the report. This is
also recognised by the aforesaid Section 229. However, the Department of Company Affairs,
Government of India, is of the view that there cannot be a firm name in case of sole
practitioners. On a closer scrutiny, it would be clear that the view of the Government is not
well- founded. In case of chartered accountants practising in partnership, the department is of
the view that putting the signature in the firm name is not contemplated by Section 229, even
Audit Report 8.11
though the name has been signed by a partner. The concerned partner should invariably sign
his own name in his own hand for and on behalf of the firm appointed to audit a company’s
accounts. Students may recall that the long standing practice was to sign in the firm name.
For example, if A, B and C were in practice as ABC & Co. Chartered Accountants, any of A or
B or C could sign as “ABC & Co.” in his own hand. But now in view of the objection raised by
the Department of Company Affairs to this practice, the Council of the Institute in the AAS28.
“The Auditor’s Report on Financial Statements” has recommended to the members who are in
practice in partnership that signature on or authentication of the auditor’s report or any other
document required to be signed or authenticated by the auditor should be made in the
following manner.
For ABC and Co.

Chartered Accountants
Signature
(Name of the Member Signing the Audit Report)
(Designation)1
In addition to the provision of the Companies Act, 1956 referred to above, Clause (13) of Part I
of the First Schedule to the Chartered Accountants Act, 1949 provides that a chartered
accountant in practice shall be deemed to be guilty of professional misconduct if he allows a
person, not being a member of the Institute or a member not being his partner, to sign on his
behalf or on behalf of his firm, any balance sheet, profit & loss account, report or financial
statements. The provision is intended to safeguard the professional purity by excluding non--
chartered accountants from signing the aforesaid documents. By excluding chartered
accountants who are not partners, it seeks to keep the line of professional responsibility clear.
Partners are mutual agents and therefore, allowing a partner to sign does not interfere with the
clarity of responsibility.
8.2.6 Audit Report under the Companies Act, 1956 - The auditors of a company are required
to report to its members in terms of Section 227 of the Companies Act, 1956. The matters
which the auditors have to report could be classified into two categories.
(i) statement of fact; and (ii) opinions.
The auditors reporting requirements are contained in sub-sections 1(A), (2), (3), (4), and (4A).
It may be recalled that sub-sections (1A) and (4A) were introduced in 1965. The former
requires the auditor to “inquire into” specific matters stated in the sub-section and pursuant to
the authority contained in the latter the Manufacturing and other Companies (Auditor’s Report)
1
Partner or Proprietor, as the case may be.
order was issued in 1975. The 1975 Order was superseded by the order issued in 1988 which
is also superceded now by Companies (Auditor’s Report) Order, 2003. When we analyse sub-
sections (2) and (3) of Section 227, we find that the auditor has to make statements of fact in
his report on the following:
(i) Whether he has obtained all the information and explanation which to the best of his
knowledge and belief were necessary for the purposes of his audit.
(ii) Whether the report on the accounts of any branch office audited under Section 228 by a
person other than the company’s auditor has been forwarded to him as required by
Section 228 (3) (c) and how he has dealt with the same in preparing the auditor’s reports.
(iii) Whether the company’s balance sheet and profit and loss account dealt with by the
report are in agreement with the books of account and the returns.
(iv) whether any director is disqualified from being appointed as director under clause (g) of
sub-section (1) of section 274.
(v) Whether the cess payable under section 441A has been paid and if not, the details of
amount of cess not so paid.
The opinions which the auditor is required to express are:
(i) Whether proper books of account as required by law have been kept by the company so
far as it appears from the examination of the books and proper returns adequate for the
purposes of the audit have been received from branches not visited by him;
(ii) Whether the accounts give the information required by the Act in the manner so required;
(iii) Whether in his opinion, the profit and loss account and balance sheet complied with the
accounting standards referred to in sub-section (3C) of Section 211.
(iv) Whether the accounts give a true and fair view, in the case of balance sheet, of the state
of the company’s state of affairs, and in the case of the profit and loss account, of the
profit or loss for the year.
It may be noted that as per section 227(3)(e), the auditor's report shall state in thick type or
italics, these observations or comments of the auditors which have any adverse effect on the
functioning of the company.
However, it should not be understood that a distinct statement of a fact makes it unnecessary
to consider the same for the purpose of opinion formation. In effect, the facts, apart from their
own significance which probably account for their, distinct disclosure, are complementary to
the opinion. On the face of adverse facts, no favourable opinion can be given. It should be
appreciated that only certain very important and basic facts about the accounts are required to
be stated under the provisions of sub-sections (2) and (3). The statement of facts by the
auditor is a very significant pointer to the credibility of the accounts. If the auditor states that
he has not been able to obtain all the information and explanations considered necessary by
him, the reliability of the accounting information under the report would be seriously impaired.
Sub-section (4) provides for reasons to be given in the auditor’s report, if any of the matters
required to be stated pursuant to sub-sections (2) and (3) are subject to qualification or
Audit Report 8.13
negative statement or denial of opinion.
A. Report under Section 227 (1A) of the Companies Act, 1956

Section 227(1A) requires the auditor to make certain specific enquiries during the course of
his audit. This requirement is without prejudice to his general rights, powers and duties
regarding access to books etc. and obtaining information and explanations, He is however not
required to report on the matters specified in this sub-section, unless he has any special
comments to make on any of the items referred to therein. If he is satisfied as a result of the
enquiries, he has no further duty to report that he is so satisfied. It should however be noted
that the auditor is required to make only enquiries on the matters specified in the sub-section
and is not to investigate into the matters referred to therein. Clause (a) requires the auditor to
inquire:
“Whether loans and advances made by the company on the basis of security have
been properly secured and whether the terms on which they have been made are
not prejudicial to the interests of the company or its members.”
This clause applies to loans and advances made by the company during the financial year
under audit, whether they are outstanding on the date of the Balance Sheet or not. The
inquiry should be made in the light of conditions prevailing when the loan or advance was
made. Loans and advances have not been defined anywhere in the Act. However, having
regard to the requirement of clause (d) of the sub-section, a distinction is obviously intended
to be made between “loans and advances” and “deposits”. A “deposit” may be defined as the
placing of money or money’s worth with a third party, either for safe keeping, or by way of
security for the performance of the depositor’s obligations, or for the purpose of earning
interest; in the last case deposit being with a party who customarily accepts deposits. Any
item required to be disclosed under the head “Loans and Advances” in Part I of the Schedule
VI to the Act which do not fall within the above definition of a “deposit” should be construed for
the purpose of this clause as “loans and advances”.
The clause applies to all loans and advances made “on the basis of the security’. “Security”
for this purpose would include any movable or immovable property, whether belonging to the
borrower or not, of which either physical possession or over which a legally effective charge is
given to lender.
The loan agreement or correspondence in regard to the terms of the loan or advance should
be seen. Where the loan or advance is made to a company, any charge on the assets of such
a company should have been registered under Section 125 of the Act in order to constitute an
effective security. The “terms” on which the loan or advance is made would primarily include
the security, the interest charged and the terms of repayment. It would be difficult to lay down
any general principles regarding the rate of interest which may be charged on loans and
advances. Various considerations, such as the position and standing of the borrower, type of
security, purpose of the loan, prevailing market rate of interest, etc., would have to be taken
into account. If the loan has been given for business considerations, e.g., loans to staff for
purchase of cars, houses, etc., loans to suppliers of raw materials or other goods, there may
be justification for interest being charged at a rate lower than the market rate, or even, in
appropriate circumstances, no interest being charged at all. However, when a loan is given
only with a view to earning interest, the interest charged would be at the commercial rate.
Particular attention should be paid to loans or advances to concerns in which the directors of
the company or their associates are interested. The question whether the terms on which a
loan or advance has been made are “prejudicial to the interests of the company or its
members” is a difficult one. Obviously, the auditor is not to inquire as to how such transactions
of the company affect the interests of individual members in their personal capacities. The
reference to “members” should therefore be construed as a reference to the members of a
company as a class, in their capacity as members. The members of the company would be
primarily interested in a reasonable return on their investment and in the safety of their capital.
The question whether a loan is prejudicial to the interests of the members should therefore be
considered from this angle.
If loan or advance has been approved by the members of the company and/or the Government
as required by Section 370 of the Act (now 372A), this would be a prima facie evidence to
show that it is not prejudicial to the interests of the company or its members.
Under Clause (b) the auditor has to inquire:
“Whether transactions of the company which are represented merely by book
entries are not prejudicial to the interests of the company.”
The transactions of a company are ordinarily matters of fact. The purpose of book entries is to
correctly record transactions which have, in fact, taken place. If a book entry is passed which
is not in accordance with the facts of the transaction, or is contrary thereto, this should be set
right or reported upon by the auditor. Again, if book entries are passed purporting to record
“transactions” which have, in fact, not taken place, similar considerations would apply. The
clause is therefore intended to cover transactions of the company for which the only evidence,
or the principal evidence, is the entry regarding the transactions in the books of account. In
such cases, the auditor should inquire whether such transactions have in fact taken place and,
if so, whether they are prejudicial to the interests of the company.
Under Clause (c) the auditor has to inquire:
“Where the company is not an investment company within the meaning of Section
372 or a banking company, whether so much of the assets of the company as
consist of shares, debentures and other securities have been sold at a price less
than that at which they were purchased by the company”.
This clause requires the auditor to inquire in all cases where shares, debentures or other
securities have been sold at a price less than their cost. If, as a result of his inquiries, the
auditor is satisfied that the sale is bonafide and the price realised is reasonable, having regard
to the circumstances of the case, he has no further duty to report on the matter.
Under Clause (d) the auditor has to inquire:
‘“Whether loans and advances made by the company have been shown as
deposits”.
A reference is invited to the definition of a “deposit” in contradistinction to that of a loan or
Audit Report 8.15
advance given in the comments on clause (a) above. It should be noted that the inquiry to be
made is whether loans and advances have been shown as deposits, and not vice versa.
Clause (e) requires the auditor to inquire:
“Whether personal expenses have been charged to revenue account.”
The practice of meeting certain types of personal expenses of employees is normal and is
recognized both by the Income tax Authorities and the Company Law Board. Illustration of
such expenses are the provision of rent-free quarters, conveyance for personal use, medical
expenses, expenses on leave travel, maternity benefits, canteen facilities, etc. The charging
to revenue of such personal expenses, either on the basis of the company’s contractual
obligations, or in accordance with accepted business practice, is perfectly normal and
legitimate and does not call for any special comment by the auditor. Where, however, personal
expenses not covered by contractual obligations or by accepted business practice are incurred
by the company and charged to revenue account, it would be the duty of the auditor to report
thereon.
Clause (f) requires the auditor to inquire:
“Where it is stated in the books and papers of the company that any shares have
been allotted for cash, whether cash has actually been so received in respect of
such allotment, and if no cash has actually been so received. Whether the position
as stated in the account books and the balance sheet is correct, regular and not
misleading.”
B. Report under the Companies (Auditor’s) Report Order, 2003.

Under Section 227(4A) of the Companies Act, the Central Government has the power to direct
by a general or special order that in the case of specified companies the auditor’s report shall
include a statement on such matters as may be specified in its order. The Central government
may before making any such order, if it finds necessary or expedient to do so, consult the
Institute of Chartered Accountants of India. In accordance with these provisions, the Central
Government had issued the Companies (Auditor’s Report) Order, 2003 dated June 12, 2003
which has now been amended by way of Companies (auditor’s Report) (Amendment) order,
2004.
The provisions of the order are supplemented to the existing provisions of the Companies Act,
1956 regarding the auditors report as contained in Section 227, Certain points of distinction
may, however, be noted. Firstly the provision of sub-sections (2), (3) and (4) of Section 227
are applicable to all companies while the Order is not applicable to the classes of companies
specified in the Order. Secondly, the provisions of sub-section (1A) only require an auditor to
enquire into the matters specified in the sub-section and as such he will report only if the
comment is necessary in the light of enquiry, whereas, the Order requires a statement on each
of the matters specified thereunder. The provision of this order is in addition to the directions
given by the Comptroller & Auditor General under Section 619 of the Companies Act, 1956.
Statement on Qualifications in the Auditor’s Report

8.3 The statutory provisions in the Companies Act, 1956 relating to qualifications in the
auditors report are contained in Section 227 (4) of the Act which provides that where the
auditors are required, in their report, to answer any of the statutory affirmations in the negative
or with a qualification; their report shall state the reasons for such an answer. It is, therefore,
necessary for the auditor to give the reason for any qualifications or reservations in this report.
Beyond this, the Companies Act, 1956 does not mention anything about the, form and manner
of qualifying the audit report. In 1970, the Council of the ICAI published the “Statement on
Qualifications in the Auditor’s Report” which attempted to enumerate some principles
regarding the purpose and manner of any qualifications in the Auditor’s Report and thereby
improving the standards of reporting by the Chartered Accountants in regard to the audits
undertaken by them. With the issuance of the AAS 28 “The Auditor’s Report on Financial
Statements”, the principles of modification of auditor’s report have been laid down herein. We
discuss below the important principles laid down in the “Statement on Qualifications in the
Auditor’s Report.”
The Statement points out that in a majority of cases the auditor’s report on the accounts
examined by them is found to be unqualified. This is due to the fact that the right of a statutory
auditor to make a qualified report is a great deterrent, and prevents the management of
companies from resorting to accounting practices and methods of disclosure which are not in
accordance with the law. The result is that the auditor of a company is in a position to
persuade the management of the company to accept his views and modify the accounts or
make such disclosures as are required by the law, as in the absence of these he would qualify
his report. According to the statement, a qualified report is not necessary unless the issues
involved are material. However, items requiring disclosures under the law, such as the
directors’ remuneration whether material or not, have to be specifically disclosed. If this is not
done, it is the duty of the auditor to qualify his report.
8.3.1 Aspects to be considered in qualifying report - While qualifying a report, it is important
to -
(i) ascertain the various items (the statement of fact and opinion referred to above) that
require a qualification;
(ii) realise whether the auditors are in active disagreement with something which has been
done by the company or are merely unable to form an opinion, say, for lack of adequate
information about an item;
(iii) establish whether the matters in question are so material as to affect the presentation of
a true and fair view of the whole of the affairs of the company, or are of such a nature as
to affect only a particular item disclosed in the accounts; and
(iv) see whether the matters constituting the qualification involve a material contravention of
any requirements of the Companies Act, 1956 which have a bearing on the accounts.
In a majority of cases, items which are the subject matter of qualification are not material as to
affect the truth and fairness of the whole of the accounts but merely create uncertainty about a
particular item. In such cases, it is possible for the auditor to report that, in their opinion, but
Audit Report 8.17
subject to the specific qualification mentioned, the accounts present a true and fair view.
Sometimes, however, the items which are the subject matter of qualifications are so material
that it would be meaningless to state that, subject to the qualification, the accounts disclose a
true and fair view.
An example would be where all the qualifications taken together substantially affect the profit
or loss as shown in the profit and loss account, including where the profit is converted into a
loss or vice versa. In such a case, the auditor should state that the profit or loss account does
not reflect a true and fair view of profit or loss for the period. Another example would be where
the auditors were not able to examine a substantial part of the books of account, e.g., they
were in police custody.
Finally, the statement reminds the auditors of a well established principle that they must give
full information about the subject matter of the qualification and not merely create grounds for
suspicion or inquiry and leave it to the shareholders to cull out the facts by diligent inquiry.
The distinction between “information” and “means to information” made in the London and
General Bank’s case is still valid.
8.3.2 Manner of qualifying reports - It is a general principle that the qualifying remarks
should be placed in such a manner as to make it very clear as to the particular item of the
auditors’ report to which the qualification relates, e.g., if the qualification is of such a nature
that it affects truth and fairness of the accounts, it should not be placed in such a manner as to
give an impression that the auditors have not obtained all the information which has been
required in the performance of their work. It enumerates the following principles regarding
manner of qualification with a view to ensuring certain degree of uniformity and to assist the
public in evaluating the contents of auditors’ reports. The principles are follows:
(i) All qualifications should be contained in the auditor’s report. The notes to accounts
normally represent explanatory statements given by the Directors of the company and
should not contain the opinion of the auditors. The practice has also grown recently of
having a large number of notes to accounts some of which are subject matter of
qualification in the auditor’s reports and some of which are merely clarificatory. It is
necessary that the auditors should “reproduce” the notes of a qualificatory nature in their
report to enable the reader to know the importance to these qualifications. The Auditing
and Assurance Standards Board of the ICAI has clarified that the use of the word
‘reproduce’ does not imply verbatim reproduction. Where notes of a qualificatory nature
appear in the accounts, the auditor should state all qualifications independently in his
report in an adequate manner so that a reader can assess the significance of these
qualifications. For this purpose, where a note is already given in detail by the
management, it is not necessary to reproduce verbatim such a note in the audit report; a
brief self- explanatory statement may be sufficient.
(ii) It is also necessary that the auditor should quantify, wherever possible, the effect of
individual as well as the total effect of all qualifications on profit or loss and/or state of
affairs these qualifications on the financial statements in a clear and unambiguous
manner. In circumstances where it is not possible to quantify the effect of the
qualifications accurately the auditor may do so on the estimates made by the
management after carrying out such audit tests as are possible and clearly indicate that
the figures given are based on the estimates of the management.
(iii) The use of the word “subject to” is essential to bring out the qualifications. It is customary
for qualifications to be made by the use of expressions, such as, “subject to” or “except
that”. The expressions “read with the notes thereon” or “together with the notes thereon”
are of an explanatory nature and do not constitute qualifications. It is therefore important
when seeking to qualify a report, that the auditors should use such recognised
terminology which clearly implies a qualification. It is not a correct practice to merely
make a factual statement in the auditors’ report without taking exception thereto. In a
case where the treatment of underwriting commission was not in accordance with
accepted accounting practice, the auditors reported as under:
Some Examples
(a) Where all qualifications are quantifiable
"We report that:
(1) No provision for Minimum Alternative Tax amounting to Rs.66.61 lacs has been made
due to which the profit during the year has been overstated and the provisions have been
understated to that extent.
(2) No depreciation has been provided for the period in the financial statements. This is
contrary to Accounting Standard (AS) 6, Depreciation Accounting, issued by the Institute of
Chartered Accountants of India and the policy being followed by the company according to
which depreciation is provided on straight line basis, Had this accounting policy been followed,
the provision for depreciation for the period would have been Rs.29.05 lacs. Accordingly,
profit for the year, fixed assets and reserves and surplus are over-stated to that extent.
We further report that had the observations made by us in paragraphs (1) and (2) above been
considered, the profit for the year would have been Rs.500.41 lacs (as against the reported
figure of Rs. 596.07 lacs), reserves and surplus would have been Rs.685.43 lacs (as against
the reported figure of Rs.781.09 lacs) and total fixed assets would have been Rs.200 lacs (as
against the reported figure of Rs.229.05 lacs).
"Subject to the above, in our opinion........................."
(b) Where all the qualifications are not quantifiable
Where it is not possible to quantify the effect of certain qualifications in the auditor's report, in
the overall-effect paragraph, reference should be made to such qualifications. For instance,
suppose in the illustrations at (a) above, the following additional qualification appears at Serial
No.3.
"No provision has been made in respect of product warranties outstanding at the
year end. The amount of provision required in this behalf could not be ascertained."
In the above situation, the overall-effect paragraph would appear as follows:
"We further report that, without considering item mentioned at 3 above the effect of which
Audit Report 8.19
could not be determined, had the observation made by us in paragraphs (1) and (2) above
been considered, the profit for the year would have been Rs.500.41 lacs, (as against the
reported figure of Rs.596.07 lacs), reserves and surplus would have been Rs.685.43 lacs) and
total fixed assets would have been Rs.200.00 lacs (as against the reported figure of Rs.229.05
lacs)".
It should be understood that a qualification can also arise in consequence of an adverse
finding by the auditor in respect of the matters covered under sub-sections (1A)and (4A) of
Section 227 of the Companies Act. If, for example, an auditor is of the view that personal
expenses have been charged to business, he may so state in his report. But, if the amount
involved is considerable, the accounts will fail to show a true and fair state of affairs; therefore,
he must then qualify his report.
8.3.3 Manner of making qualification/disclosure in the audit report - In making a
qualification/disclosure in the audit report, the auditor should consider the materiality of the
relevant item. Thus, the auditor need not make qualification/disclosure in respect of items
which, in his judgement, are not material. While making a qualification, the auditor should
follow the requirements of the ‘Statement on Qualifications in Auditor’s Report’ issued by the
Institute. A disclosure which is not a subject matter of audit qualification, should be made in
the auditor’s report in a manner that it is clear to the reader that the disclosure does not
constitute an audit qualification. The paragraph containing the auditor’s opinion on ‘true and
fair view not includes a reference to the paragraph containing the aforesaid disclosure.
Examples of qualifications/disclosures in the audit report - Given below are some
examples which illustrate the manner of making qualification/ disclosure in the audit report in
case of deviations from the requirements of mandatory Accounting Standards. It may be
clarified that these examples are aimed only at illustrating the manner of making qualifications/
disclosures and are not intended in any way to be exhaustive.
Examples of qualifications
(a) Where proper disclosures regarding changes in accounting policies have not been made
by a company:
“The company has not disclosed in its accounts the fact of change, from this year, in the
method of providing depreciation on plant and machinery from, straight-line method to
written-down value method as also the effect of this change. As a result of this change,
the net profit for the year the net block as well as the reserves and surplus are lower by
Rs. ..............each as compared to the position which would have prevailed had this
change not been made.
Subject to the above, we report that....”
(b) Where a company has capitalised financing costs related to certain fixed assets for
periods after such assets were ready to be put to use.
“Interest payable on borrowings related to the acquisition of fixed assets has been
capitalised for the periods during which the assets were in use for commercial
production. This is contrary to Accounting Standard (AS) 10. Accounting for Fixed
Assets’, issued by the Institute of Chartered Accountants of India. Consequently, the net
profit for the year, the net block and the reserves and surplus have been overstated by
Rs ... each as compared to the position which would have prevailed if the company had
complied with the requirements of AS 10.
Subject to the above, we report that.…..”
Examples of Disclosures
(a) Where a company has not disclosed all significant accounting policies and has also not
disclosed the accounting policies at one place.
“The company has disclosed those accounting policies the disclosure of which is required
by the Companies Act, 1956. Other significant accounting policies, viz, those relating to
treatment of research and development costs and treatment of exchange gains and
losses have not been disclosed nor have all the policies been disclosed at one place,
which is contrary to Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’
issued by the Institute of Chartered Accountants of India.
We, report that......
(b) Where a partnership firm does not make adequate disclosures regarding the revaluation
of its fixed assets.
“During the year, the enterprise revalued its land and buildings. The revalued amounts of
land and buildings are adequately disclosed in the balance sheet. However, the method
adopted to compute the revalued amounts has not been disclosed, which is contrary to
Accounting Standard (AS) 10. ‘Accounting for Fixed Assets’ issued by the Institute of
Chartered Accountants of India.
We report that....”
8.3.4 Use of separate reports - The Institute of Chartered Accountants of India has also
recommended in its “Statement on Qualification in Auditor’s Report” that the use of separate
reports which are referred to in the report of the auditors to the shareholders should as far as
possible, be avoided. It is desirable that the report should be comprehensive and brief. It
should specify the matters in respect of which the auditors have reservations or qualifications,
and the amounts involved, in a clear and unambiguous manner. The practice of making report,
subject to a detailed report or a special report addressed to the directors of the company,
running into several pages is not desirable as the lay shareholder is not in a position to
appreciate a mass of fact and information, and the total effect thereof on the accounts. If the
circumstances are such that a separate detailed report cannot be avoided, the auditor should
take care to ensure that the separate report is also addressed to the shareholders, rather than
to the directors or the management and the main report to the shareholders is made subject to
such a report. The auditors should take special care to ensure that it is clearly identified by
reference to numbers, date, etc. and attached to the main report. In the opinion of the Council
of the Institute of Chartered Accountants of India, where an auditor makes a qualifying report
by reference to another report, it is the duty of the directors to publish such other report
together with the accounts of the company.
Audit Report 8.21
It has been emphasised earlier that the auditor’s report should be brief. The same
consideration applies in making qualification also. At the same time, no scope should be left
for any misinterpretation. The statement should be as precise as possible bringing out clearly
the items affected and their effect on the accounts. Although normally full information should
be given in the report, where full information is not available. It is desirable to give as much
information as possible. When full information with regard to the monetary effect on Profits &
Loss A/c and/or Balance Sheet of a qualification or a comment is not available, the auditor’s
report should either indicate the approximate monetary effect or should state that it is not
possible to ascertain the monetary effect, as the case may be. The following illustration of a
qualification will explain the point.
“During the year one of the four factories of the company (none of which is insured) situated at
…………….........................…… was gutted by fire and extensive damage was caused to the
fixed assets of the company in that location. The extent of the loss has not been ascertained
and no provision has been made in the accounts against such loss, but the total written down
value of the fixed assets installed at the factory amounted to Rs. ………………………………..
Subject to the above we report that the balance sheet shows a true and fair view”.
Normally, an auditor should not include the directors’ explanations in his report in respect of
qualifications made by him. But if the qualification involves a point where two opinions are
possible, it may be appropriate for the auditor not only to state his own opinion in his report
but also to point out that a contrary opinion is held by the management or the company’s legal
advisers as the case may be. For example, if a company has capitalised the amount of
interest on long-term funds borrowed for acquiring fixed assets, the company may contend
that according to legal opinion obtained by it, the treatment followed by it is correct. However
the auditor in view of the Institute’s pronouncement on the subject may feel otherwise. In such
a case, the auditor should qualify his report giving his interpretation of the fact and should also
refer to the contrary legal opinion obtained by the company and the company’s contention.
The duty of the auditors is to exercise independent judgement and express their opinion
regardless of the views held by the directors and without regard to financial or other standing
of the company. However, it will always be a good practice to discuss the proposed
qualifications with the company’s management so that an opportunity may be afforded to the
Board of Directors to consider the issues involved, and explain the matters. In many cases,
this discussion may throw new light and the auditor may be able to view the matter in a clearer
perspective; it may also be possible to convince the management of the auditor’s viewpoint. In
the ultimate analysis, this procedure is likely to result in the presentation of a true and fair view
of financial accounts.
Where the auditors of a company have decided to give a qualified report, it is desirable that
they should discuss the contents of the report with the company’s management and make
their views clear, so that an opportunity may be afforded to the Board of Directors to consider
the issues involved. It is sometimes believed that by discussing their proposed qualifications
with the management and thereby giving the management all opportunity to meet the auditor’s
objections or offer their explanations. The auditors may prejudice their independence. This is
not at all true. The auditor has the final right and duty of deciding whether or not a qualification
is called for. The directors have a statutory duty to comment in their report on every
qualification conducted in the auditors’ report. For this reason also prior discussion between
the management and the auditors of proposed qualifications in the auditors’ report is
necessary. The explanation given by the management may also assist the auditors in framing
their qualifications more accurately when drafting their final report to the shareholders. Finally,
it should not be forgotten that the most important and fundamental purpose of a company’s
financial statements is to present a true and fair view of the state of the company’s affairs. If,
by a prior discussion of their proposed qualifications with the management, the auditors are
able to convince the management of their view point a much more useful purpose is served
thereby than if the auditors’ were to give a qualified report on financial statements prepared by
the management which do not give a true and fair view.
8.3.5 Directors’ comments on qualifications - Under Section 217 (3) of the Companies Act,
1956 the directors of a company are required to give the fullest information and explanations
“on every qualification, reservation or adverse remark in the auditor’s report.”
When the auditors have qualified their report and a similar note to the accounts is given by the
directors also, it is not necessary to give a separate explanation provided the note is
comprehensive and fully explanatory. However, where the qualification is contained only in the
auditor’s report, separate information, or explanation by the Board is called for. In this
connection it should be clearly understood that the scope of the provisions of Section 217 (3)
is quite wide and therefore, an adverse comment, whether resulting in a qualification in the
auditor’s report or not should fully be explained by the Board in its report, e.g., under Section
227 (1A) of the Companies Act, 1956 an auditor is to inquire whether shares held as
investment have been sold by the company at a price less than the price paid for them. If the
auditor finds such a situation, he has to state this fact in his report and obviously, it is an,
adverse statement. However, this will not be a qualifying statement if the transaction is
correctly reflected in the accounting statements. Nevertheless, it will be a matter on which the
Board will have to give its explanation under Section 217 (3) of the Companies Act, 1956
simply because it is an adverse statement in the auditor’s report. According to the Department
of Company Affairs, there exists no mandatory requirement for the Board of a government
company to provide explanations on adverse comments made in the C & AG’s audit report.
Audit Report Vis-a-vis Board’s Report - Can the auditor refer to any paragraphs in the
Directors’ Report in his own report to the members? This aspect, it seems, has not received
much attention of the professional bodies in India and abroad. In the context of our country,
having regard to the provisions of Sections 227 and 217 of the Companies Act, 1956 it
appears that the Board’s report is prepared subsequent to the receipt of the auditors’ report.
Naturally it seems that the auditor cannot refer to any paragraph of the Board’s report in his
report on the accounts examined by him. Therefore, the subject matter of the auditor’s report
is the books of account and the financial statements including notes thereon and not the
contents of the Board’s report. However, the auditor should ensure that on questions of fact,
his report or the accounts under his report are not at variance with any statement in the
Board’s report. Since the Board’s report is supposed to be prepared after the auditor’s report
has been received, it is rather difficult on the part of the auditors to see that Board’s report
does not contain any fact that is at variance from the facts stated in the accounting statements
Audit Report 8.23
or in his report. If any such thing happens apart from the confusion about which of the facts is
correct, it may bring avoidable embarrassment to the auditor. Therefore, it is advisable that the
auditor, before signing his report, should request the management to draft the paragraph
concerning accounts to be included in the Board’s report. If an honest difference about facts is
there, the same may also be cleared at that time, It need not require more emphasis than to
say that in no case, the facts presented be allowed to be different in the two documents;
however, it is understandable that an honest difference of opinion may exist on the same
facts.
Section 217(2AA) provides for Director’s Responsibility Statement.
8.3.6 Branch audit reports- In the case of a branch audit carried out by a person other than
the statutory auditor, Section 228 (3) (c) requires that the branch auditor shall prepare a report
on the accounts of the branch office examined by him and forward the same to be company’s
auditor who shall deal with the same in such manner as he considers necessary. If the branch
auditor’s report contains any qualification, the statutory auditors of the company should
normally include it in their own report unless they are satisfied that either:
(i) the objections of the branch auditor have been met while preparing the accounts of the
company’s or during the conduct of the company’s audit, or
(ii) the matter on which the qualification is made is not material in the context of the
company’s account as a whole, or
(iii) in the light of the information and explanations given to them, which were not available to
the branch auditor, they are satisfied that the qualification is not called for.
The Institute of Chartered Accountants of India in the Statement on Qualifications in Auditors’
Report has indicated by way of illustration certain occasions that may give rise to the
necessity of qualification in the auditor’s report. Though these illustrations are based on the
report on company accounts, some of them have general relevance also. The circumstances
under which auditors are obliged to qualify their reports are numerous, and the following
illustrations are provided merely as a guide to prevailing, practices.
Where the auditors are unable to obtain all the information and explanations which they
consider necessary for the purposes of their audit.
Examples which arise under this head are the absence of satisfactory documentary evidence
of the existence of ownership of the material assets, such as, title deeds in respect of land;
absence of vouchers in respect of material payments made by the company; destruction of
books and records by fire or accident; non-availability of books and records owing to
unavoidable circumstances, such as books and records of a foreign branch which has been
nationalised or with which no communication is possible.
It should be appreciated that in the majority of cases a qualification on this aspect of the report
is likely to be a qualification to the true and fair aspect also. An example of qualification under
this head is as follows:
Owing to the destruction by fire during the war, of the company’s old records, it has not been
possible to ascertain the original cost of and the total depreciation written off from the Fixed
Assets. An analysis of the original expenditure on Fixed Assets is also not curtailable. It is not
possible, therefore, to give the particulars of the Fixed Assets required by the Companies Act,
1956.
“Subject to the above, we report that ………………………….”
Where proper books of accounts have been kept in accordance with the law.
An example of qualification under this head is as follows:
“We report that there is no check on consumption of materials. A selective physical check of
the stock on hand at the factory as at the end of the period was made by us, but stock
inventories as at the end of the previous year and inventories taken during the period (as on
18th October, 2003) and some stock cards were not available for our inspection. No details
were available in respect of written-down value of obsolete items of stock as at the beginning
of the period. We could not therefore, verify whether these items were correctly valued as at
the end of the period under review, and whether any amounts were written - off, in respect
thereof during the period. Further no adequate control was found to have been exercised over
stocks rejected and returned or lying with customers, or over items sent on loan or approval to
customers.
“There was no evidence of a physical check of work-in-progress amounting to Rs.
1,32,819/-.”
“In view of this, the consumption of materials and the correctness of the stock at the end of the
period could not be adequately verified by us.”
“Subject to the above, we report that..........................”
The balance sheet and profit and loss account are not in agreement with the books of account
and returns;
In this case, qualification in the auditor’s report should indicate precisely in what manner the
financial statements do not agree with the books of accounts and returns.
When the information required by law is not furnished.
In this case, the auditor should ascertain and evaluate the facts requiring disclosure in the
financial statements, so that he can disclose the same in his report.
When the accounts do not disclose a true and fair view.
Examples of qualification which may arise under this head are:
(a) Where the accounting practices followed by the company are not considered appropriate
to the circumstances and nature of the business.
Illustration:
Hire purchase sales have been treated as outright sales by the company and contrary to
accept accounting practice, the entire profit thereon has been taken into account. The
profit relating to instalments not due as at the date of the balance sheet and included in
profit for the year amounted to Rs…………………..”.
Audit Report 8.25
(b) Where there has been a change in accounting principles or procedures in relation to
material items, such, valuation of stock, depreciation, treatment of by-product cost, etc.,
without adequate explanation and disclosure of effect of the change.
(c) Where differences of opinion with management have arisen regarding valuation or
realisability of assets, such as stock-in- trade, sundry debtors, loans and advances or the
extent of liabilities, contingent or otherwise.
(d) Where income or expenditure is not properly reflected so as to show a fair figure of profit
for the year.
(e) Where information is not required by law to be disclosed but the disclosure of which is
considered essential by the auditors in order to show a true and fair view.
When contravention has taken place of the provisions of the Companies Act, 1956 having a
bearing upon the accounts and transactions of the company e.g., donations to political parties
or for political purposes in contravention of provision of Section 293A; or contributions to
charitable or other funds in excess of the limitation specified in Section 293 (1) (c).
Contravention of the provisions of the Memorandum and Articles of Association of the
company.
An example of qualification under this head is as follows:
“We have to repeat our qualification of last year that we have been advised by eminent
Counsel that the investments of the company in shares of other companies, vide the details of
the investments annexed to the Balance Sheet, are ultra vires its Memorandum of Association
as there is no specific power therein to make such investments and this cannot be implied
from the objects contained in its objects clause.
“Subject to the foregoing in our opinion and to the best of our information………….”
8.3.7 Avoid Vague Statements - Vague statements, the effect of which upon the accounts is
not ascertainable should be avoided, e.g., “the debit balances are subject to confirmation”, “we
have accepted the certificate signed by the managing director that stocks are realisable at the
value stated in the balance sheet”. “Payment vouchers have been accepted by us as passed
by the management”
The auditor should avoid making qualifications in his report which do not contain any real
objection on his part e.g., a statement such as “development rebate reserve amounting to
Rs……………………… has not been made in view of the loss shown in the accounts”,
“provision for taxation has not been made in view of past losses brought forward”,
“depreciation has not been provided as the factory has not gone into production”. From the
point of view of the auditor’s report, these are superfluous even though they convey some
useful information.
These, therefore, should form part of the management’s notes on the accounts. It is also not a
good practice to qualify by reference to reports made in an earlier year because all the
shareholders may not have access to such reports. The following type of statements should,
therefore be avoided; “The position of advance to ABC amounting to Rs
…………………..remains the same as explained in our last report”. Each year’s accounts
being independent, the essential facts relating to a qualification made in an earlier year must
be repeated where appropriate.
In this context, it is worthwhile to remember that where no statutory form of auditor’s report
exists, e.g., in the case of a report on the accounts of a sole trader or a partnership,
sometimes the auditor’s report is: “examined and found correct”. This type of report or a
variation of this does not convey what an auditor’s report should convey for example, the
manner, and extent of checking, the scope of the examination, etc. Therefore the auditor
should scrupulously avoid this form of report wherever he is free to choose his own form or
report.
Some examples of explanatory notes and qualificatory notes are given hereunder:
Examples of Explanatory Notes

1. Previous year’s figures are re-grouped wherever necessary to conform to this year’s
Classification.
2. Tax amounting to Rs. 30,31,519 (previous year Rs. 42,92,728) has been deducted at
source on interest and dividends from subsidiary companies and on other investments.
The income of these accounts is shown gross.
3. Selling Agents’ Commission and Discount includes Rs. 2,18,985 (previous year Rs.
1,77,482) paid to the Sole Selling Agent of the Corporation.
4. The Corporation has, on its own to the extent of Rs. 25 lakhs and further jointly ...............
with Ltd. London, and severally to the extent of further Rs. 25 lakhs, guaranteed the
repayment of loans advanced from time to time to ................Ltd., by Union Bank of India.
The balance on 31st May, 1994, was Rs. 33,84,360 (previous year Rs. 34,39,940).
5. The method of computation of depreciation on all additions made during the year has
been changed. The company has followed the straight line method of depreciation as
provided under Section 205 (2) (b) of the Companies Act, 1956, for all assets added
during the year instead of the written down value method. Had the depreciation been
calculated on the same basis as last year, the charge for the depreciation would have
been Rs. 5,91,89,107 as against Rs. 4,68,99,693.
6. The Profit and Loss Account includes expenses (net) pertaining to prior periods, Rs.
5,72,875 (Previous year, Rs. 46,778).
7. Expenses debited to other account heads:
Purchases Rs. 74,033 (Previous year Rs. 1,27,922)
Salaries & Wages Rs.5,11,946 (Previous year Rs. 3,44,768)
Stores Rs. 3,86,387 (Previous year Rs. 2,69,414)
Insurance Rs.2,43,147 (Previous year Rs. 95,923)
Audit Report 8.27
8. Provision for taxation has been made after taking into account unabsorbed losses
brought forward from previous years.
Examples of Qualifications
1. The Balance Sheet includes Rs. 17,75,782 (1992-93 Rs. 17,73,532) being assets (mainly
Bank balances) less liabilities in Pakistan. No confirmation of this amount has been
received and; therefore this figure is unaudited.
2. The Directors have recommended dividends aggregating Rs. 2,35,01, 206 (1992-93 Rs.
2,35,00,930) subject to deduction of tax, which if approved by the shareholders at the
Annual General Meeting to be held on 12th, August, 1994 will be paid out of the General
Reserve and no separate provision has been made therefore.
3. The subsidiary company A.B. Ltd.’s working for the year ended 31st March, 1994 has
resulted in a further loss of Rs. 41,00,000 during the year, which together with the
accumulated losses incurred in earlier years amounted to Rs. 1,05,00,000. This figure is
in excess of A.B. Ltd.’s capital amounting to Rs. 80,00,000 in addition to this, provision
for depreciation is in arrear to the tune of Rs. 32,00,000. No provision has been made in
the accounts for the loss which has occurred in the value of the company’s investment in
A.B. Ltd. which continues to appear at cost as before.
4. No provision has been made in the accounts in respect of a liability likely to devolve on
the company under an arrangement arrived at between the A.P. Ltd., and the company
for sharing of expenses relating to marketing and distribution. The company’s
proportionate share of this liability amounts to Rs. 8,50,000 (Previous year Rs. 8,58,447).
Remarks which are not qualifications- It has already been indicated that in the auditor’s
report there may exist statements or observations which are not qualificatory in nature. In this
connection the matters covered under Section 227(1A) and CARO are relevant. All of them as
such are basically additional information and have no linkage with the question of qualification
or reservation etc. referred to in Section 227 (4) of the Companies Act. The special situations
that may necessitate qualification out of these have been discussed earlier in this chapter.
Apart from these, it occasionally happens that it is necessary to include a “remark” in an audit
report which is not a qualification. In such cases, the remark should be inserted as a single
sentence prior to the auditor’s opinion which should not include any reference to the remark.
As an illustration the following is given:
“The properties abroad entered at Rs....................... are in the course of being, but have not
yet been, registered in the company’s name.”
This remark can be put in the body of the auditor’s report only when the notes on account do
not include this information.
The circumstances under which “remarks” should be inserted are rare and the following
conditions should normally exist:
(a) The matter is of such importance in relation to the balance sheet as a whole that it should
be brought to the notice of the members, and
(b) the point is not clearly brought out on the face of the account, as they stand by the notes
or otherwise; and
(c) the point does not affect the true and fair character of the accounts.
Need for qualification arising out of adverse comment by the auditor on inquiry under Section
227 (1A) of the Companies Act. It has already been indicated elsewhere in this study that
there may arise a need for qualification in the auditor’s report if the auditor comes to a finding
that not only the matters are adverse, they also distort the true and fair view of the profit and
loss account or the balance sheet. Clause (a) of this provision does not leave much room for a
qualification. It requires the auditor to inquire whether loans and advances made by the
company on the basis of security have been properly secured. If the auditor finds that the
loans and advances have not been properly secured, he may enter an adverse comment in
the report but cannot probably doubt the true view of the accounts by reference to this fact so
long the loans and advances are properly described and presented in terms of Part I of
Schedule VI to the Companies Act. The remaining part of this clause (a) requires the auditor
to inquire whether or not the terms on which the loans or advances have been made are
prejudicial to the interests of the company or its members. Here again, the auditor has hardly
any scope for qualification even though the inquiry results in an adverse finding. If the effect of
the terms and conditions whatever they may be are properly reflected in the accounts, he
cannot hold the accounts to be untrue or unfair; of course, if the accounts are defective
because of not giving effect to the terms and conditions, there may arise a need for
qualification.
In clause (b) of this provision, the auditor is required to see whether transactions of the
company which are represented merely by book entries are not prejudicial to the interests of
the company. Here, the nature of book entry, there may arise a need for qualification. For
example, if fake sales or purchase entries have been passed, apart from considering whether
such entries are prejudicial to the interests of the company, the auditor has also to weigh their
effect on the true and fair view of the accounts. Because of fake or manipulative entries, the
accounts are bound to produce a view which is not true and fair and there will arise a need for
qualification in the auditor’s report.
Clause (c) of the provision also leaves little scope for qualification so long as the sale price
has been properly adjusted in the accounts and shown as such.
However clause (d) clearly suggests a need for qualification because it concerns a fair
presentation of the loans and advances. If loans and advances are shown as deposits, the
character of the accounts may undergo a change and that distorts the true and fair view of the
accounts. Here the auditor has to state his adverse finding and link it with the true and fair
character of the accounts. This will be a qualification. Clause (e) of this provision, relating to
personal expenses being charged to the revenue, has already been discussed in this Chapter.
It suffices to say that if the auditor finds that personal expenses have been charged to revenue
and if the amounts are material, he should qualify his report also. The last clause of this
provision concerns appropriate entry for the allotment of shares and appropriate disclosure
thereof in the balance sheet. This clause may give rise to a qualification in the event of the
auditor’s adverse finding. If cash has been received for allotment in the shares and if the
Audit Report 8.29
decision in Spargo’s Case does not apply then showing such shares as issued for cash
consideration will obviously distort the true and fair view of the balance sheet specially when
Schedule VI, Part I, requires a separate disclosure of shares issued for consideration other
than cash. In this regard clarification No. 8/32 [75]77-CL.V dated 13th March, 1978 issued by
the Dept. of Company Affairs is relevant. According to the clarification a genuine debt payable
by a company can be cancelled against issue of shares by the company and the issue will be
for cash consideration.
Therefore, the requirement of the provisions of Section 227 (1A) has to be viewed on two tier
basis whether there is an adverse finding by the auditor and whether the situation also distorts
the true and fair view of the account. When the primary finding is adverse but the auditor is
satisfied that it does not affect the true and fair view of the accounts he is required merely to
state his finding and comments if any, in a separate paragraph in the report and should not
link it up with the true and fair view of the profit and loss account or the balance sheet by using
any expression such as “ subject to” or “except that” If, however, the auditor is of the view that
the matter also affects the true and fair view of the accounts, he should state the fact, his
comment, if any, and connect the statement by using the expressions mentioned above, with
the truth and fairness. For example, the qualification can be made in the following way;
“Subject to our observation in paragraph............................... above to personal expense,
charged to revenue, we state that.........................................”
8.3.8 Structuring of the Report - In making his report, the auditor has to understand fully the
inter-relationship between the different requirements of sub-sections of Section 227 of the Act.
In terms of sub-section (1A) he has to make specific enquiries regarding the matters specified
therein but he has no obligation to report upon such enquiries unless such enquiries reveal an
unsatisfactory state of affairs on which he feels a report is necessary. Under the MAOCAR
(now CARO) Order, he has to report on all the items specified in the order. The requirements
of sub-section (1) or of the order do not, however, in any way diminish his responsibilities -
under sub-sections (2), (3) and (4) of the Section. Therefore, in framing his report under sub-
sections (2), (3)and (4) of the Section, the auditor has to take into account the enquiries made
by him under sub-section (4A) and the report made him under the order.
It is, therefore, suggested that the sequence of items appearing in the report should be: first,
the comments under the order may, if so desired, be given in the form of an Annexure, to the
report. However, when the comments are given in an Annexure it is necessary to, refer to the
Annexure in the main report and it is advisable to sign the Annexure in addition to signing the
main report. If any of the comments under the order are adverse, the auditor must consider
whether a qualification in the report under sub- sections (2), (3) and (4) of Section 227 is
necessary. Such a qualification must be made against the specific items which are being
qualified. An example of such a qualification would be:
“Subject to our remarks in paragraph ( ) of the Annexure referred to in paragraph ( ) above,
regarding the valuation of inventories, in our opinion ……………………”
Where several of the comments under the order are adverse and more than one results in a
qualification in the report under sub-sections (2) (3) and (4) of Section: 227, the auditor may
prefer to preface his report under those sub-sections by stating the qualifications. An example
would be: “Subject to our remark in paragraphs ( ), ( ) and ( ) of the Annexure referred to in
paragraphs ( ) above regarding ... and subject to our other observations in the Annexure we
state that………………………….
Even where there are no adverse comments under the Order, it may be advisable for the
auditor to preface his report under sub-sections (2) (3) and (4) of Section 227 with the words
“Further to our comments in the Annexure we state that ……..”
It must not however be assumed that every adverse comment under the Order must
necessarily result in a qualification in the report under sub-sections (2) (3) and (4) of Section
227. Firstly, the adverse comment may arise regarding a matter which has no relevance to a
true and fair view of the accounts. For example, the failure of the company to deposit
provident funds dues in time or to comply with the requirements regarding acceptance of
deposits. Secondly, while the non-compliance may be material enough to warrant an adverse
comment under the order, it may not be material enough to vitiate a true and fair view of the
accounts, Finally, the non-compliance may be in area which calls for remedial action on the
part of the management, for example, a lack of internal control in specific area regarding
purchases and may be important for that reason but may not be sufficiently important in the
context of the report under sub-sections (2), (3) and (4). In deciding therefore, whether a
qualification in the report under sub-sections (2), (3) and (4) is necessary, the auditor must
use his discretion in view of the facts and circumstances of each case.
Where there is a qualification both under sub-section (1A) and under the Order, it is suggested
that the qualification under sub-section (1A) and under the order should be inter-linked. An
example would be:
“Subject to the observation in paragraph above relating to personal expenses charged to
revenue and also to the observation regarding the valuation of inventories in paragraph of the
Annexure referred to in paragraph ( ) above we state that …………………………”
It is important to note that replies to many of the requirements of the order will be expression
of opinion and not necessarily statements of fact. It is necessary, therefore, that this is
indicated when making the report under the order. This can be done in either of the following
ways:
(a) By a general preface to the comments under the order on the following lines:
“In terms of the information and explanations given to us and the books and records
examined by us in the normal course of audit and to the best of our knowledge and
belief, we state that .....................”
(b) By a preface to individual comments for example: “In our opinion...” or “In our opinion and
according to the information and explanations given to us during the course of the audit
...........”
The Order requires that where the answer to a question is unfavourable or qualified, the
auditor’s report should also state the reasons for such unfavourable or qualified answer. This
requirement is similar to the requirement of sub-section (4) of Section 227 and the same
considerations should apply. It is not, therefore necessary for the auditor to give detailed
Audit Report 8.31
reasons for an unfavourable or qualified answer but the auditor is expected to explain the
nature of the qualification or adverse comment in clear and unambiguous terms. For example,
if the auditor reports that the company’s internal control system is not commensurate with its
size and nature of its business, he need not report every single shortcoming of the system but
may indicate in general that the internal audit department is not adequately staffed or that its
coverage is not adequate, etc.
Similar considerations must apply when the auditor is unable to express an opinion. For
example, if the internal audit department is unable to produce any audit programme, working
paper or other evidence of work done, the auditor will not be in a position to report whether the
system is commensurate with the size and nature of the business. In such circumstances, he
must clearly state that he is unable to express an opinion because records or evidence has
not been produced to him.
In expressing an opinion, that auditor must be quite clear as to whether the circumstances of
the case warrant a completely negative answer or whether his opinion can be expressed
subject to a qualification. To illustrate, if the system of internal audit has basic defects which
render it totally ineffective, for example, due to the absence of adequate number or requisite
quality of the staff, then the answer may be completely negative. However, if there are minor
defects in the system, for example, if the coverage is inadequate in specified directions, the
auditor may state in his report that the coverage is inadequate in a particular direction (to be
specified) but that otherwise the system is commensurate with the size of the company and
the nature of its business.
The auditor’s report under sub-section (3) of Section 227 is required to state whether the
auditor has obtained all the information and explanations which to the best of his knowledge
and belief, were necessary for the purposes of his audit. The term “audit” would include
reporting requirements under the order. Therefore, when making his report, the auditor has to
consider whether he has obtained the information and explanations needed not merely for the
general purposes of his audit, but also for the purposes of reporting in terms of the order. If he
has not received the information and explanations needed for reporting in terms of the order,
he should mention that fact both when reporting on the specific question in the order and also
when reporting generally in terms of sub-section (3) of Section 227.
8.3.9 Separate Reports to Directors - Auditors of companies sometimes submit a detailed
report on the work carried out by them which may be variously addressed either to the Board
of Directors or to the Managing Director or to other appropriate officials of the company. There
is nothing improper or irregular about the making of such reports. In many cases, the
management requires the auditor to make a detailed report for the information of the
management regarding the procedures, systems, weakness in internal control, etc., which
would enable the management to exercise a greater degree of control over the operations of
the business. Separate reports are also required to be made in the case of public sector
companies under Section 619(3) of the Companies Act, 1956 giving certain additional
information regarding the operations. It is not necessary to refer to such reports in the
auditor’s report to the shareholders. It is at the same time important to appreciate that if any
statement is contained in a detailed report which is of such a nature that the attention of the
shareholders should be drawn to it, the auditor should do so. However, it should not be
presumed that every statement made in the detailed report must necessarily be such as call
for a qualification. The nature of the facts, their materiality and their bearing upon the truth and
fairness of the accounts must be the governing factors. No rules can be made to guide the
auditor in determining what facts are of sufficient importance to warrant a reference in the
statutory report and what facts are not so important. This must be determined by individual
auditors in the light of their personal judgement and their professional experience.
Another reason for issuing a separate internal report to the management may be to obtain
information and explanations from the management on certain matters or to draw the attention
of the management on certain errors in the accounts which need correction. In response to
such detailed internal reports, the management may provide the necessary information and
explanations, or may pass the necessary corrective entries in the books of account, as the
case may be, in which case it would be quite irrelevant to refer to the detailed report when
issuing the report to the shareholders.
It is generally well recognised that in matters of reporting, it is essential to have regard to the
level at which the reports are issued, higher the level to which a report is made, less is the
detail contained therein. For this reason, a report issued to the Chief Accountant may contain
more detailed information than the one issued to the Board of Directors. For the same reason,
a report issued to the shareholders should deal with the broad and general question of the
truth and fairness of the accounts rather than the details which may in fact confuse the true
state of affair. Bearing in mind the foregoing general observations it is recommended that the
continuance of the present practice of issuing certain internal reports to the management is in
the best interest of the companies concerned.
Distinction between Audit Report and Certificate

8.4 The term ‘report’ is used where an expression of opinion is involved. The term
‘certificate’ is preferable where the auditor comments on or verifies facts such as a verification
of investment by inspection or the checking of ballot papers on a poll in a company meeting.
Under the Companies Act, 1956, a number of situations are there where an auditor is required
to issue a certificate rather than a report. Section 165 (4) of the Companies Act, 1956,
requires the auditor to certify certain matters that are included in the Statutory Report. Under
clause 24 (1) (b) of the Part II, Schedule II to the Companies Act, 1956, an auditor is required
to certify the statements of the accounts for that part of the five years ending on a date within
6 months preceding the date of the prospectus. However, the report under Section 227 of the
Companies Act, 1956, is an opinion based report and is not a certificate.
Some situations where Audit Reports and Certificates are required is given below -
(1) Under the Payment of Bonus Act, 1965 a chartered accountant may be required to issue a
‘report’ on the computation of bonus payable. The report may be as under:
“We have reviewed the figures in the above computation in comparison with the books and
records..................... produced to us, the audit of which has already been completed by us
and report that subject to the notes given on face of the computation in our opinion, and to the
Audit Report 8.33
best of our knowledge and belief and according to the information and explanation given to us,
the above computation is in due accordance therewith and has been made on a basis
reasonably consistent with the provisions of the Payment of Bonus Act, 1965.”
Place: For X & Co.
Date: Chartered Accountants
(2) Auditor’s Report in accordance with Regulation 54 of the SEBI (Mutual Fund) Regulations,
1993.
(i) All Mutual funds shall be required to get their accounts audited in terms of a
provision to that effect in their trust deeds. The Auditor’s Report shall form a part of
the Annual Report. It should accompany the Abridged Balance Sheet and Revenue
Account. The auditor shall report to the Board of Trustees and not to the unit
holders.
(ii) The auditor shall state whether:
1. He has obtained all information and explanations which, to the best of his
knowledge and belief, were necessary for the purpose of his audit.
2. The Balance Sheet and the Revenue Account are in agreement with the books
of account of the fund.
(iii) The auditor shall give his opinion as to whether:
1. The Balance Sheet gives a true and fair view of the scheme wise state of
affairs’ of the fund as at the balance sheet date, and
2. The Revenue Account gives a true and fair view of the scheme wise
surplus/deficit of the fund for the year/period ended at the balance sheet date.
(3) Certificate from a Chartered Accountant towards Application for grant of Export/Trading
Star Trading House Certificate vide Appendix 19 of the Handbook of Procedures (Export and
Import Policy) 1997-2002.
Certificate of Chartered Accountant / Cost Accountant / Company Secretary

I/we hereby confirm that I/We have examined the prescribed registers and also the relevant
records of __________________________________________ for the period from
_______________________to ________________________for the period / year ending
____________________________and hereby certify that:
(i) M/s._________________(full name and address of the applicant) have realised the sale
proceeds in net foreign exchange for the exports made for each of the three financial
years/during the preceding financial year as specified in the statement of exports as at
Sl. No.15.
(ii) The following documents/records have been furnished by the applicant and have been
examined and verified by me/us namely:
Export order/Contract, Shipping Bills, Bill of lading (and/or Airways Bills/PP Receipts),
Customs/Bank attested Invoices, Bank Certificates showing realisation of sale proceeds,
evidence of payments received in foreign exchange in their own name and connected
books of account.
(iii) The Net foreign Exchange Earnings have been calculated by deducting the following
from the f.o.b. value:
(a) The CIF value of all goods (other than capital goods) imported by the applicant in
his own name or through his associate or supporting manufacturer(s) which have
been used in manufacture of the goods exported; and
(b) The value of all payments made in foreign exchange by way of commission, royalty,
fees or any other charge for the exports made.
(iv) The relevant register has been authenticated under my/our seal/signature.
(v) The FOB value of products manufactured by SSI/Cottage/Handicraft sector units and net
realisation of foreign exchange thereof as shown in the statement of exports/Net
realisation of foreign exchange is correct.
(vi) The financial information given in the above statement is in agreement with the relevant
register and records; the same has been incorporated in the books of accounts
maintained by the exporter; and is also true and correct.
(vii) It has been ensured that the information furnished, is true and correct in all respects no
part of it is false or misleading and no relevant information has been concealed or
withheld;
(viii) Neither I, nor any of my partners is a partner, director, or an employee of the above-
named entity or its associated concerns;
(ix) I/We hereby certify that M/s......... has realised 95% or more of the export proceeds in
respect of exports made by him in the preceding three licensing years on the basis of
which the recognition is claimed.
(x) I/We hereby certify the total value of outstanding export proceeds beyond a period of six
months from the date of export made by the applicant.
(xi) I/We fully understand that any statement made in this certificate, if proved incorrect or
false, will render me/us liable for any penal or other consequences as may be prescribed
in law or otherwise warranted.
(Signature and Stamp/Seal of the Signatory)
(Chartered Accountant/Cost Accountant/Company Secretary)
Name of the Signatory: Place :
Full Address: Membership No.:
Date :
Audit Report 8.35
Audit Reports and Certificates for Special Purposes

8.5 In this first part, the relevant extracts from the Guidance Note on Audit Reports and
Certificates for Special Purposes are given below:
Government authorities may, under various statutes or notifications, require reports or
certificates from auditors in support of statements or other information prepared by an
enterprise. Reports or certificates on specific matters may also be required from auditors by
an enterprise, for its own special purposes. These reports or certificates to specific
requirements of the individual users is unlike a ‘general purposes report’ e.g. an auditor’s
report on financial statements which is intended for general use. An audit report or certificate
for special purposes is one to which the format of general purpose audit report is not
applicable.
8.5.1 Scope of Special Purpose Audit Reports and Certificates- Audit reports or certificates
for special purposes may be issued in connection with:
(a) financial statements which are prepared in addition to general purpose financial
statements:
(b) specified elements, accounts or items of financial statements;
(c) compliance with requirements of any agreement or statute or regulation;
(d) financial information given in special purpose formats or schedules; or
(e) compilation of statistics or ascertainment of basic figures e.g., for the purposes of fixed
quotas or levies.
8.5.2 Responsibility for Preparation of Special Purpose Statements - The primary
responsibility for the contents of special purpose statement rests with the enterprise and this
would be evidenced by a suitable declaration or authentication by the management on the
face of the statement.
8.5.3 Scope of Reporting Auditor’s Function - A reporting auditor should have a clear
understanding of the scope and nature of the terms of his assignment. It is desirable for him to
obtain the terms in writing to avoid any misunderstanding. A reporting auditor is not an expert on
purely technical matters and as such, when he is required to report on or certify such matters (e.g.,
composition or quality of a product) which are of paramount importance and constitute the very
basis of the figures contained in the statement, he should state his limitations clearly in the report or
certificate. At the same time he should indicate the extent to which he has been able to exercise his
own professional skill and judgement with regard to the matters being reported upon. For instance,
he may state that, for the purposes of forming his opinion he has relied upon a certificate from
technical experts. He should, of course, satisfy himself about the technical qualifications of the
expert, and subject the expert’s certificate to a reasonable review.
8.5.4 Contents of Reports and Certificates for Special Purposes- In many cases, a reporting
auditor can choose the form and contents of his report or certificate. In other cases the form
and contents of the report or certificate are specified by statute or notification and cannot be
changed. Where a reporting auditor is free to draft his report or certificate, he should consider
the following:
(a) Specific elements, accounts or items covered by the report or certificate should be clearly
identified and indicated.
(b) The report or certificate should indicate the manner in which the audit was conducted,
e.g., by the application of generally accepted auditing practices, or any other specific
tests.
(c) If the report or certificate is subject to any limitations in scope, such limitations should be
clearly mentioned.
(d) Assumptions on which the special purpose statement is based should be clearly
indicated if they are fundamental to the appreciation of the statement.
(e) Reference to the information and explanations obtained should be included in the report
or certificate. In certain cases, apart from a general reference to information and
explanations obtained, a reporting auditor may also find it necessary to refer in his report
or certificate to specific information or explanations on which he has relied.
(f) The title of the report or certificate should clearly indicate its nature, i.e., whether it is a
report or a certificate. Similarly, the language should be unambiguous, i.e., it should
clearly bring out whether the reporting auditor is expressing an opinion (as in the case of
a report) or whether he is only confirming the accuracy of certain facts (as in the case of
a certificate). For this, the choice of appropriate words and phrases is important.
(g) If the special purposes statement is based on general purpose financial statements, the
report or certificate should contain a reference to such statements. However, the report or
certificate should not contain a reference to any other statement unless the same is attached
herewith. It should be clearly indicated whether or not the statutory audit of the general
purposes financial statements has been completed and also, whether such audit has been
conducted by the reporting auditor or by another auditor. In case the general purposes
financial statements have been audited by another auditor, the reporting auditor should
specify the extent to which he has relied on them. He may communicate with the statutory
auditor for securing his co-operation and in appropriate circumstances, discuss relevant
matters with him, if possible.
(h) Where a report requires the interpretation of statute, the reporting auditor should clearly
indicate the fact that he is merely expressing his opinion in the matter. He should take
sufficient care to ensure that in respect of matters which are capable of more than one
interpretation, his report is not misconstrued as representing a settled legal position;
(i) An audit report or certificate should ordinarily be a self- contained document. It should
not confine itself to a mere reference to another report or certificate issued by the
reporting auditor but should include all relevant information contained in such report or
certificate.
(j) The reporting auditor should clearly indicate in his report or certificate, the extent of
responsibility which he assumes. Where the statement on which he is required to give
his report or certificate, includes some information which has not been audited, he should
clearly indicate in his report or certificate the particulars of such information.
Audit Report 8.37
In certain cases, the form and/or contents of the report or certificate, as prescribed by a
statute or a notification, may not be appropriate or adequate. In such situations, the reporting
auditor may consider modifying the report or certificate on the basis of the suggestion made in
above para to the extent applicable. In case this is not possible, he should clearly indicate the
limitations in his report or certificate itself.
8.5.5 Extent of Reliance on General Purpose Audit Report: - Where a special purpose engagement
is undertaken after the statutory audit has been completed, a reporting auditor should invariably
review the statutory audit report to ascertain whether there are any matters which have a bearing on
his report or certificate. In cases, where a reporting auditor is required to report or certify certain
specific matter arising from the financial statements taken as a whole, he should not normally issue
his report or certificate until the statutory audit has been completed. For instance, a reporting auditor
may be required to state whether, in the case of an Indian branch of a foreign company, the profit
shown in the accounts represents the remittable surplus of the branch, or he may be asked to report
on the computation of ‘gross profit’ for the purpose of bonus under the Payment of Bonus Act, 1965.
In such cases, it would normally not be proper for him to give his report or certificate until the statutory
audit has been completed, since he would not really be in a position to state whether the profit shown
in the accounts itself has been properly computed.
Where an audit report or certificate is required before the statutory audit is computed, a
reporting auditor should state clearly in his audit report or certificate that he is reporting on or
certifying specific matters arising out of the financial statements of the enterprise, the statutory
audit of which has not been completed. Where the reporting auditor prepares his report or
certificate on the basis of duly audited general purpose financial statements he may take the
following precautions:
(i) He may clearly state in his report or certificate that the figures from the audited general
purpose financial statements have been used and relied upon.
(ii) He may include in his report or certificate a statement showing the reconciliation between the
figures in the general purpose financial statements and the figures appearing in his report or
certificate.
8.5.6 Reports and Certificates on Specified Accounts or Items of Financial Statements - The
test of materiality which a reporting auditor uses in connection with special purpose reports
may be different, depending upon the circumstances, from the test he would use in connection
with a general purpose report. For example, where he is required to express an opinion on
specified accounts or items of financial statements, he may judge the materiality of an item
solely in relation to such individual accounts or items rather than to the aggregate thereof or to
the financial statements as a whole. A reporting auditor’s examination of certain records for an
audit report or certificate for special purpose may also be more intensive than the examination
of the same records by the statutory auditor for the purpose of expressing an opinion on the
general purpose financial statements as a whole. Certain accounts or items of financial
statements are inter - related, e.g., sales and debtors, purchases and creditors, fixed assets
and depreciation, etc. Therefore, where the reporting auditor is required to examine and report
upon or certify a specified account or items of financial statement, he may also need to
examine the related accounts or items to discover the inconsistencies, if any, between these
inter - related accounts or items.

8.5.7 Communication of Report or Certificate - The reporting auditor may address his report
or certificate to the client or to the public authority or person requiring it, as the case may be.
In appropriate circumstances, a certificate may be issued without reference to any particular
person or authority by using the words. ‘To whomsoever it may concern’. The report or
certificate should normally be issued to the client who should be responsible for forwarding the
same to the connected authority, where so required.
8.5.8 Communication with the Previous Reporting Auditor - It should be a healthy tradition if
the practice of communicating with the member who had done the work previously is followed
in every case where a member is required to give a report or certificate for a special purpose.
Audit of Company Prospectuses

8.6 Extracts from the Guidance Note on Audit of Company Prospectuses are given below:
Section 2(36) of the Companies Act, 1956 defines ‘Prospectus’ as follows:
Prospectus means any document described or issued as a prospectus and includes any
notice, circular, advertisement or other document inviting deposits from the public or inviting
offers from the public for the subscription or purchase of any shares in, or debentures of a
body corporate.
In order to enable the potential investors to take a well-informed decision in the matter, the Act
spells out in some detail, the information to be given in a prospectus.
8.6.1 Who are eligible to make the reports - The report to be included in a prospectus under
B(1) of Part II of Schedule II should be made by the auditors of the company. In case the
company has joint auditors, the report should be made by all the joint auditors. The report
under clauses B(4) and B(5) should be made by an accountant who shall be named in the
prospectus. According to clause 21(a) of Part III of Schedule II, the accountant shall be a
person qualified under the Act for appointment as auditor of a company. Clause 21(b) of Part
III of Schedule II further states that the report shall not be made by any accountant who is an
officer or a servant or a partner or in the employment of an officer or servant of the company
or of the company’s subsidiary or holding company or of a subsidiary of the company’s holding
company. It has been clarified that the expression “Officer” does not include an auditor. Thus,
an auditor of a company is eligible to make a report under clauses B(4) and B(5) of Schedule
II as well as under Clauses 1 and 2 of both Schedules III and IV. Schedules III and IV also
contain identical provisions.
It is important to note that in terms of Section 226(3)(d), a chartered accountant who is
indebted to a company for an amount exceeding one thousand rupees, or who has given any
guarantee or provided any security in connection with the indebtedness of any third person to
the company for an amount exceeding one thousand rupees, is disqualified for appointment as
its auditor. However there seems nothing to prohibit such person from acting as an
“accountant” for the purpose of making a report under the relevant provisions of Schedules II,
III and IV.
Audit Report 8.39
The reporting accountant should ensure that he does not commit any misconduct, as defined
in the Chartered Accountants Act, 1949. In particular, if he has substantial interest in the
business, he should disclose the same in his report. [See Institute’s publication, “Code of
Ethics”.]
8.6.2 Fees for Issuing the Reports - B(1) of Part II of Schedule II states that the report shall
be made by the auditor of the company. An auditor appointed under Section 224 at the Annual
General Meeting holds office until the conclusion of the next Annual General Meeting on a fee
fixed under Section 224(8). It is advisable for the members to advise the Board of Directors of
their client companies to draft the resolutions appointing them in such a way as to leave with
the Board the authority for fixing the fees for making the reports to be set out in the company
prospectuses. The fee for making the reports under clauses B(1) and B(4) is a matter of
agreement between the Board of Directors and the reporting accountant and should be
determined on the basis of factors such as the quantum of work involved, extent of the
reporting accountant’s responsibility, etc.
8.6.3 Signing the Report - Where the report is issued in a firm name, it should be signed by
the member in his individual name, as partner, for and on behalf of the firm, as in the case of
other company audit reports.
8.6.4 Consent Letters - Section 60(3) requires that a prospectus delivered to the Registrar of
Companies for registration shall be accompanied by the consent, in writing, of the persons
named therein as the auditor, legal adviser, attorney, solicitor, banker or broker of the
company, to act in that capacity. Section 60 (1) requires that the prospectus should have
endorsed thereon, or attached thereto, any consent required by Section 58 from any person
as an expert. As stated earlier, a chartered accountant whose report is included in the
prospectus is to be treated as an expert. According to Section 58, the expert should give his
written consent to the issue of the prospectus, with his statement or report included in the form
and context in which it is included. The prospectus should further state that he has not
withdrawn his consent as aforesaid.
8.6.5 Liability for mis-statement in Prospectus- Section 62 casts, inter alia, on every person
who has authorised the issue of the prospectus, a liability to pay compensation to every
person who subscribes for shares or debentures on the faith of the prospectus for any loss or
damage he may have sustained by reason of any untrue statement included therein. However,
a Chartered Accountant giving his consent under Section 58 or 60(3), shall be liable, only in
respect of an untrue statement, if any, purporting to be made by him as an expert.
A statement shall be deemed to be untrue, if the statement is misleading in the form and
context in which it is included. Where the omission from a prospectus of any matter is
calculated to mislead, the prospectus shall be deemed, in respect of such omission, to be a
prospectus in which an untrue statement is included (Section 65). Where a Chartered
Accountant is liable to pay compensation, he may claim contribution, as provided in Section
62(5).
8.6.6 Reports and Certificates - Clause B(1) of Part II of Schedule II begins with the words
“a report by the auditor.........,” but later in the para below sub- clauses (a) and (b) of the said
clause B(1), the words “together with certificate from the auditor” have been used. The
certificate referred to therein obviously means the report.

8.6.7 Rights and Powers - The next point for consideration is, what are the rights and powers
which the Chartered Accountant has for performing his onerous duties? In this connection, it
should be noted that only the report required by clause B(1) of Part II of Schedule II is to be
made by the company’s auditors; all other reports (clauses B(4) and B(5) of part II of Schedule
II; clauses 1 and 2 of part II of Schedules III and IV) are to be made by accountants to be
named in the prospectus or statement in lieu of prospectus, and not necessarily by the
company’s auditors.
In cases coming under clause B(1) of Part II of Schedule II, the report is to be given by the
auditors, who are empowered, by Section 227(l) to have right of access at all times to the
books and accounts and to require from the officers of the company necessary information
and explanations. Thus, they seem to be vested with sufficient powers to discharge their
duties.
For an Accountant under clause B(4) and B(5) of Part-II of Schedule-II, he should be a
Chartered Accountant but not an “officer or a servant, etc., of the company. It will be observed
that such an accountant has no statutory powers. Therefore, he should ensure that the
necessary authority is given to him by the Board of Directors to discharge his duties.
8.6.8 To whom should the report be made- There is no provision in the Act in this behalf.
The usual practice is to address the report to the Board of Directors of the company.
Accounting Aspects - As stated earlier, the reporting accountant is required to report on the
profits and losses (distinguishing items of non-recurring nature) for the preceding 5 years and
on the assets and liabilities, after making such adjustments as he may consider necessary.
The Act does not spell out the nature of these adjustments. The reporting accountant should
therefore keep in mind the object of the law viz., the protection of potential investors, and
accordingly, his report should provide the information which will be relevant for a reader to
make decisions regarding investment in the company. Of course, the report has to deal only
with past data (and not projections), but they should be stated in such a manner as to enable
a reader to get a clear idea of the trend in profits.
Adjustments to the figure of profits will usually be required in the following circumstances:
(a) Where there are material facts which would have been taken into consideration while
preparing the accounts for the respective years, had those facts been known at that time.
(b) Where certain types of income earned or expenditure incurred in the past, which are of a
material nature, are unlikely to recur. Such items might have been considered normal at
the time the accounts were prepared, but due to subsequent developments they may not
recur, and hence adjustments may be necessary.
(c) Where the accounting policies have not been consistently applied during the period and
the effect of a change therein is material.
Adjustments may also become necessary in relation to the statement of assets and liabilities
included in the report. In particular, the accountant will have to decide whether all the Notes
on Accounts appearing in the published accounts should be reproduced. It may well be that
Audit Report 8.41
many of them can be omitted; it may equally be found necessary to add certain new items.
Audit Reports/Certificates on Financial Information in Offer Documents.

8.7 Requirement Regarding Audit of Financial Information in Offer Documents- In the
context of the growth of the capital markets in India in the recent years and the consequent
need for providing relevant and timely information to investors, the Securities and Exchange
Board of India (SEBI) has issued ‘Guidelines for Disclosure and Investor Protection, 2000,
which include, inter alia, certain financial information to be disclosed in addition to the
requirements of Schedule II to the Companies Act, 1956.
(A) Financial Information Required To Be Contained In The Report Of The Company’s
Auditor
The financial information under this category is required to be contained in the report of the
auditor of the company for inclusion in the offer document. With regard to the guidance on
financial information to be contained in the offer document in the report of the company’s
auditor as per the requirements of Part II. B. (‘Financial Information’) of Schedule II to the
Companies Act, 1956, a reference may be made to the Guidance Note on Reports in
Company Prospectuses to the extent it is not modified by the guidance given in this Guidance
Note pursuant to the requirements of the Guidelines contained in SEBI (Disclosure of Investor
Protection Guidelines, 2000). The discussion following herein after is, therefore, basically with
regard to the aforesaid clarifications.
Adjustments in Statements of Profit or Loss and Assets and Liabilities

Clause 20 of Part III of Schedule II to the Companies Act, 1956 requires that any report
required by Part II of this Schedule shall either;
(a) indicate by way of note any adjustments as respects the figures of any profits or losses
or assets and liabilities dealt with by the report which appear to the persons making the
report necessary; or
(b) make those adjustments and indicate that adjustments have been made.
Clause B. l (b) of part II of Schedule II to the Companies Act, 1956, inter alia, requires that the
statements of profits or losses or assets and liabilities may indicate the nature of provisions or
adjustments made or are yet to be made.
Para 6.18.7 of SEBI (Disclosure and Investors Protection) Guideline, 2000, requires following
disclosure and adjustments in the financial statement which is to be incorporated in offer
document.
(a) All significant accounting policies and standards followed in the preparation of the
financial statement shall be disclosed.
(b) Statements of assets and liabilities and profit and loss or any other financial information
shall be incorporated after making the following adjustment, wherever quantification is
possible.
(i) Adjustments/rectification for all incorrect accounting practices or failures to make

provisions or other adjustments which resulted in audit qualifications;
(ii) Material amounts relating to adjustments for previous years shall be identified and
adjusted in arriving at the profits of the year to which they relate irrespective of the
year in which the event triggering the profit or loss occurred;
(iii) Where there has been change in accounting policy, the profits or losses of the
earlier years (required to be shown in the offer documents) and of the year in which
the change in the accounting policy has taken place shall be recomputed to reflect
what the profits or losses of those years would have been if a uniform accounting
policy was followed in each of these years. However, if an incorrect accounting
policy is being followed, the recomputation of the financial statements would be in
accordance with correct accounting policies;
(iv) Statement of profit or loss shall disclose both the profit or loss arrived at before
considering extraordinary items and after considering the profit or loss from
extraordinary items.
(v) The statement of assets and liabilities shall be prepared after deducting the balance
outstanding on revaluation reserve account from both fixed assets and reserve and
the networth arrived at after such deduction.
Objective of the adjustments

The objective of the profit and loss account and the balance sheet in the annual accounts,
(being general purpose statements), is to provide a true and fair view of the actual profit (loss)
for the accounting period and of the state of affairs as at the closing date, respectively, the
prime objective of the corresponding statements in an offer document, (being special purpose
statements), is to provide adequate data, on uniform basis, for making an evaluation of the
enterprise for the purpose of reaching rational investment decisions.
General considerations
(i) The auditor should obtain from the management of the issuer the adjusted statements of
profit or loss and assets and liabilities as approved by the Board of Directors. The
statements should be supported by detailed notes showing how the figures have been
arrived at. The auditor should examine the audited accounts, the adjusted statements
and the detailed notes prepared by the management regarding the required adjustments
and make such further adjustments as deemed necessary by him.
(ii) On a reading of the requirements in para 6.18.7 of SEBI (Disclosure and Investor
Protection Guideline, 2000) reproduced above, it appears that the adjustments should be
made by the auditor in respect of the items (i) to (iv), only if the said items form the
subject matter of qualifications in auditor’s report. However, on a harmonious
interpretation of the aforesaid requirement it is apparent that the adjustments in the
statements of profit or loss and assets and liabilities would also have to be made in
respect of adjustments for previous years and changes in accounting policies even if
Audit Report 8.43
these do not form the subject of qualifications in the auditor’s report on annual accounts.
This is because these adjustments are necessary to present the statements of profit or
loss and assets and liabilities on uniform basis. Similarly, the disclosure of profit or loss
before and after considering extraordinary items has nothing to do with the qualifications
in the auditor’s report. Thus, adjustments on account of audit qualifications pertain only
to item (i) of the requirement, i.e., qualifications in respect of incorrect accounting
practices or failure to make provisions or other adjustments contained in the auditor’s
report on annual accounts.
(iii) It is suggested that adjustments as per para 6.18.7 of SEBI (Disclosure and Investor
Protection Guideline, 2000) should be made in respect of the amounts directly affected
by the qualifications, previous year adjustments and changes/incorrect accounting
policies. Thus, adjustments which may arise consequent to the aforesaid adjustments
may not be made unless the impact is so substantial as to render the data meaningless.
(iv) The adjustments specified in para 6.18.7 of SEBI (Disclosure and Investor Protection
Guideline, 2000) are not mutually exclusive. An adjustment may arise, for example, due
to change in an accounting policy as well as on account of qualification in auditor’s report
where the changed accounting policy is a subject matter of qualification by the auditor.
The auditor should ensure that appropriate adjustment(s) are made as per the
requirements in the Guideline, particularly ensuring that the adjustment is not made twice
for the same item.
(v) Part II.B of Schedule II to the Companies Act, 1956 as well as SEBI Guideline also
requires inclusion of financial information regarding profits and losses, and assets and
liabilities of the subsidiaries of the company. Therefore, adjustments required in para
6.18.7 of SEBI (Disclosure and Investor Protection Guideline, 2000) should also be made
for the purpose of presenting aforesaid financial information of the subsidiaries.
(vi) It should be noted that in making the adjustments, regard should be had to the
‘materiality’ of the amounts involved in respect of various items of adjustments.
Adjustments / Rectifications on account of Qualifications in Auditors’ Report

(a) The adjustments/rectifications on this account are required to be made in respect of such
qualifications which were made because there were (i) incorrect accounting practices, or
(ii) failures to make provisions or other adjustments. Thus, such matters which represent
incorrect accounting practices or failures to make provisions/other adjustments are
required to be adjusted / rectified if they form part of subject matter of a qualification by
the auditors in their reports on annual accounts for the period covered by the financial
statements.
(b) Adjusted/rectified statements of profit or loss for the five financial years and assets and
liabilities as on the specified date, immediately preceding the issue of the prospectus
should be prepared after considering the qualifications made by the auditors only in
respect of those financial years.
(c) Where it is not possible to make adjustments/rectifications, it should be specifically so

stated, and the exact qualification should be reproduced by way of a note. For example,
there may be a qualification regarding non-availability of significant information.
(d) It is quite possible that the auditors have made a qualification in a particular period in the
light of the information available at the time of finalisation of the audit report of that
period. Subsequently, however, certain developments may provide objective information
which, in the opinion of the auditor, renders the qualification unnecessary. No
adjustment should be made in respect of such a qualification. For example, no
adjustment may be made in case of a qualification regarding non-provision of a liability
which was disputed in a court of law if the subsequent decision of the court is in favour of
the company and, in the opinion of the auditor, the qualification is no longer necessary.
There can be some adjustments which, apart from having effect on the accounts of the year in
which the qualification has been made, may also have effect on the accounts of the
succeeding year(s). For example, an adjustment relating to valuation of closing stock of a
particular year may have an impact on the profit and loss account of the subsequent year. If it
is so, then adjustments should be made in the figures relating to both the years.
Adjustments relating to Previous Years

It is required that adjustments related to previous years should be made in arriving at the
profits of the years to which they relate irrespective of the years in which the event triggering
the profit or loss occurred. Previous years’ adjustments would cover the following:
(i) Prior period items, i.e., material charges or credits which arise in the current period as a
result of errors or omissions in the preparation of the financial statements of one or more
prior periods.
(ii) Material adjustments necessitated by circumstances which though related to previous
periods are determined in the current period.
As per the requirement, in case a material error pertaining to the accounting year 1992-93 is
shown as a prior period item in the accounts of the year 1993-94, for the purpose of the offer
document, adjustment/rectification has to be made in the statement of profit or loss pertaining
to the year 1992-93. This would also mean that as a corollary the statement of profit or loss for
the year 1993-94 will have to be prepared after adjusting the effect of the aforesaid prior
period item. Similarly, adjustments/ rectifications will have to be made in respect of ‘material
adjustments’ pertaining to each of the earlier years. For example, similar adjustments would
be required in case of creation of a liability pertaining to earlier years due to a retrospective
amendment of a law and in case of price fixation of a product with retrospective effect.
Change in Accounting Policy

The impact of a change in an accounting policy is required to be made with retrospective
effect over the five year period under report so that the profits or losses of earlier years can be
reflected on the basis of the changed accounting policy. The policy being followed in the last
year under report would become the applicable policy for each of the five years. For instance,
Audit Report 8.45
in case a company changes in its accounting policy regarding method of depreciation from
SLM to WDV in 1995-96, the profit or loss statements of earlier years would also have to be
recast on the basis of the changed accounting policy. The purpose is to state the profits on
losses of the earlier years on the basis of a uniform accounting policy as far as the offer
document is concerned.
In certain circumstances, it may not be possible to restate the figures in the statements of
profit or loss and/or assets and liabilities in the offer document on the basis of the changed
accounting policy. For example, if a company changes its method of inventory valuation from
FIFO to weighted average cost in the fifth year, it may not have detailed data or
documentation to adjust the figures in the earlier years (this is because the company may not
have documentation required for the new method which was not followed in the earlier years).
In such a case, the auditor may state that it is not possible to restate the figures. Where he
does so, he should state the reason(s) also.
Incorrect accounting policies

It is, inter alia, required under para 6.18.7(b) (iiib) of SEBI (Disclosure and Investor Protection
Guideline, 2000) that “if an incorrect accounting policy is being followed, the recomputation of
the financial statements would be in accordance with correct accounting policies”. It is noted
that the requirement is in respect of the accounting policies being followed, which would
normally mean that the accounting policies on the basis of which the accounts of the last year
contained in the offer document are made. In such a situation, generally, the auditors would
have qualified their reports on the said annual accounts. Accordingly, the adjustment on this
account should be made as an adjustment arising from qualification in auditor’s report.
However, where the auditors did not qualify their report, the relevant adjustments should be
made in the accounts for all the five years under this para of the clarification if the reporting
auditor is of the opinion that the accounting policy being followed by the company was
incorrect.
Extraordinary Items
It is required that profit or loss arrived at both before considering extraordinary items and after
considering the profit or loss from extraordinary items should be disclosed. Extraordinary
items are gains or losses which arise from events or transactions that are distinct from the
ordinary activities of a company but which are both material and expected not to recur
frequently, e.g., sale of a part of the undertaking,
It is to be noted that the amount of the ‘Extraordinary Items’ should be net of tax. It would
mean that the taxation provisions and rate relevant to the extraordinary item should be
considered for computing the tax payable on the extraordinary item.
Material Changes in Activities

Disclosure is required in the offer document in respect of changes (with quantification
wherever possible) in the activities of the issuer which may have had a material effect on the
statement of profit and loss for the five years, Disclosure of these changes in the activities of
the company shall include discontinuance of lines of business, loss of agencies or markets
and similar factors. Para 6.18.7(e) of SEBI (Disclosures and Investor Protection) Guidelines,
2000.
As per the above requirement, certain changes in the activities of the company are required to
be disclosed (with quantification, wherever possible). In this regard, it may be mentioned that
in every business a number of changes in business activities take place constantly. The
intention behind this requirement is not to identify the impact of each such change which is a
part of normal business activities, e.g., updation of technology, change in emphasis in
markets, normal changes in product-mix, changes in ordinary agency relationships etc. The
intention seems to be that only such changes that pertain to separate major lines of business,
loss of major agencies or markets etc., which have material effect on profits or losses be
identified and disclosed. An example would be a diversified company selling or abandoning
one of its main lines of business.
The statement providing the disclosures specified above has to be prepared by the
management. The auditor would use his knowledge of the business of the company and
satisfy himself that prima facie the statement corresponds to his knowledge.
It is suggested that the following information be disclosed in case of a discontinued operation
of the type covered in the above requirement;
(a) The nature of the discontinued operation.
(b) The effective date of discontinuance for accounting purposes.
(c) The manner of discontinuance [sale, abandonment etc.].
(d) Turnover of the discontinued operation. Where divisional accounts are maintained, the
gain or loss on discontinuance and the accounting policies used to measure that gain or
loss should be disclosed, e.g., the policy regarding allocation on overheads.
Similar disclosures should be made in respect of loss of major agencies or markets etc.
A material change in activities of a company can also arise due to addition of new lines of
business. Similar disclosures should be made in this regard also on the lines suggested
above, for the year in which the new activity was started.
Significant Accounting Policies

Disclosure shall be made in the offer document in respect of all significant accounting policies
followed in the preparation of the financial statements. para 6.18.7(a) of SEBI (Disclosure and
Investor Protection Guideline, 2000)
A general criterion for ‘significant’ accounting policies is that these are those policies which
affect certain items of financial statements to a material extent or are critical for the purpose of
determining the net profit (loss) and/or the financial position of the enterprise. In this context,
reference may be made to Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’,
Audit Report 8.47
The accounting policies on the basis of which the last statements of profit or loss and assets
and liabilities have been prepared, should be disclosed.
Disclosure under the Heading ‘Other Income’

In modification of the existing requirements, the offer document shall disclose details of ‘Other
Income in all cases where such income (net of related expenses) exceeds 20% of the net
profit before tax, including.
(i) the sources and other particulars of such income; and
(ii) an indication as to whether such income is recurring or non- recurring, or has arisen out
of business activities other than the normal business activities. para 6.18.7(d) of SEBI
(Disclosure and Investor Protection Guideline, 2000).
(a) ‘Other income’ constitutes all items of income other than the turnover. Turnover for
the aforesaid purpose would be the aggregate amount for which sales are effected
and/or services rendered.
(b) The computation of 20 per cent has to be made in relation to the net profit or net
loss before tax and extraordinary items. It may be noted that the concerned income
and related expenses are to be netted off only for computing relevant ‘other income’
for the purpose of the above requirement. Thus, for the purpose of disclosure in the
relevant statement of profit or loss, the incomes and expenses should be disclosed
at gross amounts in the normal way.
(c) The requirement stated above has two aspects. Firstly, the items of ‘other income’
should be identified on the basis of criteria dealt with in paras (a) and (b) above.
The second aspect is the disclosures to be made in this regard in the statement of
Profit or loss in the often document. As per the requirement, the following
disclosures should be made with regard to the ‘other income’:
♦ The source
♦ The nature
♦ The amount
♦ Whether recurring or non-recurring
♦ Whether on account of normal business activity or not.
Disclosure of Bifurcated Turnover

The turnover disclosed in the Profit or Loss Statement shall be bifurcated into:
(a) turnover of products manufactured by the company;
(b) turnover of products traded in by the company; and
(c) details of products not normally dealt in by the company but included in (b) above, shall
be mentioned separately. (Para 6.18.7(c) of SEBI (Disclosure and Investor Protection
Guidelines, 2000)
Although, as per the above requirements, the turnover in respect of products manufactured
and traded is required to be disclosed is recommended that separate disclosures should also
be made in respect of turnover from services rendered. For this purpose, turnover of
processed products should be clubbed with the turnover of manufactured products.
As per the requirement, separate disclosure is required of turnover of products ‘not normally’
dealt in by the company. What are the products that are not normally dealt in by the company
should be determined on the basis of the actual facts and circumstances of each case. Those
products should be considered to be not normally dealt in, dealings in respect of which are
non- recurring in nature.
Statement of assets and liabilities

The statement of assets and liabilities prepared after deducting the amount of revaluation
reserve from both fixed assets and reserves and the net worth arrived at after such deduction.
(Para 6.18.7 [b(v)] of SEBI Disclosure and Investor Protection Guidelines, 2000).
The statement of assets and liabilities referred to in the above requirement is the same as that
required to be prepared under Schedule II to the Companies Act, 1956.
The requirement stated above has two aspects. Firstly, the book values of assets and
liabilities should be adjusted to the extent of the corresponding revaluation reserves. The
second aspect is the computation of net worth. For this purpose, all fictitious assets and
revaluation reserves should be excluded.
(B) Financial Information to Be Contained In the Report of the Accountant
Financial information to be contained in the report of the ‘accountant, has been prescribed in
paragraphs 4 and 5 of Part II B of Schedule II to the Companies Act, 1956.
(C) Financial Information In Respect Of Which the Auditor Should Give Separate
Report to Management
It may be noted that apart from financial information contained in categories ‘A’ and ‘B’ dealt
with above, there is some other financial information to be disclosed in the offer document.
Such information has to be provided by the management, but being in the nature of financial
information, it has to be audited by the auditor of the issuer company. The report on this
financial information submitted by the auditor should also be contained in the offer document..
The guidance to the auditor on audit of financial information pertaining to this category is given
in the following paragraphs.
Tax Shelters
Profits after tax are often affected by the tax shelters which are available. Some of these are
of a relatively permanent nature (for example, arising out of export profits) while other may be
limited in point of time (for example, tax holidays for new undertakings). Tax provisions are
Audit Report 8.49
also affected by timing differences which can be reversed in the future (for example, the
differences between book depreciation and tax depreciation). For a proper understanding of
the future tax incidence, these factors shall be identified and explained through proper
disclosures.
The above requires a reconciliation between the income tax as would have been applicable
had it been based on profits as per the statement of profit or loss for the five years period
included in the offer document and the tax expense reflected as provision for taxation based
on actual taxable income so that the incidence of various tax shelters (both temporary and
permanent) is apparent. The auditor should examine whether income tax is computed on the
basis of actual rates on the profits after making adjustments for qualifications in auditor’s
report, previous year adjustments, changes in accounting policies etc.
Accounting Ratios
Disclosure is required to be made of the following accounting ratios for each of the accounting
periods for which financial information is given:
(i) Earnings per share;
(ii) Return on Net Worth; and
(iii) Net Asset Value per share.
The above accounting ratios are required to be disclosed for each of the five financial years.
The components of formulae should also be disclosed in the offer document. The auditor
should satisfy himself that for making various computations for the above accounting ratios,
the various items of profit/loss and assets/liabilities have been adjusted as per the
requirements relating to qualifications in auditor’s report, previous years’ items etc.
(i) Earnings Per Share (EPS)
Earnings per share may be either
(i) basic earnings per share, or
(ii) diluted earnings per share.
(i) Basic earnings per share is the amount of net profit for the period attributable to each
equity share. The disclosure of basic earnings per share is considered useful because:
♦ basic earnings per share relates the net profit or loss for the period to the equity
shares outstanding and thus gives an objective amount of net profit per share;
♦ the calculation of basic earnings per share does not require any assumptions
relating to the future conversion of potential equity shares into equity shares; and
♦ basic earnings per share is readily understandable.
A company may also have ‘potential equity shares’, i.e., instruments or other contracts
that may entitle their holders to equity shares, e.g.,
(a) debentures or other similar instruments and preference shares that are convertible
into equity shares;
(b) share warrants and options which, when exercised, would entitle the holder to
equity shares;
(ii) It may be noted that while disclosure of diluted earnings per share is mandatory as per
the requirement regarding ‘Basis of Issue Price’, it is not so under the aforesaid
requirement under ‘Accounting Ratios’. Thus, under this head disclosure of basic
earnings per share is required. However, both, basic earnings per share and diluted
earnings per share, provide information which is useful in evaluating past performance
and future potential of a company. A company may, therefore, besides disclosing basic
earnings per share, also disclose diluted earnings per share where the dilution is
material.
It should be noted that the term ‘earnings per share’ encompasses loss per share. Thus, in
case of a loss, the auditor should examine that ‘loss per share’ has been disclosed. The
computation of Basic and Diluted Earnings per share can be referred from AS 20.
(ii) Return on Net Worth
Return on Net Worth is computed by using the following formula:
Net proft before extraordinary items but after adjusted tax
× 100
Net worth excluding revaluation reserve as at the end of the year
In the above formula, ‘adjusted tax’ means the provision for taxation for the period after
adjusting for the tax attributable to extraordinary items.
The auditor should satisfy himself that for the purpose of computation of above ratio, it has
been assumed that the net profit accrues evenly during the year. The computation of net
worth is explained earlier. However, in case the assets have been revalued, the effect of
revaluation would be ignored to determine the book value of the assets. In other words, assets
would be valued at historical cost.
(iii) Net Asset Value Per Share
The auditor should check that the net asset value (NAV) has been calculated as per the latest
audited balance sheet date. Net asset value can be computed either by the net assets method
or by the net equity method. Under the former, from the total assets of the company, all
liabilities and preference capital, if any, are deducted. The net asset value as calculated from
the assets side of the balance sheet in the above manner can be cross - checked by
calculating the same by net equity method whereby equity share capital is added to reserves
and surplus, deducting there from miscellaneous expenditure to the extent not written off and
the debit balance of profit and loss account to the extent not adjusted against reserves and
surplus.
The following points, inter alia, should be particularly kept in view by the auditor while
examining the computations of the net asset value whether on net assets basis or net equity
basis:
(i) Intangible assets like goodwill, patents, trade marks, copyrights, etc., have not been
taken into account, unless they have been paid for.
Audit Report 8.51
(ii) Revaluation of assets, if any, have not been taken into account.
(iii) Arrears of preference dividend have been provided for.
NAV per share is calculated as below:
NAV arrived at as above
No. equity shares at the end of the accounting period
Disclosures Under ‘Basis Of Issue Price’

Under the heading ‘Basis for issue price’ the following information shall be disclosed:
(a) (i) Earnings per share, i.e., EPS pre-issue for the last three years (as adjusted for
changes in capital);
(ii) P/E pre-issue and comparison thereof with industry P/E where available (giving the
source from which industry P/E has been taken);
(iii) average return on net worth in the last three years;
(iv) minimum return on increased net worth required to maintain pre-issue EPS;
(v) Net Asset Value per share based on last balance sheet;
(vi) Net Asset Value per share after issue and comparison thereof with the issue price.
Provided that projected earnings shall not be used as a justification for the issue
price in the offer document.
(b) The accounting ratios disclosed in the offer document in support of basis of the issue
price shall be calculated after giving effect to the consequent increase of capital on
account of compulsory conversions outstanding, as well as on the assumption that the
options outstanding, if any, to subscribe for additional capital will be exercised.
Earnings Per Share (EPS)

On a perusal of para 6.13 of SEBI-Disclosure and Investor Protection Guideline , 2000)
reproduced above, it is apparent that all ratios specified under this requirement shall be
adjusted for all outstanding conversions and options. Accordingly, EPS to be disclosed as per
this requirement is the EPS after taking into account all outstanding conversions and options.
The manner of computing the EPS for this purpose would be similar to that used for computing
diluted EPS as discussed above. However, it should be specifically noted by the auditor that
while the diluted EPS as per the above paragraphs is calculated only if the dilution of the
equity shares due to conversions/options results in a reduction in the basic earnings per
share, the EPS under this requirement is to be disclosed even if it is higher than the basic
earnings per share. Thus, the auditor should satisfy himself that the requirements in this
regard have been applied, mutatis mutandis, in calculating EPS under this requirement.
Price/Earnings Ratio (P/E Ratio)

The pre-issue Price/Earnings ratio should be calculated by using the following formula:
Issue price per share

EPS
EPS to be used in the above formula would be that calculated as discussed above.
It may be noted that the issue price per share which is to be used for computing this ratio (and
not the market price per share which is normally used for computation of the Price/Earnings
ratio). Accordingly, for this purpose, issue price per share is required to be used. However,
the P/E ratio of the company based on issue price is to be compared with the industry P/E
ratio based on market price. For the purpose of the industry P/E ratio, the auditor should
check that the market price should be the market price for the industry prevailing within one
month prior to the date of auditor’s report, or as close thereto as possible.
Average Return on Net Worth

The auditor should check that average return on net worth is computed on the basis as
described above. However, since the ratio is also required to be computed after giving effect
to all outstanding conversions and options, the auditor should also examine whether
necessary adjustments have been made as explained above.
For computation of minimum return on increased net worth required to maintain pre-issue
EPS, the increased net worth would be the increased in the net worth after the issue,
presuming the entire capital issue is subscribed and paid up.
Net Assets Value

The auditor should check that the net asset value per share based on last balance sheet is
computed as discussed above. NAV per share after issue should be based on the presumption
that the entire capital issue would be subscribed and paid up. However, since this ratio is also
required to be computed after giving effect to all outstanding conversions and options, the
auditor should examine whether necessary adjustments have been made as explained above.
Capitalisation Statement
A Capitalisation Statement shows total debt and net worth and the debt equity ratios before
and after the issue is made. Where there has been a change in the share capital since the
date as of which the financial information has been disclosed in the offer document, there shall
be a note explaining the nature of the change.
In examining the computation of the debt/equity ratio, the following points should be
considered by the auditor:
(i) Debt includes only long-term debt, for example, debentures, bonds, long-term loans from
financial institutions, etc.
(ii) Preference share capital has been considered as a part of equity, unless it is to be repaid
shortly, e.g., within 12 months.
(iii) Convertible debentures and other loans carrying compulsory conversion clause, to the
extent of convertibility, has been considered as equity.
Audit Report 8.53
(iv) Equity includes paid-up equity share capital, preference capital, and reserves and
surplus after deducting there from the miscellaneous expenditure to the extent not written
off and the debit balance of profit and loss account to the extent not adjusted against
reserves and surplus. Further, adjustments for partly paid shares as stated in paragraph
72 of this Guidance Note have also been made.
It may be noted that two debt/equity ratios would be calculated and disclosed, namely, one for
pre-issue and the other for post - issue.
In case there is any change in the share capital since the date in respect of which the financial
information has been disclosed in the offer document, the auditor should check that there is a
note explaining the nature of the change, for example, issue of bonus shares, issue of shares
to vendors against acquisition of property.
Disclosure Of Project Expenditure

Details of:
(a) actual expenditure incurred on the project (in cases of companies raising capital for a
project) up to a date not earlier than 2 months of filing the prospectus with Registrar of
Companies.
(b) means and source of financing such expenditure;
(c) year wise break-up of the expenditure proposed to be incurred on the said project. (Para
6.6.5 of SEBI Disclosure Investor Protection Guideline, 2000).
It may be noted that the above requirements regarding disclosure of actual expenditure
incurred on the project and the means and sources of financing such expenditure has to be
given up to a date not earlier than two months of filing be prospectus with Registrar of
Companies. Thus, this information may not necessarily reconcile with the information
contained in the statements of profit or loss and assets and liabilities forming part of the offer
document which may have been prepared with reference to a different date.
The auditor should obtain a management representation regarding the details of project
expenditure as per the aforesaid requirements and means and sources of financing such
expenditure. With regard to the verification of information in respect of the aforesaid aspect,
the auditor should follow appropriate audit procedures. A management representation may
also be obtained regarding year wise break-up of the expenditure proposed to be incurred on
the project. However, since the information required to be disclosed as per (c) above is
entirely based on management’s estimates, this need not be audited.
Bridge Loans
Details of “bridge loan” or other financial arrangement, if any, for incurring expenditure on the
project and which would be repaid from the proceeds of the issue. (Para 6.6.5(b) of SEBI
Disclosures Investor Protection Guideline, 2000).
It should be noted that not all ‘bridge loans’ or other financial arrangements made for incurring
expenditure on the project are required to be disclosed; only those ‘bridge loans’ which have
both the characteristics, viz., (a) the loans are for incurring project expenditure and (b) the
loans would be repaid out of the proceeds of the issue, are required to be disclosed. The
auditor should check that the information provided under this requirement reconciles with the
information given pursuant to the requirement as per “loans” given in the following contained
in paragraphs, to the extent relevant. With regard to the audit procedures to be followed in
respect of the above types of loans and other financial arrangements, if any, they would
broadly be the same as that followed in case of audit of loans.
Loans
The offer document should disclose principal terms of loan and assets charged as security
(Para 6 of Part II.B. of Schedule II to the Companies Act, 1956).
The auditor should refer to the relevant loan documents to verify the principal terms of loans
and assets charged as securities.
Accounting Standard for preparation of financial Statement: As per para 6.18.8 of SEBI
(Disclosure and Investor Protection Guidelines, 2000), the issues company, if so desire, may
include in the offer document, the financial statement prepared on the basis of more than one
accounting standards. Subject to disclosure of the material differences arising because of
difference in the accounting policies of two different accounting standards.
The Management Discussion and Analysis and Accounting and Other Ratio computed as per
clause 6.8 and 6.13 of the guidelines shall be based on the financial statements prepared on
the basis of Indian Accounting Standards. In addition, the issuer company may present MDA
based on Other Accounting Standard.
Statement On The Companies (Auditor’s Report) Order, 2003

8.8 The Central Government, in exercise of the powers conferred, under sub-section (4A)
of section 227 of the Companies Act, 1956 (hereinafter referred to as “the Act”), has issued
the Companies (Auditor’s Report) Order, 2003 (hereinafter referred to as “the Order” or “the
CARO, 2003”), vide Notification No. G.S.R. 480(E) dated June 12, 2003. The Order contains
certain matters on which the auditors of companies (except of those categories of companies
which are specifically exempted under the Order) have to make a statement in their audit
report. The Central Government vide Notification No.GSR.766(E) dated November 25, 2004
amended the said Order and issued the Companies (Auditor’s Report) (Amendment) Order,
2004.
General provisions regarding Auditor’s Report

The requirements of the Order are supplemental to the existing provisions of section 227 of
the Act regarding the auditor’s report. It may be noted that the Order is supplemental to the
directions given by the Comptroller and Auditor General of India under section 619 in respect
of government companies. These directions continue to be in force. Therefore, in respect of
government companies, the matters specified in the Order will form part of the auditor’s report
submitted to the members and the replies to the questionnaire issued by the Comptroller and
Auditor General of India under section 619 will continue to be furnished as hitherto. The Order
Audit Report 8.55
is not intended to limit the duties and responsibilities of auditors but only requires a statement
to be included in the audit report in respect of the matters specified therein. For example,
examination of the system of internal control is one of the basic audit procedures employed by
the auditor. The fact that the Order requires a statement regarding the internal control
applicable to purchases of inventories, fixed assets and sale of goods only is no justification
for the auditor to conclude that an examination of internal control regarding the other areas of
a company’s business is not important or not required.
Applicability of the Order
Companies Covered by the Order

The Order applies to all companies except certain categories of companies specifically
exempted from the application of the Order. The Order also applies to foreign companies as
defined in section 591 of the Act. The Order is also applicable to the audits of branch(es) of a
company under the Act since sub-section 3(a) of section 228 of the Act clearly specifies that a
branch auditor has the same duties in respect of audit as the company’s auditor. It is,
therefore, necessary that the report submitted by the branch auditor contains a statement on
all the matters specified in the Order to enable the company’s auditor to consider the same
while complying with the provisions of the Order.
Companies not Covered by the Order

The Order provides that it shall not apply to:
(i) a banking company as defined in clause (c) of section 5 of the Banking Regulation Act,
1949 (10 of 1949);
(ii) an insurance company as defined in clause (21) of section 2 of the Companies Act, 1956
(1 of 1956);
(iii) a company licensed to operate under section 25 of the Companies Act, 1956 (1 of 1956);
and
(iv) a private limited company with a paid-up capital and reserves not more than rupees fifty
lakhs and has not accepted any public deposit and does not have outstanding loan
exceeding rupees ten lakhs or more from any bank or financial institution and does not
have a turnover exceeding rupees five crores.
The Order specifically exempts banking companies, insurance companies and companies
which have been licensed to operate under section 25 of the Act.
The Order also exempts from its application a private limited company which fulfils all the
following conditions:
(i) its paid-up capital and reserves are rupees fifty lakhs or less;
(ii) it has no outstanding loan exceeding rupees twenty five lakhs from any bank or financial
institution; and
(iii) its turnover does not exceed rupees five crores at any point of time during the financial
year.
A private limited company, in order to be exempt from the applicability of the Order, must
satisfy all the conditions mentioned above cumulatively. In other words, even if one of the
conditions is not satisfied, a private limited company’s auditor has to report on the matters
specified in the Order.
(i) Private Limited Company The term “private limited company”, as used in the Order,
should be construed to mean a company registered as a “private company” {as defined in
clause (iii) of sub-section (1) of section 3 of the Act} and which has a limited liability. In other
words, the Order would be applicable to private unlimited companies irrespective of the size of
their paid-up capital and reserves, turnover, borrowings from banks/financial institutions.
(ii) Paid-up Capital and Reserves Sub-section (32) of section 2 of the Act defines the term
“paid-up capital” as capital credited as paid-up. The Guidance Note on Terms Used in
Financial Statements, issued by the Institute of Chartered Accountants of India, defines the
term “paid-up share capital” as, “that part of the subscribed share capital for which
consideration in cash or otherwise has been received. This includes bonus shares allotted by
the corporate enterprise”. Paid-up share capital would include both equity share capital as well
as the preference share capital. While calculating the paid-up capital, amount of calls unpaid
should be deducted from and the amount originally paid-up on forfeited shares should be
added to the figure of paid-up capital. Share application money received should not be
considered as part of the paid-up capital.
For determining the applicability of the Order to a private limited company, both capital as well
as revenue reserves should be taken into consideration while computing the limit of rupees
fifty lakhs prescribed for paid-up capital and reserves. Revaluation reserve, if any, should also
be taken into consideration while determining the figure of reserves for the limited purpose of
determining the applicability of the Order. The credit balance in the profit and loss account
should also be considered as a part of reserve since the balance in the profit and loss account
is available for general purposes like declaration of dividend. The debit balance of the profit
and loss account, if any, should be reduced from the figure of revenue reserves. However,
miscellaneous expenditure to the extent not written off should not be deducted from the figure
of reserves for the purpose of computing the above limit.
(iii) Loan Outstanding Loans from banks or financial institutions are normally in the form of
term loans, demand loans, export credits, working capital limits, cash credits, overdraft
facilities, bills purchased or discounted. Outstanding balances of such loans should be
considered as loan outstanding for the purpose of computing the limit of rupees twenty five
lakhs. Non-fund based credit facilities to the extent such facilities have devolved and have
been converted into fund-based credit facilities should also be considered as outstanding loan.
In case of term loans, interest accrued and due is considered as a loan whereas interest
accrued but not due is not considered as a loan. It is clarified that since the words used by the
Order are ‘any bank or financial institution’, the limit of exceeding twenty five lakh rupees
applies in aggregate to all loans and not with reference to each bank or financial institution.
For example, if a private limited company has three outstanding loans of rupees ten lakhs
Audit Report 8.57
each from two banks and a financial institution, the Order would be applicable to such a
private limited company irrespective of the fulfilment of the other conditions laid down for
exemption from the applicability of the Order.
(iv) Financial Institution Explanation to sub-clause (xi) of Rule 2(b) of the Companies
(Acceptance of Deposits) Rules, 1975 explains the term “financial institution” for the purposes
of the said sub-clause. Therefore, the term “financial institution” used in the Order should be
construed to have the same meaning as assigned to it in the explanation to the said sub-
clause in the Companies (Acceptance of Deposits) Rules, 1975. It may, however, be noted
that a non-banking financial company is not a “financial institution”.
(v) Turnover The term, “turnover”, has not been defined by the Order. Part II of Schedule VI
to the Act, however, defines the term “turnover” as the aggregate amount for which sales are
effected by the company. It may be noted that the “sales effected” would include sale of
goods as well as services rendered by the company. In an agency relationship, turnover is the
amount of commission earned by the agent and not the aggregate amount for which sales are
effected or services are rendered. The term “turnover” is a commercial term and it should be
construed in accordance with the method of accounting regularly employed by the company.
For ascertaining the limit of rupees five crores:
(a) sales tax collected or excise duties collected should not be taken into account if they are
credited separately to sales tax account or excise duty account;
(b) trade discounts should be deducted from the figure of turnover;
(c) commission allowed to third parties should not be deducted from the figure of turnover;
and
(d) sales returns should be deducted from the figure of turnover even if the returns are from
the sales made in the earlier years.
(vi) Date of Determination of Limits The Order does not clarify the point of time at which
various limits laid down by the Order are to be tested for determining its applicability to a
private limited company. It is clarified that the Order would become applicable to a private
limited company. If, at any point of time, during the financial year covered by the audit report:
(a) its paid-up capital and reserves exceed the limit of rupees fifty lakhs; or
(b) its turnover exceeds rupees five crores; or
(c) its turnover exceeds rupees five crore.
Date of Coming into Force of the Order

The Companies (Auditor’s Report) Order, 2003 was issued in June 2003 and comes into force
on the 1st day of July, 2003. The said Order, from the date it came into force, superceded the
MAOCARO, 1988. Further, the Order requires that every report made by the auditor under
section 227 of the Act on the accounts of every company examined by him to which the Order
applies, for every financial year ending on any day on or after the commencement of this
Order, shall contain matters specified in paragraphs 4 and 5 of the Order. This implies that the
auditor’s report, on accounts in respect of financial year ending on or before 30th June 2003,
even if issued on or after 1st July, 2003 is not required to contain report on-matters specified
in the CARO, 2003. However, the auditor’s report, in such cases, should include a statement
on matters specified in the erstwhile MAOCARO, 1988.
The Government’s Notification notifying the Companies (Auditor’s Report) (Amendment)
Order, 2004 clarifies that the Amendment Order would be effective from the date of its
publication in the Official Gazette; i.e., November 25, 2004. Therefore, all audit reports issued
on or after November 25, 2004 are required to comply with amendments contained herein
read with the Companies (Auditor’s Report) Order, 2003 of June 12, 2003.
Matters To Be Included In The Auditor’s Report

Whether the company is maintaining proper records showing full particulars, including
quantitative details and situation of fixed assets. [Paragraph 4(i)(a)]
Comments
1. The clause requires the auditor to comment whether the company is maintaining proper
records showing full particulars, including quantitative details and situation of fixed
assets. Accounting Standard (AS) 10, “Accounting for Fixed Assets” defines “fixed asset”
as an “asset held with the intention of being used for the purpose of producing or
providing goods or services and is not held for sale in the normal course of business”.
2. The Order is silent as to what constitutes ‘proper records’. In general, however, the
records relating to fixed assets should contain, inter alia, the following details:
(i) sufficient description of the asset to make identification possible;
(ii) classification, that is, the head under which it is shown in the accounts, e.g., plant
and machinery, office equipment, etc;
(iii) situation;
(iv) quantity, i.e., number of units;
(v) original cost;
(vi) year of purchase;
(vii) adjustment for revaluation or for any increase or decrease in cost, e.g., on
revaluation of foreign exchange liabilities;
(viii) date of revaluation, if any;
(ix) rate(s)/basis of depreciation or amortisation, as the case may be;
(x) depreciation/amortisation for the current year;
(xi) accumulated depreciation/amortisation;
(xii) particulars regarding impairment;
(xiii) particulars regarding sale, discarding, demolition, destruction, etc.
Audit Report 8.59
3. The records should contain the above-mentioned particulars in respect of all items of
fixed assets, whether tangible or intangible, self-financed or acquired through finance
lease. These records should also contain particulars in respect of those items of fixed
assets that have been fully depreciated or amortised or have been retired from active use
and held for disposal. The records should also contain necessary particulars in respect
of item of fixed assets that have been fully impaired during the period covered by the
audit report.
4. It is necessary that the aggregate original cost, depreciation or amortisation to date, and
impairment loss, if any, as per these records under individual heads should tally with the
figures shown in the books of account.
5. In cases where the original cost cannot be ascertained, Schedule VI to the Act provides
that the book value as at 1st April, 1956 may be considered as cost. For the limited
purpose of determining whether proper records are maintained, it should be considered
as sufficient if, in respect of assets acquired prior to 1st April, 1956 where the original
cost cannot be ascertained, the book value as on that date is considered as the cost.
6. Schedule XIV to the Act provides that depreciation on assets, whose actual cost does not
exceed rupees five thousand, shall be provided at the rate of hundred percent. The
records of fixed assets should include the necessary particulars in respect of such assets
also.
7. The purpose of showing the situation of the assets is to make verification possible. There
may, however, be certain classes of fixed assets whose situation keeps changing, for
example, construction equipment which has to be moved to sites. In such circumstances,
it should be sufficient if record of movement/custody of the equipment is maintained.
8. Where assets like furniture, etc., are located in the residential premises of members of
the staff, the fixed assets register should indicate the name/designation of the person
who has custody of the asset for the time being. In this connection, it may be necessary
for the auditor to consider whether there are good reasons for the asset to be so located.
9. In cases where the details regarding allocation of cost over identified units of assets are
not available, it would have to be made by an analysis of the purchases and the
disposals of the preceding years.
Whether these fixed assets have been physically verified by the management at reasonable
intervals; whether any material discrepancies were noticed on such verification and if so,
whether the same have been properly dealt with in the books of account. [Paragraph 4(i)(b)]
Comments
1. The clause requires the auditor to comment whether the fixed assets of the company
have been physically verified by the management at reasonable intervals. The clause
further requires the auditor to comment whether any material discrepancies were noticed
on such verification and if so, whether those discrepancies have been properly dealt with
in the books of account.
2. Physical verification of the assets has to be made by the management and not by the
auditor. It is, however, necessary that the auditor satisfies himself that such verification
was done and that there is adequate evidence on the basis of which he can arrive at
such a conclusion. The auditor may prefer to observe the verification, particularly when
verification of all assets can be made by the management on a single day or within a
relatively short period of time. If, however, verification is a continuous process or if the
auditor is not present when verification is made, then he should examine the instructions
issued to the staff (which should, therefore, be in writing) by the management and should
examine the working papers of the staff to substantiate the fact that verification was done
and to determine the name and competence of the person who did the verification. In
making this examination, it is necessary to ensure that the person making the verification
had the necessary technical knowledge where such knowledge is required. It is not
necessary that only the company’s staff should make verification. It is also possible for
verification to be made by outside expert agencies engaged by the management for the
purpose.
3. The Order requires the auditor to report whether the management “at reasonable
intervals” has verified the fixed assets. What constitutes “reasonable intervals” depends
upon the circumstances of each case. The factors to be taken into consideration in this
regard include the number of assets, the nature of assets, the relative value of assets,
difficulty in verification, situation and spread of the assets, etc. The management may
decide about the periodicity of physical verification of fixed assets considering the above
factors. While an annual verification may be reasonable, it may be impracticable to carry
out the same in some cases. Even in such cases, the verification programme should be
such that all assets are verified at least once in every three years. Where verification of
all assets is not made during the year, it will be necessary for the auditor to report that
fact, but if he is satisfied regarding the frequency of verification he should also make a
suitable comment to that effect.
4. Apart from the audit procedures mentioned above, it would be appropriate for the auditor
to obtain a management representation letter confirming that the fixed assets are
physically verified by the company in accordance with the policy of the company. The
management representation letter should also mention the periodicity of the physical
verification of fixed assets. The letter should also include the details of the material
discrepancies noticed during the physical verification of the fixed assets. If no
discrepancies were noticed during the physical verification, the management
representation letter should also mention this fact clearly.
If a substantial part of fixed assets have been disposed off during the year, whether it has
affected the going concern. [Paragraph 4(i)(c)]
Comments
1. This clause requires the auditor to comment, in case where a substantial part of the fixed
assets has been disposed off during the year, whether such disposal has affected the
going concern status of the company.
Audit Report 8.61
2. Accounting Standard (AS) 1, “Disclosure of Accounting Policies” states, “the enterprise is

normally viewed as a going concern, that is, as continuing in operation for the
foreseeable future. It is assumed that the enterprise has neither the intention nor the
necessity of liquidation or of curtailing materially the scale of its operations”.
3. The auditor, in the normal course, when planning and performing audit procedures and in
evaluating the results thereof, is required to consider the appropriateness of the going
concern assumption underlying the preparation of financial statements in accordance
with the requirements of Auditing and Assurance Standard (AAS) 16, “Going Concern”.
As a result of such audit procedures and evaluation, if the auditor is of the opinion that
there exists any indication of risk that the going concern assumption might not be
appropriate, the auditor should gather sufficient appropriate audit evidence to resolve, to
his satisfaction, the question regarding the company’s ability to continue operations for
the foreseeable future.
4. The Order does not define the word “substantial”. The response to the issue as to what
constitutes “substantial part of fixed assets” depends primarily upon the facts and
circumstances of each case. The auditor should use his professional judgement to
determine whether an asset or group of assets sold by the company is a substantial part
of fixed assets.
5. The auditor should carry out audit procedures to gather sufficient appropriate audit
evidence to satisfy himself that the company shall be able to continue as a going concern
for the foreseeable future despite the sale of substantial part of fixed assets. These
procedures may include:
(i) discussion with the management and analysis as to the significance of the fixed
asset to the company as a whole;
(ii) scrutiny of the minutes of the meetings of the board of directors and important
committees for understanding the entity’s business plans for the future (for example,
replacement of the substantial part of the fixed asset disposed off with another fixed
asset having more capacity or for taking up a more profitable line of business);
(iii) review of events after the balance sheet date for analysing the effect of such
disposal of substantial part of fixed asset on the going concern.
6. The auditor should also obtain sufficient appropriate audit evidence that the plans of the
management are feasible, are likely to be implemented and that the outcome of these
plans would improve the situation. The auditor should also seek written representation
from the management in this regard.
Whether physical verification of inventory has been conducted at reasonable intervals by the
management. [Paragraph 4(ii)(a)]
Comments
1. Inventories encompass goods purchased and held for resale, for example, merchandise
purchased by a retailer and held for resale, computer software held for resale, or land
and other property held for resale. Inventories also encompass finished goods produced,
or work in progress being produced, by the enterprise and include materials,
maintenance supplies, stores and spares, consumables and loose tools awaiting use in
the production process. It may be noted that packing materials are also included in
inventories. Inventories do not include machinery spares covered by Accounting
Standard (AS) 10, “Accounting for Fixed Assets”, which can be used only in connection
with an item of fixed asset and the use of which is expected to be irregular.
2. Physical verification of inventory is the responsibility of the management of the company
which should verify all material items at least once in a year and more often in
appropriate cases. It is, however, necessary that the auditor satisfies himself that the
physical verification of inventories has been conducted at reasonable intervals by the
management and that there is adequate evidence on the basis of which the auditor can
arrive at such a conclusion. For example, the auditor may examine the documents
relating to physical verification conducted by the management during the year as also at
the end of the financial year covered by the auditor’s report.
3. What constitutes “reasonable intervals” depends on circumstances of each case. The
periodicity of the physical verification of inventories depends upon the nature of
inventories, their location and the feasibility of conducting a physical verification. The
management of a company normally determines the periodicity of the physical
verification of inventories considering these factors. Normally, wherever practicable, all
the items of inventories should be verified by the management of the company at least
once in a year. It may be useful for the company to determine the frequency of
verification by ‘A-B-C’ classification of inventories, ‘A’ category items being verified more
frequently than ‘B’ category and the latter more frequently than ‘C’ category items.
Are the procedures of physical verification of inventory followed by the management
reasonable and adequate in relation to the size of the company and the nature of its business?
If not, the inadequacies in such procedures should be reported. [Paragraph 4(ii)(b)]
Comments
1. This clause requires the auditor to comment on the reasonableness and adequacy of the
inventory verification procedures followed by the management of the company. In case
the procedures of physical verification of inventories, in the opinion of the auditor, are not
reasonable and adequate in relation to the size of the company and the nature of its
business, the auditor has to report the same.
2. While the physical verification of inventories is primarily the duty of the management, the
auditor is expected to examine the methods and procedures of such verification. The
auditor may, if considered appropriate by him, be also present at the time of stock-taking.
The auditor should establish the reasonableness and adequacy of procedures adopted
for physical verification of inventories having regard to the nature of inventories, their
locations, quantities and feasibility of conducting the physical verification. This would
require the auditor to make use of his professional judgement. The AAS-34, Audit
Audit Report 8.63
Evidence – Additional Consideration for Specific Items, lays down the guidance
regarding the audit procedures to be applied for physical verification of inventory.
3. While commenting on this clause, the auditor should point out the specific areas where
he believes the procedure of inventory verification is not reasonable or adequate.
Whether the company is maintaining proper records of inventory and whether any material
discrepancies were noticed on physical verification and if so, whether the same have been
properly dealt with in the books of account. [Paragraph 4(ii)(c)]
Comments
1. The clause requires the auditor to comment whether the company is maintaining proper
records of inventory. The clause also requires the auditor to comment whether any
material discrepancies were noticed on physical verification of inventory and if so,
whether those material discrepancies have been properly dealt with in the books of
account.
2. What constitutes “proper records” has not been defined. However, in general, records
relating to inventories should contain, inter alia, the following:
(i) particulars of the item like nomenclature, nature, etc.
(ii) identification code of the item;
(iii) details regarding quantity of the receipts, issues, balances and dates of transactions
in a chronological manner;
(iv) relevant document number and department identification, if any;
(v) location.
3. If priced stores ledger is maintained, the records of the inventory should also disclose the
prices at which the recording of the issues and receipts is made.
4. The records should contain the particulars in respect of all items of inventories. The
auditor should also satisfy himself that the stock registers are updated as and when the
transactions occur. The auditor should also verify that the transactions entered in stock
registers are duly supported by relevant documents.
Has the company either granted or taken any loans, secured or unsecured to/from companies,
firms or other parties covered in the register maintained under section 301 of the Act. If so,
give the number of parties and amount involved in the transactions. [Paragraph 4 (iii)(a)]
Comments
1. The duty of the auditor, under this clause, is to determine whether the company has
either granted or taken any loans, secured or unsecured to/from companies, firms or
other parties in the register maintained under section 301 of the Act. If the company has
done so, the clause requires that the auditor’s report should disclose the “number of
parties” and “amount involved” in such cases.
For this purpose, the auditor should obtain a list of companies, firms or other parties
covered in the register maintained under section 301 of the Act from the management.
The auditor is required to disclose the requisite information in his report in respect of all
parties covered in the register maintained under section 301 of the Act irrespective of the
period to which such loan relates.
2. It may so happen that a party listed in the register maintained under section 301 of the
Act might take a loan from the company and repays it to the company during the financial
year concerned. Similar situation may exist in the case of loans taken by the company.
Therefore, while examining the loans, the auditor should also take into consideration the
loan transactions that have been squared-up during the year and report such
transactions under the clause.
Whether the rate of interest and other terms and conditions of loans given or taken by the
company, secured or unsecured, are prima facie prejudicial to the interest of the company.
[Paragraph 4 (iii)(b)]
Comments
1. This clause, read with Paragraph 4(iii)(a) of the Order, requires the auditor to examine
and comment whether the rate of interest and other terms and conditions of loans given
or taken by the company (whether secured or unsecured) to companies, firms or other
parties covered in the register maintained under section 301 of the Act are prima facie
prejudicial to the interest of the company
2. The auditor’s duty is to determine whether, in his opinion, the rate of interest and other
terms and conditions of the loans given or taken are prima facie prejudicial to the interest
of the company. The “other terms” would primarily include security, terms and period of
repayment and restrictive covenants, if any. In determining whether the terms of the
loans are “prima facie” prejudicial, the auditor would have to give due consideration to a
number of factors connected with the loan, including the company’s/borrower’s financial
standing, its ability to borrow/lend, the nature of the security, the availability of alternative
sources of finance, the urgency of the borrowing, purpose of the loan, prevailing market
rate of interest and so on.
3. It may be mentioned that clause (a) of sub-section (1A) of section 227 of the Act also
requires the auditor to inquire whether loans and advances made by the company on the
basis of security have been properly secured and whether the terms on which they have
been made are not prejudicial to the interests of the company or its members. The
auditor’s inquiry under the aforesaid clause may also be useful for the purposes of
reporting under this clause.
Whether the payment of principal amount and interest are also regular. [Paragraph 4 (iii)(c)]
Comments
1. This part of the clause requires the auditor to report upon the regularity of payment of
principal amount of loans and interest thereon. Again, read with clause 4(iii)(a) of the
Audit Report 8.65
Order, the scope of auditor’s inquiry under this clause shall be restricted in respect of
companies, firms or other parties covered in the register maintained under section 301 of
the Act.
2. The auditor has to examine whether the payment of principal and interest is regular. The
word ‘regular’ should be taken to mean that the principal and interest should normally be
paid or received whenever they fall due respectively. If a due date for payment of
interest is not specified, it would be reasonable to assume that it falls due annually.
3. Where no stipulation has been made for the repayment of the loan , the auditor is not in a
position to make any specific comments. However, the auditor should state the fact that
he has not made any comments because the terms of repayment have not been
stipulated.
If overdue amount is more than one lakh, whether reasonable steps have been taken by the
company for recovery/payment of the principal and interest. [Paragraph 4(iii)(d)]
Comments
1. This clause requires the auditor to state whether reasonable steps have been taken by
the company for recovery/payment of the principal and interest, wherever the overdue
amount is more than rupees one lakh. A loan is considered to be overdue when the
payment has not been made or received on the due date as per the borrowing/lending
arrangements. In such cases, the auditor has to examine the steps, if any, taken for
recovery/repayment of this amount. It may, however, be noted that the scope of the
auditor’s inquiry under this clause is restricted to loans given to/taken by the company to
parties covered in the register maintained under section 301 of the Act.
2. In making this examination, the auditor would have to consider the facts and
circumstances of each case, including the amounts involved. It is not necessary that
steps to be taken must necessarily be legal steps. Depending upon the circumstances,
the degree of delay in recovery/repayment and other similar factors, issue of reminders
or the sending of an advocate’s or solicitor’s notice, may amount to “reasonable steps”
even though no legal action is taken. The auditor is not, therefore, required to comment
adversely on the mere absence of legal steps if he is otherwise satisfied that reasonable
steps have been taken by the company. The auditor should ask the management to give
in writing the steps which have been taken. The auditor should arrive at his opinion only
after consideration of the management’s representations.
Is there an adequate internal control procedure commensurate with the size of the company
and the nature of its business, for the purchase of inventory and fixed assets and for the sale
of goods? Whether there is a continuing failure to correct major weaknesses in internal
control. [Paragraph 4(iv)]
Comments
1. The clause requires the auditor to comment whether there is an adequate internal control
procedure commensurate with the size of the company and the nature of its business, for
the purchase of inventory, fixed assets and sale of goods. Further, the clause also
requires the auditor to report whether there is a continuing failure by the company to
correct major weaknesses in the internal controls in regard to purchase of inventory,
fixed assets and the sale of goods and services.
2. “Internal Control System” means all the policies and procedures (internal controls)
adopted by the management of an entity to assist in achieving management’s objective
of ensuring, as far as practicable, the orderly and efficient conduct of its business,
including adherence to management policies, the safeguarding of assets, prevention and
detection of fraud and error, the accuracy and completeness of the accounting records,
and the timely preparation of reliable financial information.
3. In making the evaluation, the auditor has to give due regard not merely to the size of the
company and the nature of its business but also to the organisational structure. This
suggests that whereas detailed internal control procedures may be absolutely essential
for a large company with a diversified business operating at several locations, internal
control may be less formal in an “owner-managed” or a small company where there is a
greater degree of personal supervision. Reference in this regard may also be made to
paragraph 49 of the Auditing and Assurance Standard (AAS) 6, “Risk Assessments and
Internal Control”.
4. The auditor should review the reports of internal auditor, if any. The reports of internal
auditors may point out cases of weaknesses in the design of internal controls and non-
observance of the laid down controls. The auditor should also review the minutes of the
meetings of the board of directors and audit committee, if any, with a view to determine
the cases of weaknesses in internal controls. The auditor may come across situations
where a weakness in internal control has been placed before the board of directors or the
audit committee but the same has not been considered. Such cases may point out the
instances where there is a continuing failure to correct a major weakness in internal
controls. The auditor should also review his previous years’ working papers to determine
the weaknesses in the internal controls, if any, already communicated to the
management. Further, the Auditor should examine the follow-up actions taken by the
management in response to weaknesses communicated to the management.
5. In case there is a continuing failure on the part of the company to correct major
weakness in the internal controls, the auditor should also make a re-assessment of the
control risk, at the assertion level, for each material account balance or class of
transactions related to purchase of inventory, fixed assets and sale of goods so that
appropriate audit procedures can be designed to reduce the overall risk to an acceptably
low level. Further, if the auditor is of the opinion that the major weaknesses in the internal
control have serious implications on the adequacy or reliability of the books of account of
the company, the auditor should consider modifying his audit report on the financial
statements. Where the auditor decides to do so, he should comply with the requirements
of the Auditing and Assurance Standard (AAS) 28, “The Auditor’s Report on the Financial
Statements” in this regard.
Whether of the particulars or arrangements referred to in section 301 of the Act have been
Audit Report 8.67
entered in the register required to be maintained under that section. [Paragraph 4(v) (a)]
Comments
1. This part of the clause requires that the auditor should report whether the transactions
that need to be entered into a register in pursuance of section 301 of the Act have been
so entered. Section 301 of the Act requires that every company shall keep one or more
registers in which shall be entered separately particulars of all contracts or arrangements
to which sections 297 and 299 of the Act apply. The following are salient features of
sections 301, 297 and 299 of the Act:
(i) Under section 301 of the Act, every company is required to maintain one or more
registers which contains the particulars of all contracts or arrangements to which
section 297 or section 299 of the Act applies. The particulars of contracts and
arrangements required to be entered in the register maintained under section 301
include, among other things, names of the parties to the contract or arrangement.
(ii) Under section 297 of the Act, except with the consent of the Board of Directors of a
company, a director of the company or his relative, a firm in which, a director or his
relative is a partner or any other partner in such a firm, or a private company of
which the director is a member or director, shall not enter into any contract with the
company –
(a) for the sale, purchase or supply of any goods, materials or services; or
(b) after the commencement of this Act, for underwriting the subscription of any
shares in or debentures of, the company.
It may also be noted that in the case of a company having a paid-up capital of not
less than rupees one crore, no such contract can be entered into without the
previous approval of the Central Government. Whenever a contract, to which
section 297 applies, is entered into, the board of directors accords its approval by a
resolution passed at a meeting of the Board, before the date the contract is entered
into or within three months of the date on which the contract was entered into. The
particulars of such contracts or arrangements including names of the parties to the
contract or arrangement are required to be entered into the register maintained
under section 301 of the Act.
(iii) Under section 299 of the Act, every director of a company, who is in any way,
whether directly or indirectly, concerned or interested in a contract or arrangement,
or proposed contract or arrangement, entered into or to be entered into, by or on
behalf of the company, is required to disclose the nature of his concern or interest
at a meeting of the Board of Directors. The disclosure required under section 299
of the Act can be made by a director either at a meeting of the Board under sub-
section (2) or by way giving a general notice for disclosure of interest to the Board
of Directors under sub-section (3) of section 299 of the Act. The disclosure of
interest is made in Form 24AA of Companies (Central Government’s) General Rules
& Forms, 1956. Based on the disclosures made by directors in Form 24AA,
particulars of contracts and arrangements including, among other things, the names
of the parties concerned are entered into the register maintained under section 301
of the Act.
2. It may, however, be noted that as per section 299(6) of the Act, the requirements of
section 301 of the Act do not apply to a contract or arrangement entered into or to be
entered into between two companies where any of the directors of one of the company or
two or more of them together holds or hold not more than two percent of the paid-up
share capital in the other company. For example, the mere fact that a director is a
shareholder in a public limited company will not mean that he is interested unless, of
course he, together with other directors, holds more than 2% or more of the share
capital.
3. The auditor should verify, on the basis of information provided by the management and
on the basis of the results of the procedures performed by him, whether transactions that
need to be entered into a register in pursuance of section 301 of the Act have been so
entered or not. The auditor also evaluates whether the registers under section 301 are
updated and maintained properly. The auditor should also examine, wherever applicable,
secretarial compliance certificate issued under section 383A of the Act in regard to the
completeness of the register maintained under section 301 of the Act.
Whether transactions made in pursuance of such contracts or arrangements have been made
at prices which are reasonable having regard to the prevailing market prices at the relevant
time. [Paragraph 4(v) (b)]
[This information is required only in case of transactions exceeding the value of five lakh
rupees in respect of any party and in any one financial year.]
Comments
1. This clause requires the auditor to comment upon the reasonableness of the prices of
all the transactions, which have been entered in pursuance of contracts or arrangements
covered in the register(s) maintained under section 301 of the Act if such transactions in
respect of any party and in any one financial year exceed the value of rupees five lakhs. The
auditor is required to determine the reasonableness of prices having regard to the prevailing
market prices at the relevant time. It is clarified here that the scope of the auditor’s inquiry
under this clause is restricted to such transactions to which sections 297 and 299 of the Act
apply and thereby required to be entered in the register maintained under section 301 of the
Act.
2. The auditor is not expected to make a roving market inquiry to determine the market
prices prevailing at the time the transactions were entered into. However, he may examine
information such as price lists, quotations, and records relating to prices at which similar
transactions have been entered into with other parties, etc., at the relevant time. The auditor
has to satisfy himself, taking into account all the relevant information as well as any
explanations given by the management, whether the prices at which various transactions have
been made are reasonable. In determining the reasonableness of the prices, the auditor
should take into account all the factors surrounding the transactions such as the delivery
Audit Report 8.69
period/schedule of implementation, the quality and the quantity of the product/service, the
credit terms, the previous record of supplier/buyer/client, etc. For example, in a transaction of
purchase, it is not necessary that purchases be made in all cases at the lowest rates. When
the rates paid are higher than the prevailing market prices, the auditor have to use his
professional judgement to determine whether the difference in rates is reasonable having
regard to the other factors mentioned above. This may often be the case where the company
wishes to have more than one source of supply or where there is limit to the manufacturing
capacity of the supplier who quotes a lower price.
In case the company has accepted deposits from the public, whether directives issued by the
Reserve Bank of India and the provisions of sections 58A and 58AA or any other relevant
provisions of the Act and the rules framed there under, where applicable, have been complied
with. If not, the nature of contraventions should be stated; if an order has been passed by
Company Law Board or National company Law Tribunal or Reserve bank of India or any Court
or any other Tribunal whether the same has been complied with or not ?[ Paragraph 4(vi)]
Comments
1. The clause, in addition to requiring the auditors to report on compliance with the
requirements of section 58A and the directives of the Reserve Bank of India for
acceptance of public deposits, also requires the auditor to:
(i) report on compliance with the provisions of section 58AA of the Act; and
(ii) report on compliance with the order, if any, passed by the company Law Board or
National company Law Tribunal or Reserve Bank of India or any Court or any other
Tribunal.
2. Section 58A of the Act empowers the Central Government to prescribe, in consultation
with the Reserve Bank of India, the limits up to which, the manner in which and the
conditions subject to which deposits may be invited or accepted by a company either
from the public or from its members. The section does not apply to a banking company or
to such other company as the Central Government may, after consultation with the
Reserve Bank of India, specify in that behalf.
3. On 3rd February 1975, the Central Government issued the Companies (Acceptance of
Deposits) Rules, 1975. The Rules apply only to such companies as are not banking
companies and are also not financial companies. Thus, financial companies are not
covered by the Rules. Such companies continue to be governed by the directives issued
by the Reserve Bank of India.
4. Section 58AA was inserted by the Companies (Amendment) Act, 2000 with effect from
13th December 2000. The section deals with small depositors. According to the section, a
small depositor is a depositor who has deposited in a financial year, a sum not exceeding
twenty thousand rupees in a company. The section lays down certain requirements to be
complied with by the companies which have accepted deposits from such small
depositors. Audit considerations similar to those that have been mentioned for section
58A would apply in regard to section 58AA also.
5. Non-compliance of section 58AA would occur in the event when a company fails to
intimate the Company Law Board any default in repayment of deposit made by small
depositors or part thereof or any interest thereupon. The auditor has to, therefore, first
determine whether there is a default in any repayment of such deposits. This would
require the auditor to examine all the accounts related to small depositors. In case where
a company has large number of deposits accepted from small depositors, it may not be
feasible for the auditor to first verify each account for default in repayment and then
check whether the company has complied with the requirements of section 58AA of the
Act. The auditor, in such a case, should examine the internal control in place in this
regard and determine its efficacy. The auditor should obtain a schedule of repayment of
loans taken from small depositors from the management of the company. The auditor,
thereafter, should make reasonable test checks of the repayments made by the
company. In case the results of the test check reveal that the management has
defaulted in repayment of deposits made by small depositors or part thereof or interest
thereupon, the auditor should examine whether the same has been intimated to the
Company Law Board.
6. Apart from the audit procedures mentioned above, the auditor should also enquire of the
management about the possible instances of non-compliance with sections 58A, 58AA
and the relevant rules. The auditor should also enquire of the management about any
order passed by the Company Law Board for contravention of sections 58A, 58AA and
the relevant rules. The auditor should obtain a management representation to the effect
whether:
(a) the company has complied with the directives issued by the Reserve Bank of India
and the provision of section 58A and 58AA of the Act and the relevant rules; and
(b) Where an order has been passed by the Company Law Board, the company has
complied with the requirements of the Order.
In the case of listed companies and/or other companies having a paid-up capital and reserves
exceeding Rs.50 lakhs as at the commencement of the financial year concerned, or having an
average annual turnover exceeding five crores rupees for a period of three consecutive
financial years immediately preceding the financial year concerned, whether the company has
an internal audit system commensurate with its size and nature of its business. [Paragraph
4(vii)]
Comments
1. This clause requires the auditor to comment whether the company has an internal audit
system commensurate with the size and nature of the business. The clause is required
to be commented upon by the auditor in case of companies having a paid-up capital and
reserves exceeding rupees 50 lakhs as at the commencement of the financial year
concerned, or having an average annual turnover exceeding five crores rupees for a
period of three consecutive financial years immediately preceding the financial year
concerned. ‘Financial year concerned’ means the financial year under audit.
Audit Report 8.71
2. This clause has a mandatory application for the listed companies irrespective of the size
of paid-up capital and reserves or turnover. It may be noted that the Order does not
specify the date with reference to which the listing status of the company should be
determined. In this regard, it is clarified that if the company is listed on a recognised
stock exchange as on the date of the balance sheet, it should be considered as listed for
the purpose of this clause. In respect of non-listed companies the clause is applicable
only if:
(i) the paid-up capital and reserves of the company are more than rupees fifty lakhs
as at the commencement of the financial year; or
(ii) average annual turnover exceeds rupees five crores for a period of three
consecutive financial years immediately preceding the financial year concerned.
3. The auditor has to examine whether the internal audit system is commensurate with the
size of the company and the nature of its business. The following are some of the factors
to be considered in this regard:
(i) What is the size of the internal audit department? In considering the adequacy of
internal audit staff, it is necessary to consider the nature of the business, the
number of operating points, the extent to which control is decentralised, the
effectiveness of other forms of internal control, etc.
(ii) What are the qualifications of the persons who undertake the internal audit work?
Internal auditing, as its name implies, is an aspect of audit and, therefore, it is
reasonable to expect that the internal audit department should normally be headed
by a chartered accountant and that, depending upon the size of the department, it
employs other qualified persons. In deciding the adequacy of the internal audit
department, it is, therefore, necessary that there is adequate number of qualified
personnel.
(iii) To whom does the internal auditor report? In general, the higher the level to which
the internal auditor reports, the greater will be his independence.
(iv) What are the areas covered by the internal audit? Internal audit can cover a large
number of areas including operational auditing, organisation and methods studies,
special investigations and the like. For the purposes of the Order, however, the
important areas which should be covered by internal audit are the examination of
the operating systems to ensure that the systems are adequate and functioning in
practice.
(v) Has the internal auditor adequate technical assistance? In a number of companies,
where the operations are highly technical in nature, an internal auditor cannot
function effectively unless he has adequate technical assistance. This can be
provided either by having full-time technically qualified persons in the internal audit
department or by such persons being deputed to the internal audit department for
specific assignments. Similar considerations would apply where a large part of the
transactions are computerised. In such cases, the internal auditor should have the
assistance of persons who are able to audit computer systems.
(vi) What are the reports which are submitted by the internal auditor or what other
evidence is there of his work? It is important that the auditor should satisfy himself
that not merely does an internal audit system exist but also that it is functioning
effectively. He can do so by examining the reports submitted by the internal auditor.
(vii) What is the follow-up? It is not sufficient that the internal audit system should point
out errors in operation or deficiencies in the internal control system. It is equally
necessary that there is an adequate follow-up system to ensure that the errors
pointed out are corrected and remedial action taken on the deficiencies reported
upon.
4. The auditor should examine the minutes of the meetings of the audit committee, if any.
These minutes would provide the auditor with useful evidence regarding the efficiency
and efficacy of the internal audit system.
Where maintenance of cost records has been prescribed by the Central Government under
clause (d) of sub-section (1) of Section 209 (1) (d) of the Act, whether such accounts and
records have been made and maintained. [Paragraph 4(viii)]
Comments
1. Section 209 (1) (d) of the Act requires a company pertaining to a class of companies
engaged in production, processing, manufacturing or mining activities to maintain proper
books of account showing particulars relating to utilization of material or labour or to
other items of cost as may be prescribed, if the Central Government requires such class
of companies to maintain such records. Pursuant to this requirement and in exercise of
the powers conferred by sub-section (1) of section 642, the Central Government has
made rules in respect of a number of classes of companies. These books of account and
records form part of the books of account of the company within the meaning of section
209.
2. The Cost Accounting Records Rules issued for various industries contain requirements
relating to two matters:
(i) maintenance of proper books of account relating to materials, labour, and other
items of cost; and
(ii) preparation of cost statements at the end of the financial year in accordance with
the rules specific to the industry concerned.
While the records relating to materials, labour, etc., are required to be maintained on a
day-to-day basis, the cost statements have to be prepared periodically.
3. The Order requires the auditor to report whether cost accounts and records have been
made and maintained. The word “made” applies in respect of cost accounts (or cost
statements) and the word “maintained” applies in respect of cost records relating to
materials, labour, overheads, etc. The auditor has to report under the clause irrespective
of whether a cost audit has been ordered by the Central Government. The auditor should
obtain a written representation from the management stating (a) whether cost records are
Audit Report 8.73
required to be maintained for any product(s) of the company under section 209(1)(d); and
(b) whether cost accounts and records are being made and maintained regularly. The
auditor should also obtain a list of books/records made and maintained in this regard.
The Order does not require a detailed examination of such records.
4. The Order does not require a detailed examination of such records. The auditor should,
therefore, conduct a general review of the cost records to ensure that the records as
prescribed are made and maintained. He should, of course, make such reference to the
records as is necessary for the purposes of his audit.
Is the company regular in depositing undisputed statutory dues including Provident Fund,
Investor Education and Protection Fund, Employees’ State Insurance, Income-tax, Sales-tax,
Wealth tax, Custom Duty, Excise Duty, Cess and any other statutory dues with the appropriate
authorities and if not, the extent of the arrears of outstanding statutory dues as at the last day
of the financial year concerned for a period of more than six months from the date they
became payable, shall be indicated by the auditor. [Paragraph 4(ix) (a)]
Comments
1. This clause requires the auditor to report upon the regularity of the company in
depositing undisputed statutory dues including provident fund, investor education and
protection fund, employees’ state insurance, income-tax, sales-tax, wealth-tax, custom
duty, excise duty, cess and any other statutory dues to appropriate authorities. If the
company is not regular in depositing the above mentioned undisputed statutory dues, the
auditor is required to state the extent of arrears of statutory dues which have remained
outstanding as at the last day of the financial year concerned for a period of more than
six months from the date they became payable.
2. It may be noted that the use of the words “any other statutory dues” indicates that the
clause covers all type of dues under various statues which may be applicable to a
company having regard to its nature of business.
3. The intention of the Government, in this clause is to ascertain how regular the company
is in depositing statutory dues with the appropriate authorities. Since the emphasis of
the clause is on the regularity, the scope of auditor’s inquiry is restricted to only those
statutory dues which the company is required to deposit regularly to an authority.
4. It may be noted that the auditor has to report on the regularity of deposit of statutory
dues irrespective of the fact whether or not there are any arrears on the balance sheet
date. This is because there may be situations where a company has deposited the
relevant dues before the end of the year while it has been in default in the matter for a
significant part of the year. In cases where there are no arrears on the balance sheet
date but the company has been irregular during the year in depositing the statutory dues,
the auditor should state this fact in his audit report.
5. For the purpose of this clause, the auditor should consider a matter as “disputed” where
there is a positive evidence or action on the part of the company to show that it has not
accepted the demand for payment of tax or duty, e.g., where it has gone into appeal. For
this purpose, where an application for rectification of mistake (e.g., under section 154 of
the Income Tax Act, 1961) has been made by the company, the amount should be
regarded as disputed. Where the demand notice/intimation for the payment of a statutory
due is for a certain amount and the dispute relates only to a part and not the whole of
such amount, only such amount should be treated as disputed and the balance amount
should be regarded as undisputed.
6. It may be noted that penalty and/or interest levied under the respective laws would be
covered within the term “amounts payable”.
7. The auditor should obtain a written representation with reference to the date of the
balance sheet from the management -
(i) specifying the cases and the amounts considered disputed;
(ii) containing a list of the cases and the amounts in respect of the statutory dues which
are undisputed and have remained outstanding for a period of more than six months
from the date they became payable;
(iii) containing a statement as to the completeness of the information provided by the
management.
8. While the auditor has to report upon the regularity of the deposit, he is not required to
specify in detail each instance where there has been a delay or the extent of the delay. It
should be sufficient if he indicates whether generally the deposits have been regular or
otherwise.
In case dues of sales tax/income tax/custom tax/wealth tax/excise duty/cess have not been
deposited on account of any dispute, then the amounts involved and the forum where dispute
is pending may please be mentioned. [Paragraph 4(ix)(b)]
{A mere representation to the Department shall not constitute the dispute.}
Comments
1. This clause requires that in case of disputed statutory dues, the amounts involved should
be stated along with the forum where the dispute is pending.
2. It is clarified here that mere representation to the concerned Department does not
constitute dispute. According to the Order, it is necessary that there should be an appeal
before the relevant appellate authority. It is, however, reiterated that where an
application for rectification of mistake (.e. , under Section 154 of the Income tax Act,
1961) has been made by the company, the amount should be regarded as disputed.
3. A show-cause or similar notice generally contains the requirements /queries of the
assessing officer. Normally, issuance of a show cause notice by the concerned
department should not be construed to be a demand payable by the company. However,
in some cases, a show cause notice and demand may be combined in one document.
Normally, in such cases, the demand would not be constructed to have arisen till the time
the assessee has disposed off the requirements of the show cause order. Hence, it
would be necessary to evaluate each situation individually.
Audit Report 8.75
4. It is possible that in respect of same nature of statutory dues, there may be more than
one dispute pertaining to different periods for which, appeals might have been filed
separately. For example, different years’ income tax liabilities might have been disputed
at different levels of appellate authorities. Hence, in such cases, the information required
by the clause should be given separately in respect of each period.
The information required by the clause may be reported in the following format:
Statement of Disputed Dues
Name of the Nature of the Amount (Rs.) Period to which Forum where
Statute Dues the amount dispute is
relates pending
Whether in case of a company which has been registered for a period not less than five years,
its accumulated losses at the end of the financial year are not less than fifty per cent of its net
worth and whether it has incurred cash losses in such financial year and in the immediately
preceding financial year. [Paragraph 4(x)]
Comments
1. The clause is applicable to all the companies that are in existence for more than five
years from the date of registration till the last day of the financial year covered by the
auditor’s report. The clause requires the auditor to report:
whether the accumulated losses at the end of the financial year are more than 50% of its
net worth; and
whether the company has incurred cash losses during the period covered by the report
and in the financial year immediately preceding the period covered by the report.
2. A question arises about the exact connotation of the term “loss” for ascertaining the
amount of accumulated losses. More specifically, the issue is whether, for the purpose of
reporting by the auditor, the net loss shown by the profit and loss account should be
taken as the loss or whether any adjustments need to be made in the figure of such net
profit/loss. The term “loss” should be construed to mean the net profit/loss shown by the
profit and loss account of the company as adjusted after taking into account qualifications
in the audit report to the extent the qualifications are quantified.
3. Section 2(29A) of the Act defines the term “net worth” as “sum total of the paid-up capital
and free reserves after deducting the provisions or expenses as may be prescribed”.
The explanation to the definition further provides that for the purpose of this definition,
“free reserves” means all reserves created out of profits and share premium account but
does not include reserves created out of revaluation of assets, write back of depreciation
provisions and amalgamation. The provisions or expenses to be deducted from the paid-
up capital and reserves for calculating net-worth have not yet been prescribed. It,
thereby, implies that the ‘net worth’ is the sum total of the paid-up capital and free
reserves until the provisions or expenses to be deducted therefrom are prescribed under
section 2(29A) of the Act. The figure of net worth computed from the balance sheet of
the company should also be adjusted for the effect of qualifications in the audit report to
the extent the qualifications are quantified.
4. The figure of cash loss of the company for the financial year covered by the audit report
and the immediately preceding financial year should also be adjusted for the effect of
qualifications in the respective audit reports to the extent the qualifications are quantified.
5. The auditor while reporting on this clause should indicate that his opinion on the matters
specified in the clause has been arrived at after considering the effect of the
qualifications on the figures of accumulated losses, net worth and cash losses. Where
any of the qualifications in the audit report is not capable of being quantified, the auditor
should state that the effect of such unquantified qualification(s) has not been taken into
consideration for the purpose of making comments in respect of this clause.
Whether the company has defaulted in repayment of dues to a financial institution or bank or
debenture holders? If yes, the period and amount of default to be reported. [Paragraph 4 (xi)]
Comments
1. Under this clause, the auditor is required to report whether the company has defaulted in
repayment of dues to a financial institution or bank or to debenture holders. If the answer
is in the affirmative, the auditor is also required to mention the period of default and the
amount of default. Dues to financial institutions,banks or debenture holders would
include the principle as well as interest.
2. A question that arises is whether the scope of the auditor’s inquiry would cover defaults
made by the company during the year only or whether the defaults committed in previous
years and continuing until the year end would also be covered. It is clarified that the
auditor should report the period and amount of all defaults existing at the balance sheet
date irrespective of when those defaults have occurred.
3. The auditor should obtain a schedule of repayments to banks, financial institutions and
debenture holders from the management of the company. The schedule should indicate
the amount and the due dates of the payments that the company is required to make to
banks, financial institutions and debenture holders.
4. The auditor should examine the agreement or other documents containing the terms and
conditions of the loans and borrowings of the company from banks and financial
institutions. The auditor should also examine the debenture trust deed. This examination
would enable the auditor in verifying the amount and due dates of the payments
mentioned in schedule of repayments provided by the management of the company. The
auditor should then verify whether the repayments as per the books of account are in
accordance with the terms and conditions of the relevant agreement. The auditor should
also satisfy himself that the repayment have actually been made to the party concerned.
5. It may happen that the company might have submitted application for
reschedulement/restructuring proposals to the lenders, which may be in different stages
of processing. Submission of application for reschedulement/restructuring does not mean
that no default has occurred. Accordingly, in such situations also the auditor should
Audit Report 8.77
report the period of default and the amount of default. However, if the application for
reschedulement of loan has been approved by the concerned bank or financial institution
or if the default has been made good by the company during the accounting period
covered by the auditor’s report, the auditor should state in his audit report the fact of
reschedulement of loan or the fact of default having been made good.
6. The auditor may come across a situation where there may be disputes between the
company and the lender on certain issues relating to repayments. In all such situations,
the auditor should give a disclaimer that since there is a dispute between the company
and the lender; he is unable to determine whether there is a default in repayment of dues
to the lender concerned.
7. The following is an example of negative reporting under the clause:
“The company has defaulted in repayment of dues to debenture holders. Debentures
amounting to Rs.50,00,000/- became due for redemption on 30th May 20X4 which were
redeemed by the company on 15th March 20X5.”
Whether adequate documents and records are maintained in cases where the company has
granted loans and advances on the basis of security by way of pledge of shares, debentures
and other securities; If not, the deficiencies to be pointed out. [Paragraph 4 (xii)]
Comments
1. The clause requires the auditor to comment on the adequacy of documents and records
maintained in cases where the company has granted loans and advances on the basis of
security by way of pledge of shares, debentures and other securities. If the auditor is not
satisfied about the adequacy of documents and records, he has to report the
inadequacies and point out deficiencies in maintenance of records.
2. This requirement is confined to loans and advances which are secured by way of pledge
of shares, debentures and other securities, and does not extend to other forms of
security, e.g., hypothecation, guarantee, etc.
3. Pledge implies that the physical possession of the security must be transferred to the
company along with a power to sale of the security in the case of default. This transfer
can be actual or constructive. For example, the share or debenture may be physically in
the custody of the company or it may be with a person like a bank which holds it on
behalf of the company.
4. A question may arise as to the exact meaning of the term “other securities”. The term,
‘other securities’ may be construed to mean bonds or promissory notes issued by a
government or semi-government authority.
5. The auditor has to report whether adequate documents and records have been
maintained. What records would be considered adequate depends upon the nature of the
security and the party to whom the loan or advance is granted. But the records should
generally include the following particulars:
(i) the full name and address of the borrower;
(ii) the amount of the loan or advance;

(iii) stipulations regarding period of repayment, the rate of interest, the security to be
pledged and all other terms of the loan or advance;
(iv) the record of the disbursements, repayments towards the loan or advance and
recovery of the interest;
(v) full particulars of the security pledged, for example, if the security consists of
shares, the particulars would include the names of the companies, number of
shares, class of shares, distinctive numbers of the shares, particulars of the parties
in whose names the shares stand, etc.;
(vi) the documents needed to transfer the ownership of the security in case of need;
(vii) periodical acknowledgements from the parties confirming the balances due;
(viii) proof that the party has power to borrow, e.g., in case the borrower is a company,
its memorandum of association, board resolution or shareholders’ resolution; etc.
6. The clause does not cast a duty upon the auditor to examine the adequacy of the
security on the basis of which loans have been granted. This may be due to the fact that
an inquiry in this regard has to be made by the auditor in terms of section 227 (1A) of the
Act. In any event, it remains the duty of the auditor to ensure by physical verification that,
where a loan or advance is given on the basis of a pledge of shares, debentures or other
securities, the securities are in the custody of the company and that the market value of
the securities is adequate to cover the outstanding amount of the loan and interest.
Whether the provisions of any special statute applicable to chit fund have been duly complied
with? [Paragraph 4(xiii) First Part]
Comments
1. The clause requires the auditor to comment whether the provisions of any special statute
applicable to chit fund have been complied with. It may be noted that clause is required
to be commented upon by the auditor only in case of a chit fund company. Therefore,
the auditor should determine whether the company is carrying on the chit fund business.
It may be noted that the Order contains a single definition of the terms “chit fund
company”, “nidhi company” or “mutual benefit company”. According to the Order, “chit
fund company”, “nidhi company” or “mutual benefit company” means a company engaged
in the business of managing, conducting or supervising as a foreman or agent of any
transaction or arrangement by which it enters into an agreement with a number of
subscribers that every one of them shall subscribe to a certain sum of instalments for a
definite period and that each subscriber, in his turn, as determined by lot or by auction or
by tender or in such other manner as may be provided for in the agreement, shall be
entitled to a prize amount, and includes companies whose principal business is accepting
fixed deposits from, and lending money to, members.”
2. This is a very wide requirement and taken literally would mean that the auditor has to
ensure that the company complies with all the requirements of the relevant special
Audit Report 8.79
statutes. Obviously, this cannot be the intention. A more rational interpretation would,
therefore, be that the auditor has to satisfy himself and report that the company has
complied with all the provisions of the special statutes in so far as they are applicable to
the accounts of the chit fund company. It is necessary that the audit report should clearly
state the above interpretation. The following is an example of the report:
“According to the information and explanations give to us, the company has complied
with the provisions of ..................... in so far as those provisions are applicable to the
accounts under report.”
In respect of nidhi/mutual benefit fund/societies:
(a) whether the net-owned funds to deposit liability ratio is more than 1:20 as on the date of
balance sheet;
(b) whether the company has complied with the prudential norms on income recognition and
provisioning against sub-standard/default/loss assets;
(c) whether the company has adequate procedures for appraisal of credit
proposals/requests, assessment of credit needs and repayment capacity of the
borrowers;
(d) whether the repayment schedule of various loans granted by the nidhi is based on the
repayment capacity of the borrower and would be conducive to recovery of the loan
amount. [Paragraph 4(xiii) Second Part; sub-clauses (a) to (d)]
Comments
1. It may be noted that a “nidhi” or a “mutual benefit society” may accept deposits not
exceeding twenty times of its net owned funds as per last audited balance sheet.
2. According to the directions issued by the Central Government vide notification number
GSR 555(E) dated 26th July, 2001 [as modified by notification number GSR 308(E) dated
30th April, 2002], the term “net owned funds” means the aggregate of paid-up equity
capital and free reserves as reduced by accumulated losses and intangible assets
appearing in the last audited balance sheet of the company. A reserve is considered as
a “free reserve” if it is available for distribution as dividend. Further, the amount
representing the proceeds of issue of preference shares shall not be included for
calculating net-owned funds. However, for nidhis or mutual benefit societies existing on
or before 26.7.2001, the proceeds of issue of preference shares shall be included for
calculation of net-owned funds up to the financial year 31st March 2004.
3. A nidhi or a mutual benefit society can accept fixed deposits, recurring deposits accounts
and savings deposits from its members in accordance with the directions notified by the
Central Government. The aggregate of such deposits is referred to as “deposit liability”.
4. The auditor should ask the management to provide the computation of the deposit liability
and net-owned funds on the basis of the requirements contained herein above. This
would enable him to verify that the ratio of deposit liability to net owned funds is in
accordance with the requirements prescribed in this regard. The auditor should verify the
ratio using the figures of net owned funds and deposit liability computed in accordance
with what is stated above. The comments of the auditor should be based upon such a
statement provided by the management and verification of the same by the auditor.
5. Nidhis and mutual benefit societies can give loans to its shareholders or members
against the security of gold, silver, jewellery, immovable property, fixed deposit, kisan
vikas patra, national savings certificates, insurance policies and other Government
securities. The Central Government, vide notification number GSR 309 (E) dated 30th
April 2002 issued prudential norms for revenue recognition and classification of assets in
respect of mortgage or loans.
6. The sub-clause (c) requires the auditor to comment upon whether the company has
adequate procedures for appraisal of credit proposals/requests, assessments of credit
needs and repayment capacity of the borrowers. The auditor should study the procedures
regarding appraisal of credit proposals/requests, assessment of credit needs and
repayment capacity of the borrowers. It may so happen that a company might have a
separate set of procedures for appraisal of credit proposals/requests of employees. The
auditor should also study the same. Such procedures should normally include steps to be
followed for detailed verification of the proposal to assess need of credit and the
repayment capacity of the borrower. Study of the individual borrower files would indicate
whether proper systems and procedures have been followed.
7. The sub-clause (d) requires the auditor to comment on whether the repayment schedule
of various loans granted by the nidhi is based on the repayment capacity of the borrower
and would be conducive to recovery of the loan amount. It may be noted that the scope
of the auditors’ enquiry for this clause is limited to examination of the documentation
available with the company in regard to grant of loans. Based on his examination of the
documentation in regard to grant of loans, the auditor would form an opinion whether the
repayment schedule of various loans granted by the nidhi is based on the repayment
capacity of the borrower. Where the number of loans granted by the company is very
large, it is obviously not feasible for the auditor to satisfy himself that every single loan’s
repayment schedule granted by the nidhi is based on the repayment capacity of the
borrower and would be conducive to recovery of the loan amount. It is important to note
that the auditor’s comments on this clause would have to be based on the auditor's
examination of the documentation of all large loans, say, exceeding a particular limit
determined by the auditor having regard to the concept of materiality and a test check of
the documentation of other loans with a view to determine that the repayment schedule of
various loans granted by the nidhi is based on the repayment capacity of the borrower.
If the company is dealing or trading in shares, securities, debentures and other
investments, whether proper records have been maintained of the transactions and
contracts and whether timely entries have been made therein; also whether the shares,
securities, debentures and other investments have been held by the company, in its own
name except to the extent of the exemption, if any, granted under section 49 of the Act.
[Paragraph 4(xiv)]
Audit Report 8.81
Comments
1. The requirement applies to companies, which deal or trade in shares, debentures and
other securities. To deal or trade implies a purchase or sale with a view to make profit.
Therefore, this requirement does not apply to companies which are not dealing or trading
in investments but which purchase investments with a view to hold such investments and
earn income from dividend or interest thereon.
2. This requirement can be considered in three parts, namely:
(i) whether records regarding transactions and contracts are maintained;
(ii) whether timely entries have been made in such records; and
(iii) whether the investments are in the company’s own name.
3. In deciding whether records have been properly maintained, the auditor has to examine
both, whether the form in which records are maintained is adequate and also whether the
records themselves are properly written up and preserved. Some of the features to be
examined in this connection would be the following:
(i) Details regarding the purchase and sale, that is, market or off market, the rate at
which the purchase or sale was made, the number of shares or other investments
and the document, for example, bought note or sale note evidencing the sale.
(ii) The adjustment, if any, necessary when securities are purchased or sold and
whether the quotations are exclusive of interest accrued or, when shares are
purchased or sold ex-dividend whether dividend has to be paid or received.
(iii) The details of holdings in individual companies, the classes of investments (e.g.,
equity shares, preference shares, debentures, etc.), the basis on which the closing
stock is valued and the profit or loss on sale is to be computed.
(iv) The recording of shares received as bonus shares; the accounting of rights
subscribed for or sold.
(v) The individual accounts of the parties from whom moneys are due for sale or to
whom moneys are payable for purchases and the settlements made there against.
4. The auditor is also required to examine whether timely entries are made in the records.
This may be done by one or more of the following methods:
(i) a surprise inspection of the records;
(ii) an examination of the system of internal control with particular reference to the
manner in which and the time at which entries are made in the records; and
(iii) an examination of the internal audit reports to ensure if the programme of internal
audit specifically covers an inspection of the records to determine whether entries
are made in time.
5. Section 49 of the Act requires that all investments have to be made and held in the
company’s own name. The exemptions provided by the section are:
(i) where a person is appointed as a nominee of the company on the board of directors
of another company and such nominee is required to hold qualification shares, then
to the extent of such qualification shares;
(ii) where a company has a subsidiary and it is necessary to ensure that the number of
members of the subsidiary is not reduced below seven in the case of a public
company and two in the case of a private company;
(iii) in the case of a company whose principal business consists of the buying and
selling of shares or securities;
(iv) in the case of investments deposited with a bank for collection of dividend or
interest or for transfer into such bank’s name to facilitate transfer; and
(v) in the case of investments pledged as security for loans or for performance of
obligations.
6. When a company deals or trades in investments it is possible that investments which are
intended or contracted to be sold immediately may not have been transferred to the
company’s own name. The auditor should, therefore, use his discretion to ascertain
whether, in the circumstances of each case, the failure to transfer the investments to the
company’s name is understandable.
Whether the company has given any guarantee for loans taken by others from bank or
financial institutions, the terms and conditions whereof are prejudicial to the interest of the
company. [Paragraph 4 (xv)]
Comments
1. It may be noted that several types of guarantees are in vogue. The type of guarantee
within the scope of the clause is the one which the company has provided to a bank or
financial institution in respect of loans taken by a third party. In other words, the
company has a legal binding to indemnify the bank or financial institution if the third
party, on behalf of whom the guarantee has been furnished, fails to fulfill the conditions
subject to which the loan was granted by the bank or financial institution. Section 126 of
the Indian Contract Act, 1872 defines a contract of guarantee as a contract to perform
the promise, or discharge the liability, of a third person in case of his default.
2. Guarantee given by a company is a contingent liability. In respect of contingent liabilities,
the auditor is normally concerned with seeking reasonable assurance that all contingent
liabilities are identified and properly valued and disclosed as an off-balance sheet item.
The auditor should obtain a written representation from the management that:
(i) there are no guarantees issued up to the year-end which are yet to be recorded;
and
(ii) all obligations in respect of guarantees have been duly recorded in the register of
guarantees and disclosed.
3. The auditor should examine the Memorandum of Association of the company with a view
to determine whether the company can give a guarantee. It may be noted that if a
Audit Report 8.83
company provides any guarantee without having a clause in this regard in the
Memorandum of Association, the act of providing guarantee would be ultra vires. The
auditor, in such a situation, should make necessary disclosure in the audit report.
4. The auditor should review the issuance of guarantee(s) to establish the reasonableness
thereof in the light of previous experience and knowledge of the current year's activities.
In determining whether the guarantee is prejudicial to the interest of the company, the
auditor would have to give due consideration to a number of factors connected with the
guarantee, including the financial standing of the party on whose behalf the company has
given the guarantee, party’s ability to borrow, the nature of the security offered by the
party, the availability of alternative sources of finance and the urgency of the borrowing, if
available, for which the company has given guarantee and so on. The auditor should
obtain this information from the management.
5. The auditor should also verify whether the company has complied with the requirements
of sections 295 and 372A of the Act. If the company has obtained the previous approval
of the Central Government under section 295, it should be construed that the guarantee
is not prejudicial to the interest of the company.
Whether the term loans were applied for the purpose for which the loans were obtained.
[Paragraph 4 (xvi)]
Comments
1. This clause requires the auditor to examine whether term loans were applied for the
purpose for which these loans were obtained. First of all, the auditor should ascertain
whether the company has taken any “term loans”. Term loans normally have a fixed or
pre-determined repayment schedule. In the common parlance of the expression, loans
with repayment period beyond 36 months are usually known as “term loans”. Cash
credit, overdraft and call money accounts/deposits are, therefore, not covered by the
expression “term loans”. Terms loans are generally provided by banks and financial
institutions for acquisition of capital assets which then become the security for the loan,
i.e., end use of funds is normally fixed.
2. The auditor should examine the terms and conditions subject to which the company has
obtained the term loans. The auditor should compare the purpose for which term loans
were sanctioned with the actual utilisation of the loans. The auditor should obtain
sufficient appropriate audit evidence regarding the utilisation of the amounts raised. If the
auditor finds that the funds have not been utilized for the purpose for which they were
obtained, the auditor’s report should state the fact.
3. It is not necessary to establish a one-to-one relationship with the amount of term loan
and its utilisation. It is quite often found that the amount of term loan disbursed by the
bank is deposited in the common account of the company from which subsequently the
utilisation is made. In such cases, it should not be construed that the amount has not
been utilised for the purpose it was raised.
4. During construction phase, companies, generally, temporarily invest the surplus funds to
reduce the cost of capital or for other business reasons. However, subsequently the
same are utilised for the stated objectives. In such cases, the auditor should mention the
fact that pending utilisation of the term loan for the stated purpose, the funds were
temporarily used for the purpose other than for which the loan was sanctioned but were
ultimately utilised for the stated end-use.
5. It may so happen that the term loans taken during the year might not have been applied
for the stated purpose during the year, for example, the loan was disbursed at the fag
end of the year. In such a case, the auditor should mention in his audit report that the
term loan obtained during the year has not been utilised. This also implies that the
auditor, while making inquiry in respect of this clause, should also consider the term
loans which although were taken in the previous accounting period but have been
actually utilised during the current accounting period.
Whether the funds raised on short-term basis have been used for long-term investment. If yes,
the nature and amount is to be indicated. [Paragraph 4 (xvii)]
Comments
1. The principles of financial management suggest that the long-term assets of an
enterprise should be financed from long-term funds. The genesis of the principle is that if
funds raised from short-term sources are used for long-term investments, the enterprise
can face liquidity problems as soon as the short-term sources fall due for payment. The
application of the principle is considered to be of utmost importance for the financial
health of an enterprise. The clause requires the auditor to comment whether the funds
raised on short-term basis have been used for long-term investment, so that the readers
can assess whether the company has followed the above-mentioned principle of financial
management.
2. Short-term sources of funds include temporary credit facilities like cash credits, overdraft.
Reduction in current assets or increase in current liabilities are also sources of short-term
increase in funds. Long-term sources of funds would include share capital, reserves and
surplus, provision for depreciation, long-term debt securities, long-term loans. Long-term
application of funds includes investment in fixed assets, long-term investments in share
debentures and other securities and other assets of similar nature, repayment of long-
term loans and advances or redemption of long-term debt or securities, etc.
3. The auditor should determine the long-term sources and the long-term application of
funds by a company using the data contained in the financial statements. If the quantum
of long-term funds of a company is not significantly different from the long-term
application of funds, it is an indication that the long-term assets of the company are
financed from the long-term sources. However, if the quantum of long-term funds is
significantly less than the long-term application of funds, it is an indication that short-term
funds have been used to finance the long-term assets of the company. Similarly, if the
quantum of long-term funds is significantly more than the long-term application of funds,
it is an indication that long-term funds have been used to finance the short-term assets of
Audit Report 8.85
the company. The difference between the figures of long-term funds and long-term
assets of the company indicate the extent to which short-term funds have been used to
finance long-term assets of the company.
4. Working capital is normally understood to be a short-term application of funds which
keeps on changing its form throughout the working capital cycle. It may, however, be
noted that core or permanent working capital of an enterprise should be financed from
long-term funds (preferably the owners’ capital). Core or permanent working capital is
that component of the working capital of the enterprise that always remains invested in
business and is never allowed to exit.
5. An example of negative reporting under the clause is as follows:
“According to the information and explanations given to us and on an overall examination
of the balance sheet of the company, we report that the company has used funds raised
on short-term basis for long-term investment. The company has accepted public
deposits amounting to rupees 5 crores which would fall due for repayment two years from
the date of their acceptance. The company has invested the money for the increase of
the production capacity which would be completed in the next four years.”
Whether the company has made any preferential allotment of shares to parties and companies
covered in the Register maintained under Section 301 of the Act, and if so whether the price at
which shares have been issued is prejudicial to the interest of the company. [Paragraph 4
(xviii)]
Comments
1. It may be noted that the term “preferential allotment” is not defined under the Act. It may
also be noted that the clause requires the auditor to report on the preferential allotment
only in the case of shares issued by the company and not on preferential allotment of
other securities issued by the company. The term “shares” includes both equity as well
as preference shares. For the purpose of this clause, preferential allotment of shares
would mean an allotment of shares to parties and companies covered in the register
maintained under section 301 of the Act in preference to others. The preference can be
with regard to the price or other terms and conditions associated with the allotment.
2. In the case of a listed company, preferential allotment of securities is governed by the
SEBI (Disclosure and Investor Protection) Guidelines, 2000. A listed company can make
preferential issues of equity shares, fully convertible debentures, partly convertible
debentures or any other instrument which may be converted into or exchanged with
equity shares at a later date. A listed company can issue shares on a preferential basis
at a price not less than the higher of the following:
(i) the average of the weekly high and low of the closing prices of the related shares
quoted on the stock exchange during the six months preceding the relevant date;
or
(ii) the average of the weekly high and low of the closing prices of the related shares
quoted on a stock exchange during the two weeks preceding the relevant date.
3. In the case of a private company and an unlisted public company, the auditor would have
to examine whether the price at which the company has made the preferential allotment
of shares is prejudicial to the interest of the company. In so far as the price at which
preferential allotment is made is concerned, it may be noted that valuation of shares of a
company involves use of judgment, knowledge of the business, analysis and
interpretation and the use of different methods, which may result in assigning different
values based on different methods. There are certain basic factors, which affect the
value of a company’s shares for which the price calculated is adjusted. The factors are
earnings, dividends declared, asset value and goodwill of the company. Methods
generally used for determining the fair value of the business by the company, which take
into consideration one or more factors mentioned above are:
(i) Net Assets Basis—considers the valuation of assets, subtracting therefrom
liabilities, etc., to arrive at the value of the equity shares.
(ii) Maintainable Profits Basis—this is based on the future maintainable profits/earnings
of the company.
(iii) Yield Basis—this method recognises the yield/dividends as a base for arriving at the
fair value of the shares.
(iv) Discounted Cash Flow Method — this method estimates the value of shares by
estimating the future cash flows from operations and discounting the cash flows at a
specified rate.
It is not rare to find a combination of different methods used in the context of
valuation of shares; for example, an averaging of maintainable profits basis and the
net assets basis.
4. Companies sometimes do make allotment of shares based on the valuation reports
issued by experts in this field. While the auditor uses the report of an expert to
determine whether the price for the preferential allotment of share is not prejudicial to the
interest of the company, the auditor should also comply with the requirements of Auditing
and Assurance Standard (AAS) 9, “Using the Work of an Expert”.
5. In case, the company has made preferential issue of shares by passing an ordinary
resolution under clause (b) of sub-section (1A) of section 81 of the Act, apart from
examining the method used for valuation of shares of the company and ascertaining the
reasonableness of the assumptions underlying the calculation, the auditor should also
examine the Order of the Government as to its satisfaction that the proposal is most
beneficial to the company. Where the Government is satisfied in this regard, the auditor
need not make his assessment as to the reasonableness of the prices of the shares for
the preferential allotment of shares. The auditor, however, is not precluded from doing
so. If the auditor forms his opinion on the basis of the Order issued by the Government,
he should state the fact of his reliance on the Government Order for the purpose of
reporting.
Audit Report 8.87
Whether securities have been created in respect of debentures issued? [Paragraph 4(xix)]
Comments
1. The auditor, under this clause, is required to examine whether the company has created
proper ‘security’ or charge on the assets for the debentures issued by it.
2. Where the company has issued any debentures, the auditor should also examine the
debenture trust deed executed under section 117A of the Act. The auditor should pay
particular attention to verify whether proper security or charge has been created in favour
of the debenture trust. The auditor can examine the relevant documents creating the
charge in favour of the trustees for the debenture holders duly registered in the
concerned Registrar’s office if the security is an immovable property.
3. If the company has not created any security, the auditor should report the fact in this
report.
Whether the management has disclosed on the end use of money raised by public issues and
the same has been verified. [Paragraph 4(xx)]
Comments
1. In case the company has made a public issue of any of its securities like shares,
preference shares, debentures and other securities, the auditor is required to report upon
the disclosure of end-use of the money by the management in the financial statements.
The auditor is also required to state whether he has verified the disclosure made by the
management in this regard.
2. Currently, there is no legal requirement under the Act to disclose the end use of money
raised by public issues in the financial statements. The companies, however, make such
a disclosure in the Board’s Report. Schedule VI to the Act requires that only unutilized
amount of any public issue made by the company should be disclosed in the financial
statements of a company. In the absence of any legal requirement of such disclosure, it
appears that the clause envisages that the companies should disclose the end use of
money raised by the public issue in the financial statements by way of notes and the
auditor should verify the same.
3. It may also be noted that according to the SEBI (Disclosure & Investor Protection)
Guidelines, in case the issue exceeds Rs. 500 crores, the issuer company is required to
make arrangements for the use of proceeds of the issue to be monitored by financial
institutions. The monitoring agency so appointed is required to submit its report to the
SEBI, on a half-yearly basis, till the completion of the project. In case, the company has
appointed a monitoring agency for the purpose of the issue, reports of the monitoring
agency would also be helpful to the auditor while reporting under the clause.
4. Normally, the companies do mention the end-use of the money proposed to be raised
through the public issues in the prospectus. An examination of the prospectus would
provide the auditor an understanding of the proposed end-use of money raised from
public. The auditor should verify that the amount of end-use of money disclosed in the
financial statements by the management is not significantly different from the proposed
and actual end use. The auditor should obtain a representation from the management as
to the completeness of the disclosure with regard to the end-use of money raised by
public issues. If the auditor is of the opinion that adequate disclosure in this regard has
not been made in the financial statements, the auditor should state the fact of inadequate
disclosures in his audit report. If, for any reason, the auditor is not able to verify the end-
use of money raised from public issues, he should state that he is not able to comment
upon the disclosure of end-use of money by the company since he could not verify the
same. He should also mention the reasons, which contributed to the auditor’s inability to
verify the disclosure.
Whether any fraud on or by the company has been noticed or reported during the year, If yes,
the nature and the amount involved is to be indicated. [Paragraph 4(xxi)]
Comments
1. This clause requires the auditor to report whether any fraud has been noticed or reported
either on the company or by the company during the year. If yes, the auditor is required
to state the amount involved and the nature of fraud. The clause does not require the
auditor to discover the frauds on the company and by the company. Irrespective of the
auditor’s comments under this clause, the auditor is also required to comply with the
requirements of Auditing and Assurance Standard (AAS) 4, “The Auditor’s Responsibility
to Consider Fraud and Error in an Audit of Financial Statements”.
2. The term "fraud" refers to an intentional act by one or more individuals among
management, those charged with governance, employees, or third parties, involving the
use of deception to obtain an unjust or illegal advantage. Although fraud is a broad legal
concept, the auditor is concerned with fraudulent acts that cause a material misstatement
in the financial statements.
3. Two types of intentional misstatements are relevant to the auditor's consideration of
fraud—misstatements resulting from fraudulent financial reporting and misstatements
resulting from misappropriation of assets.
4. Fraudulent financial reporting involves intentional misstatements or omissions of amounts
or disclosures in financial statements to deceive financial statement users. Fraudulent
financial reporting may involve:
Deception such as manipulation, falsification, or alteration of accounting records or
supporting documents from which the financial statements are prepared.
Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information.
Intentional misapplication of accounting principles relating to measurement, recognition,
classification, presentation, or disclosure.
5. Misappropriation of assets involves the theft of an entity's assets. Misappropriation of
assets can be accomplished in a variety of ways (including embezzling receipts, stealing
Audit Report 8.89
physical or intangible assets, or causing an entity to pay for goods and services not
received); it is often accompanied by false or misleading records or documents in order
to conceal the fact that the assets are missing.
6. The auditor should examine the reports of the internal auditor with a view to ascertain
whether any fraud has been reported or noticed by the management. The auditor should
examine the minutes of the audit committee, if available, to ascertain whether any
instance of fraud pertaining to the company has been reported and actions taken
thereon. The auditor should enquire of the management about any frauds on or by the
company that it has noticed or that have been reported to it. The auditor should also
discuss the matter with other employees of the company. The auditor should also
examine the minute book of the board meeting of the company in this regard.
7. Because management is responsible for adjusting the financial statements to correct
material misstatements, it is important that the auditor obtains written representation from
management that any uncorrected misstatements resulting from fraud are, in
management's opinion, immaterial, both individually and in the aggregate. Such
representations are not a substitute for obtaining sufficient appropriate audit evidence.
Form of Report
The Order requires that the auditor should make a statement on all the matters contained
therein. This requirement applies even where the answers to any of the questions are
unfavourable or qualified. The Order further provides that where an auditor is unable to
express any opinion, he should indicate such fact. The auditor is also required to give reasons
for any unfavourable or qualified answer or for his inability to express an opinion on any of the
matters specified in the Order.
There may be situations where one or more of the clauses are not applicable. For example,
the requirement regarding internal audit system does not apply in case of all the companies. In
such situations, it would be appropriate for the auditor to make a suitable comment in his
report bringing out the fact of non-applicability of a particular clause. To illustrate, where the
maintenance of cost records has not been prescribed by the Central Government under
section 209(1)(d) of the Act, the auditor may state:
“The Central Government has not prescribed maintenance of cost records under
section 209(1)(d) of the Companies Act, 1956 for any of the products of the
company”.
A question may also arise whether it is necessary for the auditor to include in his report the
management’s explanation for any matter on which he makes an adverse comment. Normally,
such an explanation need not be included but there may be circumstances where the auditor
feels such inclusion is necessary. Examples of such circumstances would be:
(a) to make the comment itself more meaningful and complete. For example, physical
verification of inventories, though planned, may not have been carried out because of a
strike or a lockout. An adverse comment without this explanation would be misleading;
(b) to explain the fact why in spite of an adverse comment, the true and fair view of the
financial statements is not vitiated. For example, physical verification of a part of the
inventories at the year-end may not have been carried out, but there is sufficient other
evidence produced by the management which satisfies the auditor regarding the
existence, condition and value of the inventories.
It is suggested that the sequence of the items as appearing in the report should be: first, the
comments, if any, under sub-section (1A); second, the comments under the Order; and finally,
the report under sub-sections (2), (3) and (4) of section 227. The comments under the Order
may, alternatively, be given in the form of an Annexure to the report. However, when the
comments are given in an Annexure, it is necessary to refer to the Annexure in the main report
and it is advisable to sign the Annexure in addition to signing the main report.
If any of the comments on matters specified in the Order are adverse, the auditor should
consider whether his comments have a bearing on the true and fair view presented by the
financial statements and, therefore, might warrant a modification in the report under sub-
sections (2), (3) and (4) of section 227. For example, in case where a company has disposed
off a substantial part of fixed assets and consequently the going concern assumption is not
resolved, the auditor apart from giving an appropriate comment under the Order, should also
make a suitable qualification in the audit report on the financial statements.
If the auditor is of the opinion that any of the adverse comments on matters specified in the
Order results in a qualification under sub-sections (2), (3) and (4) of section 227 the auditor
may prefer to preface his report under those sub-sections by stating the qualification(s). Such
a qualification(s) should be made against the specific item which is being qualified.
Even where there are no adverse comments under the Order, it may be advisable for the
auditor to preface his report under sub-sections (2), (3) and (4) of section 227 with the words:
“Further to our comments in the Annexure, we state that...........................”
It should not, however, be assumed that every adverse comment under the Order would
necessarily result in a qualification in the report under sub-sections (2), (3) and (4) of section
227.
Where there is a qualification both under sub-section (1A) and under the Order, it is
suggested that the qualification under sub-section (1A) precede the qualification under
the Order.
It is important to note that replies to many of the requirements of the Order will involve
expression of opinion and not necessarily statement of facts. It is necessary, therefore, that
this is indicated when making the report under the Order. This can be done in either of the
following ways:
(a) By a general preface to the comments under the Order on the following lines:
“In terms of the information and explanations given to us and the books and
records examined by us in the normal course of audit and to the best of our
knowledge and belief, we state that..............................”
or
Audit Report 8.91
(b) by a preface to individual comments, for example,

“In our opinion” or “In our opinion and according to the information and
explanations given to us during the course of the audit...”
The Order requires that where the answer to a question is unfavourable or qualified, the
auditor’s report should also state the reasons for such unfavourable or qualified answer. The
requirement is similar to the requirement of sub-section (4) of section 227 and the same
considerations would apply. Thus, while it is not necessary for the auditor to give very detailed
reasons for an unfavourable or qualified answer, he is expected to explain the nature of the
qualification or adverse comment in clear and unambiguous terms.
Similar considerations would apply when the auditor is unable to express an opinion. For
example, if the internal audit department is unable to produce any audit programme, working
papers, report, or other evidence of work done, the auditor may not be in a position to report
whether the system is commensurate with the size and nature of the business of the company.
In such circumstances, he should clearly state that he is unable to express an opinion
because such records or evidence have not been produced before him.
In expressing an opinion, auditor should be quite clear as to whether the circumstances of the
case warrant a negative answer or whether his opinion can be expressed subject to a
qualification. To illustrate, if the system of internal audit has basic defects which render it
totally ineffective, for example, due to grossly inadequate number of qualified staff, then the
answer may be unfavourable. However, if there are minor defects in the system, for example,
if the coverage is inadequate in certain areas, the auditor may state in his report that the
coverage is inadequate in a particular area (to be specified) but otherwise the system is
commensurate with the size of the company and the nature of its business.
Section 227(3)(e) of the Act requires that the auditor’s report should also state in thick type or
in italics the observations or comments of the auditor which have any adverse effect on the
functioning of the company. The auditor should also consider whether any observations or
comments made by the auditor in his report under the Order contain such matters, which, in
his opinion, might have any adverse effect on the functioning of the company. If so, the
auditor should give his comment in thick type or italics as required by the said section. An
example in this regard may be where accumulated losses of the company at the end of the
financial year are more than fifty per cent of its net worth and it has incurred cash losses in
period covered by the audit report and in the financial year immediately preceding financial
year also.
The auditor’s report under sub-section (3) of section 227 is required to state whether the
auditor has obtained all the information and explanations which, to the best of his knowledge
and belief, were necessary for the purposes of his audit. The term “audit” would include the
reporting requirements under the Order. Therefore, when making his report, the auditor has to
consider whether he has obtained the information and explanations needed not merely for the
purposes of normal audit, but also for the purpose of reporting in terms of the Order. If he has
not received the information and explanations necessary for reporting in terms of the Order,
he should mention that fact both when reporting on the specific question in the Order and also
when reporting generally in terms of sub-section (3) of section 227.

A specimen form of report is given in Appendix I.
Board’s Report
Section 217 of the Act requires that the board of directors shall be bound to give in its report
the fullest information and explanations regarding every reservation, qualification or adverse
remark contained in the auditor’s report. The auditor’s comments in terms of the Order form
part of his report and, therefore, the board will be bound to give in its report the fullest
information and explanations regarding every adverse comment therein.
The auditor’s comments in terms of the Order may be in respect of matters of fact or they may
be an expression of opinion. It is necessary that there should be no inconsistency in the facts
as stated by the auditor and as explained in the board’s report. It is, therefore, suggested that
wherever possible, a draft report should be submitted to the board to verify and confirm the
facts stated therein.
It is, however, possible that, on the same facts, there may be a genuine difference of opinion
between the auditor and the board. In such a case, each is entitled to hold his or its view.
Therefore, the expression of a different opinion in the board’s report should not be regarded
as any reflection on the opinion expressed by the auditor.
Audit Report 8.93
Appendix-I
SPECIMEN AUDITOR’S REPORT TO THE

MEMBERS OF THE COMPANY
The Members of ………………(name of the Company)
1. We have audited the attached balance sheet of ………………. (name of the company), as at 31st
March 20XX, the profit and loss account and also the {cash flow statement} for the year ended
on that date annexed thereto. These financial statements are the responsibility of the company’s
management. Our responsibility is to express an opinion on these financial statements based on
our audit.
2. We conducted our audit in accordance with the auditing standards generally accepted in India.
Those Standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our opinion.
3. As required by the Companies (Auditor’s Report) Order, 2003 issued by the Central Government
of India in terms of sub-section (4A) of section 227 of the Companies Act, 1956, we enclose in the
Annexure a statement on the matters specified in paragraphs 4 and 5 of the said Order.
4. Further to our comments in the Annexure referred to above, we report that:
(i) We have obtained all the information and explanations, which to the best of our knowledge
and belief were necessary for the purposes of our audit;
(ii) In our opinion, proper books of account as required by law have been kept by the company
so far as appears from our examination of those books (and proper returns adequate for the
purposes of our audit have been received from the branches not visited by us. The Branch
Auditor’s Report(s) have been forwarded to us and have been appropriately dealt with)
(iii) The balance sheet, profit and loss account and cash flow statement dealt with by this report
are in agreement with the books of account (and with the audited returns from the
branches);
(iv) In our opinion, the balance sheet, profit and loss account and cash flow statement dealt with
by this report comply with the accounting standards referred to in sub-section (3C) of
section 211 of the Companies Act, 1956;
(v) On the basis of written representations received from the directors, as on 31st March 20XX
and taken on record by the Board of Directors, we report that none of the directors is
disqualified as on 31st March 20XX from being appointed as a director in terms of clause (g)
of sub-section (1) of section 274 of the Companies Act, 1956;
(vi) In our opinion and to the best of our information and according to the explanations given to
us, the said accounts give the information required by the Companies Act, 1956, in the
manner so required and give a true and fair view in conformity with the accounting principles
generally accepted in India:
(a) in the case of the balance sheet, of the state of affairs of the company as at 31st
March 20XX;
(b) in the case of the profit and loss account, of the profit/loss for the year ended on that
date; and
(c) in the case of the cash flow statement, of the cash flows for the year ended on that
date.
For ABC and Co.
Signature
(Designation)
Membership Number
Place of Signature
Date
Audit Report 8.95
Annexure II
Re:…………………Limited
Referred to in paragraph 3 of our report of even date,
(i) (a) The company has maintained proper records showing full particulars including quantitative
details and situation of fixed assets.
(b) All the assets have not been physically verified by the management during the year but
there is a regular programme of verification which, in our opinion, is reasonable having
regard to the size of the company and the nature of its assets. No material discrepancies
were noticed on such verification.
(c) During the year, the company has disposed off a major part of the plant and machinery.
According to the information and explanations given to us, we are of the opinion that the
sale of the said part of plant and machinery has not affected the going concern status of the
company.
(ii) (a) The inventory has been physically verified during the year by the management. In our
opinion, the frequency of verification is reasonable.
(b) The procedures of physical verification of inventories followed by the management are
reasonable and adequate in relation to the size of the company and the nature of its
business.
(c) The company is maintaining proper records of inventory. The discrepancies noticed on
verification between the physical stocks and the book records were not material.
(iii) (a) The company had taken loan from five other companies covered in the register maintained
under section 301 of the Companies Act, 1956. The maximum amount involved during the
year was Rs.50 crores and the year-end balance of loans taken from such parties was Rs.
NIL. There are two firms covered in the register maintained under section 301 of the
Companies Act, 1956 to which the company has granted loans. The maximum amount
involved during the year was Rs.20 crores and the year-end balance of loans granted to
such parties was Rs. 20 crores.
(b) In our opinion, the rate of interest and other terms and conditions on which loans have been
taken from/granted to companies, firms or other parties listed in the register maintained
under section 301 of the Companies Act, 1956 are not, prima facie, prejudicial to the
interest of the company.
(c) The company is regular in repaying the principal amounts as stipulated and has been
regular in the payment of interest. The parties have repaid the principal amounts as
stipulated and have been regular in the payment of interest.
(d) There is no overdue amount of loans taken from or granted to companies, firms or other
parties listed in the register maintained under section 301 of the Companies Act, 1956.
(iv) In our opinion and according to the information and explanations given to us, there are adequate
internal control procedures commensurate with the size of the company and the nature of its
business with regard to purchases of inventory, fixed assets and with regard to the sale of goods.
During the course of our audit, we have not observed any continuing failure to correct major
weaknesses in internal controls.
(v) (a) According to the information and explanations given to us, we are of the opinion that the
transactions that need to be entered into the register maintained under section 301 of the
Companies Act, 1956 have been so entered.
(b) In our opinion and according to the information and explanations given to us, the
transactions made in pursuance of contracts or arrangements entered in the register
maintained under section 301 of the Companies Act, 1956 and exceeding the value of
rupees five lakhs in respect of any party during the year have been made at prices which
are reasonable having regard to prevailing market prices at the relevant time.
(vi) In our opinion and according to the information and explanations given to us, the company has
complied with the provisions of sections 58A and 58AA of the Companies Act, 1956 and the
Companies (Acceptance of Deposits) Rules, 1975 with regard to the deposits accepted from the
public. No order has been passed by the Company Law Board.
(vii) In our opinion, the company has an internal audit system commensurate with the size and nature
of its business.
(viii) We have broadly reviewed the books of account relating to materials, labour and other items of
cost maintained by the company pursuant to the Rules made by the Central Government for the
maintenance of cost records under section 209 (1) (d) of the Companies Act, 1956 and we are of
the opinion that prima facie the prescribed accounts and records have been made and
maintained.
(ix) (a) The company is regular in depositing with appropriate authorities undisputed statutory dues
including provident fund, investor education protection fund, employees’ state insurance,
income tax, sales tax, wealth tax, custom duty, excise duty, cess and other material
statutory dues applicable to it.
(b) According to the information and explanations given to us, no undisputed amounts payable
in respect of income tax, wealth tax, sales tax, customs duty, excise duty and cess were in
arrears, as at............ for a period of more than six months from the date they became
payable.
(c) According to the information and explanation given to us, there are no dues of sale tax,
income tax, customs duty, wealth tax, excise duty and cess which have not been deposited
on account of any dispute.
(x) In our opinion, the accumulated losses of the company are not more than fifty percent of its net
worth. The company has not incurred cash losses during the financial year covered by our audit
and the immediately preceding financial year.
Audit Report 8.97
(xi) In our opinion and according to the information and explanations given to us, the company has
not defaulted in repayment of dues to a financial institution, bank or debenture holders.
(xii) We are of the opinion that the company has maintained adequate records where the company
has granted loans and advances on the basis of security by way of pledge of shares, debentures
and other securities.
(xiii) In our opinion, the company is not a chit fund or a nidhi/ mutual benefit fund/ society. Therefore,
the provisions of clause 4(xiii) of the Companies (Auditor’s Report) Order, 2003 are not applicable
to the company.
(xiv) In our opinion, the company is not dealing in or trading in shares, securities, debentures and
other investments. Accordingly, the provisions of clause 4(xiv) of the Companies (Auditor’s
Report) Order, 2003 are not applicable to the company.
(xv) In our opinion, the terms and conditions on which the company has given guarantees for loans
taken by others from banks or financial institutions are not prejudicial to the interest of the
company.
(xvi) In our opinion, the term loans have been applied for the purpose for which they were raised.
(xvii) According to the information and explanations given to us and on an overall examination of the
balance sheet of the company, we report that the no funds raised on short-term basis have been
used for long-term investment. No long-term funds have been used to finance short-term assets
except permanent working capital.
(xviii) According to the information and explanations given to us, the company has made preferential
allotment of shares to parties and companies covered in the register maintained under
section 301 of the Act. In our opinion, the price at which shares have been issued is not
prejudicial to the interest of the company.
(xix) According to the information and explanations given to us, during the period covered by our audit
report, the company had issued 1,00,000 debentures of Rs. 100 each. The company has created
security in respect of debentures issued.
(xx) We have verified the end use of money raised by public issues as disclosed in the notes to the
(xxi) According to the information and explanations given to us, no fraud on or by the company has
been noticed or reported during the course of our audit.
For ABC and Co.,

Signature
(Designation)
Membership Number
Place of Signature
Date
9
AUDIT COMMITTEE AND CORPORATE GOVERNANCE
Introduction
9.1 Corporate Governance is the system by which companies are directed and governed by
the management in the best interests of the stakeholders and others ensuring better
management, greater transparency and timely financial reporting. The Board of Directors are
responsible for governance of their companies.
A number of reports and codes of Corporate Governance have already been published
internationally – notable among them are the Report of Cadbury Committee, the Report of
Greenbury Committee, the Combined Code of the London Stock Exchange, the OECD Code
on Corporate Governance, the Blue Ribbon Committee on Corporate Governance, the Hampel
Committee on Corporate Governance and the Review of the Role and Effectiveness of Non-
executive Directors published by the Department of Trade and Industry, U.K.
Similarly in the Indian scenario, the Confederation of Indian Industry (CII) had published in
April, 1988, Desirable Corporate Governance – A Code, which was followed by setting up of a
committee by The Securities and Exchange Board of India (hereinafter referred to as ”SEBI”)
in May, 1999 under the Chairmanship of Shri Kumar Mangalam Birla to formulate the code of
Corporate Governance. Based on the report of this committee and developments thereafter,
SEBI has issued seven Circulars on the subject of Corporate Governance inter-alia detailing
provisions of Corporate Governance.
Besides, the Reserve Bank of India constituted an Advisory Group on Corporate Governance,
which submitted its report in April 2001. Thereafter, the then Ministry of Finance and Company
Affairs constituted a Committee on Corporate Audit and Governance under the Chairmanship
of Shri Naresh Chandra, which submitted its report in November, 2002. Currently the Ministry
of Company Affairs is considering further reforms in the arena of Corporate Governance
through the Expert Committee on Simplification of New Company Law i.e., Dr J.J. Irani
Committee.
Further, in its constant endeavor to improve the framework of Corporate Governance in India
in line with needs of a dynamic market, SEBI constituted a Committee on Corporate
Governance under the Chairmanship of Shri N. R. Narayana Murthy, which submitted its
report in February, 2003. Based on the recommendations of the said Committee and public
comments received on the report, SEBI in exercise of powers conferred by section 11 (1) of
the Securities and Exchange Board of India Act, 1992 read with section 10 of the Securities
Contracts (Regulation) Act 1956, SEBI has revised the Clause 49 of the Listing Agreement as
per Circular SEBI/CFD/DIL/CG/1/2004/12/10 dated 29th October, 2004 which is a Master
Circular and has replaced all the earlier Circulars issued on Clause 49 of the Listing
Agreement. In View of the fact that many listed companies could not comply with
requirements, the SEBI vide its circular No. SEBI/CFD/DIL/CG/1/2005/29/3 dated 29th March,
2005 extended the date of ensuring compliance with the revised Clause 49 (i.e. Circular dated
29th October, 2004) to December 31, 2005. Subsequently, SEBI vide Circular No.
SEBI/CFD/DIL/CG/1/2006/13 dated 13th January, 2006 has made further clarificatory
amendments and removed certain operational difficulties.
The provisions of the revised Clause 49 is implemented as per the schedule of implementation
given below:
(a) For entities seeking listing for the first time, at the time of seeking in-principle approval
for such listing.
(b) For existing listed entities which were required to comply with revised Clause 49 i.e.
those having a paid up share capital of Rs. 3 crores and above or net worth of Rs. 25
crores or more at any time in the history of the company, by 31st December, 2005.
Companies complying with the provisions of the existing Clause 49 at present (issued vide
circulars dated 21st February, 2000, 9th March 2000, 12th September 2000, 22 nd January,
2001 16th March 2001 and 31st December 2001) shall continue to do so till the revised
Clause 49 of the Listing Agreement is complied with or till 31st December, 2005, whichever is
earlier.
The requirements of Clause 49 for Corporate Governance are divided into mandatory and
non-mandatory requirements. (Refer to Appendix – I, Annexure ID) The non-compliance of
any mandatory requirement of Clause 49 with reasons thereof should be specifically
highlighted. The extent to which the non-mandatory requirements have been adopted /
complied with should be mentioned in the Corporate Governance Report.
As Clause 49 VII (1) of the Listing Agreement, a company is required to obtain a certificate
either from the auditors of the company or practicing company secretaries as regards
compliance of requirements of Corporate Governance. This certificate is required to be
annexed with the Directors’ Report, which is sent annually to all the shareholders of the
company. Further, the same certificate is also required to be sent to the stock exchange (s)
along with the Annual Report filed by the company. The expression “auditors of the company”
would mean the auditors appointed to audit the financial statements of the company under the
Companies Act, 1956.
Definition of Corporate Governance

9.2 The word ‘Corporate’ is associated by legal enactment for the transaction of a business.
Similarly, the word ‘Governance’ means exercise of authority, direction or control. Thus, the
concept of ‘Corporate Governance’ is the system by which the management of a business
entity directs and controls the activities in the best interest of the stakeholder.
Audit Committee and Corporate Governance 9.3
As per N. R Narayana Murthy, Chairman, Committee on Corporate Governance, SEBI,

Mumbai, February 8, 2003
“Corporate governance is the acceptance by management of the inalienable rights of
shareholders as the true owners of the corporation and of their own role as trustees on behalf
of the shareholders. It is about commitment to values, about ethical business conduct and
about making a distinction between personal and corporate funds in the management of a
company.”
9.2.1 Issues of Corporate Governance - Clause 49 of the listing agreement covers SEBI
guidelines regarding Corporate Governance. Issues address in Clause 49 regarding
Corporate Governance are:
Board’s Director including its composition and compensation;
Provisions regarding Board’s Committee including composition and functioning of Audit
Committee which is an important pillar of the Corporate Governance;
Management of subsidiary companies;
Disclosures of important issues regarding related party transactions accounting policies,
principle of risk management, accounting for proceeds from public issues, right issues,
preferential issues, etc;
Content of management discussion and analysis;
Information to shareholders;
CEO/ CFO certification;
Report of Corporate Governance and compliance certificate. (Refer to Appendix –I for text of
the SEBI Circulars)
Management’s Responsibility
9.3 Managements’ responsibility for conducting its business implicitly requires it to take
reasonable steps to ensure the implementation of the requirements of corporate governance
as stipulated in Clause 49 of the Listing Agreement. Under the terms of the Listing Agreement,
a company is statutorily bound to implement the requirements of Clause 49 of the Listing
Agreement. This flows from provision of Section 21 of the Securities Contracts (Regulation)
Act, 1956. Section 23 of SCRA, 1956 provides for stringent penalties for non-compliance of
Section 21 of the said Act.
Audit Committee Under Clause 49

9.4 The summarised requirements of Corporate Governance under clause 49 of the listing
Agreement are discussed below.
9.4.1 Qualified and Independent Audit Committee [Clause 49 (II) (A)] - As per the SEBI
circular a qualified and independent audit committee shall be set up taking into account the
following norms:
(i) The audit committee shall have minimum three directors as members. Two-thirds of the
members of audit committee shall be independent directors
(ii) All members of audit committee shall be financially literate and at least one member shall
have accounting or related financial management expertise.
(iii) The Chairman of the Audit Committee shall be an independent director
(iv) The Chairman of the Audit Committee shall be present at Annual General Meeting to
answer shareholder queries
(v) The audit committee may invite such of the executives, as it considers appropriate (and
particularly the head of the finance function) to be present at the meetings of the
committee, but on occasions it may also meet without the presence of any executives of
the company. The finance director, head of internal audit and a representative of the
statutory auditor may be present as invitees for the meetings of the audit committee
(vi) The Company Secretary shall act as the secretary to the committee.
The term "financially literate" means the ability to read and understand basic financial
statements i.e. balance sheet, profit and loss account, and statement of cash flows.
A member will be considered to have accounting or related financial management expertise if
he or she possesses experience in finance or accounting, or requisite professional certification
in accounting, or any other comparable experience or background which results in the
individual’s financial sophistication, including being or having been a chief executive officer,
chief financial officer or other senior officer with financial oversight responsibilities.
9.4.2 Meeting of Audit Committee [Clause 49 (II) (B)] - The audit committee should meet at
least four times in a year and not more than four months shall elapse between two meetings.
The quorum shall be either two members or one third of the members of the audit committee
whichever is greater, but there should be a minimum of two independent members present.
9.4.3 Powers of Audit Committee [Clause 49 (II) (C)] - The audit committee shall have powers,
which should include the following:
(1) To investigate any activity within its terms of reference.
(2) To seek information from any employee.
(3) To obtain outside legal or other professional advice.
(4) To secure attendance of outsiders with relevant expertise.
Further it may be noted that the four powers as mentioned above are only illustrative and not
exhaustive.
The auditor should check whether the terms of reference of the audit committee have been
suitably framed mentioning the above powers. It is mandatory for the above-mentioned four
powers to be vested in the Audit Committee. The Board may delegate/vest further powers to
the committee.
9.4.4 Role of Audit Committee [Clause 49 (II) (D)] - The role of the audit committee shall
include the following:
a) Oversight of the company’s financial reporting process and the disclosure of its financial
information to ensure that the financial statement is correct, sufficient and credible.
b) Recommending the appointment and removal of external auditors, fixation of audit fee
and also approval for payment of any other services.
c) Reviewing with management the annual financial statements before submission to the
Board, focusing primarily on:
(i) Any changes in accounting policies / and practices;
(ii) Major accounting entries based on exercise of judgments by management;
(iii) Qualification in draft audit report;
(iv) Significant adjustments arising out of audit;
(v) The going concern assumption;
(vi) Compliance with accounting standards;
(vii) Compliance with stock exchanges and legal requirement concerning financial
statements.
(viii) Any related party transactions.
d) Reviewing with the management, external and internal auditors, the adequacy of internal
control system.
e) Reviewing the adequacy of internal audit function, if any including the structure of the
internal audit department, staffing and seniority of the official heading the department,
reporting structure coverage and frequency of internal audit.
f) Discussion with internal auditors any significant findings and follow-up thereon.
g) Reviewing the findings of any internal investigation by the internal auditors into matters
where there is suspected fraud or irregularity or a failure of internal control systems of a
material nature and reporting the matter to the Board.
h) Discussion with external auditors before the audit commences, nature and scope of audit
as well as have post audit discussion to ascertain any area of concern.
i) Reviewing the company’s financial and risk management policies.
j) To look into the reasons for substantial defaults in the payment to the depositors,
debenture holders, shareholders (in case of non-payment of declared dividend) and
creditors.
k) Carrying out any other function as is mentioned in the terms of reference of the Audit
Committee.
The term "related party transactions" shall have the same meaning as contained in
the Accounting Standard 18, Related Party Transactions, issued by the Institute of Chartered
If the company has set up an audit committee as per section 292A of the Companies Act, the
company agrees that the said audit committee shall have such additional functions / features
as is contained in the Listing Agreement.
Functions of the Audit Committee

9.5 The Audit Committee performs various important functions like investigating the matters
referred by board, discuss about internal control system etc. The sub-section 6 & 7 of Section
292A are reproduced hereunder which specify the functions of the audit committee:
(6) The Audit Committee should have discussions with the auditors periodically about
internal control systems, the scope of audit including the observations of the auditors and
review the half-yearly and annual financial statements before submission to the Board
and also ensure compliance of internal control systems.
(7) The Audit Committee shall have authority to investigate into any matter in relation to the
items specified in this section or referred to it by the Board and for this purpose, shall
have full access to information contained in the records of the company and external
professional advice, if necessary.
Review of Information by Audit Committee

9.6 The Audit Committee shall mandatorily review the following information as per
Clause 49 II (E):
1. Management discussion and analysis of financial condition and results of operations;
2. Statement of significant related party transactions (as defined by the audit committee),
submitted by management;
3. Management letters / letters of internal control weaknesses issued by the statutory
auditors;
4. Internal audit reports relating to internal control weaknesses; and
5. The appointment, removal and terms of remuneration of the Chief internal auditor shall
be subject to review by the Audit Committee.
The auditor should ascertain from the minutes book of the audit committee and other sources
like agenda papers, etc. whether the audit Committee has reviewed the above-mentioned
information. The auditor should ascertain whether as a part of directors’ report or as an
addition thereto, a management discussion and analysis report forms part of the annual report
to the shareholders. Under the old Clause 49, this was specifically mandated, but now not
spelt out clearly. The auditor should further ascertain whether the management discussion and
analysis includes discussion on the matters stipulated in this sub-clause.
Where certain deficiencies or adverse findings are noted by the audit committee, the auditor
will be required to see that these have been suitably dealt with by the management in the
Report on Corporate Governance.
The auditor should ascertain that the information reviewed by the Audit Committee is
consistent with the reporting in the financial statements including those drawn up giving
segment wise break-up for compliance of AS 17 (Segment Reporting).
Audit Committee under Section 292 A of The Companies Act, 1956

9.7 All companies listed on a stock exchange in India have to set-up in Audit Committee in
Compliance with clause 49 of the Listing Agreement. This is in addition to the creation of Audit
Committee under section 292 A of the Companies Act, 1956, the main features of which as
per the provision is outlined below:
Section 292 A of the Companies Act, 1956 provides:
(1) Every public company having paid-up capital of not less than five crores of rupees shall
constitute a committee of the Board known as “Audit Committee” which shall consist of
not less than three directors and such number of other directors as the Board may
determine of which two-thirds of the total number of members shall be directors, other
than managing or whole-time directors.
(2) Every Audit Committee constituted under sub-section (1) shall act in accordance with
terms of reference to be specified in writing by the Board.
(3) The members of the Audit Committee shall elect a chairman from amongst themselves.
(4) The annual report of the company shall disclose the composition of the Audit Committee.
(5) The auditors, the internal auditor, if any, and the director-in-charge of finance shall attend
and participate at meetings of the Audit Committee but shall not have the right to vote.
(6) The Audit Committee should have discussions with the auditors periodically about
internal control systems, the scope of audit including the observations of the auditors and
review the half-yearly and annual financial statements before submission to the Board
and also ensure compliance of internal control systems.
(7) The Audit Committee shall have authority to investigate into any matter in relation to the
items specified in this section or referred to it by the Board and for this purpose, shall
have full access to information contained in the records of the company and external
professional advice, if necessary.
(8) The recommendations of the Audit Committee on any matter relating to financial
management, including the audit report, shall be binding on the Board.
(9) If the Board does not accept the recommendations of the Audit Committee, it shall record
the reasons therefore and communicate such reasons to the shareholders.
(10) The chairman of the Audit Committee shall attend the annual general meetings of the
company to provide any clarification on matters relating to audit.
(11) If a default is made in complying with the provisions of this section, the company, and
every officer who is in default, shall be punishable with imprisonment for a term which
may extend to one year, or with fine which may extend to fifty thousand rupees, or with
both.”
Audit Committee - A Comparative

9.8 An Audit Committee is basically a committee formed with the Board of Director’s of the
company who are entrusted with the authority to oversee or supervise the process of financial
reporting of the enterprise including issues related to audit function and review of financial
policies, risk management policies etc. Introduction of such Committee under clause 49 of the
listing agreement and section 292 A of the Companies Act, 1956 in respect of specified
companies in India has brought about a marked change in the financial reporting process as
auditors now have an opportunity to bring forth audit - related issues to the attention of BOD,
mainly composed of non-executive or independent director for ensuring effective Corporate
Governance.
The comparative chart showing the requirements under clause 49 and Section 292A is
tabulated herein below:
Clause 49 of the Listing Agreement Section 292A of the Companies Act, 1956
1(a) All companies seeking listing for the 1. Every public company having paid-up
first time, at the time of seeking in capital of not less than five crores of rupees
principle approval for such listing and shall constitute an audit committee
(b) All existing listed companies with a immediately on the enactment of Companies
paid-up capital of Rs.3 Crores and above (Amendment) Act, 2000, i.e. with effect from
or net worth of Rs.25 crores or more at 13th December, 2000.
any time in the history of the company are
required to set up an audit committee.
2. The audit committee shall have 2. The audit committee shall have minimum
minimum three directors as members. three directors of which two-third of the total
Two-thirds of the members of audit number of such directors shall be directors
committee shall be independent directors. other than managing or whole-time directors.
3. All members of audit committee 3. No such reference is contained in the
shall be financially literate and at least Companies Act, 1956.
one member shall have accounting or
related financial management expertise.
4. The Chairman of the audit 4. The members of the audit committee shall
committee shall be an “independent” elect a chairman from amongst themselves.
director and shall be present at Annual The Chairman of the Audit Committee shall
General Meeting to answer queries of the attend the annual general meetings of the
shareholders. company to provide any clarification on
matters relating to audit.
5. A representative of the external 5. The Auditors, the internal auditor, if any,

auditor, when required shall be present as and the director-in-charge of finance shall
an invitee for the meetings of the audit attend and participate at meetings of the audit
committee. The audit committee may committee but shall not have the right to vote.
invite such of the executives to be present
at the meetings of the committee. The
Finance Director, head of internal audit
and a representative of the statutory
auditor may be present as invitees for the
meetings of the audit committee.
6. The Company Secretary shall act as 6. No such reference is contained in the
Secretary to the audit committee. Companies Act, 1956.
The following additional requirements are stipulated as per Clause 49 of the Listing Agreement
on which Section 292A (relating to audit committee) is silent:
(i) The audit committee may invite such of the executives, as it considers appropriate (and
particularly head of the finance function) to be present at the meeting of the committee,
but on occasions, it may also meet without the presence of any executives of the
company.
(ii) The company secretary shall act as secretary to the committee.
(iii) The audit committee shall meet at least four times in a year. The gap between two
meetings should not be more than four months.
(iv) The quorum of the audit committee shall be two members or one-third of the members of
the audit committee whichever is higher and minimum of two independent directors be
present.
(v) The powers and role of the audit committee are elaborately contained in Clause 49 II (C)
& (D).
(vi) All members of the audit committee shall be financially literate and at least one member
shall have accounting or related financial management expertise.
The following additional requirements are stipulated as per Section 292A the Companies Act,
1956 (relating to audit committee) on which Clause 49 of the Listing Agreement is silent:
(i) The audit committee constituted shall act in accordance with terms of reference to be
specified in writing by the Board.
(ii) The recommendations of the audit committee on any matter relating to financial
management, including the audit report, shall be binding on the Board.
(iii) If the Board does not accept the recommendations of the audit committee, it shall record
the reasons thereof and communicate such reasons to the shareholders.
The auditor should ascertain from the minutes book of the Board meetings whether a qualified
and independent audit committee is set up which comprises of minimum three members. The
auditor should ascertain whether two-thirds of the members of audit committee are
independent directors and whether all members of audit committee are financially literate and
at least one member has accounting or related financial management expertise. The term
"financially literate" means the ability to read and understand basic financial statements i.e.
balance sheet, profit and loss account, and statement of cash flows.
The auditor should have met at least four times in a year and not more than 4 months have
elapsed between two meetings.
The auditor should ascertain from the minute book of the audit committee whether quorum i.e.
two ascertain from the minute book of the audit committee whether the audit committee
members or one-third of the members of the audit committee, whichever is higher with a
minimum of two independent directors was present in every meeting of the audit committee.
The auditor should ascertain whether the Chairman of the Audit Committee is an independent
director. The expression “independent director” has been discussed in Clause 49 (I) (A) (iii).
The auditor should ascertain from the annual general meeting (herein after referred to as
AGM) attendance book and minutes book whether the chairman of the audit committee was
present at such meeting to answer shareholders’ queries. In case the Chairman has not been
present at the AGM, auditor should ensure that this is suitably disclosed. The AGM of the
financial year which is under audit would be held subsequent to the auditor submitting the
certificate of compliance of conditions of corporate governance and hence, the requirement
would be to verify this condition with reference to the last AGM held.
The auditor should ascertain whether there is a practice of inviting the executives (and
particularly the head of the finance function) in the audit committee meetings and he should
further ascertain from the minutes book of the audit committee whether such executives did
attend the audit committee meetings. His presence at such audit committee meetings
(pursuant to Section 292A) would be required only when he has been invited to, duly given
notice of such meeting
The auditor should ascertain from the minutes book of the audit committee, whether the
finance director, head of internal audit representative of the statutory auditor when required
was present as invitee in the meetings of the audit committee.
Role of Auditor in Audit Committee and Certification of Compliance of Conditions of

Corporate Governance
9.9 The amendment to Listing Agreement as well as the Companies Act, 1956 in respect of
constitution of audit committee underline the importance of audit process and its contribution
to the corporate governance process. Clause 49 stipulates that a representative of the
statutory auditor, when required, shall be present as an invitee for the meetings of the audit
committee. Section 292A of the Companies Act, 1956 stipulate that the auditors, the internal
auditor, if any, and the director-in-charge of finance shall attend and participate at meetings of
the Audit Committee but shall not have the right to vote.
The auditor would be informing the audit committee on various matters connected with the
audit from time to time. He can contribute significantly in assisting and advising the audit
committee as per the request of the audit committee, particularly in improving corporate
governance, oversight of financial reporting process, implementation of accounting policies
and practices, compliance with accounting standards, strengthening of the internal control
systems in regard to financial reporting and reporting processes.
The auditor would be devoting substantial professional time in assisting the management and
the audit committee to enable it to discharge its functions effectively and in certification of
requirements of corporate governance.
The auditor has to keep in mind that his role is not to drive corporate governance directly by
ensuring compliance of the requirements of corporate governance. It is the management
responsibility for ensuring the same and in the process he would play a significant role in
assisting the management for ensuring better standards of corporate governance.
9.9.1 Auditor’s Responsibility - The Auditor’s responsibility in certifying compliance of
requirements of corporate governance relate to verification and certification of factual
implementation of requirements of corporate governance as stipulated in Clause 49 of the
Listing Agreement. Such verification and certification is neither an audit nor an expression of
opinion on financial statements of the company.
The certificate from the Auditor as regards compliance of requirements of corporate
governance is neither an assurance as to the future viability of the company nor the efficiency
or effectiveness with which the management has conducted the affairs of the company.
9.9.2 General Principles of Audit - The Standards set out in Statements on Auditing and
Assurance Standards (hereinafter referred to as AAS) would be applicable in performance of
certification of requirements of corporate governance by the Auditor, to the extent relevant.
As in the case of other professional assignments, in certification of compliance of
requirements of corporate governance, the Auditor should comply with the “Code of Ethics ”
The Auditor should conduct verification of compliance of requirements of corporate
governance as stipulated in Clause 49 of the Listing Agreement in accordance with this
Guidance Note.
9.9.3 Documentation - The auditor should document matters, which are important in providing
evidence to support the certificate of factual findings in accordance with AAS 3 on
“Documentation”.
9.9.4 Management Representations - The auditor should consider obtaining management
representations on conditions of Corporate Governance in accordance with AAS 11,
“Management Representations”.
9.9.5 Verification regarding composition of Board - The students may refer appendix I and III
to understand the SEBI requirements as regards the composition of board of directors
The auditor should ascertain throughout the reporting period whether the Board of Directors
comprises not less than 50% of the directors who are non-executive directors. The
expressions “executive directors” and “non-executive directors” have not been explained in
Clause 49. The non-executive directors are directors who are not involved in day-to-day
management of the company. However, the expression “independent director” has been
explained in the Clause 49 I (A) (iii) of the Listing Agreement. The minutes of the Board in this
regard should be verified by the auditor for ascertaining as to which director is an independent
director. It may further be noted that nominee directors appointed by an institution, which has
invested in or lent to the company shall be deemed to be independent directors. For the
purpose of applying the test of “independence” of a director, reference may be made to Clause
49 I (A) (iii). It may, however, be noted that in the ultimate analysis, apart from the above
referred objective tests, judgment based on facts of the case may also be kept in mind. A non-
executive director may or may not be independent. However, an executive director cannot be
considered as an independent director. Also such independent director should not be related
to promoters or persons occupying management positions at the Board level or at one level
below the Board. The minutes of the Board of Directors’ should be verified to ascertain
whether a director is an executive director or a non-executive director.
The auditor should also verify that where the Chairman of the Board is a non-executive
director, at least 1/3rd of the Board should comprise of independent directors. In case the
Chairman is an executive director, at least half of the Board should comprise of independent
directors. In determining the number of requisite independent directors and/or non-executive
directors, the fraction, if any, in number of one-half or one-third as the case may be should be
rounded off. Since the terms in this clause refer to ‘not less than’ and ‘at least’, it would be
appropriate to compute the number by rounding off any fraction to the next integer. For
example, in a Board headed by non-executive Chairman and comprising of six other directors
(i.e., seven directors) the independent directors should be three or more.
Annual Declaration by directors to the Board of Directors may be examined for this purpose. If
Board of Directors has followed any particular procedure(s) to ascertain independence of
directors, the auditor should examine the same. Effect of changes in the composition of the
Board and/or its Chairman and its impact on compliance throughout the reporting period may
also be looked into.
It may be noted that a independent non-executive director apart from receiving remuneration
should not have any material pecuniary relationship or transactions with the company, its
promoters, its senior management or its holding company, its subsidiaries and associates
which may affect independence of the director.
Since the meaning of the term ‘associate’ is not apparent from Clause 49, a reference may be
made to AS 23 (Accounting for Investments in Associates in Consolidated Financial
Statements) which defines an associate as an enterprise in which the investor has significant
influence and which is neither a subsidiary nor a joint venture of the investor. However, for the
purpose of sub-clause (iii) only an associate, which is a company, should be considered.
The term ‘promoter’ has been defined in Explanation I in paragraph 6.8.3.2 of the SEBI
(Disclosure and Investor Protection) Guidelines, 2000. The same term has also been
differently defined in Regulation 2(1) (h) of the SEBI (Substantial Acquisition of Shares and
Takeovers) Regulation, 1997. Further the term ‘promoter’ has also been defined in Clause 4
(12) of the SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme)
Guidelines, 1999.(Refer to appendix IV)
Also, such independent director should not be a material supplier, service provider or
customer or a lessor or lessee of the company, which may affect independence of the director
and should not also be a substantial shareholder of the company. In determining ‘not a
substantial shareholder’, he should not own 2% or more of the block of voting shares. For this
purpose, reference can be made to Section 299 of the Companies Act, 1956.
According to Section 2(41) of the Companies Act, 1956, ‘relative’ means, with reference to any
person, any one who is related to such person in any of the ways specified in Section 6, and
no others. Further according to Section 6 of the Companies Act, 1956, a person shall be
deemed to be a relative of another if, and only if:
(a) They are members of a Hindu Undivided Family; or
(b) They are husband and wife; or
(c) The one is related to the other in the manner indicated in schedule 1A.
9.9.6 Remuneration of Directors [Clause 49 IV (E)] – Disclosure requirements regarding
directors remuneration are stated below:
(i) All pecuniary relationship or transactions of the non-executive directors vis-à-vis the
company shall be disclosed in the Annual Report.
(ii) Further the following disclosures on the remuneration of directors shall be made in the
section on the corporate governance of the Annual Report:
(a) All elements of remuneration package of individual directors summarized under
major groups, such as salary, benefits, bonuses, stock options, pension etc.
(b) Details of fixed component and performance linked incentives, along with the
performance criteria.
(c) Service contracts, notice period, severance fees.
(d) Stock option details, if any – and whether issued at a discount as well as the period
over which accrued and over which exercisable.
(iii) The company shall publish its criteria of making payments to non-executive directors in
its annual report. Alternatively, this may be put up on the company’s website and
reference drawn thereto in the annual report.
(iv) The company shall disclose the number of shares and convertible instruments held by
non-executive directors in the annual report.
(v) Non-executive directors shall be required to disclose their shareholding (both own or held
by / for other persons on a beneficial basis) in the listed company in which they are
proposed to be appointed as directors, prior to their appointment. These details should
be disclosed in the notice to the general meeting called for appointment of such director.
All pecuniary relationship or transactions of the non-executive director vis-à-vis the company
is required to be disclosed in the annual report. Auditor should check whether the particulars
regarding remuneration package of individual directors summarized under major groups have
been disclosed in the section in the Corporate Governance of the annual report.
Sub-Clause (iii) requires the publication of the criteria of making payments to non-executive
directors. This implies that the Board or the Remuneration Committee will have to frame a
specific policy for such remuneration. Such policy or criteria will have to be published in its
annual report. Alternatively, if the same is put up on the company’s website, a reference to
this disclosure will have to be made in the annual report.
Companies are required to annually disclose the details relating to shareholding by the non-
executive directors. However, non-executive directors shall be required to make such
disclosure on one time basis prior to his joining the Board. Further, the notice of general
meeting proposing to appoint such Director is required to disclose details of shareholding of
the directors in the company. For this purpose, the Director shall make suitable disclosure to
the company prior to his appointment and annually.
9.9.7 All fees/compensation, if any paid to non-executive directors, including independent
directors, shall be fixed by the Board of Directors and shall require previous approval of
shareholders in limits for the maximum number of stock options that can be granted to non-
executive directors, including independent directors, in any financial year and in aggregate.
Provided that the requirement of obtaining prior approval of shareholders in general meeting
shall not apply to payment of sitting fees to non-executive directors, if made within the limits
prescribed under the Companies Act, 1956 for payment of sitting fees without approval of the
Central Government.
In this context the auditor may note -
That no approval from the Central Government is required so along as the remuneration is
within the limits prescribed in Schedule XIII to the Companies Act, 1956.
Should ascertain from the minutes of the Board of Directors’ meeting, shareholders’ meetings,
relevant agenda papers, notices, explanatory statements etc., whether remuneration of non-
executive directors has been decided by the Board of directors and previous approval of the
shareholders in general meeting have been obtained.
May note that in regard to sitting fees payable to non-executive directors, prior approval in
general meeting will not be required if made within the limits prescribed under the Companies
Act, 1956.
Should also verify whether the remuneration is in compliance with Section 198, 309, 314, 349
and 350 of the Companies Act, 1956 and whether the stock options that are granted to the
non-executive directors are in accordance with SEBI (Employee Stock Option Scheme and
Employee Stock Purchase Scheme) Guidelines, 1999.
Should further refer to the Articles of Association of the Company wherever applicable.
Should examine the report of the Board of directors on Corporate Governance to be included
in the annual report of the company and ascertain whether the same contains the disclosures
required of remuneration to non-executive directors. The auditor should correlate this data
with that contained in the financial statements.
Since Clause 49 I (B) (i) refers to stock options that can be granted to non-executive directors,
reference may be made to ICAI Guidance Note on Accounting for Employee Share-based
Payments which defines the following terms:
a. Employee Stock Option plan is a plan under which the enterprise grants Employee
Stock Options.
b. Employee Stock Option is a contract that gives the employees of the enterprise the right,
but not the obligation, for a specified period of time, to purchase or subscribe to the
shares of the enterprise at a fixed or determinable price.
c. Employee Stock Purchase Plan is a plan under which the enterprise offers shares to its
employees as part of a public issue or otherwise.
Where application of this clause requires the value of ESOP to be determined, the services of
expert may have to be utilized. In this regard, reference may be made to AAS 9 dealing with
‘Using the Work of an Expert’
9.9.8 Other provisions as to Board and Committees as per Clause 49 I (C) –
(i) The board shall meet at least four times a year, with a maximum time gap of four months
between any two meetings. The minimum information to be made available to the board
is given in Annexure– I A.
(ii) A director shall not be a member in more than 10 committees or act as Chairman of more
than five committees across all companies in which he is a director. Furthermore it
should be a mandatory annual requirement for every director to inform the company
about the committee positions he occupies in other companies and notify changes as and
when they take place.
Explanation:
1. For the purpose of considering the limit of the committees on which a director can
serve, all public limited companies, whether listed or not, shall be included and all
other companies including private limited companies, foreign companies and
companies under Section 25 of the Companies Act shall be excluded.
2. For the purpose of reckoning the limit under this sub-clause,
Chairmanship/membership of the Audit Committee and the Shareholders’ Grievance
Committee alone shall be considered.
(iii) The Board shall periodically review compliance reports of all laws applicable to the
company, prepared by the company as well as steps taken by the company to rectify
instances of non-compliances.
9.9.9 Section 285 of the Companies Act, 1956 requires that - “Board to meet at least once in
every three calendar months- In the case of every company, a meeting of its Board of
Directors shall be held at least once in every three months and at least four such meetings
shall be held in every year.
Provided that the Central Government may, by notification in the Official Gazette, direct that
the provisions of this section shall not apply in relation to any class of companies or shall
apply in relation thereto subject to such exceptions, modifications or conditions as may be

specified in the notification.”
Clause 49 and Section 285 stipulate that the Board meeting shall be held at least four times a
year. The further requirement of Clause 49 is that the maximum time gap between any two
meetings should not exceed four months. The requirement under the Companies Act, 1956 is
that the Board meeting would be held at least once in every three months.
The auditor should ascertain from the minutes book of the Board meetings whether Board
meetings were held at least four times a year, with a maximum time gap of four months
between any two meetings. The auditor should also ascertain whether minimum information
was made available to the Board as given in Annexure –1C to Clause 49 of the Listing
Agreement.
The auditor should also ascertain that a director of the Company is not a member in more than
ten committees or is acting as chairman of more than five committees across all companies in
which he is a director. A suitable declaration from the management and/or director should be
obtained to this effect. This information should be verified from the mandatory annual
requirement for every director to inform the company about the committee positions he
occupies in other companies as well as from the changes notified by every director when they
take place. The Explanation (1) to Clause 49 (1) (C) (ii) clarifies that the limit of the
committees on which a director can serve would comprise of all public limited companies,
whether listed or not and excluding private limited companies, foreign companies and
companies which are granted license under section 25 of the Companies Act, 1956. Further
Explanation (2) clarifies that only two committees namely Audit Committee, and Shareholders’
Grievance Committee shall be considered for the purpose of limit.
For the purpose of reviewing compliance reports of all laws applicable to the company, the
said reports prepared by the company as well as steps taken by the company to rectify
instances of non-compliances, the auditor should take into consideration AAS 21, dealing with
consideration of Laws and Regulations in an Audit of Financial Statements. It is the
management’s responsibility to ensure that company operations are conducted in accordance
with Laws and Regulations. The responsibility for the prevention and detection of non-
compliance rests with the management. The auditor’s responsibility is limited to verification
that management has taken suitable steps and has put in place policies and procedures to
ensure compliance with laws and regulations and to detect deviation from such procedures.
9.9.10 Code of Conduct as per Clause 49 I (D) -
(i) The Board shall lay down a code of conduct for all Board members and senior
management of the company. The code of conduct shall be posted on the website of the
company.
(ii) All Board members and senior management personnel shall affirm compliance with the
code on an annual basis. The Annual Report of the company shall contain a declaration
to this effect signed by the CEO.
For this purpose, the term “senior management” shall mean personnel of the company who
are members of its core management team excluding Board of Directors. Normally, this would
comprise all members of management one level below the executive directors, including all
functional heads.
The auditor should ascertain whether the Board of Directors of the company has laid down a
code of conduct for all Board members and senior personnel of the company and obtain a
copy of the same. He should also verify whether all Board members and senior management
personnel have affirmed compliance with the code on an annual basis and whether the code
has been posted on company’s website.
9.9.11 Subsidiary Companies Clause 49 (III) -
(i) At least one independent director on the Board of Directors of the holding company shall
be a director on the Board of Directors of a material non listed Indian subsidiary
company.
(ii) The Audit Committee of the listed holding company shall also review the financial
statements, in particular, the investments made by the unlisted subsidiary company.
(iii) The minutes of the Board meetings of the unlisted subsidiary company shall be placed at
the Board meeting of the listed holding company. The management should periodically
bring to the attention of the Board of Directors of the listed holding company, a statement
of all significant transactions and arrangements entered into by the unlisted subsidiary
company.
The term “material non-listed Indian subsidiary” shall mean an unlisted subsidiary,
incorporated in India, whose turnover or net worth (i.e. paid up capital and free reserves)
exceeds 20% of the consolidated turnover or net worth respectively, of the listed holding
company and its subsidiaries in the immediately preceding accounting year.
The term “significant transaction or arrangement” shall mean any individual transaction or
arrangement that exceeds or is likely to exceed 10% of the total revenues or total expenses or
total assets or total liabilities, as the case may be, of the material unlisted subsidiary for the
immediately preceding accounting year.
Where a listed holding company has a listed subsidiary which is itself a holding company, the
above provisions shall apply to the listed subsidiary insofar as its subsidiaries are concerned.
Clause 49 III (i) requires the appointment of at least one of the independent director of a
holding company to be appointed as a director of a material non-listed Indian subsidiary
company. The concept of “material” non-listed subsidiary is explained in Explanation 1 under
the said clause.
In regard to taking note of the proceedings of the Board of the unlisted company, Clause 49 III
(iii) requires the minutes of the Board of every unlisted subsidiary to be placed before the
Board of the holding company. Apart from the above, the management of the holding company
should periodically bring to the attention of the Board of Directors of the listed holding
company, a statement of all significant transactions and arrangements entered into by the
unlisted subsidiary company. This applies only in regard to “significant transaction or
arrangement” the meaning of which is given in Explanation 2 under the clause.
Reading the Explanation 2 in totality, it would be seen that the disclosure to the Board of the
holding company would apply only where such significant transaction or arrangement are
entered into by a company which is a material unlisted subsidiary as mentioned above.
It may further be noted that the plain reading of Explanation 2 would indicate that the least of
total revenues, total expenses, total assets or total liabilities of the immediately preceding
accounting year are to be considered as the basis for computing benchmark of 10% thereof.
However, the use of the words ‘or’ coupled with ‘as the case may be’ would support the more
logical view that one has to apply the test comparing with like items. For example a capital
expenditure has to be compared with aggregate capital expenditure for the year. When making
the comparison of any transaction with ‘total revenues”, “total expenses” etc., one may take
into consideration the total revenue or expenditure ‘likely to’ arise for the entire financial year
and not necessarily the aggregate expenditure incurred.
Clause 49 III (ii) requires the audit committee of the listed holding company to review the
financial statements and in particular, the investments made by the unlisted subsidiary
company would apply all unlisted subsidiary companies. This is required in regard to all
unlisted subsidiaries, without reference to materiality or place of incorporation etc. Where
however the subsidiary of a listed company is itself a listed company, the Explanation 3 would
apply.
9.9.12 Proceeds from public issues, rights issues, preferential issues etc Clause 49 IV (D) -
When money is raised through an issue (public issues, rights issues, preferential issues etc.),
it shall disclose to the Audit Committee, the uses / applications of funds by major category
(capital expenditure, sales and marketing, working capital, etc), on a quarterly basis as a part
of their quarterly declaration of financial results. Further, on an annual basis, the company
shall prepare a statement of funds utilized for purposes other than those stated in the offer
document/prospectus/notice and place it before the audit committee. Such disclosure shall be
made only till such time that the full money raised through the issue has been fully spent. This
statement shall be certified by the statutory auditors of the company. The audit committee
shall make appropriate recommendations to the Board to take up steps in this matter.
The object of this sub-clause is to ensure that in case of diversion of funds from the proceeds
of issues, it should be appropriately brought to the notice of audit committee for suitable action
to be taken. Also, it is desirable that quarterly and yearly report on the same is placed before
the audit committee for its review and action if any. It is to be noted that the disclosure under
the sub-clause should continue to be made till such time the issue money is utilized in full and
the statutory auditors certify the said statement. Further it may be noted that statement shall
pertain only to the year in which money has been raised or till such time the money is fully
spent whichever is later.
The following procedure may be noted in carrying out the aforesaid action on the uses and
applications of funds from proceeds from public issues etc:
The quarterly report on the uses/application of funds shall be placed before the Audit
Committee by the management.
Diversion of funds, if any shall be brought to the attention of the Audit Committee by the
management
The management would then obtain the duly certified statement from the statutory auditors of
the company and place it before the Audit Committee to enable the discontinuance of
reporting thereafter.
9.9.13 Content of Management Discussion and Analysis [Clause 49 IV (F)] -
(i) As part of the directors’ report or as an addition thereto, a Management Discussion and
Analysis report should form part of the Annual Report to the shareholders. This
Management Discussion & Analysis should include discussion on the following matters
within the limits set by the company’s competitive position:
(i) Industry structure and developments.
(ii) Opportunities and Threats.
(iii) Segment–wise or product-wise performance.
(iv) Outlook
(v) Risks and concerns.
(vi) Internal control systems and their adequacy.
(vii) Discussion on financial performance with respect to operational performance.
(viii) Material developments in Human Resources / Industrial Relations front, including
number of people employed.
(ii) Senior management shall make disclosures to the board relating to all material financial
and commercial transactions, where they have personal interest, that may have a
potential conflict with the interest of the company at large (for e.g. dealing in company
shares, commercial dealings with bodies, which have shareholding of management and
their relatives etc.)
Explanation: For this purpose, the term "senior management" shall mean personnel of the
company who are members of its core management team excluding the Board of Directors).
This would also include all members of management one level below the executive directors
including all functional heads.
The above information presented by the Management is likely to include non-financial
information, which may be outside the area of auditors’ expertise. In such situations, the
auditor may keep in mind the AAS 20 relating to Knowledge of the Business and the fact that
he is only required to review the compliance with Disclosure requirements and not verify the
particular facts as disclosed by the management.
The auditor should ascertain that this information [i.e. segment-wise or product-wise
performance (sub-clause (iii) as stated above) and considered as a part of Management
Discussion and Analysis Report] is consistent with what is reported in financial statements
complying with AS 17 (Segment Reporting) and also as per provisions of Section 211,
217(2AA) and 227 of the Companies Act, 1956.
9.9.14 Information to Shareholders [Clause 49 IV (G)] -

(i) In case of the appointment of a new director or re-appointment of a director the
shareholders must be provided with the following information:
(a) A brief resume of the director;
(b) Nature of his expertise in specific functional areas;
(c) Names of companies in which the person also holds the directorship and the
membership of Committees of the Board; and
(d) Shareholding of non-executive directors as stated in Clause 49 (IV) (E) (v) above
(ii) Quarterly results and presentations made by the company to analysts shall be put on
company’s web-site, or shall be sent in such a form so as to enable the stock exchange
on which the company is listed to put it on its own web-site.
(iii) A board committee under the chairmanship of a non-executive director shall be formed to
specifically look into the redressal of shareholder and investors complaints like transfer of
shares, non-receipt of balance sheet, non-receipt of declared dividends etc. This
Committee shall be designated as ‘Shareholders/ Investors Grievance Committee’.
(iv) To expedite the process of share transfers, the Board of the company shall delegate the
power of share transfer to an officer or a committee or to the registrar and share transfer
agents. The delegated authority shall attend to share transfer formalities at least once in
a fortnight.
The auditor should ascertain from the communications sent, whether in the case of
appointment of a new director or re-appointment of a director the shareholders have been
provided with the information stipulated in sub-clause (i) as mentioned above.
The auditor should see that the references contained in the above paragraph are complied
therewith.
The Auditor should ascertain from the company’s website whether information like quarterly
results, presentation made by the entity to analyst have been put on company’s website. In the
alternative whether such information has been sent in a form so as to enable the Stock
Exchange in which the company’s securities are listed to enable such Stock Exchange to put it
on its own website. The auditor should also ascertain whether the other information which are
mandatorily required to be disclosed to the shareholders as per the Listing Agreement or as
per the Companies Act, 1956 are put on company’s web-site or alternatively sent in such form
to enable the stock exchange on which the company’s securities are listed to enable such
stock exchange to put it on its own web-site.
The auditor should ascertain from the minute book of the Board meeting whether a Board
committee namely Shareholders/ Investors Grievance Committee has been set up under the
chairmanship of a non-executive director to specifically look into the redressing of shareholder
and investors complaints like transfer of shares, non receipt of balance sheet, non receipt of
declared dividends, etc. Further the auditor should also ascertain from the minute book of the
Shareholders/ Investors Grievance Committee whether such committee is prima-facie

functioning.
The auditor should also verify from the records of the Shareholders/ Investors Grievance
Committee as well as from the certificate obtained by the company from SEBI and Stock
Exchange(s), if any, as regards the investors grievances pending upto the date of certificate of
compliance of conditions of corporate governance.
The auditor should ascertain from the minute book of the Board meeting whether the company
has delegated the power of share transfer to an officer or a committee or to the registrar and
share transfer agents. The auditor should also verify from the records maintained to ascertain
whether the delegated authority has attended to share transfer formalities at least once in a
fortnight. The auditor may verify whether any transfer request are pending for more than a
fortnight and are not attended to in terms of this sub-paragraph.
9.9.15 CEO/CFO certification Clause 49 V - The CEO, i.e. the Managing Director or Manager
appointed in terms of the Companies Act, 1956 and the CFO i.e. the whole-time Finance
Director or any other person heading the finance function discharging that function shall certify
to the Board that:
(a) They have reviewed financial statements and the cash flow statement for the year and
that to the best of their knowledge and belief:
(i) These statements do not contain any materially untrue statement or omit any
material fact or contain statements that might be misleading;
(ii) These statements together present a true and fair view of the company’s affairs and
are in compliance with existing accounting standards, applicable laws and
regulations.
(b) There are, to the best of their knowledge and belief, no transactions entered into by the
company during the year which are fraudulent, illegal or violative of the company’s code
of conduct.
(c) They accept responsibility for establishing and maintaining internal controls for financial
reporting and that they have evaluated the effectiveness of the internal control systems
of the company pertaining to financial reporting and they have disclosed to the auditors
and the Audit Committee, deficiencies in the design or operation of internal controls, if
any, of which they are aware and the steps they have taken or propose to take to rectify
these deficiencies.
(d) They have indicated to the auditors and the Audit committee
(i) Significant changes in internal control over financial reporting during the year;
(ii) Significant changes in accounting policies during the year and that the same have
been disclosed in the notes to the financial statements; and
(iii) Instances of significant fraud of which they have become aware and the
involvement therein, if any, of the management or an employee having a significant
role in the company’s internal control system over financial reporting.”
The amendments effected in Clause 49V(c) & (d) clearly bring out that
The responsibility entrusted to the CEO/CFO is in relation to establishing and maintaining
internal controls for financial reporting.
The CEO/CFO certificate has to assert that they have evaluated the effectiveness of internal
control systems of the company pertaining to financial reporting.
The CEO/CFO certificate will further state the manner in which deficiencies (if any) in the
design or operation of such internal controls has been disclosed to the auditors and the audit
committee.
The CEO/CFO certification will also state the steps they have taken or propose to take to
rectify these deficiencies in the design or operation of such internal controls pertaining to
financial reporting.
In the context of internal controls, the auditor should ensure that
The management has institutionalized an internal control framework with respect to financial
reporting controls. The framework should be examined in the context of the documentation
created for each significant process in terms of the related risk and mitigating control;
He has further examined whether the assessment process followed for evaluation of controls
is reasonable and there is a process by which significant deficiencies as well as steps taken to
correct them is communicated to the audit committee and to the auditors; and
He should also examine whether a process exists in the company whereby all significant
changes in the accounting policies and in the system of internal controls are communicated to
the audit committee and the auditors.
The auditor should examine the adequacy of the process followed for issuing the CEO/CFO
certificate and should review the same in regard to matters stated in Para 9.52 above and the
consideration of the same by the Audit Committee. For this purpose he should refer to the
minutes of the Audit Committee.
In certain situations negative or adverse comment or exclusions/disclaimer contained in the
CEO/CFO certificate, the auditor should take cognizance of the same as the circumstances
require in the audit report and or the Certificate of Compliance of conditions of Corporate
Governance.
Disclosures
9.10 The Report on Corporate Governance requires disclosure of certain transactions with
related parties or transactions, which may not be ‘arms length’ transactions. The auditor is
required to verify whether the management has placed periodically the information before the
Audit Committee. The disclosures to be made is mentioned below
The transactions required to be disclosed by the management are as under -
- Transactions with related parties, entered into in the ordinary course of business are to be
disclosed in summary form (Grouping them into broad categories of the transactions).
- Transactions with related parties which do not fall within the normal business transactions
(and are therefore not covered in (a) above) are to be disclosed individually if such
transactions are material transactions.
- Transactions with any party (related or otherwise), which are not considered as arm’s length
transactions, are to be disclosed individually if such transactions are material transactions.
The auditor has to verify whether a transaction is a related party transaction as per AS 18
(Related Party Disclosures). As per AS 18, parties are considered to be related if at any time
during the reporting period one party has the ability to control the other party or exercise
significant influence over the other party in making financial and/or operating decisions. For
the purpose of carrying out verification, reference may be made to AAS 23 (Related Parties).
Materiality depends on the size and nature of the item judged in the particular circumstances.
9.10.1 Basis of related party transactions Clause 49 IV (A) -
(i) A statement in summary form of transactions with related parties in the ordinary course
of business shall be placed periodically before the audit committee.
(ii) Details of material individual transactions with related parties which are not in the normal
course of business shall be placed before the audit committee.
(iii) Details of material individual transactions with related parties or others, which are not on
an arm’s length basis should be placed before the audit committee, together with
Management’s justification for the same.
9.10.2 Disclosure of Accounting Treatment Clause 49 IV (B) - Where in the preparation of
financial statements, a treatment different from that prescribed in an Accounting Standard has
been followed, the fact shall be disclosed in the financial statements, together with the
management’s explanation as to why it believes such alternative treatment is more
representative of the true and fair view of the underlying business transaction in the Corporate
Governance Report.
In this regard the auditor has to refer to Sections 211(3B), 217(2AA) and 227 of the
Companies Act, 1956. Also the auditor should refer to the CEO/CFO certification given under
Clause 49 (IV).
9.10.3 Board Disclosures – Risk management Clause 49 IV (C) - The company shall lay down
procedures to inform Board members about the risk assessment and minimization procedures.
These procedures shall be periodically reviewed to ensure that executive management
controls risk through means of a properly defined framework.
Report on Corporate Governance
9.11 As per Clause 49 (VI) -
(i) There shall be the separate section on Corporate Governance in the Annual Reports of
Company, with a detailed compliance report on Corporate Governance. Non-Compliance
of any Mandatory Requirement i.e., which is a part of the Listing Agreement with reasons
thereof and the extent to which the Non-Mandatory requirements have been adopted
should be specifically highlighted. The suggested list of items to be included in this report
is given in Annexure-IC and list of non-mandatory requirements is given in Annexure–I D.
(ii) The companies shall submit a quarterly compliance report to the stock exchanges within
15 days from the close of quarter as per the format given in Annexure-IB. The report
shall be signed either by the Compliance Officer or the Chief Executive Officer of the
company.
The auditor should ascertain whether the Board of directors have included in the annual report
of the company, a separate section on corporate governance with a detailed compliance
report on corporate governance. This would specifically highlight non-compliance of any
mandatory requirement. (i.e. which is part of the Listing Agreement) with reasons thereof and
also the extent to which the non-mandatory requirements have been adopted. The auditor
should also verify whether the suggested list of items to be included in this report as per
Annexure-I C of Clause 49 and list of non-mandatory requirements as per Annexure-I D of
Clause 49 have been incorporated in such report.
Any data in the report on corporate governance should not be inconsistent with that contained
in the financial statements.
Auditors’ Certificate
9.12 As per the listing agreement of Clause 49 (VII) a company shall obtain a Certificate from
the Auditor of the company regarding compliance of conditions of Corporate Governance and
annex the Certificate with the Directors’ Report which is sent annually to all the shareholders
of the company. The same Certificate shall also be sent to the stock exchange along with
annual returns filed by the company.
9.12.1 Adverse or Qualified Statement - Depending upon the facts and circumstances, some
situations may require an adverse or qualified statement or a disclosure without necessarily
making it a subject matter of qualification in the Auditors’ Certificate, in respect of compliance
of requirements of Corporate Governance for e.g.,
(a) The number of non-executive directors is less than 50% of the strength of Board of
directors.
(b) A qualified and independent audit committee is not set up.
(c) The chairman of the audit committee is not an independent director.
(d) The audit committee does not meet four times a year.
(e) The necessary powers in terms of Clause 49 II (D) of the Listing Agreement have not
been vested by the Board in the audit committee.
(f) The time gap between two Board meetings is more than four months.
(g) A director is a member of more than ten committees across all companies in which he is
a director.
(h) The information of quarterly results is neither put on the company’s website nor sent in a
form so as to enable the Stock Exchange on which the entity’s securities are listed to
enable such Stock Exchange to put it on its own website.
(i) The power of share transfer is not delegated to an officer or a committee or to the
registrar and share transfer agents.
A Performa of the Certificate to be issued by the Auditors regarding compliance of conditions
of Corporate Governance is shown below:
CERTIFICATE
To,
The Members of................
(Name of the entity)
We have examined the compliance of conditions of Corporate Governance by ( name of
the entity ) for the year ended on ......... as stipulated in clause 49 of the listing Agreement of
the said with stock Exchange (s).
The compliance of conditions of Corporate Governance is the responsibility of the
management. Our examination was limited to procedures and implementation thereof, adopted
by the company for ensuring the compliance of the conditions of the Corporate Governance. It
is neither an audit nor an expression of opinion on the financial statement of the company.
In our opinion, and to the best of our information and according to the explanations given
to us, subject to the following:
1)
2)
We certify that the company has complied with the conditions of Corporate Governance as
stipulated in the above mentioned listing Agreement.
We state that no / ...... investor grievance(s) is / are pending for a period exceeding one month
against the company as per the records maintained by the shareholders / investors Grievance
Committee.
We further state that such compliance is neither an assurance as to the future viability of the
company nor the efficiency or effectiveness with which the management has conducted the
affairs of the company.
For & on behalf of
XYZ & Co.
(Partner / Proprietor)
Place..........
Date............
1. State important requirement of Clause 49 of listing agreement regarding Corporate
Governance.
2. Briefly discuss the composition powers and functions of the Audit Committee as per the
Clause 49 of the listing agreement.
3. State the role of Audit Committee as per Clause 49 of the listing agreement.
4. Which information should the Audit Committee review mandatory.
5. Compare the requirement relating to Audit Committee as per Section 292 A of the Companies
Act, 1956 and Clause 49 of the listing agreement.
6. Explain the audit techniques regarding certification of compliance of conditions of
corporate governance by an auditor.
7. Explain the requirements of Clause 49 regarding disclosure of proceed from public
issues, right issues and preferential issues and purpose thereof.
8. State the information to be disclosed for the shareholders under [Clause 49 II (G) ]
9. Explain the requirements of CO/CFO certification under Clause 49 (V).
10. Design a Performa of auditor certificate as per Clause 49 of the listing agreement.
APPENDIX – I
EXTRACTS OF SEBI CIRCULARS ON CORPORATE GOVERNANCE

(Circular No. SEBI/CFD/DIL/CG/1/2004/12/10) dated October 29, 2004
Sub: Corporate Governance in listed Companies – Clause 49 of the Listing Agreement
1. All Stock Exchanges are hereby directed to amend the Listing Agreement by replacing the
existing Clause 49 of the listing agreement (issued vide circulars dated 21st February, 2000, 9th
March 2000, 12th September 2000, 22nd January, 2001, 16th March 2001 and 31st December
2001) with the revised Clause 49 given in Annexure I through I D to this circular. SEBI Circular
no. SEBI/MRD/ SE/31/2003/26/08 dated August 26, 2003 (which has been since deferred) is
hereby withdrawn. The revised Clause 49 also specifies the reporting requirements for a
company.
2. Please note that this is a master circular which supersedes all other earlier circulars issued by
SEBI on Clause 49 of the Listing Agreement.
3. The provisions of the revised Clause 49 shall be implemented as per the schedule of
implementation given below:
(a) For entities seeking listing for the first time, at the time of seeking in-principle approval for
such listing.
(b) For existing listed entities which were required to comply with Clause 49 which is being
revised i.e. those having a paid up share capital of Rs. 3 crores and above or net worth of
Rs. 25 crores or more at any time in the history of the company, by April 1, 2005.
Companies complying with the provisions of the existing Clause 49 at present (issued vide
circulars dated 21st February, 2000, 9th March 2000, 12th September 2000, 22nd January, 2001
16th March 2001 and 31st December 2001) shall continue to do so till the revised Clause 49 of
the Listing Agreement is complied with or till March 31, 2005, whichever is earlier.
4. The companies which are required to comply with the requirements of the revised Clause 49 shall
submit a quarterly compliance report to the stock exchanges as per sub Clause VI (ii), of the
revised Clause 49, within 15 days from the end of every quarter. The first such report would be
submitted for the quarter ending June 30, 2005. The report shall be signed either by the
Compliance Officer or the Chief Executive Officer of the company.
5. The revised Clause 49 shall apply to all the listed companies, in accordance with the schedule of
implementation given above. However, for other listed entities which are not companies, but body
corporate (e.g. private and public sector banks, financial institutions, insurance companies etc.)
incorporated under other statutes, the revised Clause 49 will apply to the extent that it does not
violate their respective statutes and guidelines or directives issued by the relevant regulatory
authorities. The revised Clause 49 is not applicable to Mutual Funds.
6. The Stock Exchanges shall ensure that all provisions of the revised Clause 49 have been
complied with by a company seeking listing for the first time, before granting the in-principle
approval for such listing. For this purpose, it will be considered satisfactory compliance if such a
company has set up its Board and constituted committees such as Audit Committee,
Shareholders/ Investors Grievances Committee etc. in accordance with the revised clause before
seeking in-principle approval for listing.
7. The Stock Exchanges shall set up a separate monitoring cell with identified personnel to monitor
the compliance with the provisions of the revised Clause 49 on corporate governance. The cell,
after receiving the quarterly compliance reports from the companies which are required to comply
with the requirements of the revised Clause 49, shall submit a consolidated compliance report to
SEBI within 60 days from the end of each quarter.
Encl: Annexure I, I A, I B, I C & I D

ANNEXURE - I
Clause 49 - Corporate Governance

(Circular No. SEBI/CFD/DIL/CG/1/2004/12/10) dated October 29, 2004
The company agrees to comply with the following provisions:
I. Board of Directors
(A) Composition of Board
(i) The Board of directors of the company shall have an optimum combination of executive and non-
executive directors with not less than fifty percent of the board of directors comprising of non-
executive directors.
(ii) Where the Chairman of the Board is a non-executive director, at least one-third of the Board
should comprise of independent directors and in case he is an executive director, at least half of
the Board should comprise of independent directors.
(iii) For the purpose of the sub-clause (ii), the expression ‘independent director’ shall mean a non-
executive director of the company who:
(a) apart from receiving director’s remuneration, does not have any material pecuniary
relationships or transactions with the company, its promoters, its directors, its senior
management or its holding company, its subsidiaries and associates which may affect
independence of the director;
(b) is not related to promoters or persons occupying management positions at the board level
or at one level below the board;
(c) has not been an executive of the company in the immediately preceding three financial
years;
(d) is not a partner or an executive or was not partner or an executive during the preceding
three years, of any of the following:
(i) the statutory audit firm or the internal audit firm that is associated with the company,
and
(ii) the legal firm(s) and consulting firm(s) that have a material association with the
company.
(e) is not a material supplier, service provider or customer or a lessor or lessee of the company,
which may affect independence of the director; and
(f) is not a substantial shareholder of the company i.e. owning two percent or more of the block
of voting shares.
Explanation: For the purposes of the sub-clause (iii):
(a) Associate shall mean a company which is an “associate” as defined in Accounting Standard
(AS) 23, “Accounting for Investments in Associates in Consolidated Financial Statements”,
(b) “Senior management” shall mean personnel of the company who are members of its core
management team excluding Board of Directors. Normally, this would comprise all members
of management one level below the executive directors, including all functional heads.
(c) “Relative” shall mean “relative” as defined in section 2(41) and section 6 read with Schedule
IA of the Companies Act, 1956.
(iv) Nominee directors appointed by an institution which has invested in or lent to the company
shall be deemed to be independent directors.
Explanation: “Institution’ for this purpose means a public financial institution as defined in Section 4A
of the Companies Act, 1956 or a “corresponding new bank” as defined in section 2(d) of the Banking
Companies (Acquisition and Transfer of Undertakings) Act, 1970 or the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1980 [both Acts].”
(B) Non executive directors’ compensation and disclosures
All fees/compensation, if any paid to non-executive directors, including independent directors, shall be
fixed by the Board of Directors and shall require previous approval of shareholders in general meeting.
The shareholders’ resolution shall specify the limits for the maximum number of stock options that can
be granted to non-executive directors, including independent directors, in any financial year and in
aggregate.
Provided that the requirement of obtaining prior approval of shareholders in general meeting shall not
apply to payment of sitting fees to non-executive directors, if made within the limits prescribed under
the Companies Act, 1956 for payment of sitting fees without approval of the Central Government.
(C) Other provisions as to Board and Committees
(i) The board shall meet at least four times a year, with a maximum time gap of four months between
any two meetings. The minimum information to be made available to the board is given in
Annexure– I A.
(ii) A director shall not be a member in more than 10 committees or act as Chairman of more than
five committees across all companies in which he is a director. Furthermore it should be a
mandatory annual requirement for every director to inform the company about the committee
positions he occupies in other companies and notify changes as and when they take place.
Explanation:
1. For the purpose of considering the limit of the committees on which a director can serve, all public
limited companies, whether listed or not, shall be included and all other companies including
private limited companies, foreign companies and companies under Section 25 of the Companies
Act shall be excluded.
2. For the purpose of reckoning the limit under this sub-clause, Chairmanship/membership of the
Audit Committee and the Shareholders’ Grievance Committee alone shall be considered.
(iii) The Board shall periodically review compliance reports of all laws applicable to the company,
prepared by the company as well as steps taken by the company to rectify instances of non-
compliances.
(D) Code of Conduct
(i) The Board shall lay down a code of conduct for all Board members and senior management of the
company. The code of conduct shall be posted on the website of the company.
(ii) All Board members and senior management personnel shall affirm compliance with the code on
an annual basis. The Annual Report of the company shall contain a declaration to this effect
signed by the CEO.
Explanation: For this purpose, the term “senior management” shall mean personnel of the company
who are members of its core management team excluding Board of Directors.. Normally, this would
comprise all members of management one level below the executive directors, including all functional
heads.
II. Audit Committee
(A) Qualified and Independent Audit Committee
A qualified and independent audit committee shall be set up, giving the terms of reference subject to
the following:
(i) The audit committee shall have minimum three directors as members. Two-thirds of the members
of audit committee shall be independent directors.
(ii) All members of audit committee shall be financially literate and at least one member shall have
accounting or related financial management expertise.
Explanation 1: The term “financially literate” means the ability to read and understand basic
financial statements i.e. balance sheet, profit and loss account, and statement of cash flows.
Explanation 2: A member will be considered to have accounting or related financial management
expertise if he or she possesses experience in finance or accounting, or requisite professional
certification in accounting, or any other comparable experience or background which results in the
individual’s financial sophistication, including being or having been a chief executive officer, chief
financial officer or other senior officer with financial oversight responsibilities.
(iii) The Chairman of the Audit Committee shall be an independent director;
(iv) The Chairman of the Audit Committee shall be present at Annual General Meeting to answer
shareholder queries;
(v) The audit committee may invite such of the executives, as it considers appropriate (and
particularly the head of the finance function) to be present at the meetings of the committee, but
on occasions it may also meet without the presence of any executives of the company. The
finance director, head of internal audit and a representative of the statutory auditor may be
present as invitees for the meetings of the audit committee;
(vi) The Company Secretary shall act as the secretary to the committee.
(B) Meeting of Audit Committee
The audit committee should meet at least four times in a year and not more than four months shall
elapse between two meetings. The quorum shall be either two members or one third of the members of
the audit committee whichever is greater, but there should be a minimum of two independent members
present.
(C) Powers of Audit Committee
The audit committee shall have powers, which should include the following:
1. To investigate any activity within its terms of reference.
2. To seek information from any employee.
3. To obtain outside legal or other professional advice.
4. To secure attendance of outsiders with relevant expertise, if it considers necessary.
(D) Role of Audit Committee
The role of the audit committee shall include the following:
1. Oversight of the company’s financial reporting process and the disclosure of its financial
information to ensure that the financial statement is correct, sufficient and credible.
2. Recommending to the Board, the appointment, re-appointment and, if required, the replacement
or removal of the statutory auditor and the fixation of audit fees.
3. Approval of payment to statutory auditors for any other services rendered by the statutory
auditors.
4. Reviewing, with the management, the annual financial statements before submission to the board
for approval, with particular reference to:
(a) Matters required to be included in the Director’s Responsibility Statement to be included in
the Board’s report in terms of clause (2AA) of section 217 of the Companies Act, 1956
(b) Changes, if any, in accounting policies and practices and reasons for the same
(c) Major accounting entries involving estimates based on the exercise of judgment by
management d. Significant adjustments made in the financial statements arising out of audit
findings
(d) Compliance with listing and other legal requirements relating to financial statements
(e) Disclosure of any related party transactions
(f) Qualifications in the draft audit report.
5. Reviewing, with the management, the quarterly financial statements before submission to the
board for approval
6. Reviewing, with the management, performance of statutory and internal auditors, adequacy of the
internal control systems.
7. Reviewing the adequacy of internal audit function, if any, including the structure of the internal
audit department, staffing and seniority of the official heading the department, reporting structure
coverage and frequency of internal audit.
8. Discussion with internal auditors any significant findings and follow up there on.
9. Reviewing the findings of any internal investigations by the internal auditors into matters where
there is suspected fraud or irregularity or a failure of internal control systems of a material nature
and reporting the matter to the board.
10. Discussion with statutory auditors before the audit commences, about the nature and scope of
audit as well as post-audit discussion to ascertain any area of concern.
11. To look into the reasons for substantial defaults in the payment to the depositors, debenture
holders, shareholders (in case of non payment of declared dividends) and creditors.
12. To review the functioning of the Whistle Blower mechanism, in case the same is existing.
13. Carrying out any other function as is mentioned in the terms of reference of the Audit Committee.
Explanation (i): The term "related party transactions" shall have the same meaning as contained
in the Accounting Standard 18, Related Party Transactions, issued by The Institute of Chartered
Explanation (ii): If the company has set up an audit committee pursuant to provision of the
Companies Act, the said audit committee shall have such additional functions / features as is
contained in this clause.
(E) Review of information by Audit Committee
The Audit Committee shall mandatorily review the following information:
1. Management discussion and analysis of financial condition and results of operations;
2. Statement of significant related party transactions (as defined by the audit committee), submitted
by management;
3. Management letters / letters of internal control weaknesses issued by the statutory auditors;
4. Internal audit reports relating to internal control weaknesses; and
5. The appointment, removal and terms of remuneration of the Chief internal auditor shall be subject
to review by the Audit Committee
III. Subsidiary Companies
(i) At least one independent director on the Board of Directors of the holding company shall be a
director on the Board of Directors of a material non listed Indian subsidiary company.
(ii) The Audit Committee of the listed holding company shall also review the financial statements, in
particular, the investments made by the unlisted subsidiary company.
(iii) The minutes of the Board meetings of the unlisted subsidiary company shall be placed at the
Board meeting of the listed holding company. The management should periodically bring to the
attention of the Board of Directors of the listed holding company, a statement of all significant
transactions and arrangements entered into by the unlisted subsidiary company.
Explanation 1: The term “material non-listed Indian subsidiary” shall mean an unlisted
subsidiary, incorporated in India, whose turnover or net worth (i.e. paid up capital and free
reserves) exceeds 20% of the consolidated turnover or net worth respectively, of the listed
holding company and its subsidiaries in the immediately preceding accounting year.
Explanation 2: The term “significant transaction or arrangement” shall mean any individual
transaction or arrangement that exceeds or is likely to exceed 10% of the total revenues or total
expenses or total assets or total liabilities, as the case may be, of the material unlisted subsidiary
for the immediately preceding accounting year.
Explanation 3: Where a listed holding company has a listed subsidiary which is itself a holding
company, the above provisions shall apply to the listed subsidiary insofar as its subsidiaries are
concerned.
IV. Disclosures
(A) Basis of related party transactions
(i) A statement in summary form of transactions with related parties in the ordinary course of
business shall be placed periodically before the audit committee.
(ii) Details of material individual transactions with related parties which are not in the normal course
of business shall be placed before the audit committee.
(iii) Details of material individual transactions with related parties or others, which are not on an arm’s
length basis should be placed before the audit committee, together with Management’s
justification for the same.
(B) Disclosure of Accounting Treatment
Where in the preparation of financial statements, a treatment different from that prescribed in an
Accounting Standard has been followed, the fact shall be disclosed in the financial statements, together
with the management’s explanation as to why it believes such alternative treatment is more
representative of the true and fair view of the underlying business transaction in the Corporate
Governance Report.
(C) Board Disclosures – Risk management
The company shall lay down procedures to inform Board members about the risk assessment and
minimization procedures. These procedures shall be periodically reviewed to ensure that executive
management controls risk through means of a properly defined framework.
(D) Proceeds from public issues, rights issues, preferential issues etc.
When money is raised through an issue (public issues, rights issues, preferential issues etc.), it shall
disclose to the Audit Committee, the uses / applications of funds by major category (capital
expenditure, sales and marketing, working capital, etc), on a quarterly basis as a part of their quarterly
declaration of financial results. Further, on an annual basis, the company shall prepare a statement of
funds utilized for purposes other than those stated in the offer document/prospectus/notice and place it
before the audit committee. Such disclosure shall be made only till such time that the full money raised
through the issue has been fully spent. This statement shall be certified by the statutory auditors of the
company. The audit committee shall make appropriate recommendations to the Board to take up steps
in this matter.
(E) Remuneration of Directors
(i) All pecuniary relationship or transactions of the non-executive directors vis-à-vis the company
shall be disclosed in the Annual Report.
(ii) Further the following disclosures on the remuneration of directors shall be made in the section on
the corporate governance of the Annual Report:
(a) All elements of remuneration package of individual directors summarized under major
groups, such as salary, benefits, bonuses, stock options, pension etc.
(b) Details of fixed component and performance linked incentives, along with the performance
criteria.
(c) Service contracts, notice period, severance fees.

(d) Stock option details, if any – and whether issued at a discount as well as the period over
which accrued and over which exercisable.
(iii) The company shall publish its criteria of making payments to non-executive directors in its annual
report. Alternatively, this may be put up on the company’s website and reference drawn thereto in
the annual report.
(iv) The company shall disclose the number of shares and convertible instruments held by non-
executive directors in the annual report.
(v) Non-executive directors shall be required to disclose their shareholding (both own or held by / for
other persons on a beneficial basis) in the listed company in which they are proposed to be
appointed as directors, prior to their appointment. These details should be disclosed in the notice
to the general meeting called for appointment of such director.
(F) Management
(i) As part of the directors’ report or as an addition thereto, a Management Discussion and Analysis
report should form part of the Annual Report to the shareholders. This Management Discussion &
Analysis should include discussion on the following matters within the limits set by the company’s
competitive position:
(i) Industry structure and developments.
(ii) Opportunities and Threats.
(iii) Segment–wise or product-wise performance.
(iv) Outlook
(v) Risks and concerns.
(vi) Internal control systems and their adequacy.
(vii) Discussion on financial performance with respect to operational performance.
(viii) Material developments in Human Resources / Industrial Relations front, including number of
people employed.
(ii) Senior management shall make disclosures to the board relating to all material financial and
commercial transactions, where they have personal interest, that may have a potential conflict
with the interest of the company at large (for e.g. dealing in company shares, commercial
dealings with bodies, which have shareholding of management and their relatives etc.)
Explanation: For this purpose, the term "senior management" shall mean personnel of the
company who are members of its. core management team excluding the Board of Directors).
This would also include all members of management one level below the executive directors
including all functional heads.
(G) Shareholders
(i) In case of the appointment of a new director or re-appointment of a director the
shareholders must be provided with the following information:
(a) A brief resume of the director;
(b) Nature of his expertise in specific functional areas;
(c) Names of companies in which the person also holds the directorship and the
membership of Committees of the Board; and
(d) Shareholding of non-executive directors as stated in Clause 49 (IV) (E) (v) above
(ii) Quarterly results and presentations made by the company to analysts shall be put on
company’s web-site, or shall be sent in such a form so as to enable the stock exchange on
which the company is listed to put it on its own web-site.
(iii) A board committee under the chairmanship of a non-executive director shall be formed to
specifically look into the redressal of shareholder and investors complaints like transfer of
shares, non-receipt of balance sheet, non-receipt of declared dividends etc. This Committee
shall be designated as ‘Shareholders/Investors Grievance Committee’.
(iv) To expedite the process of share transfers, the Board of the company shall delegate the
power of share transfer to an officer or a committee or to the registrar and share transfer
agents. The delegated authority shall attend to share transfer formalities at least once in a
fortnight.
V. CEO/CFO certification
The CEO, i.e. the Managing Director or Manager appointed in terms of the Companies Act, 1956 and
the CFO i.e. the whole-time Finance Director or any other person heading the finance function
discharging that function shall certify to the Board that:
(a) They have reviewed financial statements and the cash flow statement for the year and that to the
best of their knowledge and belief :
(i) these statements do not contain any materially untrue statement or omit any material fact or
contain statements that might be misleading;
(ii) these statements together present a true and fair view of the company’s affairs and are in
compliance with existing accounting standards, applicable laws and regulations.
(b) There are, to the best of their knowledge and belief, no transactions entered into by the company
during the year which are fraudulent, illegal or violative of the company’s code of conduct.
(c) They accept responsibility for establishing and maintaining internal controls for financial reporting
and that they have evaluated the effectiveness of the internal control systems of the company
pertaining to financial reporting and they have disclosed to the auditors and the Audit Committee,
deficiencies in the design or operation of internal controls, if any, of which they are aware and the
steps they have taken or propose to take to rectify these deficiencies.
(d) They have indicated to the auditors and the Audit committee
(i) significant changes in internal control over financial reporting during the year;
(ii) significant changes in accounting policies during the year and that the same have been
disclosed in the notes to the financial statements; and
(iii) instances of significant fraud of which they have become aware and the involvement
therein, if any, of the management or an employee having a significant role in the
company’s internal control system over financial reporting.
VI. Report on Corporate Governance

(i) There shall be a separate section on Corporate Governance in the Annual Reports of company,
with a detailed compliance report on Corporate Governance. Non-compliance of any mandatory
requirement of this clause with reasons thereof and the extent to which the non-mandatory
requirements have been adopted should be specifically highlighted. The suggested list of items to
be included in this report is given in Annexure- I C and list of non-mandatory requirements is
given in Annexure – I D.
(ii) The companies shall submit a quarterly compliance report to the stock exchanges within 15 days
from the close of quarter as per the format given in Annexure I B. The report shall be signed
either by the Compliance Officer or the Chief Executive Officer of the company
VII. Compliance
(1) The company shall obtain a certificate from either the auditors or practicing company secretaries
regarding compliance of conditions of corporate governance as stipulated in this clause and
annex the certificate with the directors’ report, which is sent annually to all the shareholders of the
company. The same certificate shall also be sent to the Stock Exchanges along with the annual
report filed by the company.
(2) The non-mandatory requirements given in Annexure – I D may be implemented as per the
discretion of the company. However, the disclosures of the compliance with mandatory
requirements and adoption (and compliance) / non-adoption of the non-mandatory requirements
shall be made in the section on corporate governance of the Annual Report.
ANNEXURE – IA
Information to be placed before Board of Directors

1. Annual operating plans and budgets and any updates.
2. Capital budgets and any updates.
3. Quarterly results for the company and its operating divisions or business segments.
4. Minutes of meetings of audit committee and other committees of the board.
5. The information on recruitment and remuneration of senior officers just below the board level,
including appointment or removal of Chief Financial Officer and the Company Secretary.
6. Show cause, demand, prosecution notices and penalty notices which are materially important
7. Fatal or serious accidents, dangerous occurrences, any material effluent or pollution problems.
8. Any material default in financial obligations to and by the company, or substantial non-payment
for goods sold by the company.
9. Any issue, which involves possible public or product liability claims of substantial nature, including
any judgment or order which, may have passed strictures on the conduct of the company or taken
an adverse view regarding another enterprise that can have negative implications on the
company.
10. Details of any joint venture or collaboration agreement.
11. Transactions that involve substantial payment towards goodwill, brand equity, or intellectual
property.
12. Significant labour problems and their proposed solutions. Any significant development in Human
Resources/ Industrial Relations front like signing of wage agreement, implementation of Voluntary
Retirement Scheme etc.
13. Sale of material nature, of investments, subsidiaries, assets, which is not in normal course of
business.
14. Quarterly details of foreign exchange exposures and the steps taken by management to limit the
risks of adverse exchange rate movement, if material.
15. Non-compliance of any regulatory, statutory or listing requirements and shareholders service
such as non-payment of dividend, delay in share transfer etc.
ANNEXURE - IB
Format of Quarterly Compliance Report on Corporate Governance

Name of the Company:
Quarter ending on:
Particulars Clause of Listing Compliance Remarks
Agreement Status
Yes/No
I. Board of Directors 49 I
(A) Composition of Board 49(IA)
(B) Non-executive Directors’ 49 (IB)
compensation & disclosures
(C) Other provisions as to Board and 49 (IC)
Committees
(D) Code of Conduct 49(ID)
II. Audit Committee 49 (II)
(A) Qualified & Independent Audit 49 (IIA)
Committee
(B) Meeting of Audit Committee 49 (IIB)
(C) Powers of Audit Committee 49 (IIC)
(D) Role of Audit Committee 49 (IIE)
III. Subsidiary Companies 49 (IV)
IV. Disclosures 49 (IV)
(A) Basis of related party transactions 49 (IVA)
(B) Board Disclosures 49 (IVB)

(C) Proceeds from public issues, rights 49 (IVC)
issues, preferential issues etc.
(D) Remuneration of Directors 49 (IVD)
(E) Management 49 (IVE)
(F) Shareholders 49 (IVF)
V. CEO/CFO Certification 49 (V)
VI. Report on Corporate Governance 49 (VI)
VII. Compliance 49 (VII)
Note:
(1) The details under each head shall be provided to incorporate all the information required as per
the provisions of the Clause 49 of the Listing Agreement.
(2) In the column No.3, compliance or non-compliance may be indicated by Yes/No/N.A.. For
example, if the Board has been composed in accordance with the Clause 49 I of the Listing
Agreement, "Yes" may be indicated. Similarly, in case the company has no related party
transactions, the words “N.A.” may be indicated against 49 (IV A).
(3) In the remarks column, reasons for non-compliance may be indicated, for example, in case of
requirement related to circulation of information to the shareholders, which would be done only in
the AGM/EGM, it might be indicated in the "Remarks" column as – “will be complied with at the
AGM”. Similarly, in respect of matters which can be complied with only where the situation arises,
for example, "Report on Corporate Governance" is to be a part of Annual Report only, the words
"will be complied in the next Annual Report" may be indicated.
ANNEXURE - IC
Suggested List of Items to Be Included In the Report on Corporate Governance in the Annual
Report of Companies
1. A brief statement on company’s philosophy on code of governance.
2. Board of Directors:
(i) Composition and category of directors, for example, promoter, executive, non-executive,
independent non-executive, nominee director, which institution represented as lender or as
equity investor.
(ii) Attendance of each director at the Board meetings and the last AGM.
(iii) Number of other Boards or Board Committees in which he/she is a member or Chairperson
(iv) Number of Board meetings held, dates on which held.
3. Audit Committee:
(i) Brief description of terms of reference
(ii) Composition, name of members and Chairperson
(iii) Meetings and attendance during the year

4. Remuneration Committee:
(i) Brief description of terms of reference
(ii) Composition, name of members and Chairperson
(iii) Attendance during the year
(iv) Remuneration policy
(v) Details of remuneration to all the directors, as per format in main report.
5. Shareholders Committee:
(i) Name of non-executive director heading the committee
(ii) Name and designation of compliance officer
(iii) Number of shareholders’ complaints received so far
(iv) Number not solved to the satisfaction of shareholders
(v) Number of pending complaints
6. General Body meetings:
(i) Location and time, where last three AGMs held.
(ii) Whether any special resolutions passed in the previous 3 AGMs
(iii) Whether any special resolution passed last year through postal ballot – details of voting
pattern
(iv) Person who conducted the postal ballot exercise
(v) Whether any special resolution is proposed to be conducted through postal ballot
(vi) Procedure for postal ballot
7. Disclosures:
(i) Disclosures on materially significant related party transactions that may have potential
conflict with the interests of company at large.
(ii) Details of non-compliance by the company, penalties, strictures imposed on the company by
Stock Exchange or SEBI or any statutory authority, on any matter related to capital markets,
during the last three years.
(iii) Whistle Blower policy and affirmation that no personnel has been denied access to the audit
committee.
(iv) Details of compliance with mandatory requirements and adoption of the non-mandatory
requirements of this clause
8. Means of communication:
(i) Quarterly results
(ii) Newspapers wherein results normally published
(iii) Any website, where displayed
(iv) Whether it also displays official news releases; and

(v) The presentations made to institutional investors or to the analysts.
9. General Shareholder information:
(i) AGM : Date, time and venue
(ii) Financial year
(iii) Date of Book closure
(iv) Dividend Payment Date
(v) Listing on Stock Exchanges
(vi) Stock Code
(vii) Market Price Data : High., Low during each month in last financial year
(viii) Performance in comparison to broad-based indices such as BSE Sensex, CRISIL index etc.
(ix) Registrar and Transfer Agents
(x) Share Transfer System
(xi) Distribution of shareholding
(xii) Dematerialization of shares and liquidity
(xiii) Outstanding GDRs/ADRs/Warrants or any convertible instruments, conversion date and
likely impact on equity
(xiv) Plant Locations
(xv) Address for correspondence.
ANNEXURE - ID
Non-Mandatory Requirements
(1) The Board
A non-executive Chairman may be entitled to maintain a Chairman’s office at the company’s expense
and also allowed reimbursement of expenses incurred in performance of his duties.
Independent Directors may have a tenure not exceeding, in the aggregate, a period of nine years, on
the Board of a company.
(2) Remuneration Committee
(i) The board may set up a remuneration committee to determine on their behalf and on behalf of the
shareholders with agreed terms of reference, the company’s policy on specific remuneration
packages for executive directors including pension rights and any compensation payment.
(ii) To avoid conflicts of interest, the remuneration committee, which would determine the
remuneration packages of the executive directors may comprise of at least three directors, all of
whom should be non-executive directors, the Chairman of committee being an independent
director.
(iii) All the members of the remuneration committee could be present at the meeting.
(iv) The Chairman of the remuneration committee could be present at the Annual General Meeting, to
answer the shareholder queries. However, it would be up to the Chairman to decide who should
answer the queries.
(3) Shareholder Rights
A half-yearly declaration of financial performance including summary of the significant events in last
six-months, may be sent to each household of shareholders.
(4) Audit qualifications
Company may move towards a regime of unqualified financial statements.
(5) Training of Board Members
A company may train its Board members in the business model of the company as well as the risk
profile of the business parameters of the company, their responsibilities as directors, and the best ways
to discharge them.
(6) Mechanism for evaluating non-executive Board Members
The performance evaluation of non-executive directors could be done by a peer group comprising the
entire Board of Directors, excluding the director being evaluated; and Peer Group evaluation could be
the mechanism to determine whether to extend/continue the terms of appointment of non-executive
directors.
(7) Whistle Blower Policy
The company may establish a mechanism for employees to report to the management concerns about
unethical behaviour, actual or suspected fraud or violation of the company’s code of conduct or ethics
policy. This mechanism could also provide for adequate safeguards against victimization of employees
who avail of the mechanism and also provide for direct access to the Chairman of the Audit committee
in exceptional cases. Once established, the existence of the mechanism may be appropriately
communicated within the organization.
APPENDIX – II

(Circular No.SEBI/CFD/DIL/CG/1/2005/29/3) dated March 29, 2005
Sub: Corporate Governance – Clause 49 of the Listing Agreement

Please refer to SEBI circular no. SEBI/CFD/DIL/CG/1/2004/12/10 dated October 29, 2004 containing
the revised provisions of Clause 49 of the listing agreement.
It has been brought to our notice that a large number of companies are still not in a state of
preparedness to be fully compliant with the requirements as contained in the aforesaid circular. As it is
our wont that all listed companies and companies desirous of getting listed should achieve best
corporate governance status, it was felt that more time should be allowed to them to conform to Clause
49 of the listing agreement as revised in terms of the aforesaid circular. Accordingly, the date for
ensuring compliance with the revised Clause 49 of the listing agreement has been now extended upto
December 31, 2005.
APPENDIX –III
(Circular No. SEBI/CFD/DIL/CG/1/2006/13/1) dated January 13, 2006
Sub: Corporate Governance in listed Companies – Clause 49 of the Listing Agreement

SEBI, vide circular SEBI/CFD/DIL/CG/1/2004/12/10 dated October 29, 2004, issued the revised clause
49 of the listing agreement, which was to come into effect by April 1, 2005. Since it was brought to
SEBI’s notice that a large number of companies were still not in a state of preparedness to be fully
compliant with the requirements as contained in the revised clause 49, SEBI extended the date for
ensuring compliance with the revised Clause 49 of the listing agreement upto December 31, 2005 vide
circular no. SEBI/CFD/DIL/CG/1/2005/29/3 dated March 29, 2005. The revised clause 49 thus has
come into effect from January 1, 2006.
SEBI has been in receipt of a number of requests/suggestions to bring about clarifications on certain
provisions of the revised Clause 49. After examining the same, it has been decided to make the
following changes to certain provisions of the revised clause 49:
The maximum time gap between two Board meetings has been increased from three months to four
months.
Sitting fees paid to non-executive directors as authorized by the Companies Act, 1956 would not
require the previous approval of shareholders.
Certification of internal controls and internal control systems by CEO/ CFO would be for the purpose for
financial reporting.
In view of the above, certain changes have to be incorporated in the revised Clause 49, details of which
are placed in Annexure I
The Stock Exchanges are advised to accordingly amend the listing agreement with immediate effect.
ANNEXURE I
(Circular dated 13th January 2006)
Clause 49 of the Listing Agreement shall be amended as follows –
1. After sub-clause (I)(B), the following proviso shall be inserted, namely –
“Provided that the requirement of obtaining prior approval of shareholders in general meeting
shall not apply to payment of sitting fees to non-executive directors, if made within the limits
prescribed under the Companies Act, 1956 for payment of sitting fees without approval of the
Central Government.”
2. In sub-clause (I)(C), for the words “three months” occurring in the first sentence, the words “four
months” shall be substituted;
3. Sub-clause (V)(c) shall be substituted with the following, namely –
“(c) They accept responsibility for establishing and maintaining internal controls for financial
reporting and that they have evaluated the effectiveness of internal control systems of the
company pertaining to financial reporting and they have disclosed to the auditors and the Audit
Committee, deficiencies in the design or operation of such internal controls, if any, of which they
are aware and the steps they have taken or propose to take to rectify these deficiencies.”
4. Sub-clause (V)(d) shall be substituted with the following, namely –
“(d) They have indicated to the auditors and the Audit committee
(i) significant changes in internal control over financial reporting during the year;
(ii) significant changes in accounting policies during the year and that the same have been
disclosed in the notes to the financial statements; and instances of significant fraud of
which they have become aware and the involvement therein, if any, of the management or
an employee having a significant role in the company’s internal control system over financial
reporting.”
APPENDIX – IV
SEBI (Disclosure and Investor Protection) Guidelines, 2000
According to the Explanation I in paragraph 6.8.3.2, for the purpose of sub-clause (k) and (l) (of Clause
6.8.3.2) the term “promoter” shall include:
(a) The person or persons who are in overall control of the company;
(b) The person or persons who are instrumental in the formulation of a plan or programme pursuant
to which the securities are offered to the public;
(c) The person or persons named in the prospectus as promoter(s);
Provided that a director/officer of the issuer company or person, if they are acting as such merely
in the professional capacity shall not be included in the Explanation.
Regulation 2(1) (h) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulation,
1997.)
Promoter means –
(i) The persons or persons who are in the control of the company, directly or indirectly, whether
as a shareholder, director or otherwise; or
(ii) Person or persons named as promoters in any document of offer of securities to the public
or existing shareholders, and includes
(a) Where the promoter is an individual, -
(1) a relative of the promoter within the meaning of section 6 of the Companies Act, 1956
(1 of 1956);
(2) any firm or company, directly or indirectly, controlled by the promoter or a relative of
the promoter or a firm or Hindu undivided family in which the promoter or his relative is
a partner or a coparcener or a combination thereof ;
Provided that, in case of a partnership firm, the share of the promoter or his relative, as the
case may be, in such firm should not be less than 50%.
(b) where the promoter is a body corporate,-
(1) a subsidiary or holding company of that body; or
(2) any firm or company, directly or indirectly, controlled by the promoters of that body
corporate or by the relative or a firm or Hindu undivided family in which the promoter
or his relative is a partner or coparcener or a combination thereof
Provided that, in case of a partnership firm, the share of such promoter or his relative, as
the case may be, in such firm should not be less than 50%;] SEBI (Employee Stock Option
Scheme and Employee Stock Purchase Scheme) Guidelines, 1999)
According to Clause 4 (12), “promoters” means;
(a) The person or persons who are in over all control of the company;
(b) The person or persons who are instrumental in the formation of the company or programme
pursuant to which the shares were offered to the public;
(c) The person or persons named in the offer document as promoter (s);
Provided that a director or officer of the company, if they are acting as such only in their
professional capacity will not be deemed to be a promoter.
[Explanation: Where a promoter of a company is a body corporate, the promoters of that body
corporate shall also be deemed to be promoters of the company].
10
AUDIT OF CONSOLIDATED FINANCIAL STATEMENTS
Introduction
10.1 The Council of the Institute of Chartered Accountants of India has issued Accounting
Standard (AS) 21 ‘Consolidated Financial Statements’ which lays down principles and
procedures for preparation and presentation of consolidated financial statements.
Consolidated financial statements are presented for a group of entities under the control of a
parent. A ‘parent’ is an entity that has one or more subsidiaries. A group comprises a parent
and its subsidiaries. Thus, consolidated financial statements are the financial statements of a
group presented as those of a single entity. AS 21 is applicable to a parent that presents
consolidated financial statements. In other words, whenever a parent decides to prepare and
present consolidated financial statements, it should do so in accordance with the requirements
of Accounting Standard (AS) 21, Consolidated Financial Statements.
Consolidated financial statements normally include consolidated balance sheet, consolidated
statement of profit and loss, and notes, explanatory material that form an integral part thereof,
and also consolidated cash flow statement (in case a parent presents its own cash flow
statement). Consolidated financial statements are presented, to the extent possible, in the
same format as adopted by the parent for its separate financial statements.
An entity which prepares the consolidated financial statements, either under any law or
regulation governing the entity or suo motu, might be required to or otherwise engage a
member for conducting the audit of consolidated financial statements.1 The auditor of the
consolidated financial statements may not necessarily be the auditor of the separate financial
statements of the parent or one or more of the components 2 included in the consolidated
financial statements. However, a law or regulation governing the entity may require the
1 The Securities and Exchange Board of India, vide its circular SMDRP/Policy/Cir.44/01 dated August 31, 2001 has
amended clause 32 of the listing agreement which now requires the listed companies to publish consolidated financial
statements in addition to the separate financial statements in its annual report. The amended clause further requires that
the statutory auditors of the company should audit the consolidated financial statements. The filing of consolidated
financial statements with stock exchanges has also been made mandatory.
Similarly, the Reserve Bank of India, vide its circular no. DBOD No. BP.BC. 72/21.04.018/2001-02 dated February 25,
2003 have required the banks to prepare consolidated financial statements to facilitate consolidated financial supervision.
2 Paragraph 8 of Auditing and Assurance Standard (AAS) 10, Using the Work of Another Auditor defines “components”
as a division, branch, subsidiary, joint venture, associated enterprises or other entity whose financial information is
included in the financial information audited by the principal auditor.
consolidated financial statements to be audited by the statutory auditor of the entity. This
Guidance Note provides guidance on the specific issues and audit procedures to be applied in
an audit of consolidated financial statements.
Definitions
10.2 Various terms used in this Guidance Note, have the same meaning as in Accounting
Standard (AS) 21, ‘Consolidated Financial Statements’, Accounting Standard (AS) 23,
‘Accounting for Investments in Associates in Consolidated Financial Statements’ and
Accounting Standard (AS) 27, ‘Financial Reporting of Interests in Joint Ventures’ respectively.
Responsibility of Parent
10.3 The responsibility for the preparation and presentation of consolidated financial
statements, among other things, is that of the management of the parent. This includes:
(a) identifying components, and including the financial information of the components to be
included in the consolidated financial statements;
(b) where appropriate, identifying reportable segments for segmental reporting;
(c) identifying related parties and related party transactions for reporting;
(d) obtaining accurate and complete financial information from components; and
(e) making appropriate consolidation adjustments.
Apart from the above, the parent ordinarily issues instructions to the management of the
component specifying the parent’s requirements relating to financial information of the
components to be included in the consolidated financial statements. The instructions ordinarily
cover the accounting policies to be applied, statutory and other disclosure requirements
applicable to the parent, including the identification of and reporting on reportable segments,
and related parties and related party transactions, and a reporting timetable.
Responsibility of the Auditor of the Consolidated Financial Statements

10.4 The auditor of the consolidated financial statements is responsible for expressing an
opinion on whether the consolidated financial statements are prepared, in all material
respects, in accordance with the financial reporting framework under which the parent
prepares the consolidated financial statements.
Therefore, the auditor's objectives in an audit of consolidated financial statements are:
(a) to satisfy himself that the consolidated financial statements have been prepared in
accordance with the requirements of Accounting Standard (AS) 21, Consolidated
Financial Statements, Accounting Standard (AS) 23, Accounting for Investments in
Associates in Consolidated Financial Statements and Accounting Standard (AS) 27,
Financial Reporting of Interests in Joint Ventures; and
(b) to enable himself to express an opinion on the true and fair view presented by the
consolidated financial statements.
Audit of Consolidated Financial Statements 10.3
Auditing and Assurance Standards, Statements and Guidance Notes on auditing matters
issued by the Institute of Chartered Accountants of India apply in the same manner to audit of
consolidated financial statements as they apply to audit of separate financial statements. It
means that the auditors, while conducting the audit of consolidated financial statements are,
inter alia, expected to:
(a) plan their work to enable them to conduct an effective audit in an efficient and timely
manner;
(b) obtain an understanding of the accounting and internal control systems sufficient to plan
the audit and determine the nature, timing and extent of his audit procedures. Such an
understanding would help the auditors to develop an effective audit approach;
(c) use professional judgement to assess audit risk and to design audit procedures to ensure
that the risk is reduced to an acceptable level; etc.
Audit Considerations
10.5 The following features of consolidated financial statements have an impact on the related
audit procedures:
(a) The consolidated financial statements are prepared on the basis of separate financial
statements of the parent and its subsidiaries and associates and/or joint ventures, using
the consolidation procedures prescribed by Accounting Standard (AS) 21, Consolidated
Financial Statements, Accounting Standard (AS) 23, Accounting for Investments in
Associates in Consolidated Financial Statements and Accounting Standard (AS) 27,
Financial Reporting of Interests in Joint Ventures; and
(b) The auditor of the consolidated financial statements has to use the work of other auditors
unless the auditor of consolidated financial statements is not the auditor of the other
components of the group. This may, however, not be true in all cases.
The consolidated financial statements are prepared using the separate financial statements of
the parent, subsidiaries, associates and joint ventures and also other financial information,
which might not be covered by the separate financial statements of these entities. The ‘other
financial information’ would include disclosures to be made in the consolidated financial
statements about the subsidiaries associates and joint ventures, proportion of items included
in the consolidated financial statements to which different accounting policies have been
applied, adjustments made for the effects of significant transactions or other events that occur
between the financial statements of subsidiaries, associates or joint ventures and the parent,
as the case may be, etc. Thus, this ‘other financial information’ would be required to be
additionally generated.
When an auditor accepts the audit of consolidated financial statements, the auditor should
assess whether based on his work alone he would be able to express an opinion on the true
and fair view presented by the consolidated financial statements. If the auditor is of the view
that his own participation may not be enough or sufficient, he should consider using the work
of ‘other auditors’.
Such ‘other auditors’ might be the auditors of the separate financial statements of one or more
of the components of the consolidated financial statements or the auditors appointed
specifically for assisting the auditor of the consolidated financial statements (the principal
auditor).
Where the statutory auditors of one or more of the components of the consolidated financial
statements are also requested to assist the principal auditor, the work to be performed by
such statutory auditors for use by the principal auditor would constitute an assignment
separate from the assignment to conduct the statutory audit of the respective component.
The Auditing and Assurance Standard (AAS) 1, ‘Basic Principles Governing an Audit’, states
(paragraph 9):
“When the auditor delegates work to assistants or uses work performed by other
auditors and experts, he will continue to be responsible for forming and expressing
his opinion on the financial information. However, he will be entitled to rely on work
performed by others, provided he exercises adequate skill and care and is not
aware of any reason to believe that he should not have so relied. In the case of any
independent statutory appointment to perform the work on which the auditor has to
rely in forming his opinion, such as in the case of the work of branch auditors
appointed under the Companies Act, 1956 the auditor’s report should expressly
state the fact of such reliance”.
Auditing and Assurance Standard (AAS) 10, ‘Using the Work of Another Auditor’ establishes
standards when an auditor, reporting on the financial statements of an entity (the group—in
the case of consolidated financial statements), uses the work of another auditor on the
financial information of one or more components included in the financial statements of the
entity. The principal auditor, if he decides to use the work of another auditor in relation to the
audit of consolidated financial statements, should comply with the requirements of AAS 10.
While complying with the requirements of AAS 10, ‘Using the Work of Another Auditor’, the
principal auditor should keep the following under consideration:
(a) When planning to use the work of another auditor, the principal auditor is not required to
consider the professional competence of the other auditor if the other auditor is a
member of the Institute of Chartered Accountants of India.
(b) The principal auditor should perform procedures to obtain sufficient appropriate audit
evidence, that the work of the other auditor is adequate for the principal auditor's
purposes, in the context of the audit of consolidated financial statements. When using
the work of another auditor, the principal auditor should ordinarily perform the following
procedures:
(i) The principal auditor should determine the information/assurance required by the
other auditor; this emanates/precludes the principal auditor’s determination of how
the work of the other auditor would affect the audit of consolidated financial
statements, for example, the information required from the auditor of a subsidiary
would be different from that required from the auditor of a joint venture.
(ii) Advise the other auditor of the use that is to be made of the other auditor's work
and report and make sufficient arrangements for co-ordination of their efforts at
the planning stage of the audit. The principal auditor would inform the other
auditor of matters such as areas requiring special consideration, procedures for
the identification of inter-component transactions that may require disclosure and
the timetable for completion of audit. It may, however, be noted that the principal
auditor, if using the work of the auditors of one or more of the components unless
such other auditors are specifically appointed for the purpose, should not enlarge
the scope of the audit of the separate financial statements of the subsidiary or
component to be included in the consolidated financial statements. Thus, the
instructions that are to be issued should be confined to the other information
required for consolidation.
(iii) Advise the other auditor of the significant accounting, auditing and reporting
requirements and obtain representation as to compliance with them.
Auditing the Consolidation

10.6 Before commencing an audit of consolidated financial statements, the auditor should plan
his work to enable him to conduct an effective audit in an efficient and timely manner. The
auditor should make plans, among other things, for the following:
(a) understanding of accounting policies of the parent, subsidiaries, associates and joint
ventures;
(b) determining the extent of use of other auditor’s work in the audit;
(c) determining and programming the nature, timing, and extent of the audit procedures to
be performed; and
(d) coordinating the work to be performed.
A parent which presents consolidated financial statements is required to consolidate all
subsidiaries, include all associates and jointly controlled entities in the consolidated financial
statements other than those for which exceptions have been provided in the relevant
Accounting Standards.
The auditor should obtain a listing of subsidiaries, associates and joint ventures included in
the consolidated financial statements. The auditor should review the information provided by
the management of the parent identifying the subsidiaries, associates and joint ventures. The
auditor should verify that all the subsidiaries, associates and joint ventures have been
included in the consolidated financial statements unless a subsidiary, associate or joint
venture meets a criterion for exclusion. In respect of completeness of this information, the
auditor should perform the following procedures:
(a) review his working papers for the prior years for the known subsidiaries, associates and
joint ventures;
(b) review the parent’s procedures for identification of subsidiaries, associates and joint
ventures;
(c) review the investments to determine the shareholding in other entities;
(d) review the joint venture and other relevant agreements entered into by the parent;
(e) review the statutory records maintained by the parent, for example registers under
section 302, 372A of the Companies Act, 1956.
The auditor should also identify the changes in the shareholding that might have taken place
since the last audit.
It is also important to note that ownership of voting power is not necessary for an entity to
own more than one-half of the voting power of another to control the other enterprise. Control
of the composition of the Board of Directors (in the case of a company) or corresponding
governing body (in the case of any other enterprise), with a view to obtain economic benefits
from its activities, ownership of voting power is not important. For example, an entity holds
only 10 percent of the share capital of another entity but it has control over the composition of
the Board of Directors/governing body of the second entity. In such a case, the first entity
would be considered as a parent of the second entity and, therefore, it would consolidate the
second entity in the consolidated financial statements as subsidiary. The auditor, therefore,
apart from carrying out above procedures, should verify whether the parent controls the
composition of the Board of Directors or corresponding governing body of any entity. There
would be various means by which such kind of control can be obtained. In this regard, the
auditor may verify the Board’s minutes, shareholder agreements entered into by the parent,
agreements with the entities to which the parent might have provided any technology or know
how, enforcement of statute, as the case may be, etc. The auditor would have to use his
professional judgement to determine whether the parent controls the composition of the Board
of Directors of any other entity. If yes, whether that entity has been consolidated as a
subsidiary in the consolidated financial statements.
Where a subsidiary or an associate or a jointly controlled entity is excluded from the
consolidated financial statements, the auditor should examine the reasons for exclusion.
There could be two reasons for exclusion of a subsidiary, associate or jointly controlled entity
– one, that the relationship of parent with the subsidiary, associate or jointly controlled entity is
intended to be temporary or the subsidiary, associate or joint venture operates under several
long-term restrictions which significantly impair its ability to transfer funds to the parent. The
auditor should satisfy himself that the exclusion made by the management falls within these
two categories. The auditor should verify such long-term restrictions from the relevant laws
and regulations, agreements entered by the parent with such entities which prohibit transfer of
funds. In the case of an entity which is excluded from consolidation on the ground that the
relationship of parent with the other entity as subsidiary, associate or joint venture is
temporary, the auditor should verify that the intention of the parent, to dispose the subsidiary,
investment in associate or interest in jointly controlled entity, in the near future, existed at the
time of acquisition of the subsidiary, making investment in associate or jointly controlled entity.
The auditor should also verify that the reasons for exclusion are given in the consolidated
financial statements. If an entity is excluded from the consolidated financial statements for
reasons other than those allowed by the relevant accounting standards, the auditor should
consider its effect on the report to be issued. The auditor should consider the need to issue a
modified report on the consolidated financial statements. The auditor should also verify that in
consolidated financial statements, investments in such subsidiaries, associates or jointly
controlled entities should be accounted for in accordance with Accounting Standard (AS) 13,
Accounting for Investments.
The auditor should also examine whether any subsidiary, associate or jointly controlled entity
has ceased to be a subsidiary, associate or jointly controlled entity during the period under
audit. It is also possible that a subsidiary might have become an associate or an associate
might have become a subsidiary of the parent. The auditor, in such cases, should examine
whether these changes have been appropriately accounted for in the consolidated financial
statements as required by the respective accounting standards.
In preparing consolidated financial statements, the financial statements of the parent and its
subsidiaries are combined on a line by line basis by adding together like items of assets,
liabilities, income and expenses and then certain calculations like determination of goodwill or
capital reserve, minorities interest and adjustments like elimination of intra group transactions,
balances and unrealised profits etc. are made in accordance with the requirements of
Accounting Standard (AS) 21, Consolidated Financial Statements. Investments in associates
are accounted for using the Equity Method as prescribed in Accounting Standard (AS) 23,
Accounting for Investments in Associates in Consolidated Financial Statements. A parent that
has an interest in a jointly controlled entity, reports its interest in the consolidated financial
statements using proportionate consolidation method in accordance with Accounting Standard
(AS) 27, Financial Reporting of Interests in Joint Ventures. Many of the procedures
appropriate for the application of equity method and the proportionate consolidation are similar
to the consolidation procedures set out in Accounting Standard (AS) 21, Consolidated
Financial Statements.
The auditor should verify that the adjustments warranted by the relevant accounting standards
have been made wherever required and have been properly authorised by the management of
the parent. The preparation of consolidated financial statements gives rise to permanent
consolidation adjustments and current period consolidation adjustments.
10.7 Special Considerations

10.7.1 Permanent Consolidation Adjustments - Permanent consolidation adjustments are those
adjustments that are made only on the first occasion of the preparation and presentation of
consolidated financial statements. Permanent consolidation adjustments are:
(a) determination of excess or deficit of the cost to the parent of its investment in a
subsidiary over the parent’s portion of equity of the subsidiary, at the date on which
investment in the subsidiary is made (determination of goodwill or capital reserve);
(b) determination of the amount of equity attributable to minorities at the date on which
investment in subsidiary is made; and
(c) determination of goodwill or capital reserve arising on application of equity method to

account for investments in associates in consolidated financial statements.
The auditor should verify that the above calculations have been made appropriately. The
auditor should pay particular attention to the determination of pre-acquisition reserves of the
subsidiary and associates. Date(s) of investment in subsidiary and associates assumes
importance in this regard. The auditor should also examine whether the pre-acquisition
reserves have been allocated appropriately between the parent and the minorities of the
subsidiary. The auditor should also verify the changes that might have taken place in these
permanent adjustments on account of subsequent acquisition of shares in the
subsidiary/associates, disposal of the subsidiary/associate in the subsequent years. The
auditor should also examine the joint venture agreements, to establish whether any change
has taken place in the interest of the parent in the joint venture.
It may happen that in the case of one subsidiary, goodwill arises and in the case of another
subsidiary a capital reserve arises. The parent may choose to net off these amounts to
disclose a single amount in the consolidated balance sheet. In such cases, the auditor should
verify that the gross amounts of goodwill and capital reserves arising on acquisition of various
subsidiaries have been disclosed in the notes to the consolidated financial statements to
reflect the excess/shortage over the parents’ portion of the subsidiary’s equity.
10.7.2 Current Period Consolidation Adjustments - Current period adjustments are those
adjustments that are made in the accounting period for which the consolidation of financial
statements is done. Current period consolidation adjustments primarily relate to elimination of
intra-group transactions and account balances including:
(a) intra-group interest paid and received, or management fees, etc;
(b) unrealised intra-group profits on assets acquired from other subsidiaries;
(c) intra-group indebtedness;
(d) adjustments related to harmonising the different accounting policies being followed by
the parent enterprise and its subsidiaries;
(e) adjustments made for the effects of significant transactions or other events that occur
between the date of the financial statements of the parent and one or more of the
components, if the financial statements to be used for consolidation are not drawn upto
the same reporting date; and
(f) determination of movement in equity attributable to the minorities since the date of
acquisition of the subsidiary.
The adjustments required for preparation of consolidated financial statements are made in
memorandum records kept for the purpose by the parent. The auditor should review the
memorandum records to verify the adjustment entries made in the preparation of consolidated
financial statements. This would also help the auditor in ascertaining whether there is any
difference in the elimination. Apart from reviewing the memorandum records, the auditor
should:
(a) verify that the inter-group transactions and account balances have been eliminated;
(b) verify that the consolidated financial statements have been prepared using uniform
accounting policies for like transactions and other events in similar circumstances;
(c) verify that adequate disclosures have been made in the consolidated financial statements
of application of different accounting policies in case, it was impracticable to do so;
(d) verify the adjustments made to harmonise the different accounting policies; and
(e) verify that the calculation of minorities interest has been correctly done.
The auditor should gain an understanding of the procedures adopted by the management of
the enterprise to make the above mentioned adjustments. This helps the auditor in reducing
the audit risk to an acceptably low level.
One of the important adjustment that may be required in the current period is determination of
impairment loss that might exist for goodwill arising on consolidation. Goodwill arising on
consolidation is carried at the value determined at the date of acquisition of the subsidiary,
and the same is to be tested for impairment at every balance sheet date. The auditor should
examine whether any impairment loss has been determined by the parent. If yes, the auditor
should examine the procedure followed for determination of impairment. The auditor should
satisfy himself that the amount of impairment loss determined is fair.
The auditor should also verify that the disclosures required by Accounting Standard (AS) 21,
Consolidated Financial Statements, Accounting Standard (AS) 23, Accounting for Investments
in Associates in Consolidated Financial Statements and Accounting Standard (AS) 27,
Financial Reporting of Interests in Joint Ventures have been made in the consolidated
Apart from verifying that the calculation and disclosures regarding minorities interest have
been made appropriately, the auditor also determines, in cases where the minority interests’
share of the losses exceed the minority interests’ share of the equity, the excess, and any
further losses applicable to the minority interest, have been accounted for in accordance with
the relevant accounting standards. Where the minority interest has a binding obligation to
make good losses, the auditor of the consolidated financial statements determines whether it
is able to do so.
If the financial statements of one or more of the components are drawn upto different financial
reporting dates, the auditor of the consolidated financial statements should review the
component’s results between its financial reporting date and that of the parent for significant
transactions or other events that have taken place during the period and therefore, need to be
reflected in the consolidated financial statements. For example, where a subsidiary has a
different accounting period and after the end of its accounting period, the subsidiary has
discontinued its one of the major operations, adjustments would be required to be made to
reflect this in the consolidated financial statements.
The fundamental accounting assumption of “consistency” requires the auditor of the
consolidated financial statements to consider whether the length of the reporting periods and
any difference in financial year-ends are the same from period to period.
Notes to accounts and other explanatory material are an integral part of any financial
statements since they provide information which is per se not reflected in the balance sheet
and profit and loss account. Consolidated financial statements are not an exception to the
need of notes to accounts and other explanatory material. In this regard paragraph 6 of
Accounting Standard (AS) 21, Consolidated Financial Statement states as below:
“6. Consolidated financial statements normally include consolidated balance sheet,
consolidated statement of profit and loss, and notes, other statements and
explanatory material that form an integral part thereof. Consolidated cash flow
statement is presented in case a parent presents its own cash flow statement. The
consolidated financial statements are presented, to the extent possible, in the same
format as that adopted by the parent for its separate financial statements”.
The Accounting Standards Board of the Institute has issued General Clarification (GC)–5/2002
on Notes to the Consolidated Financial Statements. The Clarification lays down certain
principles that should be observed in respect of notes and other explanatory material that form
integral part of the consolidated financial statements. The auditor should verify that the
principles enunciated by the Clarification have been followed in preparation of notes to
accounts. The auditor to verify, the compliance, should:
(a) examine that the notes which are necessary for presenting a true and fair view of the
consolidated financial statements have been included in the consolidated financial
statements as an integral part thereof; and
(b) examine that additional statutory information disclosed in separate financial statements
of the subsidiary and/or a parent having bearing on the true and fair view of the
consolidated financial statements have been disclosed in the consolidated financial
statements.
If as a result of the above examinations, the auditor is of the view that the consolidated
financial statements do not disclose all the information which is necessary for presenting a
true and fair view, the auditor should give a modified report.
Management Representations
10.8 Auditing and Assurance Standard (AAS) 11, “Representations by Management” requires
the auditor to obtain appropriate representations from management. The auditor of the
consolidated financial statements should obtain evidence that the management of the parent
acknowledges its responsibility for a true and fair presentation of the consolidated financial
statements in accordance with the financial reporting framework applicable to the parent and
that parent management has approved the consolidated financial statements. In addition, the
auditor of the consolidated financial statements obtains written representations from parent
management on matters material to the consolidated financial statements. Examples of such
representations include:
(a) Completeness of components included in the consolidated financial statements;
(b) Identification of reportable segments for segmental reporting;
(c) Identification of related parties and related party transactions for reporting;
(d) Appropriateness and completeness of consolidation adjustments, including the

elimination of intra-group transactions.
Reporting
10.9 There could be two situations in an audit of consolidated financial statements–-when the
parent’s auditor is also the auditor of all the components to be included in the consolidated
financial statements and when the parent’s auditor is not the auditor of one or more
subsidiaries and therefore, uses the work of other auditors in the audit. The auditor should,
while preparing the report, should consider the requirements of Auditing and Assurance
Standard (AAS) 28, The Auditor’s Report on Financial Statements. Where, the auditor uses
the work of other auditors in the audit of consolidated financial statements, the requirements
of Auditing and Assurance Standard (AAS) 10, Using the Work of Another Auditor should also
be considered. An illustrative audit report is given in annexure- I .
When the Parent’s Auditor is also the Auditor of its Subsidiaries
10.10 While drafting the audit report, the auditor should report whether principles and
procedures for preparation and presentation of consolidated financial statements as laid down
in the relevant accounting standards have been followed. In case of any deviation, the auditor
should make adequate disclosure in the audit report so that users of the consolidated financial
statements are aware of such deviation.
Auditor should issue an audit report expressing opinion whether the consolidated financial
statements give a true and fair view of the state of affairs of the Group as on balance sheet
date and as to whether consolidated profit and loss statement gives true and fair view of the
results of consolidated profit or losses of the Group for the period under audit. Where the
consolidated financial statements also include a cash flow statement, the auditor should also
give his opinion on the true and fair view of the cash flows presented by the consolidated cash
flow statements. Suggested format of the audit report to be issued in such circumstance is
given as Annexure I to this Guidance Note.
When the Parent’s Auditor is not the Auditor of its Subsidiary(ies)
10.11 In a case where the parent’s auditor is not the auditor of the components included in the
consolidated financial statements, the auditor of the consolidated financial statements should
also consider the requirement of AAS 10.
When the parent’s auditor decides that he will make reference to the audit of the other
auditors, the auditor’s report on consolidated financial statements should disclose clearly the
magnitude of the portion of the financial statements audited by the other auditor(s). This may
be done by stating the rupee amounts or percentages of total assets and total revenue of
subsidiary(s) included in consolidated financial statements not audited by the parent’s auditor.
However, reference in the report of the auditor of consolidated financial statements to the fact
that part of the audit of the group was made by other auditor(s) is not to be construed as a
qualification of the opinion but rather as an indication of the divided responsibility between the
auditors of the parent and its subsidiaries. Suggested format of the audit report to be issued
by the auditor of consolidated financial statements in this circumstance is given in Annexure II
to this Guidance Note.
Annexure I
Illustrative Auditor’s Report on the Consolidated Financial Statements When the Parent’s Auditor
is also the Auditor of all the Components
Auditor’s Report
The Board of Directors _________ (Name of the Parent)3
We have audited the attached consolidated balance sheet of XYZ Group, as at 31st March 2XXX, and
also the consolidated profit and loss account and the {consolidated cash flow statement}4 for the year
ended on that date annexed thereto. These financial statements are the responsibility of the XYZ’s
management. Our responsibility is to express an opinion on these financial statements based on our
audit.
We conducted our audit in accordance with the auditing standards generally accepted in India. Those
Standards require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a reasonable
basis for our opinion.
We report that the consolidated financial statements have been prepared by the XYZ’s management in
accordance with the requirements of Accounting Standards (AS) 21, Consolidated financial statements,
{Accounting Standards (AS) 23, Accounting for Investments in Associates in Consolidated Financial
Statements and Accounting Standard (AS) 27, Financial Reporting of interests in Joint Ventures} issued
by the Institute of Chartered Accountants of India.
In our opinion and to the best of our information and according to the explanations given to us, the
consolidated financial statements give a true and fair view in conformity with the accounting principles
generally accepted in India:
(a) in the case of the consolidated balance sheet, of the state of affairs of the XYZ Group as at 31st
March 2XXX;
(b) in the case of the consolidated profit and loss account, of the profit / loss4 for the year ended on that
date; and
(c) in the case of the consolidated cash flow statement, of the cash flows for the year ended on that
date. .
For ABC and Co. Chartered Accountants
Signature
(Designation)
Membership Number
Place of Signature
Date
3As per paragraph 8 of AAS 28, “The Auditor’s Report on Financial Statements”, “The auditor’s report should be
appropriately addressed as required by the circumstances of the engagement and applicable laws and regulations.
Ordinarily, the auditor’s report is addressed to the authority appointing the auditor”.
4
Where Applicable
Annexure II
Illustrative Auditor’s Report on the Consolidated Financial Statements When the Parent’s
Auditor is Not the Auditor of All the Components
Auditor’s Report
The Board of Directors _________ (Name of the Parent) 5
We have audited the attached consolidated balance sheet of XYZ Group, as at 31st March 2XXX, and
also the consolidated profit and loss account and the {consolidated cash flow statement} 6 for the year
ended on that date annexed thereto. These financial statements are the responsibility of the XYZ’s
management and have been prepared by the management on the basis of separate financial
statements and other financial information regarding components. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with the auditing standards generally accepted in India. Those
Standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
We did not audit the financial statements of certain subsidiaries, whose financial statements reflect
total assets of Rs.____ as at 31st March 2XXX, the total revenue of Rs. _____ and cash flows
amounting to Rs._____ for the year then ended. These financial statements and other financial
information have been audited by other auditors whose report(s) has (have) been furnished to us, and
our opinion is based solely on the report of other auditors.
We report that the consolidated financial statements have been prepared by the XYZ’s management in
accordance with the requirements of Accounting Standards (AS) 21, Consolidated financial statements,
{Accounting Standards (AS) 23, Accounting for Investments in Associates in Consolidated Financial
Statements and Accounting Standard (AS) 27, Financial Reporting of interests in Joint Ventures}
Based on our audit and on consideration of reports of other auditors on separate financial statements
and on the other financial information of the components, and to the best of our information and
according to the explanations given to us, we are of the opinion that the attached consolidated financial
statements give a true and fair view in conformity with the accounting principles generally accepted in
India:
(a) in the case of the consolidated balance sheet, of the state of affairs of the XYZ Group as at 31 st
March 2XXX;
5 See Footnote 3
6 Where applicable.
(b) in the case of the consolidated profit and loss account, of the profit / loss for the year ended on
that date; and
(c) in the case of the consolidated cash flow statement, of the cash flows for the year ended on that
date. .
For ABC and Co. Chartered Accountants
Signature
(Designation)
Membership Number
Place of Signature:
Date:
References
1. Guidance note on audit of Consolidated Financial Statements
2. AS-21
3. AS-23
4. AS-27
11
AUDIT OF BANKS
Introduction
11.1 A well-organised and efficient banking system is a pre-requisite for economic growth.
Banks play an important role in the functioning of organised money markets. They act as a
conduit for mobilising funds and channelising them for productive purposes. The Indian
banking system, like the banking system in other countries, has played a significant role in the
economic growth of the country. In order to meet the banking needs of various sections of the
society, a large network of bank branches has been established. Presently, there are four
types of banking institutions in India. These are:
♦ Commercial banks
♦ Regional rural banks
♦ Co-operative banks
♦ Development banks (more commonly known as ‘term-lending institutions’)
Besides, the Reserve Bank of India (hereinafter referred to as RBI) acts as the central bank of
the country.
Commercial banks are by far the most widespread banking institutions in India. Typically,
commercial banks provide the following major products and services:
(a)Acceptance of Deposits; (b) Granting of Advances; (c) Remittances; (d) Collections; (e)
Cash Management Product; (f) Issuance of Letters of Credit and Guarantees; (g) Merchant
Banking Business; (h) Credit Cards; (i) Technology-based Services; (j) Dividend / Interest /
Refund Warrants; (k) Safe-keeping Services; (l) Lockers; (m) Handling Government Business;
(n) Depository Participant (DP) Services; (o) Automated Teller Machines (ATMs); (p)
Exchange of Notes, (q) Debit Cards, (r) Cross –selling, (s) Auto Sweep facility in saving
account, (t) Third party advertisement on ATM network, (u) Securitization of future lease
rentals, (v) Derivative business.
Commercial banks operating in India can be divided into two categories based on their
ownership – public sector banks and private sector banks. However, irrespective of the pattern
of ownership, all commercial banks in India function under the overall supervision and control
of the RBI.
Public sector banks comprise the State Bank of India, its seven subsidiaries (also called
‘associate banks’ of State Bank of India; these are State Bank of Bikaner and Jaipur, State
Bank of Hyderabad, State Bank of Indore, State Bank of Mysore, State Bank of Patiala, State
Bank of Saurashtra, and State Bank of Travancore) and nineteen nationalised banks.
The ownership of private sector banks is in private hands. They are of three types:
(a) Indian scheduled commercial banks other than public sector banks. (The term ‘scheduled
commercial banks’ refers to commercial banks which are included in the Second
Schedule to the Reserve Bank of India Act, 1934.) It may be noted that not all scheduled
banks are commercial banks; some co-operative banks are also scheduled banks.
Commonly known as ‘banking companies’, these banks are ‘companies’ registered under
the Companies Act, 1956 or an earlier Indian Companies Act.
(b) Non-scheduled banks.
(c) Indian branches of banks incorporated outside India, commonly referred to as ‘foreign
banks’.
Regional Rural Banks have been established “with a view to developing the rural economy by
providing, for the purpose of development of agriculture, trade, commerce, industry and other
productive activities in the rural areas, credit and other facilities, particularly to the small and
marginal farmers, agricultural labourers and artisans and small entrepreneurs” (Preamble to
the Regional Rural Banks Act, 1976).
Co-operative Banks are banks in the co-operative sector which cater primarily to the credit
needs of the farming and allied sectors. Co-operative banks include central co-operative
banks, state co-operative banks, primary co-operative banks and land development banks.
Development Banks were started with the objective of providing only long-term finance for
development purposes; they are referred to as ‘development banks’ or ‘term-lending
institutions’. There are a number of all-India level term-lending institutions.
Special Features
11.2 Banks have the following characteristics which distinguish them from most other
commercial enterprises:
♦ They have custody of large volumes of monetary items, including cash and negotiable
instruments, whose physical security has to be ensured. This applies to both the storage
and the transfer of monetary items and makes banks vulnerable to misappropriation and
fraud. They, therefore, need to establish formal operating procedures, well-defined limits
for individual discretion and rigorous systems of internal control.
♦ They engage in a large volume and variety of transactions in terms of both number and
value. This necessarily requires complex accounting and internal control systems.
♦ They normally operate through a wide network of branches and departments which are
geographically dispersed. This necessarily involves a greater decentralisation of authority
and dispersal of accounting and control functions, with consequent difficulties in
Audit of Banks 11.3
maintaining uniform operating practices and accounting systems, particularly when the
branch network transcends national boundaries.
♦ They often assume significant commitments without any transfer of funds. These items,
commonly called 'off-balance-sheet' items, may not involve accounting entries and,
consequently, the failure to record such items may be difficult to detect.
♦ They are regulated by governmental authorities and the resultant regulatory requirements
often influence accounting and auditing practices in the banking sector.
Special audit considerations arise in the audit of banks because of:
♦ the particular nature of risks associated with the transactions undertaken by banks;
♦ the scale of banking operations and the resultant significant exposures which can arise
within short periods of time;
♦ the effect of the statutory and regulatory requirements; and
♦ the continuing development of new services and banking practices which may not be
matched by the concurrent development of accounting principles and auditing practices.
The auditor should consider the effect of the above factors in designing his audit approach.
Legal Framework
11.3 There is an elaborate legal framework governing the functioning of banks in India. The
principal enactments which govern the functioning of various types of banks are:
♦ Banking Regulation Act, 1949
♦ Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970
♦ Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980
♦ State Bank of India Act, 1955
♦ State Bank of India (Subsidiary Banks) Act, 1959
♦ Regional Rural Banks Act, 1976
♦ Companies Act, 1956
♦ Co-operative Societies Act, 1912 or the relevant state Co-operative Societies Act.
Besides, the above enactments, the provisions of the Reserve Bank of India Act, 1934, also
affect the functioning of banks. The Act gives wide powers to the Reserve Bank of India to
give directions to banks; such directions also have considerable effect on the functioning of
banks.
Form and Content of Financial Statements

11.4 Sub-sections (1) and (2) of section 29 of the Banking Regulation Act, 1949, deal with
form and content of financial statements of a banking company and their signing. Sub-section
(1) of section 29 requires every banking company to prepare a balance sheet and a profit and
loss account in the forms set out in the Third Schedule to the Act or as near thereto as the
circumstances admit. These financial statements have to be prepared as on the last working
day of each financial year (i.e., 31st March) in respect of all business transacted during the
year. A foreign banking company (i.e., a banking company incorporated outside India and
having a place of business in India) has to similarly prepare a balance sheet and a profit and
loss account every year in respect of all business transacted through its branches in India.
Salient Features of the Third Schedule - Form A of the Third Schedule to the Banking
Regulation Act, 1949, contains the form of balance sheet and Form B contains the form of
profit and loss account. The balance sheet as well as the profit and loss account is required
to be presented in a vertical form.
In the balance sheet, capital and liabilities are to be presented under the following five broad
heads:
♦ Capital
♦ Reserves and Surplus
♦ Deposits
♦ Borrowings
♦ Other liabilities and provisions
Assets are required to be presented under the following six broad heads:
♦ Cash and Balances with Reserve Bank of India
♦ Balances with Banks and Money at call and short notice
♦ Investments
♦ Advances
♦ Fixed assets
♦ Other assets
Details of items of capital, liabilities and assets are required to be presented in the prescribed
form in various schedules.
The aggregate amounts of contingent liabilities and bills for collection are to be presented on
the face of the balance sheet while details of contingent liabilities are to be presented by way
of a schedule.
The following items are required to be presented on the face of the profit and loss account:
I. Income
Interest earned
Other income
II. Expenditure
Interest expended
Audit of Banks 11.5
Operating expenses
Provisions and contingencies
III. Profit (Loss)
Net profit (loss) for the year
Profit/loss brought forward
IV. Appropriations
Transfer to statutory reserves
Transfer to other reserves
Transfer to Government/Proposed Dividend
Balance carried over to balance sheet
Prescribed details of interest earned, other income, interest expended and operating expenses
are required to be given by way of schedules to the profit and loss account. The Schedules of
Balance sheet and Profit and Loss account are given in Annexure II to this chapter.
Other Disclosures - In addition to the disclosures to be made in the balance sheet and profit
and loss account in pursuance of the requirements of the Third Schedule to the Act, the RBI
has directed to disclose some other information specified by RBI by way of notes on accounts.
These informations have been given in Annexure II to this chapter.
Financial Statements, Auditor's Report and Directors Report of Subsidiary - Public
Sector Banks are also required to annex the balance sheet, profit and loss account, report of
the Board of Directors and Auditor’s Report in respect of each of their subsidiaries, to their
own financial statements. The banking companies are required to attach the financial
statements, directors report and auditor's report to their own annual reports by virtue of
section 212 of the Companies Act.
Notes and Instructions Issued by Reserve Bank of India - The Reserve Bank of India has
issued notes and instructions for compilation of balance sheet and profit and loss account.
These notes and instructions provide an authoritative interpretation of the requirements of the
Third Schedule to the Act and are thus useful in preparation of financial statements of banks.
Notes and instructions are reproduced as Annexure II.
Signatures - Sub-section (2) of section 29 of the Act requires that the financial statements of
banking companies incorporated in India should be signed by the manager or principal officer
of the banking company and by at least three directors (or all the directors in case the number
is less than three). The financial statements of a foreign banking company are to be signed by
the manager or agent of the principal office in India. It may be noted that the accounts of a
branch are usually signed by the manager of the branch and/or the accountant.
The provision of sub-section (2) of section 29 are also applicable to nationalised banks, State
Bank of India, its subsidiaries, and regional rural banks.
Requirements of Banking Regulation Act, 1949, vis a vis Companies Act, 1956 - The
requirements of the Companies Act, 1956, relating to the balance sheet and profit and loss
account of a company, in so far as they are not inconsistent with the Banking Regulation Act,
1949, also apply to the balance sheet or profit and loss account, as the case may be, of a
banking company [sub-section (3) of section 29 of the Act]. It may be noted that this provision
does not apply to nationalised banks, State Bank of India, its subsidiaries and regional rural
banks. Banks listed on a stock exchange have to comply with the requirements of the Listing
Agreement as amended from time to time.
Audit of Accounts
11.5 Sub-section (1) of section 30 of the Act requires that the balance sheet and profit and
loss account of a banking company should be audited by a person duly qualified under any
law for the time being in force to be an auditor of companies. Similar provisions are contained
in the enactments governing nationalised banks [section 10 of the Banking Companies
(Acquisition and Transfer of Undertakings) Act of 1970/1980], State Bank of India [section 41
of the State Bank of India Act, 1955], subsidiaries of State Bank of India [section 41 of the
State Bank of India (Subsidiary Banks) Act, 1959], and regional rural banks [section 19 of the
Regional Rural Banks Act, 1976]. It is important to note that section 41 of the State Bank of
India Act, 1955, specifically provides that the affairs of the bank shall be audited by “two or
more auditors”.
Qualifications of Auditor - According to section 226 of the Companies Act, 1956, a chartered
accountant, a firm of chartered accountants, or a restricted state auditor can be appointed as
auditor of a company. However, the following persons cannot be appointed as auditor of a
company:
(a) a body corporate;
(b) an officer or employee of the company;
(c) a person who is a partner, or who is in the employment, of an officer or employee of the
company;
(d) a person who is indebted to the company for an amount exceeding one thousand rupees,
or who has given any guarantee or provided any security in connection with the
indebtedness of any third person to the company for an amount exceeding one thousand
rupees;
(e) a person holding any security means an instrument which carries voting rights of the
company (this disqualification is applicable from the expiry of a period of one year from
the date of commencement of the Companies (Amendment) Act, 2000.
It may be noted that in case of indebtedness in excess of the specified limit as mentioned at
(d) above, the chartered accountant concerned (or the firm of chartered accountants) becomes
disqualified to audit any branch of the bank; the disqualification is not confined to appointment
as auditor of the particular branch to which the debt is owed.
In the context of banks, the expression indebtedness would cover, inter alia, the amounts
outstanding in respect of credit cards issued by a bank. Thus, where the credit card
outstandings exceed the prescribed limit of Rs.1,000, the chartered accountant in whose
Audit of Banks 11.7
name the card is issued as well as the firm of which he is a partner would be disqualified for
appointment as auditor of the issuing bank.
Appointment of Auditor - As per the provisions of the relevant enactments, the auditor of a
banking company is to be appointed at the annual general meeting of the shareholders,
whereas the auditor of a nationalised bank is to be appointed by the bank concerned acting
through its Board of Directors. In either case, approval of the Reserve Bank is required before
the appointment is made. The auditors of the State Bank of India are to be appointed by the
Reserve Bank of India in consultation with the Central Government. The auditors of the
subsidiaries of the State Bank of India are to be appointed by the State Bank of India. The
auditors of regional rural banks are to be appointed by the bank concerned with the approval
of the Central Government.
As mentioned earlier, the State Bank of India Act, 1955, specifically provides for appointment
of two or more auditors. Besides, nationalised banks and subsidiaries of State Bank of India
also generally appoint two or more firms as joint auditors.
Remuneration of Auditor - The remuneration of auditor of a banking company is to be fixed
in accordance with the provisions of section 224 of the Companies Act, 1956 (i.e., by the
company in general meeting or in such manner as the company in general meeting may
determine). The remuneration of auditors of nationalised banks and State Bank of India is to
be fixed by the Reserve Bank of India in consultation with the Central Government. The
remuneration of auditors of subsidiaries of State Bank of India is to be fixed by the latter. In
the case of regional rural banks, the auditors’ remuneration is to be determined by the bank
concerned with the approval of the Central Government.
Powers of Auditor - The auditor of a banking company or of a nationalised bank, State Bank
of India, a subsidiary of State Bank of India, or a regional rural bank has the same powers as
those of a company auditor in the matter of access to the books, accounts, documents and
vouchers. He is also entitled to require from the officers of the bank such information and
explanations as he may think necessary for the performance of his duties. In the case of a
banking company, he is entitled to receive notice relating to any general meeting. He is also
entitled to attend any general meeting and to be heard there at on any part of the business,
which concerns him as auditor.
It is important to note that under section 10 of the Banking Companies (Acquisition and
Transfer of Undertakings) Act, 1970/1980, the auditor of a nationalised bank may employ
accountants or other persons at the expense of the bank to assist him in audit of accounts.
Similar provisions exist in section 41 of the State Bank of India Act, 1955 and the State Bank
of India (Subsidiary Banks) Act, 1959. These provisions are aimed at facilitating the work of
auditors of these banks by empowering them to appoint the auditors of branches and are
particularly important in the context of the fact that the above enactments do not contain any
specific provisions for audit of branches of these banks. This is unlike banking companies
where audit of branches is required under section 228 of the Companies Act, 1956. It may be
noted that the Regional Rural Banks Act, 1976, does not contain any provisions relating to
audit of branches. Accordingly, in the case of such banks, audit of branches is also carried
out by the auditors appointed for the bank as a whole.
Auditor's Report - In the case of a nationalised bank, the auditor is required to make a report
to the Central Government in which he has to state the following:
(a) whether, in his opinion, the balance sheet is a full and fair balance sheet containing all
the necessary particulars and is properly drawn up so as to exhibit a true and fair view of
the affairs of the bank, and in case he had called for any explanation or information,
whether it has been given and whether it is satisfactory;
(b) whether or not the transactions of the bank, which have come to his notice, have been
within the powers of that bank;
(c) whether or not the returns received from the offices and branches of the bank have been
found adequate for the purpose of his audit;
(d) whether the profit and loss account shows a true balance of profit or loss for the period
covered by such account; and any other matter which he considers should be brought to
the notice of the Central Government.
The report of auditors of State Bank of India is also to be made to the Central Government and
is almost identical to the auditor’s report in the case of a nationalised bank.
The auditor’s report in the case of subsidiaries of State Bank of India is identical to the
auditor’s report in the case of a nationalised bank, except that all references to Central
Government have to be construed instead as references to the State Bank of India. Similar is
the position in the case of regional rural banks, except that the references are instead to the
bank concerned.
In addition to matters on which he is required to report to the shareholders under the
Companies Act, 1956, the auditor of a banking company is required to state in his report:
(a) Whether or not the information and explanations required by him have been found to be
satisfactory;
(b) whether or not the transactions of the company which have come to his notice have been
within the powers of the company;
(c) whether or not the returns received from the branch offices of the company have been
found adequate for the purpose of his audit;
(d) whether the profit and loss account shows a true balance of profit or loss for the period
covered by such account; and
(e) any other matter which he considers should be brought to the notice of the shareholders
of the company.
It may be noted that in the case of a banking company, by virtue of the provisions of clause (d)
of sub-section (3) of section 227 of the Companies Act, 1956, the auditor has to specifically
report whether, in his opinion, the profit and loss account and balance sheet of the banking
company comply with the accounting standards referred to in sub-section (3C) of section 211
of the Companies Act, 1956.
Long Form Audit Report - Besides the audit report as per the statutory requirements
Audit of Banks 11.9
discussed above, the terms of appointment of auditors of public sector banks, private sector
banks and foreign banks [as well as their branches, require the auditors to also furnish a long
form audit report (LFAR)]. The matters which the banks require their auditors to deal with in
the long form audit report have been specified by the Reserve Bank of India.
11.5.1 Books and Accounts - A banking company is required to maintain the books of account
in accordance with Section 209 of the Companies Act. There are, however, certain
imperatives in banking business they are the requirements to maintain accurate and always
up-to-date accounts. Banks, therefore, device their accounting systems to suit these
requirements. The main characteristics of a bank’s system of book keeping are as follows:
(a) Entries in the personal ledgers are made directly from vouchers instead of being posted
from the books of prime entry.
(b) The vouchers entered into different personal ledgers each day are summarised on
summary sheet, the totals of which are posted to the control accounts in the general
ledger.
(c) The general ledger trial balance is extracted and agreed every day.
(d) All entries in the detailed personal ledgers and the summary sheets are checked by
persons other than those who have made the entries, with the general result that most
clerical mistakes are detected before another day begins.
(e) A trial balance of the detailed personal ledgers is prepared periodically, usually every two
weeks, and agreed with the general ledger control accounts.
(f) Excepting for cash transactions, always two vouchers are prepared for each transaction,
one for debit and the other for credit. This system ensures double entry at the basic level
and obviate the possibility of errors in posting.
Principal books of account

(i) General Ledger - It contains control accounts of all personal ledger, the profit and loss
account and different assets and liabilities accounts. There are certain additional accounts
known as contra accounts which is unique feature of bank accounting. These contra accounts
are maintained with a view to keeping control over transactions which have no direct effect on
the bank’s position, e.g., letters of credit opened, bills received for collection, guarantees
given, etc.
(ii) Profit and Loss Ledger - Some banks keep one account for profit and loss in this general
ledger and maintain separate books for the detailed accounts. These are columnar books
having separate columns for each revenue receipt and expense head. Other banks keep
separate books for debits and credits. These books are directly posted from vouchers. The
totals of debits and credits posted are entered into the profit and loss account in the general
ledger. In some cases, the revenue accounts are also maintained in the general ledger itself,
while in some others, broad revenue accounts are kept in the general ledger and the details
are recorded in a subsidiary ledger. The account heads are maintained in greater detail than
those that appear in the bank’s published profit and loss accounts.
Subsidiary Books of Accounts

(i) Personal Ledgers - Separate ledgers are maintained by banks for different types of
accounts. For example, there are separate ledgers for current accounts, saving accounts,
fixed deposits (often further classified by length of period of deposit), cash certificates, loans,
overdrafts, etc. As has been mentioned earlier, these ledgers are posted directly from
vouchers and all the vouchers entered in each ledger in a day are summarised into Voucher
Summary Sheets. The Voucher Summary Sheets are prepared in the department which
originates the transactions by persons other than those who write the ledgers. They are
subsequently checked, with the vouchers by different persons generally unconnected with the
writing up of ledgers or the preparation of Voucher Summary Sheets.
(ii) Bill Registers - Details of different types of bills are kept in separate registers which have
suitable columns. For example, bills purchased, inward bills for collection, outward bills for
collection, etc. are entered serially day to day in separate registers. In case of bills purchased
or discounted, party-wise details are also kept in normal ledger form. This is done to ensure
that the sanctioned limits of parties are not exceeded. Entries in these registers are made by
reference to the original documents. A voucher for the amount of transactions of each day is
prepared in respect of each register. The voucher is entered in the Day Book. When a bill is
realised or returned, its original entry in the register is marked off. A daily summary of such
realisations or returns is prepared in separate registers whose totals are taken to vouchers
which are posted in the Day Book. In respect of Bills for collection, contra vouchers reflecting
both sides of the transactions are prepared at the time of the original entry, and this entry is
reversed on realisation. Outstanding entries are summarised frequently, usually twice a month
and their total is agreed with the balance of respective control accounts in the General Ledger.
(iii) Other Subsidiary registers - There are different registers for various types of
transactions. Their number, volume and details which differ according to the individual needs
of each Bank. For example, there will be registers for-
(a) Demand Drafts, Telegraphic and Mail Transfers issued on branches or agencies.
(b) Demand Drafts, Telegraph Transfers and Mail Transfers received from branches and
Agencies.
(c) Letters of Credit.
(d) Letters of Guarantee.
Entries into these Registers are made from original documents which are also summarised on
vouchers every day. These vouchers are posted into the Day Book. Outstanding entries are
summarised frequently and their total agreed with the control heads in the General Ledger.
(iv) Departmental Journals - Each department of the Bank maintains a journal to note the
transfer entries passed by it. These journals are memoranda books only, as all the entries
made there are also made in the Day Book, through Voucher Summary Sheets. The purpose
is to maintain a record of all transfer entries originated by each department. For example, the
Loans and Overdraft Section will pass transfer entries for interest charged on various
accounts every month, and as all these entries are posted in the journal of the department, the
Audit of Banks 11.11
officer concerned can easily find out the accounts in respect of which the interest entry has
been passed. Since all the vouchers passed during the day are entered in the Day Book only
in a summary form, it may not be possible to get this information from the Day Book without
looking into the individual vouchers.
As has been mentioned earlier, two vouchers are generally made for each transfer entry, one
for debit and the other for credit. The vouchers are generally made by and entered into the
journal of the department which is accordingly credited to the other departments. For example,
if any amount is to be transferred from Current Account of a customer to his Saving Bank
Account, vouchers will be prepared by the Current Account Department and entered in the
journal of that department.
(v) Other Memoranda Books - Besides the books mentioned above, various departments of
a bank have to maintain a number of memoranda books to facilitate their work. Some of the
important books are described below:
Cash Department
(a) Receiving Cashiers’ Cash Book.
(b) Paying Cashiers’ Cash Book.
(c) Main Cash Book.
(d) Cash Balance Book.
The main cash book is maintained by a person other than cashiers. Each cashier keeps a
separate cash book. When cash is received, it is accompanied by pay-in-slips or other similar
documents. The cashier makes the entry in his book which is checked by the chief cashier.
The pay-in-slip then goes to the Main Cash Book writer who makes an entry in his book. The
cash book checker checks the entry with the slip and then the counterfoil of the slip is
returned back to the customer and the foil is sent to the appropriate department for entering
into the ledger. The foil is used as a voucher. Cash is paid against a cheque or other
documents (e.g. Travellers’ cheques, demand drafts, pay orders, etc.) after it has been duly
passed and entered in the appropriate account in the ledger. Cheques, demand drafts, pay
orders, etc. are themselves used as vouchers.
Quick Payment System - Banks introduce different systems so that their customers may
receive payment of cash, etc. quickly. The most prevalent system is the teller system. Under
this system, tellers keep cash as well as ledger cards and specimen signature cards of each
customer in respect of Current and Savings Bank Accounts, A teller is authorised to make
payment upto a particular amount say, Rs. 1000/-. On receipt of a cheque, he checks it,
passes it for payment, enters it in the ledger card and makes payment to the customer. The
teller also receives cash deposited in these accounts.
Outwards Clearing -
(a) Clearing Cheques Received Book for entering cheques received from customers for
clearing.
(b) Bank-wise list of the above cheques, one copy of which is sent to the clearing house
together with cheques.
A person checks the vouchers (foil of pay-in-slip) and list with the Clearing Cheques Received
Book. The vouchers are then sent to appropriate departments, where customers’ accounts are
immediately credited. If any cheque is received back unpaid, the entry is reversed. Normally
no drawings are allowed against clearing cheques deposited the same day but exceptions are
often made by the manager in the case of established customers.
Inward Clearing - Cheque received are checked with the accompanying list. These are then
distributed to different departments and the number of cheques given to each department is
noted in a memo book. When the cheques are passed and posted into ledger, their number is
independently agreed with the Memo Book. If the cheques are found unplayable, they are
returned to the Clearing House. The cheques themselves serve as vouchers.
Loans & Overdrafts Department
(a) Registers to record details of documents executed by the borrowers and guarantors in
respect of credit facilities.
(b) Securities register for recording details of securities in respect of credit facilities.
(c) Pending documents and document deficiency register.
(d) Godown registers maintained by the godown -keepers of the bank.
(e) Price register giving the wholesale prices of commodities pledged with the bank.
(f) Overdraft sanction register
(g) Drawing power book
(h) Delivery order books
(i) Storage books
(j) Stock statements registers for loan accounts
(k) Suit filed register
(l) Inspection registers for loan accounts.
Deposits Department
(a) Account Opening & Closing registers.
(b) For fixed deposits, rate register giving analysis of deposits according to rates.
(c) Due Date Diary.
(d) Specimen signature book.
Establishment Department
(a) Salary and allied registers such as attendance register, leave register, overtime register,
etc.
(b) Register of fixed assets e.g., furniture and fixtures, motor cars, vehicles, etc.
(c) Stationery registers.

(d) Old records register.
General
(a) Signature book of bank’s officers.
(b) Private Telegraphic Code and cyphers.
(c) Back up registers for various types of returns/statements.
(d) Safe Deposit Lockers/Safe Custody registers
(e) Registers to record particulars of lost instruments (Draft, Cheques, etc) based on details
received from the head office.
(f) Transit books through which instruments are sent to the cash department for payment by
the official authorizing such payment.
(g) Registers to record particulars of outstanding inter-office entries received from the
reconciliation department of the bank which are to be responded to by the branch.
(h) Cheque books issued register.
(i) Token register.
Statistical Books - Statistical records kept by different books are in accordance with their
individual needs. For example, there may be books for recording (1) average balances in
loans and advances etc. (2) Deposits received and amounts paid out each month in the
various departments (3) Number of cheques paid, (4) Number of cheques, bills and other
items collected.
11.5.2 Conducting an Audit -The audit of banks or of their branches involves the following
stages -
(a) Preliminary work.
(b) Evaluation of internal control system.
(c) Preparation of audit programme for substantive testing and its execution.
(d) Preparation and submission of audit report.
(a) Preliminary work
(i) The auditor should acquire knowledge of the regulatory environment in which the
bank operates. Thus, the auditor should familiarise himself with the relevant
provisions of applicable law(s) and ascertain the scope of his duties and
responsibilities in accordance with such law(s). He should be well-acquainted with
the provisions of the Banking Regulation Act, 1949, as well as any other applicable
law(s) e.g. Companies Act, 1956 in the case of audit of a banking company
particularly in so far as they relate to preparation and presentation of financial
statements and their audit.
(ii) The auditor should also acquire knowledge of the economic environment in which
the bank operates. Similarly the auditor needs to acquire good working knowledge
of the services offered by the bank. In acquiring such knowledge, the auditor needs
to be aware of the many variations in the basic deposit, loan and treasury services
that are offered and continue to be developed by banks in response to market
conditions. To do so, the auditor needs to understand the nature of services
rendered through instruments such as letters of credit, acceptances, forward
contracts, and other similar instruments.
The auditor should also obtain an understanding of the accounting system of the bank and the
terminology used by the bank to describe various types of transactions and operations. Most
banks have well-designed accounting and procedures manual which can serve as an
important source of information on these aspects. Banks are extensively using information
technology for its operations. The advent of technology has added a risk parameter to the
auditor’s process of risk assessment.
In addition to the above, the auditor should also undertake the following:
♦ Review relevant instructions issued by the bank, particularly those relating to closing of
annual accounts. These instructions contain standardised accounting procedure required
to be followed at head office, at regional offices, zones offices and branches.
♦ Review the audit report for the previous year including the long form audit report. In case
of branch auditors, the audit report on the financial statements of the branch for the
previous year or for the audit last conducted should be reviewed. The purpose of this
review is to understand the nature of observations/comments made on the financial
statements and for enquiring into the follow-up action taken on matters contained in
such report.
♦ Review the revenue audit reports, internal audit reports, inspection reports and
concurrent audit reports pertaining to the bank/branch, as the case may be.
♦ One set of tests which the auditors at both the branch level and Head Office Level may
apply for audit of banks is analytical procedures.
(b) Risk assessments and Internal Control System - AAS-6, ‘Risk Assessment and
Internal Control’, states that auditor’s procedure should be addressed to keep the audit risk at
an acceptably low level and also require the auditor to assess the components of the audit
risk. Internal control evaluation is an important element of audit process. In the case of audit of
banks, it assumes even greater importance due to the enormous volume of transactions
entered into by banks. Evaluation of design and operation of internal control system enables
the bank auditors to perform more effective audits. The auditor should, therefore, study and
evaluate the design and operation of internal controls. This would assist him in determining
the nature, timing and extent of substantive procedures in various areas, depending upon
whether the internal controls are adequate and observed in practice.
(c) Preparation of audit programme for substantive testing and its execution - Having
familiarized himself the requirements of audit, the auditor should prepare an audit programme
for substantive testing which should adequately cover the scope of his work. In framing the
audit programme, due weightage should be given by the auditor to areas where, in his view,
there are weaknesses in the internal controls. The audit programme for the statutory auditors
would be different from that of the branch auditor. At the branch level, basic banking
operations are to be covered by the audit. On the other hand, the statutory auditors at the
head office level have to deal with consolidation of branch returns (both audited and
unaudited), verification of investments, items normally deal with at the head office (like
provision for gratuity, inter-office accounts, etc). The scope of the work of the statutory
auditors would also involve dealing with various accounting aspects and disclosure
requirements arising out of the branch returns. The auditor should ensure that the work is
executed in accordance with the audit programme by persons having the requisite skills and
competence.
(d) Preparation and submission of audit report - The branch auditor forwards his report to
the statutory auditors who have to deal with the same in such manner as they consider
necessary. It is desirable that the branch auditors’ reports are adequately detailed in
unambiguous terms. As far as possible, the financial impact of all qualifications or adverse
comments on the branch accounts should be clearly brought out in the branch audit report. It
would assist the statutory auditors if a standard pattern of reporting, say, head-wise,
commencing with assets, then liabilities and thereafter items related to income and
expenditure, is followed. Similarly, for statutory auditors of a bank, the form and content of the
audit report should be determined by the auditor taking into account his terms of engagement
and applicably statutory, regulatory and professional requirements.
Concept of Materiality: In preparing the audit report, the auditor should keep in mind the
concept of materiality. Thus, items which do not materially affect the view presented by the
financial statements may be ignored. However, if in the judgement of the auditor, an item
though not material, is contrary to accounting principles or any pronouncements of the
Institute of Chartered Accountants of India or is such as would require a review of the relevant
procedure, it would be appropriate for him to draw the attention of the management to this
aspect in his long form audit report. In all cases, matters covering the statutory responsibilities
of the auditors should be dealt with in the main report. The LFAR should be used to further
elaborate matters contained in the main report and not as a substitute thereof. Similarly, while
framing his main report, the auditor should consider, wherever practicable, the significance of
various comments in his LFAR, where any of the comments made by the auditor therein is
adverse, he should consider whether a qualification in his main report is necessary by using
his discretion on the facts and circumstances qualification in his main report is necessary by
using his discretion on the facts and circumstances of each case. It may be emphasized that
the main report should be self-contained document.
11.5.3 Special Considerations in a CIS Environment - As in today’s environment all banks
have embarked upon a large scale computerization, this has resulted in changes in the
processing and storage of information and affects the organisation and procedures employed
by the entity to achieve adequate internal control. Thus, while the overall objective and scope
of audit do not change simply because data is maintained on computers, the procedures
followed by the auditor in his study and evaluation of the accounting system and related
internal controls and the nature, timing and extent of his other audit procedures are affected in
a CIS environment.
11.5.4 Internal Audit and Inspection - Banks generally have a well organised system of internal
audit. Their internal auditors pay frequent visit to the branches. They are an important link in
the internal control of the bank. The systems of internal audit in different banks also have a
system of regular inspection of branches and head office. The internal audit and inspection
function is carried out by a separate department within the bank by firms of chartered
accountants. Apart from these, the inspectors of Reserve Bank of India also review the
systems and transactions of important branches, most banks also have a vigilance department
which regularly investigates frauds, defalcations, etc. Vide its Circular No.
BC.182/16.13.100/93-94 dated October 11, 1993 addressed to all scheduled commercial
banks except, regional rural banks the Reserve Bank of India advised the banks to institute an
appropriate system of concurrent audit in such a manner as to cover at least 50 to 70% of the
bank’s business operations by 31 October, 1993. The guidelines have since been revised.
Concurrent Audit is discussed separately in the Chapter.
The statutory auditors should evaluate internal audit, concurrent audit and inspection functions
to the extent they consider that these will be relevant in designing their audit procedures. They
should also review the internal/concurrent/inspection/audit programmes. Such a review helps
the statutory auditors in determining the nature, timing and extent of their audit tests. They can
assist the bank management in improving the effectiveness of internal audit/concurrent
audit/inspection functions.
Internal Control in Certain Selected Areas

11.6 General -
(a) The staff and officers of a bank should be shifted from one position to another frequently
and without prior notice.
(b) The work of one person should always be checked by another person (usually by an
officer) in the normal course of business.
(c) The arithmetical accuracy of the books should be proved independently every day.
(d) All bank forms (e.g. Cheque books, demand draft books, travellers’ cheques etc.) should
be kept in the possession of an officer, and another responsible officer should
occasionally verify the stock of such stationery.
(e) The mail should be opened by a responsible officer. Signatures on all the letters and
advices received from other branches of the bank or its correspondence should be
checked by an officer with the signature book.
(f) The signature book and the telegraphic code book should be kept with responsible
officers and used and seen by authorised officers only.
(g) The bank should take out insurance policies against loss and employees’ infidelity.
(h) The powers of officers of different grades should be clearly defined.
(i) There should be surprise inspection of head office and branches at periodic interval by
the internal audit department. The irregularities pointed out in the inspection reports
should be promptly rectified.
Cash
(a) Cash should be kept in the joint custody of two responsible officers.
(b) In addition to normal checking by the chief cashier, cash should be test-checked daily
and counted in full occasionally by a responsible officer unconnected with the cash
department. Actual cash in hand should agree with the balance shown by the Day Book
every day.
(c) The cashier should have no access to the customer’s ledger accounts and the Day Book.
This is an important safeguard. Bank managements are often tempted to use cashiers
because of their shorter working hours as ledger clerks in the absence of regular staff on
leave, etc. This can be a very expensive price of economy.
(d) The counterfoil cash receipt vouchers (e.g. counterfeits of pay-in-slips lodged by the
depositors) should be signed by an officer in Cash Department, in addition to the
receiving cashier.
(e) Payments should be made only after the vouchers (e.g. cheques, demand drafts etc.)
have been passed for payment by the proper officer and have been entered in the
customer’s account.
(f) Receipt and payment scrolls or their totals should be compared with the cash column of
the Day-Book by independent persons.
(g) Where the teller system is prevalent.
(i) A limit should be placed on the powers of tellers to make payment.
(ii) All vouchers relating to the accounts of customers which the tellers handle should
first be sent to them and entered by them in the ledger cards.
(iii) Total payment made by a teller should be reconciled with the cash columns of the
Voucher Summary Sheet of the ledger concerned every day.
(iv) There should be frequent rotation of tellers.
Clearings
(a) Cheques received by the bank in clearing should be checked with the list accompanying
them. Independent list should be prepared for cheques debited to different customers
accounts and those returned unpaid and these should be checked by officers. The total
number and amount of cheques included in these lists should be agreed with the list first
mentioned by a person unconnected with both the customers, ledgers and the clearing
department.
(b) The total number and amount of cheques sent out by the bank for clearing should be
agreed with the total of the clearing pay- in-slips, by an independent person.
(c) The unpaid cheques received back in return clearing should be checked in the same
manner as the cheques received.
Constituents’ Ledgers
(a) Before making payment, cheques should be properly checked in respect of signature,
date, balance in hand etc. and should be passed by an officer and entered into
constituents’ accounts.
(b) No withdrawals should normally be allowed against clearing cheques deposited on the
same day.
(c) An officer should check all the entries made in the ledger with the original documents
particularly noting that the correct accounts have been debited or credited.
(d) Ledger keepers should not have access to Voucher Summary Sheet after they have been
checked by an officer and to the Day Book.
(e) Interest debited or credited to constituents’ accounts should be independently checked.
Bills for Collection
(a) All the documents accompanying the bills should be received and entered in the Register
by a responsible officer. At the time of despatch, the officer should also see that all the
documents are sent along with the bills.
(b) The accounts of customers or principals should be credited only after the bills have been
collected or an advice to that effect received from the branch or agent to which they were
sent for collection.
(c) It should be ensured that bills sent by one, branch for collection to another branch of the
bank, are not taken in the bills for collection twice in the amalgamated balance sheet of
the bank. For this purpose, the receiving branch should reverse the entries regarding
such bills at the end of the year for closing purposes.
Bills Purchased
(a) At the time of purchase of the bills, an officer should verify that all the documents of title
are properly assigned to the bank.
(b) Sufficient margin should be kept while purchasing or discounting a bill so as to cover any
decline in the value of the security etc.
(c) If the bank is unable to collect a bill on the due date, immediate steps should be taken to
recover the amount from the drawer against the security provided.
(d) All irregular outstanding accounts should be reported to the Head Office.
(e) In the case of bills purchased outstanding at the close of the year the discount received
thereon should be properly apportioned between the two years.
Loans and Advances
(a) The bank should make advances only after satisfying itself as to the creditworthiness of
the borrowers and after obtaining sanction from the proper authorities of the bank.
(b) All the necessary documents (e.g., agreements, demand promissory notes, letters of
hypothecation, etc.) should be executed by the parties before advances are made.
(c) Sufficient margin should be kept against securities taken so as to cover any decline in
the value thereof and also to comply with Reserve Bank directives. Such margins should
be determined by the proper authorities of the bank as a general policy or for particular
accounts.
(d) All the securities should be received and returned by responsible officer. They should be
kept in the Joint custody of two such officers.
(e) All securities requiring registration should be registered in the name of the bank or
otherwise accompanied by the documents sufficient to give title of the bank.
(f) In the case of goods in the possession of the bank, contents of the packages should be
test checked at the time of receipts. The godowns should be regularly and frequently
inspected by a responsible officer of the branch concerned, in addition by the inspectors
of the bank.
(g) Surprise checks should be made in respect of hypothecated goods not in the possession
of the bank.
(h) Market value of goods should be checked by officers of the bank by personal enquiry in
addition to the invoice value given by the borrowers.
(i) As soon as any increase or decrease takes place in the value of securities proper entries
should be made in the Drawing Power Book and Daily Balance Book. These entries
should be checked by an officer.
(j) All accounts should be kept within both the drawing power and the sanctioned limit at all
times.
(k) All the accounts which exceed the sanctioned limit or drawing power or are against
unapproved securities or are otherwise irregular should be brought to the notice of the
Management/Head Office regularly.
(l) The operation (in each advance should be reviewed at least once every year.)
Telegraphic Transfers and Demand Drafts
(a) The bank should have a reliable private code known only to responsible officers of its
branches, coding and decoding of telegrams should be done only by such officers.
(b) The signatures on a demand draft should be checked by an officer with the Signature
Book.
(c) All the T.Ts and D.Ds. sold by a branch should be immediately confirmed by the advices
to the branches concerned.
(d) If the paying branch does not receive proper confirmation of any T.T. or D.D. from the
issuing branch or does not receive credit in its account with that branch, it should take
immediate steps to ascertain the reasons.
Inter Branch Accounts

(a) The accounts should be adjusted only on the basis of advices (and not on the strength of
entries found in the statement of account) received from other branches,
(b) Prompt action should be taken preferably by central authority, if any entries (particularly
debit entries) are not responded to by any branch within a reasonable time.
Credit Card Operations
(a) There should be effective screening of applications with reasonably good credit
assessments.
(b) There should be strict control over storage and issue of cards.
(c) There should be at system whereby a merchant confirms the status of unutilised limit of a
credit-card holder from the bank before accepting the settlement in case the amount to
be settled exceeds a specified percentage of the total limit of the card holder.
(d) There should be a system of prompt reporting by the merchants of all settlements
accepted by them through credit cards.
(e) Reimbursement to merchants should be made only after verification of the validity of
merchant’s acceptance of cards.
(f) All the reimbursement (gross of commission) should be immediately charged to the
customer’s account.
(g) There should be a system to ensure that statements are sent regularly and promptly to
the customer.
(h) There should be a system to monitor and follow-up customers’ payments.
(i) Items overdue beyond a reasonable period should be identified and attended to carefully.
Credit should be stopped by informing the merchants through periodic bulletins, as early
as possible, to avoid increased losses.
(j) There should be a system of periodic review of credit card holders’ accounts. On this
basis, the limits of customers may be revised, if necessary, The review should also
include determination of doubtful amounts and the provisioning in respect thereof.
Verification of Assets and Balances

11.7 The following are the steps involved in verification of assets and balances.
I. Cash, Bank Balances and Money at Call and Short Notice - The Third Schedule to the
Banking Regulation Act, 1949, requires the following disclosures to be made in the balance
sheet regarding cash, balances with Reserve Bank of India, balances with other banks, and
money at call and short notice.
Cash and Balances with Reserve Bank of India
I. Cash in hand (including foreign currency notes)
II. Balances with Reserve Bank of India
(i) In Current Account

(ii) In Other Accounts
Balances with Banks and Money at Call and Short Notice

I. In India
(i) Balances with banks
(a) In Current Accounts
(b) In Other Deposit Accounts
(ii) Money at call and short notice
(a) With banks
(b) With other institutions
II. Outside India
(i) In Current Accounts
(ii) In Other Deposit Accounts
(iii) Money at call and short notice
Cash Reserve - One of the important determinants of cash balances to be maintained by
banking companies and other scheduled banks is the requirement for maintenance of a certain
minimum cash reserve. While the requirement for maintenance of cash reserve by banking
companies is contained in the Banking Regulation Act, 1949, corresponding requirement for
scheduled banks is contained in the Reserve Bank of India Act, 1934.
Statutory Liquidity Ratio - Section 24 of the Act requires that every banking company shall
maintain in India in cash, gold or unencumbered approved securities an amount which shall
not, at the close of business on any day, be less than twenty five per cent, or such other
percentage not exceeding forty, as the RBI may from time to time specify, of the total of its
demand and time liabilities in India as on the last Friday of the second preceding fortnight.
This is referred to as ‘statutory liquidity ratio’. (The RBI vide its circulars DBOD No.761-
A/08/07/003/93 dated February 8, 1993 and 829/08.07.003/93 dated February 20, 1993 has
required all banks to advise their statutory central auditors to verify the compliance of statutory
liquidity ratio on twelve odd dates in different months not being Fridays).
Deposits by Foreign Banking Companies - Section 11(2) of the Act requires the banking
companies incorporated outside India to deposit with the Reserve Bank certain amount either
in cash or in unencumbered approved securities or partly in cash and partly in such securities.
Money at Call and Short Notice - Money at call and short notice represents short-term
investment of surplus funds in the money market. Money lent for one day is money at ‘call’
while money lent for a period of more than one day and up to fourteen days is money at ‘short
notice’. The lender bank does not get any security for money lent at call or short notice. The
participants of call and short-term money market are commercial and co-operative banks,
mutual funds and all-India financial institutions approved by the Reserve Bank such as Life
Insurance Corporation, General Insurance Corporation, Unit Trust of India and Industrial
Development Bank of India. Some of the participants of the market are allowed to act only as
lenders. Commercial banks and co-operative banks are, however, allowed to both borrow as
well as lend funds. Commercial banks usually borrow from this market to meet the
requirements relating to cash reserve or statutory liquidity ratio. The decisions to borrow from,
or lend in, the market are taken usually at the head office level and communicated to select
branches for effecting the borrowing/lending.
Audit Procedures
(a) Cash - The auditor should count the balance of cash on hand. As far as possible, the
auditor should visit the branch at the close of business on the last working day of the year or
before the commencement of business on the next day for carrying out the physical
verification of cash. If, for any reason, the auditor is unable to do so, he should carry out the
physical verification of cash as close to the balance sheet date as possible. It is sometimes
arranged by the branch to deposit a large portion of its cash balance with the Reserve Bank of
India or the State Bank of India or any other bank on the closing day, in which case, the work
of the auditor is reduced substantially.
The cash balance as physically verified should be agreed with the balance shown in the cash
book and the cash balance book. When the physical verification of cash is carried out by the
auditor before or after the date of the balance sheet, the auditor should work
forward/backward (as the case may be) to reconcile the results of his verification with the cash
balance at the balance sheet date as shown by the books.
(b) Balance with Reserve Bank of India - In a bank, only a few select branches are
designated to have account with the Reserve Bank. Thus, this item would not appear in the
balance sheet of every branch. The following procedures are therefore applicable only to
branches having account with the Reserve Bank of India.
Verify the ledger balances in each account with reference to the bank confirmation certificates
and reconciliation statements as at the year-end.
Review the reconciliation statements. He should pay special attention to the following items
appearing in the reconciliation statements:
(i) Cash transactions remaining unresponded;
(ii) Revenue items requiring adjustments/write-offs; and
(iii) Old outstanding balances remaining unexplained / unadjusted for over one year.
Obtain a written explanation from the management as to the reasons for old outstanding
transactions in bank reconciliation statements remaining unexplained / unadjusted for over
one year.
(c) Balance with Banks (Other than Reserve Bank of India) - Apart from the procedures
described above in examining the balances with banks other than Reserve Bank, while
reviewing the reconciliation statements, the auditor should pay particular attention to the
following.
(i) Examine that no debit for charges or credit for interest is outstanding and all the items
which ought to have been taken to revenue for the year have been so taken.
(ii) Examine that no cheque sent or received in clearing is outstanding.
(iii) Examine that all bills or outstanding cheques sent for collection and outstanding as on
the closing date have been credited subsequently.
The balances with banks outside India should also be verified in the manner described above.
These balances should be converted into the Indian currency at the exchange rates prevailing
on the balance sheet date.
(d) Money at Call and Short Notice - The auditor should examine whether there is a proper
authorisation, general or specific, for lending of the money at call or short notice. Compliance
with the instructions or guidelines laid down in this behalf by the head office or controlling
office of the branch, including the limits on lendings in inter-bank call money market, should
also be examined.
Call loans should be verified with the certificates of the borrowers and the call loan receipts
held by the bank. The auditor should examine whether the aggregate balances comprising this
item as shown in the relevant register tally with the control accounts as per the general ledger.
He should also examine subsequent repayments received from borrowing banks to verify the
amounts shown under this head as at the year-end. It may be noted that call loans made by a
bank cannot be netted-off against call loans received.
II. Investments
The Third Schedule to the Banking Regulation Act, 1949, requires the disclosure of
investments in the balance sheet as follows:
I. Investments in India in
(i) Government securities
(ii) Other approved securities
(iii) Shares
(iv) Debentures and Bonds
(v) Subsidiaries and/or joint ventures
(vi) Others (to be specified)
II. Investments outside India in
(i) Government securities (including local authorities)
(ii) Subsidiaries and/or joint ventures abroad
(iii) Other investments (to be specified)
The following are some of the terms which are commonly used in relation to investments of
banks:
(a) Approved Securities - Section 5(a) of the Banking Regulation Act, 1949 defines
‘approved securities’ to mean securities in which a trustee may invest money under clauses
(a) to (d) and (f) of section 20 of the Indian Trusts Act, 1882. Approved securities comprise
primarily the securities issued or guaranteed by the Central or a State Government, or any
other security expressly authorised by the Central Government by notification in the official
gazette.
(b) Prudential Exposure Limits - The Reserve Bank of India from time to time prescribes the
limits upto which investments in any one type of security or in any one company/group of
companies, etc. can be made by a bank. These limits are known as 'prudential exposure
limits'.
(c) Portfolio Management Scheme (PMS) - In a portfolio management scheme the bank
administering the scheme makes investments on behalf of clients for a ‘management fee’.
This is a fiduciary activity in which the profit or loss from the transactions belongs to the client.
(d) Ready-forward Transactions - Ready-forward transactions are arrangements for current
sale of securities and their simultaneous re-purchase at a future date at a price fixed at the
time of sale. From the viewpoint of the other party, the transaction involves current purchase
and subsequent resale of the securities concerned. In substance, a ready forward transaction
involves financing of the bank that sells and agrees to repurchase the securities subsequently
by the other party to the transaction. From the viewpoint of such other party, the difference
between its current purchase price and subsequent resale price represents the yield on the
transaction.
(e) Bank Receipt (BR) - Bank receipt is acknowledgement from the selling bank to the
buying bank that the former has received payment for certain securities which it will deliver
within a certain time. BR is non-transferable and can be issued by banks and certain specified
institutions only.
(f) Government Security - A government security is an instrument issued by the Central or a
State Government which is redeemable after a fixed period and carries a fixed rate of interest.
(g) Treasury Bills - Treasury bills are government securities representing obligations which
mature in one year or less.
(h) Subsidiary General Ledger (SGL) - This is a ledger maintained by the Public Debt Office
(PDO) of Reserve Bank of India in which accounts of different banks are maintained regarding
their holding of select government securities. On a purchase or a sale of the securities, the
transaction is recorded when the purchasing bank sends to PDO the Subsidiary Ledger Form
(SGL Form), signed on behalf of both the transferor and the transferee banks. PDO acts like a
depository in respect of government securities.
(i) Yield-to-Maturity (YTM) - This is the average annual compound rate of return on a
security (taking into account both the interest and the redemption value) which the investor will
earn if he holds it till maturity.
Audit Procedures
Internal Control Evaluation and Review of Investment Policy - The central auditor should
familiarise himself with the instructions issued by the Reserve Bank of India regarding
transactions in securities. He should review the investment policy of the bank to ascertain that
the policy conforms, in all material respects, to the RBI’s guidelines as well as to any statutory
provisions applicable to the bank. While examining the internal controls over investments
(including those on SGL forms and BRs), the auditor should particularly examine whether the
same are in consonance with the guidelines of the Reserve Bank of India. He should also
judge their efficacy. The auditor should satisfy himself that investments made by the bank are
in accordance with the laid down investment policy.
Separation of Investment Functions - One of the guidelines of RBI relates to separation of
functions relating to investments made by banks on their own Investment Account, on PMS
clients’ account, and on behalf of other constituents (including brokers). The auditor should
examine whether separate records are maintained for investments under each of these
categories. As per the RBI guidelines, banks are required to get their investments under PMS
separately audited by external auditors. (It may be noted that such separate audit of PMS
transactions can be carried out by any firm of chartered accountants including the statutory
auditors.) The auditor should review the report of such external auditors, if available, and
check whether the discrepancies pointed out in the report have been adequately dealt with.
The auditor should also verify that PMS transactions are carried through a separate SGL
account, and that there is no switching between the bank’s own investment account and PMS
clients’ account except in accordance with the guidelines laid down by the Reserve Bank of
India in this regard.
Examination of Reconciliation - The auditor should examine the reconciliation of the
investment account, physically verify the securities on hand, obtain confirmations from
counter-party banks for BRs issued by such banks and on hand, obtain confirmation of SGL
balances with the PDO, and examine the control and reconciliation of BRs issued by the bank.
Examination of Documents - The auditor should ascertain whether the investments made by
the bank are within its authority.
The auditor should satisfy himself that the transactions for the purchase/sale of investments
are supported by due authority and documentation. The acquisition/disposal of investments
should be verified with reference to the broker’s contract note, bill of costs, receipts and other
similar evidence. The auditor should pay special attention to ascertaining whether the
investments have been purchased or sold cum-dividend/ex-dividend, cum-interest/ex-interest,
cum-right/ex-right, or cum-bonus/ex-bonus. He should check whether appropriate
adjustments in this regard have been made in the cost/sales value of securities purchased or
sold.
In the case of a right issue, the offer to the bank contained in the letter of rights should be
examined.
As regards bonus shares, the intimation to the bank regarding such issue should be examined
with a view to ascertaining the receipt and recording of the requisite number of shares in the
records maintained by the bank in this regard.
Physical Verification - The auditor should verify the investment scrips physically at the close
of business on the date the balance sheet. In exceptional cases where physical verification of
investment scrips on the balance sheet date is not possible the auditor should carry out the
physical verification on a date as near to the balance sheet date as possible. In such a case,
he should take into consideration any adjustments for subsequent transactions of purchase,
sale, etc. He should take particular care to see that only genuine investments are produced
before him, and that securities held by the bank on behalf of others (e.g., those held as
security against loans and advances) are not shown to him as the bank’s own investments.
To ensure this, the auditor should require that all investment scrips in the possession of the
bank – whether belonging to it or to borrowers or to constituents under PMS or otherwise –
should be produced before him simultaneously. The auditor should keep them under his
control until he completes his checking.
Normally, the investments of a bank are held by:
(a) The bank itself; or
(b) The Public Debt Office (PDO) of the Reserve Bank of India; or
(c) A depository (in the case of dematerialised securities other than government securities).
To facilitate the work of verification, the auditor may advise the bank to list out investments
held in physical form separately from those held in dematerialised form with the PDO or with a
depository.
Investments should not normally be held by any other person (as laid down in the City
Equitable Fire Insurance Co. case). If any investments are so held, proper enquiry should be
made to ensure that there is some justification for it, e.g., shares may be held by brokers for
the purpose of transfer or splitting-up etc. Shares may also be lodged with the companies
concerned for transfer etc. When investments are held by any other person on behalf of the
bank, the auditor should obtain a certificate from him. The certificate should state the reason
for holding the investment (e.g., in safe custody or as security).
In respect of dealings in government securities through SGL account, confirmation of balances
should be obtained from the Public Debt Office of the Reserve Bank. In respect of investments
held by a custodial or depository organisation, the auditor should examine whether there is an
effective system of periodic reconciliation of balances as per the records of the bank and
those as per the records of the custodial or depository organisation. The auditor should also
examine the certificate issued by such organisation confirming the year-end holding of the
bank.
If certain securities are held in the names of nominees, the auditor should examine whether
there are proper transfer deeds signed by the holders and also an undertaking from them that
they hold the securities on behalf of the bank.
While examining the investment portfolio, the auditor should pay special attention to securities
whose maturity dates have already expired. It is possible that income on such investments
may also not have been received. In case the amount of such investments or the income
accrued thereon is material, the auditor should seek an explanation from the management on
this aspect. He should also consider whether the income accrued requires reversal as also
whether any provision for loss in respect of such investments is required.

Examination of Valuation - Investments in securities now-a-days constitute a substantial part
of total assets of many banks. Method of valuation of investments followed by a bank may,
therefore, have a significant effect on its balance sheet and profit and loss account. The
auditor should examine whether the method of accounting followed by the bank in respect of
investments, including their year-end valuation, is appropriate. The auditor should examine
the manner of accounting for investments in the context of the guidelines of the Reserve Bank
of India (discussed earlier in this chapter) and the accounting policy followed by the bank in
respect of’ investments.
Extract from Master Circular-Prudential norms for classification, valuation and

operation of investment portfolio by banks issued on July 17, 2004.
Investment Policy - Banks should frame and implement a suitable investment policy to
ensure that operations in securities are conducted in accordance with sound and acceptable
business practices.
With the approval of respective Boards, banks should clearly lay down the broad investment
objectives to be followed while undertaking transactions in securities on their own investment
account and on behalf of clients, clearly define the authority to put through deals, procedure to
be followed for obtaining the sanction of the appropriate authority, procedure to be followed
while putting through deals, various prudential exposure limits and the reporting system.
While laying down such investment policy guidelines, banks should strictly observe Reserve
Bank's detailed instructions on the following aspects:
(a) Ready Forward (buy back) deals
(b) Transactions through Subsidiary General Ledger A/c
(c) Use of Bank Receipts
(d) Retailing of Government securities
(e) Internal Control System
(f) Dealings through Brokers
(g) Audit, Review and Reporting
(h) Non- SLR investments
Classification of Investments
i) The entire investment portfolio of the banks (including SLR securities and non-SLR
securities) should be classified under three categories viz. ‘Held to Maturity’, ‘Available
for Sale’ and ‘Held for Trading’. However, in the balance sheet, the investments will
continue to be disclosed as per the existing six classifications viz. a) Government
securities, b) Other approved securities, c) Shares, d) Debentures & Bonds, e)
Subsidiaries/ joint ventures and f) Others (CP, Mutual Fund Units, etc.).
ii) Banks should decide the category of the investment at the time of acquisition and the
decision should be recorded on the investment proposals.
Held to Maturity
i) The securities acquired by the banks with the intention to hold them up to maturity will be
classified under Held to Maturity.
ii) The investments included under 'Held to Maturity' should not exceed 25 per cent of the
bank’s total investments. The banks may include, at their discretion, under 'Held to
Maturity' category securities less than 25 per cent of total investment.
iii) The following investments will be classified under ‘Held to Maturity’ but will not be
counted for the purpose of ceiling of 25% specified for this category:
a) Re-capitalisation bonds received from the Government of India towards their re-
capitalisation requirement and held in their investment portfolio. This will not include
re-capitalisation bonds of other banks acquired for investment purposes.
b) Investment in subsidiaries and joint ventures. [A joint venture would be one in which
the bank, along with its subsidiaries, holds more than 25% of the equity.]
c) The investments in debentures/ bonds, which are deemed to be in the nature of an
advance.
Debentures/ bonds must be treated in the nature of an advance when:
♦ The debenture/bond is issued as part of the proposal for project finance and the
tenure of the debenture is for a period of three years and above
Or
The debenture/bond is issued as part of the proposal for working capital finance and
the tenure of the debenture/ bond is less than a period of one year
And
♦ the bank has a significant stake i.e.10% or more in the issue
And
the issue is part of a private placement, i.e. the borrower has approached the
bank/FI and not part of a public issue where the bank/FI has subscribed in response
to an invitation.
The debentures/ bonds deemed to be in the nature of advance will be subject to the
usual prudential norms applicable to advances.
iv) Profit on sale of investments in this category should be first taken to the Profit & Loss
Account and thereafter be appropriated to the ‘Capital Reserve Account’. Loss on sale
will be recognised in the Profit & Loss Account.
Available for Sale & Held for Trading

i) The securities acquired by the banks with the intention to trade by taking advantage of
the short-term price/ interest rate movements will be classified under Held for Trading.
ii) The securities which do not fall within the above two categories will be classified under
Available for Sale
iii) The investments classified under Held for trading category would be those from which
the bank expects to make a gain by the movement in the interest rates/ market rates.
These securities are to be sold within 90 days.
iv) Profit or loss on sale of investments in both the categories will be taken to the Profit &
Loss Account.
Shifting Among Categories

i) Banks may shift investments to/from Held to Maturity category with the approval of the
Board of Directors once a year. Such shifting will normally be allowed at the beginning of
the accounting year. No further shifting to/ from this category will be allowed during the
remaining part of that accounting year.
ii) Banks may shift investments from Available for Sale category to Held for Trading
category with the approval of their Board of Directors/ ALCO/ Investment Committee. In
case of exigencies, such shifting may be done with the approval of the Chief Executive of
the bank/ Head of the ALCO, but should be ratified by the Board of Directors/ ALCO.
iii) Shifting of investments from Held for Trading category to Available for Sale category is
generally not allowed. However, it will be permitted only under exceptional
circumstances like not being able to sell the security within 90 days due to tight liquidity
conditions, or extreme volatility, or market becoming unidirectional. Such transfer is
permitted only with the approval of the Board of Directors/ ALCO/ Investment Committee.
iv) Transfer of scrips from one category to another, under all circumstances, should be done
at the acquisition cost/ book value/ market value on the date of transfer, whichever is the
least, and the depreciation, if any, on such transfer should be fully provided for.
Valuation
Held to Maturity
i) Investments classified under Held to Maturity category need not be marked to market
and will be carried at acquisition cost unless it is more than the face value, in which case
the premium should be amortised over the period remaining to maturity.
ii) Banks should recognise any diminution, other than temporary, in the value of their
investments in subsidiaries/ joint ventures which are included under Held to Maturity
category and provide therefor. Such diminution should be determined and provided for
each investment individually.
Available for Sale

i) The individual scrips in the Available for Sale category will be marked to market at the
quarterly or at more frequent intervals. While the net depreciation under each
classification referred to in Para (i) of ‘Classification of Investments’ given above should
be recognised and fully provided for, the net appreciation under each classification
referred in that para should be ignored. The book value of the individual securities would
not undergo any change after the revaluation.
ii) The provisions required to be created on account of depreciation in the Available for Sale
category in any year should be debited to the Profit & Loss Account and an equivalent
amount (net of tax benefit, if any, and net of consequent reduction in the transfer to
Statutory Reserve) or the balance available in the Investment Fluctuation Reserve
Account, whichever is less, shall be transferred from the Investment Fluctuation Reserve
Account to the Profit & Loss Account. In the event provisions created on account of
depreciation in the Available for Sale category are found to be in excess of the required
amount in any year, the excess should be credited to the Profit & Loss Account and an
equivalent amount (net of taxes, if any, and net of transfer to Statutory Reserves as
applicable to such excess provision) should be appropriated to the Investment
Fluctuation Reserve Account to be utilised to meet future depreciation requirement for
investments in this category.
The amounts debited to the Profit & Loss Account for provision and the amount credited
to the Profit & Loss Account for reversal of excess provision should be debited and
credited respectively under the head “Expenditure – Provisions & Contingencies”. The
amounts appropriated from the Profit & Loss Account and the amount transferred from
the Investment Fluctuation Reserve to the Profit & Loss Account should be shown as
‘below the line’ items after determining the profit for the year.
Held for Trading

The individual scrips in the Held for trading category will be marked to market at monthly or at
more frequent intervals as in the case of those in the Available for Sale category. The book
value of the individual securities in this category would not undergo any change after marking
to market.
Investment Fluctuation Reserve

(i) With a view to building up of adequate reserves to guard against any possible reversal of
interest rate environment in future due to unexpected developments, banks are advised
to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the
investment portfolio within a period of 5 years. IFR should be computed with reference to
investments in two categories, viz., “Held for Trading” and “Available for Sale”. It will not
be necessary to include investment under “Held to Maturity” category for the purpose of
computation of IFR. However, banks are free to build up a higher percentage of IFR up to
10 per cent of the portfolio depending on the size and composition of their portfolio, with
the approval of their Board of Directors.
(ii) Banks should transfer maximum amount of the gains realized on sale of investment in
securities to the IFR.
(iii) The IFR, consisting of realized gains from the sale of investments from the two
categories, viz., “Held for Trading” and “Available for Sale”, would be eligible for inclusion
in Tier 2 capital as hitherto.
(iv) Transfer to IFR shall be as an appropriation of net profit “below the line” after
appropriation to statutory reserve.
General
Income recognition
i) Banks may book income on accrual basis on securities of corporate bodies/ public sector
undertakings in respect of which the payment of interest and repayment of principal have
been guaranteed by the Central Government or a State Government, provided interest is
serviced regularly and as such is not in arrears.
ii) Banks may book income from dividend on shares of corporate bodies on accrual basis
provided dividend on the shares has been declared by the corporate body in its Annual
General Meeting and the owner's right to receive payment is established.
iii) Banks may book income from Government securities and bonds and debentures of
corporate bodies on accrual basis, where interest rates on these instruments are pre-
determined and provided interest is serviced regularly and is not in arrears.
iv) Banks should book income from units of mutual funds on cash basis.
Broken Period Interest

Banks should not capitalise the Broken Period Interest paid to seller as part of cost, but treat it
as an item of expenditure under Profit and Loss Account in respect of investments in
Government and other approved securities. It is to be noted that the above accounting
treatment does not take into account taxation implications and hence the banks should comply
with the requirements of Income Tax Authorities in the manner prescribed by them.
Dematerialised Holding
Banks have been advised to settle the transactions in securities as notified by Securities and
Exchange Board of India (SEBI) only through depositories. Banks were also advised that after
the commencement of mandatory trading in demat form, they would not be able to sell the
shares of listed companies if they were held in physical form. In order to extend the demat
form of holding to other instruments like bond, debentures and equities, it was decided that,
with effect from October 31, 2001, banks, FIs, PDs and SDs will be permitted to make fresh
investments and hold bonds and debentures, privately placed or otherwise, only in
dematerialized form. Outstanding investments in scrip forms shall have to be converted into
dematerialized form by June 30, 2002. As regards equity instruments, they will be permitted
to be held by the above-mentioned institutions only in dematerialized form, from a date to be
notified in consultation with SEBI.

III. Advances
The Third Schedule to the Act requires classification of advances made by a bank from three
different angles, viz., nature of advance, nature and extent of security, and place of making
advance (i.e. whether in India or outside India). Accordingly, the advances are to be classified
in Schedule 9 to the balance sheet as follows.
A. (i) Bills purchased and discounted
(ii) Cash credits, overdrafts and loans repayable on demand
(iii) Term loans
B. (i) Secured by tangible assets
(ii) Covered by bank/government guarantees
(iii) Unsecured
C. I. Advances in India
(i) Priority sectors
(ii) Public sector
(iii) Banks
(ii) Others
II. Advances outside India
(i) Due from banks
(ii) Due from others
(iii) Bills purchased and discounted
(iv) Syndicated loans
(v) Others
Extracts from Prudential Norms on Income Recognition, Asset Classification,

Provisioning and Other Related Matters
Vide its Circular No. BP.BC.10/21.04.048 dated April 10, 1992, the Reserve Bank issued
guidelines to be followed by all scheduled commercial banks (excluding regional rural banks)
for income recognition, asset classification, provisioning and other related matters. These
guidelines (commonly referred to as ‘prudential guidelines’ or ‘prudential norms’) have since
been modified in several respects through various circulars of the Reserve Bank. The salient
points of the guidelines as presently in force are discussed below.
Non-performing assets - Under the guidelines, income recognition, and provisioning in
respect of a credit facility are based on its status as performing or non-performing. In concept,
a credit facility becomes non-performing “when it ceases to generate income for a bank”.
With effect from March 31, 2004, a non-performing asset (NPA) is a loan or an advance
where;
(i) interest and/ or instalment of principal remain overdue for a period of more than 90 days
in respect of a term loan,
(ii) the account remains ‘out of order’ for a period of more than 90 days, in respect of an
Overdraft/Cash Credit (OD/CC),
(iii) the bill remains overdue for a period of more than 90 days in the case of bills purchased
and discounted,
(iv) interest and/or instalment of principal remains overdue for two harvest seasons but for a
period not exceeding two half years in the case of an advance granted for agricultural
purposes, and In respect of advances granted for agricultural purposes, w.e.f. September
30, 2004, a loan granted for short duration crops will be treated as NPA, if the installment
of principal or interest thereon remain overdue for two crop reasons and, a loan granted
for long duration crops will be treated as NPA, of the installment of principal and interest
thereon remains overdue for one crop season, and
any amount to be received remains overdue for a period of more than 90 days in respect
of other accounts.
As per the guidelines, “long duration” crops would be crops with crop season longer than
one year and crops, which are not “long duration” crops, would be treated as “short
duration” corps. The crop season for each crop, which means the period up to harvesting
of the crops raised, would be as determined by the State Level Bankers’ Committee in
each State depending upon the duration of crops raised by an agriculturist, the above
NPA norms would also be made applicable to agricultural term loans availed of by him.
Exempted Assets - Certain categories of advances have been exempted from being treated
as non-performing for the purpose of income determination and/or provisioning, even though
they meet the aforesaid criteria (this aspect is discussed later in this chapter).
Regularisation of Account by Year end - The identification of NPAs to be done on the bases
of the status of assets as on the balance sheet date. If the account indicates inherent
weakness on the basis of the data available, the account should be deemed as NPA. In other
cases where there are solitary or few credits to regularize the account, the statutory auditor
may ask the banks to furnish satisfactory evidence about the manner of regularization of the
account to eliminate doubts on their performing status, and to ensure that such credits are
through genuine sources. Gathering of such evidence may include examining the relevant
vouches whereby credits appear in borrower’s accounts.
Temporary Deficiencies - Banks have been advised that they may not classify a cash
credit/overdraft account as NPA merely due to existence of some deficiencies which are of
temporary nature such as non-availability of adequate drawing power, balance outstanding
exceeding the limit, non-submission of stock statements, non-renewal of limits on the due
date, etc.
Accounts with Temporary Deficiencies - In the matter of classification of accounts with
temporary deficiencies, banks have to follow the following guidelines:

(a) Banks should ensure that drawings in the working capital accounts are covered by the
adequacy of current assets.
(b) Drawing power is required to be arrived at based on the stock statement which is current.
However, considering the difficulties of large borrowers, stock statements relied upon by
the banks for determining drawing power should not be older than three months.
(c) The outstanding in the account based on drawing power calculated from stock
statements older than three months is deemed as irregular.
(d) A working capital borrowing account will become NPA if such irregular drawings are
permitted in the account for a continuous period of 180 days even though the unit may be
working or the borrower's financial position is satisfactory.
(e) The accounts where regular/advance credit limits have not been reviewed/renewed within
180 days from the due date/date of ad hoc sanction, the account should be treated as
NPA.
Determination of NPAs - Borrower-wise, Not Facility-wise: If any of the credit facilities
granted to a borrower becomes non-performing, all the facilities granted to the borrower will
have to be treated as NPA without having any regard to performing status of other facilities.
Advances Under On-lending Arrangement: An exception to the above rule has been made in
respect of agricultural advances as well as advances for other purposes granted by banks to
ceded Primary Agricultural Credit Societies (PACSs) or Farmers Service Societies (FSSs)
under the on-lending system. In such cases, only that particular credit facility granted to a
PACS/FSS is to be classified as NPA which is in default for a period of two crop seasons in
case of short duration crops and one crop season in case of long duration crops in the case of
agricultural advances; or
(a) two harvest seasons not exceeding two half years in the case of agricultural advances;
or
(b) two quarters in the case of other advances.
Other credit facilities granted to the PACS/FSS will not be treated as NPA. However, other
direct loans and advances have been granted by the bank to the member borrower of a
PACS/FSS outside the on-lending arrangement will become NPA if even one of the credit
facilities granted to the borrower becomes NPA. Thus, the above exemption does not extend
to credit facilities granted outside the on-lending system.
Project Finance - In the case of bank finance given for industrial projects or for agricultural
plantations etc. where moratorium is available for payment of interest, payment of interest
becomes due after the moratorium or gestation period is over, and not on the date of debit of
interest.
Advances to Staff - In the case of bank finance given for industrial projects or for agricultural
plantations etc. where moratorium is available for payment of interest, payment of interest
becomes due after the moratorium or gestation period is over, and not on the date of debit of
interest. Therefore, such amounts of interest do not become overdue and hence the accounts
do not become NPA, with reference to the date of debit of interest.
Agricultural Advances affected by Natural Calamities - In terms of RBI instructions, where
natural calamities impair the repayment capacity of agricultural borrowers, the bank can
convert short-term production loan into term loan or reschedule the repayments, and sanction
fresh short-term loan. In such cases, the term loan as well as fresh short-term loan may be
treated as current dues and need not be classified as NPA. The asset classification of these
loans would thereafter be done according to the guidelines. In other words, term loan as well
as fresh short-term loan would be reckoned as having been granted for the first time.
Advances Guaranteed by EXIM Bank - In the case of advances covered under the
guarantee-cum-refinance programme of EXIM Bank, to the extent payment has been received
by the bank from the EXIM Bank, the advance may not be treated as NPA. The balance
should, however, be treated as NPA (if the conditions for treating it as NPA are satisfied).
Consortium Advances - In respect of consortium advances, each bank may classify the
borrowal accounts according to its own record of recovery and other aspects having a bearing
on the recoverability of the advances.
Income Recognition - Banks recognise income (such as interest, fees and commission) on
accrual basis, i.e., as it is earned. It is an essential condition for accrual of income that it
should not be unreasonable to expect its ultimate collection. In view of the significant
uncertainty regarding ultimate collection of income arising in respect of non-performing assets,
the guidelines require that banks should not take to income interest on non-performing assets
until it is actually realised. When a credit facility is classified as non-performing for the first
time, interest accrued and credited to the income account in the previous year which has not
been realised should be reversed or provided for.
Interest income on advances against term deposits, NSCs, IVPs KVPs and Life policies may
be taken to income account on the due date, provided adequate margin is available in the
accounts.
If interest income from assets in respect of a borrower becomes subject to non-accrual, fees,
commission and similar income with respect to the same borrower that have been accrued
should cease to accrue in the current period and should be reversed or provided for with
respect to previous year if uncollected.
Advances Secured Against Certain Instruments - Advances secured against term deposits,
national savings certificates (NSCs) eligible for surrender, Indira Vikas Patras, Kisan Vikas
Patras and life insurance policies have been exempted from the above guidelines. Thus,
interest on such advances may be taken to income account on due dates provided adequate
margin is available in the respective accounts.
Take-out Finance: Take out finance is a product of the funding of long term infrastructure
projects. Under this arrangement, the institution /the bank financing infrastructure projects will
have an arrangement with any financial institution for transferring to the latter the outstanding
in respect of such financing in their books on predetermined basis. The norms of asset
classification will have to be followed by the concerned bank/financial institution in whose
books the account stands as balance sheet item as on the relevant date. If the lending
institution observes that the asset has turned NPA on the basis of the record of recovery, it
should classified accordingly. The lending institution should make provisions against a ‘take-
out finance’ turning into NPA pending its take over by the taking over institution.
Appropriation of Recoveries in NPAs - Interest partly realised in NPAs can be taken to
income. However, it should be ensured that the credits towards interest in the relevant
accounts are not out of fresh/additional credit facilities sanctioned to the borrowers concerned.
In the absence of a clear agreement between the bank and the borrower for the purpose of
appropriation of recoveries in NPAs (i.e. towards principal or interest due), banks should adopt
an accounting principle and exercise the right of appropriation of recoveries in a uniform and
consistent manner.
Classification of advances - The guidelines require banks to classify their advances into four
broad categories as follows.
(a) Standard assets - A standard asset is one which does not disclose any problems and
which does not carry more than normal risk attached to the business. Such an asset is
not a non-performing asset.
(b) Sub-standard asset - A sub-standard asset is one which has been classified as NPA for
a period not exceeding 18 months.
(c) Doubtful assets - A doubtful asset is one which has remained NPA for a period
exceeding 12 months.
(d) Loss assets - A loss asset is one where loss has been identified by:
(a) the bank; or
(b) the internal or external auditors; or
(c) the RBI Inspection.
but the amount has not been written off, wholly or partly. In other words, such an asset is
considered uncollectible and of such little value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery value.
It may be noted that the above classification is meant for the purpose of computing the amount
of provision to be made in respect of advances and not for the purpose of presentation of
advances in the balance sheet. The balance sheet presentation of advances is governed by
the Third Schedule to the Banking Regulation Act, 1949, which requires classification of
advances altogether differently.
Threats to Recovery - As per the guidelines, upon becoming NPA, a credit facility would be
classified first as sub-standard for a period not exceeding 18 months and then as doubtful. It
has been clarified, however, that in respect of accounts where there are potential threats to
recovery on account of erosion in the value of security or non-availability of security and
existence of other factors such as frauds committed by borrowers, it will not be prudent for
banks to clarify them first as sub-standard and thereafter as doubtful. Banks have been
advised to classify such accounts straightaway as doubtful or loss assets, as appropriate,
irrespective of the period for which the account has remained NPA.
Erosion in the value of security - Erosion in the value of security can be reckoned as
significant when the realisable value of the security is less than 50 per cent of the value
assessed by the bank or accepted by RBI at the time of last inspection, as the case may be.
Such NPAs are required to be straightaway classified under doubtful category and
provisioning should be made as applicable to doubtful assets.
If the realisable value of the security, as assessed by the bank/approved valuers/RBI is less
than 10 per cent of the outstanding in the borrowal accounts, the existence of security should
be ignored and the asset should be straightaway classified as loss asset. It may be either
written off or fully provided for by the bank.
Restructuring/Reschedulement of Loans - The restructuring / rescheduling / renegotiation
of terms of loan agreement can take place at the following stages:
(a) before commencement of commercial production;
(b) after commencement of commercial production but before the asset has been classified
as sub-standard; and
(c) after commencement of commercial production and the asset has been classified as sub-
standard;
In each of these stages of rescheduling of principal and/or interest there could be ‘sacrifice’ on
part of the banks. Reschedulement of installments of only principal amount at any stage
before classification of advance as sub-standard i.e. first two stages, would not cause a
standard asset to be classified in the sub-standard category provided the loan / credit facility is
fully secured. Further, even the reschedulement of the interest at first two stages would not
cause the standard asset to be classified as sub-standard, if the sacrifice of interest measured
in present value terms is either written off or fully provided for. For the purpose of calculating
the sacrifice in present value terms, the discount rate to be used is PLR plus the appropriate
credit risk premium for the concerned borrower category. In other words, the discount rate is
the existing pre-reschedulement rate of interest charged to the borrower concerned.
In case of reschedulement/refixation of terms of loan agreement after classification of asset as
sub-standard i.e. at the third stage, the asset would be continued to be classified in the same
category i.e. in accordance with NPA norms if the loan/credit facility is fully secured. Where
there is sacrifice of interest, the same would have to be written off or provided for. Sub-
standard accounts subjected to restructuring can be upgraded to standard category only after
a period of one year from the date of first payment of interest or principal as per rescheduled
term subject to satisfactory performance during the period. On such up-gradation, the
provision made earlier can be reversed after taking into account the interest sacrificed.
However, if satisfactory performance of such sub-standard account is not evident during the
one-year period, the asset classification of restructured account would be governed as per the
applicable prudential norms with reference to the pre-reschedulement payment schedule.
The provision made for sacrifice is required to be reviewed and recalculated at each balance
sheet date and excess provision, if any, can be reversed. On the contrary the short provision,
if any, has to be further made.

Where the restructured asset is not fully secured, then provision to the extent of shortfall of
security should also be made. The amount of corporate/personal guarantees available should
not be considered as security for this purpose. Further, if interest has been recognised as
income, then an equal amount should be provided for.
Corporate Debt Restructuring (CDR) - A Corporate Debt Restructuring system has been
evolved for restructuring of the corporate debts of viable entities facing problems, which are
out side the purview of BIFR, DRT and other legal proceedings. All the banks have been
advised by RBI to follow the Corporate Debt Restructuring mechanism which would be a non-
statutory voluntary system based on debtor creditor agreement and inter creditor agreement.
The mechanism will apply only to the multiple banking account/syndicate/consortium with an
outstanding exposure of Rs. 20 crore and above by bank and financial institutions. In respect
of restructuring of account through Corporate Debt Restructuring mechanism also, the
treatment of account and other requirement shall be as given in ‘Reschedulement of Loans’
above.
Corporate Debt Restructuring (CDR) would generally affect the operations both at Branch
level as well as the Head Office level, although, in most of the cases the effects of
provisioning as envisaged in the Reserve Bank of India’s circular due to sacrifice in the
interest would be made at the Head Office level.
In case of restructuring of the principal amount, auditors should verify that adequate security
coverage of the loan/credit account is available.
Projects Under Implementation1 - Projects Under Implementation are not required to be
classified as non performing assets for a period not exceeding 2 years beyond the date when
the project ought to be completed (deemed date of completion). For the purpose of
determining the date when the project ought to be completed three categories have been
prescribed by RBI:
Category Particular Deemed date of completion
I. Project where financial closure have been As envisaged at the time of original
achieved and finally documented financial closure.
II. Projects sanctioned before 1997 with As decided by independent group
original project cost of Rs. 100 crore or formed by RBI
more where financial closure was not
formally documented
III. Projects sanctioned before 1997 with As envisaged at the time of
original project cost of less than 100 sanction
crores where financial closure was not
formally documented
In case of project financed after 1997 where the financial closure had not been formally
1 Master Circular DBOD No. BP.BC.1/21.04.048/2002-2003 dated July 4, 2002
documented, the norms enumerated for Category III above would apply. The financial closure
means the date by which all the sanctions of financial assistance have been received.
In all the categories mentioned above, the time over run beyond two years would require
classification of the account of the borrowers as sub-standard irrespective of the record of
recovery and necessary provision is to be made accordingly.
In case of projects financed by the banks, the date of completion of the project should be
mentioned at the time of financial closure. If the commercial production starts after a period of
more than six months from the date of completion of the project, as given at the time of
financial closure, the account shall be classified as sub-standard asset.
Income Recognition on Projects Under Implementation - RBI has advised the banks that
although the account of the project may be classified as standard asset based on above
norms but if the same is not standard as per the general norms, income in such account could
be recognised on realisation basis and not on accrual basis. Any income recognised in such
account in the past on accrual basis, should be provided for.
Provisioning - Some of the banks created provisions against projects under implementation
prior to the issuance of circular by the Reserve Bank of India stating that projects under
implementation are not required to be classified as non performing assets for a period not
exceeding 2 years beyond the date when the project ought to be completed. The banks which
already created provisions against some of the accounts (projects under implementation),
which are now required to be classified as ‘standard’, have been advised continue to hold the
provisions and should not reverse any provision so created consequent to change in
classification.
Provisioning for loans and advances - The guidelines require provisions for different
classes of advances to be made as follows:
(a) Loss assets - The entire amount should be written off or full provision should be made for
the amount outstanding.
(b) Doubtful assets -
(i) Full provision to the extent of the unsecured portion should be made. In doing so,
the realisable value of the security available to the bank should be determined on a
realistic basis. DICGC/ECGC cover is also taken into account (this aspect is
discussed in detail later in this chapter).
(ii) In regard to the secured portion, provision may be made on the following basis, at
the rates ranging from 20 to 100% of secured portion depending upon the period for
which the asset has remained doubtful in case the advance covered by CGTSI
guarantee becomes non-performing, no provision need to be made towards the
guaranteed portion. The amount outstanding in excess of the guaranteed portion
should be provided for as per the extant guidelines on provisioning for non-
performing advances.
Period for which the advance has been considered as % of provision

doubtful
Upto 1 year 20
More than 1 year and upto 3 years 30
More than 3 years
i. Outstanding stock as on 31.03.2004 60%
w.e.f. 31.03.2005
75%
w.e.f 31.03.2006
100 %
w.e.f from 31.03.2007
ii. Advances classified as doubtful for more than three years 100 %
on or after01.04.2004 w.e.f. from 31.03.2005
Based on Master Circular issued by the RBI, two illustrations are furnished below for clarity in
this regard.
Illustration 1. Existing stock of advances classified as ‘doubtful more than 3 years’ as on 31
March 2004.
The outstanding amount as on 31 March 2004: Rs. 25,000
Realisable value of security : Rs. 20000
Period for which the advance has remained in ‘doubtful’ category as on 31 March 2004 : 4
years (i.e. doubtful more than 3 years)
Provisioning requirement
As on Provisions on secured Provisions on unsecured Total (Rs)
portion portion
% Amount % Amount
31 March 2004 50 10000 100 5000 15000
31 March 2005 60 12000 100 5000 17000
31 March 2006 75 15000 100 5000 20000
31 March 2007 100 20000 100 5000 25000
Illustration 2. Advances classified as ‘ doubtful more than three years on or after 1 April 2004.
The outstanding amount as on 31 march 2004: Rs. 10,000
Realisable value of security: Rs. 8,000

Period for which the advance has remained in ‘doubtful category as on 31 March 2004: 2.5
years
Provisioning requirement:
As on Asset Provisions on secured Provisions on Total (Rs

classification portion unsecured portion
% Amount % Amount
31 March Doubtful 1 to 3 30 2400 100 2000 4400
2004 years
31 March Doubtful more 100 8000 100 2000 10000
2005 than 3 years
(iv) Banks are permitted to phase the additional provisioning consequent upon the reduction
in the transition period from substandard to doubtful asset from 18 to 12 months over a
four year period commencing from the year ending March 31, 2005, with a minimum of
20% each year.
Valuation of Security for provisioning purposes - With a view to brining down divergence
arising out of difference in assessment of the value of security,in cases of NPAs with balance
of Rs. 5 crore and above stock audit at annual intervals by external agencies appointed as per
the guidelines approved by the Board would be mandatory in order to enhance the reliability
on stock valuation. Collaterals such as immovable properties charged in favour of the bank
should be got valued one in three years by valuers appointed as per the guidelines approved
by the Board of Directors.
(a) Sub-standard assets - A general provision of 10% on total outstanding should be made
without making any allowance for DICGC/ECGC cover and securities available. An
additional provision of 10% (ie total 20% of total outstanding ) is required to be made on
‘unsecured exposure’ an initio sanction of loan generally such a situation may arise in
case of personal and education loans etc. Unsecured exposure is defined as ‘an
exposure where the realizable value of security is not more than 10% of the outstanding
exposure (fund based and non-fund based). Security would not include guarantees,
comfort letters etc
Illustration 1.
Prudential Norms of Provisioning Applicable to Advances
identified as Sub-Standard During 2004-05
Exposures Security
Assessed
Nature Amount I II III IV V VI VII
(Rs)
Funded 100 129 99 39 19 10 8 @2
Unfunded 200 21 21 21 21 21 21 19
Total 300 150 120 60 40 31 29 21
Security (%) to 50 40 20 13.33 10.33 9.66 7
Total
Exposure
Provision 10 10 10 10 10 20 20
required
(based on %
of funded)
Notes:
(a) I, II, III, IV, V, VI, VIII represent individual borrowers.
(b) @ It may be noted that the assessed security in funded exposure is only 2% (ie. Less
than 10% criteria adopted to treat the asset a Loss Asset as per Para 5.2.8 (ii) of the
Prudential Norms, but the same cannot be done as the assessed security will also reckon
that held in Unfunded exposures (Rs. 19); the assessed total security, being more than
10% of the funded exposure (Rs. 21 ie. Rs. 2 + Rs.19).
It would no doubt be clear that the Borrower would be a problem account, to be carefully
examined, notwithstanding the technical prudential norms, and may require ad hoc, generic or
additional provision due to its inherent weaknesses.
Illustration 2.
Prudential Norms of Provisioning Applicable to Advances
Identified as Sub Standard during 2004-05
Exposures
Security Assessed
Nature Amount I II III IV V VI VII
(Rs)
Funded 200 251 111 51 31 22 @8 10
Unfunded 100 9 9 9 9 9 9 9
Total: 300 260 120 60 40 31 27 19
Security (5) to 86.33 40 20 13.33 10.33 9 6.33
Total exposure
Provision 20 20 20 20 20 40 @@
required
(based on %
of funded)
Notes:
(a) I, II, III, IV, V, VI, VII represent individual borrowers
(b) @ It may be noted that the assessed security in funded exposure is only 9% (ie., less
than 10% criteria adopted to treat the asset a Loss Asset as per Para 5.2.8 (ii) of the
Prudential Norms, but the same cannot be done as the assessed security will also reckon
that held in Unfunded exposure(Rs. 9);the assessed total security, being more than 10%
of the funded exposure (Rs. 18 ie. Rs.9 + Rs. 27 = 13.5% of funded exposure).
It would no doubt be clear that the Borrower would be a problem account, to be carefully
examined, notwithstanding the technical prudential norms requiring 20% provision
(Rs.20), and the account may require ad hoc or additional provision due to its inherent
weaknesses.
(c) @ Since the total assessed security is less than 10% of the funded exposure as well as
the unfounded exposure, whether taken individually or in the aggregate, the Borrower will
have to be classified as a Loss Asset, by virtue of the definition as per the prudential
norms.
(d) Standard assets: A general provision of a minimum of 0.25% of total standard assets
should be made. It has been clarified that the provision should be made on global loan
portfolio basis and not on domestic advances alone.
(i) The provisions on standard assets should not be reckoned for arriving at net NPAs.
(ii) The provisions towards Standard Assets need not be netted from gross advances
but shown separately as 'Contingent Provisions against Standard Assets' under
'Other Liabilities and Provisions - Others' in Schedule 5 of the balance sheet.
The RBI has increased the rate of general provision on Standard Assets by commercial banks
and All-India Term Lending and Refinancing Institutions from 0.25 per annum to 0.40 per cent
per annum, except for direct advances to agricultural and SME Sectors.
Provisioning for Certain Specific Types of Advances: The guidelines also deal with
provisioning for certain specific types of advances as follows:
Advances Secured Against Term Deposits, National Savings Certificates, Surrender Value of
Life Policies, etc.
Advances secured against term deposits, NSCs eligible for surrender, Indira Vikas Patras,
Kisan Vikas Patras and life insurance policies are exempted from provisioning requirements.
Accordingly, the banks need not treat such accounts as NPAs. Interest on such advances may
be taken to income provided adequate margin is available in accounts. It may be noted that
advances against gold ornaments, government securities, and all other kinds of securities are
not exempted from provisioning requirements.
Advances Guaranteed by Government of India and/or State Governments: The credit facilities
backed by guarantees of central government though overdue may be treated as NPA only
when the government repudiates its guarantee when invoked. Therefore, advances
guaranteed by Central Government will become NPA only if the guarantee is invoked and
repudiated. Accordingly, central government guaranteed advance even if become overdue
should be classified as "standard asset". However, the interest on such an advance is not to
be taken to income account if it is not realised.
In case of State Government guaranteed loans, this exemption was available only where the
guarantees have not been invoked despite the existence of defaults in respect of principal
and/or interest. However, income recognition norms shall be applicable as in case of any other
advance i.e. in case of interest being overdue for a period exceeding 90 days, no revenue
shall be recognised unless realised for the year ended 31.03.2005. These advances shall be
classified as substandard or doubtful or loss where interest income and /or principal /any other
amount due to the bank remains overdue more than 180 days for the year ended 31.3.2005.
With effect from the year ending 31.03.2006 such account will be NPA if interest/
Principal/other dues remains overdue for more than 90 days.
Advances Guaranteed by ECGC/DICGC: In the case of advances guaranteed by Export Credit
Guarantee Corporation (ECGC) or by Deposit Insurance and Credit Guarantee Corporation
(DICGC), provision is required to be made only for the balance in excess of the amount
guaranteed by these corporations. In case the bank also holds a security in respect of an
advance guaranteed by ECGC/DICGC, the realisable value of the security should be deducted
from the outstanding balance before the ECGC/DICGC guarantee is off-set. The Reserve
Bank of India has also-clarified that if the banks are following more stringent method of
provisioning in respect of advances guaranteed by ECGCIDICGC, such banks may continue to
do so.
The manner of determining the amount of provision in respect of ECGC/DICGC guaranteed
advances in accordance with the above guidelines is illustrated below. (It may be noted that
these illustrations are merely intended to facilitate understanding of the RBI guidelines, they
have not been issued by the RBI). The DICGC cover is assumed to be 50%.
Example 1
Outstanding Balance Rs. 4 lakhs
DICGC Cover 50 Percent
Period for which the advance has remained doubtful More than 3 years remained doubtful
Value of security held (excludes worth of Rs) Rs. 1.50 lakhs
Provision required to be made
Outstanding balance Rs. 4.00 lakhs

Less : value of security held Rs. 1.50 lakhs
Unrealised balance Rs. 2.50 lakhs
Less : DICGC Cover (50% of unrealizable Rs. 1.25 lakhs
balance)
Net unsecured balance Rs. 1.25 lakhs
Provision for unsecured portion of advance Rs. 1.25 lakhjs (@ 100 percent of unsecured
portion)
Provision for secured portion of advance Rs. 0.90 lakhs (@ 60 percent of secured
portion)
Total provision required to be made Rs. 2.15 lakhs
Advance covered by CGTSI guarantee

In case the advance covered by CGTSI guarantee becomes non-performing, no provision
need be made towards the guaranteed portion. The amount outstanding in excess of the
guaranteed portion should be provided for as per the extant guidelines on provisioning for non
performing advances. Two illustrative examples are given below:
Example 2
Asset classification status: Doubtful-More than 3 years (as on March 31, 2004)
CGTSI Cover 75 % of the amount outstanding or 75% of the unsecured
amount or Rs. 18.75 lakh, whichever is the least
Realisable value of security Rs. 1.50 lakh
Balance outstanding Rs. 10.00 lakh
Less : Realisable value of Rs. 1.50 lakh
security
Unsecured amount Rs. 8.50 lakh
Less : CGTSI cover (75%) Rs. 6.38 lakh

Net unsecured and uncovered Rs. 2.12 lakh
portion
Provision Required (as on
March 31, 2005)
Secured portion Rs. 1.50 lakh Rs. 0.90 lakh (@ 60%)
Unsecured & uncovered portion Rs. 2.12 lakh Rs. 2.12 (100%)
Total provision required Rs. 3.02 lakh
Example 3
Asset classification status: Doubtful-More than 3 years (as on March 31, 2005)
CGTSI Cover 75 % of the amount outstanding or 75% of the unsecured
amount or Rs. 18.75 lakh, whichever is the least
Realisable value of security Rs. 10.00 lakh
Balance outstanding Rs. 40.00 lakh
Less : Realisable value of Rs. 10.00 lakh
security
Unsecured amount Rs. 30.00 lakh
Less : CGTSI cover (75%) Rs. 18.75 lakh
Net unsecured and uncovered Rs.11.25 lakh
portion
Provision required (as on
March 31,2005)
Secured portion Rs. 10.00 lakh Rs. 10.00 lakh (@ 100 %)
Unsecured & uncovered portion Rs. 11.25 lakh Rs. 11.25 lakh (100%)
Total provision required Rs. 21.25 lakh
Advances under Rehabilitation Packages - In case of renegotiation of the terms of advance,

the classification of the advance should not be upgraded unless the renegotiated terms have
worked satisfactorily for a period of one year. Where additional facilities are granted to a unit
under rehabilitation packages approved by the Board for Industrial and Financial
Reconstruction (BIFR) or by term-lending institutions or the bank (on its own or under a
consortium arrangement), provision should continue to be made for the dues in respect of
existing credit facilities. As regards the additional facilities, provision need not be made for a
period of one year from the date of disbursement in respect of additional facilities sanctioned
under rehabilitation packages approved by BIFR/term-lending institutions.
Other Aspects - Certain other important aspects of the guidelines relating to provisioning are
discussed below.
Floating Provisions - Floating provisions (i.e. provisions made by a bank over and above the
specific provisions made in respect of accounts identified as NPAs), wherever available, can
be set-off against provisions required to be made as per the guidelines.
Write off of NPAs - The auditors should ascertain the bank’s policy for write-off/prudential
write-off of NPAs and the record thereof on a centralized/decentralized basis keeping in view
the related tax implications where the advances are retained at branches and write-off is
centralized at Head Office, provision be required only in respect of the amount not written off
Interest Suspense Account - As mentioned earlier, the guidelines prohibit recognition of
income on non-performing assets until it is actually realised. In order to comply with
guidelines while ensuring at the same time that legal remedies against defaulting borrowers
are not adversely affected and that proper control is exercised over non-performing advances,
many banks follow the practice of recording interest on non-performing advances to a
separate account which is usually styled as ‘Interest Suspense Account’. The balance in this
account represents interest on non-performing advances debited to the respective borrowers’
accounts in accordance with the terms of the agreement but not recognised as income. For
purposes of balance sheet presentation, the gross advances portfolio is arrived at after
deducting the credit balance in Interest Suspense Account from the total advances as per the
ledgers. In some banks, the borrowers’ accounts are not debited and the Interest Suspense
Account is maintained only in memoranda books (sometimes called ‘dummy ledgers’).
The guidelines require that the amounts held in Interest Suspense Account should not be
reckoned as part of provisions. Amounts lying in the Interest Suspense Account should be
deducted from the advances concerned and provisions as per the guidelines should be made
on the balances remaining after such deduction.
Illustration :
This Annexure illustrates the manner of application of some of the more important aspects of
the guidelines of the Reserve Bank relating to income recognition, asset classification and
provisioning.
Determination of Status of a Credit Facility: Whether NPA or Not
Illustration 1: Term Loan

A term loan is to be repaid in 36 instalments . Interest is debited to the account at the end of
every month and is to be paid in addition to the instalment of principal. Interest debited or
instalment fall due or both on December 30th remains unpaid on 31st March next.
The account becomes NPA on March 31( March 30 if the month of February falls in a leap
year).
It can be generalized that if, in a term loan account, the default occurs on or after January 1st,
the account would not be treated as NPA in the balance sheet for that financial year (unless
there are threats to recover), provided the month of February of the financial year does not fall
in a leap year. If February falls in a leap year, for the account to be classified as a performing
asset, the default in respect of instalment of principal should arise on or after January 2nd.
Agricultural advances
i. Short duration Crop Loan: Agricultural advances granted for short duration crops are to
be treated as NPA if interest and/or instalment of principal remain overdue for a period of
two crop seasons. The crop seasons for each crop means the period upto harvesting of
crop raised would be as determined by State Level Bankers Committee in each state
(Auditor’s need to verify the decision of the State Level Bankers Committee of the
concerned state where the borrower is located, to determine the period of harvesting of
the crop raised). The following illustrations clarify the manner of determination of NPA
status in agricultural advances.
Case I
A crop loan is due for repayment on March 31 of Financial Year (FY) XXX4. If unpaid, it
becomes NPA on March 31, FY XXX5 (presuming that two crop seasons period is over).
ii Long Duration Agricultural Advance
Case II
A long duration crop loan is due for repayment on March 31 of Financial Year (FY) XXX4. If
unpaid, it becomes NPA on 31st March of (FY) XXX5, (presuming that the crop season period
is over).
Illustration 2: Cash Credit
The following information pertains to a cash credit account.
Case-1
Sanctioned Limit Rs. 50,00,000/-
Drawing Power Rs. 45,00,000/-
Balance outstanding continuously from
1.01.2005 to 31.03.2005 Rs. 47,00,000/-
Category Sub-standard
Reason – Since the balance remained continuously in excess of drawing power for 90 days
the account has turned to NPA on 31.03.2005.
Case-2
Drawing Power Rs. 55,00,000/-
Amount outstanding outstanding continuously
From 1.01.2005 to 31.03.2005 and no credit observed
during the said period in the account. Rs. 47,00,000/-
Category – Sub standard

Reason- Since there is no credit for 90 days as on the balance sheet date account has turned
to NPA
Case-3
Sanctioned limit Rs. 60,00,000/-
Drawing power Rs. 55,00,000/-
Amount outstanding continuously from
1.01.2005 to 31.03.2005 Rs. 47,00,000/-
Total interest debited during the said period Rs. 3,42,000/-
Total credit during the above period in the accounts Rs. 1,25,000/-
Category-Sub standard
Since the credit in the account is not sufficient to cover the interest debited during the period
the account will be said as NPA.
Case-4
Drawing power Rs. 50,00,000/-
Outstanding balance as on 31-03-2005 is Rs. 45,00,000/-
Renewal due on 2nd Oct 2004. Account has not been renewed upto 31.03.2005.
Category- Sub standard

As no renewal is done within 180 days the account shall be treated as NPA.
Case V:The account was due for renewal on 29th September 2004, and in absence of non-
availability of financial statements and other data the account could not be renewed upto 31st
March 2005. Although the account is regular otherwise but in view of overdue in renewal
beyond 180 days the account has become NPA.
Case VI: For Adhoc Sanctions
Considering that the borrower was granted an adhoc sanction for a period of three months, of
Rs. 25/- lakhs included in Rs. 50/- Lakhs on 25th June 2004, which was due on 25th September
2004. The amount is still outstanding and not further renewed in such a case also the account
will turn to NPA as on 31st March 2005.
Case-5: For non-submission of stock statement.
If stock statement not received from the borrower for month of December and onwards till 31st
March 2005 the account shall be treated as NPA even though the account is performing as per
other IRAC norms.
Determining Date of Default - The manner of determining the date of default in payment of
interest or instalment of principal is illlustrated below. The amount of the loan is Rs. 90,000/-
plus Rs. 30,000/- (interest over the term of loan), the loans is repayable in 24 equal monthly
instalments of Rs. 5,000 each beginning June 1 and interest is charged at the end of each
calendar month.
Debit Credit Balance

Year 1
May 1 Loan granted 90,000 90,000
May 31-March 31 Interest 18,000
on monthly basis
June 1 –March Case received 33,000 75,000
31
Break up of the amount of Rs. 33,000/-: Principal 15,000 Interest Rs. 18,000.
Analysis - Since the amount due Rs. 17,000/-, is equivalent to instalment of more than three
months ie. Rs. 15,000/- hence the account is non performing.
Reversal of Interest/Income Recognition

1. In respect of accounts classified as NPA for the first time (i.e. new NPAs), the unrealised
portion of interest debited to the borrowal account and credited to the income account in
the previous year as well as interest debited during the current year has to be reversed.
Banks generally follow the practice of debiting the interest on quarterly basis to such
accounts during the current year (including on March 31) even if the account is identified
as NPA before the close of the year and then reversing the unrecovered portion. For the
purpose of identifying the status of a term loan as NPA or otherwise, banks generally
appropriate any credit in the account first towards interest (as well as expenses) in
chronological order of debits. The total amount of principal recovered in a term loan
account is represented by the difference between the amount originally granted as loan
and the minimum balance in the loan account at any time during the year. The difference
between the year-end balance and the minimum balance represents interest (and
expenses) debited to the account but remaining unpaid by the borrower. In the illustration
given above regarding manner of determining the date of default, the amount of Rs.
13,972 representing interest credited but remaining unrealised at the end of Year 1 would
not be recognised as income for the year and may be reversed.
2. In respect of accounts that were classified as NPA in the previous year also, banks
generally do not debit any interest to the account. There is, therefore, no question of
reversal of interest. However, in the case of operative cash credit/overdraft accounts,
some banks follow a practice whereby unrealised interest is reversed in the year in which
the account is classified as NPA for the first time, but is re-debited at the beginning of the
next financial year. During such next financial year, interest is debited to the account in
the usual manner; unrealised interest at the year-end is reversed and again re-debited at
the beginning of the subsequent financial year. This procedure is adopted in order to
appropriate any credits in the account first towards interest. In the illustration referred to
in paragraph 1 above, the total unrealised interest in the account at the end of Year 2 is
Rs. 13,624 (Rs. 125,527 – Rs. 111,633). This represents the unrealised interest as at the
end of the previous year (Rs. 13,972) and the interest debited during the year (Rs.
19,652) reduced by payment received during the year and appropriated towards interest
(Rs. 20,000). The amount of Rs. 20,000 appropriated towards interest would be
recognised as income for the year.
Audit Procedures - In carrying out audit of advances, the auditor is primarily concerned with
obtaining evidence about the following:
♦ Amounts included in balance sheet in respect of advances are outstanding at the date of
the balance sheet.
♦ Advances represent amount due to the bank.
♦ There are no unrecorded advances.
♦ The stated basis of valuation of advances is appropriate and properly applied, and that
the recoverability of advances is recognised in their valuation.
♦ The advances are disclosed, classified, and described in accordance with recognised
accounting policies and practices and relevant statutory and regulatory requirements.
Evaluation of Internal Controls - The auditor should examine the efficacy of various internal
controls over advances to determine the nature, timing and extent of his substantive
procedures. In general, the internal controls over advances should include, inter alia, the
following.
(a) The bank should make an advance only after satisfying itself as to the credit worthiness
of the borrower and after obtaining sanction from the appropriate authorities of the bank.
(b) All the necessary documents (e.g., agreements, demand promissory notes, letters of
hypothecation, etc.) should be executed by the parties before advances are made.
(c) Sufficient margin should be kept against securities taken so as to cover for any decline in
the value thereof and also to comply with the Reserve Bank directives. Such margins
should be determined by the appropriate authorities of the bank as a general policy or for
particular accounts.
Examining the Validity of Recorded Amounts - The auditor should ascertain the status of
balancing of subsidiary ledgers relating to advances. The total of balances in the subsidiary
ledgers should be agreed with the control accounts in the General Ledger. The auditor should
also tally the total of the statement of advances with the balances as per general
ledger/subsidiary ledgers. He should also cross-check the balances of the advances selected
for examined as listed in the statement of advances with the balances in the relevant advance
accounts in the subsidiary ledgers. Banks often obtain balance confirmation statements from
borrowers periodically. Such statements have a dual advantage in preventing disputes by the
customer and extending the period of limitation by reference to the date of confirmation.
Wherever available, such confirmations may be seen.
Examination of Loan Documents - As indicated earlier, the documents relating to advances
would be affected by the legal status of the borrower and the nature of security. Thus, were
the borrower is a company, loan documents would include certificate of incorporation,
memorandum and articles of association, certificate of commencement of business (in the
case of public limited companies), resolution of board of directors, and resolution of
shareholders [in cases covered by section 293(1)(d) of the Companies Act, 1956]. Where the
borrower is a partnership firm, loan documents would include copy of partnership deed.
Where the security is in the form of mortgage, apart from mortgage deed (in the case of
English Mortgage) or letter of intent to create mortgage (in the case of Equitable Mortgage),
the evidence of registration of the charge with the Registrar of Companies would also form
part of loan documentation if the borrower is a company. Each bank has its own set of rules
regarding the documents to be obtained from various types of borrowers and in respect of
different kinds of securities. The formats of many of the documents are also prescribed. The
auditor should evaluate the adequacy of the loan documents in the context of the rules framed
by the bank in this regard.
Review of Operation of Account - The auditor should review the operation of the advance
accounts. In doing so, an intelligent scrutiny of the operation of the account should be carried
out to see that the limit is not generally exceeded; that the account is not becoming stagnant;
that the customer is not drawing against deposits which are not free from lien; that the account
is not window-dressed by running down overdrafts at the year end and again drawing further
advances in the new year, etc. The auditor should also examine whether there is a healthy
turnover in the account. The auditor may also review the following to assess the recoverability
of advances.
♦ Periodic statements submitted by the borrowers indicating the extent of compliance with
terms and conditions.
♦ Latest financial statements of borrowers.
♦ Reports on inspection of security.
♦ Auditors’ reports in the case of borrowers enjoying aggregate credit limits of Rs. 10 lakh
or above for working capital from the banking system.
In the case of advances covered by guarantees of DICGC/ECGC, in case of default the
auditor should examine whether appropriate steps have been taken for lodging of claims for
guarantees in accordance with the applicable procedure.
Verification of Security against Advances - From the view point of security, advances are to
be classified in the balance sheet in the following manner:
(a) Secured by tangible assets
(b) Covered by bank/government guarantees
(c) Unsecured
An advance should be treated as secured to the extent of the value of the security on the
balance sheet date. If only a part of the advance is covered by the value of the security as at
the date of the balance sheet, that part only should be classified as secured; the remaining
amount should be classified as unsecured.
The following points are relevant for classifying the advances based on security.
(a) Government guarantees include guarantees of Central/State Governments and also
advances guaranteed by Central/State Government owned corporations and financial
institutions like IDBI, IFCI, ICICI, State Financial Corporations, State Industrial
Development Corporations, ECGC, DICGC, etc.
(b) Advances covered by bank guarantees also include advances guaranteed against any
negotiable instrument, the payment of which is guaranteed by a bank.
(c) Advances covered by bank/government guarantees should be included in unsecured
advances to the extent the outstandings in these advances exceed the amount of related
guarantees.
(d) While classifying the advances as secured, the primary security should be applied first
and for the residual balance, if any, the value of collateral security should be taken into
account. If the advance is still not fully covered, then, to the extent of bank/government
guarantees available, the advance should be classified as ‘covered by bank/government
guarantee’. The balance, if any, remaining after the above classification, should be
classified as ‘unsecured’.
(e) There may be situations where more than one facility is granted to a single borrower and
a facility is secured, apart from primary and collateral securities relating specifically to
that facility, by the residual value of primary security relating to any other credit facility (or
facilities) granted to the borrower. In such a case, in the event of shortfall in the value of
primary security in such a credit facility, the residual value of primary security of the other
facility (or facilities, as the case may be) may be applied first to the shortfall and the
value of collateral securities should be applied next. Such an application should be
started from the credit facility which has the highest shortfall, then for the credit facility
with the next highest amount of shortfall, and so on.
(f) In the case of common collateral security for advances granted to more than one
borrower, if there is a shortfall in value of primary security in any one or more of the
borrowal accounts, the value of collateral security may be applied proportionately to the
shortfall in each borrowal account.
In examining whether an advance is secured and, if so, to what extent, the auditor is
concerned with determining -
(a) whether the security is legally enforceable, i.e., whether the necessary legal formalities
regarding documentation, registration, etc., have been complied with;
(b) whether the security is in the effective control of the bank; and
(c) to what extent the value of the security, assessed realistically, covers the amount
outstanding in the advance.
The following paragraphs deal with the different types of securities against advances generally
accepted by banks and the manner in which the auditor should verify them.
Stock Exchange Securities and Other Securities - The auditor should verify stock exchange
securities and their market value in the same manner as in the case of investments. The
auditor should examine whether the securities have been got registered or assigned in favour
of the bank, wherever required. If the securities have been lodged for registration/assignment
and the amounts involved are material, the auditor should insist on production of evidence of
lodgement, e.g., certificates/acknowledgements from the companies concerned.
As already discussed, advances by a banking company against its own shares are prohibited
under section 20 of the Banking Regulation Act. A contravention of this provision may warrant
a qualification in the auditor’s report.
In addition to any directions of the Reserve Bank of India under section 21 of the Banking
Regulation Act, banks generally have their own lists of approved and unapproved securities.
Advances are generally made against approved securities only. Unapproved securities should
be accepted only with a special sanction of the appropriate authority. Advances made against
unapproved securities are, nevertheless, to be classified as secured advances in the same
manner as those against approved securities.
It sometimes happens that a quoted security may not have frequent transactions on the stock
exchange and the quotation included in the official quotations may be that of a very old
transaction. In such a case, the auditor should satisfy himself as to the market value by
scrutiny of balance sheet, etc., of the company concerned, particularly if the amount of
advance made against such security is large.
Banks do not generally make advances against partly-paid securities. If, however, any such
shares are accepted by the bank as security and these are registered in the name of the bank,
the auditor should examine whether the issuing company has called up any amount on such
securities and, if so, whether the amount has been paid in time by the borrower/bank.
Goods - In respect of hypothecated goods, the auditor should check the quantity and value of
goods hypothecated with reference to the statement received from the borrower. He should
also examine the reasonableness of valuation. Letter of hypothecation should also be
examined by the auditor. If the value of the goods is higher than the amount mentioned in the
letter of hypothecation, the bank’s security is only to the extent of the latter.
Sometimes, goods are in the possession of third parties, such as clearing and forwarding
agents, transporters, brokers, warehouse-keepers, etc. If these parties have given an
undertaking to the bank that they will hand over the goods or sale proceeds thereof to the
bank only, i.e., they have 'attorned' to the bank the advances made against such goods should
be considered as secured. In such cases, certificates should be obtained by the bank from
such third parties regarding quantities on hand on balance sheet date. The valuation of such
goods should be checked by the auditor.
In case the borrower is a company, the auditor should examine the certificate of registration of
charge on the goods hypothecated with the Registrar of Companies. It may be mentioned that
in case of pledge of goods, registration of charge is not necessary.
Documents of Title to Goods - The auditor should inspect the documents of title on the
closing date, particularly noting the quantity of goods and whether the documents are
endorsed/registered in favour of the bank. He may check the valuation as in the case of
goods.
Gold Ornaments and Bullion - The auditor should inspect and weigh (on a test basis) the
ornaments on the closing date. He should also see the Assayer’s certificate regarding the net
gold content of the ornaments and their valuation. Valuation should also be checked with
reference to the current market price of gold.
In respect of gold and silver bars, the auditor should inspect the bars on a test basis and see
that the mint seals are intact. The weights mentioned on the bars may generally be accepted
as correct.
Life Insurance Policies - The auditor should inspect the policies and see whether they are
assigned to the bank and whether such assignment has been registered with the insurer. The
auditor should also examine whether premium has been paid on the policies and whether they
are in force. Certificate regarding surrender value obtained from the insurer should be
examined. The auditor should particularly see that if such surrender value is subject to
payment of certain premia, the amount of such premia has been deducted from the surrender
value.
Bank’s Own Deposit Certificates - The auditor should inspect such certificates and examine
whether they have been properly discharged and whether the lien of the bank is noted on the
face of the certificates as well as in the relevant register of the bank.
Hire-purchase Documents - These advances may be classified as secured against the
hypothecation of goods. Where there is no hypothecation, the advance will be classified as
unsecured.
The auditor should examine the agreement between the seller and purchaser, the endorsed
promissory notes of the purchaser, and the guarantee of the insurance company.
Plantations - These advances are classified as secured against the crop and/or the fixed
assets of the plantation. The auditor should examine the agreement and the title deeds.
Regarding the estimate of the crop, he may examine the record of the garden for the last few
years. He should also ascertain whether the crop is properly insured against natural
calamities and other disasters such as hail, etc.
Immovable Property - The auditor should inspect the title deed, the solicitor’s opinion taken
by the bank in respect thereof, and the mortgage deed. For valuation, he may rely upon the
architect’s or valuer’s report (which should be taken at reasonable intervals) after carrying out
appropriate audit procedures to satisfy himself about the adequacy of the work of the
architect/valuer for his purpose. He should also examine the insurance policies.
In some cases, banks make advances against immovable properties where the title deeds are
not in the name of the borrower. For example, an advance may be given against the security
of a flat in a co-operative group housing society, the title deeds of which may not be in the
name of the borrower. In such cases, the auditor should examine the evidence regarding the
right or interest of the borrower in the property mortgaged, e.g., power of attorney, share
certificate of co-operative group housing society, ‘no objection certificate’ from the
society/lessor (in the case of leasehold properties) for offering the property as security, etc.
Third Party Guarantees - The auditor should examine the guarantee bonds and the demand
promissory notes in order to verify the third party liability. He should satisfy himself that the
guarantee is in force as at the date of the balance sheet. In the absence of a provision to the
contrary, a guarantee terminates by revocation or upon death of the surety. The surety is also
discharged (unless there is a specific covenant to the contrary) if the creditor arranges with
the principal debtor for composition, or agrees to give time or agrees not to sue him, without
consulting the surety. If any variation is made in the terms of the contract between the
principal debtor and the creditor without the surety’s consent, it discharges the surety as to
transactions subsequent to the variation. The guarantee forms used by banks normally seek
to ensure the continuing obligation of the guarantor in spite of these contingencies.
Verification of Bills Purchased and Discounted - Bills purchased and discounted have to
be shown separately in the balance sheet as a part of ‘advances’. Further, under the head
‘advances outside India’ in the balance sheet, bills purchased and discounted outside India
have to be shown separately. This category will include bills covering export of goods, bills
discounted by foreign branches of the bank and payable in their respective countries, etc.
Banks purchase or discount bills of exchange drawn or endorsed by their customers. The
bank credits the amount of the bill to its customer after deducting the discount. The total
amount of such bills is shown as an asset in the balance sheet.
In certain eligible cases, the bills purchased or discounted by the bank may be rediscounted
by it with the Reserve Bank of India/IDBI/SIDBI. Such bills would not be included under
advance but would constitute a contingent liability.
Bills purchased and discounted by the bank are generally drawn on outstation parties and are,
therefore, sent by the bank to its branches or agents for collection immediately after their
receipt. They are generally not in the possession of the bank on the closing date. The
auditor, therefore has to rely upon the Register of Bills Purchased and Discounted and the
party-wise Register of Bills maintained by the bank. The auditor should examine these
registers and satisfy himself that:
(a) all the outstanding bills have been taken in the balance sheet;
(b) all the details, including the nature of the bills and documents, are mentioned in the
register and that the bills have been correctly classified;
(c) the bills purchased or discounted from different parties are in accordance with the
agreements with them and the total of outstanding bills of each party is not in excess of
the sanctioned limit;
(d) the bills are not overdue. If there are any overdue bills, the auditors should ascertain the
reasons for the delay and the action taken by the bank.
The auditor should examine whether registers of bills purchased and discounted are properly
maintained and the transactions are recorded therein correctly. He should examine whether
the bills and the documents accompanying the bills are properly endorsed and assigned in
favour of the bank. In checking the bills, it should be ensured that the bills are held along with
the documents of title. In the case of documentary bills, it should be ensured that the related
RRs/TRs are held along with the invoices/hundies/bills and that these have not been parted
with. Wherever such RRs/TRs are not held on record, the fact should be duly considered by
the auditor. The auditor should also examine bills collected subsequent to the year-end to
obtain assurance regarding completeness and validity of the recorded bill amounts.
Other Aspects - Sometimes, a customer is sanctioned a cash credit limit at one branch but is
authorised to utilise such overall limit at a number of other branches also, for each of which a
sub-limit is fixed. In such a case, the determination of status of the account as NPA or
otherwise should be determined at the limit-sanctioning branch with reference to the overall
sanctioned limit/drawing power, and not by each of the other branches where a sub-limit has
been fixed. The auditor of the limit-sanctioning branch should examine whether it receives
particulars of all transactions in the account at sub-limit branches and whether the status of
the account has been determined by considering the total position of operation of the account
at all concerned branches. As far as sub-limit branches are concerned, they should show the
balances of sub-limit account separately in the statement of advances so that such balances
can be excluded when branch returns are consolidated.
The auditor should examine that any advance made by a banking company otherwise than in
the course of banking business, such as, prepaid expenses, is not included under the head
‘advances’ but is included under ‘other assets’. On the other hand, moneys paid under a
guarantee when the principal debtor fails to pay, moneys paid under indemnity, moneys sent
for subscription of new shares in the bank’s name on behalf of its customers, etc. are some of
the examples of items which should be included under ‘advances’.
The amounts of advances in India and those outside India are to be shown separately in the
balance sheet. This classification will depend upon where the advance was actually made
and not where it has been utilised. Generally speaking, figures of Indian branches will be
shown as advances in India and figures of foreign branches as advances outside India.
Verification of Provision for Non-performing assets - An important aspect of audit of
advances relates to their valuation. This implies that a proper provision should be made in
respect of advances where the recovery is doubtful. As mentioned earlier, the Reserve Bank
has prescribed objective norms for determining the quantum of provisions required in respect
of advances. However, these norms should be construed as laying down the minimum
provisioning requirements and wherever a higher provision is warranted in the context of the
threats to recovery, such higher provision should be made. In this regard, the provisions of
section 15 of the Banking Regulation Act may be noted. This section, which applies to
banking companies, nationalised banks, State Bank of India, its subsidiaries, and regional
rural banks, requires the bank concerned to make adequate provision for bad debts to the
satisfaction of its auditor before paying any dividends on its shares.

The provision in respect of debts that are doubtful of recovery is usually made at the head
office level and is not recorded in the books at the branch level. The amount of provision to be
made at the head office level is based largely on the classification of various advances into
standard, sub-standard, doubtful and loss categories. The auditor should carefully examine
whether the classification made by the branch is appropriate. In doing so, he should
particularly examine the classification of advances where there are threats to recovery. The
auditor should also examine whether the secured and the unsecured portions of advances
have been segregated correctly.
As per the Reserve Bank guidelines, if an account has been regularised before the balance
sheet date by payment of overdue amount through genuine sources, the account need not be
treated as NPA. Where, subsequent to repayment by the borrower (which makes the account
regular), the branch has provided further funds to the borrower (including by way of
subscription to its debentures), the auditor should carefully assess whether the repayment was
out of genuine sources.
The Reserve Bank has specified that advances against book debts may be included under the
head ‘secured by tangible assets’. The book debts are not in the nature of tangible assets and
therefore, the classification of advances covered by book debts under the heading ‘secured by
tangible assets’ is inappropriate. Where the amount of advances covered by book debts is
significant, the auditor should make a suitable qualification in his audit report.
IV. Fixed Assets
The Third Schedule to the Banking Regulation Act, 1949, requires fixed assets to be classified
into two categories in the balance sheet: premises, and other fixed assets.
The Third Schedule to the Banking Regulation Act, 1949, does not specifically deal with
disclosure of land. Land may be shown either as a separate heading under ‘fixed assets’ or
as a sub-heading under ‘other fixed assets’.
Audit Procedures
In carrying out an audit of fixed assets, the auditor is concerned primarily with obtaining
evidence about their existence and valuation.
The branch auditor should ascertain whether the accounts in respect of premises and/or other
fixed assets are maintained at the branch or centrally. Similarly, he should ascertain the
location of documents of title or other documents evidencing ownership of various items of
fixed assets.
Premises - The auditor should verify the opening balance of premises with reference to
schedule of fixed assets, ledger or fixed assets register. Acquisition of new premises should
be verified with reference to authorisation, title deeds, record of payment, etc. Self-constructed
fixed assets should be verified with reference to authorisation and documents such as
contractors’ bills, work order records and record of payments. In the case of leasehold
premises, capitalisation and amortisation of lease premium, if any, should be examined. The
auditor should also examine whether the balances as per the fixed assets register reconcile
with those as per the ledger and the final statements.
In case the title deeds are held at the head office or some other location, the auditor should
obtain a written representation to this effect from the branch management and should bring
this fact to the notice of the central auditor through a suitable mention in his report.
In recent years, banks have incurred substantial expenditure on computer hardware and
software. Computer hardware qualifies the definition of a ‘fixed asset’ as given in AS-10,
Accounting for Fixed Assets (viz. “an asset held with the intention of being used for the
purpose of producing or providing goods or services and is not held for sale in the normal
course of business”). Systems software that are essential for the functioning of the hardware
(e.g., operating system) can be considered an integral part of the related hardware.
Applications software is intangible assets that can be identified separately from the hardware.
In respect of fixed assets sold during the year, a copy of the sale deed and receipt of the sale
value should be examined by the auditor. In such a case, it should also be seen that the
original cost and accumulated depreciation on the assets sold have been correctly adjusted.
Profit earned or loss incurred made on such sales should also be checked.
The auditor should examine whether the balance in the control account in the general ledger
tallies with that as per subsidiary records and as per fixed assets register.
Where the accounting procedure followed in the bank envisages provision of depreciation on
some or all fixed assets at the branch, the auditor should examine whether the computation of
depreciation has been made in accordance with the accounting policy followed by the bank.
V. Other Assets
The following items are to be disclosed under the head 'Other Assets':
♦ Inter-office adjustments (net)
♦ Interest accrued
♦ Tax paid in advance/tax deducted at source
♦ Stationery and stamps
♦ Non-banking assets acquired in satisfaction of claims
♦ Others
Audit Procedures
The branch auditor may carry out the audit of various items appearing under the head ‘other
assets’ in the following manner.
Inter-Office Adjustments - The balance in the inter-branch accounts, if in debit, is to be
shown under this head. The inter-branch accounts are generally sub-divided into segments or
specific areas, e.g., ‘Demand Drafts Paid’, ‘Inter-branch Remittances’, ‘Head Office Account’,
etc. The net aggregate of all such accounts should be shown under this head.
The auditor may pay special attention to the following points in the conduct of audit of inter-
branch transactions.
(a) While verifying the closing balance, special attention should be paid to the origin and
validity of old outstanding unmatched entries, particularly debit entries. The auditor may
also seek confirmation of transactions relating to outstandings in appropriate cases.
(b) Whether there are any reversal entries indicating the possibility of irregular payments or
frauds.
(c) Whether the balances include any items in the nature of cash-in-transit (e.g. cash meant
for deposit into currency chest) included in this head which remain pending for more than
a reasonable period, say, within a week. This is because such items are not expected to
remain outstanding beyond a very small period during which they are in transit.
(d) Whether transactions other than those relating to inter-branch transactions have been
included in inter-branch accounts. Any unusual items put through inter-branch accounts
as well as old or large entries outstanding in inter-branch accounts should be carefully
looked into. The auditor may also seek explanations from the management in this regard
in appropriate cases.
Interest Accrued - The main components of this item are interest accrued but not due on
investments and advances and interest due but not collected on investments. As banks
normally debit the borrower’s account with interest due on the balance sheet date, there would
not usually be any amount of interest accrued but not due on advances. On the other hand,
interest on government securities, debentures, bonds, etc. which accrues from day to day
should be calculated and brought into account, insofar as it has accrued on the date of the
balance sheet. According to the Notes and Instructions for compilation of balance sheet,
issued by the Reserve Bank, only such interest as can be realised in the ordinary course of
business should be shown under this head.
Tax Paid in Advance/Tax Deducted at Source - Generally, this item is dealt with at the
head office level only and would therefore not appear in the balance sheet of a branch, except
that tax deducted at source on fixed deposits and other products/services is handled at the
branch level.
Stationery and Stamps - Internal controls over stationery of security items (like term deposit
receipts, drafts, pay orders, cheque books, traveller’s cheques, gift cheques, etc.) assume
special significance in the case of banks as their loss or misuse could eventually lead to a
misappropriation of the most valuable physical asset of a bank, viz., cash.
The auditor should physically verify the stationery and stamps on hand as at the year-end,
especially stationery of security item. Any shortage should be inquired into as it could expose
the bank to a potential loss from misuse. The auditor should examine whether the cost of
stationery and stamps consumed during the year has been properly charged to the profit and
loss account for the year in the context of the accounting policy/instructions from the head
office regarding treatment of cost of stationary and stamps.
Non-Banking Assets Acquired in Satisfaction of Claims - Under this heading will be

included those immovable properties/tangible assets which the bank has acquired in
satisfaction of debts due or its other claims. These items are held with the intention of being
disposed of.
While examining this item, the auditor should specifically keep in mind the provisions of
section 9 of the Banking Regulation Act, 1949, which prohibit a banking company from holding
any immovable property, however acquired (i.e. whether acquired by way of satisfaction of
claims or otherwise), except such as is required for its own use, for any period exceeding
seven years from the date of acquisition thereof. During this period, the bank may deal or
trade in any such property for the purpose of facilitating the disposal thereof. The RBI has the
power to extend the aforesaid period in a particular case up to another five years. (It may be
noted that the aforesaid section is applicable to banking companies only and not to other
types of banks like nationalised banks.)
The auditor should verify such assets with reference to the relevant documentary evidence,
e.g., terms of settlement with the party, order of the Court or the award of arbitration, etc. He
should satisfy himself that the ownership of the property has legally vested in the bank. If
there is any dispute or other claim about the property, the auditor should examine whether the
recording of the asset is appropriate or not. In case the dispute arises subsequently, the
auditor should examine whether a provision for liability or disclosure of a contingent liability is
appropriate, keeping in view the requirements of AS 4, Contingencies and Events Occurring
after the Balance Sheet Date.
Non-Interest Bearing Staff Advances - The auditor should examine non-interest bearing
staff advances with reference to the relevant documentation. The availability, enforceability
and valuation of security, if any, should also be examined.
Security Deposits - Security deposits with various authorities (e.g., on account of telephone,
electricity, etc.,) and with others (e.g., deposits in respect of premises taken on rent) should be
examined with reference to documents containing relevant terms and conditions, and receipts
obtained from the parties concerned.
Suspense Account - 'Suspense' account is another item included under 'other assets'.
Ideally, where accounts are maintained properly and on a timely basis, the suspense account
may not arise. However, in a practical situation, suspense account is often used to temporarily
record certain items such as the following:
(i) amounts temporarily recorded under this head till determination of the precise nature
thereof or pending transfer thereof to the appropriate head of account;
(ii) debit balances arising from payment of interest warrants/ dividend warrants pending
reconciliation of amounts deposited by the company concerned with the bank and the
payment made by various branches on this account;
(iii) amounts of losses on account of frauds awaiting adjustment.
Prepaid Expenses - The auditor should verify prepaid expenses in the same manner as in the
case of other entities. Thus, the auditor should examine whether the basis of allocation of
expenditure to different periods is reasonable. He should particularly examine whether the

allocation of discounting and rediscounting charges paid by the bank to different accounting
periods is in consonance with the accounting policy followed for the bank as a whole.
Miscellaneous Debit Balances on Government Account - Miscellaneous debit balances on
government account in respect of pension, public provident funds, compulsory deposit scheme
payments, etc., for which the branch obtains reimbursement from the government through a
designated branch, are also included under the head 'others'. The auditor should review the
ageing statements pertaining to these items. He should particularly examine the recoverability
of old outstanding items. The auditor should also examine whether claims for reimbursement
have been lodged by the branch in accordance with the relevant terms and conditions.
VI. Capital
The following particulars have to be given in respect of share capital in the balance sheet.
(a) For Nationalised Banks
Capital: The capital owned by Central Government as on the date of balance sheet
including contribution from Government, if any, for participating in World Bank Projects
should be shown.
(b) For Banks Incorporated Outside India
Capital (the amount brought in by banks by way of start-up capital as prescribed by RBI
should be shown under this head).
Amount of deposit kept with the RBI under section 11(2) of the Banking Regulation Act,
1949.
(c) For Other Banks
Authorised Capital (… shares of Rs ….. each)
Issued Capital (-do-)
Subscribed Capital (-do-)
Called-up Capital (-do-)
Less: Calls unpaid
Add: Forfeited shares
The auditor should verify the opening balance of capital with reference to the audited balance
sheet of the previous year. In case there has been an increase in capital during the year, the
auditor should examine the relevant documents supporting the increase. For example, in case
of an increase in the authorised capital of a banking company, the auditor should examine the
special resolution of shareholders and the memorandum of association. An increase in
subscribed and paid-up capital of a banking company, on the other hand, should be verified
with reference to prospectus/other offer document, reports received from registrars to the
issue, bank statement, etc.
VII. Reserves and Surplus

The following are required to be disclosed in the balance sheet under the head ‘Reserves and
Surplus’.
I. Statutory Reserves
II. Capital Reserves
III. Share Premium
IV. Revenue and Other Reserves
(In respect of items I – IV above, opening balance, additions during the year and
deductions during the year are to be shown separately in respect of each item)
V. Balance in Profit and Loss Account
Audit Procedures
The auditor should verify the opening balances of various reserves with reference to the
audited balance sheet of the previous year. Additions to or deductions from reserves should
also be verified in the usual manner, e.g., with reference to board resolution. In the case of
statutory reserves and share premium, compliance with legal requirements should also be
examined. Thus, the auditor should specifically examine whether the requirements of the
governing legislation regarding transfer of the prescribed percentage of profits to reserve fund
have been complied with. In case the bank has been granted exemption from such transfer,
the auditor should examine the relevant documents granting such exemption. Similarly, it
should be examined whether the appropriations from share premium account conform to the
relevant legal requirements.
VIII. Deposits
Deposits are required to be classified in the balance sheet under the following heads.
A. I. Demand Deposits
(i) From Banks
(ii) From Others
II. Savings Bank Deposits
III. Term Deposits
(i) From Banks
(ii) From Others
B. I. Deposits of branches in India
II. Deposits of branches outside India
Audit Procedures
The auditor may verify various types of deposits in the following manner.
Current Accounts - The auditor should verify the balances in individual accounts on a
sampling basis. He should also examine whether the balances as per subsidiary ledgers tally
with the related control accounts in the General Ledger.
The auditor should ensure that debit balances in current accounts are not netted out on the
liabilities side but are appropriately included under the head ‘advances’.
Inoperative accounts are a common area of frauds in banks. While examining current
accounts, the auditor should specifically cover in his sample some of the inoperative accounts
revived during the year. The auditor should also ascertain whether inoperative accounts are
‘revived’ only with proper authority. For this purpose, the auditor should identify cases where
there has been a significant reduction in balances compared to the previous year and examine
the authorisation for withdrawals.
Savings Bank Deposits - The auditor should verify the balances in individual accounts on a
sampling basis. He should also examine whether the balances as per subsidiary ledgers tally
with the related control accounts in the General Ledger.
The auditor should also check the calculations of interest on a sampling basis. It is not
unusual for branches to compute interest savings bank upto a date close to the end of the
accounting period e.g. 25th March based on the actual balances with interest for the remaining
period on an estimated basis at the head office level.
Term Deposits - ‘Term deposits’ are deposits repayable after a specified period. They are
considered time liabilities of the bank.
While evaluating the internal controls over deposits, the auditor should specifically examine
whether the deposit receipts and cash certificates are issued serially and all of them are
accounted for in the registers. The auditor should also satisfy himself that there is a proper
control over the unused forms of deposit receipts and cash certificates to prevent their misuse.
The auditor should verify the deposits with reference to the relevant registers. The auditor
should also examine, on a sampling basis, the registers with the counter-foils of the receipts
issued and with the discharged receipts returned to the bank.
Deposits Designated in Foreign Currencies - In the case of deposits designated in a foreign
currency, e.g., foreign currency non-resident deposits, the auditor should examine whether
they have been converted into Indian rupees at the rate notified in this behalf by the head
office.
Interest Accrued But Not Due - The auditor should examine that interest accrued but not due
on deposits is not included under the relevant deposits but is shown under the head ‘other
liabilities and provisions’.
IX. Borrowing
Borrowings of a bank are required to be shown in balance sheet as follows.
I. Borrowings in India
(i) Reserve Bank of India
(ii) Other Banks

(iii) Other Institutions and Agencies
II. Borrowings outside India
Audit Procedures
(i) Borrowings from RBI, other banks/financial institutions, etc. should be verified by the
auditor with reference to confirmation certificates and other supporting documents such
as agreements, correspondence, etc.
(ii) The auditor should also examine whether a clear distinction has been made between
‘rediscount’ and ‘refinance’ for disclosure of the amount under the above head since
rediscount does not figure under this head.
(iii) The auditor should examine whether borrowings of money at call and short notice are
properly authorised. The rate of interest paid/payable on, as well as duration of, such
borrowings should also be examined by the auditor.
X. Other Liabilities and Provisions

The Third Schedule to the Banking Regulation Act, 1949, requires disclosure of the following
items under the head ‘Other Liabilities and Provisions’.
(a) Bills payable
(b) Inter-office adjustments (net)
(c) Interest accrued
(d) Others (including provisions)
Audit Procedures
The auditor may verify the various items under the head ‘other liabilities and provisions’ in the
following manner.
Bills Payable - Bills payable represent instruments issued by the branch against moneys
received from customers which are to be paid to the customer or as per his order (usually at a
different branch). These include demand drafts, telegraphic transfers, mail transfers,
traveller’s cheques, pay-orders, banker's cheques and similar instruments issued by the bank
but not presented for payment till the balance sheet date.
Based on his evaluation of the efficacy of the relevant internal controls, the auditor should
examine an appropriate sample of outstanding items comprised in bills payable accounts with
the relevant registers. Reasons for old outstanding debits in respect of drafts or other similar
instruments paid without advice should be ascertained. Correspondence with other branches
after the year-end (e.g., responding advices received from other branches, advices received
from other branches in respect of drafts issued by the branch and paid by the other branches
without advice) should also be examined specially insofar as large value items outstanding on
the balance sheet date are concerned.
Inter-office Adjustments - The balance in inter-office adjustments account, if in credit, is to

be shown under this head.
Interest Accrued - Interest accrued but not due on deposits and borrowings is to be shown
under this head. The auditor should examine this item with reference to terms of the various
types of deposits and borrowings. It should be specifically examined that such interest has not
been clubbed with the figures of deposits and borrowings shown under the head ‘Deposits and
Borrowings’.
Others (including provisions) - According to the Notes and Instructions for compilation of
balance sheet and profit and loss account, issued by the Reserve Bank of India, the following
items are to be included under this head:
(a) Net provision for income-tax and other taxes like interest tax, less advance payment and
tax deducted at source.
(b) Surplus in aggregate in provisions for bad and doubtful debts provision account (such
surplus is in the nature of a reserve).
(c) Surplus in aggregate in provisions for depreciation in securities (such surplus is in the
nature of a reserve).
(d) Contingency funds which are actually in the nature of reserves but are not disclosed as
such.
(e) Provisions toward standard assets. These are to be shown separately as ‘contingent
provisions against standard assets’.
(f) Proposed dividend/transfer to Government.
XI. Contingent Liabilities

The Third Schedule to the Banking Regulation Act, 1949, requires the disclosure of the
following as a footnote to the balance sheet.
(a) Contingent Liabilities
I. Claims against the bank not acknowledged as debts
II. Liability for partly paid investments
III. Liability on account of outstanding forward exchange contracts.
IV. Guarantees given on behalf of constituents
(a) In India
(b) Outside India
V. Acceptances, endorsements and other obligations
VI. Other items for which the bank is contingently liable
(b) Bills for Collection
Audit Procedures
In respect of contingent liabilities, the auditor is primarily concerned with seeking reasonable
assurance that all contingent liabilities are identified and properly valued. To this end, the
auditor should, generally follow the audit procedures given below.
(a) Ascertain whether there are adequate internal controls to ensure that transactions giving
rise to contingent liabilities are executed only by persons authorised to do so and in
accordance with the laid down procedures.
(b) Ascertain whether the accounting system of the bank provides for maintenance of
adequate records in respect of such obligations and whether the internal controls ensure
that contingent liabilities are properly identified and recorded.
(c) Performs substantive audit tests to establish the completeness of the recorded
obligations. Such tests include confirmation procedures as well as examination of
relevant records in appropriate cases.
(d) Review the reasonableness of the year-end amount of contingent liabilities in the light of
previous experience and knowledge of the current year's activities.
(e) Obtain representation from the management that all contingent liabilities have been
disclosed and that the disclosed contingent liabilities do not include any
contingencies which are likely to result in a loss and which, therefore, require
adjustment of assets or liabilities.
(f) To verify that the provisions of AS29 ‘Provisions, contingent liabilities and contingent
assets’ have been complied with.
Claims Against the Bank Not Acknowledged as Debts - The auditor should examine the
relevant evidence, e.g., correspondence with lawyers/others, claimants, workers/ officers, and
workmen’s /officers’ unions. The auditor should also review the minutes of meetings board of
directors/committees of board of directors, contracts, agreements and arrangements, list of
pending legal cases, and correspondence relating to taxes, and duties, etc. to identify claims
against the bank. The auditor should ascertain from the management the status of claims
outstanding as at the end of the previous year. A review of subsequent events would also
provide evidence about completeness and valuation of claims.
Liability on Partly Paid Investments - If the bank holds any partly paid shares, debentures,
etc., the auditor should examine whether the uncalled amounts thereof are shown as
contingent liability in the balance sheet.
Liability on Account of Outstanding Forward Exchange Contracts - The auditor may verify
the outstanding forward exchange contracts with the register maintained by the branch and
with the broker's advice notes. In particular, the net "position" of the branch in relation to each
foreign currency should be examined to see that the position is generally square and not
uncovered by a substantial amount. The net "position" as reported in the financial statements
may be verified with reference to the foreign exchange position report prepared by the back
office.
Guarantees Given on Behalf of Constituents - The auditor should ascertain whether there
are adequate internal controls over issuance of guarantees, e.g., whether guarantees are
issued under proper sanctions, whether adherence to limits sanctioned for guarantees is
ensured, whether margins are taken from customers before issuance of guarantees as per the
prescribed procedures, etc.
The auditor should ascertain whether there are adequate controls over unused guarantee
forms, e.g., whether these are kept under the custody of a responsible official, whether a
proper record is kept of forms issued, whether stock of forms are periodically verified and
reconciled with the book records, etc.
The auditor should examine the guarantee register to seek evidence whether the prescribed
procedure of marking off the expired guarantees is being followed or not.
Acceptances, Endorsements and Other Obligations - This item includes the following
balances:
(a) letters of credit opened by the bank on behalf of its customers; and
(b) Bills drawn by the bank's customers and accepted or endorsed by the bank (to provide
security to the payees).
The auditor should evaluate the adequacy of internal controls over issuance of letters of credit
and over custody of unused L/C forms in the same manner as in the case of guarantees.
The auditor should verify the balance of letters of credit from the register maintained by the
bank. The register indicates the amount of the letters of credits and payments made under
them. The auditor may examine the guarantees of the customers and copies of the letters of
credit issued. The security obtained for issuing letters of credit should also be verified.
Other Acceptances and Endorsements - The auditor should study the arrangements made
by the bank with its customers. He should test check the amounts of the bills with the register
maintained by the bank for such bills. The auditor should also examine whether such bills are
marked off in the register on payment at the time of maturity.
In respect of letters of comfort, the auditor should examine whether the bank has incurred a
potential financial obligation under such a letter. If a comfort letter does not cast any such
obligation on the bank, no contingent liability need be disclosed on this account.
Bills for Collection - Bills held by a bank for collection on behalf of its customers are to be
shown at the foot of the balance sheet.
These bills are generally hundies or bills of exchange accompanied by documents of title to
goods. Frequently, no bills of exchange are actually drawn; the bank is asked to present
invoices and documents of title with instructions to collect the amount thereof from the party in
whose name the invoice has been made. The documents of title enclosed with the bills for
collection are usually not assigned to the bank.
A bank may get bills for collection from -
(a) its customers, drawn on outstation parties;
(b) its other branches or other outstation banks or parties, drawn on local parties.
The auditor should also examine collections made subsequent to the date of the balance
sheet to obtain further evidence about the existence and completeness of bills for collection.
In regard to bills for collection, the auditor should also examine the procedure for crediting the
party on whose behalf the bill has been collected. The procedure is usually such that the
customer's account is credited only after the bill has actually been collected from the drawee
either by the bank itself or through its agents, etc. This procedure is in consonance with the
nature of obligations of the bank in respect of bills for collection.
The commission of the branch becomes due only when the bill has been collected. The auditor
should, accordingly, examine that no income has been accrued in the accounts in respect of
bills outstanding on the balance sheet date.
XII. Accounting Policies

The term ‘accounting policies’ refers to the specific accounting principles and the methods of
applying those principles adopted by an enterprise in the preparation and presentation of
The specimen form given by the Reserve Bank recommends the disclosure of the fact that the
financial statements are prepared on the historical cost basis and conform to the statutory
provisions and practices prevailing in the country. Besides, disclosure of accounting policies
relating to the following areas is recommended in the specimen form.
(a) Transactions involving foreign exchange, viz., monetary assets and liabilities, non-
monetary assets, income and expenditure of Indian branches in foreign currency and of
overseas branches, and profit/loss on pending forward contracts.
(b) Investments
(c) Provisions in respect of doubtful advances
(d) Fixed assets and depreciation
(e) Staff benefits
(f) Significant provisions deducted in computing net profit, e.g., provision for income,
provision for doubtful advances, etc.
(g) Grouping of contingency funds in presenting balance sheet.
The specimen form of accounting policies was issued by the Reserve Bank in 1991. Since
then, the Reserve Bank has issued a number of guidelines relating to income recognition,
asset classification, provisioning and investments. These guidelines have had a profound
impact on the accounting policies of banks in the relevant areas. Disclosure of accounting
policies formulated by banks to comply with these guidelines is essential to enable the users
to properly understand the financial statements. Besides, in the case of banks having
overseas branches, the methodology adopted for translating the financial statements of such
branches may also constitute a significant accounting policy.
Capital Adequacy
11.8 The term ‘capital adequacy’ is used to describe the adequacy of capital resources of a
bank in relation to the risks associated with its operations.
Capital Adequacy Measures in India - In India, the statutes governing various types of banks
lay down the minimum capital requirements for them. Besides, these are also requirements
for maintenance of statutory reserves.
Considering the variations in minimum capital requirements applicable to different types of
banks and taking into account the approach adopted by Basle Committee, the Reserve Bank
prescribed, in year 1992, a uniform methodology for determining the capital adequacy of
scheduled commercial banks (other than regional rural banks). The methodology, which is
based on risk asset approach, is considered by the Reserve Bank as “more equitable as it
requires those institutions with a higher risk assets profile to maintain a higher level of capital
funds”. The Reserve Bank also believes that this approach “would encourage the banks to be
more risk-sensitive and to structure their Balance Sheets in a more prudent manner.”
While the basic approach to determining capital adequacy has remained unchanged since
1988, the Reserve Bank has, through its various circulars issued from time to time, modified
and refined the detailed manner of computation of risk-assets and capital.
Concurrent Audit
11.9 Concurrent audit, as the name suggests, is an audit or verification of transactions or
activities of an organisation concurrently as the transaction/activity takes place. It is not a pre-
audit. The concept in this audit is to verify the authenticity of the transaction/activity within the
shortest possible time after the same takes place. It is akin to internal audit which is a
concept recognised under the Companies Act. In view of the complexities of economic
activities it is now well recognised that there must by a system of someone, other than the
person involved in the operations, verifying the authenticity of the transaction/activity on a
regular basis so that any deviation from the laid down procedures can be noticed in the
shortest possible time and remedial action can be taken.
The concept of concurrent audit in the public as well as the private sector banks has gained
acceptance in recent years. In some banks this task has been entrusted to the internal
inspection staff who are not engaged in operational activities. In other banks, this work is
allotted to outside professional firms of chartered accountants. The Reserve Bank of India
(RBI) has issued certain guidelines for the conduct of this audit.
These guidelines are mandatory and all banks are required to cover 50 percent of total
deposits and 50 per cent of total advances under this audit. This will mean that all banks will
have to put their large branches under this audit.
11.9.1 Scope of Concurrent Audit - The guidelines issued by the RBI cover all the important
areas of activities of the branch which is under concurrent audit. Most banks have prepared
an Audit Manual for this purpose. Broadly stated, the following areas are covered by these
guidelines:
(i) Daily cash transactions with particular reference to any abnormal receipts and payments.
This will include currency chest transactions, major expenses incurred by cash payments
and high value cash receipts and disbursements.
(ii) Purchase and sale of shares, securities, etc. physical verification of investments and
verification of rates at which transactions are entered into. Similarly, examination of
capital expenditure on purchase of capital assets as well as sales of such assets. This
will include verification of relevant documents and authorisation.
(iii) Verification of procedure and documentation for opening new current, savings, term
deposit accounts, etc. If there are any unusual operations in these new accounts the
same should be examined thoroughly and unusual-features should be reported.
(iv) Verification of Advances-Overdrafts, TOD, CC Accounts, Term Loans, Bills Purchase,
L.C., Guarantees, Overdues, devolvement, and L.C./Guarantee, etc. For this verification
special attention is required to be given to (a) procedure for sanction and renewal of
limits and proper authorisation (b) disbursement of funds within limits and according to
terms of sanction (c) recovery of funds (d) verification of godown, stock, securities, etc.
(e) documentation including renewal of documents, registration of charges, mortgages,
etc. (f) classification of advances (g) study of financial health of customers by
observation about conduct of accounts, regular compliance by submission of financial
information, stock statements, etc. and study of audited annual accounts of corporate as
well as non-corporate customers, (h) timely signals for accounts likely to become
doubtful (I) timely legal action for recovery (j) verification of interest and other service
charges levied as per terms of sanction (k) credit rating of borrower and (l) compliance
with special conditions contained in the terms of sanction.
(v) Foreign Exchange transactions – if the branch is authorised to handle foreign exchange
transactions these transactions have to be verified in detail in accordance with RBI
guidelines. All aspects of Import/Export transactions, Foreign Bills transactions, Foreign
L.C./Guarantees, FCNR/NRI deposits, Nostro/Vostro accounts, compliance with RBI
guidelines and reporting will have to be examined.
(vi) House keeping – This is another sensitive area. This will include verification of balancing
of all ledgers and registers, inter-branch reconciliation, bank reconciliation, bank
reconciliation, test calculations and verification of interest, discount, commission and
exchange income, vouchers for expenses, transactions with staff members, reconciliation
of clearing differences, reconciliation of suspense and other sensitive accounts, debit
balances in savings accounts and Temporary Overdrafts.
(vii) Special effort to detect revenue leakage should be made.
(viii) Special attention to be paid to all fraud prone areas. The attempt should be to ensure
that effective measures are taken to prevent frauds. Inspite of these measures, if some
manipulation is done by any staff or outside party, the auditor should be able to detect
the same as early as possible so that further damage is prevented and timely action is
taken.
(ix) Verification of high value transactions.
(x) Procedure for safe custody of security forms with the branch.
(xi) Whether all procedures for tax deduction at source from salaries, rent, interest,
professional fees, etc. are followed and tax deducted is deposited with Government in
time.
(xii) Verification of statements, H.O. Returns, statutory returns, calculation of capital
adequacy ratio, and compliance with requirements of government business (collection of
tax and disbursements).
(xiii) Study of RBI and internal inspection reports, statutory auditor’s report, LFAR relating to
branch, etc. and compliance thereto.
(xiv) Whether customers’ complaints are dealt with promptly.
11.9.2 Concurrent audit system in commercial banks -
1. It hardly needs to be stressed that the concurrent audit system is to be regarded as part
of a bank’s early-warning system to ensure timely detection of irregularities and lapses
which helps in preventing fraudulent transactions at branches. It is, therefore, necessary
for the bank’s management to bestow serious attention to the implementation of various
aspects of the system such as selection of branches/coverage of business operations,
appointment of auditors, appropriate reporting procedures, follow-up/rectification
processes and utilisation of the feedback from the system for appropriate and quick
management decisions.
2. The bank should once in a year review the effectiveness of the system and take
necessary measures to correct the lacunae in the implementation of the programme.
(A) Scope of concurrent audit
Concurrent audit is an examination which is contemporaneous with the occurrence of
transactions or is carried out as near thereto as possible. It attempts to shorten the interval
between a transaction and its examination by an independent person not involved in its
documentation. There is an emphasis in favour of substantive checking in key areas rather
than test checking. This audit is essentially a management process integral to the
establishment of sound internal accounting functions and effective controls and setting the
tone for a vigilance internal audit to preclude the incidence of serious errors and fraudulent
manipulations.
A concurrent auditor may not sit in judgement of the decisions taken by a branch manager or
an authorised official. This is beyond the scope of concurrent audit. However, the audit will
necessarily have to see whether the transactions or decisions are within the policy parameters
laid down by the Head Office, they do not violate the instructions or policy prescriptions of the
RBI, and that they are within the delegated authority.
In very large branches, which have different divisions dealing with specific activities,
concurrent audit is a means to the incharge of the branch to ensure on an on going basis that
the different divisions function within laid-down parameters and procedures.
(B) Coverage of business/branches

(i) The Departments/Divisions at the Head Office dealing with Treasury functions viz
investments, funds management including inter-bank borrowings bill rediscount and
foreign exchange business are to be subjected to concurrent audit. In addition, all
branch offices, undertaking such business and dealing rooms have to be subjected to
continuous audit.
(ii) The coverage of branches should ensure that concurrent audit covers:
(a) Branches whose total credit and other risk exposures aggregate to not less than
50% of the total credit and other risk exposures of the bank; and
(b) Branches whose aggregate deposits cover not less than 50% of the aggregate
deposits of the Bank.
(iii) To achieve these twin criteria it is suggested that branches may be listed according to
credit and other risk exposures and selected in the descending order of exposures to
achieve a 50% coverage. If the deposits of these branches do not aggregate to 50% of
the Bank’s deposits, additional branches in descending order of deposits may be added
to achieve a 50% coverage of the branches.
(iv) While complying with the above parameters, it is necessary to ensure that the coverage
encompasses:
♦ exceptionally large branches
♦ very large and large branches
♦ special branches handling foreign exchange business, merchant banking business,
large corporate wholesale banking business and forex dealing room operations
♦ large problem branches rated as poor/very poor
♦ Head Office department dealing with treasury/funds management and handling
investment portfolio
♦ any other branches or departments where in the opinion of the Bank concurrent
audit is desirable.
(v) Branches subjected to concurrent audit should not normally be included for
revenue/income audit.
(C) Types of activities to be covered
(1) The main role of concurrent audit is to supplement the efforts of the bank in carrying out
simultaneous internal check of the transactions and other verifications and compliance
with the procedures laid down.
(2) The scope of concurrent audit should be wide enough to cover certain fraud-prone areas
like handling of cash, deposits, safe custody of securities, investments, overdue bills,
exercise of discretionary powers, sundry and suspense accounts, inter-branch
reconciliation, clearing differences, foreign exchange business including Nostro
accounts, off-balance sheet items like letters of credit and guarantee, treasury functions
and credit-card business.
(3) The detailed scope of the concurrent audit should be clearly and uniformly determined for
the Bank as a whole by the Bank’s Inspector and Audit Department in consultation with
the Bank’s Audit Committee of the Board of Directors (ACB).
(4) In determining the scope, importance should be given to checking high-risk transactions
having large financial implications as opposed to transactions involving small amounts.
(5) While the detailed scope of the concurrent audit may be determined and approved by the
ACB.
(D) Appointment of Auditors and accountability
(i) The option to consider whether concurrent audit should be done by bank’s own staff or
external auditors is left to the discretion of individual banks.
(ii) In case the bank has engaged its own officials, they should be experienced, well trained
and sufficiently senior. The staff engaged on concurrent audit must be independent of the
branch where concurrent audit is conducted.
(iii) Appointment of an external audit firm may be initially for one year and extended up to
three years - after which an auditor could be shifted to another branch subject to
satisfactory performance.
(iv) If external firms are appointed and any serious acts of omissions or commissions are
noticed in their working their appointments may be cancelled and the fact may be
reported to RBI & ICAI.
(E) Facilities for effective Concurrent Audit

It has been represented that Concurrent Audit is not often effective because adequate
facilities in terms of space, availability of records, etc are not available. To improve the
effectiveness of concurrent audit it is suggested that -
(i) banks arrange for an initial and periodical familiarisation process both for the bank’s own
staff when entrusted with the concurrent audit and for the external auditors appointed for
the purpose;
(ii) all relevant internal guidelines/circulars/important references as well as relevant circulars
issued by RBI/SEBI and other regulating bodies should be made available to the
concurrent auditors on an on - going basis;
(iii) where adequate space is not available, concurrent auditors can commence work
immediately after the close of banking hours.
(F) Remuneration - Terms of appointment of the external firms of Chartered Accountants

for the concurrent audit and their remuneration may be fixed by banks at their discretion.
Broad guidelines should be framed by ACB for these purposes. Suitable packages should be
fixed by each bank’s management in consultation with its ACB, keeping in view various factors
such as coverage of areas, quality of work expected, number of people required for the job,
number of hours to be spent on the job, etc.
(G) Reporting Systems

(i) Concurrent auditors should be attached to the branches and not the zonal offices.
(ii) Minor irregularities pointed out by the concurrent auditors are to be rectified on the spot.
Serious irregularities should be straightaway reported to the controlling offices/Head
Offices for immediate action.
(iii) There should be zone-wise reporting of the findings of the concurrent audit to ACB and
an annual appraisal/report of the audit system should be placed before the ACB.
(iv) Whenever fraudulent transactions are detected, they should immediately be reported to
Inspection & Audit Department (Head Office) as also the Chief Vigilance Officer as well
as Branch Managers concerned (unless the branch manager is involved).
(v) There should be proper reporting of the findings of the concurrent auditors. For this
purpose, each bank should prepare a structured format. The major
deficiencies/aberrations noticed during audit should be highlighted in a special note and
given immediately to the bank’s branch/controlling offices. A quarterly review containing
important features brought out during the concurrent audits should be placed before the
ACB.
(vi) Follow-up action on the concurrent audit reports should be given high priority by the
controlling office/Inspection and Audit Department and rectification of the features done
without any loss of time.
(vii) A Special Cell in the Inspection and Audit Department may be created in each bank to:
(1) review the selection of auditors;
(2) initiate and operate a system for the appraisal of the performance on concurrent
auditors;
(3) ensure that the work of concurrent auditors is properly documented;
(4) be responsible for the follow-up on audit reports and the presentation of the
quarterly review to the ACB.
Suggested items of coverage are given below:
(A) Cash
(i) Daily cash transactions with particular reference to any abnormal receipts and payments.
(ii) Proper accounting of inward and outward cash remittances.
(iii) Proper accounting of currency chest transactions, its prompt reporting to the RBI.
(iv) Expenses incurred by cash payment involving sizeable amount.
(B) Investments
(i) Ensure that in respect of purchase and sale of securities the branch has acted within its
delegated power having regard to its Head Office instructions.
(ii) Ensure that the securities held in the books of the branch are physically held by it.
(iii) Ensure that the branch is complying with the RBI/head Office guidelines regarding BRs,
SGL forms, delivery of scrips, documentation and accounting.
(iv) Ensure that the sale or purchase transactions are done at rates beneficial to the bank.
(C) Deposits
(i) Check the transactions about deposits received and repaid.
(ii) Percentage check of interest paid on deposits may be made including calculation of
interest on large deposits.
(iii) Check new accounts opened particularly current accounts. Operations in new current/SB
accounts may be verified in the initial periods to see whether there are any unusual
operations.
(D) Advances
(i) Ensure that loans and advances have been sanctioned properly (i.e. after due scrutiny
and at the appropriate level).
(ii) Verify whether the sanctions are in accordance with delegated authority.
(iii) Ensure that securities and documents have been received and properly
charged/registered.
(iv) Ensure that post disbursement supervision and follow-up is proper, such as receipt of
stock statements, instalments, renewal of limits, etc.
(v) Verify whether there is any mis utilisation of the loans and whether there are instances
indicative of diversion of funds.
(vi) Check whether the letters of credit issued by the branch are within the delegated power
and ensure that they are for genuine trade transactions.
(vii) Check the bank guarantees issued, whether they have been properly worded and
recorded in the register of the bank. Whether they have been promptly renewed on the
due dates.
(viii) Ensure proper follow-up of overdue bills of exchange.
(ix) Verify whether the classification of advances has been done as per RBI guidelines.
(x) Verify whether the submission of claims to DICGC and ECGC is in time.
(xi) Verify that instances of exceeding delegated powers have been promptly reported to
controlling/Head Office by the branch and have been got confirmed or ratified at the
required level.
(xii) Verify the frequency and genuineness of such exercise of authority beyond the delegated
powers by the concerned officials.
(E) Foreign Exchange transactions

(i) Check foreign bills negotiated under letters of credit.
(ii) Check FCNR and other non-resident accounts whether the debits and credits are
permissible under rules.
(iii) Check whether inward/outward remittance have been properly accounted for.
(iv) Examine extension and cancellation of forward contracts for purchase and sale of foreign
currency. Ensure that they are duly authorised and necessary charges have been
recovered.
(v) Ensure that balances in Nostro accounts in different foreign currencies are within the limit
as prescribed by the bank.
(vi) Ensure that the over bought/oversold position maintained in different currencies is
reasonable taking into account the foreign exchange operations.
(vii) Ensure adherence to the guidelines issued by RBI/HO of the bank about dealing room
operations.
(viii) Ensure verification/reconciliation of Nostro and Vostro account transactions/balances.
(F) Housekeeping
(i) Ensure that the maintenance and balancing of accounts, ledgers and registers including
clean cash is proper.
(ii) Early reconciliation of entries outstanding in the inter-branch and inter-bank accounts,
Suspense Account, Sundry Deposits Account, DDRR Account, Drafts Account, etc.
Ensure early adjustment of large value entries.
(iii) Carry out a percentage check of calculations of interest, discount, commission and
exchange.
(iv) Check whether debits in income account have been permitted by the competent
authorities.
(v) Check the transactions of staff accounts,
(vi) In case of difference in clearing there is a tendency to book it in an intermediary
suspense account instead of locating the difference. Examine the day book to verify as to
how the differences in clearing have been adjusted. Such instances should be reported
to Head Office in case the difference persists.
(vii) Detection & prevention of revenue leakages through close examination of income and
expenditure persists.
(viii) Check cheques returned/bills returned register and look into reasons for return of those
instruments.
(ix) Checking of inward and outward remittances (DDs, MTs & TTs).
(G) Other items

(i) In case the branch has been entrusted with government business, ensure that the
transactions are done in accordance with the instructions issued by Government, RBI &
HQ.
(ii) Ensure that the branch gives proper compliance to the internal inspection/audit reports.
(iii) Ensure that customers’ complaints are dealt with promptly.
(iv) Verification of statements, returns, statutory returns. The aforesaid list is illustrative and
not Exhaustive.
11.9.3 Reporting by Concurrent Auditors - Timely reporting is the essence of the concurrent
audit. Therefore, depending on the size of the operations in a branch the bank decides to get
the audit conducted on a daily basis, monthly basis or quarterly basis. In any of these
assignments, the auditor has to cover the entire area of operations. In the case of daily or
monthly, audit, the audit report of the work done for a particular work is required to be
submitted by the auditor by the 10th of the next month. In the case of quarterly audit the report
is to be given by the 10th of the month after the end of the quarter. In the case of any serious
irregularity noticed by the auditor while conducting the audit he has to give a flash report
immediately so that the bank can take remedial action without any delay. Where monthly
reports are given, the auditor is required to give an executive summary of audit report at the
end of the each quarter. The auditor has to adhere to this discipline of timely reporting.
A member of the accounting profession has to use his specialised knowledge, skill and
experience while drafting his audit report. Normally, the audit report should be divided in three
parts. The first part should deal with major irregularities. The second part should deal with
minor irregularities which have not been attended during the course of audit. The last part
should deal with compliance with earlier reports. All issues pointed out in earlier reports which
have not been complied with should be briefly stated in this last part. Items where no
irregularities are found need not be stated in the report. Areas covered by the audit for the
period covered by the report may be stated in the preamble. The rest of the reporting should
be by exception so that only those items which require attention by the bank management are
stated in the report.
Before submission of the report the auditor should discuss the important issues on which he
wishes to report with the branch manager and concerned officers. This will enable him to take
into consideration the opposite view point and clarify his doubts. In the case of a bank where
there is four-tier system, that is, Branch, Regional Office, Zonal Office and Central Office, the
detailed monthly/quarterly report is to be given to branch manager and regional manager.
Quarterly executive summary is to be given to all the four authorities.
It is also essential for the bank management to take effective steps to study these reports and
take remedial action so as to improve the working of the branches. Since this type of audit is
conducted at the large branches only, the bank management should view the common
irregularities pointed out by the auditors as illustrative and ensure that such irregularities do
not take place in other branches which are not under concurrent audit. It is also essential that
periodical meetings are held by the regional managers with the concurrent auditors. This will
enable them to know the views of the auditors on certain important issues covering their audit
assignments.
11.9.4 Audit Committee - In pursuance of RBI circular September 26, 1995, a bank is required
to constitute an Audit Committee of its Board. The membership of the audit committee is
restricted to the Executive Director, nominees of the Central Government and the RBI,
Chartered Accountant director and one of the non-official directors.
One of the functions of this committee is to provide direction and also oversee the operations
of the total audit function in the bank. The committee also has to review the internal
inspection/audit function in the bank, with special emphasis on the system, its quality and
effectiveness in terms of follow up. The committee has to review the system of appointment
and remuneration of concurrent auditors.
The Audit Committee is, therefore, connected with the functioning of the system of concurrent
audit. The method of appointment of auditors, their remuneration and the quality of their work
is to be reviewed by the Audit Committee. It is in this context that periodical meetings by the
members of the audit committee with the concurrent auditors and statutory auditors help the
audit committee to oversee the operations of the total audit function in the bank.
Considering the coverage of this audit assignment and the specialised nature of work there is
also a need for training to be imparted to the staff of the auditors. This training has to be
given in specialised fields such as foreign exchange, computerisation, areas of income
leakage, fraud prone areas, determination of credit rating and other similar specialised areas.
The bank can organise such training programmes at various places so that it can ensure the
quality of audit.
Annexure I
A. Salient Provisions of Banking Regulation Act, 1949
Of the above, the Banking Regulation Act, 1949 (hereinafter referred to as the Act), is the most
important as it affects the functioning of all institutions carrying on banking business whereas the other
enactments relate only to certain specific type(s) of banks. Some of the important provisions of the Act
are briefly described below since familiarity with them is essential for the performance of the duties of
an auditor. It may, however, be emphasised that the ensuing discussion is not an exhaustive
discussion on all the relevant provisions of the Act. It may also be noted that some of the provisions
discussed hereunder are not applicable to certain types of banks in view of there being specific
provisions with regard to the relevant matters in the respective principal statutes governing their
functioning.
Banking Companies: A banking company means “any company which transacts the business of
banking in India” [section 5(c) of the Banking Regulation Act]. The term ‘company’ for this purpose
covers companies registered in India as well as foreign companies, i.e., companies incorporated
outside India and having a place of business within India [section 5(d)].
Forms of Business of Banking Companies: ‘Banking’ is defined as “the accepting, for the purpose of
lending or investment, of deposits of money from the public, repayable on demand or otherwise, and
withdrawable by cheque, draft, order or otherwise” [section 5(b)]. It has been clarified that any company
which is engaged in the manufacture of goods or carries on any trade and which accepts deposits of
money from the public merely for the purpose of financing its business as such manufacturer or trader
shall not be deemed to transact the business of banking [Explanation to section 5(c)].
Section 6 of the Act permits a banking company to engage in certain forms of business in addition to
the business of banking. Besides the forms of business specifically listed in clauses (a) – (m) of sub-
section (1) of section 6, a banking company may do “all such other things as are incidental or
conducive to the promotion or advancement of the business of the company” [clause (n) of sub-section
(1) of section 6]. Under clause (o), a banking company may engage in any other form of business
(besides those covered by other clauses) which the Central Government may, by notification in the
Official Gazette, specify as a form of business in which it is lawful for a banking company to engage.
Under sub-section (2) of section 6, a banking company is prohibited from entering into any form of
business other than those covered by sub-section (1) of the said section. Section 8 specifically
prohibits a banking company from buying, selling or bartering of goods except in connection with the
realisation of a security held by it. It also prohibits a banking company from engaging in any trade or
buying, selling or bartering of goods for others except in connection with collecting or negotiating bills
of exchange or in connection with undertaking the administration of estates as executor, trustee or
otherwise. However, the above prohibitions are not applicable to any business specified by the Central
Government in pursuance of clause (o) of sub-section (1) of section 6.
Licensing of Banking Companies: Section 22 of the Act prohibits a company from carrying on
banking business in India unless it holds a license issued by the Reserve Bank of India. The licence
may be a conditional licence. The licence may be cancelled if the company ceases to carry on banking
business in India or fails to comply with the conditions of the licence or fails to fulfil any other condition
laid down in the section.

Power to Suspend Operation of the Act: On a representation made by the RBI in this behalf, the
Central Government may suspend the operation of the Act or of any provision thereof for a period up to
60 days either generally or in relation to any specified banking company. In case of a special
emergency, the Governor of the Reserve Bank or, in his absence, any authorised Deputy Governor
may also similarly suspend such operation for a period up to 30 days. In either case, the Central
Government may extend the period of suspension from time to time for periods not exceeding 60 days
at any one time. The total period of suspension cannot, however, exceed one year [section 4].
Requirements as to Minimum Paid-up Capital and Reserves and Regulation of Capital: Section 11
of the Act lays down the requirements as to minimum paid-up capital and reserves. Different limits have
been laid down for banking companies incorporated outside India and other banking companies. Under
section 12, the capital of a banking company can consist of ordinary (i.e., equity) shares only, except
where preference shares have been issued prior to July 1, 1944 or where the banking company has
been incorporated before January 15, 1937.
Restrictions on Opening and Transfer of Places of Business: Under section 23, prior permission of
the RBI is required for opening of new, or transfer of existing, places of business in India. Similar
permission is required by a banking company incorporated in India for opening a new, or transferring
an existing, place of business outside India. The above restrictions, however, do not cover the change
of location of an existing place of business within the same city, town or village. Opening of a
temporary place of business for a period not exceeding one month is also exempted provided the
conditions laid down in this behalf are satisfied. The term ‘place of business’ includes any sub-office,
pay office, sub-pay office and any place of business at which deposits are received, cheques encashed
or moneys lent.
It may be noted that recently, the RBI has permitted banks to open new places of business or transfer
existing ones without obtaining specific permission from it provided certain conditions specified by the
Reserve Bank in this behalf are satisfied.
Monthly Return to be Submitted to Reserve Bank: Every banking company is required to submit a
monthly return to the Reserve Bank in the prescribed form and manner showing its assets and liabilities
in India as at the close of business on the last Friday of the month (or if that Friday is a public holiday,
at the close of business on the preceding working day). The return has to be submitted before the close
of the succeeding month. The RBI also has the power to call for other returns and information [section
27].
Inspection by the Reserve Bank: Wide powers have been given to the RBI under section 35 for
inspection of any banking company and its books and accounts. The Central Government can also
direct the Reserve Bank to cause such an inspection.
Power of the Reserve Bank to Give Directions: The RBI is empowered to issue such directions to
banking companies generally or to any banking company in particular as it deems fit in public interest,
or in the interest of banking policy, or to prevent the affairs of any banking company from being
conducted in a manner detrimental to the interests of the depositors or in a manner prejudicial to the
interests of the banking company, or to secure the proper management of any banking company
generally (section 35A). The RBI is also empowered to caution or prohibit banking companies generally
or any particular banking company against entering into any particular transaction or class of
transactions, and generally give advice to any banking company [Clause (a) of sub-section (1) of
section 36].
Provisions Relating to Accounts and Audit: Section 29 of the Act lays down requirements as to
profit and loss account and balance sheet. Section 30 deals with audit of profit and loss account and
balance sheet prepared in accordance with section 29. Section 31 deals with publication of profit and
loss account and balance sheet and their submission to RBI whereas section 32 deals with submission
of profit and loss account and balance sheet to Registrar of Companies. Section 33 deals with display
of audited balance sheet, and profit and loss account by companies incorporated outside India and
carrying on banking business in India. These provisions are discussed in detail in Chapter 3. It may be
noted that some of the above provisions are not applicable to nationalised banks, State Bank of India,
subsidiaries of State Bank of India, regional rural banks, and co-operative banks (this aspect is
discussed later in this chapter).
Other Important Provisions of the Banking Regulation Act, 1949: Besides the above provisions, a
number of other provisions of the Act are relevant to the work of the auditor. The more important of
these provisions are as follows.
Section 9 Disposal of non-banking assets
Section 13 Restriction on commission, brokerage, discount, etc., on sale of shares
Section 14 Prohibition of charge on unpaid capital
Section 15 Restrictions as to payment of dividend
Section 17 Reserve fund
Section 18 Cash reserve
Section 19 Restriction on nature of subsidiary companies
Section 20 Restrictions on loans and advances
Section 20A Restrictions on power to remit debts
Section 21 Power of Reserve Bank to control advances by banking companies
Section 24 Maintenance of a percentage of (liquid) assets
Section 25 Assets in India
Section 26 Return of unclaimed deposits
Section 45Y Power of Central Government to make rules for the preservation of records
B. Applicability of Various Enactments to Different Types of Banks
As mentioned in paragraph 2.01, a number of enactments govern the functioning of banks in India.
While the Banking Regulation Act, 1949 is applicable to all types of banks (though some of its
provisions may not be applicable to certain types of banks or may be applicable with certain
modifications), the other enactments are relevant only to particular type(s) of banks. The enactments
applicable to different types of banks are discussed below.
Nationalised Banks: Nationalised banks are governed by –

(a) Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980; and
(b) specified provisions of the Banking Regulation Act, 1949.
Fourteen banks were nationalised under the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 while another six were nationalised under the Banking Companies (Acquisition
and Transfer of Undertakings) Act, 1980. The provisions of these two enactments are identical and
deal, inter alia, with such matters as the following:
♦ Authorised and paid-up capital
♦ Annual accounts
♦ Qualifications, appointment, powers and duties of auditor (including contents of audit report)
♦ Disposal of profits
♦ Special audit at the instance of the Central Government
♦ Time and place of annual general meeting and business to be transacted thereat
♦ Restrictions on payment of bonus to officers and other employees
♦ Powers of the Board of Directors to make regulations in consultation with the Reserve Bank and
with the previous sanction of the Central Government
Apart from all the provisions of the aforesaid Act of 1970/1980, the following provisions of the Banking
Regulation Act, 1949, also apply to nationalised banks by virtue of section 51 of the latter Act.
Section 10 Prohibition of employment of managing agents and restrictions on certain forms
of employment
Section 13 Restriction on commission, brokerage, discount, etc., on sale of shares
Section 14 Prohibition of charge on unpaid capital
Section 14A Prohibition of floating charge on assets
Section 15 Restrictions as to payment of dividend
Section 17 Reserve Fund
Section 19 Restriction on nature of subsidiary companies
Section 20 Restrictions on loans and advances
Section 20A Restriction on power to remit debts
Section 21 Power of Reserve Bank to control advances by banking companies
Section 21A Rate of interest charged by banking companies not to be subject to scrutiny by
Courts
Section 23 Restrictions on opening of new, and transfer of existing, places of business
Section 24 Maintenance of a percentage of assets
Section 25 Assets in India

Section 26 Return of unclaimed deposits
Section 27 Monthly returns and power to call for other returns and information
Section 28 Power to publish information
Section 29 Accounts and balance sheet
[excluding sub-
section (3)]
Section 30 Audit
[excluding sub-
sections (1), (1A)
and (3)]
Section 31 Submission of returns
Section 34 Accounting provisions of the Act not retrospective
Section 35 Inspection
Section 35A Power of the Reserve Bank to give directions
Section 36 Further powers and functions of Reserve Bank
[excluding clause
(d) of sub-
section (1)]
Section 45Y Power of Central Government to make rules for the preservation of records
Section 45Z Return of paid instruments to customers
Section 45ZA Nomination for payment of depositors’ money
Section 45ZB Notice of claims of other persons regarding deposits not receivable
Section 45ZC Nomination for return of articles kept in safe custody with banking company
Section 45ZD Notice of claims of other persons regarding articles not receivable
Section 45ZE Release of contents of safety lockers
Section 45ZF Notice of claims of other persons regarding safety lockers not receivable
Section 46 Penalties
Section 46A Chairman, director, etc., to be public servants for the purposes of Chapter IX of
the Indian Penal Code
Section 47 Cognizance of offences
Section 47A Power of Reserve Bank to impose penalty
Section 48 Application of fines
Section 50 Certain claims for compensation barred
Section 52 Power of Central Government to make rules

Section 53 Power to exempt in certain cases
State Bank of India and its Subsidiaries: State Bank of India and its subsidiaries are governed by –
(a) State Bank of India Act, 1955/State Bank of India (Subsidiary Banks) Act, 1959, as the case may
be; and
The provisions of the Banking Regulation Act, 1949, applicable to State Bank of India and its
subsidiaries are specified in section 51 of the said Act and are the same as those applicable to
nationalised banks (described in paragraph 2.21).
Banking Companies: Section 2 of the Banking Regulation Act, 1949, provides that the provisions of
the Act shall be in addition to, and not, save as expressly provided thereunder, in derogation of the
Companies Act, 1956, and any other law for the time being in force. Thus, banking companies attract
the provisions of both the Banking Regulation Act, 1949, as well as the Companies Act, 1956. In case
the provisions of these enactments are at variance, the provisions of the Banking Regulation Act, 1949,
shall prevail.
Regional Rural Banks: Regional rural banks are governed by –
(a) Regional Rural Banks Act, 1976; and
The provisions of the Banking Regulation Act, 1949, applicable to regional rural banks are specified in
section 51 of the said Act and are the same as those applicable to nationalised banks (described in
paragraph 2.21).
Co-operative Banks: Co-operative banks are governed by –
(a) the Co-operative Societies Act, 1912, or the Co-operative Societies Act of the state concerned, as
the case may be; and
(b) Part V of the Banking Regulation Act, 1949.
Part V of the Banking Regulation Act, 1949, modifies certain provisions of the Act in their application to
co-operative banks and omits certain others. The sections which have been significantly modified in
their application to co-operative banks are sections 2, 5-A, 8, 9, 11, 18, 19, 20, 22, 23, 24, 27, 29, 31,
35, 35A, 36, 36A, 49A, 54 and 55. Besides, the First Schedule to the Act is not applicable to co-
operative banks while the Third and the Fourth Schedules to the Act have been replaced by a schedule
applicable only to co-operative banks.
C. Scheduled Banks
These are the banks included in the Second Schedule to the Reserve Bank of India Act, 1934. The
Reserve Bank includes a bank in this Schedule if it fulfils certain conditions.
The Reserve Bank gives certain facilities to scheduled banks including the following:
(a) Purchase, sale and rediscounting of certain bills of exchange (including foreign bills of exchange)
or promissory notes.
(b) Purchase and sale of foreign exchange.
(c) Making of loans and advances to scheduled banks.
(d) Maintenance of the accounts of scheduled banks in its banking department and issue department.
(e) Remittance of money between different branches of scheduled banks through the offices,
branches or agencies of the Reserve Bank free of charge or at nominal charges.
D. Returns to be Submitted to the Reserve Bank of India
The Banking Regulation Act, 1949, requires banking companies, nationalised banks, State Bank of
India, its subsidiaries, and regional rural banks to furnish the following returns to the Reserve Bank of
India:
(a) Monthly return of assets maintained in India in accordance with section 24 and demand and time
liabilities in India at the close of business on each alternate Friday during the month. [Section 24]
(b) Quarterly return of assets and liabilities in India at the close of business on the last Friday of
every quarter. [Section 25]
(c) Annual return of unclaimed accounts which have not been operated for 10 years. [Section 26]
(d) Monthly return of assets and liabilities in India at the close of business on the last Friday of every
month. [Section 27]
The above types of banks have also to furnish such other statements or information as may be required
by the RBI under section 27 of the Act. In exercise of its powers under the aforesaid section, the RBI
requires a large number of returns to be furnished to it. Some of the important returns required to be
furnished to the RBI are as enumerated below, with their periodicity indicated in parentheses.
(a) Report on Non-performing Advances (annual)
(b) Statement showing the position of reconciliation of investment account (annual)
(c) Statement on compromises and settlements involving write off (half-yearly)
(d) Statement on bad debts written off (annual)
(e) Details of Doubtful or Loss Assets and also Suit Filed accounts with outstandings aggregating Rs.
1.00 crore and above (half-yearly)
(f) Details of remittance of profits / surplus retained in India (annual)
(g) Particulars of provisions held on problem credits of overseas branches (half-yearly)
(h) Inter-branch reconciliation (quarterly)
(i) Reconciliation of outstanding inter-branch accounts (annual)
(j) Reconciliation of clearing differences (annual).
(k) Position of balancing of books (quarterly)
(l) Returns relating to frauds, robbery, etc. including fraud involving Rs. 1.00 crore and above
(quarterly).
(m) Return of Capital Adequacy (quarterly)

(n) Return on Asset Quality (quarterly)
Annexure II
Notes and Instructions for Compilation
(The Reserve Bank of India has issued a number of instructions for compilation of the balance sheet
and profit and loss account in the prescribed formats. These are given below.)
General Instructions
1. The formats of Balance Sheet and Profit and Loss Account cover all items likely to appear in
these statements. In case a bank does not have any particular item to report, it may be omitted
from the formats.
2. Corresponding comparative figures for the previous year are to be disclosed as indicated in the
formats. The words ‘current year’ and ‘previous year’ used in the formats are only to indicate the
order of presentation and may not appear in the balance sheet.
3. Figures should be rounded off to the nearest thousand rupees. Thus, a sum of Rs. 19,75,821.20
will appear in the balance sheet as Rs 19,76.
4. Unless otherwise indicated, the term ‘bank/s’ in these statements will include banking companies,
nationalised banks, State Bank of India, associate banks and all other institutions including co-
operatives carrying on the business of banking, whether or not incorporated or operating in India.
5. The Hindi version of the balance sheet will be a part of the annual report.
Balance Sheet
Coverage Notes and instructions for compilation
(3) (4)
Scheduled I – Capital
Nationalised Banks: The capital owned by Central Government as on the date
Capital (Fully owned by Central of the Balance Sheet including contribution from
Government, if any, for participating in World Bank Projects
Government)
should be shown.
Banking companies incorporated
(i) The amount brought in by banks by way of start-up
outside India
capital as prescribed by RBI should be shown under
this head.
(ii) The amount of deposits kept with RBI, under sub-
section (2) of section 11 of the Banking Regulation
Act, 1949 should also be shown.
Other Banks (Indian):
Authorised Capital Authorised, Issued, Subscribed, Called-up capital should
(.... Shares of Rs ... each) be given separately. Calls-in-arrears will be deducted from
Called-up capital while the paid-up value of forfeited shares
Issued Capital should be added thus arriving at the paid-up capital. Where
necessary items which can be combined should be shown
(.... Shares of Rs ... each)
under one head, for instance ‘Issued and Subscribed
Subscribed Capital Capital’.
Called-up Capital
Less: Calls unpaid
Add: Forfeited shares
Paid up Capital Notes – General
The changes in the above items, if any, during the year,
say, fresh contribution made by Government, fresh issue of
capital, capitalisation of reserves, etc. may be explained in
the notes.
Schedule 2 – Reserves and Surplus
I. Statutory Reserves Reserves created in terms of section 17 or any other
section of Banking Regulation Act must be separately
disclosed.
II. Capital Reserves The expression ‘Capital Reserves’ shall not include any
amount regarded as free for distribution through the profit
and loss account. Surplus on revaluation should be treated
as Capital Reserves. Such reserves will have to be
reflected on the face of the Balance Sheet as Revaluation
Reserves.
Surplus on translation of financial statements of foreign
branches (which includes fixed assets also) is not a
revaluation reserve.
III. Share Premium Premium on issue of share capital may be shown
separately under this head.
IV. Revenue and Other Reserves The expression ‘Revenue Reserve’ shall mean any reserve
other than capital reserve. This item will include all
reserves other than those separately classified. The
expression ‘reserve’ shall not include any amount written
off or retained by way of providing for depreciation,
renewals or diminution in value of assets or retained by
way of providing for any known liability.
Excess provision towards depreciation on investments
should be transferred to ‘Investment Fluctuations Reserve
Account’ which should be shown as a separate item under
the head ‘Revenue and Other Reserves’. The amount held

in ‘Investment Fluctuation Reserve Account’ could be
utilised to meet the depreciation requirement on investment
in securities in future. Extra provision needed in the event
of a depreciation in the value of the investments should be
debited to the Profit and Loss Account and if required, an
equivalent amount may be transferred from the ‘Investment
Fluctuation Reserve Account’ to the Profit and Loss
Account as a ‘below the line’ item after determining the
profit for the year.
V. Balance of Profit Includes balance of profit after appropriations. In case of
loss, the balance may be shown as a deduction.
Notes – General
Movements in various categories of reserves should be
shown as indicated in the schedule.
Schedule 3 – Deposits
A. I. Demand Deposits
(i) from banks Includes all bank deposits repayable on demand.
(ii) from others Includes all demand deposits of the non-bank sectors.
Credit balances in overdrafts, cash credit accounts,
deposits payable at call, overdue deposits, inoperative
current accounts, matured time deposits and cash
certificates, certificates of deposits, etc., are to be included
under this category.
II. Savings Bank Deposits Includes all savings bank deposits (including inoperative
savings bank accounts).
III. Term Deposits
(i) from banks Includes all types of bank deposits repayable after a
(ii) from others specified term.
Includes all types of deposits of the non-bank sector
repayable after a specified term. Fixed deposits, cumulative
and recurring deposits, cash certificates, certificates of
deposits, annuity deposits, deposits mobilised under
various schemes, ordinary staff deposits, foreign currency
non-resident deposits accounts, etc. are to be included
under this category.
B. (i) Deposits of branches in The total of these two items will agree with the total
India deposits.
(ii) Deposits of branches
outside India
Notes – General
(a) Interest payable on deposits which is accrued but not
due should not be included but shown under Other
Liabilities.
(b) Matured time deposits and cash certificates, etc.
should be treated as demand deposits.
(c) Deposits under special schemes should be included
under term deposits if they are not payable on
demand. When such deposits have matured for
payment they should be shown under demand
deposits.
(d) Deposits from banks will include deposits from the
banking system in India, co-operative banks, foreign
banks which may or may not have a presence in
India.
Schedule 4 – Borrowings
I. Borrowings in India
(i) Reserve Bank of India Includes borrowings/refinance obtained from Reserve Bank
of India.
(ii) Other banks Includes borrowings/refinance obtained from commercial
banks (including co-operative banks).
(iii) Other institutions and Includes borrowings/refinance obtained from Industrial
agencies Development Bank of India, Export-Import Bank of India,
National Bank for Agriculture and Rural Development and
other institutions, agencies (including liability against
participation certificates, if any).
II. Borrowings outside India Includes borrowings of Indian branches abroad as well as
borrowings of foreign branches.
Secured borrowings included above This item will be shown separately. Includes secured
borrowings/refinance in India and outside India.
Notes-General
(i) The total of I & II will agree with the total borrowings
shown in the balance sheet.
(ii) Inter-office transactions should not shown as
borrowings.
(iii) Funds raised by foreign branches by way of

certificates of deposits, notes, bonds, etc., should be
classified depending upon documentation, as
‘deposits’, ‘borrowings’, etc.
(iv) Refinance obtained by banks from Reserve Bank of
India and various institutions are being brought under
the head ‘Borrowings’. Hence, advances will be
shown at the gross amount on the assets side.
Schedule 5 – Other Liabilities and
Provisions
I. Bills payable Includes drafts, telegraphic transfers, traveller's cheques,
mail transfers payable, pay slips, banker's cheques and
other miscellaneous items.
II. Inter-Office adjustments (Net) The inter-office adjustments balance, if in credit, should be
shown under this head. Only net position of inter-office
accounts, inland as well as foreign, should be shown here.
In working out the net position, credit entries outstanding
for more than five years in inter-branch accounts should be
segregated and transferred to a separate Blocked Account.
While arriving at the net amount of inter-branch
transactions for inclusion under Schedule 5 or 11 as the
case may be, the aggregate amount of Blocked Account
should be excluded and only the amount representing the
remaining credit entries should be netted against debit
entries.
III. Interest accrued Includes interest accrued but not due on deposits and
borrowings.
IV. Others (including provisions) (i) Includes net provision for income tax and other taxes
like interest tax (less advance payment, tax deducted
at source, etc.); surplus in aggregate in provisions for
bad debts provision account; surplus in aggregate in
provisions for depreciation in securities; contingency
funds which are not disclosed as reserves but are
actually in the nature of reserves; proposed
dividend/transfer to Government; other liabilities
which are not disclosed under any of the major heads
such as unclaimed dividend, provisions and funds
kept for specific purposes; unexpired discount,
outstanding charges like rent, conveyance, etc.
Certain types of deposits like staff security deposits,
margin deposits, etc. Certain types of deposits like
staff security deposits, margin deposits, etc. where
the repayment is not free, should also be included

under this head.
(ii) Provisions toward standard assets should be shown
separately as ‘Contingent Provisions against
Standard Assets’ under this head.
(iii) Amount of subordinated debt raised as Tier II capital
should be shown in Schedule 5 as well as by way of
explanatory notes / remarks in the balance sheet.
The Blocked Account arising from transfer of credit
entries in inter-branch accounts outstanding for more
than five years should be shown under this head.
Any adjustment from the Blocked Account should be
permitted only with the authorisation of two officials
one of whom should be from outside the branch
concerned, preferably from the Controlling / Head
Office if the amount exceeds Rupees one lakh.
Notes – General
(i) For arriving at the net balance of inter-office
adjustments all connected inter-office accounts
should be aggregated and the net balance only will be
shown, representing mostly items in transit and
unadjusted items.
(ii) The interest accruing on all deposits, whether the
payment is due or not, should be treated as a liability.
(iii) It is proposed to show only pure deposits under the
head ‘deposits’ and hence all surplus provisions for
bad and doubtful debts, contingency funds, secret
reserves, etc., which are not netted off against the
relative assets, should be brought under the head
‘Others (including provisions)’.
(iv) The amount of subordinated debt raised against Tier
II capital be indicated.
Schedule 6 – Cash and Balances
with Reserve Bank of India
I. Cash in hand (including foreign Includes cash in hand including foreign currency notes and
currency notes) also of foreign branches in the case of banks having such
II. Balances with Reserve Bank of branches.
India
(i) in Current Account
(ii) in Other Accounts

Schedule 7 – Balances with Banks
and Money at Call and Short Notices
I. In India
(i) Balances with banks Includes all balances with banks in India (including co-
operative banks). Balances in current accounts and deposit
(a) in Current accounts
accounts should be shown separately.
(b) in Other Deposit accounts
(ii) Money at call and short Includes deposits repayable within 15 days or less than 15
notice days’ notice lent in the inter-bank call money market.
(a) with banks
(b) with other institutions
II. Outside India
(i) Current accounts Includes balances held by foreign branches and balances
held by Indian branches of the banks outside India.
(ii) Deposit accounts Balances held with foreign branches by other branches of
the bank should not be shown under this head but should
be included in inter-branch accounts. The amounts held in
‘current accounts’ and ‘deposit accounts’ should be shown
separately.
(iii) Money at call and short Includes deposits usually classified in foreign countries as
notice money at call and short notice.
Schedule 8 – Investments
I. Investments in India
(i) Government securities Includes Central and State Government securities and
Government treasury bills. These securities should be
shown at the book value. However, the difference between
the book value and market value should be given in the
notes to the balance sheet.
(ii) Other approved securities Securities other than Government Securities, which
according to the Banking Regulation Act, 1949, are treated
as approved securities, should be included here.
(iii) Shares Investments in shares of companies and corporations not
included in item (ii) should be included here.
(iv) Debentures and Bonds Investments in debentures and bonds of companies and
corporations not included in item (ii) should be included
here.
(v) Investments in subsidiaries/ Investments in subsidiaries/joint ventures (including RRBs)
joint ventures should be included here.

(vi) Others Includes residual investments, if any, like gold, commercial
paper and other instruments in the nature of
shares/debentures/bonds.
II. Investments outside India
(i) Government securities All foreign Government securities including securities
(including local authorities) issued by local authorities may be classified under this
head.
(ii) Subsidiary and/or joint All investments made in the share capital of subsidiaries
ventures abroad floated outside India and/or joint ventures abroad should be
classified under this head.
(iii) Others All other investments outside India may be shown under
this head.
Notes – General
Indicate the gross value of investments in India and outside
India, the aggregate of provisions for depreciation
separately on investments in India and outside India, and
the net value of investments in India and outside India, the
total of which will be carried to balance sheet. The gross
value of investments and provisions need not, however, be
shown against each of the categories specified in the
Schedule. The break-up of net value of investments in
India and outside India (gross value of investments less
provision) under each of the specified category need only
be shown.
Schedule 9 - Advances
A. (i) Bills purchased and In classification under Section ‘A’, all outstandings – in
discounted India as well as outside – less provisions made will be
(ii) Cash credits, overdrafts and classified under three heads as indicated and both secured
and unsecured advances will be included under these
loans repayable on demand
heads.
Outstanding in credit card operations should be included as
part of “Advances” [under item A(ii) – Cash Credits,
Overdrafts and Loans Repayable on Demand].
All interest-bearing advances given by bank to its own staff
should also be included under 'Advances'
(iii) Term loans Including overdue instalments.
B. (i) Secured by tangible assets* All advances or part of advances which are secured by
tangible assets may be shown here. The item will include
(*includes advances against advances in India and outside India.

book debts)
(ii) Covered by Bank/ Advances in India and outside India to the extent they are
Government Guarantees covered by guarantees of Indian and foreign governments
and Indian and foreign banks and DICGC & ECGC are to
be included.
(iii) Unsecured All advances not classified under (i) & (ii) will be included
here.
Total of ‘A’ should tally with total of ‘B’.
C. I. Advances in India Advances should be broadly classified into ‘Advances in
India’ and ‘Advances outside India’. Advances in India will
(i) Priority sectors
be further classified on the sectoral basis as indicated.
(ii) Public sector Advances to sectors which for the time being are classified
(iii) Banks as priority sectors according to the instructions of the
Reserve Bank are to be classified under the head ‘Priority
(iv) Others
Sector’. Such Advances should be excluded from item (ii)
C. II Advances outside India i.e., advances to public sector. Advances to Central and
(i) Due from banks State Governments and other Government undertakings
including Government companies and corporations which
(ii) Due from others are, according to the statutes, to be treated as public sector
(a) Bills purchased and companies are to be included in the category ‘Public
discounted Sector’. All advances to the banking sector including co-
operative banks will come under the head ‘Banks’. All the
(b) Syndicated loans
remaining advances will be included under the head
(c) Others ‘Others’ and typically this category will include non-priority
advances to the private, joint and co-operative sectors.
Notes – General
(i) The gross amount of advances including refinance
but excluding rediscounts and provisions made to the
satisfaction of auditors should be shown as advances.
(ii) Term loans will be loans not repayable on demand.
(iii) Consortium advances would be shown net of share
from other participating banks/institutions.
Schedule 10 – Fixed Assets
I. Premises
(i) At cost as on 31st March of Premises wholly or partly owned by the banking company
the preceding year for the purpose of business including residential premises
should be shown against ‘Premises’. In the case of
(ii) Additions during the year
premises and other fixed assets, the previous balance,
additions thereto and deductions therefrom during the year
(iii) Deductions during the year as also the total depreciation written-off should be shown.
Where sums have been written off on reduction of capital
(iv) Depreciation to date
or revaluation of assets, every balance sheet after the first
balance sheet subsequent to the reduction or revaluation
should show the revised figures for a period of five years
with the date and amount of revision made.
II. Other Fixed Assets Motor Vehicles and all other fixed assets other than
(including furniture and fixtures) premises but including furniture and fixtures should be
(i) At cost as on 31st March of shown under this head.
the preceding year
(ii) Additions during the year
(iii) Deductions during the year
(iv) Depreciation to date
Schedule 11 - Other Assets
I. Inter-Office adjustments (net) The Inter-office adjustments balance, if in debit, should be
shown under this head. Only net position of inter-office
accounts, inland as well as foreign, should be shown here.
For arriving at the net balances of inter-office adjustment
accounts, all connected inter-office accounts should be
aggregated and the net balance, if in debit, only should be
shown representing mostly items in transit and unadjusted
items.
In working out the net position, credit entries outstanding
for more than five years in inter-branch accounts should be
segregated and transferred to a separate Blocked Account.
While arriving at the net amount of inter-branch
transactions for inclusion under Schedule 5 or 11, as the
case may be, the aggregate amount of Blocked Account
should be excluded and only the amount representing the
remaining credit entries should be netted against debit
entries.
II. Interest accrued Interest accrued but not due on investments and advances
and interest due but not collected on investments will be
the main components of this item. As banks normally debit
the borrowers’ account with interest due on the balance
sheet date, usually there may not be any amount of interest
due on advances. Only such interest as can be realised in
the ordinary course should be shown under this head.
III. Tax paid in advance/tax deducted The amount of tax deducted at source on securities,
at source advance tax paid, etc., to the extent that these items are
not set off against relative tax provisions should be shown
against this item.
IV. Stationery and stamps Only exceptional items of expenditure on stationery like
bulk purchase of security paper, loose leaf or other ledgers,
etc., which are shown as quasi-asset to be written off over
a period of time should be shown here. The value should
be on a realistic basis and cost escalation should not be
taken into account, as these items are for internal use.
V. Non-banking assets acquired in Immovable properties/tangible assets acquired in
satisfaction of claims satisfaction of claims are to be shown under this head.
VI. Others This will include items like claims which have not been met,
for instance, clearing items, debit items representing
additions to assets or reduction in liabilities which have not
been adjusted for technical reasons, want of particulars,
etc., non-interest bearing loans and advances given to staff
by a bank, etc. Items which are in the nature of expenses
which are pending adjustments should be provided for and
the provision netted against this item so that only realisable
value is shown under this head. Accrued income other than
interest may also be included here.
Outstandings in credit card operations should be shown as
part of ‘advances’ (Schedule 9) instead of clubbing these
under ‘other assets’
Schedule 12 – Contingent Liabilities
I. Claims against the bank not
acknowledged as debts
II. Liability for partly paid Liability on partly paid shares, debentures, etc. will be
investments included in this head.
III. Liability on account of outstanding Outstanding forward exchange contracts may be included
forward exchange contracts here.
IV. Guarantees given on behalf of Guarantees given for constituents in India and outside India
constituents may be shown separately.
(i) In India
(ii) Outside India
V. Acceptances, endorsements and This item will include letters of credit and bills accepted by
other obligations the bank on behalf of its customers.
VI. Other items for which the bank is Arrears of cumulative dividends, bills rediscounted,
contingently liable commitments under under-writing contracts, estimated
amounts of contracts remaining to be executed on capital

account and not provided for etc. are to be included here.
Bills for Collection Bills and other items in the course of collection and not
adjusted will be shown against this item in the summary
version only. No separate schedule is proposed.
Profit and Loss Account
Schedule 13 – Interest earned
I. Interest/discount on advances/ Includes interest and discount on all types of loans and
bills advances like cash credit, demand loans, overdrafts, export
loans, term loans, domestic and foreign bills purchased and
discounted (including those rediscounted), overdue interest
and also interest subsidy, if any, relating to such
advances/bills.
II. Income on investments Includes all income derived from the investment portfolio by
way of interest and dividend.
III. Interest on balances with Reserve Includes interest on balances with Reserve Bank and other
Bank of India and other inter-bank banks, call loans, money market placements, etc.
funds
IV. Others Includes any other interest/discount income not included in
the above heads.
Schedule 14 – Other Income
I. Commission, exchange and Includes all remuneration on services such as commission
brokerage on collections, commission/exchange on remittances and
transfers, commission on letters of credit and guarantees,
commission on Government business, commission on other
permitted agency business including consultancy and other
services, brokerage, etc. on securities. It does not include
foreign exchange income.
II. Profit on sale of investments Includes profit/loss on sale of securities, furniture, land and
buildings, motor vehicles, gold, silver, etc. Only the net
Less: Loss on sale of investments
position should be shown. If the net position is a loss, the
III. Profit on revaluation of amount should be shown as a deduction. The net profit/loss
investments on revaluation of assets may also be shown under this
Less: Loss on revaluation of item.
investments
IV. Profit on sale of land, buildings
and other assets
Less: Loss on sale of land
buildings and other assets
V. Profit on exchange transactions Includes profit/loss on dealing in foreign exchange, all

income earned by way of foreign exchange, commission
Less: Loss on exchange
and charges on foreign exchange transactions excluding
transactions
interest which will be shown under interest. Only the net
position should be shown. If the net position is a loss, it is
to be shown as a deduction.
VI. Income earned by way of
dividends etc. from subsidiaries,
companies and/or joint ventures
abroad/in India
VII. Miscellaneous Income Includes recoveries from constituents for godown rents,
income from bank’s properties, security charges,
insurance, etc. and any other miscellaneous income. In
case any item under this head exceeds one percentage of
the total income, particulars may be given in the notes.
Schedule 15 – Interest Expended
I. Interest on deposits Includes interest paid on all types of deposits including
deposits from banks and other institutions.
II. Interest on Reserve Bank of Includes discount/interest on all borrowings and refinance
India/inter-bank borrowings from Reserve Rank of India and other banks.
III. Others Includes discount/interest on all borrowings/refinance from
financial institutions. All other payments like interest on
participation certificates, penal interest paid, etc., may also
be included here.
Schedule 16 – Operating Expenses
I. Payments to and provisions for Includes staff salaries/wages, allowances, bonus, other
employees staff benefits like provident fund, pension, gratuity, liveries
to staff, leave fare concessions, staff welfare, medical
allowance to staff, etc.
II. Rent, taxes and lighting Includes rent paid by the banks on buildings and other
municipal and other taxes paid (excluding income tax and
interest tax) electricity and other similar charges and levies.
House rent allowance and other similar payments to staff
should appear under the head ‘Payments to and provisions
for employees’.
III. Printing and stationery Includes books and forms and stationery used by the bank
and other printing charges which are not incurred by way of
publicity expenditure.
IV. Advertisement and publicity Includes expenditure incurred by the bank for
advertisement and publicity purposes including printing
charges of publicity matter.
V. Depreciation on bank’s property Includes depreciation on bank’s own property, motor cars
and other vehicles, furniture, electric fittings, vaults, lifts,
leasehold properties, non-banking assets, etc.
VI. Directors’ fees, allowances and Includes sitting fees and all other items of expenditure
expenses incurred on behalf of directors. The daily allowance, hotel
charges, conveyance charges, etc. which though in the
nature of reimbursement of expenses incurred may be
included under this head. Similar expenses of local
committee members may also be included under this head.
VII Auditors’ fees and expenses Includes the fees paid to the statutory auditors and branch
(including branch auditors’ fees auditors for professional services rendered and all
and expenses) expenses for performing their duties, even though they may
be in the nature of reimbursement of expenses. If external
auditors have been appointed by banks themselves for
internal inspections and audits and other services, the
expenses incurred in that context including fees may not be
included under this head but shown under ‘other
expenditure’.
VIII. Law charges All legal expenses and reimbursement of expenses
incurred in connection with legal services are to be
included here.
IX. Postage, telegrams, telephones, Includes all postal charges like stamps, telegram,
etc. telephones, teleprinter, etc.
X. Repairs and maintenance Includes repairs to bank’s property, their maintenance
charges, etc.
XI. Insurance Includes insurance charges on bank’s property, insurance
premium paid to Deposit Insurance & Credit Guarantee
Corporation etc., to the extent they are not recovered from
the concerned parties.
XII. Other expenditure All expenses other than those not included in any of the
other heads, like, licence fees, donations, subscriptions to
papers, periodicals, entertainment expenses, travel
expenses, etc. may be included under this head. In case
any particular item under this head exceeds one
percentage of the total income, particulars may be given in
the notes.
Includes all provisions made for bad and doubtful debts,

provisions for taxation, provisions for diminution in the
value of investments, transfers to contingencies and other
similar items.
While preparing the Balance Sheet and Profit and Loss
Account accumulated losses should be brought forward
under Item III of Form ‘B’ before appropriation of the
balance of profit made.
Provisions and contingencies Includes all provisions made for bad and doubtful debts,
provisions for taxation, provisions for diminution in the
value of investments, transfers to contingencies and other
similar items.
Treatment of accumulated losses While preparing the Balance Sheet and Profit and Loss
Account accumulated losses should be brought forward
under Item III of Form ‘B’ before appropriation of the
balance profit made.
Notes on Accounts
In ‘Notes on Accounts’, the following
disclosures should be made:
Capital adequacy ratio The sum of Tier I and Tier II capital should be taken as the
numerator while the denominator should be arrived at by
converting the minimum capital charge for open exchange
position stipulated by the Exchange Control Department of
the RBI into ‘notional risk assets’ by multiplying it by 12.5
(the reciprocal of the minimum capital to risk-weighted
assets ratio of 8 %) and then adding the resulting figure to
the sum of risk weighted assets, compiled for credit risk
purposes.
Capital adequacy ratio – Tier I Capital Tier I capital should be taken as the numerator while the
denominator should be arrived at by converting the
minimum capital charge for open exchange position
stipulated by the Exchange Control Department of the RBI
into ‘notional risk assets’ by multiplying it by 25 (the
reciprocal of the minimum capital to risk-weighted assets
ratio of 4 %) and then adding the resulting figure to the
sum of risk weighted assets, compiled for credit risk
purposes.
Capital adequacy ratio – Tier II capital
Amount of subordinated debt raised as This item should be shown by way of explanatory
Tier II capital notes/remarks in the balance sheet as well as in Schedule
5 relating to ‘Other Liabilities and Provisions’

Percentage of shareholding of the
Government of India in the nationalised
banks
Gross value of investments in India and
outside India, the aggregate of
provisions for depreciation separately
on investments in India and outside
India and the net value of investments in
India and outside India
Percentage of net NPAs to net Net NPAs mean gross NPAs minus (balance in Interest
advances Suspense Account plus DICGC/ECGC claims received and
held pending adjustment plus part payment received and
kept in Suspense Account plus provisions held for loan
losses).
Movements in NPAs The disclosures should include the opening balances of
Gross NPAs (after deducting provisions held, interest
suspense account, DICGC claims received and part
payments received and kept in suspense account) at the
beginning of the year, reductions/additions to the NPAs
during the year and the balances at the end of the year.
The amount of provisions made towards These provisions along with other provisions and
NPA, towards depreciation in the value contingencies should tally with the aggregate of the
of investments and the provisions amount held under ‘Provisions and contingencies’ in the
towards income-tax during the year profit and loss account.
Maturity pattern of investment securities Banks may follow the maturity buckets prescribed in the
guidelines on Asset-Liability Management System
(forwarded vide Circular DBOD.BP.BC.8/21.04.098/99
dated February 10, 1999) for disclosure of maturity pattern.
Maturity pattern of loans and advances Banks may follow the maturity buckets prescribed in the
Foreign currency assets and liabilities In respect of this item, the maturity profile of the bank’s
foreign currency assets and liabilities should be given.
Maturity pattern of deposits Banks may follow the maturity buckets prescribed in the
Maturity pattern of borrowings Banks may follow the maturity buckets prescribed in the

Lending to sensitive sectors Banks should disclose lending to sectors which are
sensitive to asset price fluctuations. These should include
advances to sectors such as capital market, estate, etc.
and such other sectors to be defined as ‘sensitive’ by the
RBI from time to time.
Interest income as a percentage to Working funds mean total assets as on the date of balance
working funds sheet (excluding accumulated losses, if any).
Non-interest income as a percentage to
working funds
Operating profit as a percentage to Operating profit means total income minus (interest
working funds expenses plus operating expenses).
Return on assets Return on assets means net profit divided by average of
total assets as at the beginning and end of the year.
Business (deposits plus advances) per This means fortnightly average of deposits (excluding
employee inter-bank deposits) and advances divided by number of
employees as on the date of balance sheet.
Profit per employee
Annexure III
Minimum Capital Adequacy Norm: All Indian scheduled commercial banks (excluding regional rural
banks) as well as foreign banks operating in India have to maintain the capital adequacy ratio at a
minimum of 9 per cent.
Computation of Capital Adequacy Ratio: The capital adequacy ratio is worked out as below:
Capital funds
× 100
Risk weighted assets and off balance sheet items
Constituents of Capital Funds: For purpose of computing the capital adequacy ratio, capital funds are
classified into two categories: Tier I Capital and Tier II Capital.
Tier I capital (also known as core capital) provides the most permanent and readily available support to
a bank against unexpected losses. Tier I capital comprises:
The Aggregate of :
♦ paid-up capital;
♦ statutory reserves; and
♦ other disclosed free reserves including share premium and capital reserves arising out of surplus
on sale of assets,
As Reduced by:
♦ equity investments in subsidiaries;
♦ intangible assets; and
♦ current and brought forward losses.
Tier II capital comprises elements that are less permanent in nature or are less readily available than
those comprising Tier I capital. The elements constituting Tier II capital are as follows:
(a) Undisclosed Reserves: Such reserves can be included in Tier II capital if they represent
accumulations of post-tax profits, are not encumbered by any known liability, and are not routinely used
for absorbing normal loan or operating losses.
(b) Cumulative Perpetual Preference Shares: To qualify for inclusion in Tier II capital, cumulative
perpetual preference shares should be fully paid-up and should not contain clauses which permit
redemption by the holder.
(c) Revaluation Reserves: The extent to which revaluation reserves (i.e. reserves arising from
revaluation of assets like bank premises and marketable securities) can be relied upon as a cushion for
unexpected losses depends largely on the reliability of estimates of market values of relevant assets,
deterioration in values under difficult market conditions or in a forced sale, possibility of actual
liquidation of assets at those values, tax implications, etc. Accordingly, while including revaluation
reserves in Tier II capital, they are to be discounted by 55 per cent. It is required that “such reserves
will have to be reflected on the face of the balance sheet as revaluation reserves.”
(d) General Provisions and Loss Reserves: Banks often create excessive provisions to meet future
contingencies. Accordingly, general provisions and loss reserves are eligible to be included in Tier II
capital provided –
(i) they are not attributable to actual diminution in value or identifiable potential loss in any specific
asset, and
(ii) sufficient provision has been made to meet all known losses and foreseeable potential losses.
General provisions and loss reserves (including general provisions on standard assets) are allowed to
be included in Tier II capital only upto a maximum of 1.25 per cent of risk-adjusted assets.
(e) Hybrid debt capital instruments: These are instruments that contain certain characteristics of
equity and certain characteristics of debt (e.g., convertible bonds). Where these instruments have
close similarities to equity, in particular when they are able to absorb losses on an on-going basis
without triggering liquidation, they may be included in Tier II capital.
(f) Subordinated debt: This category comprises those debt instruments which are –
(i) fully paid-up;
(ii) unsecured;
(iii) subordinated to the claims of other creditors;
(iv) free of restrictive clauses; and
(v) not redeemable at the initiative of the holder or without the consent of the bank’s
supervisory authorities.
Subordinated debt instruments with an initial maturity of less than 5 years or with a remaining maturity
of one year or less are not eligible to be included in Tier II capital. Also, for purposes of inclusion in
Tier I capital, subordinated debt instruments should be subjected to progressive discount as they
approach maturity.
The maximum extent to which subordinated debt instruments are eligible to be included in Tier II capital
is 50 per cent of Tier I capital.
Ratio of Tier II capital to Tier I capital: The quantum of Tier II capital is limited to a maximum of
100% of Tier I capital. This seeks to ensure that the capital funds of a bank predominantly comprise of
core capital rather than items of a less permanent nature. It may be clarified that the Tier II capital of a
bank can exceed its Tier I capital; however, in such a case, the excess will be ignored for the purpose
of computing the capital adequacy ratio.
Foreign Banks: As in the case of Indian banks, capital funds of foreign banks operating in India would
also comprise of Tier I capital and Tier II capital.
Tier I Capital: This would comprise the following elements.
(i) Interest free funds from Head Office kept in a separate account in Indian books specifically for the
purpose of meeting the capital adequacy norms.
(ii) Statutory reserves kept in Indian books.
(iii) Remittable surplus retained in Indian books which is not repatriable so long as the bank functions
in India.
(iv) Capital reserve representing surplus arising out of sale of assets in India held in a separate
account and which is not eligible for repatriation so long as the bank functions in India.
(v) Interest free funds remitted from abroad for the purpose of acquisition of property and held in a
separate account in Indian books.
(vi) The net credit balance, if any, in the inter-office account with Head Office/overseas branches will
not be reckoned as capital funds. However, any debit balance in Head Office account will have to
be set off against the capital.
Tier II capital: The elements of Tier II capital of foreign banks are similar to those of Indian banks.
Risk-adjusted Assets and Off-Balance Sheet Items: These constitute the denominator in the
computation of capital adequacy ratio.
Risk-adjusted Assets: Various assets of a bank are exposed to varying degrees of risks. For
example, cash balances are not susceptible to any risks whereas advances are susceptible to credit
risks. Even within advances, the risk of loss arising from failure of the customer to settle his obligation
fully is less in the case of loans guaranteed by DICGC/ECGC as compared to unguaranteed loans.
Similarly, different off-balance sheet items also involve varying degree of risk. For example, the risk
involved in guarantees given against counter-guarantees of other banks is much less compared to
other guarantees. Similarly, guarantees related to particular transactions are less risky compared to
general guarantees of indebtedness.
Recognising the above, the Reserve Bank has assigned different risk weights to different categories of
assets. For example, cash, balances with Reserve Bank of India and other banks and several other
assets have been assigned a risk weight of zero, loans and advances have generally been assigned a
risk weight of 100 per cent (except certain specified loans which have been assigned a risk weight of
zero or lesser than 100 per cent considering the nature of security/guarantee against them). The risk
adjusted value (with reference to which capital adequacy is to be assessed) of a category of assets is
determined by multiplying the nominal value of the category as per the balance sheet with the risk
weight assigned thereto. For example, if a bank has DICGC/ECGC guaranteed advances of Rs.100
crore outstanding on the balance sheet date, the risk-adjusted value of these advances would be Rs.50
crore (loans guaranteed by DICGC/ECGC have been assigned a risk weight of 50).
The following table shows the weights to be assigned to the value of different assets and off-balance
sheet items.
A. Funded risk assets Percentage
weight
♦ Cash in hand (including foreign currency notes) 0
♦ Balances with Reserve Bank 0
♦ Balances with banks (other than Reserve Bank of India) 20
♦ Money at call and short notice 0
♦ Investments (See Note 1(b)]
¾ Investments in government securities 2.5
¾ Investment in other approved securities guaranteed by the Central 2.5
Government or a State Government
¾ Investment in other securities where payment of interest and repayment of 2.5
principal are guaranteed by the Central Government or a State Government
¾ (However, in case of a default in interest/principal by the State Government
concerned, the risk weight in respect of investments issued by the defaulting
entities would be 100%.)
¾ Investment in government guaranteed securities of government undertakings 20
which do not form part of the approved market borrowing programme
¾ Investment in other approved securities where payment of interest and 20
repayment of principal are not guaranteed by Central/State Government
¾ Investment in bonds issued by other banks/ public financial institutions 20
¾ Investment in securities which are guaranteed by banks or public financial 20
institutions as to payment of interest and repayment of principal
¾ Claims on banks/public financial institutions (excluding bonds issued for Tier II 20
capital)
¾ Investment in subordinated debt issued in the form of Tier II capital bonds by 100
other banks/public financial institutions
¾ Other investments 100
♦ Loans and advances including bills purchased and discounted and other credit
facilities (see Note 1):
¾ Loans guaranteed by Central Government 0
¾ Loans guaranteed by State Governments 0
(However, in respect of cases where the
guarantee has been invoked and the State
Government concerned has remained in default,
a risk weight of 20% on such advances should
be assigned. Where State Governments
continue to be in default in respect of such
invoked guarantees after March 31, 2001, a risk
weight of 100% should be assigned.)
¾ Advances against term deposits, life policies,
NSCs, Indira Vikas Patras and Kisan Vikas
Patras (where adequate margin is available) 0
¾ Loans to staff which are fully covered by 20
superannuation benefits and mortgage of flat /
house.
(However, in respect of cases where loans to
staff are not covered by superannuation
benefits and mortgage of flat or house, a risk
weight of 100% should be assigned.)
¾ Loans guaranteed by DICGC/ECGC (limited to
the amount guaranteed) 50
¾ Loans granted to public sector undertakings of
Central Government/State Government 100
¾ Claims on other banks 20
¾ Take-out finance (see Note 2)
• Unconditional take-out finance where the
full credit risk is assumed by the taking 20
over institution
• Unconditional take-out finance where only
partial credit risk is assumed by the taking
over institution
Amount to be taken over
Amount not to be taken over 20

100
• Conditional take-out finance 100
¾ Others 100
♦ Premises, furniture and fixtures 100
♦ Other assets (except the following) 100
¾ Income-tax deducted at source (net of provision) 0
¾ Advance tax paid (net of provision) 0
¾ Interest due on government securities 0
¾ Accrued interest on CRR balances and claims on
RBI on account of government transactions (net of
claims of government/RBI on the bank on account
of such transactions) 0
Notes:
1. In the case of loans and advances, the following amounts are deducted:
(a) The amount of cash margin or deposit made against the advances as a collateral.
(b) The amount of provision for bad and doubtful debts. (Similarly, in the case of other assets,
e.g., investments, provisions for depreciation are deducted.)
(c) Credit balances in the current or other accounts of the borrower which are not earmarked
for specific purposes and are free from any lien.
2. In respect of take-out finance, the 20 per cent risk weight will apply only if the taking-over
institution is a bank or an all-India financial institution specified in this behalf by the Reserve
Bank. If the counter-party risk is guaranteed by the Government, the risk weight will be zero.
3. The all-India financial institutions whose bonds/ debentures would qualify for 20 per cent risk
weight for capital adequacy ratio are as the following.
(i) Industrial Credit and Investment Corporation of India Ltd.
(ii) Industrial Finance Corporation of India Ltd.
(iii) Industrial Development Bank of India
(iv) Industrial Investment Bank of India Ltd.
(v) Tourism Finance Corporation of India Ltd.
(vi) Risk Capital and Technology Finance Corporation Ltd.
(vii) Technology Development and Information Company of India Ltd
(viii) Power Finance Corporation Ltd.
(ix) National Housing Bank.
(x) Small Industries Development Bank of India.

(xi) Rural Electrification Corporation Ltd.
(xii) Indian Railways Finance Corporation Ltd.
(xiii) National Bank for Agriculture and Rural Development
(xiv) Export-Import Bank of India
(xv) Infrastructure Development Finance Co. Ltd.
(xvi) Housing and Urban Development Corporation Ltd.
(xvii) Indian Renewable Energy Development Agency Ltd.
4. Equity investments in subsidiaries, intangible assets and losses have to be deducted in
computing Tier I capital.
Off-Balance Sheet Items: In the case of off-balance sheet items, the credit risk exposure has to be
calculated by first multiplying the face amount of each of the off-balance sheet items (as reduced by
any cash margins/deposits) by the ‘credit conversion factor’ and then multiplying the resultant figure by
the ‘risk-weight’ attributable to the relevant counter-party as indicated in the table below. While the
credit conversion factors reflect the risk of loss inherent in the nature of the off-balance sheet item, the
risk weight attributable to the relevant counter-party recognises the degree of likelihood of the counter-
party making the default
Off-balance sheet items Credit Risk weight

conversion (per cent)
factor (per
cent)
♦ Direct credit substitutes, e.g., general guarantees of
indebtedness (including stand-by letters of credit serving as
financial guarantees for loans and securities) and acceptances
(including endorsements with the character of acceptances)
¾ Guaranteed by Central Government/ State Government 100 0
¾ Counter-guaranteed by other banks 100 20
¾ Others 100 100
♦ Certain transaction-related contingent items (e.g. performance
bonds, bid bonds, warranties and standby letters of credit
related to particular transactions)
¾ Guaranteed by Central Government/State Government 50 0
¾ Others 50 100
♦ Short-term self-liquidating trade-related contingencies (such as
documentary credits collateralised by the underlying shipments)

¾ Others 20 100
♦ Sale and repurchase agreements and asset sales with recourse,
where the credit risk remains with the bank
¾ Others 100 100
♦ Forward asset purchases, forward deposits and partly paid 100 100
shares and securities, which represent commitments with
certain drawdown
♦ Note issuance facilities and revolving under-writing facilities 50 100
♦ Unconditional take-out finance where the bank is the taking-over 100 100
institution
♦ Conditional take-out finance where the bank is the taking-over
institution
¾ Where the counter-party risk is guaranteed by the 50 0
Government
¾ Others 50 100
♦ Other commitments (e.g. formal stand-by facilities and credit
lines) with an original maturity of over one year
¾ Others 20 100
♦ Similar commitments with an original maturity up to one year, or 0 0
which can be unconditionally cancelled at any time
♦ Aggregate outstanding foreign exchange contracts of original
maturity –
¾ up to 14 calendar days 2 0
¾ more than 14 calendar days but less than one year 2 100
¾ for each additional year or part thereof 3 100
Foreign Exchange/Gold Open Positions: Besides meeting the prescribed minimum capital
requirement in relation to risk-weighted assets and off-balance-sheet items, banks are also required to
maintain Tier I capital to the extent of 5% of their foreign exchange open position limit and gold open
position limit. For this purpose, the open positions in respect of foreign exchange as well as gold carry
a risk weight of 100.
12
AUDIT OF GENERAL INSURANCE COMPANIES
Introduction
12.1 The general insurance business in India is governed by the Insurance Act, 1938 which
is based on the British Insurance Act. The Act was amended in 1969 for social control to
govern the general insurance business on healthy lines. However, it was felt that there still
existed some scope for improvement. In view of this, on May 13, 1971 the government
nationalised the general insurance industry by an ordinance which became the General
Insurance (Nationalisation) Act, 1972. At that time there were 63 domestic insurance
companies and 44 foreign, insurance companies operating in India. The managements of all
the 107 companies were taken over by the Government and accordingly the General
Insurance Corporation (GIC) was formed as a government company on November 22, 1972.
The GIC as the holding company is entrusted with the task of superintending, controlling and
carrying on the general insurance business in the country. Its subsidiaries in all the four
zones of the country viz., the Oriental Fire & General Insurance Company (now known as the
Oriental Insurance Co. Ltd.), the National Insurance Company Ltd., the New India Assurance
Company Ltd. and the United India Insurance Company write all classes of direct business of
general insurance except aviation which is written by the GIC.
The liberalisation of insurance sector has changed the nature of State involvement in
insurance from controlling operations to establishing and monitoring market functioning rules,
prudential regulations, focussing on solvency requirements and customer protection
measures. Accordingly, the Government of India, with a view to achieving effective regulation,
decided to establish a regulator of the insurance industry. The decision of the Government
was translated into reality by the enactment of Insurance Regulatory and Development
Authority (IRDA) Act in the year 1999. The Insurance Regulatory and Development Authority
Act, 1999 (Authority in brief) provided for the establishment of an Authority to protect the
interests of holders of insurance policies, to regulate, promote and ensure orderly growth of
the insurance industry and for matters connected therewith or incidental thereto. The
Authority has been assigned the duty to regulate, promote and ensure orderly growth of the
insurance business and re-insurance business.
Legal Framework
12.2 It is important for the auditor to familiarise himself with various statutes governing the
insurance industry. The auditor, while familiarising himself with various rules, regulations,
relevant notifications, should also look into the important aspects arising out of those which
might have an effect on determination of nature, timing and extent of audit procedures, while
performing his role as an auditor.
The primary legislations which deal with the insurance business in India are the Insurance Act,
1938 and the IRDA Act, 1999. Various aspects relating to audit are dealt with around the
framework of the following statutes and rules made thereunder:
(a) The Insurance Act, 1938 (including Insurance Rules, 1939);
(b) The Insurance Regulatory and Development Authority Act, 1999;
(c) The Insurance Regulatory and Development Authority Regulations framed under the
IRDA, Act, 1999;
(d) The Companies Act, 1956; and
(e) The General Insurance Business (Nationalisation) Act, 1972 (including Rules framed
thereunder).
Some relevant statutory provisions are discussed below:
Insurer - Section 2(9) of the Insurance Act, 1938 (hereinafter referred to as the ‘Act’) defines
the term ‘Insurer’ as:
“(a) any individual or unincorporated body of individuals or body corporate incorporated under
the law of any country other than India, carrying on insurance business not being a
person specified in sub-clause (c) of this clause which –
(i) carries on that business in India, or
(ii) has his or its principal place of business, employs a representative, or maintains a
place of business, in India;
(b) any body corporate not being a person specified in sub-clause (c) of this clause carrying
on the business of insurance, which is a body corporate incorporated under any law for
the time being in force in India; or stands to any such body corporate in the relation of a
subsidiary company within the meaning of the Indian Companies Act, 1913 , (7 of 1913),
as defined by sub-section (2) of Section 2 of that Act; and
(c) any person who in India has a standing contract with underwriters who are members of
the Society of Lloyd’s whereby such person is authorised within the terms of such
contract to issue protection notes, cover notes, or other documents granting insurance
cover to others on behalf of the underwriters,
but does not include a principal agent, chief agent, special agent, or an insurance agent
or a provident society”.
Audit of General Insurance Companies 12.3
Policy Holder - Section 2(2) of the Insurance Act, 1938 defines the term policy holder as a
person to whom the whole of the interest of the policy holder in the policy is assigned once
and for all, but does not include an assigner thereof whose interest in the policy is defensible
or is for the time being subject to any condition.
Prohibition of Insurance Business by Certain Persons - Prior to the Insurance Regulatory
and Development Authority Act, 1999 coming into force, as per Section 2C of the Insurance
Act, 1938, the insurance business could be transacted by a public company, a co-operative
society or any body corporate. All the three kinds of organisations were permitted to engage
in the business of any class of insurance. Third proviso to section 2C(1) of the Insurance Act,
1938 (inserted by the IRDA Act, 1999) prohibits persons other than an Indian insurance
company to begin to transact the insurance business after the commencement of the
Insurance Regulatory and Development Authority Act, 1999. Thus, the enterprises that were
engaged in the insurance business prior to the commencement of the IRDA Act, 1999
continue to exist but a new insurance industry entrant can only be an Indian insurance
company. The proviso inserted under section 2C(1) of the Act is reproduced below:
“Provided also that no insurer other than an Indian Insurance Company shall begin
to carry on any class of insurance business in India under this Act on or after the
commencement of the Insurance Regulatory and Development Authority Act, 1999”.
The definition of Indian Insurance Company given under section 2(7A) of the Insurance Act,
1938 is also reproduced:
“An Indian insurance company means an insurer being a company-
(a) which is formed and registered under the Companies Act, 1956;
(b) in which the aggregate holding of equity shares by a foreign company, either by itself or
through its subsidiary companies or nominees does not exceed 26% of the paid up equity
capital of such Indian insurance company; and
(c) whose sole purpose is to carry on life insurance business or general insurance business
or re-insurance business.
Explanation: For the purposes of this clause, the expression “foreign company” shall have the
meaning assigned to it under Clause (23A) of section 2 of the Income-tax Act, 1961 (43 of
1961).”
The Insurance (Amendment) Act, 2002 provides as per sub-section (3) of Section 2C that an
insurance cooperative society may carry on any class of insurance business in India.
Registration of Indian Insurance Companies - Section 3 of the Insurance Act, 1938
requires every insurer to obtain a certificate of registration before commencement of insurance
business in India. The section empowers the Authority to make regulations for registration of
insurers. It may be noted here that no insurer other than an Indian insurance company can
commence the insurance business after the enactment of the IRDA Act, 1999. The
registration of Indian insurance companies is done in accordance with the Insurance
Regulatory and Development Authority (Registration of Indian Insurance Companies)

Regulations, 2000. The salient features of these Regulations are as follows:
Licensing of Insurance Agents - Section 42 of the Insurance Act, 1938 requires that a
person desirous of becoming an insurance agent for the purpose of soliciting or procuring
insurance business should not suffer from any of the disqualifications mentioned in sub-
section (4) of Section 42 of the Act. In order to be qualified under sub-section (4), a person
desirous of becoming an insurance agent should possess the requisite qualifications and
practical training for a period not exceeding 12 months, as may be specified by the regulations
made by the Authority in this behalf. It may be noted that the Authority has issued IRDA
(Licensing of Insurance Agents) Regulations, 2000. An insurance agent seeking renewal of
his license is also required to comply with the IRDA (Licensing of Insurance Agents)
Regulations, 2000. There is also a stringent code of conduct prescribed for the insurance
agents and for those seeking renewal of license, at least 50 hours of training is a prerequisite.
Obligations of Insurance Companies to the Rural and Social Sectors - Like any other
industry, the insurance industry also has certain social obligations. For effective discharge of
these obligations, the IRDA Act, 1999 inserted sections 32B and 32C in the Act. Section 32B
empowers the Authority to prescribe the percentages of life insurance business, and general
insurance business in the rural or social sector. Section 32C makes it mandatory for every
insurer to discharge his obligations mentioned under section 32B of the Act. The obligations
include providing life insurance and general insurance cover to the persons residing in the
rural sector including insurance for crops, workers in the unorganised or informal sector or for
economically vulnerable or backward classes of the society and such other categories of
persons as maybe specified by the Regulations made by the Authority. In exercise of the
powers conferred by section 32B and section 32C of the Act, the Authority has issued IRDA
(Obligation of Insurers to Rural or Social Sectors) Regulations, 2000. According to the
Regulations, during the first five financial years, an insurance company is required to ensure
that the total gross premium income pertaining to the rural sector (including insurance for
crops) should be atleast 2% in the first financial year, 3% in the second financial year and 5%
thereafter of the total gross premium income written directly in that year.
‘Rural sector’ means any place as per the latest census, which has –
(i) a population of not more than five thousand;
(ii) a density of population of less than four hundred per square kilometer; and
(iii) at least twenty-five per cent of the male working population is engaged in agriculture.
Power to Suspend Registration- The Authority, under section 14(2)(a) of the IRDA Act,
1999, has the power to suspend a class or classes of insurance business for such period as
may be specified, after holding an inquiry in accordance with the procedures prescribed in the
Regulations. Insurers have to cease to transact new insurance business of such class(es)
from the date of suspension or cancellation of the Certificate.
Requirements as to the Minimum Paid-up Capital - The minimum paid-up equity share
capital of an Indian insurance company carrying on general insurance business should be
Rs.100 crores or more, excluding deposits under Section 7 of the Insurance Act, 1938 and
preliminary expenses incurred in the formation and registration of company. The transitional
period of six months for existing insurance companies is allowed from the date of
commencement of the IRDA Act, 1999 for achieving the minimum paid up capital. The
management of an insurance company needs to certify the pattern of shareholding as on
every Balance Sheet date.
Deposits - Section 7 of the Insurance Act, 1938 requires every insurer, carrying a general
insurance business, to deposit and keep deposited with RBI in it’s one of the offices in India a
sum equivalent to three percent of total gross premium written in India in any financial year.
The maximum limit of deposit under this section is Rupees ten crores. The deposit is to be for
and on behalf of the Government of India. The deposit can be made either by way of cash or
investment in approved securities. If securities are deposited, their estimated market value on
the date of deposit is to be seen. The amount of deposit required in the case of reinsurance
business is rupees twenty crores. The proviso to sub-section (1) of Section 7 relaxes the
deposit requirement in cases where the business done or to be done is marine insurance
business or relates exclusively to country craft or its cargo or both. The amount of deposit
required in such cases is Rupees one lacs only. It may be noted here that an insurer cannot
be registered for any class of insurance business in addition to the class or classes for which
the insurer is already registered until the full deposit required under section (7) has been made
in respect of insurance business already being carried on by the insurer.
According to section 8 of the Insurance Act, 1938, the deposit made under section 7 are not
susceptible of any assignment or charge and are also not available for discharge of any
liability of the insurer other than those arising from the insurance policies issued and
remaining undischarged. The deposit is also not liable to attachment or decree except a
decree obtained by a policyholder in case of non discharge of liability arising out of the
insurance policy issued. Section 9 of the Act provides for refund of deposit in case the
insurance business is closed and all the liabilities have been settled. The Court, after
satisfaction and an application made by insurer, may order refund.
Insurance Regulatory and Development Authority (IRDA) Act, 1999 and Regulations
Framed Thereunder
12.3 As mentioned earlier, the IRDA Act, 1999 has established the Insurance Regulatory
and Development Authority (the Authority) and has also provided for establishment of the
Insurance Advisory Committee to advise the Authority on various matters. The IRDA Act,
1999 has also made amendments to the Insurance Act, 1938, the Life Insurance Corporation
Act, 1956 and the General Insurance Business (Nationalisation) Act, 1972 by insertion of the
First, Second and Third Schedules to the IRDA Act, 1999. These Schedules contain
amendments to rationalise the provisions of the Insurance Act, 1938 and other statutes with
the IRDA Act, 1999 and the Regulations.
Features of Accounting System of Insurance Companies
12.4 The system of recording, classifying and summarising the transactions in insurance
companies, is, in substance, no different from other entities. However, in case of insurance
companies, the ledger accounts specially those of premiums, claims, commissions, etc. need
to be given greater attention. The functions of accounting system in general insurance
business under IT environment may be based on:
♦ Underwriting module
♦ Claims module
♦ Agency management module
♦ Accounts module
♦ Investment module
♦ Reinsurance module
Every insurer, after the commencement of the Insurance Regulatory and Development
Authority Act, 1999, in respect of insurance business transacted and in respect of
shareholder’s funds, is required to prepare a Balance Sheet, a Profit and Loss Account, a
separate Account of Receipts and Payments, a Revenue Account for each year in accordance
with the Regulations made by the Authority. Sub-section 1B of section 11, of the Insurance
Act, 1938, specifies that every insurer should keep separate accounts relating to funds of
shareholders and policyholders.
12.4.1 Form and Contents of Financial Statements - Section 11(1A) of the Insurance Act, 1938
provides -
“Every insurer, on or after the commencement of the Insurance Regulatory and
Development Authority Act, 1999, in respect of insurance business transacted by
him and in respect of his shareholders’ funds, shall, at the expiration of each
financial year, prepare with reference to that year, a balance-sheet, a profit and loss
account, a separate account of receipts and payments, a revenue account in
accordance with the regulations made by the Authority.”
The Authority, in pursuance of the powers conferred to it by the provisions of Section 114 A of
the Insurance Act, 1938, has issued regulations for the preparation of the financial statements
and auditor’s report of companies carrying on insurance business. The Regulations contain
three schedules. Schedule A is applicable to companies carrying on life insurance business.
Schedule B of the Regulations lays down the accounting principles, disclosures forming part of
financial statements, general instructions for preparation of financial statements, the contents
of the management report and the formats in which the financial statements of an insurer
carrying on general insurance business should be drawn up. Schedule B is in five parts,
covering various aspects related to the preparation of financial statements, which form the
main basis for preparation of financial statements of general insurance companies. The five
parts have been outlined in the following paragraphs. Schedule C to the Regulations lays
down the matters to be dealt with by the auditor’s report of an insurance company. Schedule
C is applicable to insurers carrying on general insurance business as well as life insurance
business.
12.4.2 Requirements of Schedule B to the IRDA (Preparation of Financial Statements and

Auditors’ Report of Insurance Companies) Regulations, 2002 -
Part I – Accounting Principles for Preparation of Financial Statements
1. Applicability of Accounting Standards---Every Balance Sheet, Receipts and Payments
Account [Cash Flow statement] and Profit and Loss Account [Shareholders’ Account] of the
insurer shall be in conformity with the Accounting Standards (AS) issued by the ICAI, to the
extent applicable to the insurers carrying on general insurance business, except that:
(i) Accounting Standard 3 (AS 3) – Cash Flow Statements – Cash Flow Statement shall be
prepared only under the Direct Method.
(ii) Accounting Standard 13 (AS 13) – Accounting for Investments, shall not be applicable.
(iii) Accounting Standard 17 (AS 17) - Segment Reporting – shall apply to all insurers
irrespective of the requirements regarding listing and turnover mentioned therein.
2. Premium--Premium shall be recognised as income over the contract period or the period
of risk, whichever is appropriate. Premium received in advance, which represents premium
income not relating to the current accounting period, shall be disclosed separately in the
A reserve for unexpired risks shall be created as the amount representing that part of the
premium written which is attributable to, and to be allocated to the succeeding accounting
periods and shall not be less than as required under section 64 V(1) (ii) (b) of the Act.
Premium Received in Advance, which represents premium received prior to the
commencement of the risk, shall be shown separately under the head ‘Current Liabilities’ in
3. Premium Deficiency -- Premium deficiency shall be recognised if the sum of expected
claim costs, related expenses and maintenance costs exceeds related reserve for unexpired
risks.
4. Acquisition Costs---Acquisition costs, if any, shall be expensed in the period in which
they are incurred. Acquisition costs are those costs that vary with, and are primarily related
to, the acquisition of new and renewal insurance contracts. The most essential test is the
obligatory relationship between costs and the execution of insurance contracts (i.e.
commencement of risk).
5. Claims--The components of the ultimate cost of claims to an insurer comprise the claims
under policies and specific claims settlement costs. Claims under policies comprise the claims
made for losses incurred, and those estimated or anticipated under the policies following a
loss occurrence.
A liability for outstanding claims shall be brought to account in respect of both direct business
and inward reinsurance business. The liability shall include: -
(a) Future payments in relation to unpaid reported claims;
(b) Claims Incurred But Not Reported (IBNR) including inadequate reserves [sometimes
referred to as Claims Incurred But Not Enough Reported (IBNER)],
this will result in future cash/asset outgo for settling liabilities against those claims. Change in
estimated liability represents the difference between the estimated liability for outstanding
claims at the beginning and at the end of the financial period.
The accounting estimate shall also include claims cost adjusted for estimated salvage value if
there is sufficient degree of certainty of its realisation.
Actuarial Valuation of claim liability – in some cases
Claims made in respect of contracts where the claims payment period exceeds four years
shall be recognised on an actuarial basis, subject to regulations that may be prescribed by the
Authority. In such cases, certificate from a recognised actuary as to the fairness of liability
assessment must be obtained. Actuarial assumptions shall be suitably disclosed by way of
notes to the account.
6. Procedure to determine the value of investments---An insurer shall determine the
values of investments in the following manner:-
(a) Real Estate – Investment Property-- Investment Property shall be measured at
historical cost less accumulated depreciation and impairment loss, residual value being
considered zero and no revaluation being permissible.
The Insurer shall assess at each balance sheet date whether any impairment of the
investment property has occurred.
An impairment loss shall be recognised as an expense in the Revenue/Profit and Loss
Account immediately.
Fair value as at the balance sheet date and the basis of its determination shall be
disclosed in the financial statements as additional information.
(b) Debt Securities--Debt securities including government securities and redeemable
preference shares shall be considered as “held to maturity” securities and shall be
measured at historical cost subject to amortisation.
(c) Equity Securities and Derivative Instruments that are traded in active markets---
Listed equity securities and derivative instruments that are traded in active markets shall
be measured at fair value as at the balance sheet date. For the purpose of calculation of
fair value, the lowest of the last quoted closing price of the stock exchanges where the
securities are listed shall be taken.
The insurer shall assess on each balance sheet date whether any impairment of listed
equity security(ies)/ derivative(s) instruments has occurred.
An active market shall mean a market, where the securities traded are homogenous,
availability of willing buyers and willing sellers is normal and the prices are publicly
available.
Unrealised gains/losses arising due to changes in the fair value of listed equity shares
and derivative instruments shall be taken to equity under the head ‘Fair Value Change
Account’. The ‘Profit on sale of investments’ or ‘Loss on sale of investments’, as the case
may be, shall include accumulated changes in the fair value previously recognised in
equity under the heading Fair Value Change Account in respect of a particular security
and being recycled to Profit and Loss Account on actual sale of that listed security.
For the removal of doubt, it is clarified that balance or any part thereof shall not be
available for distribution as dividends. Also, any debit balance in the said Fair Value
Change Account shall be reduced from the profits/free reserves while declaring
dividends.
The insurer shall assess, at each balance sheet date, whether any impairment has
occurred. An impairment loss shall be recognised as an expense in Revenue/Profit and
Loss Account to the extent of the difference between the remeasured fair value of the
security/ investment and its acquisition cost as reduced by any previous impairment loss
recognised as expense in Revenue/Profit and Loss Account. Any reversal of impairment
loss earlier recognised in Revenue/Profit and Loss Account shall be recognised in
Revenue/Profit and Loss Account.
(d) Unlisted and other than actively traded Equity Securities and Derivative
Instruments--Unlisted equity securities and derivative instruments and listed equity
securities and derivative instruments that are not regularly traded in active market will be
measured at historical costs. Provision shall be made for diminution in value of such
investments. The provision so made shall be reversed in subsequent periods if estimates
based on external evidence show an increase in the value of the investment over its
carrying amount. The increased carrying amount of the investment due to the reversal of
the provision shall not exceed the historical cost.
For the purposes of this regulation, a security shall be considered as being not actively
traded, if as per guidelines governing mutual funds laid down from time to time by SEBI,
such a security is classified as “thinly traded”.
7. Loans -- Loans shall be measured at historical cost subject to impairment provisions. The
insurer shall assess the quality of its loan assets and shall provide for impairment. The
impairment provision shall not be lower than the amounts derived on the basis of guidelines
prescribed from time to time by the Reserve Bank of India that apply to companies and
financial institutions.
8. Catastrophe Reserve -- Catastrophe reserve shall be created in accordance with norms, if
any, prescribed by the Authority. Investment of funds out of catastrophe reserve shall be made
in accordance with prescription of the Authority.
PART II: Disclosures forming part of Financial Statements

The following shall be disclosed by way of notes to the Balance Sheet -
1. Contingent Liabilities:
(a) Partly-paid up investments
(b) Underwriting commitments outstanding
(c) Claims, other than those under policies, not acknowledged as debts
(d) Guarantees given by or on behalf of the company
(e) Statutory demands/liabilities in dispute, not provided for
(f) Reinsurance obligations to the extent not provided for in accounts
(g) Others (to be specified)
2. Encumbrances to assets of the company in and outside India.
3. Commitments made and outstanding for Loans, Investments and Fixed Assets.
4. Claims, less reinsurance, paid to claimants in/outside India.
5. Actuarial assumptions for determination of claim liabilities in the case of claims where the
claims payment period exceed four years.
6. Ageing of claims – distinguishing between claims outstanding for more than six months
and other claims.
7. Premiums, less reinsurance, written from business in/outside India.
8. Extent of premium income recognised, based on varying risk pattern, category wise, with
basis and justification therefor, including whether reliance has been placed on external
evidence.
9. Value of contracts in relation to investments, for:
(a) Purchases where deliveries are pending;
(b) Sales where payments are overdue.
10. Operating expenses relating to insurance business: basis of allocation of expenditure to
various classes of business.
11. Historical costs of those investments valued on fair value basis.
12. Computation of managerial remuneration.
13. Basis of amortisation of debt securities.
14. (a) Unrealised gain/losses arising due to changes in the fair value of listed equity
shares and derivative instruments are to be taken to equity under the head ‘Fair
Value Change Account’ and on realisation reported in profit and loss Account.
(b) Pending realisation, the credit balance in the ‘Fair Value Change Account’ is not
available for distribution.
15. Fair value of investment property and the basis therefor.
16. Claims settled and remaining unpaid for a period of more than six months as on the
balance sheet date.
The following accounting policies shall form an integral part of the financial
statements -
1. All significant accounting policies in terms of the accounting standards issued by the
ICAI, and significant principles and policies given in Part I of Accounting Principles. Any
other accounting policies followed by the insurer shall be stated in the manner required
under Accounting Standard AS 1 issued by the ICAI.
2. Any departure from the accounting policies as aforesaid shall be separately disclosed
with reasons for such departure.
The following information shall also be disclosed -
1. Investments made in accordance with any statutory requirement should be disclosed
separately together with its amount, nature, security and any special rights in and outside
India.
2. Segregation into performing/ non performing investments for purpose of income
recognition as per the directions, if any, issued by the Authority.
3. Percentage of business sector-wise.
4. A summary of financial statements for the last five years, in the manner as may be
prescribed by the Authority.
5. Accounting Ratios as may be prescribed by the Authority.
6. Basis of allocation of Interest, Dividends and Rent between Revenue Account and Profit
and Loss Account.
Part III: General Instructions for Preparation of Financial Statements
1. The corresponding amounts for the immediately preceding financial year for all items
shown in the Balance Sheet, Revenue Account, Profit and Loss Account and Receipts
and Payments Account should be given.
2. The figures in the financial statements may be rounded off to the nearest thousands.
3. Interest, dividends and rentals receivable in connection with an investment should be
stated as gross value, the amount of income tax deducted at source being included
under 'advance taxes paid'.
4. Income from rent shall not include any notional rent.
5. For the purposes of financial statements, unless the context otherwise requires -
(a) the expression ‘provision’ shall, subject to note II below mean any amount written
off or retained by way of providing for depreciation, renewals or diminution in value
of assets, or retained by way of providing for any known liability or loss of which the
amount cannot be determined with substantial accuracy;
(b) the expression "reserve" shall not, subject to as aforesaid, include any amount
written off or retained by way of providing for depreciation, renewals or diminution in
value of assets or retained by way of providing for any known liability;
(c) the expression capital reserve shall not include any amount regarded as free for
distribution through the profit and loss account; and the expression "revenue
reserve" shall mean any reserve other than a capital reserve;
(d) The expression "liability" shall include all liabilities in respect of expenditure
contracted for and all disputed or contingent liabilities.
Where:
(a) any amount written off or retained by way of providing for depreciation,
renewals or diminution in value of assets, or
(b) any amount retained by way of providing for any known liability
is in excess of the amount which in the opinion of the directors is reasonably
necessary for the purpose, the excess shall be treated for the purposes of
these accounts as a reserve and not as a provision.
6. The company should make provisions for damages under lawsuits where the
management is of the opinion that the award may go against the insurer.
7. Extent of risk retained and reinsured shall be separately disclosed.
8. Any debit balance of Profit and Loss Account shall be shown as deduction from
uncommitted reserves and the balance if any, shall be shown separately.
Part IV: Contents of Management Report
There shall be attached to the financial statements, a management report containing,
inter alia, the following duly authenticated by the management -
1. Confirmation regarding the continued validity of the registration granted by the Authority;
2. Certification that all the dues payable to the statutory authorities have been duly paid;
3. Confirmation to the effect that the shareholding pattern and any transfer of shares during
the year are in accordance with the statutory or regulatory requirements;
4. Declaration that the management has not directly or indirectly invested outside India the
funds of the holders of policies issued in India;
5. Confirmation that the required solvency margins have been maintained;
6. Certification to the effect that the values of all the assets have been reviewed on the date
of the Balance Sheet and that in his (insurer’s) belief the assets set forth in the Balance-
sheets are shown in the aggregate at amounts not exceeding their realisable or market
value under the several headings – “ Loans”, “ Investments”, “Agents balances”,
“Outstanding Premiums”, “Interest, Dividends and Rents outstanding”, “Interest,
Dividends and Rents accruing but not due”, “Amounts due from other persons or Bodies
carrying on insurance business”, “ Sundry Debtors”, “ Bills Receivable”, “ Cash” and the
several items specified under “Other Accounts”;
7. Disclosure with regard to the overall risk exposure and strategy adopted to mitigate the
same;
8. Operations in other countries, if any, with a separate statement giving the management’s
estimate of country risk and exposure risk and the hedging strategy adopted;
9. Ageing of claims indicating the trends in average claim settlement time during the
preceding five years;
10. Certification to the effect as to how the values, as shown in the balance sheet, of the
investments and stocks and shares have been arrived at, and how the market value
thereof has been ascertained for the purpose of comparison with the values so shown;
11. Review of asset quality and performance of investment in terms of portfolios, i.e.,
separately in terms of real estate, loans, investments, etc.
12. A responsibility statement indicating therein that:
(i) in the preparation of financial statements, the applicable accounting standards,
principles and policies have been followed along with proper explanations relating to
material departures, if any;
(ii) the management has adopted accounting policies and applied them consistently
and made judgements and estimates that are reasonable and prudent so as to give
a true and fair view of the state of affairs of the company at the end of the financial
year and of the operating profit or loss and of the profit or loss of the company for
the year;
(iii) the management has taken proper and sufficient care for the maintenance of
adequate accounting records in accordance with the applicable provisions of the
Insurance Act 1938 (4 of 1938) / Companies Act, 1956 (1 of 1956), for safeguarding
the assets of the company and for preventing and detecting fraud and other
irregularities;
(iv) the management has prepared the financial statements on a going concern basis;
(v) the management has ensured that an internal audit system commensurate with the
size and nature of the business exists and is operating effectively.
13. A schedule of payments, which have been made to individuals, firms, companies and
organisations in which Directors of the insurer are interested.
Part V: Preparation of Financial Statements

(1) An insurer shall prepare the Revenue Account, Profit and Loss Account [Shareholders’
Account] and the Balance Sheet in Form B-RA, Form B-PL, and Form B-BS, or as near
thereto as the circumstances permit.
Provided that an insurer shall prepare Revenue Accounts separately for fire, marine, and
miscellaneous insurance business and separate schedules shall be prepared for Marine
Cargo, Marine – Other than Marine Cargo and the following classes of miscellaneous
insurance business under miscellaneous insurance and accordingly application of AS 17
– Segment Reporting - shall stand modified.
1. Motor, 2.Workmen’s Compensation/Employers’ Liability, 3. Public/Product Liability,
4. Engineering, 5. Aviation, 6. Personal Accident, 7. Health Insurance,
8. Others
(2) An insurer shall prepare separate Receipts and Payments Account in accordance with
the Direct Method prescribed in AS 3 – “Cash Flow Statement” issued by the ICAI.
(These formats are given in Appendix)
Audit Considerations - As mentioned earlier, Schedule C to the IRDA (Preparation of
Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2000
prescribes the matters to be dealt with by the auditor’s report. The auditors, under clause (3)
of Schedule C to the Regulations, are required to certify that they have reviewed the
management report and there is no apparent mistake or material inconsistencies in the
management report with the financial statements. The auditors are also required to certify that
the insurer has complied with the terms and conditions of the registration stipulated by the
Authority.
From the foregoing, it is clear that the auditor has to examine the contents of the management
report with a view to certify that there are no material inconsistencies in the same with the
financial statements. The auditor should, based upon the audit conducted and information
and explanations gathered during the course of the audit, verify that there are no material
misstatements in the management report. As far as certification of compliance with the terms
and conditions of the registration stipulated by the Authority is concerned, the auditor should
ask for the relevant documents from the management of the company and conduct an
examination thereof. Based on his observation, the auditor should certify the aforesaid
compliance.
12.4.3 Signatures and Reports to be attached with the Accounts and Statements- Sub-section
(2) of section 11 of the Insurance Act, 1938 provides that the accounts and statements
referred to in sub-section (1) should be signed, in the case of a company, by the chairman, if
any, and two directors and the principal officer of the company. It further provides that the
accounts and statements should be accompanied by a statement containing the names,
descriptions and occupations of, and the directorships held by, the persons in charge of the
management of the business during the period to which such statements refers, and by a
report on the affairs of the business during that period.
12.4.4 Requirements of the Insurance Act, 1938 vis a vis the Companies Act, 1956 -
Disclosures under the Companies Act, 1956 relating to the Balance Sheet and Profit and Loss
Account of the company, in so far as they are not inconsistent with the provisions of the
Insurance Act, 1938, also apply to the Balance Sheet and Profit and Loss Account of an
insurance company.
Sub-section (5) of section 211 of the Companies Act, 1956 provides that the Balance Sheet
and the Profit and Loss Account of a company should not be treated as not disclosing a true
and fair view of the state of affairs of the company, merely by reason of the fact that they do
not disclose, in the case of an insurance company, any matters which are not required to be
disclosed under the Insurance Act, 1938 (4 of 1938). However, if an insurance company so
desires, it may disclose the information not required to be disclosed under the Insurance Act,
1938.
According to Section 616 of the Companies Act, 1956, the provisions of the Companies Act,
1956 apply to insurance companies, except in so far as the said provisions are inconsistent
with the provisions of the Insurance Act, 1938. Section 117 of Insurance Act, 1938, provides
that nothing in the Insurance Act, 1938 shall affect the liability of an insurer, being a company,
to comply with the provisions of the Indian Companies Act, 1913 in matters not otherwise
specifically provided for by Insurance Act, 1938. Therefore, the provisions of the Companies
Act, 1956 would be applicable wherever the Insurance Act, 1938 does not cover the relevant
aspects and the insurer is a company within the meaning of the Companies Act, 1956. The
provisions of the Companies Act, 1956 should be applied in a harmonised manner with the
provisions of the Insurance Act, 1938, and the rules and regulations framed thereunder.
It may be mentioned here that the erstwhile Indian Companies Act, 1913 has been replaced by
the Companies Act, 1956. Therefore, it is suggested that reference to 1913 legislation should
be construed as a reference to the corresponding provisions of the Companies Act, 1956.
12.4.5 Accounting Policies - The term ‘Accounting Policies’ refers to the specific accounting
principles and methods of applying those principles adopted by an enterprise for preparation
and presentation of its financial statements, since there is no single list of accounting policies
which are applicable in all circumstances, the accounting policies adopted vary from one
enterprise to another. The selection of an accounting policy is based upon the management’s
judgement of relevance of policies. The primary consideration in the selection of accounting
policies is that the financial statements prepared and presented using the accounting policies
should present a true and fair view of the state of affairs as on the balance sheet date and of
results of preparations for the period ended on that date.
The IRDA Regulations on preparation of financial statements and auditor’s report specify that
the following accounting policies should form an integral part of the financial statements:
(a) All significant policies in terms of Accounting Standards issued by the Institute of
Chartered Accountants of India, and significant principles and policies given in Part I of
Accounting Principles. Any other accounting policies followed by the insurer should be
stated in the manner required under AS-1 issued by the Institute of Chartered
(b) Any departure from the accounting policies as aforesaid is required to be separately
disclosed with reasons for such departure.
In connection with the matters in respect of which the auditor has to express an opinion as
prescribed in Schedule C to the IRDA (Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations, 2000, the auditor has to report whether the
financial statements are prepared in accordance with the requirements of the Insurance Act,
1938 (4 of 1938), the Insurance Regulatory and Development Authority Act, 1999 (41 of 1999)
and the Companies Act, 1956 (1 of 1956), to the extent applicable and in the manner so
required.
Audit of Accounts
12.5 Under section 12 of the Insurance Act, 1938, the financial statements of every insurer
are required to be audited annually by an auditor. Section 2(4) of the Insurance Act, 1938
defines the term ‘auditor’ as a person qualified under the Chartered Accountants Act, 1949 to
act as an auditor of a company. The auditor, for audit of financial statements, has the powers
to exercise the rights vested in, and discharge the duties and be subject to the liabilities and
penalties imposed on auditors of companies under the Companies Act, 1956.
The provisions of Section 12 of the Insurance Act, 1938 apply only in a case where the
financial statements of the insurer are not subject to audit under the Companies Act, 1956. A
company carrying on general insurance business is subject to audit requirements laid down
under the Companies Act, 1956.
The financial statements under section 12 include Balance Sheet, Profit and Loss Account and
Revenue Account. Section 12 of the Insurance Act, 1938 does not cover the requirement for
audit of the Receipts and Payments Account of an insurer. It may be noted that the Insurance
Regulatory and Development Authority Act, 1999 inserted a new sub-section (1A) in Section
11 of the Insurance Act, 1938. The sub-section has an overriding effect over sub-section (1)
of section 11 that prescribed the financial statements to be prepared by an insurer. The new
sub-section requires that after the commencements of IRDA Act, 1999, every insurer, in
respect of insurance business transacted by him and in respect of his shareholders funds,
should prepare, at the end of each financial year, a Balance Sheet, a Profit and Loss Account,
a separate Account of Receipts and Payments and a Revenue Account in accordance with the
regulations made by the IRDA. Since Receipts and Payments Account has been made a part
of financial statements of an insurer, it is implied that the Receipts and Payment Account is
also required to be audited.
The Authority, in exercise of the powers conferred by the Insurance Act, 1938, issued the
IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance Companies)
Regulations, 2000. These Regulations require the auditor of an insurance company to report
whether the Receipts and Payments Account of the insurer is in agreement with the books of
account and returns. The auditor is also required to express an opinion as to whether the
Receipts and Payments Account has been prepared in accordance with the provisions of the
relevant statutes and whether the Receipts and Payments Account gives a true and fair view
of the receipts and payments of the insurer for the period under audit. This also implies that
the auditor is required to audit the Receipts and Payments Account of the insurer.
12.5.1 Appointment of auditors - The appointment of statutory auditors in the General Insurance
Corporation of India, and its subsidiaries and the divisions is made by the Comptroller and
Auditor General of India, as in the case of other public sector undertakings. The appointment
of auditors of the agencies abroad is made by the Board of Directors of each company.
12.5.2 Rights and duties of Branch Auditors -It is a practice that the divisional offices prepares
a trial balance in a manner that it provides information required to be included in the various
formats of financial statements prescribed in the Insurance Act. Each trial balance, in which
are incorporated the figures relating to the branches of the divisions, is required to be audited
and the report thereon is furnished to the statutory auditors. The divisions of the companies
carrying on general insurance business are treated for the purposes of the Companies Act,
1956 as their branches. It follows that the branch auditors appointed to conduct the audit of
the divisions have the same rights and obligations under the statute as those of the, statutory
auditors to whom they are expected to submit their report.
12.5.3 Auditors’ Report - The Authority has prescribed the matters to be dealt with by the
Auditors’ Report vide Regulation 3 under Schedule C of IRDA (Preparation of Financial
Statements and Auditor’s Report of Insurance Companies) Regulations, 2000. The Schedule
C is reproduced below -
“The report of the auditors on the financial statements of every insurer shall deal with the
specified herein -
1. (a) That they have obtained all the information and explanations which, to the best of
their knowledge and belief, were necessary for the purposes of their audit and
whether they have found them satisfactory;
(b) Whether proper books of account have been maintained by the insurer so far as
appears from an examination of those books;
(c) Whether proper returns, audited or unaudited, from branches and other offices have
been received and whether they were adequate for the purpose of their audit;
(d) Whether the Balance Sheet, Revenue Accounts and Profit and Loss Account dealt
with by the report and the Receipts and Payments Account are in agreement with
the books of account and returns;
(e) Whether the actuarial valuation of liabilities is duly certified by the appointed
actuary, including to the effect that the assumptions for such valuation are in
accordance with the guidelines and norms, if any, issued by the authority and/or the
Actuarial Society of India in concurrence with the Authority.
2. The auditors shall express their opinion on:
(a) (i) Whether the Balance Sheet gives a true and fair view of the insurer’s affairs
as at the end of the financial year/period;
(ii) Whether the Revenue Account gives a true and fair view of the surplus or the
deficit for the financial year/period;
(iii) Whether the Profit and Loss Account gives a true and fair view of the profit or
loss for the financial year/period;
(iv) Whether the Receipts and Payments Account gives a true and fair view of the
receipts and payments for the financial year/period;
(b) The financial statements stated at (a) above are prepared in accordance with the
requirements of the Insurance Act, 1938 (4 of 1938), the Insurance Regulatory and
Development Authority Act, 1999 (41 of 1999) and the Companies Act, 1956 (1 of
1956), to the extent applicable and in the manner so required.
(c) Investments have been valued in accordance with the provisions of the Act and the
Regulations.
(d) The accounting policies selected by the insurer are appropriate and are in
compliance with the applicable Accounting Standards and with the accounting
principles, as prescribed in these Regulations or any order or direction issued by the
Authority in this behalf.
3. The auditors shall further certify that:
(a) they have reviewed the management report and that there is no apparent mistake or
material inconsistencies with the financial statements; and
(b) the insurer has complied with the terms and conditions of the registration stipulated
by the Authority.
4. A certificate signed by the auditors (which is in addition to any other certificate or report
which is required by law to be given with respect to the balance sheet) certifying that :
(a) they have verified the cash balances and the securities relating to the insurer’s
loans, reversions and life interests (in the case of life insurers) and investments;
(b) the extent, if any, to which they have verified the investments and transactions
relating to any trusts undertaken by the insurer as trustee; and
(c) no part of the assets of the policyholders’ funds has been directly or indirectly
applied in contravention of the provisions of the Insurance Act, 1938 (4 of 1938)
relating to the application and investments of the policyholders’ funds.”
Students may also note that auditors are required to follow the format of report prescribed by
the Institute.
12.5.4 Direction of C & AG- The Comptroller and Auditor General of India has the power to
direct the manner in which the accounts shall be audited and give such instructions in regard
to any matter relating to performance of functions by the auditor and to conduct the
supplementary or test audit of the accounts of such companies by such person or persons as
may be authorised in this behalf. For the purposes of such audit the C & AG may require
information or additional information on such matters and in such form as may be directed by
him in terms of Section 619 (4) of the Companies Act, 1956. The statutory auditors are
required to submit a copy of their report to the C & AG who has the right to comment upon or
supplement the audit report. By virtue of the powers vested in him under Section 619(3) (a) of
the Companies Act, 1956 the C & AG has recently directed that a supplementary report be
made by the auditors appointed under Section 619 (2) of the said Act in case of companies
carrying on general insurance business. The said report would be on matters listed in the
Appendix to this unit of the study.
12.5.5 Tax Audit - It is necessary for general insurance companies to get their accounts
audited under Section 44AB of the said Act. For this purpose, the tax auditor(s) may be
appointed by the company itself by means of a resolution of the Board of Directors or by
the Chairman/Managing Director if so authorised in this behalf. The company is expected
to fix separate remuneration for the auditor (s) appointed for this purpose. The Form of tax
audit report applicable would be Form 3C and the prescribed particulars would have to be
given in Form 3CD, in accordance with Rule 6G of the Income Tax Rules, 1962, pursuant
to Section 44AB of the Income Tax Act, 1961. It is recommended that, wherever
applicable, a common audit programme be framed for statutory audit and for certification
of the prescribed particulars under the aforesaid rules for tax audit.
12.5.6 Applicability of CARO, 2003 - As per Section 1(2) of Companies (Auditor’s Report)
Order, 2003, the provisions of CARO are not applicable to insurance companies.
Specific Control Procedures Related To General Insurance Business
12.6 The internal control functions have been categorised below under main operational
cycles considering the nature of general insurance business. Areas where the internal controls
are similar to the ones adopted by other companies such as for cash and bank receipts and
payments and fixed assets, have been dealt in the Internal Control Questionnaire, published
by the Institute of Chartered Accountants of India. Since various operational cycles are inter-
linked, the internal controls operating within the systems of such cycles should be reviewed
simultaneously.
12.6.1 Underwriting - The underwriting function, which comprises of examination and
evaluation of applications for insurance, the rating of risks and the establishment of premiums,
is fundamental to the operations of a general insurance company. The prime objectives of an
internal control system for underwriting is adherence to guidelines for acceptances of
insurance, proper recording of insurance risk and its evaluation
12.6.2 Premium - Premium is the consideration received by an insurer from the insured under
an insurance contract, whereby the insurer agrees to undertake certain sum of risk on behalf
of the insured. The objectives of internal controls over premium is to ensure that correct
premium is calculated and collected before acceptance of any risk, that premium is accounted
for in an appropriate manner and that the premium is collected only in respect of such risks
which are assumed by the company.
12.6.3 Commission - The commission is the consideration payable for getting the insurance
business. The term ‘commission’ is used for the payment of consideration to get Direct
business. In case of reinsurance, the term used is ‘Commission on reinsurance accepted’.

The internal control with regard to common is aimed at ensuring that commission is paid in
accordance with the rules and regulations of the company and in accordance with the
agreement with the agent, commission is paid the agent who brought the business and the
legal compliances, for example, tax deduction at sources and provisions of the Insurance Act,
1938 have been complied with.
12.6.4 Reinsurance - The key control objectives generally associated with reinsurance
transaction involve determination of correct amounts for reinsurance ceded, proper valuation
of assets and liabilities arising out of reinsurance transactions and adherence to legal
provisions, regulations and reinsurance agreements.
12.6.5 Claims -A demand for payment of policy benefit because of the occurrence of an
insured event is known as ‘claim’. Cost of claims to the company includes all the expenses
incurred in settlement of claims. Internal controls are established over claims to ensure that
only bonafide claims are paid. Cost of claims are properly recorded and disclosed in the
Audit Procedures
12.7 The important part of the business operations of general insurance companies
comprises the issuance of policies for risks assumed and to indemnify the insured for losses
to the extent covered by such policies. In financial terms, these operations get translated into
the receipt and recording of premiums and the recording and settlement of claims. Both
premiums and claims have a significant impact on the insurance companies’ revenues, it
would be an important part of the duty of the auditor to satisfy himself that the financial
transactions involving both these operations have been fairly and properly recorded in the
relevant books of account. The auditor should also ensure that the legal requirements as to
the disclosure of these items are complied with in the financial statements.
12.7.1 Premium - Insurance premium is collected upon issuing policies. It is the consideration
for bearing the risk by the insurance company. The assumption of the risk starts on the issue
of receipt based on the acceptance of proposal form or cover note by the respective
underwriting department. This receipt is recorded as the premium income in the books of the
insurance company. Premium may be accepted either in cash/cheque/Demand Draft/pay
order, bank guarantee, cash deposit, etc. The premium collections are credited to a separate
bank account and no withdrawals are normally permitted from that account for meeting the
general expenditure. As per the policy of the insurance company, the collections are
transferred to the Regional Office or Head Office. As soon as the insurance policy is issued,
an entry is made in the Register of Policies showing all the relevant details.
No Risk Assumption without Premium - No risk can be assumed by the insurer unless the
premium is received. According to section 64VB of the Insurance Act, 1938, no insurer should
assume any risk in India in respect of any insurance business on which premium is ordinarily
payable in India unless and until the premium payable is received or is guaranteed to be paid
by such person in such manner and within such time, as may be prescribed, or unless and
until deposit of such amount, as may be prescribed, is made in advance in the prescribed
manner. The premium receipt of insurance companies carrying on general insurance business
normally arise out of three sources, viz., premium received from direct business, premium
received from reinsurance business and the share of co-insurance premium.
Verification of Premiums - Verification of premium is of utmost importance to an auditor.
The auditor should apply, inter alia, the following procedures for verification of premium -
♦ Before commencing verification of premium income, the auditor should look into the
internal controls and compliance thereof as laid down for collection and recording of the
premiums.
♦ The auditor should ascertain that all the cover notes relating to the risks assumed have
been serially numbered for each class of business. The auditor should also verify that
there is an adequate internal check on the issue of stationery comprising of cover notes,
policy documents, stamps, etc. The auditor may apply sampling techniques for
verification of larger volume of transactions.
♦ The auditor should ensure that premium in respect of risks incepting during the relevant
accounting year has been accounted as premium income of that year on the basis of
premium revenue recognition discussed in this Chapter. The auditor, as part of his audit
procedures, should make an assessment of the reasonability of the risk pattern
established by the management. The auditor should also see whether the premium
received during the year but pertaining to risk commencing in the following year has been
accounted for under the head ‘Premium Received in Advance’ and has been disclosed
separately. Normally, such instances relate to the issue of cover notes and certificates at
the end of the accounting year relating to risks commencing in the next accounting
period. Generally, there is a column in the Premium Register called “Commencement of
Risk”, indicating the date and time from which the risk under the policy issued has
commenced. The auditor should verify that policy documents have not been issued, or
where issued, the company was not at risk, in case:
(a) premium had not been collected at all;
(b) premium had been collected but the relevant cheques have been dishonoured;
(refer Cheque Dishonoured Book);
(c) premium had not immediately been collected due to furnishing of a bank guarantee
or cash deposit but either the deposit or guarantee had fallen short or has expired
or the premium had been collected beyond the stipulated time limit (i.e., there is a
shortfall in bank guarantee account or cash deposit account of the insured);
(d) premium had not been collected due to risk cover being increased or where
stipulated limits have been exhausted in respect of open declaration policies (i.e.,
where premium has accrued but has not been received); and
(e) instalments of premium have not been collected in time in respect of certain
categories of policies, e.g., marine-cum-erection policies where facility has been
granted for premium being paid in instalments (such facility is normally available
subject to certain conditions, e.g., that the first equated instalment is more by 5 per
cent of the total premium payable by instalments).
♦ The auditor should examine whether the reinsurance company is not under a risk in
respect of amount lying at credit and outstanding as at the year-end in the following
accounts:
(a) Deposit Premium Account;
(b) Premium Received in Advance Account;
(c) Inspectors’ Deposits Account; and
(d) Agent’s Premium Accounts
♦ The auditor should verify the collections lodged by agents after the balance sheet date to
see whether any collection pertains to risk commencing for the year under audit. The
auditor should also check that the premium has been recorded originally at the gross
figure, i.e., without providing for unexpired risks and reinsurances.
♦ In case of co-insurance business, where the company is not the leader, because of the
non-availability of the relevant information in many cases the premium is not booked
even though the risk has commenced during the relevant accounting year. The auditor
should see that the company’s share of the premium has been accounted for on the
basis of the available information on nature of risk and the provisional premium charged
by the leading insurer. The auditor should examine the communications issued to the
company by the leading insurers advising them of the company’s share of premium
income. Such communications should be seen even in respect of the post-audit period.
Where the company is the leader, the auditor should obtain a reasonable assurance that
only the company’s own share of premium has been shown as income and accounts of
the other companies have been credited with their share of the premium collected.
♦ The auditor should check whether Premium Registers have been maintained
chronologically, for each underwriting department, giving full particulars including service
tax charged as per acceptance advice on a day-to-day basis. The auditor should verify
whether the figures of premium mentioned in the register tally with those in General
Ledger.
♦ Where policies have been issued with a provision to collect premium periodically (i.e.,
under instalment clause, special declaration policy or periodical declaration under open
policies in marine insurance), the auditor should check whether premia are collected as
and when they become due.
♦ The auditor should verify whether instalments falling due on or before the balance sheet
date, whether received or not, have been accounted for as premium income as for the
year under audit. Also examine whether instalments of premium falling due in the
subsequent year have not been recognised in the accounts as outstanding premium.
♦ The auditor should verify the year end transactions to check that amounts received
during the year in respect of risks commencing/ instalments falling due on or after the
first day of next financial year are not credited to premium account but credited to
Premium Received in Advance Account.
♦ The auditor should verify the collections remitted by agents immediately after the cut-off
date to verify the risk assumed during the year under audit on those collections.
♦ The auditor should also check that in case of cancellation of policies/cover notes issued,
no risk has been assumed between the date of issue and subsequent cancellation
thereof.
♦ Where premium originally received has been refunded, the auditor should verify whether
the agency commission paid on such premium has been recovered.
♦ The auditor should verify whether service tax has been charged from the insured, at the
rates in force, on the total premium for all classes of business other than those exempted
under service tax laws. Check whether service tax so collected is disclosed under
‘Current Liabilities’ to the extent not deposited in Government’s Account.
♦ In the case of co-insurance business, the auditor should verify whether service tax at the
rates in force on the whole premium has been charged or collected from the insured by
the company in case it is the leader.
Check that service tax so collected on premium charged trained from the insured by the
company have been regularly deposited in the Government’s Account.
12.7.2 Claims -The components of the cost of claims to an insurer comprise the claims under
policies and claim settlement costs. Claims under policies comprise the claims paid for losses
incurred, and those estimated or anticipated claims pending settlements under the policies.
Settlement cost of claims includes surveyor fee, legal expenses, etc. A liability for outstanding
claims should be brought to account on the following:
♦ Direct Business;
♦ Inward Reinsurance Business; and
♦ Co-Insurance business
The liability includes future payments in relation to unpaid reported claims and claims incurred
but not reported including inadequate reserves which would result in future cash or asset
outgo for settling liabilities against those claims. Change in estimated liability represents the
difference between the estimated liabilities for outstanding claims in respect of claims under
policies, whether due or intimated at the beginning and at the end of the financial period. The
accounting estimate also includes claims cost adjusted for salvage value if there is sufficient
degree of certainty of its realisation.
Check that service tax so collected on premium charged trained from the insured by the
company have been regularly deposited in the Government’s Account.
Registers and Records - The following register and records are generally prepared in respect
of claims:
♦ Claims Intimation Register;
♦ Claims Paid Register;

♦ Claims Disbursement Bank Book;
♦ Claims Dockets, normally containing the following records:
♦ Claim intimation, claim form, particulars of policy, survey report, Photograph showing
damage, repairer’s bills, letter of subrogation, police report, fire service report, claim
settlement note, claim satisfaction note, salvage report, salvage disposal note, claims
discharge voucher, etc.;
♦ Report of quality assurance team; and
♦ Salvage register
The Claim Account is debited with all the payments including repair charges, fire fighting
expenses, police report fees, survey fees, amount decreed by the Courts, travel expenses,
photograph charges, etc. The provision for claims incurred but not reported is not made at
Branch/Divisional Office level but at the Head Office level.
Verification of Claims
Claims Provisions - The auditor should obtain from the divisions/branches, the information
for each class of business, categorizing the claims value-wise before commencing verification
of the claims provisions, so that appropriate statistical sampling techniques may be applied, to
ensure that representative volume of claims is verified for each class of business. The auditor
should determine the total number of documents to be checked giving due importance to claim
provisions of higher value.
The outstanding liability at the year-end is determined at the divisions/branches where the
liability originates for outstanding claims. Thereafter, based on the total consolidated figure
for all the divisions/branches, the Head Office considers a further provision in respect of
outstanding claims. The auditor should satisfy himself that the estimated liability provided for
by the management is adequate with reference to the relevant claim files/dockets, keeping in
view the following:
(i) that provision has been made for all unsettled claims as at the year-end on the basis of
claims lodged/communicated by the parties against the company. The date of loss (and
not the date of communication thereof) is important for recording/ recognizing the claim
as attributable to a particular year. In certain circumstances, the claims are incurred by
the insurance company but are not reported at the balance sheet date by the insured.
Such claims are known as claims incurred but not reported (IBNR). The auditor should
check the records for subsequent periods to ascertain that adequate provision has been
created for such claims also.
(ii) that provision has been made for only such claims for which the company is legally liable,
considering particularly, (a) that the risk was covered by the policy, if in force, and the
claims arose during the currency of the policy; and (b) that claim did not arise during the
period the company was not supposed to cover the risk, e.g., where the premium was not
paid or where cheques covering premium have been dishonoured (refer section 64 VB of
the Insurance Act, 1938) or where a total loss under a policy has already been
met/settled.
(iii) that the provision made is normally not in excess of the amount insured except in some
categories of claims where matters may be sub-judice in legal proceedings which will
determine the quantum of claim, the amount of provision should also include survey fee
and other direct expenses.
(iv) that in determining the amount of provision, events after the balance sheet date have
been considered, e.g., (a) claims settled for a materially higher/lower amount in the post-
audit period; (b) claims paid by other insurance companies during the year under audit
and communicated to company after the balance sheet date where other companies are
the leaders in co-insurance arrangements; and (c) further reports by surveyors or
assessors.
(v) that the claims status reports recommended to be prepared by the Divisional Manager on
large claims outstanding at the year-end have been reviewed with the contents of
relevant files or dockets for determining excess/short provisions. The said report should
be complete as to material facts to enable the auditor to take a fair view of the provision
made.
(vi) that in determining the amount of provision, the ‘average clause’ has been applied in
case of under-insurance by parties.
(vii) that the provision made is net of payments made ‘on account’ to the parties wherever
such payments have been booked to claims.
(viii) that in case of co-insurance arrangements, the company has made provisions only in
respect of its own share of anticipated liability.
(ix) that wherever an unduly long time has elapsed after the filing of the claim and there has
been no further communication and no litigation or arbitration dispute is involved, the
reasons for carrying the provision have been ascertained.
(x) that wherever legal advice has been sought or the claim is under litigation, the provisions
is made according to the legal advisor’s view and differences, if any, are explained.
(xi) that in the case of amounts purely in the nature of deposits with courts or other
authorities, adequate provision is made and deposits are stated separately as assets
and provisions are not made net of such deposits.
(xii) that no contingent liability is carried in respect of any claim intimated in respect of
policies issued.
(xiii) that the claims are provided for net of estimated salvage, wherever applicable.
(xiv) that intimation of loss is received within a reasonable time and reasons for undue delay
in intimation are looked into.
(xv) that provisions have been retained as at the year end in respect of guarantees given by
company to various Courts for claims under litigation.
(xvi) that due provision has been made in respect of claims lodged at any office of the
company other than the one from where the policy was taken, e.g., a vehicle insured at
Mumbai having met with an accident at Chennai necessitating claim intimation at one of
the offices of the company at Chennai.
In cases of material differences in the liability estimated by the management and that which
ought to be provided in the opinion of the auditor, the same must be brought out in the
auditor’s report after obtaining further information or explanation from the management. For
determining the adequacy of the provisions in respect of any category of business, the auditor
may resort to the method of testing the actual payments, wherever made, with the provisions
made earlier for that category of business. Whether such liability has been estimated in the
past on a fair and realistic basis can, thus, be examined by looking into current year’s
payments against provisions of the earlier year.
Claims Paid - The auditor may determine the extent of checking of claims paid on the same
line as suggested for outstanding claims. Other aspects in respect of claims paid to be
examined by the auditors are as follows:
(i) that in case of co-insurance arrangements, claims paid have been booked only in respect
of company’s share and the balance has been debited to other insurance companies.
(ii) that in case of claims paid on the basis of advices from other insurance companies
(where the company is not the leader in co-insurance arrangements), whether share of
premium was also received by the company. Such claims which have been
communicated after the year-end for losses which occurred prior to the year end must be
accounted for in the year of audit.
(iii) that the claims payments have been duly sanctioned by the authority concerned and the
payments of the amounts are duly acknowledged by the claimants;
(iv) that the salvage recovered has been duly accounted for in accordance with the
procedure applicable to the company and a letter of subrogation has been obtained in
accordance with the laid down procedure;
(v) that the amounts of the nature of pure advances/deposits with Courts, etc., in matters
under litigation/arbitration have not been treated as claims paid but are held as assets till
final disposal of such claims. In such cases, full provision should be made for outstanding
claims;
(vi) that payment made against claims partially settled have been duly vouched. In such
cases, the sanctioning authority should be the same as the one which has powers in
respect of the total claimed amount ;
(vii) that in case of final settlement of claims, the claimant has given an unqualified discharge
note, not involving the company in any further liability in respect of the claim; and
(viii) that the figures of claims, wherever communicated for the year by the Division to the
Head Office for purposes of reinsurance claims, have been reconciled with the trial
balance-figure.
12.7.3 Commission - It is a well-known fact that insurance business is solicited by insurance

agents. The remuneration of an agent is paid by way of commission which is calculated by
applying a percentage to the premium collected by him. Commission is payable to the agents
for the business procured through them and is debited to Commission on Direct Business
Account. There is a separate head for commission on reinsurance accepted which usually
arise in case of Head Office. It may be noted that under section 40 of Insurance Act, 1938, no
commission can be paid to a person who is not an agent of the insurance company.
The auditor should, inter alia, do the following for verification of commission:
♦ Vouch disbursement entries with reference to the disbursement vouchers with copies of
commission bills and commission statements.
♦ Check whether the vouchers are authorised by the officers- in –charge as per rules in
force and income tax is deducted at source, as applicable.
♦ Test check correctness of amounts of commission allowed.
♦ Scrutinise agents’ ledger and the balances, examine accounts having debit balances, if
any, and obtain information on the same. Necessary rectification of accounts and other
remedial actions have to be considered.
♦ Check whether commission outgo for the period under audit been duly accounted.
12.7.4 Operating Expenses Related to Insurance Business (Expenses of Management) - All
the administrative expenses in an insurance company are broadly classified under 13 heads
as mentioned in Schedule 4. In so far as financial statements are concerned, this Schedule is
part of the Revenue Account to be prepared for insurance business. Any other expenses are
required to be disclosed under the head ‘Others’. ‘Others’ would include foreign exchange
gains or losses as indicated in note ‘B’ of Schedule 4. Any major expenses (Rs. 5 lacs or in
excess of 1% of net premium, whichever is higher) are required to be shown separately.
Careful reading of the words ‘expenses related to insurance business’ clearly indicate any
expenses which do not have any direct relation to insurance business are to be shown
separately in the Profit and Loss Account. Expenses relating to investment department,
brokerage, bank charges, transfer fees, etc. do not have a direct relationship to the day-to-day
working of the insurance business and as such would not be included in the revenue account.
These expenses are first aggregated and then apportioned to the Revenue Account of each
class of business on a reasonable and equitable basis. The accounting policy should clearly
indicate the basis of apportionment of these expenses to the respective Revenue Accounts
(i.e., fire, marine and miscellaneous) along with the certificate that all expenses of
management, wherever incurred, directly or indirectly, read with the accounting policy, have
been fully debited to the respective Revenue Account as expenses. Refer to Schedule 4 on
Operating Expenses for specific items.
12.7.5 Legal and Professional Charges - As far as legal and professional changes are
concerned, attention is drawn to the head ‘Claims Incurred’ under Schedule 2 where it is
clearly stated that survey fees, legal and other expenses should form part of claim cost, and
therefore, are not to be included under the head Legal and Professional Charges. Hence, all
other expenses which are not covered under the claims cost are required to be included under
this head.
12.7.6 Employees’ Remuneration and Welfare Benefits -The employees’ remuneration
includes all kinds of payments made to employees in consideration of their services. The
reimbursement of medical expenses or premium in respect of employees’ health cover is
covered under the employees’ remuneration and welfare. Any medical fees incurred towards
maintenance of health care policies (which are not for employees) are required to be debited
to the claims cost under the health care and not to be included under this head. Any
expenses towards medical treatment of employees incurred by the company should also be
included under this head. Non training expenses have to be shown separately.
12.7.7 Interest and Bank charges - All expenses incurred towards maintenance of Bank
Account, interest and other charges levied by bankers to the normal course of business other
than bank expenses relating to investments (interest, bank charges, custodial charges, etc.)
are shown under the head, “Interest and Bank Charges”. Any other interest charged on the
borrowings which could not form part of the Revenue Account not to be included under this
head.
12.7.8 Depreciation -The rates of depreciation are governed by the provisions of the
Companies Act, 1956. Attention of the students is also invited to Accounting Standard (AS) 6,
Depreciation Accounting, and Guidance Note on, Depreciation in Companies, issued by the
Institute of Chartered Accountants of India.
12.7.9 Interest, Dividend and Rent -An insurance enterprise, like any other, earns interest
dividend and rent through its assets. The interest, dividend and rent earned are to be
apportioned between Revenue Account and Profit and Loss Account. The Regulations require
that basis of allocation of interest, dividend and rent between the Revenue Account and Profit
and Loss Account should be clearly indicated in the company’s accounting policy. The
interest or dividend earned as against the policyholders’ funds is required to be apportioned to
the Revenue Account. The interest earned on, say, grant of vehicle loans, housing loans,
deposits with banks of the shareholders, funds, rent received on let out properties owned by
the company, by way of investments shareholders, funds, etc. are required to be shown under
the profit and Loss Account.
Items Relating to Balance Sheet
12.8 Following are the broad classes of items in a balance sheet.
12.8.1 Investments - The legal requirements for investments by enterprises carrying on
general insurance business are provided under sections 27B, 27C and 27D of the Insurance
Act, 1938. Sub-section (1) of section 27B lays down that no insurer carrying on general
insurance business can invest or keep invested any part of its assets otherwise than in any of
the approved investments mentioned in the section. Sub-section (3), however, gives a
leverage to an insurer to invest or keep invested any part of its assets otherwise than in an
approved investment if the following conditions are satisfied:
(a) such investments should not exceed 25% of the total investments; and
(b) such investments are made with the consent of all the Directors.
The consent of Directors appointed under section 34C of the Insurance Act, 1938 is not
necessary. However, such Directors should not object to the investments so made or
continued.
Sub-section (4) of section 27B requires that an insurer should not invest or keep invested any
part of its assets in the shares of any one insurance company or an investment company
which constitutes more than ten percent of the total assets of the insurer or two percent of the
subscribed share capital or debentures of the insurance companies or investment company
concerned. Similar considerations also apply to the investment in shares or debentures of any
other company not being an insurance companies or investment company. In such cases, the
limit of two percent of the subscribed share capital or debentures of the insurance companying
company or the investment company concerned is to be read as ten percent {sub-section (5)}.
According to sub-section (6), an insurer cannot invest in the shares or debentures of a private
company. It may be noted that in case an investment has been made in the partly paid up
shares of a company, the uncalled liability on the shares is to be added to the amount
invested for the purpose of computing the percentages referred to above.
Section 27C of the Insurance Act, 1938 prohibits an insurer from investing, directly or
indirectly, funds of the policy-holders outside India. It implies that the funds which do not
belong to policy-holders can be invested outside India. Examples of such funds that do not
belong to the policyholders are the share capital, amount of loans raised, balances lying in
free reserves, etc.
The Authority has been authorized to frame regulations related to investments to be made by
an insurer. The Authority has been empowered to specify, through the regulations made by it,
the time, manner and other conditions of investments of assets held by an insurer. The
Authority has also been granted the power of framing specific directions with regard to time,
manner and other conditions subject to which the funds of policy-holders are to be invested in
the infrastructure and social sector. The Authority also has the power to issue instructions to
a single insurer, after taking into account the nature of business and the interests of the policy
holders, the manner and other conditions of investment of assets to be held, provided the
insurer is given a due opportunity of being heard before directions are issued by the Authority
(Section 27D).
In exercise of the power conferred by the Insurance Act, 1938, the Authority, in consultation
with the Insurance Advisory Committee, has made the Insurance Regulatory and Development
Authority (Investment) Regulations are subject to revision by the Authority from time to time.
Regulation 4 of the amended Regulations on investments prescribes that every insurer
carrying on the business of general insurance should invest and at all times keep invested its
total assets in the following manner:
(i) 20 percent or more of total assets Central Government Securities

(ii) 30 percent or more of total State Government Securities and other
assets Guaranteed Securities [including (i) above]
(iii) 5 percent or more of total Housing and Loans to State Government for
assets Housing and Fire Fighting Equipment
(iv) 10 percent or more of total Investment in approved securities (as
assets specified in Schedule 11 to the Regulations)
under infrastructure and social sector
(v) Upto 55 percent of total assets Other securities (covered by Exposure Norms
specified in Regulation 5). It may be noted that
investments in “other than approved
securities” can in no case exceed 25 percent
of the total assets.
It may be mentioned here that with regard to (iv) above, subscription/purchase of bonds or
debentures issued by HUDCO, National Housing Insurance Company or House Building
Institutions duly accredited by National Housing Banks, for house building activities, duly
guaranteed by Government or carrying current fating of not less than ‘AA’ by an independent,
reputed and recognized agencies also qualify to be included in the limits [under clause (iv)]
above.
Audit Procedures - The auditor’s primary objective in audit of investments is to satisfy himself
as to their existence and valuation. Examination of compliance with statutory and regulatory
requirements is also an important objective in audit of investments insofar as non-compliance
may have a direct and material affect on the financial statements.
The auditor should verify the investment scrips physically at the close of business on the date
the balance sheet. In exceptional cases where physical verification of investment scrips on
the balance sheet date is not possible, the auditor should carry out the physical verification on
a date as near to the balance sheet date as possible. In such a case, he should take into
consideration any adjustments for subsequent transactions of purchase, sale, etc. He should
take particular care to see that only genuine investments are produced before him, and that
securities held by the insurance company on behalf of others (e.g., those held as security
against loans) are not shown to him as the insurance company’s own investments. To ensure
this, the auditor should – require that all investment scrips in the possession of the insurance
company – whether belonging to it or to borrowers should be produced before him
simultaneously. The auditor should keep them under his control until he completes his
checking. Normally, the investments of an insurance company are held by the insurance
company itself or a depository (in the case of dematerialised securities other than government
securities).
Investments are normally dealt with at the Head Office and not at the branches. However,
sometimes, for realisation of interest, etc. and other similar purposes, investments of an
insurance company may be held at Branch Offices also. In such cases, the auditor should
examine the record maintained at the Head Office to record details of investments held at
other locations and request the respective branch auditors to physically verify such
investments as a part of their audit. The auditor should obtain a written confirmation to this
effect from the branch auditors. In case the verification has been done on a date other than
the balance sheet date, a statement showing the reconciliation of the investments held at the
time of physical verification with the investments held as on the balance sheet date should
also be obtained from the branch auditors. The branch auditors should report whether
adequate records are maintained by the branch for the securities held by it on behalf of the
Head Office.
Investments should not normally be held by any other person (as laid down in the City
Equitable Fire Insurance Co. case). If any investments are so held, proper enquiry should be
made to ensure that there is some justification for it, e.g., shares may be held by brokers for
the purpose of transfer or splitting-up, etc. Shares may also be lodged with the companies
concerned for transfer etc. When investments are held by any other person on behalf of the
insurance company, the auditor should obtain a certificate from him. The certificate should
state the reason for holding the investment (e.g., in safe custody or as security).
In respect of scripless dealings in investments through the OTC Exchange of India, the auditor
should verify the interim and other acknowledgements issued by dealers as well as the year-
end confirmation certificates of the depository organisation.
The auditor should also examine whether securities lodged for transfer are received back
within a reasonable period. Similarly, he should examine whether share certificates, etc. are
received within a reasonable period, of the lodging of the allotment advice. In case there is an
unusual delay in registration of transfers, etc., the auditor should see that adequate follow-up
action has been taken. He may, in appropriate cases, also enquire from the issuers, or their
registrars, about the delays. In cases where the issuer/registrar has refused to register the
transfer of securities in the name of the insurance company, the auditor should verify the
validity of the title of the insurance company over such securities.
The auditor should examine whether the portfolio of the insurance company consists of any
securities whose maturity dates have already expired. It is possible that income on such
investments may also not have been received. In case the amount of such investments or the
income accrued thereon is material, the auditor should seek an explanation from the
management on this aspect. He should also consider whether any provision for loss on this
account is required. Similarly, where income on any security is long overdue, the auditor
should consider whether provision is required in respect of such income accrued earlier.
Investments in securities now-a-days constitute a substantial part of total assets of many
insurance companies. Method of valuation of investments followed by an insurance company
may, therefore, have a significant effect on its Balance Sheet and Profit and Loss Account.
The auditor should examine whether the method of accounting followed by the insurance
company in respect of investments, including their year-end valuation, is appropriate.
The auditor should examine the manner of accounting for investments in the context of the
guidelines of the Insurance Regulatory and Development Authority (discussed earlier in this
Chapter) and the accounting policy followed by the insurance company in respect of’
investments. The auditor should examine the appropriateness of accounting policies followed
by the insurance company. In case any of the accounting policies is not appropriate, the
auditor should consider the effect of adoption of such policy on the financial statements and,
consequently, on his audit report.
A change in the method of valuation of investments constitutes a change in accounting policy
and adequate disclosure regarding the fact of the change along with its financial effect should
be made in the balance sheet.
The auditor should examine whether income from investments is properly accounted for. This
aspect assumes special importance in cases where the insurance company has opted for
receipt of income through the Electronic Clearing Service.
There may be cases where the certificates of tax deduction at source (TDS) received along
with the interest on investments are found missing. This increases the incidence of tax on the
insurance company. The auditor should see that there is a proper system for recording and
maintenance of TDS certificates received by the insurance company.
12.8.2 Cash and Bank Balances - Cash and Bank balances at Branch Office/Divisional Office
level also constitute significant items related to balance sheet. The auditor should apply the
following audit procedures for verification of claims.
♦ The auditor should physically verify cash balance collection and imprest for meeting day
to day expenditures, postage stamps balance, revenue, policy, licence fees, franking
machine balance. The auditor should also obtain a certificate from the management for
the above mentioned balances as at the balance sheet date. If for some reason, the
physical verification of the above on the balance sheet date is not possible then the same
can be done at a subsequent date and by way of backward calculations, cash in hand at
the balance sheet date can be verified.
♦ The auditor should also check whether late collections of cash and cheques on the last
working day of the financial year, which could not be deposited into bank account on the
same day, have been identified and booked as Cash in Hand and Cheques in Hand
Account, respectively.
♦ The auditor may apply test check on the bank transactions.
♦ The auditor should also check Bank Reconciliation statement and long outstanding
entries therein.
♦ The auditor should obtain confirmation of Bank Balances for all operative and inoperative
accounts.
♦ The auditor should physically verify Term Deposit Receipts issued by bankers.
♦ The auditor should verify the deposits and withdrawals transactions at random and check
whether the Account is operated by authorised persons only
♦ The auditor should verify the subsequent realisations for all items appearing in the
reconciliation.
♦ In case of funds, in-transit, he should verify that the same are properly reflected as part
of bank balance.
12.8.3 Outstanding Premium and Agents’ Balances -The following are the audit procedures to
be followed for verification of outstanding premium and agents’ balances:
♦ Scrutinise and review control account debit balances and their nature should be enquired
into.
♦ Examine inoperative balances and treatment given for old balances with reference to
company rules.
♦ Enquire into the reasons for retaining the old balances
♦ Verify old debit balances which may require provision or adjustment. Notes of
explanation may be obtained from the management in this regard.
♦ Check age-wise, sector-wise analysis of outstanding premium.
♦ Verify whether outstanding premiums have since been collected.
♦ Check the availability of adequate bank guarantee or premium deposit for outstanding
premium.
12.8.4 Provision for Taxation - The steps to be conducted by the auditor for audit and
verification are given below:
(i) The auditor should check whether the provision for taxation has been made after taking
into account the above specific provisions applicable to insurance companies carrying on
general insurance business.
(ii) It should be seen by auditor whether for the purpose of computation not only the profit as
disclosed by the annual accounts, copies of which are required under the Insurance Act,
1938 to be furnished to the Controller of Insurance, is taken but also all the other
accounts furnished by the company to the Controller of Insurance is taken into account.
(iii) The auditor should assess the past trend regarding the approach of the Income Tax
Department, the decision of the various appellate forums including the High Court and
the Supreme Court vis-a-vis the computation made.
(iv) The compliance with the provisions of Chapter III provisions the Income Tax Act, 1961
which provides for income which do not form part of total income is also to be seen.
(v) The auditor should see whether deductions under Chapter VI A of the Income Tax Act,
1961 which provides for deduction have been made in computing total income is properly
taken into account.
(vi) The auditor should examine whether income computation relating to foreign branches
and other income earned outside India is dealt with properly as per the double taxation
avoidance agreement, if any, entered into with those countries.
(vii) It should be seen whether the exemption provision relating to tax deducted at source
from certain categories of income as exempted under section 35A of the General
Insurance (Business Nationalisation ) Act, 1972 has been properly availed.
(viii) Also, the auditor should check whether the grossing up of TDS relating to the income has
been properly done for the propose of computation of taxable income.
(ix) The auditor should ensure that the provisions of the Income Tax Act, 1961 regarding the
tax to be deducted at source have been properly complied with, relating to the payments
/ credits for which the TDS provisions of the Income Tax Act and applicable and the
amount so deducted are remitted within the stipulated time. Also check TDS implication
on the interest paid /payable and included on claim settlement / outstanding claims.
(x) The auditor may also assess the applicability of the Wealth Tax Act, 1957 with reference
to the assets of the company at the end of the year.
(xi) The auditor should see the system of service tax collection and the payment to the
statutory authorities and the internal system including the filing of statutory returns.
(xii) The examination of sales tax implication on the sale of salvage should also be seen as it
is applicable to the respective states and the past trend in this regard.
(xiii) The auditor should check the liability under the VAT and whether provision for adequate
amount has been made in the books or not.
(xiv) The auditor should verify that adequate provision has been made for additional liability
relating to earlier years for which demands have been received in the current year and
where the company has gone into appeal, the fact that no provision has been made and
that an appeal has been preferred has to be disclosed in the notes to accounts.
12.8.5 Unexpired Risks Reserve - The need for Unexpired Risks Reserve arises from the fact
that all policies are renewed annually except in specific cases where short period policies are
issued. Since the insurers close their accounts on a particular date, not all risks under policies
expire on that date. Many policies normally extend beyond this date into the following year
during which risks continue. In other words, at the closing date, there is unexpired liability
under various policies which may occur during the remaining term of the policy beyond the
year end. The effort involved in calculating unexpired portion of premium under each policy is
very time consuming therefore, a simple formula to derive a percentage of premium income to
be allocated to reserve for unexpired risks is adopted. According to the requirements of the
Insurance Act, 1938, for the purpose of maintaining solvency margin, it is sufficient if the
provision is made for unexpired risks at 50 per cent for Fire, Marine Cargo and Miscellaneous
business except for Marine Hull which has to be 100 per cent. It may be mentioned that the
insurance companies are governed by the provisions of Section 44 of the Income Tax Act,
1961. In this regard Rule 5 of the First Schedule to the Income Tax Rules-Computation of
Profit & Loss of General Insurance Business-provides for creation of a reserve for unexpired
risks as prescribed under Rule 6E of the said rules. According to this Rule, the insurance
companies are allowed a deduction of 50 per cent of net premium income in respect of Fire
and Miscellaneous Business and 100 per cent of the net premium income relating to Marine
Insurance business. In view of this, the reserves are created at the rates allowed under the
Income -tax Act.
Reinsurance
12.9 A reinsurance transaction may be defined as an agreement between a ‘ceding
company’ and a ‘reinsurer’ whereby the former agrees to ‘cede’ and the latter agrees to accept
a certain specified share of risk or liability upon terms as set out in the agreement. A ‘ceding
company’ is the original insurance company which has accepted the risk and has agreed to
‘cede’ or pass on that risk to another insurance company or the reinsurance company. It may,
however, be emphasised that the insured does not acquire any right under a reinsurance
contract. In the event of loss, the insured’s claim for full amount is against the original insurer
only. The original insurer in turn, lodges a claim with the reinsurer.
12.9.1 Type of Reinsurance Contracts - There are broadly two types of reinsurance contracts,
viz., facultative reinsurance and treaty reinsurance. A diagrammatic presentation is as below:
Types of Reinsurance Contracts
Facultative Treaty
Reinsurance Reinsurance
Proportional Non-Proportional
Treaty Treaty
Quota Auto- Excess

Share Surplus fac Pool of Loss Stop Loss
Treaty Treaty Treaty s (XL) Treaty
Treaty
Facultative Reinsurance - It is that type of reinsurance whereby the contract relates to one
particular risk and is expressed in the reinsurance policy. This is the oldest method of
reinsurance and it necessitates consideration of each risk separately. Each transaction under
facultative reinsurance has to be negotiated individually. Each party to the transaction has a
free choice, i.e., for the ceding company to offer and the reinsurer to accept. The main
drawbacks of this type of insurance are the volume of work involved and time taken to cover
the risk. It is, however, still used even today, mainly when:
(i) automatic covers have already been exhausted.

(ii) the risk is excluded from the Treaties.
(iii) the insurer does not want his reinsurance treaties overburdened with particularly heavy
and abnormal risks.
(iv) the insurer has no automatic cover at his disposal in a particular branch, where he issues
policies rarely.
(v) the nature of business is such that technical guidance or consultation with the reinsurer
is required at every stage of acceptance of the risk itself or for a type of business where
the number of risks is very small, for example, in atomic energy installations, oils rigs,
etc.
Treaty Reinsurance - Under this type of reinsurance, a treaty agreement is entered into
between the ceding company and the reinsurer(s) where reinsurances are within the limits of
the treaty. These limits can be monetary, geographical, section of business, etc. Under this
contract, it is obligatory for the reinsurer to accept all risks within the scope this treaty and it is
obligatory for the ceding company to cede risks in accordance with the terms of the treaty. In
the case of treaty reinsurance contracts, the insurer generally prepares a statement of treaty
reinsurances accounts, either on quarterly basis or on half-yearly basis. These statements are
sent to the re-insurer for the purpose of reconciliation of claims lodged under the reinsurance
contracts, out standing claims, claims paid and claims paid in advance. It may be noted here
that the treaty reinsurance contracts generally provide that in the event of any large claim
being lodged with the insurer, the re-insurer shall make the payment even before the claim is
finally settled or the statement of treaty reinsurance is received by the reinsurer. The
reinsurer, in such cases, treats the amount paid to the insurer as ‘advance against claim’. The
Advance against Claim Account is squared up as and when the claim is settled and the
information of this settlement is sent to the reinsurer through statement of treaty reinsurances.
Such payments by the reinsurer are called Cash Loss Payments. Treaties can also be divided
into two categories, viz., proportional treaties and non-proportional treaties.
Proportional Treaties - Such treaties are based on pro-rata apportionment of the sum
insured, premium and losses, according to a pre-determined percentage/ratio. These treaties
can be further classified as follows:
Quota share treaty - Under this treaty, the ceding company binds itself to cede a fix
percentage of all policies issued by it under a defined scope of business covered by the
agreement. The accounting under this treaty is simpler than any other form of treaties. The
advantage to the reinsurer under this treaty is that the reinsurer receives the same proportion
of all business of the treaty class defined under the treaty. In other words, there is no
selection against him. The advantage to the ceding company under this treaty is that, it
cannot vary its retention/line for any particular risk, and therefore, it may have to pay
premiums even on small risks which could have been retained by the ceding company itself.
The use of this treaty is appropriate when a company commences business at a branch where
no relevant data is available.
Surplus Treaty - Where a company cedes those amounts which it cannot or does not want to
retain for its net account, such type of contract is known as surplus reinsurance treaty. If
certain risk is totally retained, no surplus is left to be ceded. Surplus is always determined in
multiples of ceding company’s retention. A company can arrange more surplus treaties by
having, say, second surplus treaty or third surplus treaty, etc. An example is given below:
Sum Assured Rs. 500 lakhs
Line Rs. 5 lakhs
Surplus Rs.495 lakhs
If first surplus treaty is 10 lines, it would cede Rs.50 lakhs to the treaty and the balance of
Rs.445 lakhs would have to be ceded to other treaty arrangements.
Auto-fac Treaty - Under this treaty, a ceding company may reinsure upto a defined limit after
cession of its surplus treaties. It is obligatory for the reinsurer to accept cessions within the
purview of the agreement. It, thus, resembles a facultative reinsurance treaty as the
acceptance is obligatory and in many instances, the details of the risks are submitted by way
of a Borderaux.
Pools - More than one insurer may form a Pool under an agreement whereby its members
cede a pre-determined proportion of a particular category of business directly written by them
into the Pool. They also share the aggregate premiums and claims in the proportion and the
share of premium ceded by each member. In India, the examples of this system are Indian
Market Fire Pool and Hull Pools.
Non-Proportional Treaties - Such treaties are characterised by a distribution of liability
between the ceding company and the reinsurer on the basis of losses rather than the sum
insured, as is the case in proportional reinsurance. The following are the other characteristics
of non-proportional treaties:
(i) Premium is not calculated on each cession, but on the whole portfolio of the ceding
company.
(ii) The premium rate is predetermined.
(iii) Cost of reinsurance can vary substantially each year, depending on the premium income,
loss ration and reinsurance marked situations.
(iv) Normally no commission is paid.
Non-Proportional Treaties can be further classified into following categories.
Excess of Loss (XL) Treaties - In this type of treaty, the reinsurer’s liability arises only when
a claim exceeds a predetermined figure relating to a specific branch of the ceding company’s
business or to its entire business. The Treaty would provide for maximum liability as well as
the amount upto which the ceding company would bear the loss itself, which is called the
‘Underlying Limit’. The XL cover can also be arranged for an unlimited amount in excess of
the underlying limit.
Excess of loss cover on prevent basis - In this type of cover, in case as a result of one
event several risks are effected, the loss under each risk is arrived at separately and the
underlying limit is applied to each risk to determine the liability of the insurer. This is also
known as ‘Working Excess of Loss Cover’.
Excess of loss cover on non-prevent basis- In this type of cover, losses resulting from one
event are considered together and aggregate amount of loss is determined and one loss
underlying limit is deducted from the aggregate amount of the loss to determine the liability of
the excess of loss reinsurer. This type of cover provides protection to an insurer against the
numerous losses caused by one or the same event such as cyclone, earthquake, etc. This
type of cover is also, therefore, known as ‘Catastrophic Covers’.
Stop loss treaties - This is also known as ‘Excess of Loss Ration Cover’ and it protects the
company from losing more than a specified amount for a given class of business. Normally,
the amount is fixed in relation to the ceding company’s annual premium income for the class of
business and is represented as a percentage. Thus, the reinsurer is liable for the losses
which exceed the agreed percentage of loss ratio, until the limit of liability is reached which is
expressed in the form of loss ratio. Such a treaty protects the annual results of a company in
one branch against negative deviation due to increase in the number and cost of
claims/losses.
12.9.2 Verification of Re-Insurance Inward - Under Sub-regulation 4 of the IRDA (General
Insurance Reinsurance) Regulations, 2000, every insurer desirous of writing inward
reinsurance business should have a well defined underwriting policy. The decisions on
acceptance of re-insurance should be taken by persons with good knowledge and experience,
keeping in view the financial risk involved in those transactions. The insurer is required to file
with the Authority, a note on its underwriting policy and any changes therein from time to time.
The auditor should apply the following verifications measurers for re-insurance inward
transactions:
♦ Re-Insurance Inward underwriting should be as per the norms and guidelines prescribed
by the Insurance Act, 1938 and IRDA Regulations. It is necessary to ensure that the
inward reinsurance arrangements and acceptances, both Indian and foreign are done as
per the prescribed parameters applicable for the particular year.
♦ The auditor should check that domestic inward acceptances are in accordance with the
approved programme.
♦ The auditor should verify whether re-insurance inward acceptance, both Indian and
foreign, are as per arrangements / agreements entered into with Indian and foreign
insurance companies.
♦ The auditor should also verify whether the policy adopted for booking the accounts is on
“receipt” basis or “due” basis with the appropriate basis of estimation towards accounts
not received and that the basis of estimation is fair and consistently applied and properly
disclosed.
♦ The auditor should examine whether proper system exists to have control over the
quantum of agreements existing at any point of time and also that periodical accounting
statements received in connection with the agreements.
♦ The auditor should verify whether proper closing returns have been received for
premiums and claims for facultative acceptances.
♦ The auditor should check the accounts for closure of any underwriting year, with portfolio
withdrawals as per the terms and conditions agreed.
♦ The auditor should evaluate the system and practice adopted in recognising the foreign
currency transaction and also whether it is in accordance with the Accounting Standard
(AS)-11, Accounting for Effects of Changes in Foreign Exchange Rates.
♦ The auditor should verify whether profit commission has been calculated as per the
agreement and terms and conditions and all the statements rendered are properly taken
into account.
♦ The auditor should check whether there is any run off claim / large claim of long chain in
nature which requires any provisioning.
♦ The auditor should also verify whether the Foreign Inward acceptance components,
consisting of premium, commission, brokerage and other expenses, claims consisting of
paid claims opening and closing outstanding claims etc., have been recorded and
accounted as per the accounts rendered by the companies. It is essential that the
statement should be rendered in the currency in which it was agreed to be transacted
and the conversion of foreign currency balances from the accounts submitted have been
done at the appropriate conversion rates as per Accounting Standard (AS)-11.
♦ The auditor should examine whether the outstanding claim figures have been properly
obtained well in time, under proper systematic arrangements and sufficient provisioning
has been made for all the outstanding claims. The auditor should see that regarding
foreign inward, appropriate provisioning is done after adopting prescribed conversion rate
to the Indian rupee. The auditor should ensure that confirmation regarding the
outstanding claims have been received in respect of all inward arrangements.
♦ As per IRDA (General Insurance-Reinsurance) Regulations, 2000, every insurer is
required to make provision for outstanding claims for all reinsurance arrangements
accepted on the basis of loss information advices received from brokers /cedants and
where such advices have not been received, on an actuarial estimation basis. In
addition, every insurer has to make an appropriate provision for ‘Incurred but Not
Reported (IBNR)’ claims on its reinsurance accepted portfolio on actuarial estimation
basis. This aspect has to be looked into as this may result in a lot of difference in the
financial results of the company.
♦ Closing balances of the re-insurer’s accounts should be reconciled and the confirmation
of balances should be obtained from all the companies.
♦ The auditor must ensure that foreign inward accounts balances have been re-stated at
the prevailing value at the year end and that difference arising out of re-statement has
been taken to Profit and Loss Account.
♦ The auditor should verify the requirement of provision / write off of reinsurance inward
balances based on the doubtful nature of recovery, if any.
♦ The auditor should check whether Indian inward balances including with the GIC have
reconciled and identical balances arrived at and affect, if any, due to co-insurance
transactions should also be looked into.
12.9.3 Verification of Re-Insurance Outward -The following steps may be taken by the auditor
in the verification of re-insurance outward;
♦ The auditor should verify that re-insurance underwriting returns received from the
operating units regarding premium, claims paid, outstanding claims tally with the audited
figures of premium, claims paid and outstanding claims.
♦ The auditor should check whether the pattern of re-insurance underwriting for outward
cessions fits within the parameters and guidelines applicable to the relevant year.
♦ The auditor should also check whether the cessions have been made as per the
stipulation applicable to various categories of risk.
♦ The auditor should verify whether the cessions have been made as per the agreements
entered into with various companies.
♦ It should also be seen whether the outward remittances to foreign re-insurers have been
done as per the foreign exchange regulations.
♦ It should also be seen whether the commission on cession has been calculated as per
the terms of the agreement with the re-insurers.
♦ The auditor should verify the computation of profit commission for various automatic
treaty arrangements in the light of the periodical accounts rendered and in relation to
outstanding loss pertaining to the treaty.
♦ The auditor should examine whether the cash loss recoveries have been claimed and
accounted on a regular basis.
♦ The auditor should also verify whether the Claims Paid item appears in Outstanding
Claims list by error. This can be verified at least in respect of major claims.
♦ He should see whether provisioning for outstanding losses recoverable on cessions have
been confirmed by the re-insurers and in the case of major claims, documentary support
should be insisted and verified.
♦ Accounting aspects of the re-insurance cession premium, commission receivable, paid
claims recovered, and outstanding losses recoverable on cessions have to be checked.
♦ The auditor should check percentage pattern of gross to net premium, claims paid and
outstanding claims to ensure comparative justification.
♦ The auditor should also check that the re-insurers balance on cessions and whether the
sub ledger balances tallies with the general ledger balances.
♦ The auditor should review the individual accounts to find out whether any balance
requires provisioning / write off or write back.
♦ He should verify whether the balances with re-insurers are supported by necessary
confirmation obtained from them.
♦ He should verify whether opening outstanding claims not paid during the year find place
in the closing outstanding claims vis-a-vis the reinsurance inwards outstanding losses
recoverable on cessions appears in both opening and closing list. If not, the reason for
the same should be analysed.
♦ Any major event after the Balance Sheet date which might have wider impact with
reference to subsequent changes regarding the claim recovery both paid and outstanding
and also re-insurance balances will need to be brought out suitably.
Co-Insurance
12.10 Where the insured chooses to have more than one insurer for the same transaction of
risk, it would amount to coinsurance. The concept of co-insurance emerges, when there is a
predetermined set of understandings, leader of the business receives the premium and issues
policy with a co-insurance clause in the policy and the referred leader also settle the claims to
the insured in case of the occurrence of claims. Balances pertaining to other companies
relating to premiums and claims are accounted under co-insurance as “Amounts due to / due
from” other insurance companies.
Balances are settled in periodical meetings and exchange of statements as agreed between
the companies. Suitable slot can be provided in the systems to incorporate co-insurance
requirements. Most of the practice in accounting and settlement of co-insurance transactions
are industry specific and insured specific. Hence, system may suitably be designed to
accommodate all the possibilities of co-insurance accounting and settlements.
The auditors should get information from the agreement arrived at the Insurance Council,
where the insurance companies may chose to be the members. (Wherever the concept of
Insurance Council is in place). Members of the Insurance Council could arrive the mutually
agreeable terms and norms of entering into coinsurance agreement and the norms for
settlement of dues. The Insurance Council may recommend the following norms while entering
into coinsurance agreement:
♦ Settlement of commission
♦ Collection and Remittance of service tax
♦ Standard practices for settlement of dues
♦ Settlement of claims
♦ Reinsurance arrangement for the risk booked
♦ Exceptional booking and the powers thereof deviating from the Council’s understanding
The auditor should go through the understanding of the Council and ensure that the risks are
covered as per the terms and conditions with adequate consideration and proper settlement.
Solvency Margin
12.11 Section 64VA of the Insurance Act, 1938, inter alia, requires every insurer to maintain
an excess of the value of its assets over the amount of its liabilities at all times. The excess is
known as ‘Solvency Margin’. In the case of an insurer carrying on general insurance
business, the solvency margin should be the highest of the following amounts:
(a) fifty crore rupees (one hundred crores of rupees in case of a reinsurer); or
(b) a sum equivalent to twenty percent of net premium income; or
(c) a sum equivalent to thirty percent of net incurred claims,
subject to credit for reinsurance in computing net premiums and net incurred claims being
actual but a percentage, determined by the regulation but not exceeding fifty percent. It may
be noted that conditions regarding maintenance of the above mentioned solvency margin may
be relaxed by the Authority in certain special circumstances.
If, at any time, an insurer does not maintain the required solvency margin, the insurer is
required to submit a financial plan to the Authority indicating the plan of action to correct the
deficiency in the solvency margin. If, on consideration of the plan, the Authority finds it
inadequate, the insurer has to modify the financial plan.
Maintenance of solvency margin has a great importance for an insurance company
considering their size and nature of business and also involvement of public money. Sub-
section (2C) of Section 64A states that if an insurer fails to comply with the requirements of
the Insurance Act, 1938, it shall deemed to be insolvent and may be wound up by the Court.
12.11.1 IRDA Regulations - Sub section (3) of Section 64V of the Act requires that every
insurer should value the assets and liabilities in the manner laid down by the Section 64V and
in accordance with the regulations which may be made by the Authority in this behalf.
The Authority has issued IRDA (Assets, Liabilities and Solvency Margin of Insurers)
Regulations. The Regulations lay down manner of valuation of assets and liabilities, the forms
in which assets and liabilities are to be disclosed, the manner of determination of solvency
margins and the format of certificate to be signed by the auditors.
Every Insurer is required prepare a statement of value of assets in “Form IRDA-Assets-AA.” A
statement of the amount of liabilities in case of general insurance business is to be prepared
in “Form HG” and a statement of Solvency Margin in “Form KG” as specified in the Insurance
Regulatory and Development Authority (Assets, Liabilities and Solvency Margin of Insurers)
Regulations. The statement of assets, liabilities and solvency margin are to be certified by an
auditor and filed by the insurance company with the Authority within six months from the end
of the period to which they refer to along with the audited accounts and statements. The
salient features pertaining to the valuation of assets are discussed below:
12.11.2 Statement of Solvency Margin -Every insurer is required to determine the required
solvency margin, the available solvency margin and the solvency ratio in the Form KG. The
statement of solvency margin is to be prepared in accordance with Section 64 VA of the
Insurance Act, 1938 and the same is to be certified by the auditor.
Appendix I
Format of Financial Statements
Form B-RA
Name of the Insurer:
Registration No. and Date of Registration with the IRDA
Revenue Account for the year ended 31st March, 20….

(To be prepared separately fire, marine, and miscellaneous insurance)
Particulars Schedule Current year Previous year
(Rs.’000) (Rs.’000)
1. Premiums earned (Net) 1
2. Profit/Loss on sale/redemption of
investments
3. Others (to be specified)
4. Interest, Dividend & Rent-Gross
Total (A)
1. Claims incurred (Net) 2
2. Commission 3
3. Operating Expenses related to 4
Insurance Business
4 Others – To be specified
Total (B)
Operating Profit/(Loss) from Fire/Marine/
Miscellaneous Business (A-B)
Appropriations
Transfer to Shareholders’ Account
Transfer to Catastrophe Reserve
Transfer to Other Reserves (to be specified)
Total (C)
FORM B-PL
Profit and Loss Account for the year ended 31st March 20…..

(Rs.’000) (Rs.’000)
1. Operating Profit/(Loss)
(a) Fire Insurance
(b) Marine Insurance
(c) Miscellaneous Insurance
2. Income from investments
(a) Interest, Dividend & Rent - Gross
(b) Profit on sale of investments
Less: Loss on sale of investments
3. Other income (To be specified)
Total (A)
4. Provisions (other than taxation)
(a) For diminution in the value of
investments
(b) Four doubtful debts
(c) Others (to be specified)
5. Other expenses
(a) Expenses other than those
related to Insurance Business
(b) Bad debts written off
(c) Others (To be specified)
Total (B)
Profit Before Tax
Provision for Taxation
Appropriations
(a) Interim dividends paid during the year
(b) Proposed final dividend
(c) Dividend distribution tax
(d) Transfer to any Reserves or Other
Accounts (to be specified)
Balance of profit/loss brought forward from
last year
Balance carried forward to Balance Sheet
Note:
(a) Premium income received from business concluded in and outside India shall be separately
disclosed.
(b) Reinsurance premiums whether on business ceded or accepted are to be brought into account
gross (i.e. before deducting commissions) under the head reinsurance premiums.
(c) Claims incurred shall comprise claims paid, specific claims settlement costs wherever applicable
and change in the outstanding provision for claims at the year-end,.
(d) Items of expenses and income in excess of one percent of the total premiums (less reinsurance)
or Rs.5,00,000 whichever is higher, shall be shown as a separate line item.
(e) Fees and expenses connected with claims shall be included in claims.
(f) Under the sub-head "Others” shall be included items like foreign exchange gains or losses and
other items.
(g) Interest, dividends and rentals receivable in connection with an investment should be stated as
gross amount, the amount of income tax deducted at source being included under 'advance taxes
paid and taxes deducted at source”..
(h) Income from rent shall include only the realised rent. It shall not include any notional rent.
FORM B-BS
Balance Sheet as at 31st March, 20…
(Rs.’000) (Rs.’000)
Sources of funds
Share capital 5
Reserves and surplus 6
Fair value change account
Borrowings 7
Total
Application of funds
Investments 8
Loans 9
Fixed assets 10
Current assets
Cash and Bank Balances 11
Advances and Other Assets 12
Sub-Total (A)
Current liabilities 13
Provisions 14
Sub-Total (B)
Net current assets (C ) = (A-B)
Miscellaneous expenditure (to the extent not 15
written off or adjusted)
Debit balance in profit and Loss Account
Total
Contingent Liabilities
Particulars Current Year Previous Year
(Rs.’000) (Rs.’000)
1. Partly paid-up investments
2. Claims, other than against policies, not acknowledged as
debts by the company
3. Underwriting commitments outstanding (in respect of
shares & securities)
4. Guarantees given by or on behalf of the Company
5. Statutory demands/liabilities in dispute, not provided for
6. Reinsurance obligations to the extent not provided for in
other accounts
7. Others ( to be specified)
Total
Schedules forming Part of Financial Statements

Schedule 1
Premium Earned (Net)
(Rs.’000) (Rs.’000)
Premium from direct business written
Add: Premium on reinsurance accepted
Less: Premium on reinsurance ceded
Net Premium
Adjustment for changes in reserve for unexpired risks
Total Premium Earned (Net)
Note: Reinsurance premiums whether on business ceded or accepted are to be brought into account,
before deducting commission, under the head of reinsurance premiums.
Schedule 2
Claims Incurred (Net)
(Rs.’000) (Rs.’000)
Claims paid
Direct
Add: Reinsurance accepted
Less: Reinsurance Ceded
Net Claims paid
Add claims Outstanding at the end of the year
Less Claims Outstanding at the beginning
Total Claims Incurred
Notes:
(a) Incurred But Not Reported (IBNR), Incurred But Not Enough Reported (IBNER) claims should be
included in the amount for outstanding claims.
(b) Claims include specific claims settlement costs but not expenses of management.
(c) The surveyor fees, legal and other expenses shall also form part of claims cost.
(d) Claims cost should be adjusted for estimated salvage value if there is a sufficient certainty of its
realisation.
Schedule 3
Commission
Particulars Current year Previous Year
(Rs. '000) (Rs. '000)
Commission paid
Direct
Add: Re-insurance Accepted
Less: Commission on Re-
Insurance Ceded
Net Commission
Note:
The profit/commission, if any, are to be combined with the Re-insurance accepted or Reinsurance
ceded figures.
Schedule 4
Operating Expenses Related to Insurance Business
(Rs. '000) (Rs. '000)
1 Employees' remuneration & welfare benefits
2 Travel, conveyance and vehicle running expenses
3 Training Expenses
4 Rents, rates & taxes
5 Repairs
6 Printing & stationery
7 Communication
8 Legal & professional charges
9. Auditors fees, expenses etc.
(a) as auditors
(b) as adviser or in any other capacity, in respect
of
(i) Taxation matters
(ii) Insurance Matters
(iii) Management services; and
(c) in any other capacity
10 Advertisement and publicity
11 Interest & Bank Charges
12 Others (to be specified)
13 Depreciation
Total
Note: Items of expenses and income in excess of one percent of net premium or Rs. 5,00,000
whichever is higher, shall be shown as a separate line item.
Schedule 5
Share Capital
(Rs. '000) (Rs. 000)
1. Authorised Capital
Equity Shares of Rs..... each
2. Issued Capital
Equity Shares of Rs. ... each
3. Subscribed Capital
4. Called-up Capital
Less: Calls unpaid
Add: Equity Shares Forfeited
(Amount originally paid up)

Less: Par Value of Equity Shares Brought Back
Expenses including commission or brokerage on
Underwriting or subscription of shares
Total
Notes:
(a) Particulars of the different clauses of capital should be separately stated.
(b) The amount capitalised on account of issue of bonus shares should be disclosed.
(c) In case any part of the capital is held by a holding-company, the same should be separately
disclosed.
Schedule 5A
Share Capital Pattern of Shareholding
(As certified by the Management)
Shareholder Current Year Previous year
Number of % of Holding Number of % of Holding
Shares Shares
Promoters
Indian
Foreign
Others
Total
Schedule 6
Reserves and Surplus
Particulars Current Year Previous year
(Rs. '000) (Rs. '000)
1 Capital Reserve
2 Capital Redemption reserve
3 Share Premium
4 General Reserves
Less: Debit balance in Profit and
Loss Account
Less: Amount utilzed for Buy-back
5 Catastrophe Reserve
6 Other Reserves (to be specified)
7 Balance of Profit in Profit & Loss Account
Total
Note:
(a) Additions to and deductions from the reserves should be disclosed under each of the specified
heads.
Schedule 7
Borrowings
Particulars Current year Previous year
(Rs. '000) (Rs. '000)
1 Debentures/Bonds
2 Banks
3 Financial Institutions
4 Other (to be specified )
Total
Notes:
(a) The extent to which the borrowings are secured shall be separately disclosed stating the nature
of the security under each sub-head.
(b) Amounts due within 12 months from the date of Balance Sheet should be shown separately.
Schedule 8
Investments
(Rs. '000) (Rs. '000)
Long Term Investments
1. Government securities and Government guaranteed
bonds including Treasury Bills
2. Other Approved Securities
3. Other Investments
(a) Shares
(i) Equity
(ii) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
(h) Investments in Infrastructure and Social
Sector
(i) Other than Approved Investments
Short Term Investments
1. Government securities and Government guaranteed
bonds including Treasury Bills
2. Other Approved Securities
3. Other Investments
(a) Shares
(i) Equity
(ii) Preference
(b) Mutual Funds
(c) Derivative Instruments
(d) Debentures/Bonds
(e) Other Securities (to be specified)
(f) Subsidiaries
(g) Investment Properties-Real Estate
(h) Investments in Infrastructure and Social
Sector
(i) Other than Approved Investments
Total
Investments
1. In India
2. Outside India
Total
Notes:
(a) Investments in subsidiary/holding companies, joint ventures and associates shall be separately
disclosed, at cost.
(i) Holding company and subsidiary shall be construed as defined in the Companies Act,
1956. Significant influence may be exercised in several ways, for example, by
representation on the board of directors, participation in the policy making process,
material inter-company transactions, interchange of managerial defined in the Companies
Act, 1956.
(ii) Joint Venture is contractual arrangement whereby two or more parties undertake an
economic activity, which is subject to joint control.
(iii) Joint control- is the contractually agreed sharing of power to govern the financial and
operating policies of an economic activity to obtain benefits from it.
(iv) Associate- is an enterprise in which the company has significant influence and which is
neither a subsidiary nor a joint venture of the company.
(v) Significant influence (for the purpose of this Schedule)- means participation in the
financial and operating policy decisions of a company, but not necessarily control of those
policies personnel or dependence on technical information. Significant influence may be
gained by share ownership, statute or agreement. As regards share ownership, if an
investor holds, directly or indirectly through subsidiaries, 20 per cent or more of the voting
power of the investee, it is presumed that the investor does have significant influence,
unless it can be clearly demonstrated that this is not the case. Conversely, if the investor
holds, directly or indirectly through subsidiaries, less than 20 per cent of the voting power
of the investee, it is presumed that the investor does not have significant influence, unless
such influences is clearly demonstrated. A substantial or majority ownership by another
investor does not necessarily preclude an investor from having significant influence.
(b) Aggregate amount of company's investments other that listed equity securities and derivative
instruments and also the market value thereof shall be disclosed.
(c) Investments made out of Catastrophe reserve should be shown separately.
(d) Debt securities will be considered as "held to maturity" securities and will be measured at
historical cost subject to amortisation.
(e) Investment Property means a property (land or building or part of a building or both) held to
earn rental income or for capital appreciation or for both, rather than for use in services or for
administrative purposes.
(f) Investments maturing within twelve months from balance sheet date and investments made with
the specific intention to dispose of within twelve months from balance sheet date shall be
classified as short-term investments.
Schedule 9
Loans
(Rs. '000) (Rs. '000)
1. Security-Wise Classification
Secured
(a) On mortgage of property
(i) In India
(ii) Outside India
(b) On Shares, Bonds, Government Securities
Unsecured
Total
2. Borrower-Wise Classification
(a) Central and State Governments
(b) Banks and Financial Institutions
(c) Subsidiaries
(d) Industrial Undertakings
(e) others (to be specified)
Total
3. Performance-wise Classification
Loans Classified as standard
(i) In India
(ii) Outside India
Non-performing loans less provisions
(i) In India
(ii) Outside India
Total
4. Maturity-Wise Classification
(a) Short-term
(b) Long Term
Total
Notes:
(a) Short-term loans shall include those, which are repayable within 12 months of the balance sheet
date. Long-term loans shall be the loans other than short-term loans.
(b) Provisions against non-performing loans shall be shown separately.
(c) The nature of the security in case of all long-term secured loans shall be specified in each case.
Secured loans for the purposes of this Schedule, means loans secured wholly or partly against an
asset of the company.
(d) Loans considered doubtful and the amount of provision created against such loans shall be
disclosed.
Schedule 10
Fixed Assets (Rs. ‘000)
Cost/Gross Block Depreciation Net Block
Opening Additions Deduc- Closing Upto For On Sales/ To As at Previou
tions last the Adjustments Date year end s year
Year year
Goodwill
Intangibles
(specify)
Land-
Freehold
Leasehold
property
Buildings
Furniture
and Fittings
Information
and
Technology
Equipment
Vehicles
Office
Equipment
Others
(Specify
nature)
Total
Work-in-
Progess
Grand Total
Previous
year
Note:
Assets included in land, building and property above exclude Investment Properties as defined in note (e) to
Schedule 8.
Schedule 11
Cash and Bank Balances
(Rs. ‘000) (Rs. ‘000)
1. Cash (including cheques, drafts and stamps)
2. Bank Balances
(a) Deposit Accounts
(aa) Short-term (due within 12 months)
(bb) Others
(b) Current Accounts
3. Money at Call and Short Notice
(a) with Banks
(b) with other Institutions
Total
Balances with non-scheduled banks included in 2 and 3 above
Note:
Bank Balance may include remittances in transit. If so, the nature and amount should be separately stated.
Schedule 12
Advances and Other Assets
(Rs. '000) (Rs. '000)
ADVANCES
1. Reserve deposits with ceding companies
2. Application money for investments
3. Prepayments
4. Advances to Officers/Directors
5. Advance tax paid and taxes deducted at source (Net
provisions for taxation)
Total (A)
Other Assets
1. Income accrued on investments
2. Outstanding Premiums
3. Agents’ Balances
4. Foreign Agencies Balances
5. Due from other insurance entities (including
reinsures)
6. Due from subsidiaries/holding

7. Deposit with Reserve Bank of India
(Pursuant to Section 7 of Insurance Act, 1938)
Total (B)
Total (A+B)
Notes:
(i) The items under the above heads shall note be shown net of provisions for doubtful amounts. The
amount of provision against each head should be shown separately.
(ii) The term 'officer' should conform to the definition of the word 'officer' given under the Companies
Act, 1956.
(iii) Sundry debtors will be shown under item 8.
Schedule 13
Current Liabilities
(Rs. '000) (Rs. '000)
1. Agents’ Balances
2. Balances due to other insurance companies
3. Deposits held on re-insurance ceded
4. Premiums received in advance
5. Unallocated Premium
6. Sundry creditors
7. Due to subsidiaries/holding company
8. Claims Outstanding
9. Due to Officers/Directors
Total
Schedule 14
Provisions
(Rs. '000) (Rs. '000)
1. Reserve for Unexpired risk
2. For taxation(less advance tax paid and taxed deducted
at source
3. For proposed dividends.
4. For dividend distribution tax
Total
Schedule 15
Miscellaneous Expenditure
(To the extent not written off or adjusted)
Particulars Current year Previous year
(Rs. '000) (Rs. '000)
1. Discount Allowed in issue of shares/debentures
2. Others (to be specified
Total
Notes:
No item shall be included under the head "Miscellaneous Expenditure and carried forward unless:
1. some benefit from the expenditure can reasonable be expected to be received in future, and
2. the amount of such benefit is reasonable determinable.
(b) The amount to be carried forward in respect of any item included under the head "Miscellaneous
Expenditure" shall not exceed the expected future revenue/other benefits related to the expenditure.
APPENDIX II
Directions under Section 619 (3) (a) of the Companies Act, 1956, applicable to
Insurance Companies
I. System of Accounts
1. Examine the following systems and give your views as regards their deficiencies alongwith
suggestions for remedial measures:-
(a) Recording of receipts and expenditure.
(b) Drawing periodical trial balance.
(c) Compilation of accounts.
(d) Reconciliation of inter-office accounts.
(e) Reconciliation of registers/records relating to property, assets. Investments, premiums,
claims, loans, etc., with financial books.
(f) Maintenance of up-to-date records in respect of assets, which are pledged, encumbered
or blocked in any way.
2. Are the bank accounts of the company reconciled with the bank statements regularly? If not,
describe the failures.
3. Are control accounts and subsidiary accounts up-to-date and reconciled regularly? If not,
describe the failures.
4. Examine the accounting policies of the company. Are these in conformity with the Accounting
Standards (National and in the absence of National Standards, the corresponding International
Standard)? Give particulars of material departures from these standards, if any, alongwith
their effect on the financial statements; quantify the impact wherever possible.
II. System of Financial Control
1. Examine the delegation of financial powers and indicate whether these are clearly and legally
made within the company. If not, describe the defects in the delegation of powers and suggest
remedial measures.
2. Indicate whether the cash and imprest balances were physically verified during the year on a
regular basis by an authorised officer? Highlight the inadequacies in this regard, if any.
3. Whether transfers of surplus funds are being made on a timely basis and whether these are
being properly monitored?
4. Examine whether the system of the company insures adequate control over issue and custody
of critical items of stationery, e.g., cover notes, policy documents receipts and
acknowledgements relating to risk accepted, etc? If not, describe the inadequacies.
5. Give your comments on Internal Audit system stating whether its reporting status, scope of
work, level of competence, etc. are adequate? If not, describe the short-comings thereof. Is
there an adequate compliance mechanism on internal audit observations?
6. Indicate the serious lacunae in the system of internal control which have come to your notice
during audit.
III. Investments (Applicable only at H.O.)

1. Indicate whether the Board of Directors of the company laid down on investment policy? If
yes, please indicate the following:-
(a) Is the policy in accordance with the laws, rules and regulations applicable to the
company?
(b) In your opinion, are there any defects in the policy?
(c) Has the company followed it in case of all material investments made during the year?
(d) Were the investments made by the company in its best interest?
2. Does the company have adequate system of periodic physical verification of investments and
reconciliation thereof with books? Have the discrepancies been properly dealt with?
3. Does the system of the company ensure proper recording of rights, entitlements and options
on investments held? Are adequate records maintained in support of exercise/non exercise of
such rights, etc.?
4. Does the system of the company ensure recording of accrual of dividend, interest and other
yields on investments and for follow up of the amounts accrued but not received?
5. In the case of investments matured and income due but not received/collected, is satisfactory
explanation available for non-receipt/non-collection?
IV. Loans (Applicable only at H.O.)
1. Indicate whether the Board of Directors of the company has laid down a policy regarding of
loans. If yes, please indicate the following :-
(a) Is the policy in accordance with the laws, rules and regulations applicable to the
company?
(b) In your opinion, are there any defects in the policy?
(c) Has the company followed it in the case of all material loans made during the years?
(d) Were the loans made by the company in its best interest?
(e) Has adequate provision been made in the accounts in respect of bad and doubtful
loans? If not, describe the failures.
(f) Does the company have an effective system of identifying non-performing loans? Does
the company monitor such loans effectively?
(g) Has the company taken adequate steps against the defaulters during the year? If not,
indicate significant instances of failures.
V. Revenue Accounts
1. Does the company has an effective system to ensure that premiums for risks
assumed/accepted during the year for various classes of business are properly computed and
accounted for?
2. Is the system of collections of premium on policies issued adequate? If not, give instances of
major violations of relevant legal provisions and prescribed procedures.
3. Have the norms for determining premium for non-tariff business been laid down by the
company and are these followed by divisions/branches booking the business?

4. Have you come across instances of prohibited/declined risks having been accepted in excess
of the delegated authority?
5. In respect of system relating to claims, comment on the following aspects, giving instances of
significant deviations/failures in each case.
(a) Are claims promptly recorded in the claims intimation register for each class of
business? Is the liability of the company ascertained/ assessed expeditiously?
(b) Are surveyors appointed and their preliminary/final survey reports obtained within a
reasonable time?
(c) Is collection and accounting of salvage as well as its disposal expeditious?
(d) Are close proximity claims, i.e., claims within a short period after commencement of the
risk, identified? Are the procedures for processing of such claims effective/
(e) Are pending claims reviewed periodically and follow-up action taken in appropriate
cases?
6. Does the system of the company ensure that claims are recorded net of co-insurance at the
D.O./branch and net of re-insurance as per arrangement with other insurers at the Head
Office?
7. Is the system of monitoring the accepted or ceded business and accounting of premiums and
claims in connection therewith adequate? Indicate major defects.
8. Are balances under accepted treaties periodically reconciled and action taken for outstanding
recoveries?
9. Does the system of the company ensure proper recording of incoming and outgoing co-
insurance transactions and periodic reconciliation of co-insurers balances?
10. Does the system of the company ensure periodic reconciliation of ledger balances relating to
premiums and claims with the relevant figures as per the business and claims registers as
communicated by divisions in the underwriting returns for purpose of re-insurance?
11. Were the re-insurance treaties entered into by the company in its best interest? Indicate cases
of re-insurance treaties which have resulted in heavy losses continuously.
VI. Miscellaneous
1. Are the (i) Premium deposit accounts, (ii) Bank guarantee account, (iii) Agent's balance accounts
(iv) Outstanding premium accounts, (v) Amount due to and from other persons/bodies carrying on
insurance business accounts, (vi) Treaty inwards and outwards control accounts , (vii) sundry
debtors and creditors accounts including outstanding claims, regularly reviewed and pursued for
clearance/adjustment? Have confirmations been obtained of such outstanding accounts. ? In the
case of credit Balance including premium deposits, sundry deposits and agents balances, are
appropriate premium adjustments made for risks assumed, if any ?
2. Were there any special features in the year which have affected the results shown by the profit and
Loss Account substantially ? If so, give details.
3. Are there any other significant matters which in your opinion deserve the attention of the
management?
Annexure -A
(This information is factual and should be obtained from the Management)
1. Indicate the areas where the company has computerised the accounts system. Have the General
and Application controls been reviewed periodically to derive assurance that the system is producing
results that can be relied upon by the auditors? State the deficiencies reported by internal
auditors/statutory auditors alongwith the remedial measures being taken by the management.
2. Are the accounts of the company in arrears? If so, state the reasons therefor and the action
taken/being taken to bring the accounts up-to-date.
3. Please comment on operation of foreign branches/ agencies with relevant details. In case of
adverse results remedial measures taken and results thereof should be described.
4. What are non-performing investments? Please indicate the cost, book value and market value of
such investments.
5. What is the average yield on investments in last three years?
6. What percentage of loans was considered doubtful at the end of each the three preceding years and
the absolute amount thereof?
7. Give age-wise break-up of outstanding claims for each class of business (numbers and amount).
8. List out top 30 claims (above Rs. 5 lakhs each) provided/settled during the year (10 for each class of
business).
9. Have any cases of frauds/embezzlements/ misappropriation comes to light during the year? If so,
give details
13
AUDIT OF CO-OPERATIVE SOCIETIES
Introduction
13.1 The Co-operative Societies Act, 1912, a Central Act, contains the fundamental law
regarding the formation and working of the co-operative societies in India and is applicable in
many states with or without amendments. In many states, viz., Maharashtra, West Bengal,
Orissa, the co-operative societies are governed by specific state Acts. An auditor of a co-
operative society should be familiar with the provisions of the particular Act governing the
society under audit.
A co-operative society is a business organisation with a special mode of doing business, by
pulling together all the means of production co-operatively, elimination of middlemen and
exploitation from outside forces.
Co-operative organisations are also forging ahead in large scale, industries such as sugar
mills, oil mills, paper and pulp industries, spinning and weaving mills and distilleries. However,
inspite of this growing phase of co-operative sector, it is comparatively a weaker sector as
compared to corporate sector in the sphere of management, skilled personnel, sophisticated
modern equipment, systems of accounting, internal control, internal audit and obviously
profitability.
A chartered accountant has to play a significant role in the development of co-operative
organisations on scientific lines. In this Unit, it is proposed to give a few guide lines in the
matter of audits of co-operative societies. Apart from audit some other professional services
such as (1) guidance in accounts writing, (2) installation of accounting system, (3) internal
audit, (4) management accounting services, (5) taxation etc. could be rendered by chartered
accountants. However, the main focus is to give some guidelines about the audit of co-
operative societies in general. The special features of audit applicable to all societies will be
considered first, and subsequently a few special points with reference to audit programmes of
specific types of societies will be considered.
13.1.1 Audit as per Section 17 of the Co-Operative Societies Act, 1912 -

(1) The Registrar shall audit or cause to be audited by some person authorised by him by
general or special order in writing in this behalf the accounts of every registered society once
at least in every year.
(2) The audit under sub-section (1) shall include an examination of overdue debts, if any, and
a valuation of the assets and liabilities of the society.
(3) The Registrar, the Collector or any person authorised by general or special order in writing
in this behalf by the Registrar shall at all times have access to all the books, accounts, papers
and securities of a society, and every officer of the society shall furnish such information in
regard to the transactions and working of the society as the person making such inspection
may require.
"Registrar" means a person appointed to perform the duties of a Registrar of Co-operative
Societies under this Act.
Auditor and Management
13.2 According to the nature of particular co-operative society the auditor will have to examine
in general the pattern of management, delegation of authority and fixation of responsibilities.
The examination of minute books will reveal important policy decisions taken by management.
The Board of Directors is the chief executive body and the minute book recording the minutes
of its meetings is the main evidence for an auditor to go through the entity’s management
decisions. The auditor should see how far these decisions are in line with co-operative
principles, interest of members, the provisions in the respective co-operative law of the State
applicable to the society; and lastly the provisions of bye-laws of the society. The Central Co-
operative Societies Act, 1912 does not contain any direct provisions relating to the
management and meetings. As such for the sake of guidance and reliance, regard shall be
had to the respective Co-operative Societies Act. For instance, according to Section 72 of
Maharashtra State Co-operative Societies Act, 1960 (as amended upto 1978) the
management of every society shall vest in a Committee constituted in accordance with the Act
and rules and bye-laws. The Committee shall exercise such powers and perform such duties
as may be imposed by the Act. Some of the powers are delegated by the general body to the
managing committee. The auditor should see in this case which powers and functions are
delegated, and whether they are properly discharged. For the purpose of proper functioning
and to have an effective division of labour, different sub-committees may be formed such as
purchase committee, sales committee, price fixation committee, stock valuation committee etc.
in case of a co-operative consumers stores. In case of co-operative credit societies and urban
banks, committees like loan committee, recoveries and legal suits committee etc. may be
formed. The auditor should watch whether they are functioning effectively through the
proceedings of the minutes recorded separately. The managing committee elects a chairman,
who is in charge of general administration; other administrative officers are Managing Director,
Audit of Co-operative Societies 13.3
Manager or Secretary according to the nature of the society. The administrative functions of a
managing committee include the following:
(1) Proper custody and maintenance of movable and immovable properties belonging to the
society.
(2) Proper maintenance of accounts relating to receipts and payments of the society, through
its accounting staff.
(3) To summon and attend all the meetings including Annual General Meeting and to record
the proceedings of the meetings in a proper minute book.
(4) To keep all the necessary registers and records required by the Co-operative Societies
Act and Rules and bye-laws of the society.
Generally in case of co-operative organisations the management is not manned by
professional managers and as such the auditor of a co-operative society could play a
constructive role in the capacity as a guide, friend and an adviser to the society. The auditor
should see that the actions of managing committee are not inconsistent with the resolutions
passed by the meetings of general body and managing committee, provisions of Co-operative
Societies Act and rules and bye-laws of the society.
The following points should be kept in mind in connection with the audit of a co-operative
society:
1. Qualifications of Auditors - Apart from a chartered accountant within the meaning of the
Chartered Accountants Act, 1949, some of the State Co-operative Acts have permitted
persons holding a government diploma in co-operative accounts or in co-operation and
accountancy as also a person who has served as an auditor in the co-operative department
of a government to act as an auditor.
2. Appointment of the Auditor - An auditor of a co-operative society is appointed by the
Registrar of Co-operative Societies and the auditor so appointed conducts the audit on behalf
of the Registrar and submits his report to him as also to the society. The audit fees are paid
by the society on the basis of statutory scale of fees prescribed by the Registrar, according to
the category of the society audited. For example, the audit fees of co-operative credit society
and Urban Co-operative Banks are to be calculated with reference to working capital at the
prescribed rates. ‘Working Capital’ here means funds at the disposal of the society inclusive of
paid up share capital, funds built up out of profits and monies raised by borrowing and by
other means.
3. Books, Accounts and other records of Co-operative Societies - Under section 43(h) of
the Co-operative Societies Act, a state government can frame rules prescribing the books and
accounts to be kept by a co-operative society.
For example In Maharashtra the co-operative societies are required to maintain cash book,
general ledger, personal ledger, stock register, property register, etc. It is very much clear that
requirement under State Acts resembles the provisions made under Section 209 of the
Companies Act, 1956. The books of account required to be maintained in terms of the
instructions of the Registrar are in respect of the following:
(i) All sums of money received and expended by the society and the matters in respect of
which receipts and expenditure take place.
(ii) All sales and purchases of goods by the society also an account of stock-in-hand.
(iii) Assets and liabilities of the society. It may be understood that such of the books as are
relevant to the nature of the society would be required to be maintained, for example, a
credit society cannot be expected to maintain books of account for sale and purchase of
goods.
In order to maintain proper financial accounting records so as to disclose full financial results
of working of the society, the statutory or mandatory provisions provide a directive, but they
are not conclusive. The society is at liberty to maintain such additional records according to its
convenience and which it thinks more useful for clarity and detailed explanation. Ultimately the
financial transactions and the results thereof must be presented very clearly and in a the best
possible manner. The cash book may be divided in suitable columns so as to indicate specific
main heads of expenses and receipts, and a proper distinction between capital and revenue is
brought out. The stock register should be maintained in such a manner that an up-to-date
account of receipts, issues and balances of stock at any time is capable of being disclosed.
In a co-operative consumers stores, a register of excesses and shortages should be
maintained and a standard percentage of shortages beyond, say one bag of 100 kg. of grain
should be pre-determined by means of practical experience. This may be useful to ascertain
whether actual shortage is normal or abnormal. In case of co-operative consumers stores and
manufacturing societies this is absolutely essential. Perpetual inventory records based on
proper costing method should be maintained by co-operative manufacturing concerns like
sugar and cloth mills. These records must be maintained in such a manner so as to have an
up to date control over movement of materials and avoid wastages and losses in production.
Property and Investment Register - The property register refers to the register of immovable
and movable properties belonging to the society. The register should give details regarding
brief description of assets such as situation, make, date of acquisition, cost price, depreciation
provided up-to-date etc. The register may be kept on the lines of Fixed Assets Register in
case of a limited company as no specific form of register is prescribed under the Co-operative
Societies Act. In case of investment held by the society, an investment register should be
maintained by the society giving all the needed details such as cost price, face value, market
value, interest due dates, interest realised, sales, purchases, profit or loss on sales,
purchases etc.
Fixed Deposits Register - In case of Urban Co-operative Banks and credit societies accepting
deposits from members, a fixed deposit register should be maintained showing all the
particulars such as date of acceptance, date of maturity, interest due date, repayment etc.
Surety Register - In case of co-operative credit societies loans are granted to members as per
regulations in that behalf in the bye-laws of the society. These loans are given against the
personal security of the debtor, in addition to a surety or guarantee given by two members. In
order to keep a watch on the number of borrowers for whom a person has stood surety, this
register would be of immense help. The bye-laws prescribe the limit of surety by a person
depending on his financial position, shareholding etc.
Depending upon the nature and object of the society, different kinds of books and registers will
be maintained, so as to disclose a proper and fair picture of financial transactions. In case of
large scale co-operative organisation, different subsidiary books and registers shall be
maintained and the daily summary totals will be transferred to main Cash Book. For example:
(a) Daily cash sales summary register.
(b) A register of collection from debtors if credit sales are allowed by bye-laws of society.
(c) A register of recovery of loans from salaries and directly by receipts from members in
case of credit society.
(d) Loan disbursement register in case of credit society.
(e) Any other columnar subsidiaries depending upon the nature and functions of society.
4. Restrictions on share holdings - According to Section 5 of the Co-operative Societies Act,
1912, in the case of a society where the liability of a member of the society is limited, no
member of a society other than a registered society can hold such portion of the share capital
of the society as would exceed a maximum of twenty percent of the total number of shares or
of the value of shareholding to Rs. 1,000/-. The auditor of a co-operative society will be
concerned with this provision so as to watch any breach relating to holding of shares. One
should also watch whether any provision in the bye-laws of the society is not contrary to this
statutory position. The State Acts may provide limits as to the shareholding, other than that
provided in the Central Act.
5. Restrictions on loans - A registered society shall not make a loan to any person other than
a member. With the special sanction of the Registrar, a registered society may make a loan to
another registered society (Section 29).The State Government may further put such
restrictions as it thinks fit on the loaning powers of the society to its members or to other
societies in the interest of the society concerned and its members.
6. Restrictions on borrowings - A registered society may accept loans and deposits from its
members and others subject to the restrictions and limits of the bye-laws of the society. The
auditor will have to examine the bye-laws in this respect (Section 30).
7. Investment of funds - According to Section 32 of the Central Act the modes of investment
of funds of a society may be stated as follows. A society may invest its funds in any one or
more of the following:
(a) In the Central or State Co-operative Bank.
(b) In any of the securities specified in Section 20 of the Indian Trusts Act, 1882.
(c) In the shares, securities, bonds or debentures of any other society with limited liability.
(d) In any co-operative bank, other than a Central or State co-operative bank, as approved
by the Registrar on specified terms and conditions.
(e) In any other moneys permitted by the Central or State Government.
The principal provision relating to the investments of funds of a co-operative society, the
Central as well as State Acts do not mention anything about the investment of reserve fund
outside the business specifically.
8. Appropriation of profits - Section 33 of the Central Act states that 25% of the profits
should be transferred to Reserve Fund, before distribution as dividends or bonus to members.
However, having regard to the financial position of the society, the Registrar may reduce the
percentage of transfer, but in any case not less than 10%. Generally in case of newly started
salary earners’ credit societies this liberal view is taken.
9. Contributions to Charitable Purposes - According to Section 34, a registered society
may, with the sanction of the Registrar, contribute an amount not exceeding 10% of the net
profits remaining after the compulsory transfer to the reserve fund for any charitable purpose
as defined in section 2 of the Charitable Endowments Act, 1890.
10. Investment of Reserve Fund outside the business or utilisation as working capital -
Some of the State Acts provide that a society may use the Reserve Fund:
(a) in the business of a society, as working capital (subject to the rules made in this behalf).
(b) may invest as per provisions of the Act.
(c) may be used for some public purposes likely to promote the object of the society.
The auditor should ensure strict compliance with the State Act and Rules in this regard.
11. Contribution to Education Fund - Some of the State Acts provide that every society shall
contribute annually towards the Education Fund of the State Federal Society, at the
appropriate rate as per the class of the society. Contribution to Education Fund is a charge on
profits and not an appropriation.
Apart from statutory provisions relating to Reserve Fund, the auditor may have regard to the
provisions in bye-laws and Rules and Regulations of the society regarding the appropriation of
profits. Transfers to other reserves, dividends to members etc. are the other appropriations.
Appropriations of profits must be approved by the General Body of the society, which is the
supreme authority in the co-operative management. Further, it may be noted that necessary
accounting entries for the appropriation of profits must be passed after the date of approval by
the General Body. Here there is a departure from corporate accounting practice, where
entries are passed for proposed appropriations, subject to approval of Annual General
Meeting.
According to certain State Acts, transfers to Dividend Equalization Reserve and Share
Capital Redemption Fund are stated as charges against profits. According to the generally
accepted principles of accountancy these items are not charges, but appropriation of profits.
The auditor should point out such spots where statutory provisions of any law are in
contradiction with the generally accepted accounting principles.
Special features of Co-operative Audit
13.3 The general processes of auditing involved in audit work such as checking of posting,
ascertainment of arithmetical accuracy, vouching, verification of assets and liabilities and final
scrutiny of Balance Sheet are well known to the students, and the same are to be applied in
co- operative audit as well. It need not be discussed in detail. However, the special features of
co-operative audit, to be borne in mind in general while conducting the audit are as follows:
1. Examination of overdue debts - Overdue debts for a period from six months to five years
and more than five years will have to be classified and shall have to be reported by an auditor.
Overdue debts have far reaching consequences on the working of a credit society. It affects its
working capital position. A further analysis of these overdue debts from the viewpoint of
chances of recovery will have to be made, and they will have to be classified as good or bad.
The auditor will have to ascertain whether proper provisions for doubtful debts is made and
whether the same is satisfactory. The percentage of overdue debts to the working capital and
loans advanced will have to be compared with last year, so as to see whether the trend is
increasing or decreasing whether due and proper actions for recovery are taken, the position
regarding cases in co-operative courts, District Courts etc. and the results thereof.
2. Overdue Interest - Overdue interest should be excluded from interest outstanding and
accrued due while calculating profit. Overdue interest is interest accrued or accruing in
accounts, the amount of which the principal is overdue. In practice an overdue interest
reserve is created and the credit of overdue interest credited to interest account is reduced.
3. Certification of Bad Debts - A peculiar feature regarding the writing off of the bad debts
as per Maharashtra State Co-operative Rules, 1961, is very interesting to note. As per Rule
No. 49, bad debts can be written off only when they are certified as bad by the auditor. Bad
debts and irrecoverable losses before being written off against Bad Debts Funds, Reserve
Fund etc. should be certified as bad debts or irrecoverable losses by the auditor where the law
so requires. Where no such requirement exists the managing committee of the society must
authorise the write-off.
4. Valuation of Assets and Liabilities - However, regarding valuation of assets there are no
specific provisions or instructions under the Act and Rules and as such due regard shall be
had to the general principles of accounting and auditing conventions and standards adopted.
The auditor will have to ascertain existence, ownership and valuation of assets. Fixed assets
should be valued at cost less adequate provision for depreciation. The incidental expenses
incurred in the acquisition and the installation expenses of assets should be properly
capitalised. If the difference in the original cost of acquisition and the present market price is
of far reaching significance, a note regarding the present market value may be appended; so
as to have a proper disclosure in the light of present inflatory conditions. The current assets
be valued at cost or market price, whichever is lower. Regarding the liabilities, the auditor
should see that all the known liabilities are brought into the account, and the contingent
liabilities are stated by way of a note.
5. Adherence to Co-operative Principles - The auditor will have to ascertain in general, how
far the objects, for which the co-operative organisation is set up, have been achieved in the
course of its working. The assessment is not necessarily in terms of profits, but in terms of
extending of benefits to members who have formed the society. Considered from the viewpoint
of social benefits it may be looked into that how far the sales could be effected at lower prices.
For the achievement of these activities, cost accounting methods, store control methods,
techniques of standard costing, budgetary control etc. should be adopted. However, these
modern techniques are mostly not in application and as such in practice a wide gap is found in
the goals to be achieved and the actual achievements. While auditing the expenses, the
auditor should see that they are economically incurred and there is no wastage of funds.
Middlemen commissions are, as far as possible, avoided and the purchases are made by the
committee members directly from the wholesalers. The principles of propriety audit should be
followed for the purpose.
6. Observations of the Provisions of the Act and Rules - An auditor of a co-operative
society is required to point out the infringement with the provisions of Co-operative Societies
Act and Rules and bye-laws. The financial implications of such infringements should be
properly assessed by the auditor and they should be reported. Some of the State Acts contain
restrictions on payment of dividends, which should be noted by the auditor. For example,
under the Maharashtra State Act, the maximum rate of dividend prescribed is 12% but the
dividend distributable in cash should not exceed 6% and the balance of 3% in excess of it
should be credited to individual share capital accounts of members.
7. Verification of Members’ Register and examination of their pass books - Examination
of entries in members pass books regarding the loan given and its repayments, and
confirmation of loan balances in person is very much important in a co-operative organisation
to assure that the entries in the books of accounts are free from manipulation. Specifically in
the rural and agricultural credit societies, members are not literate and as such this is a good
safeguard on their part. Of course this checking will be resorted to on a test basis, which is a
matter of judgement of the auditor.
8. Special report to the Registrar - During the course of audit, if the auditor notices that
there are some serious irregularities in the working of the society he may report these special
matters to the Registrar, drawing his specific attention to the points. The Registrar on receipt
of such a special report may take necessary action against the society. In the following
cases, for instance a special report may become necessary:
(i) Personal profiteering by members of managing committee in transactions of the society,
which are ultimately detrimental to the interest of the society.
(ii) Detection of fraud relating to expenses, purchases, property and stores of the society.
(iii) Specific examples of mis-management. Decisions of management against co-operative
principles.
(iv) In the case of urban co-operative banks, disproportionate advances to vested interest
groups, such as relatives of management, and deliberate negligence about the recovery
thereof. Cases of reckless advancing, where the management is negligent about taking
adequate security and proper safeguards for judging the credit worthiness of the party.
9. Audit classification of society - After a judgement of an overall performance of the
society, the auditor has to award a class to the society. This judgement is to be based on the
criteria specified by the Registrar. It may be noted here that if the management of the society
is not satisfied about the award of audit class, it can make an appeal to the Registrar, and the
Registrar may direct to review the audit classification. The auditor should be very careful,
while making a decision about the class of society.
10. Discussion of draft audit report with managing committee - On conclusion of the
audit, the auditor should ask the Secretary of the society to convene the managing committee
meeting to discuss the audit draft report. The audit report should never be finalised without
discussion with the managing committee. Minor irregularities may be got settled and rectified.
Matters of policy should be discussed in detail.
Rights and Duties of Co-operative Auditors
13.4 Section 17 of the Cooperative Societies Act, 1912 contains audit provision as under:
(i) The Registrar shall audit or cause to be audited by some person authorised by him by
general or special order in writing in this behalf the accounts of every registered society
once at least in every year.
(ii) The audit under sub-section (1) shall include an examination of overdue debts, if any,
and a valuation of the assets and liabilities of the society.
(iii) The Registrar, the Collector or any person authorised by general or special order in
writing in this behalf by the Registrar shall at all times have access to all the books,
accounts, papers and securities of a society, and every officer of the society shall furnish
such information in regard to the transactions and working of the society as the person
making such inspection may require.
On completion of audit, the auditor has to submit his audit report to the society, and copies
thereof to the respective authorities such as District Special Auditor, District Deputy Registrar
etc. The audit report has to be submitted in the prescribed form specified by the Registrar or
as given in the related Rules. According to the present prescribed form in some of the States,
the auditor has to state:
(a) Whether he has obtained all the necessary information and explanations which to the
best of his knowledge and belief were necessary for the purpose of audit.
(b) Whether in his opinion and to the best of his information and according to the
explanations given to him, the said accounts give all the information required by the Act,
and
(c) Whether the Profit and Loss Account of the society gives a true and fair view of the Profit
and Loss made by the society.
(d) Whether the Balance Sheet drawn up as at the end of the year gives a true and fair view
of the state of affairs of the society as on the given date.
(e) Whether in his opinion, proper books of account as required by the Act, the Rules and
the bye-laws of the society have been properly maintained.
(f) Whether the Balance Sheet and the Profit and Loss Account examined by him are in
agreement with the books of account and returns of the society.
The auditor will have to give qualifying observations, if any of the answers to the above
mentioned matters are negative.
Form of Audit Report
13.5 The form of the audit report to be submitted by the auditor, as prescribed in various
states, contains a number of matters which the auditor has to state or comment upon. For
example, the Rules formed under the Maharashtra State Co-operative Societies Act requires
the auditor to make the usual affirmation pertaining to proper maintenance of books of
accounts, true and fair nature of financial statements, etc .In addition to the above, the auditor
will have to attach schedules to the report regarding the following information:
(1) All transactions which appear to be contrary to the provisions of the Act, the rules and
bye-laws of the society.
(2) All sums, which ought to have been, but have not been brought into account by the
society.
(3) Any material, or property belonging to society which appears to the auditor to be bad or
doubtful of recovery.
(4) Any material irregularity or impropriety in expenditure or in the realisation or monies due
to society.
(5) Any other matters specified by the Registrar in this behalf.
In the case of nil report in any of the above matters, the auditor will have to give a nil report.
Further in addition to the audit certificate in the prescribed form and various schedules stated
above, the auditor of co-operative society in the applicable State has to answer two sets of
questionnaires called as audit memos. The first set of audit memo or questionnaire is of
general nature and is applicable to all types of societies such as urban banks, consumers’
stores, credit societies etc. The second set of questionnaire is specific for a particular type of
society. These questionnaires are drafted in detail and serve the practical purpose of audit
programme.
The audit report in a narrative form is also required to be submitted by the auditor addressed
to the Chairman of the society. Generally the narrative audit report as per convention is
divided into two parts styled as part I and part II. Part I of the report is very important which
throws a light on comparative financial position, capital structure, solvency position and the
profitability or otherwise of the society. It may contain comments on the working of the society
and the suggestions for future improvements. It must be suitably divided into paragraphs. Part
II of the report points out the observations of routine nature, which are the finished products of
the routine vouch and post audit such as missing vouchers, loan bonds, inadequacies of
documents, mistakes of principles in accounting etc. However mistakes having an impact on
the profitability of society should be pointed out in Part I as it has got a consequential effect on
the financial position of society.
Audit, Inquiry and Inspection of Multi-State Co-Operative Societies
13.6 The Multi-State Co-operative Societies Act, 2002, which came into force in August, 2002
applies to co-operative societies whose objects are not confined to one State. The Act
contains detailed provisions regarding registration, membership and management of such
societies.
Chapter VII of the Act deals with properties and funds of the Multi-State co-operative societies.
The funds of a Multi-State co-operative society cannot be utilised for any political purpose.
The Act contains detailed provisions regarding the investment of funds and restrictions on
loans, borrowings, etc.
Books of Accounts - As per Multi-State co-operative society rules 2002, every Multi-State
co-operative society shall keep books of account with respect to
a. all sum of money received and expended and matters in respect of which the receipt and
expenditure take place;
b. all sale and purchase of goods;
c. the assets and liabilities;
d. in the case of a Multi-State co-operative society engaged in production, processing and
manufacturing, particulars relating to utilization of materials or labour or other items of
cost as may be specified in the bye-hours of such a society.
13.6.1 Audit of Multi-State Co-operative Society -
1. Qualification of Auditors Section 72 - A person who is a Chartered Accountant with
in the meaning of the Chartered Accountants Act, 1949 can only be appointed as auditor of
Multi-State co-operative society.
However the following persons are not eligible for appointed as auditors of a Multi-State co-
operative society.
(a) A body corporate
(b) An officer or employee of the Multi-State co-operative society.
(c) A person who is a member or who is in the employment, of an officer or employee of the
Multi-State co-operative society.
(d) A person who is indebted to the Multi-State co-operative society or who has given any
guarantee or provided any security in connection with the indebtedness of any third
person to the Multi-State co-operative society for an amount exceeding one thousand
rupees.
If an auditor becomes subject, after his appointment, to any, of the disqualifications specified
above, he shall be deemed to have vacated his office as such.
2. Appointment of Auditors Section 70(6) - First auditor or auditors of a Multi-State co-
operative society shall be appointed by the board within one month of the date of registration
of such society and the auditor or auditors so appointed shall hold office until the conclusion of
the first annual general meeting. If the board fails to exercise its powers under this sub-
section, the Multi-State co-operative society in the general meeting may appoint the first
auditor or auditors.
Sub-Section 2: The subsequent auditor or auditors are appointed by Multi-State co-operative
society, at each annual general meeting, the auditor or auditors so appointed hold office from
the conclusion of that meeting until the conclusion of the next annual general meeting.
3. Power and duties of Auditors Section 73 - Every auditor of a Multi-State co-operative
society shall have a right of access at all times to the books accounts and vouchers of the
Multi-State co-operative society, whether kept at the head office of the Multi-State co-
operative society or elsewhere, and shall be entitled to require from the officers or other
employees of the Multi-State co-operative society such information and explanation as the
auditor may think necessary for the performance of his duties as an auditor.
As per Section 73(2) the auditor shall make following inquiry:
a. Whether loans and advances made by the Multi-State co-operative society on the basis
of security have been properly secured and whether the terms on which they have been
made are not prejudicial to the interests of the Multi-State co-operative society or its
members.
b. Whether transactions of the Multi-State co-operative society which are represented
merely by book entries are not prejudicial to the interests of the Multi-State co-operative
society.
c. Whether personal expenses have been charged to revenue account and
d. Where it is Stated in the books and papers of the Multi-State co-operative society that
any shares have been allotted for cash, whether cash has actually, been received in
respect of such allotment, and if no cash has actually been so received, whether the
position as stated in the account books and the balance sheet as correct regular and not
misleading.
4. Content of Auditor’s Report - As per section 73, sub-section 3 & 4 of Multi-state Co-
operative Society Rule, 2002, the Auditor’s Report shall contain the following particulars.
Sub Section 3 : The auditor shall make a report to the members of the Multi-State co-operative
society on the accounts examined by him and on every balance-sheet and profit and loss
account and on every other document required to be part of or annexed to the balance-sheet
or profit and loss account, which are laid before the Multi-State co-operative society in general
meeting during his tenure of office, and the report shall state whether, in his opinion and to the
best of his information and according to the explanation given to him, the said account give
the information required by this act in the manner so required, and give a true and fair view:
a. In the case of the balance-sheet, of the state of the Multi-State co-operative society’s
affairs as at the end of its financial year; and
b. In the case of the profit and loss account, of the profit or loss for its financial year.
Sub Section 4: The auditor’s report shall also state:
a. Whether he has obtained all the information and explanation which to the best of his
knowledge and belief were necessary for the purpose of his audit.
b. Whether, in his opinion, proper books of account have been kept by the Multi-State co-
operative society so far as appears from his examination of these books and proper
returns adequate for the purpose of his audit have been received from branches or
offices of the Multi-State co-operative society not visited by him.
c. Whether the report on the accounts of any branch office audited by a person other than
the Multi-State co-operative society’s auditor has been forwarded to him and how he has
dealt with the same in preparing the auditor’s report.
d. Whether the Multi-State co-operative society’s balance sheet and profit and loss account
dealt with by the report are in agreement with the books of account and return.
Sub Section 5: Where any of the matters referred to in sub-section 3 or sub-section 4 is
answered in the negative or with a qualification, the auditor’s report shall state the reason for
the answer.
5. Power of central Government to direct special audit in certain cases - Under
Section 77 where the Central Government is of the opinion:
a. that the affairs of any Multi-State co-operative society are not being managed in
accordance with self-help and mutual did and co-operative principles or prudent
commercial practices or with sound business principles; or
b. that any Multi-State co-operative society is being managed in a manner lively to cease
serious injury or damage to the interests of the trade industry or business to which it
pertains; or
c. that the financial position of any Multi-State co-operative society is such as to endanger
its solvency.
The central Government may at any time by order direct that a special audit of the Multi-State
co-operative society’s accounts for such period or periods as may be specified in the order,
shall be conducted and appoint either a chartered accountant as defined in clause (b) of sub-
section (1) of section 2 of the Chartered Accountants Act, 1949 or the Multi-State co-operative
society’s auditor himself to conduct the special audit.
However, central Government shall order for special audit only if that Government or the State
Government either by itself or both hold fifty-one percent or more of the paid-up share capital
in such Multi-State co-operative society.
The special auditor shall have the same powers and duties in relation to the special audit as
an auditor of a Multi-State co-operative society has under section 73. However the special
auditor shall instead of making his report to the members of the Multi-State co-operative
society make the report to the Central Government. The report of the special auditor shall,
include all the matters required to be included in the auditor’s report under section 73 and any
other matter as directed by the central Government.
On receipts of the report of the special auditor the Central Government may take such action
on the report as it considers necessary in accordance with the provision of the Act or any law
for the time being in force.
13.6.2 Inquiry by Central Registrar under Section 78 - The Central Registrar may, on a
request from a federal co-operative to which a Multi-State co-operative society is affiliated or a
creditor or not less than one-third of the members of the board or not less than one-fifth of the
total number of members of a Multi-state co-operative society hold an inquiry or direct some
person authorized by him by order in writing in his behalf to hold an inquiry into the
constitutions, working and financial condition of a Multi-State co-operative society. However,
before holding such inquiry fifteen days notice must be given to the Multi-State co-operative
society.
As per sub-section (i) of Section 78 the Central Registrar or the person authorized by him shall
have the following powers, namely:
a. he shall at all reasonable times have free access to the books, accounts, documents,
securities, cash and other properties belonging to or in the custody of the Multi-State co-
operative society and may summon any person in possession or responsible for the
custody of any such books, accounts, documents securities, cash or other properties to
produce the same at any place specified by him.
b. he may, notwithstanding any bye-law specifying the period of notice for a general
meeting of the Multi-State co-operative society, require the officers of the society to call a
general meeting of the society by giving notice of not less than seven days at such time
and place at the head quarters of the society to consider such matters as may be
directed to him, and where the officers of the society refuse or fail to call such a meeting,
he shall have power to call it himself.
c. he may summon any person who is reasonably believed by him to have any knowledge
of, or the officers of the Multi-State co-operative society to appear before him at any
place at the headquarters of the society or any branch there of and may examine such
person on oath.
The Central Registrar shall, within a period of three months of the date of receipt of the report,
communicate the report of inquiry to the Multi-State co-operative society, the financial
institutions, if any, to which the society is affiliated, and to the person or authority, if any at
whose instance the inquiry is needed.
13.6.3 Inspection of Multi-State co-operative societies under Section 79 - The Central
Registrar may, on a request from federal co-operative to which a Multi-State co-operative
society is affiliated or a creditor or not less than one-third of the members of the board or not
less than one-fifth of the total number of members of a Multi-State co-operative society by
general or special order in writing in this behalf inspect or direct any person authorized by him
by order in writing in this behalf to make an inspection into the constitution, working and
financial condition of a Multi-State co-operative society.
The Central Registrar or the person authorized by him shall have the following powers:
a. he shall at all times have access to all books, accounts, papers, vouchers, securities,
stock and other property of that society and may, in the event of serious irregularities
discovered during inspection, take them into custody and shall have power to verify the
cash balance of the society and subject to the general or special order of the central
registrar to call a meeting of the society where such general meeting is, in his opinion
necessary.
b. Every officer or member of a Multi-State co-operative society shall furnish such
information with regard to the working of the society as the central registrar or the person
making such inspection may require.
A copy of the report of inspection under this section shall be communicated to the Multi-State
co-operative society within a period of three months from the date of completion of such
inspection.
Self–examination Questions
1. Explain in the context of the audit of the co-operative societies, verification of book, accounts
and other records of co-operative societies.
2. Explain in the context of audit of co-operative societies, the following specific issues:
(i) Restriction on borrowings, (ii) Restriction on loan, (iii) Restriction on share holdings and
(v) Investment of funds.
3. State the special features of audit of co-operative societies.
14
AUDIT OF NON BANKING FINANCIAL COMPANIES
Introduction
14.1 Non-banking financial companies (NBFCs) have been the subject of focussed attention
during the nineties. In particular, the rapid growth of NBFCs, especially in the nineties, has
led to a gradual blurring of dividing lines between banks and NBFCs, with the exception of
the exclusive privilege that commercial banks exercise in the issuance of cheques. Owing to
certain disquieting developments in the NBFC sector, the RBI Act was amended in 1997,
providing for a comprehensive regulatory framework for NBFCs. The RBI (Amendment) Act,
1997 provides for compulsory registration with the Reserve Bank of all NBFCs, irrespective of
their holding of public deposits, for commencing and carrying on business, minimum entry
point norms, maintenance of a portion of deposits in liquid assets, creation of Reserve Fund
and transfer of 20 per cent of profit after tax annually to the Fund. The Amendment Act also
conferred powers on Reserve Bank to issue directions to companies and its auditors, prohibit
deposit acceptance and alienation of assets by companies and effect winding up of
companies.
Accordingly, the Reserve Bank issued directions to companies on acceptance of public
deposits, prudential norms like capital adequacy, income recognition, asset classification,
provision for bad and doubtful debts, exposure norms and other measures to monitor the
financial solvency and reporting by NBFCs. Directions were also issued to auditors to report
non-compliance with the RBI Act and regulations to the Reserve Bank, Board of directors and
shareholders.
14.1.1 Classification of NBFCs - NBFCs, normally fall into following categories:
1. Non-Banking Financial Company - In terms of the Section 45-I(f) read with Section 45-I
(c)of the RBI Act, 1934, as amended in 1997, NBFC is one whose principal business is that of
receiving deposits or that of a financial institution, such as lending, investment in securities,
hire purchase finance or equipment leasing. Such companies may also be categorised as
under:
(i) Equipment leasing company engaged in equipment leasing or financing of such activity.
(ii) Hire purchase finance company engaged in hire purchase transaction or financing of
such transactions.
(iii) Investment company engaged in acquisition of securities and trading in such securities to
earn a profit.
(iv) Loan company engaged in providing finance by making loans or advances, or otherwise
for any activity other than its own; excludes EL/HP/Housing finance Companies (HFCs).
(v) Residuary non-banking company (RNBC) which receives deposits under any scheme or
arrangement, by whatever name called, in one lump-sum or in instalments by way of
contributions or subscriptions or by sale of units or certificates or other instruments, or in
any manner. These companies do not belong to any of the categories as stated above.
2. Mutual benefit financial company (MBFC) i.e. Nidhi Company - Any company which is
notified by the Central government under Section 620A of the Companies Act 1956 (1 of
1956).
3. Mutual Benefit Company (MBC), i.e., Potential Nidhi Company - A company notified
under section 620A of the Companies Act, 1956 and by the Central Government, having
minimum Net Owned Funds and Preferential Share Capital of Rs. 10 lakh, has applied to the
RBI for Certificate of Registration and also to Ministry of Company Affairs (MCA) for
declaration as nidhi company and has not contravened directions/regulations of Reserve
Bank/MCA.
4. Miscellaneous non-banking company (MNBC), i.e., Chit Fund Company - Managing,
conducting or supervising as a promoter, foreman or agent of any transaction or arrangement
by which the company enters into an agreement with a specified number of subscribers that
every one of them shall subscribe a certain sum in instalments over a definite period and that
every one of such subscribers shall in turn, as determined by lot or by auction or by tender or
in such manner as may be provided for in the arrangement, be entitled to the prize amount.
Audit Procedure
14.2 The following are the necessary steps involved -
(1) Ascertaining the Business of the company - The first step in carrying out the audit of a
NBFC is to scan through the Memorandum and Articles of Association of the company, so as
to acquaint oneself with the type of business that the company proposes to engage itself in.
Normally, the Memorandum of Association of any company would be very wide in scope
thereby permitting it to undertake a host of business activities, but companies generally lend
to specialise in and focus on a few select activities. An auditor should therefore make a careful
study of the business policy of the company so as to ascertain its principal business activities.
For this purpose, an auditor may also scan through the minutes of the Board/Committee
Meetings and hold discussions with the top level management to ascertain the corporate
business plan/strategy which would give him a clear picture as to the principal objects of the
Audit of Non Banking Financial Companies 14.3
company. An auditor should then independently corroborate his findings with the actual
business done by the company, as reflected by the company’s financial results.
The task of ascertaining the principal business activity of any NBFC is of paramount
importance (More so with the recent amendments made to the RBI Act) since the very
classification of a company as a NBFC and its further classification into a loan company or an
investment company or an equipment leasing/hire purchase finance company would all
depend upon its principal business activity. Based on the classification of a company into a
loan Company/Investment company etc., it will be accordingly required to comply with the
provisions relating to limits on acceptance of public deposits as contained in the NBFC Public
Deposit Directions.
(2) Evaluation of Internal Control System - The responsibility of maintaining an adequate
accounting system incorporating various internal controls to the extent appropriate to the size
and nature of its business vests with the management. A sound internal control system would
enable an organisation to plug loopholes in its workings, particularly in the detection of frauds
and would also aid in timely decision making. An auditor should gain an understanding of the
accounting system and related internal controls adopted by the NBFC to determine the nature,
timing and extent of his audit procedures. An auditor should also ascertain whether the
internal controls put in place by the NBFC are adequate and are being effectively followed.
In particular, an auditor should review the effectiveness of the system of recovery prevalent at
the NBFC. He should ascertain whether the NBFC has an effective system of periodical review
of advances in place which would facilitate effective monitoring and follow up. The absence of
a periodical review system could result in non-detection of sticky advances at its very
inception which would ultimately result in the NBFC having an alarmingly high level of NPAs.
(3) Registration with the RBI - Section 45-IA inserted by the RBI Act, w.e.f. 9th January,
1997, has made it incumbent on the part of all NBFCs to comply with registration
requirements and have minimum net owned funds of Rs.25 lakhs for commencing/carrying on
its business. An auditor should obtain a copy of the certificate of registration granted by the
RBI or in case the certificate of registration has not been granted, a copy of the application
form filed with the RBI for registration. It may particularly be noted that NBFCs incorporated
after 9th January, 1997 are not entitled to commence business without first obtaining a
registration certificate from the RBI. An auditor should therefore verify whether the dual
conditions relating to registration with the RBI and maintenance of minimum net owned funds
have been duly complied with by the concerned NBFC.
Every NBFC holding public deposits is required to invest a specified percentage (as the RBI
may specify from time to time) of its deposits outstanding at the close of its business on the
last working day of the second preceding quarter in unencumbered approved securities. The
RBI has also prescribed a format for reporting to ensure compliance with the requirement of
maintenance of liquid assets on a quarterly basis. This quarterly return (duly signed by an
officer of the NBFC) is required to be submitted within 15 days from the end of the relevant
quarter and with reference to investments held in approved securities during the relevant
quarter. The auditor should ascertain whether investment in prescribed liquid assets have
been made and whether quarterly returns as mentioned above have been regularly filed with
the RBI by the concerned NBFC.
The auditors must check whether the NBFC has transferred at least 20% of its profits to a
Reserve Fund as required by Section 45-IC of the RBI Act.
(4) NBFC Public Deposit Directions - The auditors must ascertain whether the company is a
loan company or an investment company or a hire purchase finance company or an equipment
leasing company as per the classification, if any, assigned to the NBFC by the RBI. In case,
the NBFC has not been classified by the RBI, the classification of a company will have to be
determined after a careful consideration of various factors such as particulars of earlier
registration granted, if any, particulars furnished in the application form for registration,
company’s Memorandum of Association and its financial results. Thereafter, it must be
ascertained whether the company has complied with the following aspects in relation to the
activity of mobilisation of public deposits.
(i) The ceiling on quantum of public deposits has been linked to its credit rating as given by
an approved credit rating agency. Obtain a copy of the credit rating assigned to NBFC
and check whether the public deposits accepted/held by it are in accordance with the
level of credit rating assigned to it.
In the event of a downgrading of credit rating, the auditor should bear in mind that the
NBFC will have to reduce its public deposits in accordance with the revised credit rating
assigned to it within a specified time frame.
(ii) Test checks the interest calculations in respect of public deposits mobilised by a NBFC to
ascertain that the NBFC has not paid interest in excess as per specification. Likewise,
test check the brokerage calculations with the bills and vouchers for reimbursement of
out of pocket expenses submitted by a broker to ascertain that the NBFC has not paid
brokerage in excess of 2% plus a maximum of 0.5% by way of reimbursement of
expenses to brokers.
(iii) Ascertain whether the NBFC has accepted or renewed any public deposit only after a
written application form the depositor in the form to be supplied by the company, and
shall contain all particulars specified in the Non-Banking Financial Companies and
Miscellaneous Non Banking Companies (Advertisement) Rules, 1977.Further ensure
whether it contain the specific category of depositor, i.e., whether depositor is a
shareholder or a director or a promoter or a member of public.
(iv) Ascertain whether the NBFC has solicited any public deposits or whether it has
accepted public deposits without an invitation. If the company has issued any
advertisement, check whether the NBFC has complied with the Non-Banking Financial
Companies and Miscellaneous Non Banking Companies (Advertisement) Rules 1977. If
the company has accepted public deposits without issuing any advertisement, the
auditor should check whether it has filed a statement in lieu of advertisement with the
RBI containing all the above mentioned particulars before accepting public deposits.
(v) Verify the deposit register maintained by a NBFC and test check the particulars that have
been entered therein in respect of each depositor with supporting receipts issued to the
depositors. Also check whether the NBFC is regularly paying its deposits on due dates
and in the case of a delay/default, the reasons for the delay/default and the actual date of
payment.
(vi) Check whether the investments made in approved liquid assets by a NBFC holding
public deposits have been lodged in safe custody with a designated scheduled
commercial bank as required by the NBFC Public Deposit Directions. Obtain a
certificate from the bank to that effect.
(vii) In the case of NBFCs accepting/holding public deposits ascertain whether audited
statement of accounts together with a copy of the auditor’s report and director’s report
thereon have been submitted within 15 days from the date of holding the Annual general
meeting.
(viii) Check whether the NBFC has filed its annual return as specified in the First Schedule
before the 30th September with reference to its position as on the 31st March of each
year.
(ix) In the case of NBFCs not accepting/holding public deposits, check whether a board
resolution has been passed by the NBFC to the effect that it has neither accepted any
public deposits nor would it accept any public deposits during the year.
(x) In the case of Group Holding Investment Companies, check whether the NBFC has
passed a board resolution to the effect that the company has invested or would
invest/hold its investments in share and securities of group companies specifying the
names of the companies. In addition to the above, group holding investment companies
are required to give a further undertaking that it would not trade in such shares/securities
and that it has neither accepted nor would it accept any public deposits during the year.
(5) NBFC Prudential Norms Directions -
(i) Check compliance with prudential norms encompassing income recognition, income from
investments, accounting standards, accounting for investments, asset classification,
provisioning for bad and doubtful debts, capital adequacy norms, prohibition on granting
of loans by a NBFC against its own shares, prohibition on loans and investments for
failure to repay public deposits and norms for concentration of credit/investments.
(ii) An auditor should ensure that the Board of Directors of every NDFC granting/intending to
grant demand/call loans shall frame a policy for the company and shall implement too.
(iii) An auditor should assess on the basis of examinations conducted by him whether the
NBFC has complied with the prudential norms. In particular, he should verify that
advances and other credit facilities have been properly classified as standard/sub
standard/doubtful/loss and that proper provision has been made in accordance with the
Directions.
(iv) In respect of Non Performing Assets, an auditor should check whether the unrealised
income in respect of such assets has not been taken to the Profit & Loss Account on an
accrual basis. Income from NPAs should be accounted for on realisation basis only.
(v) Check whether all accounts which have been classified as NPAs in the previous year
also continue to be shown as such in the current year also. If the same is not treated as a
NPA in the current year, the auditor should specifically examine such accounts to
ascertain whether the account has become regular and the same can be treated as
performing as per the Directions.
Audit Check-List
14.3 Some special points that may be covered in the audit of NBFCs are given below.
A. Investment Companies
(i) Physically verify all the shares and securities held by a NBFC. Where any security is
lodged with an institution or a bank, a certificate from the bank/institution to that effect
must be verified.
(ii) NBFC Prudential Norms stipulates that NBFCs should not lend more than 15% of its
owned funds to any single borrower and not more than 25% to any single group of
borrower. The ceiling on investments in shares by a NBFC in a single entity and the
aggregate of investments in a single group of entities have been fixed at 15% and 25%
respectively. Moreover, a composite limit of credit to and investments in a single
entity/group of entities has been fixed at 25% and 40% respectively of the owned fund of
the concerned NBFC. Verify that the credit facilities extended and investments made by
the concerned NBFC are in accordance with the prescribed ceiling.
(iii) Verify whether the NBFC has not advanced any loans against the security of its own
shares.
(iv) Verify that dividend income wherever declared by a company, has been duly received by
a NBFC and interest wherever due [except in case of NPAs] has been duly accounted
for. NBFC Prudential Norms directions require dividend income on shares of companies
and units of mutual funds to be recognised on cash basis. However, the NBFC has an
option to account for dividend income on accrual basis, if the same has been declared by
the body corporate in its Annual General meeting and its right receives the payment has
been established. Income from bonds/debentures of corporate bodies is to be accounted
on accrual basis only if the interest rate on these instruments is predetermined and
interest is serviced regularly and not in arrears.
(v) Test check bills/contract notes received from brokers with reference to the prices vis-à-
vis the stock market quotations on the respective dates.
(vi) Verify the Board Minutes for purchase and sale of investments. Ascertain from the Board
resolution or obtain a management certificate to the effect that the investments so
acquired are current investments or Long Term Investments.
(vii) Check whether the investments have been valued in accordance with Para 6 of the
NBFC Prudential Norms Directions and adequate provision for fall in the market value of
securities, wherever applicable, have been made there against, as required by the
Directions.
(viii) Obtain a list of subsidiary/group companies from the management and verify the
investments made in subsidiary/group companies during the year. Ascertain the basis for
arriving at the price paid for the acquisition of such shares.
(ix) Check whether investments in unquoted debentures/bonds have not been treated as
investments but as term loans or other credit facilities for the purposes of income
recognition and asset classification.
(x) An auditor will have to ascertain whether the requirements of AS 13 “Accounting for
Investments” (to the extent they are not inconsistent with the Directions) have been duly
complied with by the NBFC.
(xi) In respect of shares/securities held through a depository, obtain a confirmation from the
depository regarding the shares/securities held by it on behalf of the NBFC.
(xii) In the case of securities lent/borrowed under the Securities Lending Scheme of SEBI,
verify the agreement entered into with the approved intermediary (i.e. the person through
whom the lender will deposit and the borrower will borrow the securities for
lending/borrowing) with regards to the period of depositing/lending securities, fees for
depositing/lending, collateral securities and provision for the return including pre-mature
return of the securities deposited/lent.
(xiii) Verify that securities of the same type or class are received back by the lender/paid by
the borrower at the end of the specified period together with all corporate benefits
thereof (i.e. dividends, rights, bonus, interest or any other rights or benefit accruing
thereon.)
(xiv) Verify charges received or paid in respect of securities lend/borrowed.
(xv) Obtain a confirmation from the approved intermediary regarding securities deposited
with/borrowed from it as at the year end.
B. Loan Company
(i) An auditor should examine whether each loan or advance has been properly sanctioned.
He should verify the conditions attached to the sanction of each loan or advance i.e. limit
on borrowings, nature of security, interest, terms of repayment, etc.
(ii) An auditor should verify the security obtained and the agreements entered into, if any,
with the concerned parties in respect of the advances given. He must ascertain the
nature and value of security and the net worth of the borrower/guarantor to determine the
extent to which an advance could be considered realisable.
(iii) Obtain balance confirmations from the concerned parties.
(iv) As regards bill discounting, verify that proper records/documents have been maintained
for every bill discounted/rediscounted by the NBFC. Test check some transactions with
reference to the documents maintained and ascertain whether the discounting charges,
wherever, due, have been duly accounted for by the NBFC.
(v) Check whether the NBFC has not lent/invested in excess of the specified limits to any
single borrower or group of borrowers as per NBFC Prudential Norms Directions.
(vi) Check whether the NBFC has not advanced any loans against the security of its own
shares.
(vii) In case of companies which are engaged in the business of providing short term funds in
the ICD market, the auditor should ascertain whether the NBFC has a regular system for
ascertaining the credit worthiness of the clients prior to placed by the company are being
rolled over and whether there is any risk of non-recovery. In addition, he should ascertain
that the NBFC is receiving interest regularly in respect of these ICDs. Roll over of ICDs
and non-realisation of interest and principal amounts should be thoroughly checked to
determine whether the ICD is required to be treated as a NPA.
(viii) An auditor should verify whether the NBFC has an adequate system of proper appraisal
and follow up of loans and advances. In addition, he may analyse the trend of its
recovery performance to ascertain that the NBFC does not have an unduly high level of
NPAs.
(ix) Check the classification of loans and advances (including bills purchased and
discounted) made by a NBFC into Standard Assets, Sub-Standard Assets, doubtful
assets and loss assets and the adequacy of provision for bad and doubtful debts as
required by NBFC Prudential Norms Directions.
(x) An auditor should also verify whether provision for bad and doubtful debts has been
disclosed separately in the Balance Sheet and the same have not been netted off
against the income or against the value of assets as required by the NBFC Prudential
Norms Directions.
C. Hire Purchase Finance Company
(i) Ascertain whether the NBFC has an adequate appraisal system for extending hire
purchase finance. The system of appraisal is basically concerned with obtaining
information regarding the credit worthiness of the hirer, his experience in the field, assets
owned, his past track record and future projections of his income.
(ii) Verify that the payment for acquiring an asset should be made directly to the
supplier/dealer and that the original invoice has been drawn out in the name of the
NBFC.
(iii) In the case of high value hire purchase items relating to machinery/equipment, an auditor
should ascertain whether the valuation reports and installation reports are called for. In
case of some high value items, he should also physically verify the asset in possession
of the hirers, particularly in a situation where he has any doubts as regards the
genuineness of the transaction.
(iv) If the hire purchase finance is against vehicles, check whether the registration certificate
contains an endorsement in favour of the hire purchase company.
(v) The auditor should verify whether the NBFC has a system in place for verifying the hire
purchase assets periodically to ensure that the hirers have not sold the assets or
otherwise encumbered them.
(vi) Check whether hire purchase instalments are being received regularly as and when they
fall due. Check whether adequate provision has been made for overdue hire purchase
instalments as required by the NBFC Prudential Norms directions.
(vii) Examine the method of accounting followed by the hire purchase finance company for
appropriation of finance charges over the period of the hire purchase contract. Ascertain
that there is no change in the method of accounting as compared to the immediately
preceding previous year.
(viii) Verify that the assets given on hire purchase have been adequately insured against.
(ix) In case the goods are repossessed by the hire purchase finance company on account of
non-repayment of hire purchase instalments, verify that the repossessed goods have
been valued on a realistic basis by the hire purchase finance company.
D. Equipment Leasing Finance Company
(i) Ascertain whether the NBFC has an adequate appraisal system for extending equipment
leasing finance.
(ii) The auditor should verify whether there is an adequate system in place for ensuring
installation of assets and their periodical physical verification. In respect of some major
transactions, an auditor should arrange for physical verification of the leased assets so
as to dispel any doubts that equipment leasing finance was not extended without the
corresponding assets being created.
(iii) Ascertain whether the NBFC has an adequate system for monitoring whether the assets
have been adequately insured against and regular maintenance of the leased assets is
being carried out by the lessee.
(iv) Verify the lease agreement entered into with the lessee in respect of the equipment given
on lease.
(v) An auditor should verify whether the AS issued by the Institute of Chartered Accountants
of India in respect of “Accounting for Lease” has been compulsorily followed.
Auditor’s duty
14.4 The following are the important duties of an auditor -
(i) Compliance with NBFC Auditors Report RBI Directions - The recent RBI regulations
have considerably increased the responsibility of auditors of NBFCs. A very onerous task of
reporting to the Board of Directors on certain specified matters and to the RBI on an excepting
basis have been imposed upon him. This reporting requirement is in addition to the normal
reporting requirements to the shareholders under section 227 as well as the reporting under
CARO, 2003 under section 227(4A) of the Companies Act, 1956. Auditors will thus have to be
very careful whilst carrying out audits of NBFCs to ensure that al matters which they are
required to take into consideration for the purposes of reporting to the RBI have been taken
due care of.
Section 45MA of the Reserve Bank of India Act has been introduced with effect from
13.12.1974. Under this provision the auditor of a non-banking financial company or a non-
banking miscellaneous company which as accepted public deposits, has to inquire whether or
not the company has furnished to the Reserve Bank of India statements, information of
particulars relating to the deposits as are required to the furnished under Chapter IIIB of the
Reserve Bank of India Act. The provision further states that if on inquiry the auditor is not
satisfied about the compliance by the company, it is his duty to make to the Reserve Bank
giving the aggregate amount of deposits held by the company. The auditor is also required to
incorporate the report or intended to be made to the Reserve Bank in his report to the
company under Section 227 of the Companies Act. Since January 9, 1997 has amended the
Section 45MA as under -
“(lA) The Bank may, on being satisfied that it is necessary so to do; in the public
interest or in the interest of the depositors or for the purpose of proper assessment
of the books of account, issue directions to any non-banking financial company or
any class of non- banking financial companies or non-banking financial companies
generally or to the auditors of such non-banking financial company or companies
relating to balance sheet, profit and loss account, disclosure of liabilities in the
books of account or any matter relating thereto;
In sub-section (2) for the words “a non-banking institution, being a company”, the
words “a non-banking financial company” shall be substituted;
“(3) Where the Bank is of the opinion that it is necessary so to do in, the public
interest or in the interest of the non-banking financial company or in the interest of
the depositors of such company, it may at any time by order direct that a special
audit of the accounts of the non-banking financial company in relation to any such
transaction or class of transactions or for such period or periods, as may be
specified in the order, shall be conducted and the Bank may appoint an auditor or
auditors to conduct such special audit and direct the auditor or the auditors to
submit the report to it.
(4) The remuneration of the auditors as may be fixed by the Bank, having regard to
the nature and volume of work involved in the audit and the expenses of or
incidental to the audit shall be borne by the non-banking financial company so
audited.”
(ii) Report to Board of Directors under RBI Directions

[Ref. Notification No. DFC. 117 IDG(SPT)-98 dated the January 2,1998]
In exercise of the Powers conferred by sub-section of Section 45MA of the Reserve Bank of
India Act, 1934 (2 of 1934) Reserve Bank of India hereby, gives to every auditor the directions
hereinafter specified.
1. Short title, application and commencement of the directions
(1) These directions shall be known as ‘Non-Banking Companies Auditor’s Report (Reserve
Bank) Direction 1998.”
(2) These directions shall apply to every auditor of non-banking financial as defined in
Section 451 of the Reserve Bank of India Act, 1934 (2 of 1934 ).
(3) These directions shall come into force with effect from January 2, 1998.
2. Obligation of auditor to report to Reserve Bank of India - Where, in the case of a Non-
Banking Financial company the statement regarding any of the items referred to in paragraph
3 above is unfavourable or qualified, or in the opinion of the auditor the company has not
compiled with the provisions of the Non-Banking financial Companies (Reserve Bank)
Directions, 1998 or the Non-Banking Financial companies Prudential Norms (Reserve Bank)
Directions, 1998 to the extent applicable to the said company or the provisions of the Chapter
IIIB of the Reserve Bank of India Act, 1934 (2 of 1934), it shall be the obligation of the auditor
to make a report containing the details of such unfavourable or qualified statements and/or
about the non-compliance, as the case may be, in respect of the company to the concerned
Regional Office of the Department of Non-Banking Supervisions of the Reserve Bank of India
under whose jurisdiction the registered office of the company is located as per Second
Schedule to the Non-Banking Financial Companies (Reserve Bank) Directions, 1998.
Annexure
Some of the recent important circulars issued by the Reserve Bank of India are given below -
1 .New Financial Leases – Accounting Standard 19 of ICAI. Applicability of Prudential

Provisioning Norms -
(i) The Institute of Chartered Accountants of India (ICAI) has issued Accounting Standard (AS) 19,
‘Accounting for Leases’ – The Accounting Standard is mandatory in respect of lease agreement
(financial leases) executed on or after 1 April, 2001. The accounting standard, inter alia, provides
for the capitalisation of finance lease assets in the books of lessee instead of lessor. The lessor
is now required to show the assets given on lease only as receivables in its balance sheet instead
of as fixed assets.
(ii) The implications of the above AS for the NBFCs in the matter of applicability of prudential norms
prescribed by RBI would be that all the fresh leases (financial leases) written on or after 1 April,
2001 would now be accounted like hire purchase transactions. Accordingly, it is clarified that the
prudential norms applicable to hire purchase assets would, mutatis mutandis, be applicable to the
leases written on or after 1 April, 2001. However, the leases written upto 31 March, 2001, would
continue to be governed by the prudential norms related to leased assets, as hitherto.
2. Accounting of Investments – Paragraph 16 of Prudential Norms Directions – AS 13 of ICAI –
Mandatory sub-classification into long term and current investments: As per the provisions of NBFC
Prudential Norms Directions, all accounting standards issued by ICAI are mandatory for all NBFCs.
They are permitted to value their long term investments as per AS-13 of ICAI. However, in view of the
queries from the chartered accountant fraternity and also NBFCs about certain issues emanating from
the implementation of the above accounting standard, it was considered necessary to have a relook at
the guidelines for valuation of investments. The proposals were discussed with the members of the
Informal Advisory Group, and it has been decided as follows:
(i) The Board of directors of the NBFC should frame and implement investment policy for the
company;
(ii) Each investment shall be classified into current and long term at the time of making investment.
The criteria to classify the investments into current and long term should be spelt out in the
investment policy of the company as approved by the Board;
(iii) There would be no inter-class transfer on ad hoc basis;
(iv) The inter-class transfer can take place only at the beginning of each year half year as on 1 April
or 1 October with the approval of the Board; and
(v) The investments are to be transferred scrip-wise at lower of book value or market value from long
term to current or vice versa. The depreciation, if any, in each scrip, should be fully provided for
and appreciation should be ignored. Further, the depreciation in one scrip cannot be set off
against appreciation in another scrip at the time of such inter-class transfer even though it may be
in the same category.
3. Classification of NBFCs into EL/HP categories – Inclusion of certain hypothecation loans

against specified assets -
(i) In terms of extant instructions, NBFCs having not less than 60 per cent of the total assets in
lease and hire purchase and deriving not less than 60 per cent of their total income from such activities
can be classified as hire purchase/equipment leasing companies. The assets in both these activities
could be combined to satisfy the ratio of 60 per cent.
(ii) The Bank has received representations from NBFCs and their associations that they are finding
it increasingly difficult to write further leases or enter into hire purchase agreements owing to market
conditions. The industry suggested that loans against hypothecation of assets may also be considered
along with the lease/hire purchase assets to satisfy the 60 per cent norm. The matter has been
discussed in the meeting of the Informal Advisory Group on NBFCs and it has been decided that loans
against hypothecation of –
(a) all types of automobiles like trucks, buses, tractors, cars, three wheelers, two wheelers and
dumpers which are registered with Road Transport Authority and the charge is recognised by
Motor Vehicles Act;
(b) aircrafts which are registered with Director General of Civil Aviation;
(c) ships which are registered with Director General of Shipping.
May be included along with other equipment leasing and hire purchase assets to comply with the norms
of 60 per cent of total assets and income for the purpose of classification of an NBFC as equipment
leasing or hire purchase finance company. Other instructions relating to the manner of classification of
the NBFCs, review of the classification every year on the basis of audited balance sheet, etc. would
remain unchanged. The NBFCs may review their status as on the date of last available audited
balance sheet for the purpose of their classification on the basis of the above revised norms and bring
the same to the notice of the concerned Regional Office of RBI under whose jurisdiction their registered
office is located.
(iv) However, it is clarified that prudential norms relating to loans and advances only would be
applicable to such loans against hypothecation of assets despite their clubbing with EL/HP assets for
the classification of NBFCs. In other words, classification of NBFC and prudential norms are two
different aspects.
4. Requirement of maintenance of CRAR on an on-going basis and the format of half yearly
return on Prudential Norms -
1. In terms of NBFC Directions on Prudential Norms, the NBFCs accepting/holding public deposits
have to ensure maintenance of minimum prescribed CRAR at all times. The fact that the
requirement of CRAR is applicable not only on the reporting dates but also on an on-going basis
has been reiterated in our circular DNBS(PD).CC.No.18/02.01/2001-02 dated January 1, 2002.
2. The compliance with CRAR and other prudential norms is monitored through the half yearly
returns on reporting date (March 31 and September 30), this return is to be submitted in the
format NBS-2. This return is required to be certified by the Managing Director/Chief Executive
Officer of NBFC accepting/holding public deposits stating inter alia that the company has
complied with prudential norms and that the CRAR as disclosed in the return has been correctly
determined. The statutory auditors of the company also append a report to support the veracity of
the certificate given by the company. .
3. It is observed that the format of the report appended to the prudential norms return requires the
auditors to certify the position as furnished by the company as on the date of reporting. This has
reportedly created an erroneous impression that the auditor is not required to report violation, if
any, by the NBFC of the prudential norms or other stipulations between the two reporting dates.
15
AUDIT UNDER FISCAL LAWS
Introduction
15.1 For ensuring compliance sometimes audit become a necessity. Therefore, various
statutes, including legislations governing direct and indirect tax provisions have incorporated
audit provisions in some or the other form. Under direct taxes, the Central Board of Direct
taxes has posed onerous responsibility on the auditor via Income-tax Act, 1961 which has
various provisions requiring compulsory audit. In the field of indirect taxes, audit is mostly
done by departmental officers. However, with the growing importance of the indirect taxes in
the economy, the Government is realizing the need of audit by independent bodies especially
equipped to do the same. Introduction of audit provisions in the newly introduced Value Added
Tax (VAT) legislations is a step towards this direction. Various state Governments have
incorporated compulsory audit provisions in their respective State VAT legislations. Various
provisions relating tax audit are discussed in this Chapter.
Audit(s) Under The Income-Tax Act, 1961
15.2 The Income-tax Act, 1961 (hereinafter referred to as the Act) contains several
provisions for audit of accounts of public charitable trusts, non-corporate assesses and other
assesses to meet the specific objectives of the Act. Under the Act, several sections such as
12A, 35D, 35E, 44AB, 80 IA, 142 (2A), etc., require audit of accounts for tax purposes. We
shall discuss the requirements of some of these provisions from the audit angle.
Who can audit the Accounts under the Income-tax Act -Normally, in all the sections
referred to above, subject to the exceptions specifically provided, the audit is to be conducted
by an ‘accountant’, as defined in the Explanation below Section 288(2) of the Act. The
Explanation to Section 288(2) defines ‘accountant’ as a Chartered Accountant within the
meaning of the Chartered Accountants Act, 1949 and any other person who is entitled to be
appointed as an auditor of a company under Section 226(2) of the Companies Act, 1956. It is
clear that any chartered accountant, whether in practice or not, is also covered by the
definition of the term Accountant. It may, therefore, prima facie appear that even a non-
practising member of the Institute may be covered by the definition of ‘accountant’. However,
Section 7 of the Chartered Accountants Act, 1949 requires every member who practices as a
Chartered Accountant to hold a certificate of practice and hence a member, if he wishes to
render services which amount to “practice” must hold a certificate of practice. Further, it may
be noted that by the virtue of a resolution of the Council, with effect from 1st April 2005, a
member in part-time practice (namely holding a certificate of practice and also engaging
himself in any other business/ and or occupation) is not entitled to perform attest functions
including tax audit. Therefore, although it is not directly inherent in the definition of
“accountant” given by Section 288, it is nevertheless a necessary requirement that the
member concerned must hold a certificate of practice.
15.2.1 Audit of Public Trusts - Section 12A of the Act deals with the conditions as to
registration of trust etc. According to this section, exemption from Income tax would be
available under sections 11 and 12 of the Income tax Act in relation to the income of any trust
or institution provided the following conditions are satisfied:
(A) The person in receipt of the income has made an application for registration of the trust
or institution in the prescribed form and in the prescribed manner to the Commissioner
before the expiry of one year from the date of the creation of the trust or establishment of
the institution. The Commissioner can, however, in his discretion admit an application for
registration after the expiry of the period aforesaid.
(B) Where the total income of the trust or institution as computed under this Act, without
giving effect to the provisions of Sections 11 and 12 exceeds the maximum amount
which is not chargeable to income tax in any previous year i.e Rs. 1,00,000 for the A.Y.
2007-08, the accounts of the trust or institution for that year have been audited by an
accountant as defined in the explanation below sub section (2) of Section 288 and the
person in receipt of the income furnishes alongwith the return of Income for the relevant
assessment year, the report of such audit in the prescribed form duly signed and verified
by such accountant and setting forth such particulars as may be prescribed. Rule 17B of
the Income tax Rules, 1962 provides that the report of audit of accounts of a trust or
institution which is required to be furnished under Clause(b) of Section 12A should be in
Form No. 10B. The audit programme is outlined in the following paragraphs:
(a) Preliminary:
(i) Obtain a resolution from the trust specifying the appointment as also
indicating the scope of audit. In particular, the resolution should specify the
duties of the auditor in relation to the items specified in the annexure to the
prescribed Form No. 10B.
(ii) Obtain a letter of appointment from the trust. Although the audit may have
been conducted in the past by a person appointed as an auditor for the
purpose of Section 12A, having regard to the spirit of the requirement
contained in clause (8) of Part-I of Schedule I to the Chartered Accountants
Act, 1949, it is suggested that the auditor appointed for the purpose of
Section 12A, should, before accepting the audit, communicate with such
previous auditor.
Audit Under Fiscal Laws 15.3
(iii) Obtain a certificate as to the opening balances of assets and liabilities and
the fund.
(iv) Obtain a list of books of accounts which are maintained by the trust.
(v) Obtain a certificate from the trust as to the system of accounting and internal
control.
(vi) Obtain from the trust a list of the institutions/ activities run/carried out by the
trust.
(vii) Obtain from the trust a certified true copy of the Deed of Trust or any other
scheme containing the objects and conditions of the trust as operative from
time to time.
(b) Routine Checking:
(i) Check the books of account and other records having regard to the system of
accounting and internal control.
(ii) Vouch the transactions of the trust to satisfy that:
(a) the transaction falls within the ambit of the trust;
(b) the transaction is properly authorised by the trustees or other delegated
authority as may be permissible in law;
(c) all incomes due to the trust have been properly accounted for on the
basis of the system of accounting followed by the trust;
(d) all expenses and outgoings appertaining to the trust have been
recorded on the basis of the system of accounting followed by the trust;
and
(e) amounts shown as applied towards the object of the trust are covered
by the objects of the trust as specified in the document governing the
trust.
(iii) Obtain a trial balance on the closing date certified by the trustees.
(iv) Obtain the Balance Sheet and Profit & Loss Account of the trust
authenticated by the trustees and check the same with the trial balance with
which they should agree.
(c) Accounting Principles: The auditor should follow, i.e., generally accepted
accounting principles and ascertain the accuracy, truth and fairness of the Balance
Sheet and Profit & Loss Account.
In particular, the auditor will scrutinise that:
(i) all assets of the trust are verified;
(ii) the assets of the trust have been properly valued and depreciation duly
provided for;
(iii) all liabilities of the trust are properly accounted for;
(iv) the investments of the trust are properly classified and indicated and market
values shown; and
(v) outstandings due to the trust are properly accounted for and their
recoverability examined and provision made for irrecoverables.
(d) Annexure to the Audit Report:
(i) Obtain from the trustees, a certified list of persons covered by Section 13(3).
(ii) Obtain from the trustees, a statement enlisting the various items specified in
the Annexure to Form No. 10B and giving the information against each item
together with explanatory or supporting schedules.
(iii) Verify the information supplied by the trustees in the statements specified
above in the light of available material. Where a list of persons specified in
Section 13(3) is not available, indicate against Sections II and III of the items
specified in the annexure the appropriate qualifying remarks.
The audit report is required to be furnished to the relevant year. Failure to furnish
the report will disentitle the trust or institution to the benefit of Sections 11 and 12.
The Auditor can accept as correct the list of persons covered by Section 13(3) as
given by the managing trustees.
15.2.2 Audit of accounts in connection with the claim for deduction under Sections 35D and
35E - The conditions under which certain specified preliminary expenditure incurred before the
commencement of business and once the business is commenced on expanding an industrial
undertaking or in connection with setting up a new industrial unit can be amortised are stated
in Section 35D of the Act. The manner in which deductions are allowed in respect of
expenditure on any prospecting operations relating to certain specified minerals listed in the
Seventh Schedule to the Act are stated in Section 35E of the Act. In respect of assessees
other than a company or a co-operative society, these deductions are admissible only if the
accounts for, the year or years in which the above specified expenditure is incurred are
audited by an “accountant” as defined in explanation below sub-section (2) of section 288 of
the Income-tax Act,1961 and the report of such audit is furnished by the assessee along with
the return of income. Rule 6AB of the Income-tax Rules 1962 provides that the report of audit
required to be furnished by the above-mentioned assessees under section 35D and 35E
should be in Form No.3B. While doing the audit the auditor is expected to follow general
principles of auditing as mentioned in Auditing and Assurance Standards.
Tax Audit under section 44AB
15.3 Section 44AB provides for the compulsory audit of accounts of certain persons carrying
on business or profession. Section 44AB reads as under:

Audit of accounts of certain persons carrying on business or profession.
Every person -
(a) carrying on business shall, if his total sales turnover or gross receipts, as the case may
be, in business exceed or exceeds forty lakhs rupees in any previous year.
(b) carrying on profession shall, if his gross receipts, in profession exceed ten lakhs rupees
in any previous year,
(c) carrying on the business shall, if the profits and gains from the business are deemed to
be the profits and gains of such person under section 44AD or section 44AE or section
44AF or section 44BB or section 44BBB as the case may be, and he has claimed his
income to be lower than the profits or gains so deemed to be the profits and gains of his
business, as the case may be, in any previous year,
get his accounts of such previous year audited by an accountant before the specified date and
furnish by that date the report of such audit in the prescribed form duly signed and verified by
such accountant and setting forth such particulars as may be prescribed:
Provided that this section shall not apply to the person, who derives income of the nature
referred to in section 44B or section 4BBA on and from the lst day of April, 1985 or, as the
case may be, the date on which the relevant section came into force, whichever is later:
Provided further that in a case where such person is required by or under any other law to get
his accounts audited, it shall be sufficient compliance with the provisions of this section if such
person gets the accounts of such business or profession audited under such law before the
specified date and furnishes by that date the report of the audit as required under such other
law and a further report by an accountant in the form prescribed under this section.
Explanation: For the purposes of this section,
(i) “accountant” shall have the same meaning as in the explanation below sub-section (2)
of Section 288;
(ii) “specified date”, in relation to the accounts of the assessee of the previous year relevant
to an assessment year, means the 31st day of October of the assessment year.
Note:The ICAI has issued a Guidance note on the audit of Fringe Benefits (With
Supplementary Guidance Note on tax audit under section 44AB of the Income-tax Act,
1961). The said Guidance Note has to be read along with the “Guidance Note on Tax
Audit under section 44AB of the Income-tax Act,1961”. The Guidance given in both the
Guidance Note has been intergrated in the following text.
The above section stipulates that every person carrying on business is required to get his
accounts audited before the “specified date” by a chartered accountant, if the total sales
turnover or gross receipts in the business in any previous year exceed Rs. 40 lakhs. A person
carrying on a profession will also have to get his accounts audited before the “specified date”
by a chartered accountant if his gross receipts in profession in any previous year exceed Rs.
10 lakhs.
Clause (c) of Section 44AB, inserted by the Finance Act, 1997 w.e.f. assessment year 1998-
99, provides that in the case of an assessee carrying on a business of the nature specified in
sections 44AD, 44AE, 44AF, 44BB or 44BBB, tax audit will be required if he claims his income
to be lower than the presumptive income deemed under those sections. Therefore, such
assessees will be required to have a tax audit even if their sales, turnover or gross receipts do
not exceed Rs.40 lakhs.
Under the provisions of sections 44AD and 44AF, an assessee can opt to be assessed on
presumptive basis, so long as the gross receipts/total turnover from any of the business (es)
do not exceed Rs.40 lakhs. Once the total turnover/gross receipts from any such business (es)
exceed Rs.40 lakhs, a tax audit will be required under clause (a) of Section 44AB. The
provisions of sections 44AA and 44AB shall not apply in so far as they relate to the business
of civil construction, etc. as referred to in Section 44AD(1), the business of plying, hiring or
leasing goods carriages as referred to in section 44AE(1), retail business as referred to in
section 44AF(1), the business of exploration, etc. of mineral oil as referred to in section
44BB(1) and the business of civil construction, etc. in certain turnkey power projects as
referred to in section 44BBB(1). In computing the monetary limits under sections 44AA and
44AB, the turnover/gross receipts or as the case may be the income from the said business
shall be excluded.
If a person is carrying on business(es), coming within the scope of sections 44AD, 44AE,
44AF, 44BB or 44BBB but he exercises his option given under these sections to get his
accounts audited under Section 44AB, tax audit requirements would apply, in respect of such
business(es) even if the turnover of such business(es) does not exceed Rs.40 lakhs. In the
case of a person carrying on businesses covered by sections 44AD, 44AE, 44AF, 44BB or
44BBB and opting for presumptive taxation, tax audit requirement would not apply in respect
of such businesses, If such person is carrying on other business(es) not covered by
presumptive taxation, tax audit requirements would apply in respect thereof if the turnover of
such business(es), other than the business covered by presumptive taxation thereof, exceed
Rs.40 lakhs.
The first proviso to section 44AB stipulates that the provisions of that section will not be
applicable to a person who derives income of the nature referred to in sections 44B, or
44BBA. Where the assessee is carrying on any one or more of the businesses specified in
section 44B or 44BBA referred to in the first proviso to section 44AB, the sales/turnover/gross
receipts from such businesses shall not be included in the total sales/turnover/gross receipts
for determining the applicability of section 44AB.
The report of such audit, duly signed and verified by the chartered accountant is required to be
given in such form and setting forth such particulars as prescribed by the Board. Rule 6G
provides that such audit report and particulars should be given in Form No. 3CA/3CB as may
be applicable and the statement of particulars should be given in Form No.3CD.
A question may arise in the case of an assessee who is eligible to claim deductions under
sections 80-IA, 80-IB etc., as to whether, it will be necessary for him to get separate audit
reports/certificates under these sections in addition to an audit report under Section 44AB.
The requirement of section 44AB is a general requirement covering the overall position of the
accounts of the assessee. This applies to the consolidated accounts of the assessee for the
relevant previous year covering the results of all the units owned by the assessee whether
situated at one place or at different places. If turnover of all the units put together exceeds
prescribed limits, the assessee would be required to get a separate audit report/certificate
under above said sections he wants to avail deduction under the respective sections.
Therefore it will be necessary for an assessee to get separate audit reports/certificates under
above said sections in addition to an audit report, if any, required under section 44AB.
15.3.1 Tax Auditor - The term “accountant” has been defined in sub-clause (i) of
Explanation to Section 44AB as under:
Explanation: For the purposes of this section,
(i) “accountant” shall have the same meaning as in the Explanation below sub-section (2) of
Section 288".
The above-mentioned Explanation reads as under:
1. Accountant means a chartered accountant within the meaning of Chartered Accountants
Act, 1949 (38 of 1949) and includes, in relation to any State, any person, who by virtue of
the provisions of sub-section (2) of Section 226 of the Companies Act, 1956 (I of 1956),
is entitled to be appointed to act as an auditor of companies registered in that State.” In
this context it may be noted that from April 1, 2005, any member in part-time practice
(namely, holding a certificate of practice and also engaging himself in any other business
and/or occupation) is not entitled to perform attest functions including tax audit.
2. The proviso to Section 44AB also lays down that where the accounts of an assessee are
required to be audited by or under any other law, it shall be sufficient compliance with the
provisions of this section, if such person gets the accounts of such business or
profession audited under such other law before the specified date and furnishes by that
date the report of the audit as required under such other law and a further report by an
accountant in the form prescribed under this section. It may be noted that with the
deletion of the words “by an accountant” in the former part of the proviso to section 44AB
by the Finance Act, 1985 with effect from 1st April, 1985, in the case of any assessee like
a co-operative society where the accounts under the relevant law are allowed to be
audited by a person other than a chartered accountant, the statutory auditor need not be
a chartered accountant. Further in the latter part of proviso the words ‘by the accountant’
has been inserted by Finance Act, 2001 w.e.f. 1-4-2001 which indicates that tax auditor
has to be a chartered accountant even if statutory audit has been conducted by a person
other than a chartered accountant.
3. Though the section refers to the accounts being audited by an accountant, which means
a chartered accountant as defined above, the statement of audit can also be done by a
firm of chartered accountants. This has been a recognised practice under the Act. In
such a case, it would be necessary to state the name of the partner who has signed the
audit report on behalf of the firm. The member signing the report as a partner of a firm or
in his individual capacity should give his membership number below his name. Section
44AB does not stipulate that only the statutory auditor appointed under the Companies
Act or other similar statute should perform the tax audit. The tax audit can, therefore, be
conducted either by the statutory auditor or by any other chartered accountant in full-time
practice. It should be noted that from April 1, 2005, any member in part-time practice is
not entitled to perform attest functions including tax audit.
4. Tax audit under section 44AB being a recurring audit assignment, for expressing
professional opinion on the financial statements and the statement of particulars, the
member accepting the assignment should communicate with the member who had done
tax audit in the earlier year as provided in the Chartered Accountants Act. While making
an enquiry from the retiring auditor, the member accepting the assignment should find
out whether there is any professional or other reasons why he should not accept the
appointment. While accepting any assignment the tax auditor has to keep in mind the
‘Code of Ethics’ of the ICAI also.
5. The tax auditor should obtain from the assessee a letter of appointment for conducting
the audit as mentioned in section 44AB. It is advisable that such an appointment letter
should be signed by the person competent to sign the return of income in terms of the
provisions of section 140. AAS-26- Terms of Audit Engagement has to be followed by an
auditor while accepting any new audit engagement.
6. The tax auditor should get the statement of particulars, as required in the annexures
(Annexure I and II) to the audit report, authenticated by the assessee before he proceeds
to verify the same. The tax auditor is required to submit his report to the person
appointing him viz. the assessee.
7. The Act does not prohibit a relative or an employee of an assessee to be appointed as an
tax auditor under section 44AB. However as per the decision of the Council a chartered
accountant who is in employment of a concern or in any other concern under the same
management cannot be appointed as a tax auditor of the concern. Further, as per
another decision of the Council, a member who is not in full-time practice cannot carry
out attest functions on or after April 1,2005. Therefore, an employee of an assessee or
an employee of a concern under the same management cannot audit the accounts of an
assessee under section 44AB. It may also be noted that under the Second Schedule to
the Chartered Accountants Act, if a member gives an audit report under section 44AB in
the case of a concern in which he and/or his relatives have substantial interest, it will be
necessary for him to disclose his interest in the audit report.
8. A chartered accountant who is responsible for writing or the maintenance of the books of
account of the assessee should not audit such accounts. This principle will apply to the
partner of such a member as well as to the firm in which he is a partner. In view of this, a
chartered accountant who is responsible for writing or the maintenance of the books of
account or his partner or the firm in which he is a partner should not accept tax audit
assignment under section 44AB in the case of such an assessee.
9. The audit of accounts of a professional firm of chartered accountants, under section
44AB cannot be conducted by any partner or employee of such firm.
10. A chartered accountant / firm of chartered accountants, who is appointed as tax
consultant of the assessee, can conduct tax audit under section 44AB. But an internal
auditor of the assessee cannot conduct tax audit if he is an employee of the assessee. If
the internal auditor is working in a professional capacity (as an independent chartered
accountant not being an employee of the assessee), he can conduct the tax audit.
11. A question may arise whether an assessee can remove a tax auditor appointed under
section 44AB. The answer depends upon the facts and circumstances of the case. There
is no specific procedure for removal of a tax auditor appointed under section 44AB. It is,
however, possible for the management to remove a tax auditor where there are any valid
grounds for such removal. This may arise where the tax auditor has delayed the
submission of audit report under section 44AB for an unreasonable period and if it is
found that there is no possibility of getting the audit report before the specified date. In
such cases, the assessee may be justified in removing the tax auditor.
12. Before accepting a tax audit, the chartered accountant should take into consideration the
ceiling on tax audit assignments fixed under the Notification dated 13th January, 1989,
issued by the ICAI. In view of the said Notification, a member of the Institute in practice,
shall be deemed to be guilty of professional misconduct if he accepts in a financial year
more than 30 tax audit assignments or such other limit as may be prescribed by ICAI
from time to time under section 44AB, whether in respect of a person whose accounts
have been audited under any other law or a person who carries on business or
profession but who is not required by or under any other law to get his accounts audited.
Further, as per a Council decision, audits of accounts of persons carrying on business
covered by sections 44AD, 44AE, 44AF, 44BB or 44BBB is not included in the aforesaid
limit.
13. The audit of head office and branch offices of the assessee shall be regarded as one tax
audit assignment.
15.3.2 Accounting Standards (AS) - Accounting Standards are basically issued for use in the
presentation of general purpose financial statements which are issued to the public by such
commercial, industrial or business enterprises as may be specified by the Institute from time to
time. AS also apply in respect of financial statements audited under section 44AB of the
Income-tax Act, 1961. Accordingly, members should examine compliance with the mandatory
accounting standards when conducting such audit.
AS apply in respect of commercial, industrial or business activities of an enterprise. In the
case of charitable or religious organisations, AS will not apply if all activities of such
organisations are not of commercial, industrial or business nature (e.g. an activity of collecting
donations and giving them to flood affected people). In other words, exclusion of an entity from
the applicability of the AS would be permissible only if no part of the activity of such entity is
commercial, industrial or business in nature. Even if a very small portion of the activities of an
entity is considered to be commercial, industrial or business in nature, then it cannot, claim
exemption from the application of AS. The AS would apply to all its activities including those,
which are not commercial, industrial or business in nature.
Financial Statements prepared on a basis other than accrual - With regard to the
fundamental accounting assumption of accrual, the Council has made a specific
announcement that in respect of (a) Sole proprietary concerns/individuals, (b) Partnership
firms, (c) Societies registered under the Societies Registration Act, (d) Trusts, (e) Hindu
undivided families and (f) Association of persons, the auditor should examine whether the
financial statements have been prepared on accrual basis. In case where the statute
governing the enterprise requires the preparation and presentation of financial statements on
accrual basis but the financial statements have not been so prepared, the auditor should
qualify his report. On the other hand where there is no statutory requirement for preparation
and presentation of financial statements on accrual basis, and the financial statements have
been prepared on a basis other than ‘accrual’, the auditor should describe in his audit report,
the basis of accounting followed, without necessarily making it a subject matter of a
qualification. In such a case the auditor should also examine whether those provisions of the
AS which are applicable in the context of the basis of accounting followed by the enterprise
have been complied with or not and consider making suitable qualifications in his audit report
accordingly.
Accounting Standards under Taxation Law - The Finance Act, 1995 substituted a new
section 145 w.e.f. assessment year 1997-98. The section deals with method of accounting and
is reproduced below:
“145.(1) Income chargeable under the head ‘Profits and gains of business or profession’ or
“Income from other sources’ shall, subject to the provisions of sub-section (2), be
computed in accordance with either cash or mercantile system of accounting
regularly employed by the assessee.
(2) The Central Government may notify in the Official Gazette from time to time
accounting standards to be followed by any class of assessees or in respect of any
class of income.
(3) Where the Assessing Officer is not satisfied about the correctness or completeness
of the accounts of the assessee, or where the method of accounting provided in
sub-section (1) or accounting standards as notified under sub-section (2), have not
been regularly followed by the assessee, the Assessing Officer may make an
assessment in the manner provided in Section 144.”
Standards notified by Government -AS(IT) - In exercise of the powers conferred by section
145(2), the Central Government has by Notification No. S.O.69(E), dated 25th January, 1996
notified two AS(IT). This notification came into force with effect from 1st day of April, 1996,
and is accordingly applicable from assessment year 1997-98 and subsequent assessment
years.
These AS (IT) are given below :
Accounting Standards to be followed by all assessees following mercantile system of
accounting.
A. Accounting Standard I relating to disclosure of accounting policies.
B. Accounting Standard II relating to disclosure of prior period and extraordinary items and
changes in accounting policies.
The above Accounting Standards are to be followed by all assessees following mercantile
system of accounting. Therefore, it is clear that those assessees who are following cash
system of accounting need not follow the Accounting Standards notified above.
Implications of non-compliance with the AS and AS (IT) - As mentioned earlier, AS are
applicable to tax audit also when the tax auditor performs the attest function, i.e., report on
whether the accounts are true and fair. Therefore, in case of non-compliance with the AS, the
chartered accountant should make appropriate qualifications/disclosures in the audit report.
However, such qualifications/disclosures may or may not have any impact on the computation
of total income for the purpose of the Act. Similarly, Section 145 provides that the AS(IT)
notified under that section should be followed by the assessees to whom they are made
applicable. It should be noted that the tax auditor auditing accounts under section 44AB is not
computing the income but is - (a) reporting on accounts, and (b) reporting on the relevant
information furnished in Form No. 3CD. Now, the revised Form No. 3CD vide clause 11(d)
requires reporting of the details of deviation, if any, in the method of accounting employed in
the previous year from accounting standards prescribed under section 145 and the effect
thereof on the profit or loss. Further, it may be noted that there is no material difference
between AS(IT)-l and AS(IT)-2 notified by the Government and the corresponding AS-1 and
AS-5 of the ICAI respectively.
15.3.3 Audit procedures - In the case of an audit the tax auditor is required to express his
opinion as to whether the financial statements give a true and fair view of the state of affairs of
the assessee in the case of the balance sheet and in the case of the profit and loss account or
income and expenditure account, of the profit and loss or income/expenditure. As regards the
statement of particulars to be annexed to the audit report, he is required to give his opinion as
to whether the particulars are true and correct. In giving his report the tax auditor will have to
use his professional skill and expertise and apply such audit tests as the circumstances of the
case may require, considering the contents of the audit report. He will have to conduct the
audit by applying the generally accepted auditing procedures which are applicable for any
other audit. He can apply the technique of test check depending on the type of internal control
procedures followed by the assessee. The tax auditor will also have to keep in mind the
concept of materiality depending upon the circumstances of each case. He would be well
advised to refer to the Auditing and Assurance Standards (AASs) issued by ICAI, the
“Statement on Auditing Practices’ as well as the ‘Guidance Note on Audit Reports and
Certificates for Special Purposes” while determining the extent of test checks and materiality
in each particular case. If the statutory auditor is also appointed to undertake tax audit, it is
advisable to carry out both the audits concurrently.
Section 227 of the Companies Act gives certain powers to the auditors to call for the books of
account, information, documents, explanations, etc. and to have access to all books and
records. No such powers are given to the tax auditor appointed under Section 44AB. However,
since the appointment of the tax auditor is made by assessee, it will be in the interest of the
assessee to furnish all the information and explanations and produce books of account and
records required by the tax auditor. If, however, the assessee refuses to produce any
particular record or to give any specific information or explanation, the tax auditor will be
required to report the same and qualify his report.
The audit report given under section 44AB is to assist the income-tax department to assess
the correct income of the assessee. In order that the tax auditor may be in a position to
explain any question which may arise later on, it is necessary that he should keep detailed
notes about the evidence on which he has relied upon while conducting the audit and also
maintain all his working papers. Such working papers should include his notes on the
following, amongst other matters:
(a) work done while conducting the audit and by whom;
(b) explanations and information given to him during the course of the audit and by whom;
(c) decision on the various points taken;
(d) the judicial pronouncements relied upon by him while making the audit report; and
(e) certificates issued by the client/management letters.
If the accounts of the business or profession of a person have been audited under any other
law by the statutory auditor(s), it is not necessary for the tax auditor appointed under section
44AB to conduct the audit once again in the matter of expression of “true and fair view” of the
state of affairs of the entity and of its profit and loss for the period covered by the audit.
However, the said section envisages the certification of the particulars in the prescribed form
on which the tax auditor has to express his opinion as to whether these are ‘true and correct’.
In other words, where an audit has already been conducted and the opinion of the auditor has
been expressed on the accounts, it would not be necessary to repeat the entire exercise to
express similar opinion all over again. The tax auditor has only to annex a copy of the audited
accounts and the auditor’s report and other documents forming part of these accounts to his
report and verify the particulars in the prescribed form for expressing his opinion as to whether
these are true and correct.
While test checks may suffice in the conduct of a statutory audit for the expression of the
auditor’s opinion as to whether the accounts depict a true and fair view, the tax auditor may be
required to apply reasonable tests on the total information to be prepared by the assessee in
respect of certain items in the prescribed form, e.g., in verification of payments for
purchases/expenses exceeding Rs.20,000/- in cash. While the entity may have to prepare the
details for the entire year, the tax auditor may have to ensure that no items have been omitted
in the information furnished and a reasonable test check would reveal whether or not the
information furnished is correct. The extent of check undertaken would have to be indicated by
the tax auditor in his working papers and audit notes. The tax auditor would be well advised to
so design his tax audit programme as would reveal the extent of checking and to ensure
adequate documentation in support of the information being certified.
15.3.4 Audit report - Section 44AB requires the tax auditor to submit the audit report in the
prescribed form and setting forth the prescribed particulars. Sub-rule 1 of rule 6G provides that
the report of audit of accounts of a person required to be furnished under Section 44AB shall -
(a) in the case of a person who carries on business or profession and who is required by or
under any other law to get his accounts audited, be in Form No. 3CA;
(b) in the case of a person who carries on business or profession, but not being a person
referred to in clause (a), be in Form No. 3CB.
Sub-rule (2) of Rule 6G further provides that the particulars which are required to be furnished
under Section 44AB shall be in Form No. 3CD.
It may thus be noted that the audit report is in two parts, The first part requires the tax auditor
to give his opinion as to whether or not the accounts audited by him give a true and fair view:
i. in the case of the balance sheet, of the state of affairs as at the last date of the
accounting year.
ii. in the case of the profit and loss account, of the profit or loss of the assessee for the
relevant accounting year.
The second part of the report states that the statement of particulars required to be furnished
under Section 44AB is annexed to the audit report in Form No. 3CD. The tax auditor is
required to give his opinion whether the prescribed particulars furnished by the assessee are
true and correct.
In paragraph 3 of Form No. 3CB the auditor has to report that the financial statements audited
by him give a ‘true and fair’ view. The requirement in paragraph 3 of Form No.3CA and
paragraph 4 of Form No.3CB relating to particulars in Form No.3CD is that the auditor should
report that these particulars in Form No.3CD are “true and correct”. The terminology “true and
fair” is widely understood though not defined even by the Companies Act, 1956. On the other
hand, the words “true and correct” lay emphasis on factual accuracy of the information. In this
context reference is invited to AS-1 and AS(IT)-l relating to disclosure of accounting policies.
These standards recognize that the major considerations governing the selection and
application of accounting policies are (i) prudence, (ii) substance over form and (iii) materiality.
Therefore, while giving particulars in Form No.3CD these aspects should be kept in view. In
particular, considering the nature of particulars to be given in Form No.3CD, the aspect of
materiality should be considered. In other words particulars should be given in the respect of
material items and the auditors should ensure factual accuracy relating to these particulars.
Even in case of immaterial items, particulars are required to be given by auditor for e.g., delay
in TDS deposit, untimely payment of PF/ESIdues.
In the case of a person whose accounts of the business or profession have been audited
under any other law, it is not required for the tax auditor appointed under section 44AB to give
his opinion, as to whether or not the accounts give a true and fair view as indicated herein
above. It would only be necessary for him to annex a copy of the audited accounts as well as
a copy of the audit report given by the statutory auditor with his report in Form No. 3CA along
with Form No.3CD.
In the case of a person who carries on business and also renders professional services but
who is not required by or under any other law to get his accounts audited, report should be
given in Form No, 3CB. The statement of particulars should be given in Form No. 3CD. Even
where separate sets of accounts are maintained in respect of business and professional
activities Form No. 3CB and Form No. 3CD should be used.
In the case of “person” having their accounting year which is different from the financial year,
accounts of the financial year are required to be prepared and audited. The audit report shall
be in Form 3CB.
Form No. 3CA
1. This form is to be used in a case where the accounts of the business or profession of a
person have been audited under any other law. The first part of the report refers to the
fact that the statutory audit of the assessee was conducted by a chartered accountant or
any other auditor in pursuance of the provisions of the relevant Act, and the copy of the
audit report along with the audited profit and loss account and balance sheet and the
documents declared by the relevant Act to be part of or annexed to the profit and loss
account and balance sheet, are annexed to the report in Form No. 3CA. In a case where
the tax auditor carrying out the audit under Section 44AB is different from the statutory
auditor, a reference should be made to the name of such statutory auditor. In case the
statutory auditor is carrying out the audit under section 44AB, the fact that he has carried
out the statutory audit under the relevant Act should be stated.
2. The next paragraph states that the statement of particulars required to be furnished
under section 44AB is annexed with the report in Form No. 3CD. The tax auditor has to
state further that, in his opinion and to the best of his information and according to the
explanations given to him, the particulars given in the said Form No. 3CD and annexures
theretoare true and correct.
3. Where any of the requirements in this form is answered in negative or with qualification,
the report shall state the reasons thereof. The tax auditor should state this qualification in
the audit report so that the same becomes a comprehensive report and the user of the
audited statement of particulars can realise the impact of such qualifications.
4. It is possible that in the case of a person whose accounts of the business or profession
have been audited under any other law, which has branches at various places, the
branch accounts might have been audited by branch auditors under the statute. If the
audit under section 44AB is also carried out by the same branch auditors or other
chartered accountants, they should submit the report in Form. No. 3CA to the
management or the principal tax auditor appointed for the head office under Section
44AB. Attention in this regard is drawn to AAS-10. Using the Work of Another Auditor’
which discusses the procedures in this regard as well as the principal tax auditor’s
responsibility in relation to his use of the work of the branch auditor. The principal tax
auditor should submit his consolidated report on the registered office/head office and
branch accounts and report in his tax audit report as under:
“I/We have taken into consideration the audit report and the audited statements of accounts,
and particulars received from the auditors, duly appointed under the relevant law, of the
branches not audited by me/us”.
If the assessee is unable to obtain relevant information in respect of the overseas branches
duly certified by the overseas auditor, the relevant facts should be suitably disclosed and
reported upon.
Item No.4 of the notes to Form No. 3CA requires that the person, who signs this audit report,
shall indicate reference of his membership No./certificate of practice number/authority under
which he is entitled to sign this report. No separate certificate of practice number is allotted by
ICAI. As such, where a chartered accountant acts as a tax auditor he should give his
membership number with ICAI and the status such as proprietor or partner under which he has
signed the report.
Form No. 3CB
In the case of a person who carries on business or profession but who is not required by or
under any other law to get his accounts audited the audit report has to be given in Form No.
3CB. Form No. 3CB consists of four paragraphs.
The tax auditor has to state whether he has examined the balance sheet as at 31st March of
the relevant previous year and the profit and loss account/income and expenditure account for
the year ended on the date. Further, such a balance sheet and the profit and loss account
must be attached with the audit report.
The tax auditor has to certify that the balance sheet and the profit and loss account income
and expenditure account are in agreement with the books of accounts maintained at the head
office and branches. He has also to mention the total number of branches.
He has to report his observations, comments, discrepancies or inconsistencies, if any. Subject
to the above observations, comments, discrepancies, inconsistencies he has to state whether:
(a) he has obtained all the information and explanations which, to the best of his knowledge
and belief, were necessary for the purposes of the audit;
(b) in his opinion proper books of account have been kept by the head office and branches
of the assessee so far as appears from his examination of the books;
(c) in his opinion and to the best of his information and according to the explanations given
to him the said accounts, read with notes thereon, if any, give a true and fair view;
(i) in the case of the balance sheet of the state of the affairs of the assessee as at 31st
March, _______ and
(ii) in the case of the profit and loss account / income and expenditure account of the
profit / loss or surplus/deficit of the assessee for the year ended on that date.
Under clause (a) of paragraph 3 of Form No.3CB, the tax auditor has to report his
“observations /comments/ discrepancies /inconsistencies,” if any. The expression ‘Subject to
above’ appearing in clause (b) makes it clear that such observations/comments/
discrepancies/ inconsistencies which are of qualificatory nature relate to necessary
information and explanations for the purposes of the audit or the keeping of proper books of
accounts or the true and fair view of the financial statements, respectively to be reported on in
paragraphs (A), (B) and (C) under clause (b) of paragraph 3. While reporting on clause (a) of
paragraph 3 of Form No. 3CB the tax auditor should report only such of those
observations/comments/ discrepancies/ inconsistencies which are of qualificatory nature which
affect his reporting about obtaining all the information and explanations which were necessary
for the purposes of the audit, about the keeping of proper books of account by the head office
and branches of the assessee and about the true and fair view of the financial statements.
Further, only such observations/ comments/ discrepancies/ inconsistencies, which are of a
qualificatory nature, should be mentioned under clause (a). Any other observations/
comments/ discrepancies/inconsistencies, which do not affect the reporting on the matters
specified above may form part of the notes to accounts forming part of the accounts. In case
the tax auditor has no observations/comments/ discrepancies/inconsistencies to report, which
are of qualificatory nature, the following portion of paragraph 3 may be deleted:
“3(a) *I/We report the following observations/comments/discrepancies/ inconsistencies, if any:
Subject to above,”
The tax auditor may then give his report as required by sub-paragraphs (A), (B), and (C) of
paragraphs 3 and 4.
Paragraph 4 of Form No.3CB provides that the prescribed particulars are furnished in Form
No.3CD annexed to the report and Para 5 of Form No.3CB requires the auditor to report
whether in his opinion and to the best of his information and according to the explanations
given to him, the particulars given in Form No.3CD and annexures thereto are true and
correct. The auditor may have a difference of opinion with regard to the particulars furnished
by the assessee and he has to bring these differences under various clauses in Form No.3CD.
The auditor should make a specific reference to those clauses in Form No.3CD in which he
has expressed his reservations, difference of opinion, disclaimer etc. in this paragraph.
If a person who carries on business or profession but who is not required by or under any
other law to get his accounts audited, has branches and separate accounts are
maintained at the branches, the assessee can request the tax auditor appointed under
Section 44AB to audit the head office and branch accounts. In the alternative, the
assessee can appoint separate tax auditors for branches. The branch tax auditor in such
a case will have to give an audit report in Form No. 3CB to the management or the tax
auditor appointed for the audit of head office accounts. The tax auditor appointed for the
audit of head office can rely on the report of branch tax auditors subject to such checks
and verifications as he may choose to make and shall submit his consolidated report on
the head office and branch accounts. He should make suitable reference to the audit
conducted by separate branch tax auditors in the same manner as stated above.
If the tax auditor is called upon to give his report only in respect of one or more businesses
carried on by the assessee and the books of accounts of the other businesses are not
produced as the same are not required to be audited under the Act. the tax auditor should
mention the fact that audit has not been conducted of those businesses whose books of
account had not been produced. However, if the financial statements include, inter alia, the
results of such business for which books of account have not been produced, the auditor
should qualify his report in Form No. 3CA/3CB.
Form No. 3CD
The statement of particulars given in Form No. 3CD as annexure to the audit report contains
thirty two clauses and two annexures . The tax auditor has to report whether the particulars
are true and correct. This Form is a statement of particulars required to be furnished under
section 44AB. The same is to be annexed to the reports in Forms No. 3CA and 3CB in respect
of a person who carries on business or profession and whose accounts have been audited
under any other law and in respect of person who carries on business or profession but who is
not required by or under any other law to get his accounts audited respectively.
As stated earlier, the tax auditor should obtain from the assessee, the statement of particulars
in Form No.3CD duly authenticated by him. It would be advisable for the assessee to take into
consideration the following general principles while preparing the statement of particulars:
(a) He can rely upon the judicial pronouncements while taking any particular view about
inclusion or exclusion of any items in the particulars to be furnished under any of the
clauses specified in Form No.3CD.

(b) If there is a conflict of judicial opinion on any particular issue, he may refer to the view
which has been followed while giving the particulars under any specified clause.
(c) The Accounting Standards (AS), Guidance Notes, Auditing and Assurance Standards
(AASs) issued by the Institute from time to time should be followed.
While furnishing the particulars in Form No.3CD it would be advisable for the tax auditor to
consider the following:
(a) If a particular item of income/expenditure is covered in more than one of the specified
clauses in the statement of particulars, care should be taken to make a suitable cross
reference to such items at the appropriate places.
(b) If there is any difference in the opinion of the tax auditor and that of the assessee in
respect of any information furnished in Form No. 3CD, the tax auditor should state both
the view points and also the relevant information in order to enable the tax authority to
take a decision in the matter.
(c) If any particular clause in Form No.3CD is not applicable, he should state that the same
is not applicable.
(d) In computing the allowance or disallowance, he should keep in view the law applicable in
the relevant year, even though the form of audit report may not have been amended to
bring it in conformity with the amended law.
(e) In case the prescribed particulars are given in part or piecemeal to the tax auditor or
relevant form is incomplete and the assessee does not give the information against all or
any of the clauses, the auditor should not withhold the entire audit report. In such a
case, he can qualify his report on matters in respect of which information is not furnished
to him. In the absence of relevant information, the tax auditor would have no option but
to state in his report that the relevant information has not been furnished by the
assessee.
(f) The information in Form No. 3CD should be based on the books of accounts, records,
documents, information and explanations made available to the tax auditor for his
examination.
Note1: Notification No.208/2006 dated 10th August, 2006 has made significant
amendments in Form No.3CD. It has also inserted Annexure –II for the computation of
the value of fringe benefits in terms of section 115WC read with section 115WB. All
these changes have been incorporated in this Chapter. Particulars to be furnished in
Form No. 3CD.
PART A
1. Name of the assessee :
2. Address :
3. Permanent Account Number:
4. Status :
5. Previous year ended : 31st March
6. Assessment year :
If the tax audit is in respect of a branch then the name of the branch should be mentioned
along with the name of the assessee. Similarly, in such a case the address of the branch or
unit should be given.
Part B
7. (a) If firm or Association of Persons, indicate names of partners/members and
their profit sharing ratios.
(b) ''If there is any change in the partners or members or in their profit sharing
ratio since the last date of the preceding year, the particulars of such change.''
In case where the partner of a firm or the member of AOP acts in a representative
capacity, the name of the beneficial partner/member should be stated.
The details of partners or members during the entire previous year will have to be
furnished.
The term "profit sharing ratios" would include loss-sharing ratio also since loss is
nothing but negative profits.
If there is any change in the partners of the firm or members of the association of
persons or their profit or loss sharing ratio, since the last date of preceding year, the
particulars of such change must be stated. All the changes occurring during the
entire previous year must be stated.
The particulars in this clause should be verified from the instrument or agreement or
any other document evidencing partnership or association of persons including any
supplementary documents or other documents effecting such changes. For this
purpose, the tax auditor may also verify:
(i) whether the relevant documents, if required, have been filed with the
concerned authorities,
(ii) whether notice of changes, if required, has been given to the registrar of
firms, and
any minutes or any other understanding recording any changes in the
partners/members or their profit sharing ratios.
The tax auditor should obtain certified copies of the deeds, documents,
understanding, notice of changes etc. including certified copies of the
acknowledgment, if any, evidencing filing of documents
8. (a) Nature of business or profession (if more than one business or profession is
carried on during the previous year, nature of every business or profession).
(b) If there is any change in the nature of business or profession, the particulars
of such change.
In regard to the nature of business, the principal line of each business such as
manufacturing of electronic goods, trading in chemicals, wholesale trade in food
grains or a retail trade in grocery should be stated.
In the case of a person rendering services, the nature of services should be broadly
stated. Any material change in the nature of business should be precisely set out.
The change will include change from manufacturer to trader as well as change in
the principal line of business.
A review of business report or the minutes of meetings would enable the tax auditor
to note the changes, if any.If need be the tax auditor can should get a declaration
feom the assessee regarding change in the nature of business, if any.
9. (a) Whether the books of account are prescribed under Section 44AA, if yes, list
of books so prescribed.
(b) Books of account maintained.
(In case books of account are maintained in a computer system, mention the
books of account generated by such computer system.)
(c) List of books of account examined.
The list of books of account prescribed, maintained and examined has to be stated
under this clause. There may be difference between the three lists. For example,
books of account may have been prescribed but all the prescribed books might not
have been maintained or the entire books of account maintained might not have
been produced for examination. The tax auditor should exercise his professional
judgment and skill in order to arrive at the conclusion whether such a situation
warrants any disclosure or qualifications while forming his opinion on the matters
covered by reporting requirements in Form No.3CB.2. The tax auditor should
obtain from the assessee a complete list of books of account and other documents
maintained by him (both financial and non-financial records) and make appropriate
marks of identification to ensure the identification of the books and records
produced before him for audit. The list of books of account maintained by the
assessee should be given under this clause.As to the requirement regarding the
mentioning of the books of account generated by the computer system, only such
books of account and other records which properly come within the scope of the
expression “proper books of account” should be mentioned. The tax auditor should
insist on proper print-outs of books of account being taken out.
For a person whose accounts of the business or profession have been audited
under any other laws the requirement for maintenance of books of account is
contained in the relevant statutes. In the case of other assessees, normal books of
accounts to be maintained will be cash book/ bank book, sale/ purchase journal or
register and ledger. Assessees engaged in trading/manufacturing activities should
also maintain quantitative details of principal items of stores, raw materials and
finished goods. While giving his report in Form No. 3CB about maintenance of
proper books of account, the tax auditor should ensure that they are maintained in
accordance with the above requirements.
Books of account examined would constitute the books of original entry and the
other books of account. While the assessee is required to maintain proper evidence
in the form of bills, vouchers, receipts, documents, etc., it may be noted that these
are essential to support the entries in the books of account and no reference to
such supporting evidence need be made under this clause.
10. Whether the profit and loss account includes any profits and gains assessable on
presumptive basis, if yes, indicate the amount and the relevant Sections (44 AD,
44AE, 44AF, 44B, 44BB, 44BBA, 44BBB or any other relevant section).
Where the profits and gains of the business are assessable to tax under presumptive
basis under any of the sections mentioned below, the amount of such profits and
gains credited/debited to the profit and loss account should be indicated under this
clause.
S. No. Section Business Covered

1 44AD Civil construction business
2 44AE Transport business
3 44AF Retail trade
4 44B Shipping business of a non-resident
5 44BB Exploration etc. of mineral oil by a non-resident
6 44BBA Operation of aircraft by non-resident
7 44BBB Civil construction etc. in certain turnkey power project by non-
residents.
8 Any other This refers to the sections not listed above under which
relevant income may be assessable on presumptive basis like Section
section 44D and will include any other section that may be enacted in
future for presumptive taxation.
If the profit and loss account does not include profit assessable on presumptive basis,
then, there is no requirement to furnish the particulars under this clause.
The amount to be mentioned under this clause means the amount included in the
profit and loss account. The tax auditor is not required to indicate as to whether such
amount corresponds to the amount assessable under the relevant section relating to
presumptive taxation. As such, the reporting requirement gets satisfied if the amount
as per profit and loss account is reported. However, the tax auditor may clarify by way
of a note that the amount mentioned under this clause is not necessarily the actual
amount of profits and gains chargeable to tax under the relevant section.
11. (a) Method of accounting employed in the previous year.
(b) Whether there has been any change in the method of accounting employed
vis-a-vis the method employed in the immediately preceding previous year.
(c) If answer to (b) above is in the affirmative, give details of such change, and
the effect thereof on the profit or loss.
(d) Details of deviation, if any, in the method of accounting employed in the
previous year from accounting standards prescribed under Section 145 and
the effect thereof on the profit or loss.
The Finance Act, 1995 has amended Section 145 with effect from assessment year
1997-98 to provide that the income chargeable under the head “Profits and gains of
business or profession” or ‘Income from other sources” must be computed in
accordance with either cash or mercantile system of accounting regularly employed
by the assessee. It has also been provided that the Central Government may notify
in the Official Gazette from time to time the accounting standards to be followed by
any class of assessees or in respect of any class of income. The hybrid system of
accounting viz. mixture of cash and mercantile hitherto allowed to be followed by
the assessee is not permitted from assessment year 1997-98. However, the
assessee may adopt cash system of accounting for one business and mercantile
system of accounting for other business. Once the choice of method of accounting
is decided, the assessee must follow consistently the method of accounting
employed. If he employs different methods for different businesses regularly and
consistently, the profits would have to be computed in accordance with the
respective methods, provided the result is a proper determination of profits.

It may be noted that section 209 of the Companies Act,1956 requires every
company to maintain books of account on accrual basis. However, this section is
not applicable to entities other than companies.
If there is any change the effect thereof has to be stated under this clause. In so far
as the question of effect of such change on the profit or loss is concerned, the
concept of materiality is the basic governing factor. If it is not possible to quantify
the effect of the change in the method of accounting, appropriate disclosure should
be made under this clause.
An assessee can follow a number of accounting policies for the purpose of
maintaining his books of account. As per AS-1 all significant accounting policies
adopted in the preparation and presentation of financial statements shall be
disclosed. The disclosure of the significant accounting policies shall form part of the
financial statements and the significant accounting policies shall normally be
disclosed in one place. Any change in an accounting policy which has a material
effect in the previous year or in the years subsequent to the previous year shall be
disclosed. The impact of, and the adjustments resulting from such change, if
material, shall be shown in the financial statement of the period in which such
change is made to reflect the effect of such change.
The Calcutta High Court in Snow White Food Products v CIT 11983] 141 ITR 861,
and Madras High Court in CIT v Carborandum Universal Limited [1966] 149 ITR 759
and several other decisions like CIT v. Mopeds India Ltd. [1998] 173 ITR 347,
Triveni Engg, Works Ltd. v. CIT [1987] 167 ITR 742 (All), CIT v. Ganga Trust Fund
[1986] 162 ITR 612 (Guj) have held that it is open to an assessee to change the
method of accounting provided the changed method is the regular method of
accounting and the assessee has not merely abandoned or changed it for a casual
period to suit his own purposes. Any such change which is followed consistently has
to be accepted by the department, even if it results in reduction of tax liability.
A change in an accounting policy will not amount to a change in the method of
accounting and hence such change in the accounting policy need not be mentioned
under sub-clause (b). This is due to the fact that as per the requirements of AS-1
and AS(IT)-l such changes and the impact of such changes will be disclosed in the
financial statements. It may be noted that a change in the method of valuation of
stock will amount only to a change in an accounting policy and hence such a
change need not be mentioned under sub-clause 11(b) but should be mentioned in
The tax auditor should apply reasonable checks to the earlier year’s accounts to
ascertain whether there is any change in the method of accounting in the year under
audit, after obtaining a written confirmation from the assessee as to the method of
accounting followed.
It must also be ascertained whether the AS(IT) as may be applicable, have been
followed. The tax auditor has to report the details of deviations in the method of
accounting in the previous year from the AS(IT) and the effect thereof on the profit
or loss.
12. (a) Method of valuation of closing stock employed in the previous year.
(b) Details of deviation, if any, from the method of valuation prescribed under
Section 145A, and the effect thereof on the profit or loss.
The method of valuation of closing stock is to be stated under this clause. It is the
normal practice to disclose the same as a part of disclosure of significant accounting
policies. Accordingly, a reference may be invited to the same or the method of
valuation may be again described in Form No.3CD.
The method of valuation followed by the assessee having regard to the articles or
goods dealt in or manufactured by the assessee, should be clearly indicated. Some
examples are given below:
(i) raw material at cost or net realisable value whichever is lower,
(ii) finished goods at cost or net realisable value whichever is lower,
In clause 3(i) of the old Form No. 3CD reference was to “opening and closing stock-
in-trade”. In sub-clause (a) of clause 12 of revised Form No.3CD, the reference is to
“closing stock”. The expression “stock-in-trade” means finished goods and raw
materials. Since sub-clause (b) refers to section 145A where the term “inventories”
is used, the term “closing stock” will include all items of inventories. AS-2 defines
the term “inventories” to include finished goods, raw materials, work-in progress,
materials, maintenance supplies, consumables and loose tools. Therefore, method
of valuation of items of inventories will have to be given under sub-clause (a).
The tax auditor should study the procedure followed by the assessee in taking the
inventory of closing stock at the end of the year and the valuation thereof. He
should obtain the inventory of closing stock, indicating the basis of valuation
thereof, for reporting on the method of valuation of closing stock under this
clause.
The method of stock valuation must be consistently followed from year to year and
the method followed must be brought out clearly. The tax auditor should examine
the basis adopted for ascertaining the cost and this basis should be consistently
followed. It is necessary to ensure that the method followed for valuation of stock
results in disclosure of correct profit and gains.
The details of deviation, if any, from the method of valuation prescribed under
Section 145A, and the effect thereof on the profit or loss have to be stated under
clause 12(b). Section 145A has been enacted by the Finance (No.2) Act, 1998
and has came into force from the accounting year 1.4.1998 to 31.3.1999
(assessment year 1999-2000). This section provides that the valuation of
purchase and sale of goods and inventory for the purpose of computation of
income from business or profession shall be made on the basis of the method of
accounting regularly employed by the assessee but this shall be subject to certain
adjustments. Therefore, it is not necessary to change the method of valuation of
purchase, sale and inventory regularly employed in the books of account.The
adjustments provided in this section can be made while computing the income for
the purpose of preparing the return of income. These adjustments are as follows:
(a) Any tax, duty, cess or fee actually paid or incurred on inputs should be
added to the cost of inputs (raw-materials, stores etc.); if not already added
in the books of account.
(b) Any tax, duty, cess or fee actually paid or incurred on sale of goods should
be added to the sales, if not already added in the books of accounts.
(c) Any tax, duty, cess or fee actually paid or incurred on the inventory (finished
goods, work-in-progress, raw materials etc.) should be added to the
inventories, if not already added while valuing the inventory in the accounts.
12A. Give the following particulars of the capital asset converted into stock-in-trade:
(a) Description of capital asset;
(b) Date of acquisition;
(c) Cost of acquisition;
(d) Amount at which the asset is converted into stock-in-trade.
This is a new clause that has been inserted by the Notification 208/2006 dated 10th
August, 2006. For furnishing particulars required under this clause, the provisions of
section 2(47),45(2),47(iv),(v) and 47A have tio be kept in mind.
The particulars to be stated under new clause 12A should be furnished with respect to
the previous year in which the asset has been converted into stock-in-trade. The clause
does not require details regarding the taxability of capital gains or business income
arising from such deemed transfer.
Under clause (a) description of the capital asset is required to be mentioned for example,
shares, security, land, building, plant, machinery, etc.
Under Clause (b) the date of acquisition is to be reported. For ascertaining the correct
date the tax auditor will have to refer the accounts of the financial year in which such
capital asses is acquired. The date assumes importance for the purpose of determining
whether the asset is long term or short-term in nature.

Under clause(c) the cost of acquisition is required to be reported. Here the cost of
acquisition as per the books of account is to be mentioned. In case of depreciable
assets, the carrying cost appearing in the books will be the written down value. But the
value to be reported will be the original cost of acquisition. Even in case of an asset
acquired prior to the 1st day of April 1981 the value to be reported will be the original
cost of acquisition. The assessee may exercise the option of considering the fair market
value of the asset as on 1st April, 1981 for assets acquired prior to that date for the
purpose of computation of capital gains as provided under Section 55(2)(b)(i).
Under clause (d) the amount at which the asset converted into stock-in-trade should be
stated. Such an amount may not be the fair market value as on the date of conversion or
treatment as stock in-trade. If a value other than carrying cost is recorded then the
auditor has to examine the basis of arriving at such a value. The valuation of stock-in-
trade is to be examined with reference to AS 2 Valuation of Inventories. Non-compliance
with AS 2 is to be suitably qualified in the main audit report.
13. Amounts not credited to the profit and loss account, being
(a) the items falling within the scope of Section 28;
(b) the pro forma credits, drawbacks, refund of duty of customs or excise or
service tax, or refund of sales tax or value added tax , where such credits,
drawbacks or refunds are admitted as due by the authorities concerned;
(c) escalation claims accepted during the previous year;
(d) any other item of income;
(e) capital receipt, if any.
Under this clause various incomes falling within the scope of Section 28, which are not
credited to the profit and loss account are to be stated. The information under sub-
clauses (a), (d) and (e) of clause (13) is to be given with reference to the entries in the
books of account and records made available to the tax auditor for the purpose of tax
audit under Section 44AB. Section 28 refers to (a) profits and gains of business or
profession, (b) compensation received on termination of employment, agency etc (c)
income of trade or professional or similar association from specific services to
members, (d) export incentives, (e) perquisite received during the course of business
or profession, (f) interest, salary, bonus, remuneration, etc. received by a partner of a
firm which is allowable under section 40(b) (g) sum received for not carrying out any
activity in relation to business or not shares any know-how, parent, etc. and (h) amount
received under Keyman Insurance policy. It will now be necessary to ascertain from the
assessee about any receipts under these heads, which have not been credited to profit
and loss account and state such amounts in this clause. Clauses 13 (b), (c) & (d)
require information in respect of items which may also be covered under Section 28
and as such will also fall in clause 13 (a) However, those items which are reported in
clauses 13(b), (c) and (d) need not be reported in clause 13 (a). The tax auditor may
have to obtain a management representation in writing from the assessee in respect of
all items falling under this clause.
The details of the following claims, if admitted as due by the concerned authorities but
not credited to the profit and loss account, are to be stated under sub-clause (b)
(a) Proforma credits
(b) Drawback
(c) Refund of duty of custom
(d) Refund of excise duty
(e) Refund of sales tax
In respect of items failing under sub-clause (b) the tax auditor should examine all
relevant correspondence, records and evidence in order to determine whether any
particular refund/claim has been admitted as due and accepted during the relevant
financial year.
There may be practical difficulties in verifying the information in regard to such refunds
and credits. It may, therefore, be necessary for the tax auditor to scrutinise the
relevant files or subsequent records relating to such refunds while verifying the
particulars and also obtain an appropriate management representation.
The words ‘admitted by the concerned authorities’ would mean ‘admitted by the
authorities within the relevant previous year’.
The system of accounting followed in respect of these particular items may also be
brought out in appropriate cases. If the assessee is following cash basis of
accounting, it should be clearly brought out, since the admittance of claims during the
relevant previous year without actual receipt has no significance in cases where cash
method of accounting is followed. Credits/claims which have been admitted as due
after the relevant previous year need not be reported here.
Where such amounts have not been credited in the profit and loss account but netted
against the relevant expenditure/income heads, such fact should be clearly brought
out.
Under sub-clause (c), the escalation claims accepted during the previous year but not
credited to the profit and loss account dare to be stated. The escalation claims
accepted during the year would normally mean “accepted during the relevant previous
year”. If such amount has not been credited to the profit and loss account the fact
should be brought out. The system of accounting followed in respect of this particular
item may also be brought out in appropriate cases. If the assessee is following cash
basis of accounting with reference to this item, it should be clearly brought out since
acceptance of claims during the relevant previous year without actual receipt has no
significance in cases where cash method of accounting is followed.
Escalation claims would normally arise pursuant to a contract (including contracts
entered into in earlier years), if so permitted by the contract. Only those claims to
which the other party has signified unconditional acceptance could constitute accepted
claims. Mere making of claims by the assessee or claims under negotiations or claims
which are sub-judice CIT v. Hindustan Housing & Development Trust Ltd. (1986) 161
ITR 524 (SC) cannot constitute claims accepted.
Sub-clause (d) covers any other items which the tax auditor considers as an income of
the assessee based on his verification of records and other documents and information
gathered, but which has not been credited to the profit and loss account. In giving the
details under sub-clauses (c) and (d), due regard should be had to AS-9 - Revenue
Recognition.
The tax auditor should scrutinise all the items including casual and non-recurring items
appearing in the books of account, particularly the credit items, and ensure himself
whether any such credit which is the nature of income has been credited to the profit
and loss account or not.
Under sub-clause (e), capital receipt, if any, which has not been credited to the profit and
loss account has to be stated. The tax auditor should use his professional expertise and
judgement in determining whether the receipt is capital or revenue. The tax auditor may
also indicate various judicial pronouncements on which he has relied.
The following is an illustrative list of capital receipts which, if not credited to the profit and
loss account, are to be stated under this sub-clause.
(a) Capital subsidy received in the form of Government grants, which are in the
nature of promoters’ contribution i.e., they are given with reference to the total
investment of the undertaking or by way of contribution to its total capital outlay.
For e.g., Capital Investment Subsidy Scheme.
(b) Government grant in relation to a specific fixed asset where such grant is shown
as a deduction from the gross value of the asset by the concern in arriving at its
book value.
(c) Compensation for surrendering certain rights.
(d) Profit on sale of fixed assets/investments to the extent not credited to the profit
and loss account.
14. Particulars of depreciation allowable as per the Income tax Act, 1961 in respect of
each asset or block of assets, as the case may be, in the following form :
(a) Description of asset/block of assets.
(b) Rate of depreciation.

(c) Actual cost or written down value, as the case may be.
(d) Additions/deductions during the year with dates; in the case of any addition of
an asset, date put to use ; including adjustments on account of -
(i) Modified Value Added Tax credit ∗ claimed and allowed under the
Central Excise Rules, 1944, in respect of assets acquired on or after 1st
March, 1994,
(ii) change in rate of exchange of currency, and
(iii) subsidy or grant or reimbursement, by whatever name called.
(e) Depreciation allowable.
(f) Written down value at the end of the year.
Having regard to the nature of requirements prescribed, it may be necessary for the tax
auditor to examine:
(a) Classification of the asset.
(b) Classification thereof to a block.
(c) The working of actual cost or written down value.
(d) The date of acquisition and the date on which it is put to use.
(e) The applicable rate of depreciation.
(f) The additions / deductions and dates thereof.
(g) Adjustments required - specified as well as on account of sale, etc.
For the purpose of determining the rate of depreciation, the tax auditor has to examine the
classification of assets into various blocks. Once the classification has been ascertained and
checked properly, the rates applicable as per the Income tax Rules, 1962 follow as a natural
corollary. The tax auditor must have due regard to the Income tax Rules, 1962, relevant
clarifications from the Department and judicial decisions. If there is any dispute with regard to
the classification, or the rate of depreciation applied, the tax auditor must give his working with
suitable reasons.
The additions/deductions during the year have to be reported with dates. The tax auditor is
advised to get the details of each asset or block of asset added during the year or disposed of
during the year with the dates of acquisition/disposal. Where any addition was made, the date
on which the asset was put to use is to be reported. In respect of deductions, the sale value of
the assets disposed of along with dates should be mentioned. From assessment year 2002-03
the depreciation shall be allowed mandatorily whether the assessment year it or not. This
principle applies to additional depreciation also.
∗
Now CENVAT
15. Amounts admissible under sections 33AB, 33ABA, 33AC∗(wherever applicable), 35,
35ABB, 35AC, 35CCA, 35CCB∗∗, 35D,35DD, 35DDA and 35E:
(a) debited to the profit & loss account (showing the amount debited and
deduction allowable under each section separately);
(b) not debited to the profit and loss account.
[Clause 15 (a) and (b)]
The tax auditor should indicate the amount debited in the profit and loss account and the
amount actually admissible in accordance with the concerned provisions of law. The amount
not debited to the profit and loss account but admissible under any of the sections mentioned
in the clause have to be stated. Sections 33AB and 33ABA allow deduction in respect of
amount deposited in designated account for specified purposes which, as per accounting
principles, are not to be debited to the profit and loss account. In this connection, the tax
auditor has to work out, on the basis of the conditions prescribed in the concerned section, the
amount admissible thereunder and report the same. Where the assessee is eligible for
deduction under one or more of the above sections, the tax auditor has to state the deduction
allowable under each section separately.
16. (a) Any sum paid to an employee as bonus or commission for services rendered,
where such sum was otherwise payable to him as profits or dividend. [Section
36(l)(ii)].
(b) Any sum received from employees towards contributions to any provident
fund or superannuation fund or any other fund mentioned in Section 2(24)(x);
and due date for payment and the actual date of payment to the concerned
authorities under Section 36(l) (va).
The requirement is only in respect of the disclosure of the amount and the tax auditor is not
expected to express his opinion about its allowability or otherwise. The tax auditor should
verify, the contract with the employees so as to ascertain the nature of payments.
The tax auditor should get a list of various contributions recovered from the employees which
come within the scope of this clause. He should also verify the documents relating to provident
funds and other welfare funds. He should verify the agreement under which employees have
to make contributions to provident fund and other welfare funds. The ledger account of
contributions from employees should be reviewed, the due dates of payments and the actual
dates of payment should be verified with the evidence available. In view of the voluminous
nature of the information, the tax auditor can apply test checks and compliance tests to satisfy
himself that the system of recovery and remittance is proper. Under this clause, details of the
∗
No deduction shall be allowed under this section for any assessment year commencing on or after 1st day
of April, 2005.
∗∗
No deduction shall be allowed in respect of any expenditure incurred after 31st day of March, 2002.
amount deducted, due date for payment and actual date of payment in respect of provident
fund, ESI fund or other staff welfare fund have to be stated. However, in case of big
assessees such as public sector undertakings, banks etc. where information to be stated is
voluminous, the tax auditor may exercise his professional judgement and state only those
cases under this clause where actual date of payment to the concerned authorities is beyond
the due date of payment and state this fact by way of a suitable note.
17. Amounts debited to the profit and loss account, being:
(a) expenditure of capital nature;
(b) expenditure of personal nature;
(c) expenditure on advertisement in any souvenir, brochure tract, pamphlet or the
like, published by a political party;
(d) expenditure incurred at clubs,-
(i) as entrance fees and subscription
(ii) as cost for club services and facilities used;
(e) (i) expenditure by way of penalty or fine for violation of any law for the
time being in force;
(ii) any other penalty or fine;
(iii) expenditure incurred for any purpose which is an offence or which is
prohibited by law;
(f) amounts inadmissible under section 40(a);
(g) interest, salary, bonus, commission or remuneration inadmissible under
Section 40(b)/40(ba) and computation thereof;
(h) (A) whether a certificate has been obtained from the assessee regarding
payments relating to any expenditure covered under Section 40A(3) that
the payments were made by account payee cheques drawn on a bank or
account payee bank draft, as the case may be; [Yes/No]
(B) amount inadmissible under Section 40A(3), read with rule 6DD [with
break-up of inadmissible amounts];
(i) provision for payment of gratuity not allowable under Section 40A(7);
(j) any sum paid by the assessee as an employer not allowable under Section
40A(9);
(k) particulars of any liability of a contingent nature; amount of deduction in
admissible in terms of section 14A in respect of the expenditure incurred in
relation to income which does not form part of total income,
(l) amount inadmissible under the proviso to section 36(1)(iii)
Clause 17(a): This clause requires the tax auditor to state the amount of expenditure incurred
by the assessee in respect of various items listed therein. These expenses may be allowable
or may not be allowable or maybe allowable subject to certain limits. It is important to note
that the amount of expenditure in respect of each of the items is required to be stated.
Accordingly, tax auditor will have to obtain the information and make necessary enquiries in
that behalf. It may necessitate review of books of account, basis of classification, groups
under which such expenses have been debited, and so on.
Clause 17(b): Personal expeness debited to the profit and loss account are to be specified
under this sub-clause as they are not deductible in the computation of total income under
Section 37.
Clause 17(c): Section 37(2B) provides that no allowance shall be made in respect of
expenditure incurred by an assessee on advertisement in any souvenir, brochure, tract,
pamphlet or the like published by a political party. Therefore, the expenditure of this nature
should be segregated and reported under this clause.
Clause 17(d): The amount of payments made to clubs by the assessee during the year should
be indicated under this clause. The payments may be for entrance fees as well as
membership subscription and for catering and other services by the club, both in respect of
directors and other employees in case of companies and for partners or proprietors in other
cases. The fact whether such expenses are incurred in the course of business or whether
they are of personal nature should be ascertained. If they are personal in nature, they are to
be shown separately under Clause 17(b) referred to earlier.
Clause 17(e): In this clause, sub-clause (i) covers only penalty or fine for violation of any law
for the time being in force, while sub-clause (ii) covers any other penalty or fine. The tax
auditor should obtain in writing from the assessee the details of all payments by way of
penalty or fine for violation of any law as have been made and paid or incurred during the
relevant previous year and how such amounts have been dealt with in the books of account
produced for audit. The tax auditor may not be aware of the intricacies of all the laws of the
land. It must be borne in mind that the tax auditor while reporting under this clause is not
required to express any opinion as to the allowability or otherwise of the amount of penalty or
fine for violation of law. He is only to give the details of such items as have been charged in
the account. This clause covers only penalty or fine and not the payment for contractual
breach or for redressal of contractual wrongs. While stating the particulars under this clause,
the tax auditor should take into consideration the concept of materiality.
Clause 17(f): Section 40(a) specifies certain amounts which shall not be deducted in
computing the income chargeable under the head “Profits and gains of business or
profession”. They are as follows:
(i) Any interest, royalty, fees for technical services or other sum chargeable under the
Income tax Act, which is payable outside India or in India to a non resident, not being a
company or to a foreign company on which tax has not been deducted or after deduction
has not been paid before the expiry of the time prescribes under section 200(1) and in
accordance with other provisions of Chapter XVII B.
(ii) Any interest, commission or brokerage, fees for professional services or fees for
technical services payable to a resident or amounts payable to a contractor or sub-

contractor, being resident for carrying out any work (including supply or labour for
carrying out any work) on which tax is deductible under Chapter XVII-B and such tax has
not been deducted or after deduction has not been paid during the previous year or in the
subsequent year before the expiry of the time prescribed under sub-section (1) of section
200.
(iii) Any sum paid on account of securities transaction tax.
(iv) Any sum paid on account of fringe benefit tax.
(v) Any sum paid on account of any rate or tax levied on the profits or gains of any business
or profession or assessed at a proportion of, or otherwise on the basis of, any such
profits or gains.
(vi) Any sum paid on account of wealth tax.
(vii) Any payment which is chargeable under the head “salaries”, if it is payable outside India
or to a non resident and if the tax has not been paid thereon nor deducted therefrom
under Chapter XVII-B.
(viii) Any payment to a provident or other fund established for the benefit of employees of the
assessee, unless the assessee has made effective arrangement to secure that tax shall
be deducted at source from any payment made from the fund which are chargeable to
tax under the head “Salaries”.
(ix) Any tax actually paid by an employer referred to in Clause (10CC) of section 10.
(x) The Taxation Laws amendment Act, 2006 has amended section 40(a)(ia) w.e.f 1.04.06
so as to include rent and royalty in its ambit. For the purposes of section 40(a)(ia) the
meaning of rent shall be the same as given under section 194I. Section 194J has also
been amended but w.e.f 13.07.06. It is possible that an assessee may contend that the
inadmissibility under section 40(a)(ia) with respect to the amended definition if rent and
royalty does not apply in relation to A.Y.2006-07. In such a case the tax auditor is
required to state both the view points to enable the tax authority to take the decision.
Clause 17(g): The tax auditor has to verify whether the assessee has complied with the
provisions.The tax auditor is required to state the inadmissible amount and such information is also
required to be given in respect of interest/ remuneration paid to a member of an Association of
persons (AOP) / Body of individuals (BOI). The word “inadmissible’ implies that the tax auditor will
have to examine the facts, apply the conditions for allowance or disallowance and accordingly
determine the prima facie inadmissibility of the deduction and also quantify the same.
Clause 17(h): This is an amendment to the existing sub-clause (h) of clause 17. The Taxation
Laws (Amendment) Act, 2006 has amended Section 40A(3) w.e.f 13th July, 2006 to provide
that the payment for expenditure is made only by account payee cheque or account payee
bank draft. The present provision of allowing the expenditure in case the payment has been
made by crossed cheque/bank draft has been discontinued. It should be noted that the
reporting requirements under this clause arise only after 13th July 2006.
There may be practical difficulties in verifying the payments made through crossed/account
payee cheque or bank drafts. If no proper evidence for the verification of the payment by the
crossed/ account payee cheque or draft is available, such a fact could be brought out by
appropriate comments as suggested in the Supplementary Guidance Note.
The earlier sub-clause (h) required furnishing of the amount inadmissible under Section
40A(3) read with rule 6DD along with computation. The amended sub-clause requires
disclosure of amount inadmissible under Section 40A(3) read with rule 6DD with the break-up
of inadmissible amount.
Wherever possible individual items of inadmissible expenses may be given. However where,
in view of the large volume of transactions, it is not possible to give individual items of
inadmissible amounts, the tax auditor may furnish such details under broad heads of
accounts.
Clause 17(i): The tax auditor should call for the order of the Commissioner of Income-tax
granting approval to the gratuity fund, verify the date from which it is effective and also verify
whether the provision has been made as provided in the trust deed.
In case the provision made for payment of gratuity is not allowable under Section 40A(7), the
same is to be stated under this sub-clause.
Clause 17(j): Under Section 40A(9) any payment made by an employer towards the setting up
or formation of or as contribution to any fund, trust, company, association of persons, body of
individuals, society registered under the Societies Registration Act, 1860, or other institutions
(other than contributions to recognised provident fund) is not allowable. The tax auditor should
furnish the details of payments which are not allowable under this section.
Clause 17(k): The tax auditor may look into particular items of contingent liabilities of the
earlier year in order to determine whether or not any items has been charged to the profit and
loss account of the current year and if so, whether the liability continues to be contingent in
nature. Wherever necessary, a suitable note should be given by the tax auditor as to the non-
availability of such particulars relating to the contingent liabilities.
Clause 17(l):This is a new clause inserted by notification No. 208/2006. It is primarily the
responsibility of the assessee to furnish the details of amounts of deduction inadmissible in
terms of section 14A in respect of the expenditure incurred in relation to income, which does
not form part of the total income. The method of ascertaining the inadmissible expenditure as
and when prescribed should be followed. The tax auditor has to verify the details furnished by
the assessee and should satisfy himself that the inadmissible amounts have been worked out
correctly. Where an assessee claims that no expenditure has been incurred by him in relation
to income which does not form part of the total income under the Act and does not furnish the
necessary particulars for the purpose of ascertaining the inadmissible expenditure under
Section 14A, the tax auditor has to make a proper disclaimer qualification. Attention is invited
to paragraph 5 of AAS 11, Representation by Management which is as under.
“During the course of an audit, management makes many representations to the auditor, either
unsolicited or in response to specific enquiries. When such representations relate to matters
which are material to the financial Information, the auditor should;

a) seek corroborative audit evidence from sources inside or outside the entity;
b) valuate whether the representations made by management appear reasonable and
consistent with other audit evidence obtained, including other representations; and
c) consider whether the individuals making the representation can be expected to be well
informed on the matter.”
Clause 17(m): This is a new clause inserted by notification No.208/2006. The requirements of
sub-clause (m) are applicable in respect of capital borrowed for acquisition of an asset for
extension of the existing business or profession. The assessee has to furnish he details of
amount inadmissible under the proviso to Section 36(1) (iii). The tax auditor has to verify the
correctness of the particulars furnished by the assessee with the documentary evidence.
18. Particulars of payments made to persons specified under Section 40A(2)(b)
Section 40(A)(2) provides that expenditure for which payment has been or is to be made to
certain specified persons listed in the section may be disallowed if, in the opinion of the
Assessing Officer, such expenditure is excessive or unreasonable having regard to:
(i) the fair market value of the goods, services or facilities for which the payment is made; or
(ii) for the legitimate needs of business or profession of the assessee; or
(iii) the benefit derived by or accruing to the assessee from such expenditure.
19. Amounts deemed to be profits and gains under Sections 33AB or 33ABA or 33AC
Sections 33AB and 33ABA lay down the circumstances under which amount withdrawn from
such deposit account covered thereby for purposes other than specified purposes is to be
deemed income chargeable as profit and gains of business. The tax auditor is required to
report such amounts. Likewise, Section 33AC allows deduction in respect of reserve created
out of the profit of the assessee engaged in shipping business to be utilised in accordance
with the provision of sub section (2) of Section 33AC. Sub section (3) thereof lays down the
circumstances in which the amount of reserve account shall be deemed to be the profit and
gains chargeable to tax. The tax auditor should verify the amount withdrawn from the deposit
account for purposes other than specified purposes. Similarly, he should verify whether the
reserve created under Section 33AC and utilised not in accordance with the provisions of Sub-
section (2) of Section 33AC has been properly disclosed. However, consequent to the
amendment made by the Finance (No.2) Act, 2004, no deduction shall be allowed under
section 33AC for any assessment year commencing on or after 1stday of April, 2005.
20. Any amount of profit chargeable to tax under Section 41 and computation thereof
The tax auditor should obtain a list containing all the amounts chargeable under Section 41
with the accompanying evidence, correspondence, etc. He should in all relevant cases
examine the past records to satisfy himself about the correctness of the information provided
by the assessee. The tax auditor has to state the profit chargeable to tax under this section.
This information has to be given irrespective of the fact whether the relevant amount has been
credited to the profit and loss account or not. However, if the amount has already been
credited to the profit and loss account, the tax auditor should mention the fact. The
computation of the profit chargeable under this clause is also to be stated.
21. (i)∗ In respect of any sum referred to in clause (a), (b),(c), (d), (e) or (f) of section
43B, the liability for which:
(A) pre-existed on the first day of the previous year but was not allowed in
the assessment of any preceding previous year and was
(a) paid during the previous year;
(b) not paid during the previous year;
(B) was incurred in the previous year and was
(a) paid on or before the due date for furnishing the return of income
of the previous year under Section 139(1);
(b) not paid on or before the aforesaid date.
Section 43B has been significantly amended by the Finance Act, 2001 and Finance Act, 2003.
Consequent to the above amendments an uniform treatment is being given in respect of all
sums specified in clauses (a) to (f) of section 43B including clauses (b). Therefore, the duty of
the tax auditor is restricted to reporting under clause 21(i) (A) and (B).
Section 43B provides that notwithstanding anything contained in any other provisions of the
Act, the following amounts shall be allowed as deduction in computing the business income of
an assessee in the previous year in which such amounts are actually paid:
(a) Any tax, duty (sales tax, excise duty, municipal tax, etc.), cess or fee payable by the
assessee under any law for the time being in force.
(b) Employer’s contribution to any provident fund or superannuation fund or gratuity fund or
any other fund for the welfare of employees.
(c) Any bonus or commission payable by the assessee to its employees.
(d) Interest on any loan or borrowing from any public financial institution, a state financial
corporation or a state industrial investment corporation payable in accordance with the
terms and conditions of the agreement governing such loan or borrowing.
(e) Any sum payable by the assessee as interest on any loan or advances from a scheduled
bank in accordance with the terms and conditions of the agreement governing such loan
or advances.
∗
State whether sales tax, customs duty, excise duty or any other indirect tax, levy, cess, impost
etc. is passed through the profit and loss account.
(f) Any sum payable by the assessee as an employer in lieu of any leave at the credit of his
employee.
First proviso to section 43B provides that nothing contained in this section shall apply in
relation to any sum which is actually paid by the assessee on or before the due date
applicable in his case for furnishing the return of income under section 139(1) in respect of
previous year in which the liability to pay such sum was incurred as aforesaid and the
evidence of such payment is furnished by the assessee along with such return.
In the case of an assessee maintaining its accounts on the mercantile system, the tax auditor
should verify the aforesaid particulars, from the books of account for the year under audit as
well as from the books of account, vouchers and documents of the immediately succeeding
assessment year so that the information about the aforesaid payments made in the
subsequent year can be furnished.
The above particulars are required irrespective of the fact whether they have been debited to
profit and loss account or not and such a fact should be stated under this clause. The tax
auditor is not required to determine any admissible or inadmissible amount(s).
22. (a) Amount of Modified Value Added Tax∗ credits availed of or utilised during the
previous year and its treatment in the profit and loss account and treatment of
outstanding Modified Value Added Tax credits in the accounts.
(b) Particulars of income or expenditure of prior period credited or debited to the
profit and loss account.
Clause 22 (a): The tax auditor should check relevant statutory records viz. RG-23 (both
reports) maintained under the Central Excise Rules and ascertain the amount of credit on
inputs availed and utilised during the previous year. He should verify that there is proper
reconcitiation between balance of MODVAT credits in the accounts and RG-23. In so far as
the reporting of accounting treatment of MODVAT credit is concerned the clause requires that
its treatment in profit and loss account and the treatment of outstanding MODVAT credit in the
account have to be reported upon.
The tax auditor may consider reporting under this clause in the following manner :
Capital Goods Others

Balance representing CENVAT credits as at
the beginning of the year
CENVAT credit available during the year
Less amount of CENVAT credit utilised
during the year
Balance representing outstanding amount as
at the end of the year.
∗
Now CENVAT
Clause 22(b): It may be noted that information under this clause would be relevant only in
those cases where the assessee follows mercantile system of accounting. Under cash system
of accounting, expenses debited/income credited to the profit and loss account would be
current year’s expenses/income even though they may relate to earlier years. The tax auditor
should obtain the particulars of expenditure or income of any earlier year debited or credited
to the profit and loss account of the relevant previous year when mercantile system of
accounting is followed. In the case of a person whose accounts of the business or profession
have been audited under any other law, the information may be readily available from annual
accounts. In the case of a person who carries on business or profession but who is not
required by or under any other law to get his accounts audited, however, a close scrutiny of
the ledger in regard to the period for which expenditure or income is entered in the account
books may be necessary.
23. Details of any amount borrowed on hundi or any amount due thereon (including
interest on the amount borrowed) repaid, otherwise than through an account payee
cheque. [Section 69D]
For this purpose, the tax auditor should obtain a complete list of borrowings and repayments
of hundi loans otherwise than by account payee cheques and verify the same with the books
of account.
There will be practical difficulties in verifying the loan taken or repaid on hundi by account
payee cheque. In such cases, the tax auditor should verify the borrowing/repayments with
reference to such evidence which may be available and in the absence of conclusive or
satisfactory evidence, he should make a suitable comment in his report as suggested below
which is exactly similar to the one suggested in respect of expenditure paid otherwise than
through an account payee cheque [Section 40A(3)].
“It is not possible for me / us to verify whether the amounts borrowed on hundi or any amount
due thereon (inclnding interest on the amount borrowed) were repaid otherwise than by
crossed cheque or bank draft, as the necessary evidence is not in the possession of the
assessee”.
24 (a)∗ Particulars of each loan or deposit in an amount exceeding the limit specified
in Section 269SS taken or accepted during the previous year
(i) name, address and permanent account number (if available with the
assessee) of the lender or depositor;
(ii) amount of loan or deposit taken or accepted;
(iii) whether the loan or deposit was squared up during the previous year;
∗
(These particulars need not be given in the case of a Government company, a banking
company or a corporation established by a Central, State or Provincial Act.)
(iv) maximum amount outstanding in the account at any time during the
previous year;
(v) whether the loan or deposit was taken or accepted otherwise than by an
account payee cheque or an account payee bank draft.
(b) Particulars of each repayment of loan or deposit in an amount exceeding the
limit specified in section 269T made during the previous year:
(i) name, address and permanent account number (if available with the
assessee) of the payee;
(ii) amount of the repayment;
(iii) maximum amount outstanding in the account at any time during the
previous year;
(iv) whether the repayment was made otherwise than by account payee
cheque or account payee bank draft.
(c) Whether a certificate has been obtained from the assessee regarding taking or
accepting loan or deposit, or repayment of the same through an account
payee cheque or an account payee bank draft. [Yes/No]
The particulars (i) to (iv) at (b) and the Certificate at (c) above need not be
given in the case of a repayment of any loan or deposit taken or accepted
from Government, Government company, banking company or a corporation
established by a Central, State or Provincial Act.
[Clause 24 (a), (b) & (c)]
Clause 24(a): Particulars of each loan or deposit falling within the scope of this section as
mentioned above taken or accepted during the previous year have to be stated under this sub-
clause. This sub-clause requires five specific particulars in respect of each loan or deposit
including the permanent account number of the lender, if available.
The tax auditor should obtain the above details from the assessee in respect of each loan or
deposit and verify the same from the records maintained by him.
Clause 24(b): This sub-clause requires particulars of each repayment of loan or deposit in an
amount exceeding the limits specified in section 269T. Section 269T is attracted where
repayment of the loan or deposit is made to a person, where the aggregate amount of deposits
held by such person either in his own name or jointly with any other person on the date of such
repayment together with interest, if any, payable on such deposits is Rs.20,000 or more. As
such, all repayments made to any person where the loan or deposit along with interest is
Rs.20,000 or more are to be reported under this sub-clause, even though the amount of
repayment may be less than Rs.20,000. The tax auditor should verify such repayments and
report accordingly. The second proviso to section 269T inserted by the Finance Act, 2003
w.e.f. 1.6.2002 excluded repayments of loans taken from Government, Government company,
Banking company, corporation established by a Central , State or Provincial Act, etc. from the
scope of the above section and therefore the tax auditor need not report such repayments in
his reports. However, section 269T does not exclude Government companies, banking
companies from the scope of its applicability. As such, details of repayment are to be shown in
the case of these entities also.
Clause 24(c): The tax auditor has to state whether a certificate has been obtained from the
assessee regarding taking or accepting loan or deposit , or repayment of the same through an
account payee cheque or an account payee bank draft. The mere obtaining of such certificate
does not reduce the responsibility of the tax auditor to verify the compliance with the provisions
of section 269SS and 269T. The auditor should verify the information obtained from the
assessee with the bank statements and other relevant records and if such verification is not
possible then such fact should be reported.
25. (a) Details of brought forward loss or depreciation allowance, in the following
manner, to the extent available.
Serial Assessment Nature of loss/ Amount as Amount as Remarks
Number Year allowance returned assessed (given
(in rupees) (in rupees) reference to
relevant order)
(b) whether a change in shareholding of the company has taken place in the previous
year due to which the losses incurred prior to the previous year cannot be allowed
to be carried forward in terms of Section 79.
For giving the above information, the auditors should study the assessment records i.e.
income tax returns filed, assessment orders, appellate orders and rectification/revisional
orders for the earlier years and ascertain if the figures given in the above clause are correct.
The Comparison of the composition of the shareholding is to be given with refernce to the last
day of the current previous year and the last day of every previous year in which the loss was
incurred. The carry forward of the loss incurred in respect of different previous years is to be
determined with respect to the individual previous years. This comparison can be done by
referring to the Register of members and also the relevant records available to the tax auditor.
26. Section-wise details of deductions, if any, admissible under Chapter VIA
Chapter VIA of the Act deals with various deductions which have to be given effect to by way
of allowance from gross total income of the assessee and they have been categorised under
the Act as follows:
A.. Deduction in respect of certain payments.
B. Deduction in respect of certain incomes.
C. Other Deductions.
As stated earlier, the tax audit report in Form No.3CA/3CB relates to business or professional
activity of the assessee covered by Section 44AB. Form No.3CD is an annexure to this Form
giving particulars relating to the, business/profession covered by the tax audit report.
Therefore, the requirement under clause 26 relating to the deductions admissible under
Chapter VIA will have to be restricted to the items appearing in the books of accounts audited
by the tax auditor, If the tax auditor is giving tax audit report in respect of the accounts of a
particular branch or a particular unit he will have to examine the particulars relating to
deduction admissible under Chapter VIA with reference to the books of account of that branch
or that unit which is audited by him. Similarly when the tax auditor is giving report on tax audit
of the head office he will have to take into consideration the tax audit reports of the branches
as well as other units of the assessee which may have been audited by the other tax auditors,
He will have to consider the particulars of deductions admissible under Chapter VIA with
reference to the particulars given by the tax auditor of other branches/units and also
particulars of such deductions from books of the head office.
27. (a) Whether the assessee has complied with the provisions of Chapter XVII-B
regarding deduction of tax at source and regarding the payment thereof to the
credit of the Central Government [Yes/No]
(b) If the provisions of Chapter XVII-B have not been complied with please give
the following details*, namely:
Amount
(i) Tax deductible and not deducted at all .....................
(ii) Shortfall on account of lesser deduction than required to .....................
be deducted
(iii) Tax deducted late .....................
(iv) tax deducted but not paid to the credit of the Central .....................
Government
Clause 27 (a): The newly inserted clause 27 is different from the earlier clause. In the earlier
clause the requirement was with reference to the tax deducted at source but not paid to the credit
of the Central Government in accordance with the provisions of Chapter XVII-B. The new clause
requires reporting on the compliance with the provisions of Chapter XVII-B regarding deduction of
tax at source and payment thereof to the credit of the Central Government; Thus, the scope of
reporting under the new clause is much wider. This reporting requirement is to be read with the
specific non-compliances stated under clause (b).
While reporting under this clause the tax auditor may exercise his judgment in the light of the
applicable laws and report accordingly about the compliance of this provision. The tax auditor
may rely upon the judicial pronouncements while taking any particular view. In case of
difference of opinion between the tax auditor and the assessee, the tax auditor should state
both the viewpoints. Further, in view of the voluminous nature of the transactions, the tax
auditor can apply tests checks and compliance tests for verifying the information required to
be provided under this clause.
Clause 27(b): Under clause (i),(ii) and (iii) of clause 27(b) the tax auditor has to verify the
particulars regarding tax deductible and not deducted at all. It is extremely difficult for the tax
auditor to verify each and every transaction in this regard. Therefore, while verifying such
transactions, the tax auditor can apply the concepts of materiality and test checks. The
reporting requirement in clause (b) arises where the tax auditor is not satisfied as to the
compliance by the auditee with the provisions of the Chapter XVII-B regarding deduction of tax
at source and the payment thereof to the credit of the Central Government. Such non-
compliance is required to be reported under sub-clause (i), (ii), (iii) and (iv).
28. (a) In the case of a trading concern, give quantitative details of the principal items
of goods traded :
(i) Opening stock;

(ii) Purchases during the previous year;
(iii) Sales during the previous year;
(iv) Closing stock;
(v) shortage/excess, if any.
(b) In the case of a manufacturing concern, give quantitative details of the
principal items of raw materials, finished products and by-products :
A. Raw materials:
(i) opening stock;
(ii) purchases during the previous year;
(iii) consumption during the previous year;
(iv) sales during the previous year;
(v) closing stock;
∗
(vi) yield of finished products;
(vii)* percentage of yield;
(viii)* shortage/excess, if any.
B. Finished products/By-products:
(i) opening stock;
(ii) purchases during the previous year;
(iii) quantity manufactured during the previous year;
(iv) sales during the previous year;
(v) closing stock;
(vi) shortage/excess, if any.
∗
Information may be given to the extent available.
Clause 28(a): The tax auditor should obtain certificates from the assessee in respect of the
principal items of goods traded, the balance of the opening stock, purchases, sales and
closing stock and the extent of shortage/excess/damage and the reasons thereof.
Clause 28(b): This information should be given only in respect of those items where it is
practicable to do so, having regard to the records maintained by the assessee. In other cases,
the tax auditor may indicate in his report that the relevant records were either not maintained
or were inadequate for the purpose of furnishing the requisite information.
29. In the case of a domestic company, details of tax on distributed profits under
Section 115O in the following form:
(a) total amount of distributed profits;
(b) total tax paid thereon;
(c) dates of payment with amounts.
Section 115O provides for a special levy to the extent of 12.5% plus surcharge, if any, on the
amount of dividend declared, distributed or paid by domestic company whether such dividend
is out of current profit or accumulated profits. Vide this clause the tax auditor has to report on
profit distributed during the financial year, and therefore, the amount of tax paid on such
distributed profit and the dates and amount of payment against this clause.
30. Whether any cost audit was carried out, if yes, enclose a copy of the report of
such audit [See Section 139(9)]
The tax auditor should ascertain from the management whether cost audit was carried out and
if yes enclose the copy of the report of such audit. Even though the tax auditor is not required
to make any detailed study of such report, he has to take note of any material observation
made in such cost audit report which may have relevance to the tax audit conducted by him.
The tax auditor need not express any opinion in a case where such audit has been ordered
but the same has not been carried out.
31. Whether any audit was conducted under the Central Excise Act, 1944, if yes,
enclose a copy of the report of such audit.
The tax auditor should ascertain from the management whether any audit was conducted
under the Central Excise Act, 1944 and if such audit was carried out, obtain the report, if
available and enclose the copy of the report of such audit. Even though the tax auditor is not
required to make any detailed study of such report, he has to take note of any material
observation made in such excise audit report which may have relevance to the tax audit
conducted by him. The tax auditor need not express any opinion in a case where such audit
has been ordered but the same has not been carried out.
32. Accounting ratios with calculations as follows:
(a) Gross profit/Turnover;
(b) Net profit/Turnover;

(c) Stock-in-trade / Turnover;
(d) Material consumed/Finished goods produced.
These ratios have be calculated only for assessees who are engaged in manufacturing or
trading activities. This clause is not applicable to assessees carrying on profession.
Moreover, the ratios have to be given for the business as a whole and need not be given
product wise. Further, the ratio mentioned in sub-clause (d) need not be given for trading
concern.
While calculating these ratios, the tax auditor should assign a meaning to the terms used in
the above ratios having due regard to the generally accepted accounting principles. All the
ratios mentioned in this clause are to be calculated in terms of value only.(Refer Annexure I
and II)
Audit approach and reporting responsibilities
1. In formulating the audit approach towards reporting on truth and correctness of the
particulars contained in Annexure II to Form No.3CD, it is necessary to understand the
rationale behind the introduction of the provisions relating to the fringe benefit tax in the
Act. In terms of the CBDT’s Circular No. 08/2005 of August 29, 2005, introduction of
fringe benefit tax is aimed at bringing into the tax net, such fringe benefits which
otherwise escaped being taxed or were being under-taxed on account of the fact that
they are provided to the employees in the form of reimbursements and other
miscellaneous expenses.
2. In carrying out an audit the tax auditor is primarily concerned with verifying that the
transactions of the business, as entered in the books of account, are recorded in a
manner such that the financial statements drawn up there-from reflect a true and fair
view of the state of affairs of the enterprise on a given date. The responsibility entrusted
to the tax auditor to report in Form No. 3CD would also now include the verification of the
amount expended on items that may be termed as fringe benefits or deemed fringe
benefits.
3. In carrying out the verification, an issue would arise in determination of the head of
expenditure which could be a matter of a subjective view. Thus certain items of
expenditure could be looked at from different perspectives and the appropriate head of
expenditure would be determined in accordance with the approach and policy adopted in
this regard.
For example, expenditure on providing helmets or certain uniforms or umbrellas to
employees may be intended to provide an amenity to the employees. Another possibility
of the same expenditure is that the expenditure is incurred primarily with the objective of
reducing potential expenditure/loss arising from injury or illness. The accounting head to
be debited for recording such expenditure could be staff welfare or kit expenses. This
decision would depend primarily on the approach adopted.
It would be difficult to categorically say that any one of these approaches is incorrect. As
per generally accepted accounting principles and practices, whichever is the policy
adopted, so long as it reflects the substance of transaction, the same should be accepted
for the purposes of determining the appropriate head of expenditure for forming an
opinion whether the same falls within the category of fringe benefits.
4. Adoption of this approach would mean that the underlying objective of the expenditure
should be considered and not merely the apparent objective. In determining whether or
not certain expenditure falls within the specific clauses of heads mentioned in section
115WB(2), this aspect would be important. The Act states that fringe benefit would be
deemed to have been provided if any expense is incurred for the purposes mentioned in
section 115WB(2) clauses A to Q. Therefore, whether a particular item of expenditure
falls within the ambit of the fringe benefit, what is important is the purpose for which the
expenditure is incurred. The head of account to which the said expenditure is debited,
rightly or wrongly is not decisive for computing the value of fringe benefits.
5. In this connection, question number 11 of the CBDT circular number 8/2005 indicates the
meaning of the term ‘purpose’. As per the said circular “the word ‘purposes’ in the term
‘for the following purposes’ referred to in sub-section (2) of section 115WB refers to the
proximate purpose and not the distant purpose. For example, if an expenditure is
incurred on travel for discussing an advertisement plan for a product, such expenditure
shall be construed to have been incurred for the proximate purpose of travelling and not
the ultimate purpose of advertisement and accordingly liable to FBT.”
The assessee would be well advised to determine the amount of expenditure subject to
FBT by adopting the test of proximate purpose as mentioned in the circular even though
the head of account debited in the books of account is different. The tax auditor too may
keep in mind that even though such head of expense being debited may be acceptable in
carrying out the audit of the financial transactions; however, for the purpose of
verification of computation of fringe benefit tax, the test of proximate purpose in
determining the taxability of expenditure needs to be adopted. The tax auditor would
therefore have to verify the correctness of the computation of the expenditure which are
covered within the ambit of FBT keeping in mind the purpose of the expenditure as
evidenced by the supporting evidence. As mentioned above, subjectivity could arise in
regard to determining the purpose for which expenditure is incurred. In the event of the
auditee/assessee insisting on adopting a different approach for quantification of fringe
benefits from that suggested by the CBDT, it would be appropriate for the tax auditor to
make a suitable disclosure in this regard.
6. In formulating the audit approach towards reporting on true and correctness of the
particulars contained in Annexure II to Form No.3CD, it is necessary to understand that
the tax auditor would need to apply reasonable tests on the information prepared by the
auditee for working out value of fringe benefits.
7. The expression “true and fair” is widely understood though not defined even by the
Companies Act, 1956. On the other hand, the words “true and correct” lay emphasis on
factual accuracy of the information. In this context reference is invited to AS-1 and AS(IT)
– I relating to disclosure of accounting policies. These standards recognize that the major
considerations governing the selection and application of accounting policies are (i)
prudence, (ii) substance over form and (iii) materiality. Therefore, while giving the
particulars, considering the nature of expenditure to be given in the Annexure to Form
No.3CD, the aspect of materiality should be considered.
8. In giving his report the tax auditor will have to use his professional skill and expertise and
apply such audit tests as the circumstances of the case may require, considering the
contents of the audit report. He will have to conduct the audit by applying the generally
accepted auditing procedures, which are applicable for any other audit. He can apply the
test checks depending on the type of internal control procedures followed by the
assessee/employer. The tax auditor will also have to keep in mind the concept of
materiality depending upon the circumstances of each case. He would be well advised to
refer to the Auditing and Assurance Standards -13(AAS-13) “Audit Materiality” issued by
the ICAI. If the statutory tax auditor of an auditee is also appointed to undertake tax
audit, it is advisable to carry out both the audits concurrently.
9. The audit report given under this section is to assist the income-tax department to work
out the correct value of fringe benefits. In order that the tax auditor may be in a position
to explain any question which may arise later on, it is necessary that he should keep
detailed notes about the evidence on which he has relied upon while conducting the audit
and also maintain all his working papers. Such working papers should include his notes
on the following, amongst other matters:
(a) work done while conducting the audit and by whom;
(b) explanation and information given to him during the course of the audit and by
whom;
(c) decision on the various points taken;
(d) the judicial pronouncements relied upon by him while drafting the audit report; and
(e) certificates issued by the client / management letters.
The requirements of documentation and peer review concepts are applicable in respect
of tax audit conducted by chartered accountants. For this purpose attention is also
invited to AAS 3 – Documentation, which provides that the tax auditor should document
matters which are important in providing evidence that the audit was carried out in
accordance with the basic principles.
10. It is important that the audit working papers prepared and / or obtained by the tax auditor
provide evidence that:
(i) the opinion expressed by the tax auditor in respect of the particulars given in
Annexure II is based on the examination made by him;
(ii) in arriving at his opinion, the tax auditor has given due cognizance to the
information and explanations given by the assessee and that his opinion is not
arbitrary;
(iii) the information and explanations obtained were full and complete that is, the tax
auditor has called for all the information and explanations which were necessary
to be considered before arriving at his opinion; and
(iv) the tax auditor did not merely rely upon the information or explanations given by
the auditee/assessee but that he subjected such information and explanations to
reasonable tests to verify their accuracy and completeness.
11. The tax auditor is required to report whether the particulars contained in Annexure II are
“true and correct”. It is essential to note that it is the primary responsibility of the
assessee to prepare the information in such manner so that the tax auditor can verify the
compliance thereof. The tax auditor is required to verify that no items have been omitted
in the information furnished to him and reasonable tests checks would reveal whether or
not the information furnished is correct. The extent of check undertaken would have to
be indicated by the tax auditor in his working papers and audit notes. The tax auditor
would be well advised to so design his tax audit programme as would reveal the extent of
checking and to ensure adequate documentation in support of the information being
certified.
12. Annexure II to Form No.3CD requires the assessee to provide the following particulars in
respect of the fringe benefits in terms of section 115WC read with section 115WB.
(i) Amount of expenditure incurred or payment made
(a) debited to the profit and loss account
(b) accounted for in the balance sheet
(c) reimbursements
(d) any other head
(ii) deductions, if any
(iii) total
(iv) percentage of expenditure/payment being fringe benefits
(v) value of fringe benefits
Annexure II also requires that the value of fringe benefits be calculated in
accordance with the provisions of sections 115WC read with the provisions of
section 115WB.
13. The concept of valuation of fringe benefits being in its evolving stages in India, it is
possible that some difficulties might be faced by the auditee in identifying, classifying and
reporting the same. For the purposes of Annexure II, it is essential that the expenditure
is classified by the auditee under the natural head to which it belongs. For example, the
assessee might have capitalized the traveling expenses of the employees incurred in
connection with purchase of plant and machinery, in the books of account but for the
purposes of Annexure II, the said expenditure would need to be shown as travelling
expenses in terms of section 115WB(2)(Q) 1[From the A.Y.2007-08 onwards]. Though the
assessee is not required to amend his financial records yet to comply with the
requirements of the provisions of sections 115WA and 115WB(2), he should be advised
to maintain adequate records of the payments made/expenditure incurred so that
identification and examination of the fringe benefits is facilitated. The tax auditor should
apply the same degree of examination as in case of a normal audit.
14. Audit of fringe benefits would require the tax auditor to seek detailed information from the
management as required. The tax auditor should also consider obtaining management
representations in respect of the following aspects related to fringe benefits:
(i) that the management has identified and appropriately classified all such
payments/expenditures which are subject to fringe benefit tax in terms of sections
115WA and 115WB of the Act and
(ii) that the there are no unrecorded payments/expenditure which would have
otherwise qualified for being subjected to the fringe benefit tax.
While verifying the details provided in the Annexure, the auditor will have to consider the
following parameters in respect of each of the expenses on which FBT is payable:
(a) identification of the expenses and correlating the same to the respective clauses,
(b) quantification of the FB in respect of the expense,
(c) verification that no other expense of similar nature is left out or duplicated in any
other expenses and
(d) the presentation in the format required by the Annexure II.
15. The tax auditor in terms of the requirements of audit under section 44AB of the Act is
required to report whether in his opinion the particulars in respect of fringe benefits as
given in Annexure II to Form No.3CD, are true and correct.
16. The audit procedures help the tax auditor in forming his opinion; and the audit report is
the culmination of the tax auditor’s audit exercise and conclusions reached by him. The
audit report is a medium through which the tax auditor communicates the results of his
findings to the users. It is, therefore, essential that the audit report contains a clear
expression of the tax auditor’s opinion on the subject matter under audit. The attention of
the members in this regard is invited to Auditing and Assurance Standard (AAS) 28 -
“The Auditor’s Report on Financial Statements” and “Statement on Qualifications in
Auditor’s Report” issued by the ICAI contain the basic principles to be followed by the tax
auditor while giving his audit report, including the basic elements of an audit report.
However, the tax auditor, pursuant to tax audit under section 44AB of the Act, is required
to submit his report in Form No.3CA or 3CB, as the case may be. These forms have
1 115WB(2)(P) for the A.Y.2006-07

been prescribed under the Rules. Nevertheless, paragraph 6 of AAS-28 clearly states
that where the regulator prescribes the form in which the tax auditor should issue his
report, the tax auditor should report in the form prescribed by the regulator in addition to
the requirements of AAS 28. Thus, while reporting in the Form Nos. 3CA and 3CB, the
tax auditor should enquire that the report among other things complies with the
requirements of AAS-28. For example, those relating to the basic elements of the tax
auditor’s report, such as title, addressee, introductory paragraph, scope paragraph,
opinion paragraph, date of report, place of signature, membership number and tax
auditor’s signature.
17. Form Nos. 3CA and 3CB require the tax auditor to report whether in his opinion and to
the best of his information and according to the explanations given to him, the particulars
given in the above Annexure II are true and correct. As a result of his audit procedures,
the tax auditor may reach a conclusion that the particulars given in Annexure II have
been correctly identified and reported and that the value of fringe benefits has been
calculated in accordance with the provisions of sections 115WB(1) and 115WB(2) of the
Act. In such a situation, the tax auditor would give an unqualified opinion stating as
under:
“In my opinion and to the best of my information and according to the explanations given to me
and considering the materiality the particulars given in Annexure II to Form No.3CD are
true and correct”.
18. In certain situations, however, it may not be possible for the tax auditor to give a clean
report i.e. to express an unqualified opinion in respect of the particulars relating to fringe
benefits given by the assessee in Annexure II to Form No.3CD. The need to give a
modified report may arise in a situation where the assessee has not identified and
reported some/any expenditure/payment qualified for being subject to fringe benefit tax
for the purpose of Annexure II to Form No. 3CD because of factors such as:
(i) the assessee contests the applicability of some/all of the provisions of the section
115WA and/or 115WB of the Act, or
(ii) the assessee contests the applicability of all or some of the requirements of the
CBDT’s clarificatory circular No. 08/2005 dated August 29, 2005; or
(iii) the provisions of section 115WA and/or 115WB or the abovementioned circular
are silent in respect of certain issue(es) and the assessee has taken some stand
on such issue.
The tax auditor, in each of the above cases, would need to consider the type of modified
audit report most appropriate for bringing out the facts of the case and his opinion before
the readers. Where however, the tax auditor agrees with the stand taken by the auditee,
his report would need to bring out the fact. For example, there might be a case where
the auditee claims that all the guest houses maintained by it were used for the purpose of
providing accommodation for training and, accordingly the expenditure incurred by it
towards maintenance of those guest houses is exempt from being subjected to fringe
benefit tax in terms of section 115WB(2)(K) and, accordingly does not report any amount
in that respect in Annexure II to Form No. 3CD. In such a case, the tax auditor’s report
would appear as follows:
“We draw attention to Note X to Annexure II to Form No. 3CD. The assessee has not
reported the expenditure amounting to Rs…….. incurred towards maintenance of guest
houses of the assessee during the financial year ended March 31, ZXXX as a fringe
benefit since all the guest houses maintained by the assessee were used only for the
purpose of providing accommodation used for training. Based on the information and
explanations and evidence produced in this regard, we are of the opinion that the
particulars given in Annexure II to Form 3CD give a true and correct view”.
Or in another situation, the tax auditor might need to report as follows:
“We draw attention to Note X to Annexure II to Form No.3CD. The auditee has the policy
of hosting a lunch party for all its employees on the occasion of the birthday of any of its
employees. During the financial year ended March 31, 2XXX, the assessee incurred a
sum of Rs……. towards the said expenditure (including the birthday gift given to the
employee) under entertainment expenses in terms of section 115WB(2)(A) of the
Income-tax Act, 1961. The expenditure towards gift has not been debited under gifts in
terms of section 115WB(2)(O).
Based on the information and explanation provided to us we are of the opinion that the
particulars given in Annexure II to Form No.3CD give a true and correct view”.
19. In terms of the principles laid down in AAS-28, a qualified opinion should be expressed
when an auditor concludes that an unqualified opinion cannot be expressed but that the
effect of any disagreement with the management is not so material and pervasive as to
require an adverse opinion, or a limitation on scope is not so material and pervasive as to
require a disclaimer of opinion. In other words, the tax auditor should express an
adverse opinion when the effect of a disagreement is so material and pervasive that the
tax auditor concludes that a qualification of the report is not adequate to disclose the
misleading or incomplete nature of the information contained in Annexure II. A disclaimer
of opinion should be expressed when the possible effect of limitation on scope is so
material and pervasive that the tax auditor has not been able to obtain sufficient
appropriate audit evidence and is, accordingly, unable to express an opinion. Thus, the
decision as to the kind of modified report to be issued would depend upon the materiality
of the item/amount in question.
20. The tax auditor, while issuing a modified report, should give full information about
the subject matter of his qualification and not merely create grounds for suspicion
or inquiry and leave it to the readers to ascertain facts by diligent inquiry. Thus, the
tax auditor’s report should contain a clear description of all the substantive reasons
and unless impracticable, a quantification of the items under qualification.
21. The tax auditor may disagree with the auditee about matters such as:
(i) classification of the fringe benefits under various heads of account;
(ii) computation of the fringe benefits under various heads of account; or

(iii) non-availability of the details/supporting evidence regarding classification of
expenses under different heads of account.
In view of the above, the tax auditor may issue a qualified opinion in case he is in
disagreement with the auditee either about the classification or computation of the
expenditure. However, under exceptional circumstances, the tax auditor may have to
issue an adverse report in case the impact of disagreement about the
classification/computation of fringe benefits is so material and pervasive so as to
affect the overall view of Annexure II annexed to Form No. 3CD. There could be
another situation where adequate records/supporting documents are not made
available to tax auditor and he is unable to verify the classification of expenditure
leading to disclaimer of opinion. The different illustrations of the audit report formats
in above-mentioned situations are as under:
(i) Qualified opinion - Disagreement with management: The auditor may come
across a situation where the guest house(s) of the company were used for
providing accommodation for the purposes of training but the auditor is not
satisfied with the apportionment made by the auditee of the accommodation as
actually used for the purposes of training. For instance, the auditor is of the
view that the proper amount that should be apportioned for the use of guest
house(s) for training purposes is nil in place of Rs.50,000 reported by the
assessee/employer. The illustrative format of audit report may be as under:
We draw attention to clause ………of Annexure II annexed to Form No.3CD
wherein the company has treated Rs.50,000 as amount attributable to such
period during the financial year when the guest house(s) was used for the
purposes of providing accommodation for training, due to which, the amount
under clause .…. has been stated as Rs. 100,000/-. However, we are of the
opinion that Rs.50,000 was not incurred for the purpose of providing
accommodation for training and thus liable for FBT. Therefore, the total amount
of expenditure under clause …… of Annexure II shall be Rs.1,50,000/- and not
Rs.1,00,000/-.
Therefore, in our view, the total value of fringe benefits computed in accordance
with the provisions of section 115WC read with section 115WB of the Act in
respect of the A.Y. _______ has been understated by Rs.50,000
Subject to the paragraph___ above, in my/our opinion and to the best of my/our
information and according to the explanations given to me/us, I/ we are of the
opinion that the particulars given in the said Form No. 3CD and the Annexure A
and Annexure II thereto are true and correct.
(ii) Adverse opinion - Disagreement with the management: The auditor in rare
circumstances may come across a situation that the impact of his disagreement
about the classification/computation of fringe benefits is so material and
pervasive so as to affect the overall view of Annexure II annexed to Form
No.3CD. For example, if any airline company treats (i) the value of free
concessional ticket provided to its employees and their family members; and (ii)
contribution to approved superannuation fund (in excess of Rs 1 lakh per
employee from assessment year 2007-08 onwards) of the employees as
perquisites in the hands of individual since the same is identifiable in the hands
of individual employees and the management refuses to rectify the particulars
given in Annexure II and having regard to the materiality of the amount the
auditor is of the opinion that the particulars given in Annexure II to Form
No.3CD are not true and correct. The illustrative format of audit report may be
as under:
We draw attention to clause ……….. of Annexure II to Form No.3CD, regarding
travel concession to employees and approved superannuation fund wherein the
company treats (i) the value of free concessional ticket provided to its
employees and their family members; and (ii) contribution to approved
superannuation fund (in excess of Rs.1 lakh per employee from A.Y. 2007-08
onwards) of the employees as perquisites in the hands of individual since,
according to them, the same is identifiable in the hands of individual employees.
We are of the opinion that value of concessional tickets and contribution to
superannuation fund are not perquisites in the hands of individual Therefore, in
our view, the value of fringe benefits computed in accordance with the
provisions of section 115WC read with section 115WB of the Act in respect of
the A.Y._______ comes to Rs. XXX and not Rs. ZZZ as shown is Annexure II.
In my/our opinion and to the best of my/our information and according to the
explanations given to me/us, the particulars given in the said Form No. 3CD and
the Annexures A and B thereto are not true and correct.
(iii) Disclaimer - Scope limitation: The auditee has neither provided the
classification of the fringe benefits on the basis of which it has provided the
particulars given in Annexure II nor does it have any proper supporting
documents for the expenditure so classified. The illustrative format of audit
report may be as under:
We have not been able to examine the particulars provided by the assessee in
Annexure II nor have we been able to verify the classification of the expenditure
under various heads of fringe benefits in terms of section 115WB(A) and (B) of
the Act due to non availability of records/supporting evidence for a fair
allocation among various heads of account under which FBT is chargeable.
Because of the significance of the matter discussed in the preceding paragraphs

we are, therefore, not in a position to state whether the particulars given in
Annexure II to Form No.3CD are true and correct.
Audit Provisions Under Vat Law
15.4 Some of the major States who have introduced VAT on 1.4.2005 and some other
States which are in waiting to implement VAT have incorporated audit provisions in their
VAT Legislations. Some of the important features of these provisions along with the
eligibility of the professionals to undertake the audit function and their supportive role for
the successful implementation of the VAT system are dealt with in following paragraphs.
15.4.1 Necessity of audit - Like majority of the developing economies our country is also
facing the problem of lack of education and awareness about tax laws, more particularly
amongst the trading community. Further, the VAT System of taxation is new to them.
Since the trading community is not educated enough and equipped to understand the
implications of the VAT system of taxation immediately, there is every possibility that they
may not be in a position to arrange their business affairs to fall in line with the
requirements of the State Level VAT, calculate and discharge their exact tax liability under
the VAT Law. On the other hand, the tax administrator i.e. the authorities in the taxation
department also find themselves devoid of sufficient resources to educate the tax payers
and inform them about the procedural and accounting changes that are necessitated by
the implementation of VAT system.
Another reason for prescribing an audit under the VAT law by a Chartered Accountant, is
that under the VAT system a major thrust is to be laid on the ‘self assessment’ meaning
thereby that the tax liability calculated and paid by the tax payers through their periodical
returns will be accepted by and large and the tax payers will not be called to substantiate
the tax liability shown by them in the returns by producing books of account and other
relevant material. The assessments with books of account will be an exception. Therefore
there is a strong need to see that the tax payers discharge their tax liability properly while
filing the returns. This can be ensured only where the particulars furnished by the tax
payers are verified by an independent auditor in minute details by going not only through
the books of account but also by analysing and interpreting the provisions of the State-
Level VAT Laws and reporting, whether any under-assessment was made by the dealer
requiring additional payment or whether there was any excess payment of tax warranting
refund to the tax payer. In most of the countries tax evasion is rampant under the existing
tax systems. In India too evasion of excise and sales-tax is estimated to be very high. If
no audit is prescribed under VAT law, the chances of evasion of VAT tax will increase
causing revenue leakage for the Government. It is, therefore, essential that the audit of
the proposed VAT system is attempted on a regular basis. However, it is not possible to
conduct the audit of all the VAT dealers. Therefore, the criteria for audit can be the
amount of turnover or the class of dealer dealing in specified commodities.
The concept of audit is popular even in foreign countries where the system of VAT is in
practice since long in the field of indirect taxation. In countries like France and Korea the
audit has proved to be an effective tool to check the evasion of tax, which was mostly
done by producing fake invoices etc.
Since VAT is a new concept, some of the States want to keep the procedural formalities to
the minimum. Hence at the initial stage their law makers refrain from keeping any audit
provisions in their Act and rules. Perhaps, this may be due to the initial stage of
introduction of VAT. But most of the States, keeping in mind the importance of audit, have
incorporated the audit provisions since inception.
15.4.2 The role of the tax auditor - The role of tax auditor in the initial years of
implementation of VAT would be that of an adviser to the taxpayers. This role will cast
upon him the responsibility to educate and guide the auditee regarding the maintenance
of proper records and in assisting the auditees in maintaining accounting records in such
a manner as to get the information needed for filing of return without delay and extra
efforts. In playing the advisory role the auditor will have to help in devising a proper
accounting system as will generate the required information regarding the output tax,
input tax credit etc. While doing so the auditor may take the guidance from the guidance
notes issued by the Institute of Chartered Accountants of India, New Delhi.
The role of tax auditor vis-a-vis the tax administrators is that the auditor while discharging
his function finds out whether the turnover of sales/purchases is shown correctly in the
returns and is backed up by the accounts and other relevant documents; the deductions
claimed by the tax payer from the turnover of sales are genuine and are supported by
valid documents; the claim of input tax credit has been properly made i.e. it has not been
claimed on the higher side or on such purchases, which are not eligible for grant of input
tax credit. There may be certain instances wherein at the time of purchases the goods
might have been eligible for set-off and accordingly the same was claimed in the returns
but subsequent events might have rendered the input tax credit in admissible. In such
circumstances, it should be the responsibility of the VAT auditor to state whether the
inadmissible input tax credit has been reversed or not and if not, he has to point it out in
his report. Thus to a certain degree the VAT auditor is expected to assist the VAT
administrators in the proper quantification of tax liability of the tax payer and see that
State exchequer gets its revenue which is legally due.
15.4.3 Preparation for tax audit under VAT - A tax auditor has to make certain preliminary
preparations before the actual execution of tax audit under the VAT law. The major steps
required to be undertaken for the preparation are as under:
(i) Knowledge of business - After accepting the audit assignment the auditor should
familiarize himself with the business of the auditee. In this regard, the auditor should
refer to the AAS-20- “Knowledge of the business” issued by the Council of the
Institute of Chartered Accountants of India. Before starting the audit, the auditor
should have a preliminary knowledge of the industry/ business and of the nature of
ownership, management etc. More detailed information should be obtained and
should be assessed and updated during the course of audit. For this purpose the
various sources of information may be tapped. The knowledge of business is
important not only to the auditor but also to his staff engaged in the audit. The
auditor has to ensure that the audit staff assigned to an audit engagement obtains
sufficient knowledge of the business to carry out the audit work delegated to them
and further they should make effective use of the knowledge about the business and
should consider how it affects the tax liability reported in the return. The facts and
figures in the returns should be consistent with the auditor’s knowledge of the
business. The auditor should also make himself familiar with the process of
production and the distribution chain. The auditor should also obtain information
about whether the auditee is a manufacturer/ importer/ retailer, the details of major
customers to whom the sales are effected and the details of sales which are outside
the scope of VAT law. Similarly the sources of purchase and the items sold should be
listed out. Further it should be ascertained whether the auditee has opted for the
composition scheme or not.
(ii) Obtaining a list of all the accounting records maintained by the auditee - The
auditor should obtain a complete list of all the accounting records relating to
sale/purchase of goods, stocks, the various registers, the ledgers etc. maintained, in
which the transactions are recorded, the various source documents in which the
entries are recorded in the books of account and the process of their generation.
(iii) Ascertaining the major accounting policies adopted by the auditee - The auditor
should know the major accounting polices based on which books of account have
been recorded. The accounting policy regarding recording of sales, purchases and
valuation of inventory must be made known and the auditor should also find out
whether there has been any change in those policies during the year covered by
audit. If there is any significant change in the accounting policy giving rise to some
material effect on the tax liability, the same should be invariably reported.
(iv) Evaluation of internal control etc.
Before determining the extent of audit checks to be applied i.e. whether to go in-
depth or to do only test check, the auditor should ascertain whether there is an
internal check system in operation in the entity. He should particularly find out how
the purchases and sales gets initiated and ocused ized. For example, in case of
purchase, receipt of indent by the purchase department, determining the need for
purchases, initiation of purchase order, receipt of material, preparation of MRN,
entries made in the books of accounts etc. should be verified. For sales, receipt of
inquiry, acceptance of sales order, execution of sales, preparation of sale invoice
and realization of transaction. If the internal control is reliable, the extent of audit
may be reduced and should be ocused only on those areas where the auditor feels
that greater degree of audit risk is involved.
(v) Knowledge about the VAT law and allied laws
The auditor and his staff should obtain a thorough knowledge of the State VAT law
under which the audit is to be conducted. The auditor should study the VAT law
starting from the definition of various terms, the procedure to be adopted, the
provisions regarding issue of invoices, claiming of input tax credit, composition
schedule in the VAT law, the manner in which the output tax is to be calculated the
provisions of audit, the contents of the audit report, the periodicity of the return to be
filed, the format of the forms of returns, and the various notifications issued. Further
the auditor should know the Central Sales-tax law as he has to comment on the
liability under that law also. The auditor should also have some knowledge about the
judicial pronouncements made by the Tribunals and the Courts on the various facets
of these laws.
15.4.4 Approach to tax audit under VAT - The audit approach of the tax auditor under the
value added tax system will be more or less similar to the approach, which is adopted by
the auditor while conducting the tax audit under the provisions of section 44AB of the
Income-tax Act, 1961. However, the reporting requirements vary to a considerable extent.
While the auditor has to apply the basic principles of audit he has to keep in mind that the
requirements of VAT audit are different and accordingly he should design his audit
programme.
While designing the audit program the auditor has to ensure that the program includes the
performance of such audit checks as would generate the information which would enable
him to ensure the following and also to draw his audit reports.
(i) The turnover of sales /purchases of goods has been properly determined keeping in
view not only the generally accepted accounting policies but the definition of turnover
of sales in the relevant VAT law. The sales turnover arrived at by applying the
generally accepted accounting policies may not be the same as required under the
VAT law. To take an example, the sale proceeds of a fixed asset will not form a part
of turnover or sales as per the generally accepted accounting policies but will form a
part of turnover or sales for the purpose of VAT law. Similarly the price of goods
returned is deducted from the turnover or sales even if the returns are from the sales
effected in the previous years, while under VAT law, the goods returned are to be
deducted only if they are made within the prescribed time, say six months from the
date of sale. Thus, the results of the audit procedure adopted by the auditor should
be such as will give him a reasonable assurance regarding the figures of sales
reported in the returns. Not only that, he should also be able to get the exact
quantum of the sales under reported or over reported duly classified for different tax
rates and its impact on overall tax liability. The sales as per the financial statements
may include the turnover or sales effected by all the branches, but for the purposes
of VAT law the turnover or sales of only those branches will be included which are
included in one registration certificate.
(ii) The turnover of purchases should be tested by applying audit checks as will enable
the auditor to get the purchases eligible for grant of input tax credit segregated from
other purchases. Further, the purchases on which the input tax credit is available in
full and the purchases on which it is available partially should also be ascertained
correctly. Thereafter, the auditor should get the exact amount of input tax credit
available, compare the same with the credit claimed in the returns and report on the
excess/short claim of the credit in the returns filed.
(iii) The auditor is also required to comment on the timely filing of the returns under the
VAT law. For this purpose the auditor is expected to list out the due dates of filing of
returns and find out the reasons for delay in filing the returns if any.
(iv) The auditor is also required to give his report on the composition scheme. He should
apply such compliance tests as will be enable him to ascertain that the auditee is
eligible for composition, it has paid the requisite composition fee and all the
procedural formalities in relation thereto have been complied with.
(v) The auditor has to give his report on the TDS. Therefore, such tests are to be
applied as will enable him to report on the applicability of TDS provisions, the
accuracy of the amount deducted and paid, timely issue of TDS certificate and filing
of TDS returns.
(vi) The auditor is also expected to check the consolidation of the returns filed for all the
periods covered in the year under audit, both under the State-Level VAT law and the
Central Sales-tax Act, 1956. These returns are to be compared with the books of
account and the documentary evidences available. The auditor is expected to apply
such substantive steps as would enable him to judge whether all the transactions
relating to sale and purchase are entered in the books of account and have been
taken into consideration while filing the returns. In case of any inconsistency a
proper reconciliation of book figures and the returned figures should be made and
also the correct quantification of tax liability is to be done.
The above are only the major areas which are to be tested by the auditor while
conducting the tax audit under VAT laws. The auditor has to take a judgement of his
own regarding the adequacy and appropriateness of the audit checks to be applied
and the areas where the tests are to be applied, so as to give him all the information
needed to form a view not only on the authenticity of the books of account,
correctness of the returns filed but also in the quantification of tax liability.
15.4.5 Audit report under the VAT law - All State-Level VAT laws have been framed by
following a common VAT law Module suggested by the Central Government. Further the
Empowered Committee which pioneered the concept of model VAT law based on certain
common principles also insisted that the basic framework of all the VAT laws in the
various States should be common. It is felt that there should be a common design for
VAT Audit Report also so that the auditor should not find it difficult to conduct the audit
and the reports can be made more meaningful and comprehensible to all. The Institute of
Chartered Accountants of India has already taken a major initiative in this direction and
has already developed a standard format of the audit report. The standard format of audit
report was also submitted to the Empowered Committee. States can take the benefit of
the same and incorporate the format of the audit report suggested by the ICAI in their VAT
laws.
At the end of the audit the auditor has to arrive at his conclusion on the matters to be
reported in the audit report. The format of the audit report is generally prescribed under
the relevant VAT law and the auditor has to fill in all the columns of the audit report that
are applicable. While performing the audit under VAT law the auditor is expected to
conduct the audit presuming himself to be the tax assessor. His audit report will therefore
have to be comprehensive commenting on each and every aspect which goes to the root
of quantification of tax liability. The auditor is expected to give his opinion on the
adequacy of accounting records, correctness and completeness and arithmetical
consistency of returns filed. Further he has to State the basis of his opinion on the
accounts, financial statements and the documents verified by him to arrive at the above
conclusion. The auditor is also expected to give the summary of additional tax
liability/additional refund arising on his verification of the returns together with the books
of account. While the auditor is giving a general opinion on the truth and fairness of books
and account he can make a qualified opinion or an unqualified opinion. He can also
resort to disclaimer where he finds that the accounting records were insufficient to enable
him to frame either a unqualified opinion or a qualified opinion.
So far as the comment on the variation of tax liability is concerned the auditor has to
quantify exactly the amount by which the liability increases or decreases. He has also to
State the transactions against which there is variation in tax liability. Therefore, either he
has to State that the tax liability shown in the return is correct or is incorrect and to what
extent. Thus, an amount of certification of tax liability is involved therein which casts
greater responsibility on the auditor.
Several State VAT Legislations have provided for audit of accounts by chartered
accountants. Such audit becomes necessary whenever the turnover of the assessee
exceeds the prescribed limit under the relevant State VAT Legislations. In this context the
ICAI has developed a model State VAT Audit report. Maharashtra VAT legislation has also
prescribed a form of audit report and also the details to be furnished along with the audit
report. The audit report and the prescribed details are largely similar to the Model VAT
Audit report developed by the ICAI. The objective of furnishing such details is to help the
VAT authorities to determine the correct turnover and also to satisfy themselves whether
the VAT has been remitted properly to the credit of the State Government. Wherever
applicable such particulars have to be verified by the Chartered accountants. Such
verification ensures that the input VAT credit has been claimed by the assessee in a
proper manner.
1. Write an audit programme for the audit of public trust under section 12A of the
Income-tax Act, 1961?
2. Write a short note on the requirement of audit for claiming deduction under section
35D and 35E.
3. A co-operative society having receipts above 40 Lakhs gets its accounts audited by a
person eligible to do audit under Co-operative Societies Act,1912 who is not a
chartered accountant. State with reasons whether such audit report can be furnished
as tax audit report under section 44AB of the Income-tax Act, 1961?
4. A firm having turnover exceeding Rs. 40Lakhs gets its accounts audited under
section 44AB by a chartered accountant who is a Portfolio manager in that firm. State
with reasons whether he is eligible to do such tax audit?
5. A tax auditor need not communicate to the statutory auditor of the previous year who
has done the audit of the client under the Companies Act, 1956. Comment?
6. Documentation is a critical requirement for tax audit. Briefly explain based on the
relevant AAS the requirements of documentation in relation to tax audit.
7. A, a chartered accountant who has helped B Ltd. to maintain its books of account
and who is also rendering services as tax advisor is appointed as a tax auditor by the
Company. Is such appointment valid?
8. In respect of a non-corporate assessee should the tax auditor verify the compliance
with the accounting standards while doing the tax audit.
9. A and associates, a partnership firm has three businesses namely textiles, trading in
cement and hardware in three different locations. The turnover in respect of the
businesses mentioned above is Rs. 10 lakhs, 20 lakhs and 15 lakhs respectively. The
Firm contends that it is not liable to tax audit under section 44AB of the Income-tax
Act, 1961 because it is maintaining separate books of accounts in respect of each
business. Do you agree? Give reasons for your answer.
10. A firm engaged in constructions activity is assessed by the assessing officer under
section 44AD of the Income-tax Act, 1961 on an income of Rs.35 Lakhs calculated on
a presumptive basis. However, the firm contends that its actual income amount only
to Rs.25 Lakhs. Is there any remedy available to the firm?
11. What are the reporting requirements in respect of the following in the context of tax
audit:
a. Conversion of a capital asset into stock in trade of the business
b. Expenditure relating to income not assessable to income tax.
c. Payments exceeding Rs.20,000/- in respect of expenditure incurred.
d. Tax deducted at source.
12. Who is primarily responsible for preparing the particulars to be furnished in form
No.3CD? Mention the various considerations while preparing such particulars.
13. Are there any clauses in Form No. 3CD which would help the Central excise
authorities while assessing excise duty? Briefly explain.
14. What is the difference between method of accounting and accounting policy?
Suppose the assessee changes the method of valuation of stock thereby reducing
the taxable income, should the tax auditor report about the same in Form No. 3CD?
15. Can an assessee reduce his liability to Fringe benefit tax by shifting expenses from
one head to another? What are the guiding principles for the tax auditor while
checking whether expenses have been correctly classified by the assessee?
16. Briefly explain the columnar requirements of Annexure II of Form No.3CD.
17. State whether the following statements are true or false.
a. Gross profit ratio should be given in terms of quantity.
b. Professional firms need not give gross profit ratio.
c. Consistency is not relevant while furnishing the ratios.
18. To what extent a tax auditor should rely on management representations in the
course of conducting tax audit under section 44AB of the Income-tax Act, 1961?
19. Before commencing an audit of VAT what are the formalities to be completed by the
tax auditor?
20. How do you verify input tax credit in respect of inputs and capital goods under VAT
law?
Annexure I
By virtue of Notification No.280, dated November 16, 2004 issued by CBDT the tax auditor is now
required to annex to Form No.3CD a “Statement of Particulars” in the prescribed form The said
Statement has two parts, viz. Part A and Part B.
Part A contains general particulars and Part B requires following particulars to given:
♦ Paid-up share capital/ capital of partner/ proprietor
♦ Share application money/ Current account of Partner or Proprietor,
♦ Reserves and surplus/ Profit and Loss Account
♦ Secured loans
♦ Unsecured loans
♦ Current liabilities and provisions
♦ Total of balance sheet
♦ Gross turnover/ Gross receipts
♦ Gross profit
♦ Commission received
♦ Commission paid
♦ Interest received
♦ Interest paid
♦ Depreciation as per boos of account
♦ Net profit (or loss) before tax as per the Profit and Loss account
♦ Taxes on income paid/provided for the books.
Format of Financial Statements: The tax auditor of a person who carries on business or profession
but who is not required by or under any other law to get his accounts audited has to give his report in
Forms No. 3CB/3CD and will have to ensure that the financial statements i.e. balance sheet and profit
and loss account/ income and expenditure statement, are prepared in such a manner that adequate
information which is necessary to convey a true and fair view of the state of affairs of the assessee is
given. So far as a person whose accounts of the business or profession have been audited under any
other law is concerned, the information to be given in the financial statements is normally provided in
the particular statute by which the assessee is governed, since there is no such legislation in respect of
a person who carries on business or profession but who is not required by or under any other law to get
his accounts audited, it is necessary to achieve some uniformity in respect of information to be
provided in the financial statements.
Annexure II
Notification No.208/2006 dated 10th August, 2006 has also inserted an Annexure II to Form No.3CD
which requires the tax auditor to report the value of fringe benefits in the terms of section 115WC read
with section 115WB for the relevant Assessment year. The format of the said Annexure has been given
in the following pages. There are many legal issues that arise from this format which are discussed in
detail in the “Guidance Note on audit of fringe benefits under the Income-tax Act,1961” issued by the
ICAI. In this Chapter we shall only discuss the audit approach and reporting responsibilities of the tax
auditor.
Value of Fringe Benefits in the terms of section 115WC read with

Section 115WB for the assessment year
Sl. Section under Nature of Amount of expenditure incurred or payment made Deductions Total Percentage Value of
which expenditure/ if any expenditure/ fringe
chargeable to payment Debited Accounted Reimbursement Any Total Payment being benefits
Fringe Benefit to the for in the other fringe benefits
Tax P&L A/c balance head
sheet
(1) (2) (3) (4) (5) (6) (4-5) (7) (8)
1. 115WB(1)(b) Free or concessional 100%

ticket provided by the
employer for private
journeys of his
employees or their
family members
2. 115WB(1)(c) Any contribution by 100%
the employer to any
approved
superannuation fund
for employees (see
note 1)
3. 115WB(2)(A) Entertainment 20%
4. 115WB(2)(B) Provision of 20%

Hospitality of every (see note 3)
kind by the employer
to any person
(see note 2)
5. 115WB(2)(C) Conference (other 20%
than fee for
participation by the
employees in any
conference (see Note
4)
6. 115WB(2)(D) Sales promotion 20%

including publicity
(see Note 5)
7. 115WB(2)(E) Employees’ Welfare 20%
(see Note 6)
8. 115WB(2)(F) Conveyance, tour 20%
and travel (including
foreign travel) (see
Note 7)
9. 115WB(2)(G) Use of hotel, 20%
boarding and lodging (see Note 9)
facilities
10. 115WB(2)(H) Repair, running 20%
(including fuel), (see note 10)
maintenance of
motor car and the
amount of
depreciation thereon
11. 115WB(2)(I) Repair, running (including 20%
fuel), maintenance of (see Note 11)
air-crafts and the
amount of depreciation
thereon
12. 115WB(2)(J) Use of telephone 20%
(including mobile
phone other than
expenditure on
leased telephone
lines)
13. 115WB(2)(K) Maintenance of any 20%
accommodation in
the nature of guest
house other than
accommodation used
for training purposes
14. 115WB(2)(L) Festival celebrations 50%

15. 115WB(2)(M) Use of health club 50%
and similar facilities
16. 115WB(2)(N) Use of any other club 50%
facilities
17. 115WB(2)(O) Gifts 50%
18. 115WB(2)(P) Scholarships 50%
19. 115WB(2)(Q) Tour and travel 5%
(including foreign
travel) (see Note 12)
20. Total
16
COST AUDIT
Concept of Cost Audit

16.1 According to the Institute of Cost and Management Accountants of England, cost audit
represents the verification of cost accounts and a check on the adherence to cost accounting
plan. Cost audit, therefore, comprises:
(a) verification of the cost accounting records such as the accuracy of the cost accounts,
cost reports, cost statements, cost data and costing techniques, and
(b) examination of these records to ensure that they adhere to the cost accounting
principles, plans, procedures and objectives.
It, therefore, means that the cost auditors attention and approach should be to see that the
cost accounting plan is in consonance with the objectives set by the organisation and the
system of accounting is geared towards the attainment of the objectives. A cost accounting
system designed to exercise control over cost may be different from the one if the objective is
to fix price. The cost auditor should examine whether the methods laid down for ascertaining
expenses as direct or indirect are cases in point. The cost auditor should also establish the
correctness or otherwise of the figures by the processes of vouching verification, reconciliation
etc.
The origin of the concept of cost audit could be traced to the Second World War period when
the practice of assigning cost plus contracts started. However, probably India is the only
country in the “free” world where cost audit is statutorily prescribed. Cost audit can offer
valuable assistance to the management in its decision making process since it ensures
reliable cost accounting data and information. The management will be in a position to know
what price is to be fixed for a product, whether the wastages are avoidable, whether to re-
organise purchase or sales or inventory systems to make the work more efficient and so on.
Existence of such a system of audit will also be of great use for maintaining internal control
and internal check and can be an advantageous even to the statutory financial auditor. Cost
audit, apart from having all the normal ingredients of audit namely vouching, verification etc.
has within its compass elements of efficiency audit.
Types of Cost Audit

16.2 Cost audit is basically carried out at the instance of the management for obvious
advantages. Apart from this, different other circumstances also sometimes occasion audit of cost
accounts. The different types of cost audit that we come across may be the following:
16.2.1 Cost audit on behalf of the management - The principal object of this audit is to see
that the cost data placed before the management are verified and reliable and they are
prepared in such detail as will serve the purpose of the management in taking appropriate
decisions. The detailed objectives include:
(a) Establishing the accuracy of the costing data, as for example, cost of material used,
allocation of wages into direct and indirect and on different products, functions and cost
centres.
(b) Ensuring that the objectives of cost accounting are being achieved through appropriate
collection, segregation, analysis and compilation of data.
(c) Ascertaining abnormal losses and gains along with the relevant causes, expressed in
financial terms in a manner that the person responsible for such loss or gain is identified.
(d) Determination of the unit cost of production in a precise but practicable manner.
(e) Establishing proper overhead rates for absorption of overheads by various units of costs
so that the cost is properly ascertained and there is no significant over or under recovery
of expenses.
(f) Fixation of contract price and the determination of the additional or supplementary
charge that can be raised against customers for alterations, etc.
(g) Improving the quality of cost accounting system by obtaining the audit observations and
suggestions of cost auditor.
16.2.2 Cost audit on behalf of a customer - In case of cost plus contracts, often the buyer or
the contractee insists on a cost audit to satisfy himself about the correct ascertainment of cost.
More often than not, the provision, for a cost audit in such a circumstance is put in the relevant
contract with the stipulation that the supplier or the contractor will extend all co-operation to
the cost auditor. The cost of production arrived at for this purpose may differ from the cost of
production ascertained for internal purposes.
16.2.3 Cost audit on behalf of Government - Sometimes, government is approached with
requests for subsidies, protection, etc. Before taking a decision the government may prefer to
have the cost of production of the product determined on the basis of cost audit to satisfy itself
whether the need is genuine or the industry seeking assistance is generally efficiently run.
The government, of its own also may initiate cost audit, in public interest to establish the fair
price of any product.
16.2.4 Cost audit by trade association - Where activities of a trade association include
maintenance of a price of the products manufactured by the member units or where there is
pooling or contribution arrangements, the trade association may require the accuracy of
Cost Audit 16.3
costing information submitted by the member-units checked. The trade association may seek
full information on the costing system, level of efficiency, utilisation of capacity, etc.
16.2.5 Statutory cost audit - This is covered by the provisions of Section 233B of the Companies
Act.
Apart from the aforesaid types of cost audit, the undernoted circumstances may warrant the
introduction of cost audit:
(a) Price fixation - The need for fixation of retention prices in the case of materials of
national importance, like steel, cement etc. may be useful in knowing the true cost of
production.
(b) Cost variation within the industry - Where the cost of production varies significantly
from unit to unit in the same industry, cost audit may be necessary to find the reasons for
such differences.
(c) Inefficient management - Where a factory is run inefficiently and uneconomically,
institution of cost audit may be necessary. It may be particularly useful for the
Government before it takes over any unit.
(d) Tax-assessment - Where a duty or tax is levied on products based on cost of
production, the levying authorities may ask for cost audit to determine the correct cost of
production.
(e) Trade disputes - Cost audit may be useful in settling trade disputes about claim for
higher wages, bonus, etc.
Advantages of Cost Audit
16.3 Cost audit will prove to be useful to the management, society, shareholders and the
government. The advantages are as under:
16.3.1 To Management -
(i) Management will get reliable data for its day-to-day operations like price fixing, control,
decision-making, etc.
(ii) A close and continuous check on all wastages will be kept through a proper system of
reporting to management.
(iii) Inefficiencies in the working of the company will be brought to light to facilitate corrective
action.
(iv) Management by exception becomes possible through allocation of responsibilities to in-
dividual managers.
(v) The system of budgetary control and standard costing will be greatly facilitated.
(vi) A reliable check on the valuation of closing stock and work-in-progress can be
established.
(vii) It helps in the detection of errors and fraud.
16.3.2 To Society -
(i) Cost audit is often introduced for the purpose of fixation of prices. The prices so fixed are
based on the correct costing data and so the consumers are saved from exploitation.
(ii) Since price increase by some industries is not allowed without proper justification as to
increase in cost of production, inflation through price hikes can be controlled and con-
sumers can maintain their standard of living.
16.3.3 To Shareholder - Cost audit ensures that proper records are kept as to purchases
and utilisation of materials and expenses incurred on wages, etc. It also makes sure that the
valuation of closing stocks and work- in-progress is on a fair basis. Thus the shareholders are
assured of a fair return on their investment.
16.3.4 To Government -
(i) Where the Government enters into a cost-plus contract, cost audit helps government to
fix the price of the contract at a reasonable level.
(ii) Cost audit helps in the fixation of ceiling prices of essential commodities and thus undue
profiteering is checked.
(iii) Cost audit enables the government to focus its attention on inefficient units.
(iv) Cost audit enables the government to decide in favour of giving protection to certain
industries.
(v) Cost audit facilitates settlement of trade disputes brought to the government.
(vi) Cost audit and consequent management action can create a healthy competition among
the various units in an industry. This imposes an automatic check on inflation.
Functions of Cost Auditor
16.4 The Institute of Cost and Works Accountants of India has detailed the principal
functions of a cost auditor by way of comparison with the functions of the auditor of financial
accounts. The principal functions of cost auditor, according to the aforesaid Institute are the
following:
(i) Inventory
(a) Is the size of the inventory adequate or excess compared with the production
programme?
(b) Is the provision most economical?
(c) Does it ensure optimum order size?
(d) Does it take into account the storage cost on the one hand, and carrying cost on the
other?
(e) Does it take note of lead time of the various items or groups of items?
(f) Does the receipt and issue system cause any bottle-neck in production?
(g) Does it involve too many forms and too much paper work?
Cost Audit 16.5
(h) Is there any room for reduction of inventory cost consistent with production needs?
(i) Is the inventory as per the priced store ledger and as certified by the management
physically correct?
(j) Is the same amount of attention and care given to monies translated into material things
like raw materials, stores and supplies of all kinds as given to liquid cash?
(k) Does the issue of raw materials make the production in accordance with the standard or
schedule or otherwise, or covered by authorised schedule?
(i) Is the expenditure of consumable stores within the standard? If not, why not?
(ii) Opening and Closing Stocks - The cost auditor will see the following:
(a) that the opening stock is not unduly large compared with the volume of production during
the year;
(b) that the opening stock against various jobs really represents the actual physical stock in
the production shop and is not merely an accounting figure;
(c) that the responsibility of the shop foreman in-charge of the stock held in the production
shop is clear and properly documented; that he maintains proper record of actual
consumption vis-a-vis the actual withdrawal from the stock.
Valuation and correct indication of closing stock in the Trading and Profit and Loss Account
and in Balance Sheet is equally important. The Cost Auditor will examine and certify:
(a) that the physical verification is correctly carried out;
(b) that the valuation is correct with reference to the actual cost of production and
recognised policy for valuation;
(c) that volume of closing stock is commensurate with the volume of production and that it
does not reflect any failure or bottleneck in sales budget or production budget;
(d) that the volume of unmoved stores is not abnormal in comparison with the normal rate of
yearly consumption. The Cost Auditor will recommend disposal of such unmoved stores
with consequent release of capital unnecessarily locked up to the advantage of the
financial resources of the concern.
(iii) Store Issue Procedure in Stocks- The Cost Auditor will see:
(a) that withdrawal of materials or stores to production shop is scientific or covered by
authorised schedule and permits receipt to be located;
(b) that there is no possibility of loss or pilferage of stock lying in the production section;
(c) that surplus materials and scraps arising in production shops are returned to stores
correctly and without delay for which necessary credit is given to unit cost of production.
If transferred to other jobs, proper transfer voucher has been prepared and copies sent to
the accounts, stores, etc.
(iv) Work-in Progress - The Cost Auditor will see the following:
(a) that work-in-progress has been physically verified and that it agrees with the balance in
the incomplete cost card;
(b) that valuation of the work-in-progress is correct with reference to stage of completion of
each job or process and the value job cost cards or process cost sheet;
(c) that there is no over-valuation or under-valuation of opening work-in-progress or closing
work-in-progress, thereby artificially pushing up and down net profits or net assets as the
case may be;
(d) that the volume and value of work-in-progress is not disproportionate compared with the
finished out-turn.
(v) Labour -
(a) Proper utilisation of labour and increase in productivity are now receiving attention,
Several productivity teams have emphasised importance of higher productivity. It is,
therefore, essential to assess the performance efficiency of labour and compare it with
standard performance, so that labour utilisation could be progressively improved. The
labour force in Indian industries is generally very high compared to similar types of
industries in other developed countries. Our aim should be to reach that level, though
not immediately but over some time. A study of this nature would give an idea where the
inefficiency lies so that timely and adequate steps could be taken to ensure maximum
utilisation of labour to reduce labour cost.
(b) Cost of labour is allocated to different jobs with reference to time or job cards.
(vi) Capacity Utilisation -The cost auditor will see:
(a) that the idle capacity in any production shop or of transport facilities for distribution is not
excessive;
(b) that production volume and overall machine time utilised are commensurate. In other
words, the machine hours utilised have given the optimum output.
(vii) Overheads and indirect expenditure - The cost auditor will see and certify:
(a) that allocation of indirect expenditure over production, sales, and distribution is logical and
correct;
(b) that compared with the value of production in a production shop, overhead charges are not
excessive;
(c) that actual indirect expenditure does not exceed budgets or standard expenditure
significantly and that any variations are satisfactorily explained and accounted for;
(d) that the relation of indirect expenditure in keeping with the load on individual production
shop is appropriate;
Cost Audit 16.7
(e) correctness of appropriate allocation of overhead expenditure (both production and sales)
will be certified by the cost auditor;
(f) that allocation of overheads between finished products and unfinished products is in
accordance with correct principles.
Presently we shall discuss in detail the aspects to be dealt with in the cost auditor’s report pursuant
to the Cost Audit (Report) Rules, 1968 as amended in 1996 and again in 2001. These rules came
into force from October 1, 2002. The aforesaid Rules have been issued pursuant to Section 233-B
(4) of the Companies Act which requires the cost auditor to make a report on the cost accounts and
cost records maintained by the company.
It may be noted that the requirement of the statutory cost audit in our Companies Act is something
special, because statutes in most of the other countries do not contain a similar requirement. In
most of the countries the concept of cost audit as such is also non-existent and the objectives,
whatever they may be, are achieved by properly designing the scope and depth of internal audit.
The object with which the statutory requirement of cost audit has been included in the Companies
Act can only be ascertained by a study of the cost audit report requirements. They include control
over cost, wastage and losses, efficiency in the utilisation of human, material, and other resources,
determination of appropriate selling price, proper maintenance of cost records appropriate use of
the costing system, etc.
For determining the scope and extent of cost audit, the cost auditor will necessarily have regard to
the relevant costing records required to be maintained pursuant to Section 209(l)(d) of the
Companies Act, in respect of products manufactured by certain types of industries and the cost
sheets prescribed. The records are broadly based on the elements of cost and, therefore, there is
a great deal of similarity between the various records prescribed for various products. The cost
sheets, however, vary from product to product, having regard to the nature of the product and the
production process involved. The cost auditor will also have to pay special attention to the
reporting requirements laid down under the Cost Audit (Report) Rules.
Programme of Cost Audit
16.5 The audit programme should include all the usual broad steps that a financial auditor
includes in his audit programme. However, the significant things that should not be missed are:
proper vouching of expenses, capital and revenue character determination, allocation of expenses,
apportionment of overheads, arithmetical accuracy, the statutory requirements, examination of
contracts and agreements, review of the Board’s and shareholders’ minute books to trace
important decisions having bearing on costs, verification of title deeds and documents relating to
properties and assets, etc. Cost audit, in order to be effective, should be completed at one time as
far as practicable. The exact content of cost audit largely depends on the size of the organisation,
range of products, production process, the existence of a well organised costing department and of
a well designed costing system, and the existence of a capable internal auditing system. Other
relevant considerations may be :
(a) System of cost accounting in vogue and the organisation of the cost department, forms,
schedules, etc.
(b) System of internal check used in the organisation.
(c) Frequency of audits, areas to be covered, volume of transactions, efficiency of the internal
check, needs of management, purpose of cost audit, its benefits, etc.
After considering the aforesaid factors a set of procedures and instructions are evolved which may
be termed the cost audit programme. Like every other audit, a systematic planning of cost audit
routine is necessary. Broadly speaking cost audit programme may be divided into the following
stages:
(a) Review of Cost Accounting Records - This will include:
(i) Method of costing in use - batch, process or unit.
(ii) Method of accounting for raw materials; stores and spares, wastages, spoilage defectives,
etc.
(iii) System of recording wages, salaries, overtime and spares, wastages, etc.
(iv) Basis of allocation of overheads to cost centres and of absorption by products and
apportionment of service department’s expenses.
(v) Treatment of interest, recording of royalties, research and development expenses, etc.
(vi) Method of accounting of depreciation.
(vii) Method of stock-taking and its valuation including inventory policies.
(viii) System of budgetary control.
(ix) System of internal auditing.
(b) Verification of cost statements and other data - This will include the verification of:
(i) Licensed, installed and utilised capacities.
(ii) Financial ratios.
(iii) Production data.
(iv) Cost of raw material consumed, wages and salaries, stores, power and fuel, overheads
provision for depreciation etc.
(v) Sales realisation.
(vi) Abnormal non-recurring and special costs.
(vii) Cost statements.
(viii) Reconciliation with financial books.
General Features of Cost Records
16.6 The following are the general features of cost records-
Cost Audit 16.9
16.6.1 Materials - Under this broad head, records for raw materials, processed materials,
consumable stores, etc, are to be maintained. Generally, these records are to show the materials
purchased or procured, issue of the materials for production and the balance in quantities and
amounts. The cost shall include all direct charges incurred upto the works. The issues should be
identified with departments, cost centres and products. The material records should also include
separate records for recording wastage, spoilage, rejections and losses in terms of quantity and
cost, whether arising in transit, storage during manufacture or for other reasons. Sale proceeds of
the waste materials, rejected materials and scrap should also be recorded and taken into account
in determining the cost of production. The method followed for adjusting the various losses should
also be kept in record. Materials issued for capital projects should be properly indented and
recorded.
If the value of materials consumed is determined on any basis other than the actuals, say on
standard costing, the method adopted for such valuation as well as the method of reconciling such
consumption with actuals and the treatment of variances, if any, should be kept on record.
16.6.2 Manufactured components and intermediates - With regard to components and inter-
mediates manufactured by the company, separate records are required to be maintained showing
the cost of manufacture of major components and intermediates. Records of quantities and values
of manufactured components and intermediates along with the wastages, if any, are required to be
maintained.
16.6.3 Stores and spare parts - Adequate records to show receipts, issues and balances, both in
quantity and value, of various stores and spare parts required for repairs, maintenance and
production are to be maintained. The value should include all direct charges, such as freight and
insurance upto the works. The value of stores and spare parts used should be charged to the
relevant heads, i.e., production or repair to plant and machinery, repairs to building or capital
construction, if any; the value of stores charged to manufacture, should further be allocated to
different departments or production units or cost centres, as may be appropriate. Any wastage,
either in storage, transit or due to other reasons, should be shown separately. The method of
dealing with such losses in the calculation of cost should be mentioned in the cost records.
16.6.4 Wages and salaries - Proper records should be maintained to show the attendance and
earning of all employees and the departments and cost centres and the work on which they are
employed. The records should show separately:
(a) overtime wages earned;
(b) piece-rate wages earned;
(c) incentive wages earned, either individually or collectively as production bonus or under any
other scheme based on output; and
(d) earnings of casual labour.
Idle time is required to be separately recorded under classified headings, indicating the reasons.
The cost records should also contain the method followed for accounting idle time payments in
determining the cost of products.
The extent of wages and salaries capitalised, as additions to plant and machinery, buildings or
other assets, should be accounted for under the appropriate capital heads. Care should be taken
to exclude all wages and salaries that do not pertain to the manufacture of products covered under
the relevant Cost Accounting Records Rules.
16.6.5 Overheads- In respect of overheads, the requirement is for a proper maintenance of records
showing the various items of expenses comprising overheads. These expenses should be
analysed and classified under the following heads:
(a) Works,
(b) Administration, and
(c) Selling and distribution.
Overheads often are general in nature in the sense that the benefit of the expenditure is enjoyed by
various departments, products, cost centres and capital construction projects. Even within the
company to which the Cost Accounting Records Rules apply, there may be products which are
outside the ambit of the aforesaid Rules. Therefore, there should be proper and consistent
allocation of overheads; firstly, on activities of capital nature, products or departments not coming
within the purview of the Cost Accounting Records Rules and products covered by the Rules;
thereafter the part of the overheads attributable to the product or products covered by the Rule
should be apportioned to various departments, manufacturing units or cost centres otherwise than
on the basis of actuals the method of reconciling such expenses with actuals, the variations, if any,
and its treatment in determining the cost of manufactured product should be disclosed in the cost
records.
16.6.6 Service department expenses including expenses on utilities - These include expenses
incurred on power, fuel, water and steam produced or utilised for manufacturing operations,
expenses on subsidized canteen, maintenance operations by a separate maintenance department,
if any. Power, fuel, steam, water etc. may be purchased also by the company. Where these are
purchased there should be proper records of units purchased, their rates and duties, if any.
However, if power, water and steam is generated by the company itself, separate records should
be maintained to show, in sufficient detail, the different items making up the cost of such power,
water or steam produced and consumed. The records should be so maintained as would enable
the assessment of consumption of the services by the different departments or manufacturing
units. In cases, where allocation to various departments of manufacturing units is not made on the
basis of the actuals, the basis adopted for such allocation should be indicated. Similarly, the
expenses incurred on staff canteen or maintenance should also be apportioned on some
reasonable basis and the same should be indicated in cost records.
Cost Audit 16.11
16.6.7 Depreciation - Adequate records in respect of the depreciable fixed assets are required to
be maintained showing the cost and other particulars of such assets. These records should inter
alia indicate:
(a) the cost of each item of asset inclusive of installation charges;
(b) the date of installation;
(c) the rate of depreciation;
(d) the amount of depreciation provided.
In respect of those old assets, the original cost of acquisition of which cannot be ascertained
without an unreasonable expenditure or delay, the valuation shown in the books on the first day of
the financial year beginning on or after the commencement of the relevant Rules should be taken
as the opening balance. It may be useful to note in this context that a manufacturing, mining or
processing company is obliged to maintain records for fixed assets under the requirement of the
order issued by the Government under Section 227(4A) of the Companies Act. 1956. The
company may usefully integrate these two requirements to avoid duplication. The basis on which
depreciation is calculated and allocated to the various departments and cost centres and to the
products should be clearly indicated in the cost records. The amount of depreciation charged
should not be less than the amount chargeable under Section 205(2) of the Companies Act, 1956
(Students should refer to AS-6 as revised) and the depreciation allocated to the various
departments should relate to the plant and machinery and other depreciable fixed assets used in
the concerned department, etc. In case the amount of depreciation charged in the cost records in
any financial year is higher than the amount chargeable under the aforesaid Section 205(2), the
amount in excess should be disclosed separately in the records. The cumulative quantum of
depreciation charged in respect of any asset in the costing records should be limited to the original
cost of the concerned assets.
16.6.8 Packing - Proper records should be maintained showing the quantity and cost of various
backing materials such as tin, cartons, gunny bags, etc. and for wages and other expenses
incurred on packing size wise. Where packing expenses cover both products not included in the
relevant Cost Accounting Records Rules and those included, the basis of apportionment of the
total expenses incurred on packing between such products as are not included and the products
covered by the aforesaid Rules should be clearly mentioned in the cost records and the basis
should be applied consistently. Wastage, spoilage, rejections and losses of packaging materials, if
any, should be indicated separately and the method adopted for adjusting these losses should be
disclosed. Also, if any income is received by sale or disposal of these spoiled, rejected waste
materials, the method of treating these recoveries in the determination of the cost of the product
should be mentioned.
16.6.9 By-products - Proper records should be maintained for each item of by-product, if any,
showing the receipts, issues and balances both in quantity and value. The basis adopted for
valuation of the by-products should be equitable and consistent. Records indicating the actual
sales realisation of by-products should be maintained. If any expenses have been incurred in
further process of by-products, such expenses should also be separately stated. The treatment of
realization of By-products in the determination of cost of main product should also be mentioned.
16.6.10 Production and Sales - Adequate records of production are required to be maintained in
terms of value and quantity. If the goods are sold in packed condition then separate records of
production of unpacked finished goods and packed finished goods should be maintained. These
records should show all the receipts, issues and balances of goods produced by the company. The
value should be based on the cost of production of the items concerned. The value of the issues
and balances, may, if the company so desires, be recorded monthly or at such shorter intervals as
the company may decide. These records ipso facto will also constitute quantitative records of sales
of the finished goods and inventory of the finished goods.
16.6.11 Inventories - Inventories may be classified as (a) raw materials; (b) stores & spare parts;
(c) work-in-progress, and (d) finished goods. It may be observed that separate records to account
for raw materials, spare parts and production in their balance column will have to be maintained.
However, separate records should be maintained for the work-in-progress showing the quantity
and value at the end of the financial year (i.e. the period for which the costs are made up). Stock of
all kinds should be physically verified and the stock verification records should be maintained in
respect of all items held in stock, such as, raw materials, components, processed materials,
packing materials, consumable stores, machinery spares, chemicals, fuels, finished goods and
fixed assets. Reasons for shortages and excesses, if any, arising out of such verification and the
method followed for adjusting the same in the cost of the products shall be indicated in the records.
The method followed for determining the cost of work-in-progress and finished goods stock shall be
indicated in the cost records so as to reveal the cost elements that have been taken into account in
such computation. The method adopted should be followed consistently.
16.6.12 Variances - Where the company maintains cost records on any basis other than actuals,
such as standard costing, the records should indicate the procedure followed by the company in
working out the cost of the products under such a system. The method followed for adjusting the
variances on determining the actual cost of the product should be indicated clearly in the cost
records. The reasons for variances should be detailed in the cost records.
16.6.13 Cost Statements - Cost Statements or cost sheets are required to be prepared as part of
the cost records in respect of each product. The forms of cost sheets have been prescribed in the
Annexure to the respective Rules. The forms have been so devised arranged that they
progressively build up the cost of production of the concerned products. The nature, purpose and
contents of the cost sheet depend upon the nature of the products, production method, process
involved, cost centres and the elements that make up the cost.
Cost Audit 16.13
16.6.14 Reconciliation of Cost and Financial Accounts - The cost records should be reconciled
(preferably periodically with the financial books of account so as to ensure accuracy.) Variations if
any, should be clearly indicated and explained. The period for which such reconciliation be effected
should not exceed the period of the financial year of the company. The reconciliation should be
done in such a manner that profitability of the product under reference can be correctly adjudged
and reconciled with the overall profits of the company. A statement showing the total expenses
incurred by the company, including expenses excluded from the costing records and expenses on
products not covered by the relevant Cost Accounting Records Rules, should be prepared and the
share of the product covered by the Rules in such expenses should be indicated. Also the sale
realisation of the products should be shown separately for products covered by the Rules and
products not so covered and the margin representing the difference between respective sales
realisation and the corresponding total cost should be determined. This statement in turn should
be reconciled with the financial profit and loss account for the period. It may be mentioned that
where a system of integrated cost and financial accounting is in operation, this reconciliation will be
facilitated to a large extent. In this connection it may be noted that Schedule VI to the Companies
Act requires the companies to give considerable amount of information regarding licensed
capacity, installed capacity, actual production, consumption of raw material, etc. It should be
ensured that the specific information required to be contained in both the costing and financial
statements is not different. If at all any difference arises, the same should be properly reconciled
and kept on record for reference.
16.6.15 Royalty - Adequate records shall be maintained showing the royalty paid (in cases where
royalty payment exists) or any other payment made to foreign collaborators in terms of agreements
entered into with them. Such records should be kept separately for each foreign collaborator. Also
the basis of computation of royalty for the financial year shall be mentioned in cost records. If the
total royalty paid is allocable to different cost centres or semi-finished goods or products, the case
of motor vehicles, the amount of royalty may be apportioned to various components produced by
the company, sub-assemblies or completed motor vehicles according to the terms of agreement.
Royalty should be treated as a direct charge wherever it is practicable. Where it is not so, this can
be treated as overhead.
16.6.16 Statistical records - Statistical data as are relevant in the different cases are required to be
maintained. These data generally include data on plant utilisation, idle machine time with reasons,
capital employed in the activity covered by the relevant Cost Accounting Records Rules and capital
work-in-progress including fresh investment in fixed assets that have not contributed to the
production during the period under consideration. Besides, data that are of specific relevance in the
particular case also should be maintained. For example, in the case of infant milk food, data such
as percentage of fat and solid non-fat content in wet milk purchased and consumed need to be
kept; also quantitative reconciliation should be done of the fat and solid non-fat content of the wet
milk and other milk based inputs with the fat and solid non-fat content of the various outputs that
the inputs have produced including the by-product. Similarly, for cement and caustic soda proper
statistical records about actual hours worked by each manufacturing unit or plant should be
maintained. In the case of cement, records should also be maintained to show the production by
each manufacturing unit or department producing raw materials process materials or finished
products. Some similar requirements can be found in respect of other products as well. Since
almost all the Cost Accounting Records Rules require statistical data to be maintained in respect of
the actual run, i.e., hours worked, of the various plants and machines, either singly or as a
combination, it may be convenient for the company to maintain this record in the fixed asset
register itself which the company is otherwise required to maintain (Refer to para 7 above).
The specific records including the statistical records required to be maintained as aforesaid are
intended inter alia to enable the company to exercise as far as possible, control over the various
operations and costs with a view to achieving optimum economies in costs and to provide the
necessary data required by the cost auditor for furnishing his report in accordance with the Cost
Audit (Report) Rules.
16.6.17 Incorporation of Provision Relating to Inter-Company Transfer in the Cost Accounting
Records Rules - The Central Government has been prescribing Cost Accounting Records Rules
from time to time for various industries in exercise of the powers conferred under section 642(1)
read with section 209(1)(d) of the Companies Act, 1956. Cost Accounting Records Rules have so
far been prescribed in respect of 43 industries. The companies, which are covered by the Cost
Accounting Records Rules, are required to maintain the cost data in the manner prescribed under
these Rules.
The Cost Audit Reports are extensively used by the various Government agencies, revenue
authorities, regulatory bodies and other institutions. Director General of Investigation and
Registration (DGIR) has relied on these Reports as evidence in pursuit of cases with MRTP
Commission. There is a great role of Cost Audit Reports particularly in the management and
administration of Anti-Dumping Laws and Competition Laws. Cost Audit Reports can also help the
industry in cases related to dumping of goods and services by the dominant manufactures to
eliminate domestic competition. In fact Competition Law to be effective against any unfair
competition activity, pre-supposes the availability of reliable and authenticated cost data.
Pricing is central to international trade under the liberalised economy. Normally, no inter-company
transfer should take place below cost. Therefore, it is imperative that the respective Cost
Accounting Records Rules should uniformly contain appropriate provisions requiring maintenance
of cost records in all such cases. Therefore, amendments to all the existing Cost Accounting
Records Rules have been made under section 209(1)(d) of the Companies Act requiring the
prescribed industries to maintain proper cost records in respect of defined inter-company
transactions. The Rules have significant importance to the Department of Company Affairs as the
same are also linked to investor’s protection by ensuring against shifting of profits between
corporate units to the detriment of ordinary investor at large. Substantial amount of additional
Cost Audit 16.15
revenue by way of duties and taxes may also be generated by proper valuation of inter-company
transactions between the related parties, if proper records as prescribed under these Rules are
maintained.
With a view to keep pace with changing global economic trend and to identify and focus on the
areas relevant to the current requirements of various interests involved, some of the existing Cost
Accounting Records Rules viz., ‘Bulk Drugs’, ‘Formulations’, ‘Aluminium’, ‘Vanaspati’ and ‘Milk
Food’ have also been simplified/rationalised. During the revision, the rules in respect of ‘Infant Milk
Food’ have been merged with the rules relating to ‘Milk Food’. In some of the Cost Accounting
Records Rules, the scope of applicability clause has also been widened. These new Rules are
more purposeful, comprehensive and user friendly.
The Ministry of Company Affairs is also currently engaged in the process of formulating Cost
Accounting Records Rules in respect of such core sectors, which are covered or likely to be
covered under some regulatory mechanism. These Rules shall cover strategic sectors like Power,
Telecommunication, Petroleum products, etc. and will be notified in the near future.
Cost Audit under the Companies Act
16.7 We have by now known in general the requirements of the various Cost Audit Record Rules
issued under Section 209 (1)(d) of the Companies Act, 1956 and the general contents. Under
Section 233B(2), the auditor is appointed by the Board of Directors of the company in accordance
with the provisions of sub-section (lB) of Section 224 and with the previous approval of the Central
Government. Provided that before the appointment of any auditor is made by the Board, a written
certificate shall be obtained by the Board from the auditor proposed to be so appointed to the effect
that the appointment, if made, will be in accordance with Section 224 (lB). An audit conducted by
an auditor under this Section shall be in addition to an audit conducted by an auditor appointed
under Section 224. It may be emphasised here that since the requirement is for audit, the approach
and attitude of the auditor is essential in this field also. All the qualities that make a good auditor
are essential. The cost auditor, like the auditor of the financial accounts, should be independent,
detached and impersonal. He should be able to determine and correlate facts, exercise judgement
and form opinion about the matters in which he is concerned in his professional capacity. He is
expected to carry out his work by applying reasonable care, skill and competence.
16.7.1 Section 233B of the Companies Act, 1956 - Wherein the opinion of the Central Government
it is necessary so to do in relation to any company required under clause (d) of sub-section (1) of
section 209 to include in its books of account the particulars referred to therein, the Central
Government may, by order, direct that an audit of cost accounts of the company shall be
conducted in such manner as may be specified in the order by an auditor (who shall be a cost
accountant within the meaning of the Cost and Works Accountants Act, 1959 (23 of 1959):
Provided that if the Central Government is of opinion that sufficient number of cost accountants
within the meaning of the Cost and Works Accountants Act, 1959 (23 of 1959), are not available for
conducting the audit of cost accounts of companies generally, that Government may, by notification
in the Official Gazette direct that, for such period as may be specified in the said notification, such
Chartered Accountant within the meaning of the Chartered Accountants Act, 1949 (38 of 1949), as
possesses the prescribed qualifications, may also conduct the audit of the cost accounts of
companies and thereupon a chartered accountant possessing the prescribed qualifications may be
appointed to audit the cost accounts of the company.
The auditor under this section shall be appointed by the Board of directors of the company (in
accordance with the provisions of sub-section (1B) of section 224 and with the previous approval of
the Central Government):
Provided that before the appointment of any auditor is made by the Board, a written certificate shall
be obtained by the Board from the auditor proposed to be so appointed to the effect that
appointment, if made, will be in accordance with the provisions of sub-section (1B) of section 224.
An audit conducted by an auditor under this section shall be in addition to an audit conducted by an
auditor appointed under section 224.
An auditor shall have the same powers and duties in relation to an audit conducted by him under
this section as an auditor of a company has under sub-section (1) of section 227 and such auditor
shall make his report to the Central Government in such form and within such time as may be
prescribed and shall also at the same time forward a copy of the report to the company.
(a) A person referred to in sub-section (3) or sub-section (4) of section 226 shall not be
appointed or re-appointed for conducting the audit of the cost accounts of a company.
(b) A person appointed, under section 224. as an auditor of a company, shall not be
appointed or re-appointed for conducting the audit of the cost accounts of that company.
(c) If a person, appointed for conducting the audit of cost accounts of a company, becomes
such, after his appointment, to any of the disqualifications specified in clause (a) or
clause (b) of this sub-section, he shall, on and from the date on which he becomes so
subject, cease to conduct the audit of the cost accounts of the company.
Upon receipt of an order under sub-section (1), it shall be duty of the company to give all facilities
and assistance to the person appointed for conducting the audit of the cost accounts of the
company.
16.7.2 Books of Accounts to be maintained by Company u/s 209(1) - 209(1) Every company
shall keep at its registered office proper books of account with respect to
(a)............
(b) ............
(c)…………....
(d) in the case of a company pertaining to any class of companies engaged in production,
processing, manufacturing or mining activities, such particulars relating to utilization of
material or labour or to other items of cost as may be prescribed, if such class of
Cost Audit 16.17
companies is required by the Central Government to include such particulars in the

books of account:
Provided that all or any of the books of account aforesaid may be kept at such other place in
India as the Board of directors may decide and when the Board of directors so decides, the
company shall, within seven days of the decision, file with the Registrar a notice in writing
giving the full address of that other place.
16.7.3 Exemption from Cost Audit - The exemption from Cost Audit on year-to-year basis in
the following situation:
(i) Temporary Closure of the company/products
(ii) Negligible production activity
Fees:
Company having an authorized capital of Amount of fees to be paid

A Less than Rs. 25 lakh Rs. 500
B Rs. 25 lakh or more but less than Rs. 5 crore Rs.1000
C Rs. 5 crore or more Rs.2000
Appropriate fee for each year for which approval for exemption is sought may be remitted
through demand draft drawn in favour of Pay and Accounts Officer, Department of Company
Affairs, payable at New Delhi.
Documents required - Following documents are required to be furnished along with
application for exemption:
(i) Printed or attested true copy of complete Annual Report containing balance sheet and profit
and loss account for the year for which exemption is being sought along with copies of the
same pertaining to preceding two years.
(ii) An affidavit containing full facts of capacity utilization, turnover and financial status of the
company such as sick or not, duly signed by two Directors of the company and authenticated
by a Notary Public.
(iii) A brief note/status report on steps taken by the management for revival of the said unit.
Steps in Cost Audit
16.8 Broadly, cost audit is comprised of three steps i.e., review, verification and reporting.
Review - Collection and assimilation of all the relevant information and technicalities about
the industry is an essential prerequisite of cost audit. The review should cover the following
aspects:
1. Nature of the industry - priority industry, export-oriented industry etc.
2. Production method/process.
3. Important raw materials and their sources.

4. Licenced capacity and installed capacity.
5. Method of costing in use.
6. Method of accounting of raw materials, stores and production.
7. Method of accounting of wastages, spoilages and rejections.
8. Records relating to jigs and dies.
9. System of wages, salaries & overtime payment including incentive schemes, if any.
10. Basis of allocation of overheads to cost centres and of absorption to products.
11. Method of allocation of service department expenses.
12. Treatment of interest on borrowings.
13. Method of accounting of depreciation.
14. Agreement with collaborators or others for payment of royalty, its computation and
payment.
15. Treatment of research and development expenses.
16. Accounting for sales and purchase - treatment with regard to sales tax, excise duty, etc.
17. System of year-end stock-taking.
18. Method of determination of work in progress.
19. Inventory valuation policy and method.
20. System of budgetary control.
21. System of internal audit.
22. State of internal control over cost accounts and cost accounting records.
23. Cost accounting manual, if any.
24. Special cost accounting practice and methods peculiar to the industry under audit.
The cost auditor should familiarize himself with the memorandum and articles of association,
past audit reports on the financial accounts, annual reports issued by the Board, the
Chairman’s speech, etc. He should also thoroughly review the costing system in vogue in
relation to the production process and method, and should have a detailed knowledge of the
flow of the production process and the documents that arise or are received in that course. A
list of the costing books of account maintained by client should also be obtained by the cost
auditor so that he knows the purpose and contents of such books.
A detailed audit programme should thereafter be prepared so that the work to be done and the
manner in which it is to be done are planned. Students already know the purpose, contents
and utility of an audit programme in the context of audit of financial accounts. All these are
equally applicable in case of cost audit. Also, the cost auditor should do recording of all
relevant information about the client, his business, production process, unresolved queries
Cost Audit 16.19
and matters requiring follow-up or discussion in a properly organised audit note book and
working papers. Here again the functions and utilities are the same as in the case of financial
audit and note books and working papers can be maintained in the very same manner as in
the case of financial audit.
It may be noted that as per the Cost Audit (Report) Rules, 1996, the cost auditor has to send
the audit report within 180 days from the end of the company’s financial year. Thus, a cost
auditor now gets about 90 days to perform the work in an effective manner instead of 30 days
as per the Cost Audit (Report) Rules, 1986. Therefore, it is expected that the cost auditor
would have sufficient time to do justice to his work. In any case, he has necessarily to resort to
test checking for obtaining the necessary audit satisfaction. It is definitely desirable that the
cost auditor should plan his test checking on the basis of strict rules of statistical sampling so
that he knows how much risk he takes in adopting test checks and how reliable would be the
opinion that he will express. He should also carefully study and evaluate internal controls and
their operation on the costing books and records before deciding in favour of test of cost audit
and may defer the appointment of the cost auditor as much as it can and thereby reduce
further the time available to him. It is also interesting to note that no specific period of office
has been specified for the cost auditor and, therefore, it seems logical to interpret that the cost
auditor holds his office from the time he is appointed till the date of submission of his report
and the powers under Section 227 (1) of the Companies Act can be exercised only during the
aforesaid period. He is not entitled to receive any notice etc., of the annual general meeting
or to attend it. It seems also possible that removal of a cost auditor before he has finished his
term by completion of his work would be simple for any management because the law has not
prescribed any procedure therefor.
Verification of cost statements and other data - The examination of the cost statements
and other records by the cost auditor will generally cover the following:
(i) Licensed capacity, installed and utilised capacities;
(ii) Financial ratios;
(iii) Production data;
(iv) Cost of raw materials consumed;
(v) Cost of power and fuel;
(vi) Employee costs;
(vii) Cost of stores etc. consumed;
(viii) Provision for depreciation;
(ix) Overheads and their allocation;
(x) Royalty and technical aid payments;
(xi) Sales relationships, local & export;
(xii) Abnormal, non-recurring and special cost;
(xiii) Cost statements;
(xiv) Reconciliation with financial books.

Necessity to refer to financial records - It is needless to mention that the cost audit programme
should cover all the above and any other matter that the cost auditor considers necessary. It is
also obvious that cost audit under the Companies Act cannot be performed without reference to
financial books and records. This is simply for the reason that a apart from the requirement to have
reconciliation between cost and financial accounts done. The cost statements are to contain a
summary of all expenditure incurred by the company and the share in such expenditure attributable
to the activities covered by Cost Accounting Records Rules; overhead expenditure also needs
allocation between activities covered by the rules and activities not so covered. Naturally, this can
be done only be reference to the financial ledger. Expenses like salaries and wages may not be
fully reflected in the cost statements and to ascertain whether appropriate charge has been made
in the cost records, there would invariably be a necessity to refer to the full charge for salaries and
wages in the financial ledger. Under the requirement of Part II of Schedule VI to the Companies
Act, quite a few matters are there which could be of direct relevance to the cost auditor - for
example, consumption of raw materials in quantity and value, sales of finished goods under
classified headings in quantity and value, licensed and installed capacities, actual production in
quantities, inventory in quality and value in respect of each class of goods produced and/or dealt
with by the company.
We can see from the above discussion that there exists quite a sizeable overlapping between
the financial accounting records and cost accounting records. Effectiveness of both the audits,
and specially cost audit, can be enhanced substantially of if appropriate available data, and
documents pertaining to the other field are kept in view while making audit verification. It may
especially help the audit (cost and financial both) to locate errors, mistakes and omissions
present in either set of accounts. If the cost auditor takes the pain of correlating the
consumption of raw materials as appearing in the cost records with consumption disclosed in
the financial records, he may be able to locate substantial errors either in cost records or in
financial records. At least a material discrepancy between the two sets of consumption data
will put him on special enquiry about the correctness of costing data and in this process errors
in either may be established. Then comes the question: suppose he is convinced of the
presence of a mistake in financial accounts after satisfying himself about the correctness of
costing records, what he should do? He has no apparent duty to inform the auditor of financial
accounts about the detection of the mistake. But nothing forbids him from asking the company
to rectify the relevant cost statement where the complete financial data is compiled and
allocated between activities covered by the Cost Accounting Records Rules and other
activities. Also, the reconciliation statement between costing and financial data will invariably
contain indication of the discrepancy. Also he may bring the discrepancy to the notice of the
management in writing and a copy of such communication my be endorsed to the financial
auditor. In fact, no definite course of conduct has emerged as yet but it can be emphasised
that the possibility of existence of mistakes in either record being located by the other auditor
probably will lead to the development of necessary rapport between the two auditors. It may
be pertinent to note that both the auditors have access to the records in the other field under
Cost Audit 16.21
the authority of law and it is the duty of the each auditor to refer to them to obtain necessary
audit evidence that may help him in the discharge of duties cast on him. The auditor of
financial accounts examines various allocations of overheads etc. to ascertain whether
financial data is at variance with costing data. This he should provide in his audit programme
itself. However, it is doubtful whether the cost auditor’s report will be made available to the
financial auditor even though in great many cases cost audit would be over before financial
audit.
Reporting - After completion of audit of costing and other relevant records the cost auditor is
to submit his report in terms of Section 233B(4) of the Companies Act to the Central
Government. A copy of the report has to be sent to the company at the same time. Further,
as per the Cost Audit (Report) Amendment Rules, 1996, the cost auditor shall also reply to
any clarification sought by the Company Law Board on the Cost Audit Report submitted by
him, within 30 days. The form and contents of the cost auditor’s report has been specified in
the Cost Audit (Report) Rules, 1968 and as amended by the Cost Audit (Report) Amendment
Rules, 1996 and 2001. It has been stated earlier that the scope, extent and manner of audit of
a cost auditor under the Companies Act can only be determined by reference to the reporting
requirements and, of course, the costing records required to be maintained. We have seen
generally what the costing records are and what they should contain. We shall now examine
what the reporting requirements are. After that only it will be possible to formulate details of
the audit programme about which a reference has been made earlier.
16.8.1 General features of cost audit report -
1. (i) I/We have/have not obtained all the information and explanations, which to the best of
my/ our knowledge and belief were necessary for the purpose of this audit;
(ii) proper cost accounting records, as prescribed under clause (d) of sub-section (1)
of section 209 of the Companies Act, 1956, have/have not been kept by the
company;
(iii) proper returns adequate for the purpose of my/our Cost Audit have/have not been
received from the branches not visited by me/us;
(iv) the said books and records give/do not give the information required by the
Companies Act, 1956 in the manner so required;
(v) the cost statements in respect of product or activity under reference as specified
in the Annexures/Proformae of Schedules I, Schedule II or Schedule III of the
concerned Cost Accounting Records (**...........................) Rules duly audited by
me/us are kept in the company.
2. In my/our opinion, the company's cost accounting records have/have not been properly
kept so as to give a true and fair view of the cost of production, cost of sales and margin
of the product under reference as prescribed under the rules.
3. Based on my/our examination of the records of the company subject to aforesaid
qualifications, if any, I/We give my/our observations and suggestions on the following -
(a) the adequacy or otherwise of the cost accounting system including inventory
valuation in vogue in the company and suggestions for the improvement thereof.
The Cost auditor shall also indicate the persistent deficiencies in the system,
pointed out in earlier reports but not rectified;
(b) the adequacy or otherwise of the budgetary control system, if any, in vogue in the
company;
(c) matters which appear to him to be clearly wrong in principle or apparently
unjustifiable;
(d) cases, where price charged for related party transactions as defined in the
respective Cost Accounting Records Rules is different from normal price, impact
of such lower/higher price on margin of the product under reference shall be
specified;
(e) areas where the company is incurring losses or where there is considerable
decline in profitability, the cost auditor should comment on the reasons thereof
including indicative break-even point. The cost auditor shall also comment on the
default, if any on the payments due to the Government, financial institutions and
banks, penal interest levied thereon and its impact on the cost of sales and
profitability;
(f) steps required to strengthen the company under the competitive environment
especially with regard to need for protection from cheaper imports, if any;
(g) export commitments of the company vis-à-vis actual exports for the year under
review. Also comment on comparative profitability and pricing policy of the
company for domestic and export sales. Give impact of exports benefits/
incentives offered by the Government on export profitability;
(h) the scope and performance of internal audit of cost records, if any, and comment
on its adequacy or otherwise.
4. The Cost Auditor shall suggest measures for making further improvements in the
performance in respect of cost control and cost reduction.
5. The Cost Auditor may also give his other observations and suggestions, if any, relevant
to the cost audit.
Rights and Duties of Cost Auditor
16.9 The cost auditor enjoys the powers and has the duties as contained in Section 227(l) of
the Companies Act, 1956 [vide Section 233B (4) of the Companies Act, 1956]. It may be
observed that Section 227(1) does not contain any thing which may be considered a duty. It
really contains the rights and powers that are allowed to an auditor. Consequently reference to
the word “duty” in Section 233B(4) is superfluous and redundant. Like the auditor of financial
accounts, the cost auditor also has the right of access at all times to the books and vouchers,
Cost Audit 16.23
of the company (not necessarily related to cost records or cost accounts and he is entitled to
require from the officers of the company such information and explanations as he may
consider necessary in his duties as the cost auditor. Sub-section (6) of Section 233B makes it
a duty of the company to give all facilities and assistance to the cost auditor. It has also been
provided in Rule 5 of the Cost Audit (Report) Rules that the company and every officer
thereof, including persons referred to in Section 209(6) of the Companies Act, 1956, shall
make available to the cost auditor within 135 days from the end of the financial year of the
company such cost accounting records, cost statements and other books and papers that
would be required for conducting the cost audit. Under the aforesaid Rule, the company and
its officers mentioned about are required to render necessary assistance to the cost auditor so
as to enable him to complete the cost audit and sent his report within l80 days from the end of
the company’s financial year to which the cost audit report relates. The cost auditor’s duty as
contained in Section 233B(4) is to make a report to the Central Government in the form
prescribed under the Cost Audit (Report) Rules. Further, as per the Cost Audit (Report)
Amendment Rules, 2001, the cost auditor shall also reply to any clarification sought by the
Company Law Board on the Cost Audit Report submitted by him within 30 days.
The reports that the cost auditor is required to make under the aforesaid Rules indicates the
nature of duty he is to perform. It may be noticed that similar to the audit or of financial
accounts, how the cost auditor is to perform his duty, what procedures and techniques are to
be applied and how he is to plan his work, have been left to his judgement. However, it is
clear that he is to carry out an examination of the costing books of account and other relevant
records. In the process, he is to obtain information and explanations which he considers
necessary for a proper examination. He will have to assess at various stages of the
examination what information and explanations are necessary. This is a matter where skill
and experience of the cost auditor will be an indispensable aid. The power to obtain
information and explanations is a tool to accomplish the duty cast on him. He should know
how to use this tool. He should also make systematic record of the information and
explanations sought in the audit note book and keep observations about whether they have
been obtained, and, if obtained, whether they sufficiently resolve the queries in his mind. If a
cost audit is performed without seeking information and explanations or evaluation of the
information and explanation obtained, it may be construed that an essential part of the duty
has not been performed, specially when it is established that circumstances were such that
should have evoked queries. It may be observed that the requirements to report about
obtaining of information and explanations is similar to the one meant for the financial auditor.
The cost auditor has also to state in his report whether proper cost accounting records as
required under Section 229(l) (b) have been kept by the company and whether the said books
and records give the information required by the Companies Act, 1956 in the manner required.
To deal with this matter, the auditor has to satisfy himself that when cost accounting records
are required to be maintained, pursuant to the Cost Accounting (Record) Rules applicable to
the client company, these have been properly maintained. Merely having the record will not
meet with the intention of the law. The auditor has to further satisfy himself that the
information and data collected and compiled therein are correct and the cost of production
determined therefrom is fair. If the cost auditor finds departures from the prescribed form and
manner, he should look into the reasons for the departure and satisfy himself that it is not
material and is in accordance with the circumstances of the company. For example, if a
company producing infant milk food does not have the system of payment to workers on the
piece rate basis, the cost records for salaries and wages will not show any such payment
although the relevant rules require a separate disclosure of payments based on piece rate.
However, if the departure is one that can not be justified, the conclusion should be that the
records have not been kept in the manner required by the relevant Rules and therefore not in
conformity with the requirement of the Companies Act, 1956. It may be noted that the cost
auditor is concerned with the maintenance of cost records as prescribed under Section
209(1)(d) of the Companies Act, 1956, though he has access to other books and records also.
A financial auditor on the other hand is concerned with the maintenance of “proper books of
account as required by law” which is a far wider canvas and includes cost records also.
The cost auditor has also to state whether proper returns adequate for the purpose of cost
audit have been received from branches not visited by him. It may be observed that unlike the
financial audit there is no provision for separate cost audit of cost records maintained at the
branch. It may also be appreciated that a branch not physically carrying out any manufacturing
operation, nevertheless may incur expenses that figure in the various cost statements and
cost records prescribed. The cost auditor as such is responsible not only for the records
maintained at the head office or the place where manufacturing operations take place, but also
for the records that concern a cost audit, maintained at the branch. For enabling the cost
auditor to have a total view of the costing records the branch is impliedly required to send
proper returns to the head office for incorporation in the main costing records. It is necessary
that the branch returns, to the extent they concern cost accounts of the product covered by the
applicable Rules, should contain all the information that is required under the rules, as far as it
is applicable to the operations of the branch. The form of the returns should also be such as
to facilitate proper incorporation of the data and information in the main cost records.
Otherwise the returns may not be considered as proper returns. Similarly, adequate evidence
should be available alorgwith the returns to support figures contained in the returns. A visit by
the cost auditor to the branch to ascertain the true state of cost records is not precluded.
Ultimately, the cost auditor is to state whether in his opinion the company’s cost accounting
records have been properly kept so as to give a true and fair view of the cost of production,
processing etc., as the case may be, and marketing of the product. Basically whether the cost
of production ascertained is true and fair or not is dependent upon whether cost accounting
records have been properly kept. It has been observed earlier that even a mechanical
maintenance of cost accounting records, if they are in accordance with the cost records
prescribed, may, in terms of the letter of law, lead to an expression of affirmative opinion. The
question that should be resolved is: what is the objective of the whole exercise involved in
cost audit? If the objective is determination of the true cost of production, then mere
adherence with the Cost Records Rules, is not enough. By scrupulously following the Rules
one may arrive at a certain cost of production figure which may not necessarily represent a
true and fair figure. But it seems, this is not the intention of law. That is why in another part of
the Cost Audit (Report) Rules, there is a requirement to comment on the costing system
followed.
Cost Audit 16.25
16.9.1 True and fair cost of production etc. - The true and fair concept is known to us in the
context of financial accounts. Based on that knowledge, it may be assumed that the following
are the relevant considerations in determining whether the cost of production determined is
true and fair:
1. Determination of cost following the generally accepted cost accounting principles.
2. Application of the costing system appropriate to the product.
3. Materiality.
4. Consistency in the application of costing system and cost accounting principles.
5. Maintenance of cost records and preparation of cost statements in the prescribed form
and having the prescribed contents.
6. Elimination of material prior-period adjustments.
7. Abnormal wastes and losses and other unusual transactions being ignored in
determination of cost.
The report of the cost auditor discussed above will be subject to the cost auditor’s observa-
tions and conclusions, if any, made pursuant to clause 16 of the Annexure to the Cost Audit
Report Rules. Also the report is subject to observations of the cost auditor on the various
matters contained in the Annexure.
Annexure to Cost Audit Report [As per Cost Audit (Report) Rules] - Under the Cost Audit
(Report) Rules an Annexure has been provided to be filled by the cost auditor and annexed to
the report that he makes. The matters contained in the Annexure form part of the cost
auditor’s report. The annexure to the Cost Audit (Report) Rules as further amended by the
Cost Audit (Report) Amendment Rules, 2001 is briefly described below:
1. General -
(1) (a) Name and address of the registered office of the company whose accounts are audited.
(b) Name and address of the place where the cost accounting records are maintained
viz. registered office, head office or factory.
(2) Name of the product and location of the unit to which the Annexure pertains.
(3) The Company's financial year to which the Cost Audit Report relates.
(4) Date of first commencement of commercial production of the product under reference.
(5) Location of other sites manufacturing or producing or processing or mining the product or
carrying out the activity under reference.
(6) Name and address of the Cost Auditor.
(7) Membership number of the Cost Accountant. In case of firm of Cost Accountants, name
and membership number of all the partners.
(8) Reference number and date of Government Order under which the Audit is conducted.
(9) Reference number and date of the Government letter approving the appointment of the
Cost Auditor.
(10) Date of Board of Directors' meeting wherein the Annexure and Proforma to the cost audit
report were approved.
(11) The number of Audit Committee meetings held by the company, and attended by the
Cost Auditor during the year under reference.
(12) Name, qualification and designation of the officer heading the cost accounting section or
department of the company.
(13) In case of loan license/ job work arrangement by the company, mention the name of the
third party and location of the factory, where the product has been
produced/manufactured.
(14) If there is any foreign technical collaboration for the product under reference, the
following details shall be given:
(a) name and address of the foreign collaborators;
(b) main terms of agreement ;
(c) amount of royalty, lump sum payment, technical aid fee payable and the basis of
calculating the same;
(d) whether the technical collaborator has contributed to the share capital. If so, the
paid up share capital so held.
(15) If the company is engaged in other activities besides the manufacture of the product
under reference, the following details in respect of each such product or activity shall be
given:
(a) list of the products or activities;
(b) list of the products or activities for which Cost Accounting Records Rules have
been prescribed under section 209(1)(d) of the Act.;
(c) whether Cost Audit Order has been issued by the government in respect of any of
the products or activities. If so, number and date of the order.
(16) A printed copy of the Annual Report, containing audited Profit and Loss Account, Balance
Sheet and Auditor’s Report in respect of the company's financial year for which the report
is rendered, shall be enclosed with the Cost Audit Report.
2. Cost Accounting System -
(1) Briefly describe the cost accounting system existing in the company, keeping in view the
equirements of the Cost Accounting Records Rules applicable to the class of companies
manufacturing the product under reference and also its adequacy or otherwise to
determine correctly the cost of production, cost of sales, sales realisation and margin of
the product under reference.
Cost Audit 16.27
(2) Briefly specify the changes, if any, made in the costing system; basis of inventory valuation;
method of overhead allocation; apportionment to cost centers/departments and final
absorption to the product under reference etc., during the current financial year as compared
to the previous financial year.
3. Process Of Manufacture - A brief note regarding the process of manufacture along
with flow chart covering production, utility and service department of the product.
4. Quantitative Details - As per this report the cost auditor is required to give quantitative
information for the current year and two immediately preceding previous years. This
quantitative information includes, total available capacity (i.e. installed capacity + capacity
enhanced during the year), capacity used during the year and percentage of utilization. The
auditor is also required to give information about opening stock of finished good, quantity
produce during the year, quantity sold and closing stock of finished goods.
5. Major Input Materials / Component Consumed - Under this heading, the cost auditor
is required to give details of quantity, rate and amount for current year and two previous years,
in respect of major input materials each of which constitute at least 2% of total raw material
cost. These details are to be given separately for indigenous, self-manufactured and imported
input materials. The cost auditor also required to give detail of standard and actual
consumption of input material per unit.
6. Break-up of cost of input materials imported during the year - Under this heading
the cost auditor is required to give following details in respect of all major imported input
materials each of which constitute at least 2% of the total material cost. (a) FOB price in
foreign currency, (b) Insurance and freight, (c) customs duty, (d) clearing charges, (e) inland
freight, and (f) other expenses. These details are to be given for current year as well as two
previous years.
7. Power, Fuel and Utilities - Under this heading the cost auditor is required to give
information about quantity, rate and amount for current years and two previous year,
separately for indigenous, self-manufactured and imported, power, fuel and utilities. The
details should be furnished in respect of major items each constituting at least 2% of the total
material cost. The cost auditor also required to give information about standard and actual
consumption of powers, fuel and utilities in terms of quantity per unit of production.
8. Salaries and Wages - The cost auditor is required to give quantitative as well as cost
details about salaries and wages.
Under quantitative information, the auditor is required to give details of, average number of
direct and indirect workers, manday available, manday actually worked and reasonwise
analysis of idle mandays. Under cost information the auditor is required to give details of,
direct and indirect labour cost on production and employees cost for administration, selling
and distribution.
9. Repairs and Maintenance - The auditor is required to give information about repairs
and maintenance on land and building, plant and machinery, staff quarters and colony and
other.
10. Fixed Assets Register and Depreciation - The cost auditor is required to give
information about, whether fixed asset register is maintained cost centre-wise, amount of
depreciation u/s 205(2) of companies act, amount of depreciation absorbed in cost record and
amount of over/under absorbed depreciation.
11. Gross Block, Depreciation and Lease Rent - Auditor is required to give details of
gross block, depreciation and lease rent of major cost centres/products. It is not necessary to
give gross block of assets given on lease, if any.
12. Overheads - Under this the auditor is required to give information about factory
overhead, administrative overhead, selling overhead and distribution overhead. These
information are to be given for the current year and two previous year.
13. Research and Development Expenses - The auditor is required to give information
about research and development expenses for, process development, existing product
development and new product development. The auditor also required to state amount
capitalized/deferred and amount provided in the cost record. These information are to be
given for current year as well or for two previous years.
14. Royalty and Technical Know how Charges -The auditor is required to give
information about, royalty on production/sales, lumpsum payment of royalty and technical
knowhow charges. The auditor also required to state amount capitalized/deferred and amount
provided in the cost record. These information are to be given for current year as well as for
two previous years.
15. Quality Control Expenses - Under this heading the auditor is required to give
information about, ISO number of company if any, name of certifying agency, salaries and
wages and other direct expenses relating to quality control.
16. Pollution Control Expenses - Under this heading the auditor gives information about
expenses of company for pollution control on account of effluent treatment, control of air
pollution, control of ash pound and penalty for pollution under any Act. These information, are
to be given for current year as well as two previous year.
17. Abnormal Non recurring cost - The auditor is required to give details of abnormal
non-recurring cost for the current year and two previous years for the product under reference
and for factory as a whole.
18A. Non-moving stock - Under this heading the auditor is required to give information
about value of non-moving direct material, indirect material, work in progress and finished
goods. The value of these non-moving item are also to be expressed in percentage form as
compared to closing stock of that item.
18B. Written off stock - The auditor is required to give data of written off stock for the
current year and two previous year, for the product under reference and for factory as a whole.
19A. Inventory Valuation - The cost auditor is required to report on the basis of valuation as
adopted for the valuation of, input materials, chemicals, additives and consumables, stores
and spares, packing materials, work-in progress, finished goods and scrap/wastage. The
Cost Audit 16.29
auditor also required to state, total value of inventory as per cost accounts and financial
accounts and reason for major difference, if any between these two values.
19B. Physical Verification of Inventory - The cost auditor is required to indicate is there
any shortage or excess value of inventory which is discovered during physical verification of
inventory. These information are to be given separately for raw materials, chemicals,
additives, consumable, stores and spares, packing materials, tools and implements, W.I.P and
finished goods respectively.
20. Sales of the product under reference - The cost auditor is required to report on the
quantity, rate and amount of sales of major product. These details are to be given separately
for purchase goods, loan license basis and own manufactured goods. These information are
to be given for current year as well as previous year.
21. Margin per unit of output - The cost auditor is required to report on the cost of sales,
sales realization and margin, per unit of out put. These details are to be given separately for
purchase goods, loan licence basis and own manufactured goods. These details are to be
furnished for major product group and for current year and two previous year. Separate
details shall be furnished for margin on indigenous sales and export sales. Where the product
(such as sugar, bulk drugs, etc.) is sold at different price in accordance with government
policy, sales realization and margin on such product at different price shall be shown
separately along with quantity and value.
22. Competitive margin against imports - Under this heading auditor required to give
information about, total production of the product in the country, total production by the
company and percentage share of the company in total inland production. The auditor is also
required to give information about, cost of production per unit separately for inland sale and
export sale. These information are to be given for current year as well as for two previous
year.
23. Value addition and Distribution of earning - The auditor is required to give a value
add statement, in which, information about gross value added and distribution of such value
added to different segment of company.
24. Financial position and ratio analysis - Auditor is required to give financial position
information as well as ratio analysis. These information are to be given for product, factory as
a whole, company as a whole for current year and two previous years. Under financial
position details auditor is required to give information about, capital employed, networth, profit
and net sales. For ratio analysis auditor is required to give following ratio. (1) Operating
expenses as percentage of net sales, (2) profit as percentage of capital employed, networth,
net sales and value addition, (3) current ratio, (4) net working capital in terms of months of
cost of sales excluding depreciation and (5) debt equity ratio.
25. Capitalisation of revenue expenditure - Under this the auditor is required to give
information about capitalization of revenue expenditure, these information are to be given for
the product under reference and for factory as a whole. These information should contain
detail of expenditure for raw materials, direct wages and salaries, consumable stores, repairs
and maintenance, depreciation, factory overhead, administrative overhead and other

expenses.
26. Related party transactions - The auditor required to briefly describe the transfer
pricing, followed by the company in respect of “related party relationship” as defined in the
relevant cost accounting records rules made under clause (d) of sub-section (1) of section 209
of the Act. The following particulars for sale and purchase transaction with related party may
be furnished by the auditor (a) particulars of related party, (b) product/activity, (c) quantity, (d)
rate, and (e) amount.
27. Central excise reconciliation for the product under reference - Auditor is required
to give following details for excise reconciliation.
(i) Quantitative detail: Auditor is required to give details of opening stock, production, total
sales and closing stock of finished goods.
(ii) Details of clearance: Under this auditor is required to give details of assessable value,
rate and amount of duty on total excisable clearance and total duty payable.
(iii) Summary of Cenvat credit: Under this auditor is required to give details of opening
balance of cenvat credit, credit availed during the year, closing balance of cenvat credit and
credit utilized during the year.
(iv) Reconciliation of duty paid: Under this auditor is required to give details of total excise
duty payable, excise duty paid through Cenvat account and P.L.A and any difference.
(v) Reconciliation of duty paid and recovered: Under this the auditor is required to give
detail of excise duty paid as per Profit and Loss Account, excise duty recovered as per Profit
and Loss Account and any difference between duty paid and recovered, if so state amount
and reason for difference.
(vi) Reconciliation of turnover: For this auditor is required to give details of turnover as per
RT-12, turnover as per annual accounts (net off duties and taxes) and any difference between
these two, if so, state amount and reason for difference.
28. Profit Reconciliation - The auditor is required to give reconciliation between profit or
loss, as per cost accounting records and financial accounts records.
Proforma
Name of the company :
Name and address of the factory :
Name of the product :
Statement showing the cost of production, cost of sales, sales realisation and margin in
respect of the product(s) under reference produced during the year/period:
A. Quantitative Information:
Particulars (Unit of measurement to be specified)
1. (i) Installed capacity
Cost Audit 16.31
(ii) Capacity enhanced during the year by leasing arrangement etc.

2. Actual production / output :
(i) Self;
(ii) third parties, if any;
3. Production as percentage of installed capacity
4. Captive consumption, if any
5. Quantity sold
(a) Domestic
(b) Export
6. Closing Stock (finished goods)
7. Opening Stock (finished goods)
B. Cost Information:
Particulars (Quantity and Rate for unit to be stated)
1. Material consumed : (item-wise covering at least 80% of items by value)
1. Purchased :
(a) Indigenous (specify)
(b) Imported (specify)
2. Self manufactured (specify)
2. Process chemicals (specify)
3. Utilities
1. Purchased :
(a) Indigenous (specify)
(b) Imported (specify)
2. Self manufactured (specify)
4. Direct wages and salaries
5. Consumable stores and spares
6. Depreciation
7. Lease rent, if any
8. Repairs and maintenance:
(a) Building
(b) Plant and Machinery
(c) Others, if any
9. Other works overhead

10. Total Works Overheads ( 2 to 9 )
11. Royalty, if any
12. Technical assistance/ know-how fee
13. Research and development
14. Quality control
15. Administrative overhead (relating to production activities)
(a) Salaries and wages
(b) Others (specify)
(c) Total(a+b)
16. Total (1+ 10 to 15)
17. Adjustment for variances (where standard costing system is followed)
18. Add: Opening stock
Less: Closing Stock
(Work-in-progress)
19. Less: Credits (from wastage and by-products) / Recoveries, if any
20. Packing cost Primary
(a) Materials
(b) Others
(c) Total
21. Cost of production (16 to 20)
22. Finished Goods purchased, if any
23. Opening Stock
Closing Stock
(finished products)
24. Total (21+22 +23)
25. Quantity and cost transferred for :
(i) captive consumption, if any
(ii) sales
(iii) others, if any
26. Packing cost Secondary
(a) Materials
Cost Audit 16.33
(b) Others
(c) Total
27. Other expenses :
(a) Administrative overheads (others)
(b) Others (specify)
28. Selling and distribution expenses
(a) Salaries and wages
(b) Freight and transport charges
(c) Commission to selling agents
(d) Advertisement expenses
(e) Royalty on sales, if any
(f) Warranty expenses after adjusting income from chargeable services
(g) Others
(h) Total(a to g)
29. Interest and finance charges :
(a) for manufacturing activity
(b) others
(c) total
30. Total cost of sales (excluding excise duty) of packed quantity sold (24 to 29)
31. Sales realisation
Less: Excise duty and other statutory levies
32. Net sales realisation
33. Margin(32 – 30)
34. Add: export benefits and incentives, if any
35. Total margin (including export benefits)
36. Ex-factory price (excluding sales tax etc.)
37. Maximum retail price (excluding sales tax etc.)
38. Maximum retail price, if any, prescribed by the Government/ statutory/regulatory body
etc.
Notes :
1. Separate proforma shall be prepared for each type/variety/ description of product(s)
under reference.
2. Separate proforma shall be prepared for the quantity used for captive consumption,
quantity sold within the country and the quantity exported. Expenses incurred on export
and the incentive earned thereon shall be indicated in the proforma applicable for the
quantity produced and exported.
3. Separate proforma shall be prepared for any related party/inter-unit transfer of
intermediate/finished product(s) under reference.
4. The administrative overheads shall be included in the cost of production only to the
extent they contribute in putting the goods produced to their present location and
condition. The balance of administrative overheads, if any, shall be included in the cost
of goods sold. The proforma may be amended accordingly, if required.
5. The proforma may be suitably modified to cover the special features, if any, of the
product under reference on the basis of proforma prescribed for working out cost of
sales, margin, etc. of the said product in the relevant Cost Accounting Records Rules.
6. Indicate whether the prices of the product under reference are ex-factory prices, F.O.R
prices, door delivery prices or any other terms. In case of ex-factory prices, whether cost
of dispatch packing materials, freight, insurance and delivery charges are recoverable
from the customers separately.
F.No.52/10/CAB-2001
(A. Ramaswamy)
Joint Secretary to the Government of India,
Note: The principal rules were published vide G.S.R. number 511(E), dated the 4th November,
1996.
Cost Audit 16.35
1. Which of the following sentences are true?
(i) Every company required to maintain cost records under Section 209(1)(d) of the
Companies Act is required to get such records audited under Section 233(B) of
the Companies Act.
(ii) There is a set of Cost Accounting (Records) Rules prescribed under Section 209
(1) (d) of the Companies Act which is applicable to all the companies requiring
Cost Audit.
(iii) Royalty is an item of cost of production under the Cost Accounting Records Rule.
(iv) Cost Audit is a statutorily recognised form of audit in most of the countries..
(v) Cost accounting is not a distinct discipline - it is a branch of the accounting
discipline
(vi) Depreciation in excess of that computed under Section 205(2) of the Companies
Act can not be taken for determination of cost under the Cost Accounting Record
Rules.
(vii) Cost auditor is entitled to get the notice of the general meeting.
(viii) Capital work-in-progress is required to be shown in the cost records.
(ix) Cost records under Section 209(l)(d) of the Companies Act as part of the proper
books of account maintained by the company under law are required to be
reviewed by the statutory financial auditor in the normal course of audit.
(x) Cost auditor has right of access to the financial books of the company.
(xi) Cost auditor has a statutory right to visit the branch of the company.
2. Do you think cost audit and financial audit can be combined to produce a composite audit
requirement?
3. Is the cost auditor obliged to enter his observations and comments in his cost audit
report?
4. In a competitive business environment companies should be cost competitive for their
survival. In view of that critically analyse the circumstances which may want introduction
of cost audit and specific advantages thereof?
5. State the functions of Cost Auditor in respect of the following:
(i) Inventory (ii) Labour (iii) Overrate and indirect expenditure.
6. Briefly explain the salient features of cost records?
7. What are the general features of a cost audit report?
8. What are the rights and duties of cost auditor?

Answer to Questions
Correct Sentences:
1 (iii), (iv), (viii), (ix) and (x).
2. Possibility of combining the two sets of audit does not seem feasible in view of:
(a) difficulty of obtaining a proper format to contain the necessary accounting
information covering financial and costing aspects, (b) the audit report cannot be
made public because some of the matters may be considered confidential by the
company, (c) the accounting information would necessarily have to be in much
more detail than at present to be meaningful, and (d) financial accounts would
present the accounting information under the natural accounting heads while
costing information required to be presented on the basis of the product lines and
cost-centres.
3. Yes if he has observed pertinent matters that should be commented upon to properly
verify the true and fair cost of production.
17
SPECIAL AUDIT ASSIGNMENTS
Audit of Members of Stock Exchanges

17.1 A stock exchange is an organized market for the purchase and sale of listed industrial
and financial securities. The securities dealt in at a stock exchange include the shares and
debentures of public limited companies, Government securities, and bonds and securities
issued by the municipal bodies and port trusts, etc. The Securities Contracts (Regulation)
Act, 1956 defines a stock exchange as, “an association, organization or body of individuals,
whether incorporated or not, established for the purpose of assisting, regulating and
controlling business in buying, selling and dealing in securities.”
The first stock exchange in the world was setup in London about two hundred years ago. In
India, it was only in 1875 that the first stock exchange was established at Mumbai under the
name and style of the “Native Share and Stock Brokers’ Association”, which is known as
presently ‘The Stock Exchange, Mumbai (BSE)’. At present there are 23 stock exchanges in
the country - the more important stock exchanges being the National Stock Exchange of India
Limited (NSE) and the Stock Exchange, Mumbai.
Savings of investors flow into public loans and joint stock companies because of the ready
marketability and facilities for transfer of ownership of bonds, shares and securities provided
by the recognized stock exchanges. The number of public limited companies listed on the
stock exchanges in 1946 was 1125 which rose to 4344 in March, 1986 and more than
doubled to 9922 in March, 2001; the market capitalization was Rs. 24,302 in March, 1986
which rose more than 31 times to Rs. 7,68,863 crores in March 2001. The volume of
business conducted in Indian Stock Exchanges was Rs. 2,03,703 crores during the year
1993-94 which rose more than 14 times to Rs. 28,80,990 crores in the year 2000-01.
The securities market reforms included repeal of the Capital Issues (Control) Act, 1947
through which the Government used to allocate resources from capital market for specific
uses; enactment of the Securities and Exchange Board of India Act, 1992 to provide for the
establishment of the Securities and Exchange Board of India (SEBI) to regulate and promote
the development of securities market; setting up of National Stock Exchange of India Limited
(NSE) in 1993, passing of the Depositories Act, 1996 to provide for the maintenance and
transfer of ownership of securities in book entry form; amendments to the Securities

Contracts (Regulation) Act, 1956 (SCRA) in 1999 to provide for the introduction of futures
and options.
Authorities of the leading stock exchanges of the world, e.g., the London Stock Exchange
and the New York Stock Exchange have been exercising wholesome control on the
functioning of the respective stock exchanges. In India, the Securities and Exchange Board
of India, which was established through official notification on April 12, 1988 received
statutory powers through the SEBI ordinance promulgated on the January 30, 1992. The
SEBI Act was passed by the Parliament and assented to by the President of India on the
April 4, 1992. The powers vested in SEBI under the SEBI Act include powers under the
Securities Contracts (Regulation) Act like powers to call for periodic and annual returns from
stock exchanges, licensing of dealers in securities, amendment to the rules and bye-laws of
stock exchanges, etc. SEBI has multi-dimensional responsibilities which include
development and healthy growth of the capital market, regulation of market intermediaries
and investor protection. The SEBI has wide powers under the Act and the Rules to ensure
proper conduct of affairs of the stock exchanges by giving suitable directions, however, the
Securities Contracts (Regulation) Act, was promulgated only in 1956. The Securities
Contracts (Regulation) Rules were framed thereunder in 1957. The Government has wide
powers under the Act and the Rules to ensure proper conduct of affairs of the stock
exchanges by giving suitable directions.
Rule 12 of the Securities Contracts (Regulation) Rules, 1957 provides that “Every member
shall get his accounts audited by a chartered accountant whenever such audit is required by
the Central Government”.
The audit of accounts of the members of the stock exchanges by chartered accountants is
one of the important measures taken by the Government to restore the faith of the investing
public in the working of stock exchanges. It is expected that compulsory audit would
inculcate a sense of financial discipline in the members of the stock exchanges. The audit
would also lend credibility to the financial statements of members of the stock exchanges in
the eyes of various authorities.
A sole proprietor, partnership firm, a corporate body and a financial institution also become
members of the stock exchanges. Such members may get their financial statements audited
under the statue governing them. For example, a company which is a member of a stock
exchange would get its accounts audited under the provisions of the Companies Act, 1956.
The members of stock exchanges may also get their accounts audited under the Income Tax
Act, 1961.
Functioning of Stock Exchanges

17.2 It is important for auditor to understand adequate knowledge about important aspects of
on functioning of stock exchanges and the manner in which the transactions are entered into
Special Audit Assignments 17.3
by the members of stock exchanges.
17.2.1 Regulation of Stock Exchanges – The Securities and Exchange Board of India (SEBI) is
the apex, statutory regulatory body for the securities market with the express mendate of
investor protection and development and regulation of market under SEBI Act, 1992. Apart
from SEBI, Securities Contracts (Regulation) Act, 1956 which provides for regulation of
transactions in securities through control over stock exchanges, Depositories Act, 1996 which
provides for electronic maintenance and transfer of ownership of demat securities, Public Debt
Act, 1942, Companies Act, 1956, Banking Regulation Act, 1949 and Income Tax Act, 1961
also have a substantial bearing on the working of the securities market.
17.2.2 Securities and Exchange Board of India – SEBI is a body corporate having perpetual
succession. It has been given quite wide powers for the achievement of the objectives of the
SEBI Act, 1992. SEBI’s main function is to regulate the business in securities market. SEBI,
for the purposes of regulation of securities market, can issue directions to stock exchanges,
companies, stock brokers or to any other person. SEBI Act, 1992 empowers SEBI to levy
monetary fines and penalties on any person incurring a default under the Act in the following
cases:
♦ failure to furnish any document, information, books, other documents, return or report
called for by the Board,
♦ failure to maintain books of accounts and records;
♦ failure by an intermediary to enter into an agreement with his client, redress the
grievances of investors;
♦ failure by a person sponsoring or carrying on any collective investment scheme,
including mutual funds, without obtaining certificate of registration, failure to comply with
the terms and conditions of certificate of registration, failure to dispatch unit certificates,
failure to refund application moneys within the period specified, failure to invest collected
money in the manner and within the period specified.
♦ failure by a stock broker to issue contract notes in the form and manner specified by the
stock exchange, failure to deliver any security or failure to make payment of the amount
due to the investor, charging of excess brokerage.
♦ any person dealing, communicating, counselling on the basis of some price sensitive
information.
♦ failure by a person to disclose the aggregate of his shareholding in a body corporate
before he acquires any shares of that body corporate and failure to make a public
announcement to acquire shares at a minimum price in case of takeovers.
SEBI also has the power to suspend or cancel the certificate of registration of a stock-broker,
sub-broker, share transfer agent, banker to an issue, trustee of a trust deed, registrar to an
issue, merchant banker, underwriter, portfolio manager, investment adviser and such other
intermediary who may be associated with securities market. This includes depository,
depository participant, custodian of securities, foreign institutional investor and credit rating
agency also.
The Securities Contract (Regulation) Act, 1956 empowers the stock exchanges to regulate,
subject to approval of the Central Government, the following important aspects of the
functioning of a stock exchange through its bye-laws :
♦ Maintenance of a clearing house for all business transacted at the stock exchange.
♦ Regulation, limitation or abolition of blank transfers and carry over facilities.
♦ Determination and declaration of market rates.
♦ Regulation of the “taravni” business.
♦ Limitation on business done by individual members.
♦ Fixation of the scale of brokerage, fines, fees and the margin requirements.
It may be noted that since SEBI is the regulator of the securities market, the Securities
Contract (Regulation) Act, 1956, through section 10, empowers SEBI to make or amend the
byelaws of stock exchanges.
17.2.3 Governing Body – The Governing Body of a stock exchange can comprise of elected
representatives of the members of stock exchange, nominated public representatives and/or
professional directors. The Governing Body has powers, subject to SEBI approval, to make,
amend and suspend the operation of the Rules, Bye-laws and Regulations of the stock
exchange besides having jurisdiction over all its members. The Governing Body is specially
empowered to admit or expel members and their subordinates.
17.2.4 Membership – Business at a stock exchange, can only be transacted by a member of

the stock exchange. A member of NSE can not transact business at BSE unless he is a
member of BSE also. The members of stock exchanges are also called stock or share
brokers. The members enter into transactions either on their own behalf or on account of their
clients, including sub-brokers. There are several ways of placing an order with a member. It
could be either directly or indirectly through a sub-broker. Since the stock exchange
operations involve considerable financial commitments on the part of its members, its
membership is restricted to persons who are financially sound and possess adequate
experience. The Securities Contracts (Regulation) Act, 1956, the SEBI Act, 1992 and various
rules, regulations, notifications, etc., lay down the requirements for becoming a member of a
stock exchange. Each stock exchange has its own SEBI approved rules and regulations
regarding the admission of members. A stock exchange can have membership in multiple
trading segments such as Capital Market Segment, Wholesale Debt Market Segment and
Derivatives Segment. The deposit / fee structure applicable to a member depends on the
trading segments in which the member is admitted.
17.2.5 Classification of Securities Traded – A security (in common parlance also known as
scrip) which is allowed to be traded on any Exchange can either be listed with the Exchange
or be permitted to be traded without being listed on the Exchange. A listed company is bound
by the listing agreement with the exchange. The listed companies have to pay the listing fees
as prescribed by the Securities and Exchange Board of India to the Exchange. However, in
case of permitted securities, listing fees is not payable to the Exchange. Securities traded on
BSE are classified into “A”, “B1”, “B2”, “C”, “F” and “Z” group. The “F” group represents the
debt market (fixed income securities) segment. The “Z” group covers the list of companies
which fail to comply with listing requirements and /or fail to resolve investor complaints and/or
fail to make the required arrangements with both depositories viz. NSDL and CSDL for
dematerialisation of their securities by September 30, 2001. When they make arrangement for
dematerialisation, if this is the only reason for falling in Z Category, trading and settlement in
their scrips will shift to their respective erstwhile group. In addition, “C” group allows trading in
odd lot securities in “A”, “B1”, “B2” and “Z” groups. The ‘C’ group can also be used by
investors for selling upto 500 shares in physical form in respect of scrips where trades are to
be compulsorily settled by all investors in demat mode. BSE also has a derivative segment
which allows trading in futures and options of index and stocks.
Securities traded on the NSE are not classified as is done in case of securities traded on
BSE. However, different segments of NSE allow trading in various types of securities, for
example, Wholesale Debt Market segment allows members to trade in debt securities,
Capital Market segment enables members to trade in equities segment and derivatives of
index and stocks can be traded in Futures and Options Segment.
17.2.6 Margins – There can be wide fluctuations at the time of settlement in the prices of
securities since the closing rate of the earlier settlement. In order to restrict excessive
speculation and also to safeguard the interests of the investors, members are required to keep
certain deposits with the stock exchange authorities. These deposits are termed ‘margins’.
The members are required to collect the margin from their clients, wherever applicable, and
deposit the amount collected with the Clearing House. Margin is intended to protect the
members by providing them with funds to cover anticipated fluctuations in prices of securities,
particularly, if the client delays in paying the amount or is unable to meet his commitments.
Margins also help prevent excessive speculation as clients would be required to invest some
funds and not indulge in speculation without adequate resources. A member is required to
pay or deposit different margins such as Gross Exposure Margin, Mark to Market (MTM)
Margin, Volatility Margin (VM), Additional Volatility Margin (AVM), Special Margin and Adhoc
Margin. The members are required to compute margin payable for all securities traded by
them and make the margin payments on the due date to the Stock Exchange authorities.
Different types of margins are payable at stipulated time, as decided by the Exchange or
Clearing House of the Exchange. Three types of margins, viz., Mark-to-Market Margin,
Volatility Margin and Gross Exposure Margins have been explained in the following
paragraphs.
(i) Mark to Market Margin
MTM margin is the notional loss, which a member or his client would incur, if the net
cumulative outstanding positions in all securities were closed out at the closing price of the
relevant trading day, which is different from the price at which the transaction had been
entered into. For each security, this is worked out by multiplying the difference between the
closing price and the price at which the trade was executed by the cumulative buy and sell
open position (for buy position the close price being lower than actual trade price and for sell
position the close price being higher than actual trade price). The aggregate amount
computed across all securities is MTM margin payable by a member. The mark-to-market
margin is payable with reference to net position at client’s level.
(ii) Volatility Margin
Volatility margin is imposed to curb excessive volatility in the market and to act as a deterrent
to building up of excessive outstanding positions. Price variations on account of calls,
bonuses, rights, mergers, amalgamations and schemes of arrangements are adjusted for
determining volatile securities and adjustments in prices is made for the purpose of
computation of volatility, when securities are traded ex-benefits. Securities that attract
volatility margin and the applicable margin rates are announced on the last day of the trading
cycle and are applicable from the first day of the succeeding trading cycle. The volatility
margin is levied on the net outstanding positions of the member, in each security, based on
the respective margin rates.
(iii) Gross Exposure Margin
Gross exposure margin is computed on the aggregate of the net cumulative outstanding
positions (purchases or sales) in each security. Each Exchange determines its own rates of
Gross Exposure Margin and Additional Volatility Margin based on its own risk perception of
the market and other risk containment measures such as deposits and collaterals in its
possession.
A Stock Exchange may also collect the following margins -
(i) Special Margin in securities where price manipulation is suspected.
(ii) Adhoc Margin where it is felt that the margin cover vis-à-vis the exposure of the member
is inadequate or a member has a concentrated position in some securities or has
common clients along with other members.
17.2.7 Trading System – As stated earlier, a member can transact business at a stock
exchange either on his own behalf or on behalf of his clients / sub-broker. Thus, a non-
member can purchase or sell shares and other securities only through member or through
their authorised and registered sub-broker. The relationship between the client and the
member is of a fiduciary nature. When, therefore, the member receives securities from his
client for sale, he is obliged to sell the securities as per instructions and to remit the sale
proceeds thereof, after deducting brokerage and other related expenses, to his client.
Similarly, when on member buys securities for his client, he has to ensure that the
shares/securities so purchased are delivered to the client after he has received from the client
the payment for the same which includes the brokerage and other incidental expenses in
connection therewith. Thus, a member acts as a custodian and handles the securities of his
clients on their behalf. Therefore, the member must ensure that he has received payment
from other stock brokers for the securities sold on behalf of his clients. The procedures
followed by various Stock Exchanges in the purchase and sale of securities vary. In order to
provide a basic understanding of trading on Stock Exchanges, trading systems at National
Stock Exchange and the Stock Exchange, Mumbai have been discussed in this Chapter.
17.2.8 Trading on the National Stock Exchange – NSE operates on the 'National Exchange for
Automated Trading' (NEAT) system, a fully computerised screen-based trading system. It
enables members from across the country to trade simultaneously with enormous ease and
efficiency by keying the order into the system. A single consolidated order book for each
stock displays, on a real time basis, buy and sell orders originating from all over the country.
The orders are executed only if the price-quantity conditions match.
17.2.9 Types of Market – The NEAT system have four main types of market. They are:
Normal Market: All orders which are of regular lot size or multiples thereof are traded in the
normal market. For shares which are traded in the compulsory dematerialised mode the
market lot of these shares is one. Normal market consists of various book types wherein
orders are segregated as regular lot orders, special term orders, negotiated trade orders and
stop loss orders, depending on their order attributes.
Odd Lot Market: An order is called an odd lot order if the order size is less than regular lot
size; such orders are traded in the odd-lot market. These orders do not have any special
terms or attributes attached to them. In an odd-lot market, both the price and quantity of both
the orders (buy and sell) should exactly match for the trade to take place.
Spot Market: Spot orders are similar to the normal market orders except that spot orders
have different settlement periods vis-à-vis normal market. These orders do not have any
special terms or attributes attached to them.
Auction Market: In the auction market, auctions are initiated by the Exchange on behalf of
trading members for completing the settlement process.
17.2.10 Order Books – The NSE trading system provides flexibility to members in the kind of
orders that can be placed by them. Orders are first numbered and time-stamped on receipt
and then immediately processed for potential match. Every order has a distinctive order
number and a unique time stamp on it. If a match is not found, then the orders are stored in
different 'books' in price-time priority in the following sequence:
♦ Best Price
♦ Within Price, by time priority.
Price priority means that if two orders are entered into the system, the order having the best
price gets the higher priority. Time priority means if two orders having the same price are
entered, the order that is entered first gets the higher priority.
The capital market segment has following types of books:
Regular Lot Book - The Regular Lot Book contains all regular lot orders that have none of
the following attributes or conditions * attached to them.
♦ All or None (AON)
♦ Minimum Fill (MF)
♦ Stop Loss (SL)
Special Terms Book - The special terms book contains all orders that have either of the
following attributes or conditions attached:
♦ All or None (AON)
♦ Minimum Fill (MF)
Stop-Loss Book - Stop loss orders are stored in this book till the trigger price specified in
the order is reached or surpassed. When the trigger price is reached or surpassed, the order
is released in the regular lot book. The stop loss condition is met under the following
circumstances:
♦ Sell Order - A sell order in the ‘stop loss book’ gets triggered when the last traded price
in the normal market reaches or falls below the trigger price of the order.
♦ Buy Order - A buy order in the ‘stop loss book’ gets triggered when the last traded price
in the normal market reaches or exceeds the trigger price of the order.
Odd Lot Book - The odd lot book contains all odd lot orders (orders with quantity less than
marketable lot) in the system. The system attempts to match an active odd lot order against
passive orders in the book. Currently, pursuant to a SEBI directive, the Odd Lot Market is
being used for orders which he quantity less than or equal to 500 (Quantity more than the
market lot) for trading. This is referred as the Limited Physical Market (LPM).
* Conditions are explained later in the Chapter.

Spot Book - The Spot Lot Book contains all spot orders (orders having only the settlement
period different) in the system. The system attempts to match an active spot lot order against
the passive orders in the book.
Auction Book - This book contains orders that are entered for all auctions.
17.2.11 Trading on The Stock Exchange, Mumbai (BSE ) – The Exchange, which hitherto,
had an open outcry trading system, switched over to a fully automated computerised mode of
trading known as BOLT (BSE On Line Trading) System. This system, which is both order and
quote driven, was commissioned on March 14, 1995. It facilitates more efficient processing,
automatic order matching and faster execution of trades. Above all, the system is more
transparent for investors, while allowing members to keep their clients’ positions confidential
as compared to the earlier regime where the counterparty was always known. The members
now enter orders/quotes on the Trader Work Stations (TWSs) in their offices instead of
assembling in the trading ring. The scrips traded on the Exchange have been classified into
‘A’, ‘B1’, ‘B2’, ‘C’, ‘F’ and ‘Z’ group as discussed under the paragraph on Classification of
Scrips Traded. As on date, the trading system of The Stock Exchange, Mumbai also provides
more or less the same features as those provided by the trading system of the National Stock
Exchange.
17.2.12 Depositories and Dematerialisaton – The entire transaction of purchase or sale of
securities can be said to be completed only after the buyer becomes the rightful owner of the
securities and the seller gets the sale consideration. Traditional settlement system on the
Indian stock markets gave rise to settlement risk due to the time that lapsed before trades
were settled. Further, transfer of securities involved sending the same along with sellers’
endorsement on transfer deed for registration to the issuer. In many cases, the process took
much longer than two months and significant proportion of transactions ended up as bad
delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and
other irregularities were rampant and in addition to the issuers right to refuse the transfer of
security. To obviate these problems, the Depositories Act, 1996 was enacted to provide for
establishment of depositories in securities with the objective of ensuring free transferability of
securities with speed, accuracy and security by:
(a) making securities of public limited companies freely transferable subject to certain
exceptions;
(b) dematerialising the securities in the depository mode; and
(c) providing for maintenance of ownership records in book entry form.
In order to streamline both the stages of settlement process, the Depositories Act, 1996
envisaged transfer of ownership of securities electronically by book entry without making the
securities moving from person to person. The Act made the securities of public limited
companies freely transferable by restricting the company’s right to use discretion in effecting
the transfer of securities, thus, dispensing with the transfer deed and other procedural
requirements under the Companies Act, 1956.
In a depository system, securities are held in securities (depository) accounts; which is more
or less similar to holding funds in bank accounts. Transfer of ownership of securities is done
through simple account transfers.
Advantages of Depository Services -

(i) High liquidity of scrips due to immediate transfer and registration.
(ii) Receive bonus and right as direct credit to the account thereby eliminating the risk of
loss in transit.
(iii) Much lower risk of bad deliveries.
(iv) Reduction in brokerage.
(v) Saving of stamp duty worth 1% of transaction price.
(vi) Saving of courier, notary charges.
(vii) Saving of expenses to be incurred on obtaining duplicate certificates as no threat of
original shares getting mutilated or misplaced.
17.2.13 Depositories in India – National Securities Depository Limited (NSDL) and Central
Depository Services Limited (CDSL) provide depository services to investors and clearing
members through Depository Participants (DPs). They do not charge the investors and
clearing members directly but charge their DPs, who are free to have their own charge
structure for their clients. The charges for the investors are, therefore, market determined.
17.2.14 Clearing and Settlement Mechanism – Clearing and Settlement Mechanism: When a
trade has been executed, the shares and money should be transferred to the respective
parties on settlement date. When an investor enters into a transaction with a broker, shares
or funds, as the case may be, are delivered to the broker. In turn, the broker delivers these on
settlement day to the settlement agent. In BSE, the settlement agent is known as ‘Clearing
House (CH)’ whereas in NSE it is ‘National Securities Clearing Corporation Ltd. (NSCCL)’.
Settlement of trades transacted on an Exchange requires smooth, preferably instantaneous,
movement of securities and funds in accordance with the prescribed schedule of pay-in/pay-
out. Movement of securities has become almost instantaneous in the dematerialised
environment. Two depositories, namely, National Securities Depository Limited and Central
Depository Services Limited, are in place to provide electronic transfer of securities. All
actively traded scrips are held, traded and settled in demat form. The securities pay-in
obligations of members / custodians are downloaded by the clearing agency. The members /
custodians make available the required securities in their pool accounts with Depository
Participants (DPs) by the prescribed pay-in time for securities. The depository runs an
electronic file to transfer the securities from the pool accounts of members / custodians with
DPs to the DP account of the clearing agency. As per the allocation schedule determined by
the clearing agency, the securities are transferred on the pay-out day by the depository from
the DP account of the clearing agency to the DP accounts of members / custodians. In case
of trades settled under account period settlement, the pay-out of securities are effected on the
same day in case of trades settled under rolling settlement. The ownership vests with the
buyer as soon as the securities move from DP account of the member / custodian to his DP
account.
SEBI has directed by Circular No.SMDRP/Policy/Cir-56/00 dated December 15, 2000, that
the brokers can issue contract notes authenticated by means of digital signatures, provided
the broker has obtained the digital signature certificate from Certifying Authority under the IT
Act, 2000. SEBI has also directed the Exchanges to make necessary amendments to the
bye-laws, rules and regulations to give effect to the above clarifications.
Select banks have been empanelled by clearing agency for electronic transfer of funds. The
members are required to maintain accounts with any of these banks. The members are
informed electronically of their pay-in obligations of funds. The members make available
required funds in their accounts with clearing banks by prescribed pay-in day. The clearing
agency forwards funds obligations file to clearing banks which, in turn, debit the accounts of
members’ accounts with clearing banks and credits its own account. As per the schedule of
allocation of funds, determined by the clearing agency, the funds are transferred on the pay-
out day by the clearing banks from the account of the clearing agency to the accounts of
members. In some cases, the clearing agency directly credits the members’ accounts with
clearing banks and debits its own account. In case of trades settled under account period
settlement, the pay-out of funds is effected on the day following the pay-in day. The pay-in
and pay-out of funds are effected on the same day in case of trades settled under rolling
settlement.
The securities can move instantaneously from the seller to seller’s broker to clearing agency
to buyer’s broker to buyer since all these have accounts with either of the two depositories
which are connected to most of the Stock Exchanges. The depositories have been obligated
under the Depositories Act, 1996 to transfer securities electronically.
17.2.15 Disclosure of Proprietary Trading by Broker to Client – With a view to increase the
transparency in the dealings between the broker and the client, SEBI has directed that every
broker shall disclose to his client whether he does client based business or proprietary trading
as well. The broker shall disclose this information to his existing clients within a period of one
month from the date of this circular. Further, the broker shall disclose this information upfront
to his new clients at the time of entering into the Know Your Client agreement. In case of a
broker who at present does not trade on proprietary account, chooses to do so at a later date,
he shall be required to disclose this to his clients before carrying out any proprietary trading.
The Stock Exchanges are also directed to make necessary amendments to the relevant bye-
laws, rules and regulations for the implementation of the above decision [SEBI Circular Ref.
No.SEBI/MRD/SE/Cir-42/2003 Dated November 19, 2003].
Rolling Settlement
17.3 A rolling settlement is one in which trades outstanding at the end of the day have to be
settled (payments made for purchases or deliveries in the case of sale of securities) within “X”
business days from the transaction date. Thus, in a T+2 rolling settlement, a transaction
entered into on Monday for instance, will be settled on Wednesday when the pay-in or pay-out
takes place.
In the rolling settlement, trades on each single day are settled separately from the trades
done earlier or subsequent trade days. The netting of trades is done only for the day and not
for multiple days.
SEBI has gradually mandated most of the scrips to be settled exclusively on Rolling
Settlement basis (T+2). The transactions in the Compulsory Rolling Settlement (CRS) are
settled on T+2 basis, i.e., both pay- in and pay- out of monies and securities for transactions
in scrips on transaction day (T day) would take place on the day after immediately following
day.
However, transactions in ‘Z’ group securities are settled only on trade to trade basis on T+2,
i.e., the facility of netting up of buy and sell transactions of the same day, as available in other
securities, is not available with securities falling under ‘Z’ group. In other words, if an investor
buys and sells X no. of shares on the same day then he shall first have to actually deliver and
then receive the securities on the settlement day.
Value at Risk (VaR) based margining approach has been adopted for transactions done in
CRS scrips with effect from July 2, 2001. In the VaR system of margining, historical volatilities
of scrips and overall market volatility is considered to arrive at a VaR margin percentage for a
scrip. Further, the mark-to-market differences are collected on a daily basis and the broker
members are required to maintain a capital level, as prescribed by the Exchange, adequate to
support their exposure at all times.
In case, a member fails to deliver the shares sold in rolling settlement, the Exchange conducts
an auction session on T+2, to meet the shortfall created by non-delivery of shares. In this
auction session, offers are invited from the other members to deliver the shares sold by
originally selling member, since delivery has to be made to the buying member. In case no
shares are received in auction, the sale transaction is closed-out at a close-out price,
determined by higher of the following:
♦ Highest price recorded in the scrip from the settlement in which the transaction took
place upto a day prior to the auction.
OR
♦ 20% above the closing price on a day prior to the auction.
In this case, the auction price/close-out and difference between sale price, if positive is
payable by the seller who failed to deliver the scrips. In case, auction /close out price is less
than sale price, the difference is not given to the seller but is credited to Investor Protection
Fund.
Derivatives
17.4 Derivative is a security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more parties. Its
value is determined by fluctuations in the underlying asset.
17.4.1 Derivatives Market at NSE – The derivatives trading on the NSE commenced with S&P
CNX Nifty Index futures on 12th June, 2000. The futures contract on NSE is based on S&P
CNX Nifty Index. Currently, it has a maximum of 3 month expiration cycle. Three contracts
are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is
introduced on the next trading day following the expiry of the near month contract.
The Futures and Options trading system of NSE called NEAT-F&O trading system, provides
fully automated screen based trading for S&P CNX Nifty futures on a nationwide basis and an
online monitoring and surveillance mechanism. The NEAT-F&O trading system is accessed
by two types of users. The Trading Members (TM) have access to functions such as, order
entry, order matching, order and trading management. The Clearing Members (CM) use the
trader workstation for the purpose of monitoring the trading members for whom they clear the
trades. Additionally, they can enter and set limits to positions, which a trading member can
take.
There are Two Types of Clearing Members
♦ Trading Member Clearing Member (TM-CM) is a CM who is also a TM. TM-CM may
clear and settle his own proprietary trades and clients’ trades as well as clear and settle
for other TMs.
♦ Professional Clearing Members (PCM) is a CM who is not a TM. Typically banks and
custodians could become a PCM and clear and settle for TMs.
Nifty index futures contracts are cash settled on a daily basis by marking to market all open
positions on the basis of the daily settlement prices. Members are required to pay the mark to
market losses by T+1 day and the same is in turn paid to the members who have made a
profit. The contracts are finally settled on expiry of Nifty index futures contract, when NSCCL
marks the open positions of a CM to the closing price of underlying index and resulting profit /
loss is settled in cash.
For settlement purposes, the daily settlement price is the closing price of futures contract.
Trading in Index Options and Stock Futures & Options has also been introduced in Derivatives
Segment of NSE.
17.4.2 Derivative Trading at BSE – The derivatives trading on the BSE commenced with BSE
Sensitive Index futures on 9th June, 2000. The futures contract on BSE is based on BSE
Sensitive Index (Sensex). The trading and settlement mechanism is more or less on the same
lines as in NSE. However, for settlement purposes, the daily settlement price is calculated as
the weighted average price of trades during the day. Trading in Index Options and Stock
Futures & Options has also been introduced in Derivatives Segment of BSE.
Circuit Filters or Circuit Breakers

17.5 Circuit Breakers or circuit filters are the price bonds that set the upper and lower limit
within which a stock can fluctuate on any particular day. A price band for a day is a function of
previous trading day’s closing. SEBI has directed the exchanges to apply circuit filters on
scrips traded in Rolling Settlement if their price fluctuates more than 20% of the closing price
of scrips on the previous day in any direction. However, feeling the threat of high settlement
default in scrips forming part of sensex or in which derivatives and futures are available,
because of these filters, SEBI has restricted the fluctuation to 10% instead of 20%.
Price bands restrict extreme price movements and thereby resist price manipulation. These
protect investors from extreme fluctuations in a panic market created by rumours and short term
fears.
Market Wide Circuit Breakers (MWCB) - Market wide circuit breakers do the same job for
the entire market what circuit filters do for individual scrips. MWCB has been introduced to
control excessive market movements in BSE sensex and Nifty. SEBI has introduced MWCB
at 10-15-20% of the movements in these indices whichever is breached earlier. These
breakers provide the time to participants to react to the movement by way of the trading halt.
The trading halt on the exchange shall be as per following regulations –
(a) If movement in the index is 10%:
Time of Movement Duration of trading halt
Before 1 p.m. 1 hour
After 1 p.m. but before 2.30 p.m. ½ hour
On or after 2.30 p.m. No trading halt
(b) If Movement in the index is 15%:
Time of Movement Duration of trading halt
Before 1 p.m. 2 hours
After 1 p.m. but before 2 p.m. 1 hour
On or after 2 p.m. For entire remaining period of the
day
(c) If Movement in the index is 20%: The trading shall halt for remaining period of the day.
(d) Basis for calculating percentages for MWCB: These percentages are not calculated on a
day-to-day basis rather they are fixed for a quarter. These are fixed in absolute points of
index variation on the basis of the closing of index on the last trading day of previous
quarter and are reported in advance to the market participants at the beginning of the
relevant quarter.
Accounting for Stock Exchange Transactions

17.6 A trading member is required to keep proper records and accounts for securities and
monies receivable from and payable / transferable to both his clients as well as the Stock
Exchange. The trading member is firstly required to enter the order into an Electronic Order
Entry Book which then transfers the order to the Stock Exchange’s trading system. As soon
as the same is matched by a corresponding order by another trading member, the trade is said
to be confirmed. A trading member is then required to pay margins (Mark-to-Market, Volatility,
Gross Exposure) which are required to be collected from respective clients, wherever
applicable). Since it is not feasible to collect margins from a client on a frequent basis, the
trading member, generally, collects sufficient margin against each transaction at the point of
execution of transaction. This margin is finally adjusted against outstandings in case of
settlement of buy positions. If the client fails to pay for the securities purchased, the margin is
used to take delivery and subsequently adjust the loss incurred in squaring off the transaction.
In case of execution of sale order, the entire margin is refunded back alongwith the sale value
of securities (net of brokerage and other costs) after the funds pay-out is received for
securities delivered by the client. In case, the client fails to deliver the securities, the
securities are required to be bought by the selling trading member to deliver to the buying
trading member through auction. The margin is then used to adjust the loss on account of the
difference between the buying price in auction and the price at which the security was original
sold.
No entry is required to be passed by the trading member at the time of entering the order in
Order Entry Book. Again on execution of trade, no entry is required to be passed in the
books of accounts. All the transactions of each client are cumulated for an entire settlement
before passing the entries in the ledger. However, it may be possible that a client may have
made only one transaction in a given settlement.
Presuming that the client Mr. A (Client Code A0001) is the only client of the member for
Rolling Settlement No. 200102151 and has done the following transactions in the said
settlement -
Bought / Qty Scrip Name Transacti Brokerage Effective Total Value
Sold on Rate @ 1% (say) Rate (Rs.) (Rs.)
(Rs.) (Rs.)
Bought 10 Infosys 3,000 30 3,030 30,300
Technologies
Bought 100 TISCO 100 1 101 10,100
Sold 100 Reliance 300 3 297 -29,700
Industries
In the above case, it may be noted that the client has to pay Rs. 10,700/- to the trading
member. The trading member earns a brokerage of Rs. 700/- (i.e. 10 x 30 + 100 x 1 + 100 x
3) and is required to pay Rs. 10,000/- (10 x 3000 + 100 x 100 - 100 x 300) to the Clearing
Corporation / Clearing House towards his outstanding position for the settlement. The trading
member would also have to add 5 % as service tax on brokerage earned amounting to Rs.
35/- on the net settlement position which is required to be paid to the Service Tax authorities.
It may be noted that the gross value of transactions done in the abovementioned example is
Rs. 70,000/- (i.e. 10 x 3000 + 100 x 100 + 100 x 300). Considering the margin requirement @
10% on gross value of transactions done, the trading member may collect Rs. 7,000/- from the
client and for onward remittance to the Clearing Corporation / Clearing House.
In case, the client is unable to deliver the securities sold on the securities pay-in date, the
same are auctioned by the Exchange (Auction Settlement Type A). This means that the
Exchange allows any other Trading Member or his Client (through the Trading Member) bid for
delivering the same. The client who has not been able to deliver the securities is required to
treat the same as a buy order in his behalf and is bound to pay for the same.
Thus, if Mr. A (through his Trading Member) was unable to deliver 100 shares of Reliance
Industries Ltd. on or before the pay-in day for securities and the these shares were auctioned
at a rate of Rs. 320 each, a fresh purchase entry would be passed in the books while no
effect would be given to the original sales.
In case there are no bidders for selling the securities in an auction settlement for a particular
auction scrip and quantity, then the original sale is closed out by squaring as per the rules of
the Exchange. The entries nevertheless remains the same.
In case any amount is charged by the Exchange or clearing house towards any pay-in or pay-
out defaults, the same is debited and collected from the client to the extent attributable to
default committed by the client. The Member is also liable to pay transaction charges and
various other charges, fines, interest, etc. to the Exchange or Clearing Corporation / Clearing
House which along with other expenses are directly debited to the profit & loss account
through respective expense accounts.
Conduct of Audit
17.7 As stated earlier, in exercise of the powers vested in the Central Government under Rule
12 of the Securities Contracts (Regulation) Rules, 1957, the Government issued a notification
dated 29th January, 1983 requiring the accounts of active members of stock exchanges to be
audited by chartered accountants. The audit comes into effect from the financial year
commencing after 31st March, 1984 as per the Notification dated 11th January, 1984. Thus,
accounts of members in respect of the financial years beginning on and after 1st April, 1984
are required to be audited by chartered accountants. Subsequent to the corporatisation of the
Members of Stock Exchanges, statutory audit is now required under the Companies Act, 1956.
17.7.1 The Nature and Scope of the Audit – It has been clarified by the Government, vide its
letter dated 31st May, 1984, that a member of the stock exchange, irrespective of the size of
his business, would be considered ‘active’ for the purpose of audit if he has conducted
business in securities even for a single day in the accounting year. The same letter also
clarifies that the annual audit of accounts of a member of a stock exchange will be of the
nature of the normal audit, as is conducted in the case of companies, co-operative societies
and other entities. It will also hold good for the audits governed under the Companies Act,
1956.
A member of the stock exchange has to get his accounts audited by any practicing chartered
accountant.
17.7.2 The Books of Account and Other Documents subject to the Audit – According to the
notification, audit is intended to cover the books of account and other documents specified
under Securities Contracts (Regulation) Rules, 1957 and SEBI (Stock Brokers and Sub-
Brokers) Rules, 1992. The members of the Exchange are required to maintain the following
books of accounts and records as per Rule 15 of the Securities Contracts (Regulation) Rules,
1957 and Regulation 17 of the SEBI (Stock Brokers and Sub-Brokers) Rules, 1992:
♦ Register of Transactions (Sauda Book) / Daily Transaction List
♦ Clients Ledger
♦ General Ledger
♦ Journals
♦ Cash Book
♦ Bank Pass Book
♦ Documents Register / Inward-Outward Register showing full particulars of shares and
securities received and delivered
♦ Members’ contract book showing details of all contracts entered into by him with other
members of the same exchange or counterfoils or duplicates of memos of confirmation
issued to such other member
♦ Counterfoils or duplicates of contract notes issued to clients
♦ Written consent of clients in respect of contracts entered into as principals
♦ Margin Deposit Book
♦ Register of accounts of sub-brokers
♦ An agreement with a sub-broker specifying the scope of authority and responsibilities of
the stock-broker and such sub-brokers
In addition to the above statutory requirements, the Exchange as per its rules, regulations
and bye-laws, may also require their Members to maintain the following records / documents-
♦ Copies of all margin statements downloaded from the Exchange.
♦ Copies of Settlement / Valan Balance Sheet along with all relevant sheets.
♦ Details of Spot Delivery transactions entered into (including securities delivered and
payments made to the members)
♦ Client database & Broker Client Agreement.
♦ Copy of Registration Certificate of each Sub-broker issued by SEBI.
♦ Copy of approval for each Remisier given by the Exchange.
♦ Copy of the Power of Attorney / Board Resolution authorizing Directors / employees to
sign the Contract Note.
♦ Copies of Pool Account Statements.
If a member of the Stock Exchange also holds’ membership of any other recognized Stock
Exchange, or in a different segment of the same Exchange, (e.g., Derivatives Segment) then
such member is required to maintain a separate set of books of accounts, records and
documents for trades executed on each recognized stock exchange or each segment of the
exchange. The auditor should verify whether the member is maintaining all the above books,
documents, etc. and they are up to date.
Considering the extent of computerisation at the level of Stock Exchange as well as at
member’s end, an auditor may determine the extent and depth of verification of the audit.
For this, the auditor needs to study and understand the various manual and computerised
accounting processes employed by the Member and various controls and checks embodied
therein. On the basis of same and the materiality thereof, the auditor may decide his audit
procedures, extent of checking required and exercise his diligence for the purpose of
reporting. Some of the important books of accounts, documents and relevant auditing
procedures / tests are discussed below.
17.7.3 Daily Transactions List (Sauda Book) / Register of Transactions – All members are
required to maintain a ‘Sauda Book’, which contains details of all deals transacted by them on
a day to day basis. This is a basic record, which each member is required to maintain
regularly on day-to-day basis. It contains the details regarding the name of the code of the
client on whose behalf the deals have been done, rate and quantity of bought or sold. These
details are maintained datewise. This register contains all the transactions, which may be of
any of the kind mentioned below :
♦ member’s own business on the Exchange
♦ member’s business on the Exchange on behalf of clients
♦ member’s business with the clients on principal-to-principal basis
♦ member’s business with the members of other Stock Exchanges
♦ member’s business on behalf of his clients with the members of other Stock Exchanges
♦ Spot transactions, etc.
17.7.4 Contract Notes – Contract note is a document through which a contractual obligation is
established between a member and a client. Every member of the stock-exchange has to
issue contract notes to his clients for the trades executed on their behalf. The contract notes
are required to be issued to the Client within 24 hours of execution of the trades. Members
are also required to preserve counter-foils or duplicates of the copies of contract notes issued
to clients. The member is also required to maintain written consent of clients for the contracts
entered into as Principal. Contract notes issued to clients should show the brokerage
separately. The total brokerage charged by the member should not exceed the specified
value of the trade. It may be noted that the brokerage percentage is prescribed from time to
time. The Contract Notes are required to be signed either by the member himself or his
constituted attorney. In case of a sole proprietor / partnership firm wishes to authorise another
person to sign the contract notes, then the member is required to submit a power of attorney
to the Exchange. In case of corporate membership, a board resolution is required to authorise

a person including Directors to sign the contract notes.
The member then prepares a Contract Note in the prescribed form after adding the brokerage
and sends the original Contract Note to the client. The auditor should evaluate the internal
control procedures instituted by the stock broker for proper maintenance and issuance of
contract notes. The auditor should verify that the transactions done by a member are
recorded in the sauda book. It should also be examined that contract notes are issued for all
the business conducted on behalf of the clients. The auditor should verify the list of trades
executed with the bills raised. The auditor should apply appropriate audit procedures to
satisfy himself that -
♦ Contract notes have been serially numbered.
♦ No serial number has been left blank.
♦ Format of the Contract Note is as prescribed by the Regulations of the Exchange.
♦ Duplicate copies / counterfoils of contract notes are maintained.
♦ Brokerage charged in contract notes is within the permissible limits and is indicated
separately including service tax.
♦ Contract notes have been signed by an authorised person.
♦ Contract notes have been issued in respect of all transactions.
♦ Transaction Identification, Trade Identification and Trade Execution time has been
printed on the contract note issued.
♦ SEBI Registration number, Settlement number, Settlement dates have been mentioned.
♦ PAN number of the member and client has been mentioned on Contract Note where if
required.
♦ All clauses specified by the Exchange have been printed on the reverse of the contract
notes.
17.7.5 Service Tax – Service Tax on a member of a stock exchange had been introduced by
the Government in union-budget 1994-95. Service tax is levied on the value of taxable
services which shall be the gross amount changed by the service provider of such service
provided or to be provided by him at the rate prescribed from time to time by the Government
Taxable Service has been defined u/s 65(105)(a) of the Act as any service provided to any
person by a stock broker in connection with the sale or purchase of securities listed on a
recognized stock exchange services provided by sub-brokers has also been brought into tax
net by Finance (No.2) Act, 2004 w.e.f. 10.09.2004. The rate of service tax w.e.f. 10.9.2004 is
10.2% inclusive of education cess.
17.7.6 Security Transaction Tax (STT) – In the Union Budget for 2004-05, Government has
introduced Securities Transaction Tax to be levied on all transactions done on stock
exchange. As per the provisions of the Finance Bill, the stock exchanges have been entrusted
with the responsibility of levy, collection and remittance of the STT on all transactions from the
date of notification by the Government of India. SEBI vide its Circular No.MRD/DOP/Cir-
28/2004 dated August 23, 2004 directed that no stock exchange shall permit trading activities
unless it implements necessary software and procedures for the levy collection and remittance
of STT.
17.7.7 Client Bills – Client Bills represents the summary of all trades executed on behalf of the
client during a particular settlement. It also reflects the net amount receivable or payable to
the Member from / to the client. This amount is normally posted to the individual ledger
account. The auditor may call for the bills for verification and check whether the same have
been properly posted to client’s ledger.
17.7.8 Clients Ledger – Every broker is required to maintain a clients’ ledger. This ledger
contains the details of the bills raised and the payment received from or made to the clients.
As mentioned earlier, Client Ledger is required to be maintained separately for different
Exchange or for different Trading Segment of the same Exchange. It may be noted that SEBI
Rules that payment is made to the client within 48 hours of pay-out by the Exchange. He
should further verify that the clients receipts / payments are made through designated “Client
Bank Account” of the Member. It may be mentioned here that payments not made or received
since a considerable period or the amount of payment made or received is consistently
different for bills raised over a period of time in respect of some clients. These may represent
some financial or accounting irregularity which would require further attention of the Auditor.
The auditor may also scrutinise the client ledger to identify accounts whether loans or deposits
received from a paid to the clients have been passed through this account. The client may
also obtain from member clients the letters confirming their balances at the end of the financial
year as appearing in his books of account on a test basis. Preferably, such letters of
confirmation should be sent to the clients directly by the auditor. The auditor should carry out
scrutiny of the accounts appearing in the Clients’ Ledger with a view to ascertain the age of
clients’ accounts and in case of old debit balances for determining provision for bad and
doubtful debts.
17.7.9 Settlement / Vallan Control Account – At the end of the settlement, Client Bills are
posted to Client Ledger account as mentioned above. At the same time the net amount
receivable from or payable to the Exchange, Clearing house is posted to the Settlement /
Vallan Control Account. The payment made to / received from Clearing House for a particular
settlement should match with the pay-in / pay-out entries. The auditor should verify that the
balance in this account after his settlement should ideally be nil and in case of any balance in
this account, the reconciliation statement from the member should be obtained.
17.7.10 Clearing House Bank Account – At the end of the settlement, the payment related to
the pay-in or pay-out is routed through the Clearing House account. This account normally
reflects the bank entries which are passed in the Clearing Bank account. The book balance in
this account should be reconciled with the balance in Clearing Bank account as per bank
statement.
17.7.11 Brokerage Account – At the end of the each settlement, brokerage income is credited
to brokerage account appearing in general ledger. The auditor should verify whether
brokerage is credited for each settlement or not, failing which the reasons thereof can be
inquired into. The brokerage amount should be periodically reconciled with the amount on
which the service tax has been paid as disclosed in service tax return. Since brokerage is the
main source of income for members of stock exchanges, the auditor should pay particular
attention to revenue recognition aspect. Brokerage income is recognised as income on the
basis of principles laid down in Accounting Standard (AS) 9, Revenue Recognition.
17.7.12 Margin Deposit Book – A member is required to maintain a margin deposit book
wherein details of all the margins deposited with the Clearing House are to be recorded. The
book should be verified to ascertain whether the member has complied with all the directives
regarding margins, etc. issued by SEBI or Stock Exchange from time to time. The margin
payments made by the member may be cross-checked with the daily margin statements
downloaded from the Stock Exchange.
The auditor should apply appropriate audit procedures to satisfy himself that margins have
been properly calculated, collected and paid. The auditor should examine that margin deposit
lying with the Clearing House are supported by the confirmation. The auditor should verify
whether adjustment entries relating to settlement margin and daily margin which is adjusted at
the time of settlement are correctly passed or not. The auditor should also ensure that
exemptions from payment of margins of Institutional Trades has been claimed correctly.
17.7.13 Members’ Own Trading Account – Many a times, member of the Exchange executes
the trade on his own behalf. In such cases, the entry related to trades are passed in the same
way as it is done for a client. Members own trading account normally appears in general
ledger. The auditor should verify the entries appearing in this account with respect to the bills
raised for own account trading. The balance appearing in this account should be identified
into profit or loss or closing stock-in- hand, as the case may be.
17.7.14 Bank Book – A member of a Stock Exchange is required to maintain separate bank
account for the client’s money and their own money. No payment for a transaction in which
the member has traded on his own account shall be made from clients account. No money
can be paid into clients account other than -
1. Money held or received on account of clients.
2. Money for replacement for any sum which may by mistake or accident drawn from the
account.
3. A cheque or draft received from a client.
No money can be paid from client’s account other than -
1. The money required for payment to the Clearing Corporation / House on behalf of clients.
2. Money for replacement for any sum which may by mistake or accident deposited into
client account.
The auditor should verify the bank reconciliation statement for all the bank accounts in the
usual manner.
17.7.15 Documents Register (Inward / Outward Register) – This register contains the
particulars of the securities including their distinctive numbers received from or delivered to
clients in a physical form by a member. This is a primary record, which lists and identifies
every security available with the member at any given time. Generally, it is observed that
members maintain a ledger, which contains only the number received, delivered and balance.
This ledger does not provide for the distinctive numbers of the scripts received from or
delivered to the clients. It may be mentioned that if distinctive numbers are not recorded
properly then the identification of introducer cannot be established.
While scrutinizing this register, the auditor should analyse the balances of stock appearing in
this register and segregate the same into client stock and own stock. The auditor should
inquire the reasons for client’s stock remaining with the Member. Further, the auditor may
also, on a random basis, physically verify the stock available with a member in certain scrips,
if so, desired.
17.7.16 Maintenance of Books of Accounts and Other Documents – In terms of Rules 14
and 15 of Securities Contracts (Regulation) Rules, 1957, every recognized stock exchange
and its members are required to maintain and preserve the specified books of account and
documents for a period from two years to five years. Further, as per regulation 18 of SEBI
(Stock Brokers & Sub-Brokers) Regulation, 1992, every stock broker shall preserve the
specified books of account and other records for a minimum period of five years.
17.7.17 Dematerialized Securities – On account of compulsory dematerialisation of most of
the securities listed on the Exchange, All stock brokers are required to maintain two accounts
with their Depository Participants (DP) for handling the receipt and delivery of securities in
demat. One account is ‘Beneficiary Account’ wherein the demat securities belonging to the
members’ for their own account are held and the other is ‘Pool Account’ wherein the demat
securities of the clients are temporarily lodged for transfer to/from the Clients / Clearing House
in the Pay-in/Pay-out. In case of sale of securities by clients, the clients transfer the same in
the demat form to the member’s Pool Account to the Clearing House on the Pay-in day. In
case of purchase of securities by the Client, the Clearing House transfer the securities to the
Pool Accounts of the members and the members then transfer the same to the accounts of
individual clients. The members are required to maintain a proper record of all shares
received and delivered from their Pool Account as well as preserve acknowledged copy of the
delivery instructions given to their DP’s for transferring the securities from the Pool Account to
the Clients’ account after the Pay-out.
The auditor should verify whether the securities received by the member in the Pool Account
are regularly transferred to the buying clients’ Demat Accounts within 48 hours of declaration
of Pay-out of the relevant settlement of the Exchange. It may be noted that Sometimes, the
clients instruct the brokers to retain the shares in the Pool Account either because they have
not opened a demat account or because they intend to sell the shares they have bought
earlier, in the subsequent settlement and thereby avoid transaction charges. The auditor
should check that the shares lying in the Pool Account have not been utilized by the member
to meet his own pay-in obligations or used for meeting auction obligations. If the auditor
discovers someth9ing like this then, he should further enquire into the matter. Such instances
might indicate the breach of fiduciary trust by the member of the stock exchange.
Depending upon the nature of the business carried on by the member, the auditor may apply
such procedural tests as he considers necessary on major items of income and expense such
as, commission, sub-brokerage, underwriting income, interest and dividends, advisory fees,
interest, amounts payable towards transactions charges and other charges to the Exchange or
Clearing House and other income and expenses.
The auditor should apply analytical procedures on the financial statements of the member.
The auditor should compare current operating results with those of the prior period to
ascertain that the variations are logical in the circumstances such as volume of business at
the stock-exchanges, the brokerage concern’s share of the market, changed business
conditions such as volume of new securities issued, changes in the character of the business
of the brokerage concern, and trend prices of securities. A discussion of this comparative
data with the officials of the member may highlight areas where added audit emphasis may
be directed.
Auditor’s Report
17.8 The letter of the Government dated 31st May, 1984 requires that the auditor should
submit his report in the following form:
“We have audited the attached balance sheet of M/s. ABC as at _________ and the
profit and loss account for the year ended on that date annexed thereto and report that:
We have obtained all the information and explanations which to the best of our
knowledge and belief were necessary for the purpose of our audit.
In our opinion, proper books of account and records as specified in Rule 15 of the
Securities Contracts (Regulation) Rules, 1957 have been kept so far as appears from
our examination of such books.
The stock broker has complied with the requirements of the stock exchange so far as
they relate to maintenance of accounts and was regular in submitting the required
accounting information to the stock exchange.
The balance sheet and the profit and loss account referred to in this report are in
agreement with the books of account.
In our opinion and to the best of our information and according to the explanations given
to us, the said balance sheet and the profit and loss account read together with the
notes thereon give a true and fair view insofar as it relates to the balance sheet, of the
state of affairs of M/s. ABC, and insofar as it relates to profit and loss account, of the
profit of M/s. ABC for the year ended on that date.”
According to clause (c) of the form of audit report prescribed by the Government, the auditor is
required to report whether the member of the stock exchange had complied with the
requirements of the stock exchange insofar as they relate to maintenance of accounts and that
he was regular in submitting the required accounting information to the stock exchange. The
auditor is therefore required to acquaint himself with the said requirements of the stock and /
or the Ministry of Finance shall have a right to obtain a copy of the profit and exchange, if
any.
The aforesaid Notification further requires that the audit should be completed within 6 months
of the date of closing of the books of account. In individual cases, an extension for a period
not exceeding 3 months may be granted by the concerned Executive Director / Secretary of
the Stock Exchange if he is satisfied that adequate reasons exist for granting such an
extension. The audit report should be made out in triplicate and addressed to the member of
the Stock Exchange, who should submit quarterly, one of the copies of all audit reports
received during the quarter to the Ministry of Finance within one month of the end of the
quarter.
The audit reports to be submitted to the aforesaid authorities need not be accompanied by
copies of the relevant profit and loss account and balance sheet. However, the said stock
exchange authorities loss account and / or the balance sheet wherever they consider
necessary.
It may be noted that in cases where the member is a company registered under the
Companies Act, 1956 the reporting consideration that apply to other companies shall also
apply to the member company. For example the audit would have to necessarily make the
assertions given in sub-section (2) and (3) of section 227 of the Companies Act, 1956.
Audit of Mutual Funds

17.9 SEBI (Mutual Funds) Regulations, 1996 provide that every mutual fund shall have the
annual statement of accounts audited by an auditor who is not in any way associated with the
auditor of the asset management company. An auditor is a person who is qualified to act as
an auditor within the meaning of section 224 of the Companies Act, 1956. The auditor shall be
appointed by trustees. The auditor shall forward his report to the trustees and such report
shall form part of the Annual Report of the mutual fund.
17.9.1 Proper Books of Account – The Regulations require that every asset management
company for each scheme shall keep and maintain proper books of account, records and
documents, for each scheme so as to explain its transactions and to disclose at any point of
time the financial position of each scheme and in particular give a true and fair view of the
state of affairs of the fund and intimate to the Board the place where such books of account,
records and documents are maintained. Every asset management company shall maintain
and preserve for a period of 8 years its books of account, records and documents. The asset
management company shall follow the accounting policies and standards as specified in Ninth
Schedule so as to provide appropriate details of the scheme wise disposition of the assets of
the fund at the relevant accounting date and the performance during that period together with
information regarding distribution or accumulation of income accruing to the unit holder in a

fair and true manner.
17.9.2 Audit Report – The auditor’s report shall comprise the following:
(i) he has obtained all information explanations which, to the best of his knowledge and
belief, were necessary for the purpose of the audit;
(ii) the balance sheet and the revenue account give a fair and true view of the scheme, state
of affairs and surplus or deficit in the Fund for the accounting period to which the Balance
Sheet or, as the case may be, the Revenue Account relates;
(iii) the statement of account has been prepared in accordance with accounting policies and
standards as specified in the Ninth Schedule.
17.9.3 Inspection and Audit – The SEBI has a right to conduct inspection and audit the books
of account as per Regulation. The SEBI may appoint one or more persons as inspecting
officer to undertake the inspection of the books of account, records, documents and
infrastructure, systems and procedures or to investigate the affairs of a mutual fund, the
trustees and asset management company for any of the following purposes, namely:
(a) to ensure that the books of account are being maintained by the mutual fund, the trustees
and asset management company in the manner specified in these regulations;
(b) to ascertain whether the provisions of the Act and these regulations are being complied
with by the mutual fund, the trustees and asset management company;
(c) to ascertain whether the systems, procedures and safeguards followed by the mutual
fund are adequate;
(d) to ascertain whether the provisions of the Act or any rules or regulations made
thereunder have been violated;
(e) to investigate into the complaints received from the investors or any other person on any
matter having a bearing on the activities of the mutual funds, trustees and asset
management company;
(f) to suo motu ensure that the affairs of the mutual fund, trustees or asset management
company are being conducted in a manner which is in the interest of the investors or the
securities market.
The SEBI has also the power in addition to normal audit, to appoint an auditor to inspect or
investigate, as the case may be, into the books of account or the affairs of the mutual fund,
trustee or asset management company:
Provided that the Auditor so appointed shall have the same powers of the inspecting officer as
stated in regulation 61 and the obligation of the mutual fund, asset management company,
trustee, and their respective employees in regulation 63, shall be applicable to the
investigation under this regulation.
17.9.4 Ninth Schedule – As per Regulations 50(3), 55(4)(iii) to Securities and Exchange
Board of India (Mutual Funds) Regulations, 1996, ninth schedule is reproduced below:
Accounting Policies and Standards

a. For the purposes of the financial statements, mutual funds shall mark all investments to
market and carry investments in the balance sheet at market value. However, since the
unrealised gain arising out of appreciation on investments cannot be distributed, provision has
to be made for exclusion of this item when arriving at distributable income.
b. Dividend income earned by a scheme should be recognised, not on the date the dividend
is declared, but on the date the share is quoted on an ex-dividend basis. For investments
which are not quoted on the stock exchange, dividend income must be recognised on the date
of declaration.
c. In respect of all interest-bearing investments, income must be accrued on a day to day
basis as it is earned. Therefore, when such investments are purchased, interest paid for the
period from the last interest due date upto the date of purchase must not be treated as a cost
of purchase but must be debited to Interest Recoverable Account. Similarly interest received
at the time of sale for the period from the last interest due date upto the date of sale must not
be treated as an addition to sale value but must be credited to Interest Recoverable Account.
d. In determining the holding cost of investments and the gains or loss on sale of
investments, the “average cost” method must be followed.
e. Transactions for purchase or sale of investments should be recognised as of the trade
date and not as of the settlement date, so that the effect of all investments traded during a
financial year are recorded and reflected in the financial statements for that year. Where
investment transactions take place outside the stock market, for example, acquisitions
through private placement or purchases or sales through private treaty, the transaction
should be recorded in the event of a purchase, as of the date on which the scheme obtains in
enforceable obligation to pay the price or, in the event of a sale, when the scheme obtains an
enforceable right to collect the proceeds of sale or an enforceable obligation to deliver the
instruments sold.
f. Bonus shares to which the scheme become entitled should be recognised only when the
original shares on which the bonus entitlement accrues are traded on the stock exchange on
an ex-bonus basis. Similarly, rights entitlements should be recognised only when the
original; shares on which the right entitlement accrues are traded on the stock exchange on
an ex-rights basis.
g. Where income receivable on investments has been accrued and has not been received
for a period of 12 months beyond the due date, provision should be made by debit to the
revenue account for the income so accrued and no further accrual of income should be made
in respect of such investment.
h. When in the case of an open-ended scheme units are sold, the difference between the
sale price and the face value of the unit, if positive, should be credited to reserves and if
negative be debited to reserves, the face value being credited to Capital Account. Similarly,
when in respect of such a scheme, units are repurchased, the difference between the
purchase price and face value of the unit, if positive should be debited to reserves and, if
negative, should be credited to reserves, the face value being debited to the capital account.
i. In the case of an open-ended scheme, when units are sold and appropriate part of the
sale proceeds should be credited to an Equalisation Account and when units are repurchased
an appropriate amount should be debited to Equalisation Account. The net balance on this
account should be credited or debited to the Revenue Account. The balance on the
Equalisation Account debited or credited to the Revenue Account should not decrease or
increase the net income of the fund but is only an adjustment to the distributable surplus. It
should, therefore, be reflected in the Revenue Account only after the net income of the fund is
determined.
j. In a close-ended scheme which provide to the unit holders the option for an early
redemption or repurchase their own units, the par value of the unit has to be to Capital
Account and the difference between the purchase price and the par value, if positive, should
be to reserves. A proportionate part of the unamortised initial issue expenses should also be
transferred to the reserves so that the balance carried forward on that account is proportional
to the number of units remaining outstanding.
k. The cost of investments acquired or purchased should include brokerage, stamp charges
and any charge customarily included in the broker’s brought note. In respect of privately
placed debt instruments any front-end discount offered should be reduced from the cost of the
investment.
l. Underwriting commission should be recognised as revenue only when there is no
devolvement on the scheme. Where there is devolvement on the scheme, the full underwriting
commission received and not merely the portion applicable to the devolvement should be
reduced from the cost of the investment.
Audit of Depositories
17.10 The SEBI (Depositories and Participants) Regulations, 1996 empower SEBI to conduct
inspection and audit. The regulation requires that depositories shall have adequate
mechanisms for the purposes of reviewing monitoring and evaluating the depository’s controls
systems, procedures and safeguards. Depositories are required to maintain the following
records and documents, namely:
(a) records of securities dematerialised and rematerialised;
(b) the names of the transferor, transferee, and the dates of transfer of securities;
(c) a register and an index of beneficial owners;
(d) details of the holding of the securities of beneficial owners as at end of each year.
(e) records of instructions received from and sent to participants, issuers, issuers’ agents
and beneficial owners;
(f) records of approval, notice, entry and cancellation or pledge or hypothecation, as the
case may be;
(g) details of participants;
(h) details of securities declared to be eligible for dematerialisation in the depository; and
(i) such other records as may be specified by the Board for carrying on the activities as a
depository.
Every depository shall intimate the Board the place where the records and documents are
maintained. Subject to the provisions of any other law the depository shall preserve records
and documents for a minimum period of five years.
Where records are kept electronically by the depository, it shall ensure that the integrity of the
automatic data processing systems is maintained at all times and take all precautions
necessary to ensure that the records are not lost, destroyed or tampered with and in the event
of loss or destruction, ensure that sufficient back up of records is available at all times at a
different place.
The SEBI has also the power to appoint one or more persons as inspecting officer to
undertake inspection of the books of account, records, documents and infrastructure, systems
and procedures, or to investigate the affairs of a depository, a participant, a beneficial owner
an issuer or its agent for any of the following purposes, namely:
(a) to ensure that the books of account are being maintained by the depository, participant,
issuer or its agent in the manner specified in these regulations;
(b) to look into the complaints received from the depositories, participants, issuers, issuers’
agents, beneficial owners or any other person;
(c) to ascertain whether the provisions of the Act, the Depositories, the bye-laws,
agreements and these regulations are being complied with by the depository, participant,
beneficial owners, issuer or its agent;
(d) to ascertain whether the systems, procedures and safeguards being followed by a
depository, participant, beneficial owners, issuer or its agent are adequate;
(e) to suo motu ensure that the affairs of a depository, participant, beneficial owner, issuer or
its agent, are being conducted in a manner which are in the interest of the investors or
the securities market.
Further the SEBI has power to appoint an auditor to inspect or investigate, into the books of
account, records, documents, infrastructures, systems and procedures or affairs of a
depository, a participant, a beneficial owner, an issuer or its agent:
Provided that the auditor so appointed shall have the same powers of the inspecting or
investigating officer as stated in regulations 59 and 60, and the obligation of the depository,
participant, beneficial owner, issuer or its agent and their respective directors, officers and
employees, as the case may be, as stated in regulation 61, shall be applicable to the
inspection or investigation under this regulation.
Certification Pursuant to Companies ( Acceptance Of Deposit ) Rules, 1975

17.11 Rule 10(1) of the Companies (Acceptance of Deposits) Rules, 1975 requires, every
company to which these rules apply shall, on or before the 30th day of June of every year, file
with the Registrar, a return in the form annexed to these rules and furnishing the information
contained therein as on 31st day of March of that year, duly certified by the auditor of the
Company. It follows, therefore, that every company to which these rules apply shall prepare
the return as on 31st March of every year, shall get the return certified by the concerned
auditor and shall submit the audited return to the Registrar of Companies by 30th June.
It may be observed that neither the amended Rule 10 of the Companies (Acceptance of
Deposits) Rules, 1975 nor the form of return prescribed thereunder provides the manner in
which the auditor should certify the return. Even in the form of return, no space has been
provided for auditors' certificate. Consequently, no statutory guidance is available to the
auditor as regards the scope, manner and limitations inherent in this requirement of
certification.
There are inherent practical problems involved in this certification. Having regard to the
problems, the Company Law Committee of the Institute has decided to issue this Guidance
Note for aiding the members in correctly understanding the implications involved and for
securing uniformity in approach.
The problems associated with this work of certification include the following:
Accounting year ending of companies in large number of cases may not coincide with the date
prescribed for making the return i.e., 31st March. As a result the following situations may
arise:
(a) A part of the accounting data of some of the companies, relating to deposits underlying
the balances included in the return of deposit is bound to remain unchecked during the
normal cycle of statutory audit.
(b) Similarly, companies whose year-end after 31st March will invariably have data to be
included in the Return of Deposit covered by the checking of two successive statutory
audits, which may not necessarily be by the same auditor.
(c) There may also occur a change in the auditors during the reporting period, i.e., between
April and June. It is possible in such a case that the retiring auditors hold office for a part
of this period and the new auditors hold office for the remaining part.
The following can be considered as satisfactory approach in the circumstances enumerated
above.
(a) The auditor, if the period of his office has not come to an end by the time he certifies the
return or he is re-appointed, should carry out the necessary checking of the transactions
falling beyond the period covered by statutory audits so as to satisfy himself about the
accuracy of the figures, set against various items in the return and the information, if any,
contained in the return. If, however, the auditor in view of the volume of transactions in
the balance period, is unable to carry out a complete audit for the balance period, he may
qualify and indicate the extent of checking done for the balance period. In any case, the
auditor who certifies the return should ensure that any residual period not already audited
is covered by necessary checking.
(b) Where the auditor is faced with a situation that part of the period covered by the return
under certification has been statutorily audited by a different auditor, he is in the normal
course entitled to rely on the work performed by such auditor as is related to his work in
connection with the certification. It may also be pointed out that this principle has been
explicitly accepted by the Institute of Chartered Accountants of India in Clause (2) of Part
I of the Second Schedule to the Chartered Accountants Act, 1949. However, it would be
desirable that the auditor makes a mention of the fact that part of the data underlying the
figures in the return have been audited by other auditor and he has relied on such work.
In making this mention, the period covered by the audit of the other auditor should also
be mentioned. However, if there are circumstances to suggest that the work of the
previous auditor may require a review before being relied upon, it would be safer to do
the review before deciding whether to place reliance on such work or not. It is
emphasised that the need for a review would not in the normal course arise; it is,
however, possible that in course of audit of the accounts of the current year, matters may
come to the notice of the auditor to warrant a need for review.
(c) In the natural course it is expected that the outgoing auditor will do the certification if he
has covered longer part of the period for which the return is made. In case, for any
reason, the outgoing auditor is not able to undertake this certification, the incoming
auditor will certify the return in accordance with the procedure referred to earlier.
In terms of Rule 10(1) the auditor is to certify the deposit return. The deposit return is also
required to be certified by the Manager of the Company pursuant to the form of return as
annexed to the Companies (Acceptance of Deposits) Rules. The Manager has to verify and
certify the figures of deposits, liquid assets and interest rates under Parts A, B, and C of the
Return form as correctly prepared. In addition, he is to certify the aggregate of the paid-up
capital and free reserves, etc., as arrived at on the lines indicated in explanation to Rule 3 of
the Rules. It is open to debate whether the certificate of the Manager on paid-up capital and
free reserves referred to above requires a further certification by the auditor. Rule 10(1)
requires the return together with the information contained therein to be duly certified by the
auditor of the company. The Manager’s certificate on paid-up capital and free reserves
constitutes information contained in the return and accordingly this requires to be covered by
the certificate of the auditor.
The auditor in drafting the certificate should make clear what he is certifying. The Institute
does not approve the issue of a bald certificate such as “Examined and found correct.” Two
suggested certificates-an unqualified one and the other a qualified one, are given hereunder
for the guidance of the members:
(i) “We have examined the books of account and other records maintained by
……………………….. Company Ltd. in respect of the particulars furnished in the Return of
Deposits as on 31st March, 19____ and certify that to the best of our knowledge and
according to the information and explanations given to us and as shown by the records
examined by us, the figures of deposits and interest rates under Parts A, B, and C of the
Return are correct.
We further certify the correctness of the particulars of the paid-up capital and free reserves,
etc., given in the Manager’s Certificate.
Place :
Date: Chartered Accountants”
(ii) “We have verified the figures of deposits and interest recorded in the annexed Return of
Deposits of ………. as at 31st March, 19_____ with the register maintained by the Company in
accordance with the Companies (Acceptance of Deposits) Rules, 1975 and certify that to the
best of our knowledge and according to the information and explanation given to us and as
shown by the record shown to us, the annexed Return has been correctly prepared, except
that deposits from employees aggregating to Rs._______ have not been treated by the
Company as Deposits, for the purpose of this Return but instead indicated in the Return
separately in brackets against the respective items of ‘Deposits’.
We further certify the correctness of the particulars of the paid-up capital and free reserves,
etc., given in the Manager's Certificate.
Place:
Date: Chartered Accountants”
If the auditor has any reservation about the figures stated in the return either due to any error
or on account of a particular interpretation being followed by the company in treating items,
say as deposits or exempt deposits or otherwise, to which he does not subscribe, he should
include a suitable qualification in the Certificate.
The auditor should avoid statements like ‘ reliance having been placed on certain documents
or representation of the management’ as this type of statements are superfluous and may
cause confusion.
Environmental Auditing
17.12 Environmental reporting is the term now commonly used to describe the disclosure by
an entity of environmentally related data, verified (audited) or not, regarding environmental
risks, environmental impacts, policies, strategies, targets, costs, liabilities or environmental
performance to those who have an interest in such information as an aid to enabling/enriching
their relationship with the reporting entity) via either
(a) the annual report and accounts package;
(b) a stand-alone corporate environmental performance report (CER);
(c) a site-centered environmental statement; or
(d) some other medium (e.g. staff newsletter, video, CD ROM, internet site)
Environmental audits are becoming increasingly common in certain industries. The term
“environmental audit” has a wide variety of meanings. They can be performed by external or
internal experts (sometimes including internal auditors), at the discretion of the entity’s
management. In practice, persons from various disciplines can qualify to perform
“environmental audits”. Often the work is performed by a multi-disciplinary team. Normally,

“environmental audits” are performed at the request of management and are for internal use.
In Indian scenario, the Regulatory Authorities like Ministry of Environment and Forest (MOEF),
State Pollution Control Board (SPCB), State Department of Environment (SDOEn.) etc., have
come into play to clear the projects from environmental viewpoint before it’s commissioning.
The environmental Impact Assessment (EAI) is a pre-requisite to start an industry. The EAI
tries to forecast the expected damage to be caused by the development of the industries to
the environmental and the means required to mitigate that damage, incorporating the same in
the Project Report for compliance in due course, keeping in view the serious threat to all the
living beings in the universe by the rapid industrialsation which is polluting the environmental
on an irreparable extent. The Indian Govt. notified by GSR No.329E dated 13.02.1992 that
“Every person carrying on an industry, operation or process requiring consent under Section
25 of the Water (Prevention and Control of Pollution) Act, 1974 (6 of 1974) or under Section
21 of the Air (Prevention and Control of Pollution) Act, 1981 (4 of 1981) or both or
authorisation under the Hazardous Waste (Management and Handling) Rules, 1989 issued
under Environment Protection Act, 1986 (29 of 1986) shall submit an environment audit report
for the financial year ending the 31st march in form V to the concerned State Pollution Control
Board on or before the 15th day of May every year, beginning 1993”.
With a view to define the Environmental Audit, it may be stressed that it is a critical analysis
of (I) policies (ii) principles (iii) systems (iv) procedures (v) practices and (vi) performances of
the aspect which relates the environment.
But a standard scope of Environmental Audit, as ought to be defined and adopted by
standard companies, should be as follows:
“A management tool comprising a systematic, documented, periodic and objective evaluation
of how well environmental organisation, management and equipment are performing with the
aim of helping to safeguard the environment by:
(i) Facilitating management control of environmental Process.
(ii) Assessing compliance with company policies, which would include meeting regulatory
requirements”.
The objective of the Environmental Audit are to evaluate the efficacy of the utilisation of
resources of man, machines and materials, and to identify the areas of environmental risks
and liabilities and weakness(es) of management system and problems in compliance of the
directives of the regulatory agencies and control the generation of pollutants and/or waste.
As the Environmental Audit, especially in India, is still in it’s infancy the information usually
gathered in the course of Environmental Audit is only what is required for the compliance of
the statutory requirements, i.e., for Water Act, 1974, Air Act, 1981, etc., and for environmental
clearance required before establishing an industry.
If it is to enumerate, what should be the main areas over which the Environmental Audit
should be dealt, the following aspects are to be considered in respect of various industrial
units.
(i) Layout and Design – The layout to be sketched in the style which will allow adequate
provisions for installing pollution control devices, as well as provision for upgradation of
pollution control measures and the meeting of the requirements of the regulations framed
by the Government. In the course of the audit, the areas which requires attention but not
attended to by the industry to be pinpointed as well as the future requirements of the
environmental measures required in commensuration with the proposed future course of
working plan are to be identified.
(ii) Management of Resources – Management resources include air, water, land, energy,
raw materials and human resources besides others. The use of all resources are
interlinked and the best uses in a synchronised manner results the best output and
minimum waste. The waste of resources to the minimum possible extent is good for the
health of the industry as well as the environment.
(iii) Pollution Control System – An effective system of pollution control should be in
existence. One aspect should be whether all required pollution control measures are in
vogue or not next aspect should be whether the same is effective or not, further it is to
investigate, whether more measures are required, keeping ill view the type of industry
and it’s nature of working with respect to it’s grade of polluting the environment.
(iv) Emergent Safety Arrangement – The chemical, gas, etc., industries which are prone to
sudden requirement of safety arrangements, must remain alert all the while. The
emergency plans are to be reviewed periodically, sufficient staff along with other required
safety amenities should be kept ready. The staff, remained so engaged, must possess
the required awareness and alertness to meet the contingency. The degree of
awareness, however, can be upgraded with proper training provisions.
(v) Medical & Healthcare Facilities – The medical services should be maintained. The
health of the workers should be a big consideration for the management.
(vi) Industrial Hygiene – Proper system should be in vogue to eliminate industrial
unhygienic state.
(vii) Occupational Health – The requirement for safeguarding against occupational health
hazards should be available for all the workers. As the occupational health hazards
varies from industry to industry due to the difference in the nature of working atmosphere
and the pollutants present in it, the concerned industry must pay proper weightage to
those diseases which are prone to that particular type of industry.
(viii) Information Assimilation and Reporting System – The information system should be
strengthened to generate and its reporting system should be proper, keeping in view, the
authorities, responsibilities and subsequent delegations. A report of compliance of all
statutory environmental laws along with other preventive and precautionary measures
should be put to Board at regular intervals.
(ix) EIA Methodology – The Environmental Impact Assessment (EIA) is usually are pre-
requisites to start an industry. This is done considering the known spheres of activities
on the existing environmental conditions. But the predictions necessarily deviate from
the actual happenings when the industry starts working. To accommodate the deviation
in the system is also to be incorporated in the EIA report, if it is noticed that the
degradation to the environment caused on the establishment and running of the industry
is much higher than what was predicted, the mitigatory measures suggested must also
be furthered.
(x) Compliance to the Regulatory Mechanism – As the persons who are directly working
with the system, may be unaware of the latest developments and requirements for the
compliance of stipulations and standards prescribed by the various regulatory authorities,
they should be trained and instructed on regular basis, to avoid making the Board/owner
vulnerable to prosecution and penalty.
(xi) Concern for the Society – The industry very often transform the agrarian environment
into an industrial environment. The people so displaced by industrialisation feel
alienated and develop a feeling of facing the gaseous, dustful, clumsy state of
surroundings. The audit should look into this aspect how the industry is making a
balance between its own development and the society’s concern.
17.12.1 Audit Procedure - The small or medium unit does not call for an elaborate and/or
formal system, but somebody is to be given charge to look after the matter. But when the
concern is a big one, it needs a well planned system.
The audit is to be conducted at regular interval, and internal audit system should also be
supplemented to review the efficiency, effectiveness and to identify the training requirements
of the audit staff.
17.12.2 Audit Format - The following are the main aspects which may be covered in the
probable format of “Environmental Statement”.
(a) Name and address of the owner/occupier of the industry, operation or process.
(b) Date of last environmental audit report submitted.
(c) Consumption of water and other raw materials as input during current and previous year.
(d) Pollution generated in air and water along with the output and the types of pollutants and
the deviation from standard.
(e) Generation of hazardous waste (in line with the Hazardous Waste Management and
Handling Rules, 1989) in current year and previous year from processes or from pollution
control facility.
(f) Quantity of sold waste generated during current year and previous year from process/es
from pollution control facility and from recycling or reutilisation of waste, etc.
(g) The disposal practice for different type of waste.
(h) The practice sorted for conservation of natural resources.
(i) The additional investment proposal for environmental protection including abatement of
pollution.
Energy Audit
17.13 Energy shortage and the cost of environmental quality control have made the use of
energy very costly to many industrial establishments. As a result, many factories have opted
for establishing energy management programmes to cope with severe energy shortages and
for improving the profitability of their operations. Energy management involves the following
basis approaches:
(i) Reducing avoidable losses,
(ii) Improving the effectiveness of energy use, and
(iii) Increasing energy use efficiency
No matter what approach is taken, the steps to be followed are general in nature, e.g.,
conduct energy audits, implement the energy conservation measures, carry out post
installation monitoring and set targets, etc.
Energy auditing is defined as an activity that serves the purposes of assessing energy use
pattern of a factory or energy consuming equipment and identifying energy saving
opportunities. It is the first step of any energy management programmes. The function of an
energy auditor could be compared with that of a financial auditor. At the moment, while
energy auditor is not yet a mandatory requirement on an all-India basis, the financial auditor is
a pre-requisite for any organisation. Another key distinction is that the energy auditor is
normally expected to give recommendations on efficiency improvements leading to monetary
benefits and also advise on energy management issues. Generally, energy auditor for the
industry is an external party. The following are some of the key functions of the energy
auditor:
(i) Quantify energy costs and quantities
(ii) Correlate trends of production or activity to energy costs
(iii) Devise energy database formats to ensure they depict the correct picture – by product,
department, consumer, etc.
(iv) Advise and check the compliance of the organisation for policy and regulation aspects.
(v) Highlight areas that need attention for detailed investigations.
(vi) Conduct preliminary and detailed energy audits which should include the following:
(a) Data collection and analysis
(b) Measurements, mass and energy balances
(c) Reviewing energy procurement practices
(d) Identification of energy efficiency projects and techno-economic evaluation
(e) Establishing action plan including energy saving targets, staffing requirements,
implementation time requirements, procurement issues, details and cost estimates.
(f) Recommendations on goal setting for energy saving, record keeping, reporting and
energy accounting, organisation requirements, communications and public
relations.
Energy efficiency is achieved through company-wide activities involving administration,

purchase, design, engineering, production and maintenance management functions. Since it
is an inter-disciplinary activity, energy efficiency must be supported not only by technical
division but all other divisions as well. Therefore, in industries where energy cost is
substantial or widely dispersed across the plant campus, it has been the experience of some
large companies to set up internal energy audit teams. One of the effective ways of setting up
an internal energy audit team is to have representation from the various sections with rotating
membership and with atleast one team member from the area being audited. The eyes of a
stranger very often see things which familiarity has made common place and invisible to the
user of the area. To be truly effective, these audits must be made not only during normal
working hours hut also during night shifts, weekends and holidays.
17.13.1 Approach to Energy Auditing – The starting point for energy analysis of a factory
would be to assess its past performance. The energy manager should first establish the
energy efficiency indicator of the factory. To obtain this, the simplest approach is to consider
the overall factory as a “black box” and identify the different forms of energies going into the
boundary and the products leaving it over a given time period. Thus the evolution in the
consumption of these energy inputs and the production rate can be derived. From these, the
variation in the specific energy consumption (energy consumed per unit production) with time
and production rate can be established. These figures can be compared with the average
values or those pertaining to the best practices for similar industries in order to assess the
comparative performance of the plant. It is found that there is indeed any scope for reduction
in the specific energy consumption, one has to perform preliminary and/or detailed energy
audit for analysing the different utility areas where these energies are to be converted into the
final forms required by the production processes. The different phases of energy auditing in
an industry are given below. All three phases can be included in a single audit or they can be
conducted separately, depending on the size of the factory or facility under investigation.
(i) Analysis of historical energy consumption and cost data.
(ii) Preliminary energy audit, with the objectives to identify:
- Major energy consuming equipment and processes
- Obvious inefficiencies and energy wastes
- Priority areas for further detailed investigation
(iii) Detailed technical and economic analyses of energy efficiency measures, especially
those involving large capital investment or long payback periods.
Audit of Accounts of Non-Corporate Entities (Bank Borrowers)

17.14 The Reserve Bank of India (RBI), keeping in view the need for bringing discipline in the
matter of maintenance of accounts by non-corporate entities, have recently issued a circular
dated 12th April, 1985 to all Banks recommending audit of accounts of all non-corporate
borrowers enjoying working capital limits of Rs. 10 lacs (now raised to Rs.25 lacs) and above
from the banking system.
For the purpose of computing the above limit of Rs. 10 lacs, the term borrowing will include
borrowing of the following types:
(i) Packing credit facilities
(ii) Cash credit facilities
(iii) Loans-secured and unsecured
(iv) Overdraft
(v) Deferred payment facilities
(vi) Guarantees:
(a) Performance guarantees
(b) Financial guarantees
(vii) Bill Discounting Facilities
(viii) Any other credit facilities (other than loans, guarantees, letter of credit etc.).
This requirement applied in respect of the accounting year of the non-corporate entity
commencing on or after 1-4-1984. It is necessary for the non-corporate entity enjoying such
credit facility to submit the audited statements and audit report to the concerned bank as early
as possible but in any case not later than 6 months from the close of the accounting year. The
primary responsibility for maintenance of books of accounts and records is that of the non-
corporate entity.
17.14.1 Audit Procedure -
(i) The auditor is required to express his opinion as to whether the financial statements give
a true and fair view of the state of affairs of the entity. For this purpose the auditor has to
use his professional skill and expertise and apply such audit tests as the circumstances
of the case may require. Considering the contents of the audit report the auditor has to
conduct the audit by applying the same principles which are applicable for an audit in the
corporate sector. The audit report is to be given to the lending bank and therefore such
report will be in the nature of a special purpose report
(ii) If he finds that there is no internal control, it would not be advisable for him to conduct
the audit by applying test checks. The auditor will also have to keep in mind the concept
of materiality depending upon the circumstances of each case.
(iii) Section 227 of the Companies Act gives certain powers to the auditors to call for the
books of account, information, documents, explanations, etc. and to have access to all
books and records. In the case of audit of a non-corporate entity, it would be in the
interest of the entity to furnish all the information and explanations and produce books of
accounts and records required by the auditor. If, however, the entity refuses to produce
any particular record or to give any specific information or explanation the auditor would
be required to report the same and qualify his report.
(iv) The non-corporate entity is free to choose any practising Chartered Accountant to
conduct this audit. In the event of any such change it is necessary for the incoming
auditor to communicate with the outgoing auditor as explained in the Institute’s
publication “Code of Ethics”. He should also ensure that he does not resort to
undercutting while accepting any such assignment.
(v) As already noted, the primary responsibility for maintenance of books of account and
records and that for preparation of financial statements is of the non-corporate entity.
The auditor should obtain the letter of engagement and list of books of account and other
records maintained by the entity before undertaking the audit assignment.
(vi) Non-corporate entities are, in certain cases, evidenced by documents/agreements, such
as, partnership deed, deed of association, trust deed etc. It would be necessary for the
auditor to check the compliance with the terms of documents, agreements, so far as they
relate to accounts and audits and to report all material violations of such terms.
(vii) The figures of the immediately preceding year should be given in a manner so as to
enable meaningful comparison. If the accounts of such preceding year are not audited,
the fact should be indicated by way of a note and also reported by the auditor.
(viii) The audited accounts should clearly disclose the results of the working of the entity for
the year, every material feature, transactions of an exceptional and non-recurring nature
and also transactions pertaining to earlier years, if material. The said accounts should
be prepared in conformity with the generally accepted accounting principles followed
consistently. Any deviation, if material, either from the accepted principles or from the
policy/treatment followed in the preceding year should be clearly brought out in the notes
and/or the Auditors’ Report.
(ix) The overall consideration should be that the financial statements so prepared should give
a true and fair view of the working of the entity. Moreover, these statements should also
assist the lending bankers in their evaluation of the loan proposals and in ensuring strict
financial discipline, coupled with uniformity, in the existing as well as prospective
customers.
17.14.2 Special Audit Report – A lending bank may, in special cases, require the non-
corporate entity to obtain a special report from the auditor. Such a report can be called by a
lending bank if it finds that it is necessary to have more information about the working of the
entity. In such a case the report will have to be given by the auditor on a quarterly basis.
The special audit report which is to be given on a quarterly basis in the specified form is in
addition to the normal audit report which is to be given by the auditor on an yearly basis.
In the quarterly special audit report, the auditor will have to give information relating to the
operating data for each quarter. This information will have to be classified in the following
manner:
(i) Actual production;
(ii) Actual production as a percentage of rated capacity;
(iii) Sales;
(iv) Cost of goods sold/cost of production;

(v) Gross margin;
(vi) Interest on bank borrowing; and
(vii) Interest on others
It is not necessary to work out the actual filed cost for this purpose.
The age-wise classification of raw materials and finished goods is to be given. For this
purpose age-wise classification is to be made in the following manner in respect of raw
materials and finished goods separately ;
(i) Inventory for more than one year;
(ii) Between 6 months and one year;
(iii) Between three months and 6 months; and
(iv) Below 3 months.
Similar information about the work-in-progress i.e. the number of days of production which
remains in progress should also be given.
The basis of valuation of raw material and finished goods should be given. For this purpose
the following information is to be given :
(i) The manner of determination of cost (i.e. components of cost)
(ii) The method of valuing stock i.e. FIFO, weighted average cost, etc.
It is also necessary to state if there is any discrepancy between the quantity and value of the
stock as furnished to the bank and as appearing in the books. The reasons for such
discrepancy should be given in the audit report.
Age-wise classification of bills receivable and other receivables with reference to the, bills due
from domestic parties and bills in respect of exports should be given. The age-wise
classification is to be done on the same basis as the classification for raw materials and
finished goods as stated above.
Information in respect of the following items is also to be given:
(i) Balances at the end of each month of the quarter for major categories of stock,
receivables and bills receivables;
(ii) Tax assessments and payments made during the quarter;
(iii) Actual disbursement of capital expenditure during the quarter;
(iv) Outstanding contracts on capital account at the end of the quarter giving the details
about the names of parties and amounts outstanding;
(v) The contingent liability which may or may not materialise during the financial year
succeeding the relevant quarter;
(vi) Investment made during the quarter and the income from such investments including
profit on sale of investments;
(vii) Loans given during the quarter;
(viii) Loans raised during the quarter from banks and from others. Separate figures to be
given;
(ix) Overdue statutory liability at the end of the quarter;
(x) Amounts due but not paid at the end of the quarter in respect of (a) loans from banks, (b)
public deposits, and (c) other loans; and
(xi) Figures of cash losses during the last 2 years to be stated on the basis of the annual
accounts. If such accounts were not audited this fact should be stated.
The funds obtained from the lending banks have to be utilised for the purpose for which they
are given by the bank. If the auditor finds that these funds have been diverted for the
purposes other than those for which they were given by the bank the auditor will have to give
the details of the diversion for such other purposes.
In order that the lending bank may be able to ascertain the correct financial position and
financial health of the entity it is necessary for the auditor to give the details of the diversion
for such other purposes.
In order that the lending bank may be able to ascertain the correct financial position and
financial health of the entity it is necessary for the auditor to give information about the
following ratios:
(a) Current ratio
(b) Acid test ratio
(c) Raw materials-turnover ratio
(d) Finished goods-turnover ratio
(e) Receivables-turnover ratio
(f) Return on investment
(g) Interest cover ratio
(h) Net margin ratio
(i) Capital turnover ratio
(j) Debt equity ratio
(k) Operating cash flow.
Audit of Depositories
17.15 The SEBI (Depositories and Participants) Regulations, 1996 empower SEBI to conduct
inspection and audit. The regulation requires that depositories shall have adequate
mechanisms for the purposes of reviewing monitoring and evaluating the depository’s controls
systems, procedures and safeguards. Depositories are required to maintain the following
records and documents, namely:
(a) records of securities dematerialised and rematerialised;
(b) the names of the transferor, transferee, and the dates of transfer of securities;
(c) a register and an index of beneficial owners;
(d) details of the holding of the securities of beneficial owners as at end of each year.
(e) records of instructions received from and sent to participants, issuers, issuers’ agents
and beneficial owners;
(f) records of approval, notice, entry and cancellation or pledge or hypothecation, as the
case may be;
(g) details of participants;
(h) details of securities declared to be eligible for dematerialisation in the depository; and
(i) such other records as may be specified by the Board for carrying on the activities as a
depository.
Every depository shall intimate the Board the place where the records and documents are
maintained. Subject to the provisions of any other law the depository shall preserve records
and documents for a minimum period of five years.
Where records are kept electronically by the depository, it shall ensure that the integrity of the
automatic data processing systems is maintained at all times and take all precautions
necessary to ensure that the records are not lost, destroyed or tampered with and in the event
of loss or destruction, ensure that sufficient back up of records is available at all times at a
different place.
The SEBI has also the power to appoint one or more persons as inspecting officer to
undertake inspection of the books of account, records, documents and infrastructure, systems
and procedures, or to investigate the affairs of a depository, a participant, a beneficial owner
an issuer or its agent for any of the following purposes, namely:
(a) to ensure that the books of account are being maintained by the depository, participant,
issuer or its agent in the manner specified in these regulations;
(b) to look into the complaints received from the depositories, participants, issuers, issuers’
agents, beneficial owners or any other person;
(c) to ascertain whether the provisions of the Act, the Depositories, the bye-laws,
agreements and these regulations are being complied with by the depository, participant,
beneficial owners, issuer or its agent;
(d) to ascertain whether the systems, procedures and safeguards being followed by a
depository, participant, beneficial owners, issuer or its agent are adequate;
(e) to suo motu ensure that the affairs of a depository, participant, beneficial owner, issuer or
its agent, are being conducted in a manner which are in the interest of the investors or
the securities market.
Further the SEBI has power to appoint an auditor to inspect or investigate, into the books of
account, records, documents, infrastructures, systems and procedures or affairs of a
depository, a participant, a beneficial owner, an issuer or its agent:
Provided that the auditor so appointed shall have the same powers of the inspecting or
investigating officer as stated in regulations 59 and 60, and the obligation of the depository,
participant, beneficial owner, issuer or its agent and their respective directors, officers and
employees, as the case may be, as stated in regulation 61, shall be applicable to the
inspection or investigation under this regulation.
Annexure
SEBI Checklist For Auditors

Books of Accounts & Other Records
Sl. Description Reference

No.
1. Maintenance of books of accounts Rule 15 of SCR(R) Rules, 1957 and Regulation
17 of SEBI (Stock Broker and Sub-broker)
Regulations, 1992
2. Any other book / record to be maintained Rules, Regulations and Circulars of the
by the broker as per the exchange concerned Exchange.
regulations
Contract Notes
1 The member should issue contract notes Regulation 7(B)(2) of Schedule II of Code of
for all trades done by him Conduct of SEBI (Stock Broker and Sub-
brokers) Regulations, 1992
2 The member should time stamp his order Circular SMD/POICY/IECG/1-97 dated 11th
slips / records and the order time should be February, 1997
reflected in the contract note along with the
time of execution of order.
3 The contract notes should bear the contract Rules and Regulations of the Exchange.
SEBI Registration number of the member. Circular SMD/MDP/CIR/043/96 dated August 5,
Contract notes should bear pre-printed 1996.
serial numbers. Contract notes should be
issued within 24 hours of trade execution.
Appropriate stamps should be affixed on
the original contract notes. Duplicates of
the contract notes issued should be
maintained. Counterfoils maintained
should also have adequate details. The
duplicates of the contract notes issued
should be acknowledged by the client.
4 The contract notes should be signed by the Rules and Regulations of the Exchange
member or his constituted attorney
5 In case of Form A contract notes issued to Ministry of Finance Directive - Circular F. No.
clients, the brokerage should be shown 4/16/SE/19 dated 19th August, 1991
separately.
6 In case the broker acts as a principal, the SMD(B)/104/22775/93 dated 29th October, 1993
contracts issued should be in Form B
7 The consent of the client should be taken Regulation 17 J of SEBI (Stock Broker and Sub-
for any trade done by the broker while brokers) Regulations, 1992. Section 15 of
acting as a principal SC(R) Act, 1956.
8 Brokerage should be within the limits Rules and Regulations of the concerned
prescribed by the Exchange Exchange.
Dealings With Clients
1 The member should maintain client database Circular SMD/POLICY/IECG/1-97 dated

11th February, 1997
2 The member should make full payment / delivery Circular SMD/SED/CIR/93/23321 dated
within 48 hours of the relevant pay-out 18th November, 1993
3 Warehousing of trades for Institutional Clients Circular SMD/POLICY/CIR-29/97 dated
13th November, 1997
4 Rectification of bad delivery should be done Circular SMD/POLICY/4296/96 dated 4th
within a reasonable time October, 1996
5 In case of bad delivery because of fake shares, Circular SMD/RCG/PJ/671/96 dated 22nd
the introducing broker should file the necessary February, 1996
FIRs with the police.
6 The member should not charge the clients with Code of Conduct A & B under Regulation 7
rates more than the prevailing market rates of the SEBI (Brokers and Sub-brokers)
Regulation, 1992
7 The member should take adequate steps for Rule 4(e) of SEBI (Stock Broker and Sub-
redressal of investors grievances within one brokers) Regulations, 1992
month from date of receipt of the complaint
8 The member should maintain a separate bank Circular SMD/SED/CIR/93/23321 dated
account for clients’ funds. There should be a 18th November, 1993.
clear segregation of the clients’ and brokers’
money. Payments to / from the client should be
made from this separate account - there should
be a clear segregation of business. The member
should not make payments for trades in which
he is a principal from the client’s account. The
member should keep such records and books of
accounts as necessary, to distinguish client’s
securities from his own securities. The member
should keep such records and books of
accounts as necessary, to distinguish client’s
securities from his own securities.
Funds And Resources
1 The member should not be involved in fund Regulations 8(1)(f) and 8(3)(f) of SC(R)
lending / borrowing activities except those in Rules, 1957
connection with or incidental to or consequential
upon the securities business.
2 The gross turnover of the member must be in Circulars SMD/SED/CIR/93/22570 dated
direct correlation with the base capital / 21st October, 1993 and
additional capital deposited by the member with SMD/SED/RCG/270/96 dated 19th
the Exchange January, 1996
3 The member should collect margin money from Circular SMD/SED/CIR/93/23321 dated
the clients in case of large orders / clients with 18th November, 1993
frequent delays in payments deliveries / dispute
of deals
Trading Operations
1 The member should be paying margin money Circular SMD/RCG/2782/96 dated 16th July,
as per the Exchange requirements on a 1996, Circular SMD/RCG/2995/96 dated 1st
regular basis. The auditor may also check August, 1996, Circular SMD/POLICY/CIR-2/98
the authenticity of the deals exempted from dated 14th January, 1998, Circular
payment of margins, as in institutional deals, SMDRP/Policy/Circular-17/98 dated 2nd July,
etc. Margins to be paid include Marked to 1998, Circular SMDRP/POLICY/CIR-19/99 dated
Market margin, etc. 2nd July, 1999 Circular SMDRP/POLICY/CIR-
26/99 dated 17th August, 1999
2 The member should report all off-market / Circular SMD/RCG/(BKG)/293/95 dated 14th
negotiated deals to the concerned Exchange, March, 1995
within the time limits prescribed by the
Exchange.
3 All off-market deals / negotiated deals Circular SMD/POLICY/Circular 3-97 dated 31st
entered into by the member should result in March, 1997 and Circular
compulsory delivery. SMDRP/Policy/Circular-20/98 dated 4th August,
1998
4 The member should not have entered into SEBI (Stock Broker and Sub-brokers)
any fictitious transactions. Regulations, 1992 - Code of Conduct
Regulatory Requirements
1 The member should have submitted the audit Circular SMD/SED/0072/92 dated 31st
report for a financial year by 30th September December, 1992
of the next financial year
2 The member should not have any dealings Circular SMD/POLICY/CIRCULAR/3-97 dated
with sub-brokers not registered with 31st March, 1997

Securities and Exchange Board of India
3 Members of Stock Exchanges acting as sub- Circular SMD/Policy/CIR-3/98 dated 16th
brokers should register themselves with January, 1998
Securities and Exchange Board of India
4. Annual payment of registration fees to SEBI, Circular SMD/SED/1430/93 dated 7th January,
based on recommendations of the expert 1993, Circular SMD/ED/2132/96 dated 4th June,
committee / court’s order, if any 1996, Circular SMD/Policy/CIR-4/98 dated 16th
January, 1998, Circular SMD/DBA-II/CIR-31/98
dated 5th November, 1998
4 The auditor should look into the agreement Circular SMD/OPG/AA/1020/96 dated 14th
entered into by the member and sub-broker, March, 1996
including adherence to the terms mentioned
in the contract
5 The inspecting authority should check if the Circular SMD/Policy/Cir-7/98 dated 16th
member has submitted information about February, 1998.
himself, sought by SEBI

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Adcanced Auditing and Professional Ethics Vol. 1

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FINAL COURSE STUDY MATERIAL

Advanced Auditing and

© The Institute of Chartered Accountants of India

Website : www.icai.org E-mail : bosnoida@icai.org

ADVANCED AUDITING AND PROFESSIONAL ETHICS

CHAPTER 1 : AUDITING STANDARDS, STATEMENTS AND GUIDANCE NOTES - AN

CHAPTER 2: AUDIT STRATERGY, PLANNING AND PROGRAMMING

CHAPTER 4: AUDIT UNDER COMPUTERISED INFORMATION SYSTEM (CIS)

CHAPTER 6: THE COMPANY AUDIT

CHAPTER 7: LIABILITIES OF AUDITORS

CHAPTER 8: AUDIT REPORT

CHAPTER 9: AUDIT COMMITTEE AND CORPORATE GOVERNANCE

CHAPTER 11: AUDIT OF BANKS

CHAPTER 12: AUDIT OF GENERAL INSURANCE COMPANIES

CHAPTER 13: AUDIT OF CO-OPERATIVE SOCIETIES

CHAPTER 14: AUDIT OF NON-BANKING FINANCIAL COMPANIES

CHAPTER 15: AUDIT UNDER FISCAL LAWS

CHAPTER 17: SPECIAL AUDIT ASSIGNMENTS

Comparative High, but Moderate No No

Report provided Positive Negative Factual Identificatio

¾ management's assessment of the risk that the financial statements may be

♦ The auditor should obtain an understanding of the control environment sufficient to

consider the nature of and content of that report.

and with whom audit matters of governance interest are to be communicated.

• examining, on a test basis, evidence to support the amounts and disclosures in

particular item affecting assertions made by management in the financial statements. In

the client before the compilation report is signed by the accountant.

1.6.21 Guidance Note on Computer Assisted Audit Techniques - For Computerised

(ii) Statement on Payments to Auditors for Other Services,

*Accounting Standards 4 and 5 were made mandatory in respect of accounting periods

Manner of Making Qualification Disclosure in the Audit Report - In making a

Applicability of Accounting Standards to charitable and/or religious organisations - The

the appointment should be refused. Such communication is an ethical requirement as opposed

work. This will include:

♦ Relevant publications of the Institute of Chartered Accountants of India and other

Formulating an Audit Programme

(ii) Confirming ownership;

(iii) Treatment to be accorded to research and development expenses.

♦ Setting of materiality levels for audit purposes.

and report submitted by 5th August, 19XX.

the observations made on the

Designing Audit Strategy

The purpose of analytical procedures at the planning stage is attention-directing;

♦ Susceptibility of assets to loss or misappropriation, for example, assets which are

Using the Work of an Expert

♦ confidentiality of the client’s information used by the expert.

Relying upon the Work of Internal Auditor

Using the Work of another Auditor

Principal’s Ultimate Responsibility

Reliance on the Management or other Certificates by the Auditor

If a representation by management is contradicted by other evidence, the auditor should

Control of Quality of Audit Work

(iii) Special expertise required

Adequacy of Records and Documents - Accounting controls should ensure that -

Components of Internal Controls

Review of the System of Internal Controls

financial statements; and

questions should be consistent, sequential, logical, and if possible corroborative. Wherever it

The flow chart for the above may be as under -

The flow chart for the despatch section may be as follows -

The Flow Chart for this Section is given below -

Evaluation of Internal Control

Internal Control and Risk Assessment