INCOME TAX NOTES

CA IPCC CHAPTER - 3 PREPARATION FOR AN AUDIT

CHAPTER - 3

PREPARATION FOR AN AUDIT


STATISTICS OF THE CHAPTER Tentative Weightage of Chapter: 15 to 20 Marks
IMPORTANCE OF THE CHAPTER The Chapter is important not only because it is of good Weightage but also because it helps to know what kind of preparations is required by an auditor before going for an audit.
CA IPCC CHAPTER - 3 PREPARATION FOR AN AUDIT free study material





COVERAGE OF THE CHAPTER
(1) Terms of Auditor’s Engagement
(2) Audit Process
(3) Audit Planning / Audit Programme
(4) Audit Documentation
(5) Audit Sampling
(6) Audit Risk


(25) Write a note on Terms of Engagement (SA 210).
► TERMS OF ENGAGEMENT: The engagement letter documents and confirms auditor's acceptance of appointment, objective and scope of audit and extent of auditor's responsibilities to client. Auditor should send an engagement letter, before commencement of engagement, to help avoid any misunderstandings in future.
► PURPOSE: Auditor should accept or continue an audit engagement only when the basis upon which it is to be performed has been agreed, through:
a. Establishing whether the preconditions for an audit are present; and
b. Confirming that there is a common understanding between auditor and management of the terms of audit engagement.
► PRECONDITIONS FOR AN AUDIT: In order to establish whether the preconditions for an audit are present, auditor shall:
a. Determine whether financial reporting framework applied in preparation of financial statements is acceptable; and
b. Obtain the agreement of management that it acknowledges and understands its responsibility:
i. For preparation of financial statements in accordance with applicable financial reporting framework,
ii. For internal control to enable preparation of financial statements that are free from material misstatement,
iii. To provide auditor with:
Access to all information relevant to preparation of financial statements,
Additional information that auditor may request from management for audit purpose; &
Unrestricted access to persons within entity for obtaining audit evidence.
► CONTENTS OF AUDIT ENGAGEMENT LETTER:
Primary Contents
1. Objective and scope of audit;
2. Auditor’s responsibilities;
3. Management’s responsibilities;
4. Identification of applicable financial reporting framework for preparation of financial statements; and
5. Expected form and content of any reports to be issued by auditor.
Additional Contents: Auditor may also include:
1. Audit Planning
2. Expectation of receiving “Management Representations”
3. Fees and billing arrangements
4. Arrangements w.r.t. involvement of other auditors, experts, internal auditors, client’s staff or predecessor auditor.
► RECURRING AUDIT: In case of a recurring audit, the auditor may decide not to send a new engagement letter each period. However, due to following factors he may send a new letter:
Any indication that the client misunderstands the objective and scope of the audit.
Any revised or special terms of the engagement.
A recent change in senior management, board of directors or ownership.
A significant change in nature or size of the client’s business.
Legal requirements or pronouncements of the ICAI or changes in the existing ones.
► AUDIT OF COMPONENTS: When auditor of a parent entity is also auditor of its subsidiary,
branch or division, he should consider certain factors (like, appointing authority, reporting authority, legal requirements, , degree of ownership by parent entity, separate audit report for component, etc.) to decide whether to send a separate engagement letter to the component.
► CHANGES IN TERMS OF ENGAGEMENT: If before completion of engagement, auditor is requested to change the engagement to one which provides a lower level of assurance, then he should consider the appropriateness of doing so.
► If there is reasonable justification for change, then auditor should agree for change. In order to avoid confusion, the new audit report would not include reference to the original engagement or any procedures performed in the original engagement.
► If there is no reasonable justification for change, then auditor should refuse for the change and if client doesn’t agree then he should withdraw and should consider other obligations.

(26) What are the steps involved in Audit Process?
Audit Process refers to the series of activities performed in formulating an opinion on financial statements. It involves the following steps:
1) PRELIMINARY DISCUSSIONS:
Initial discussions with client to determine the scope of audit
Finalize the terms of engagement
2) AUDIT PLANNING
Formulating an audit plan based on the knowledge of client’s business
Preparation of the detailed audit programme to achieve the objective of audit efficiently, effectively and in time
3) AUDITING
Carrying out the audit as per plan with the help of compliance and substantive procedures
Documenting all the material observations and inquiries made in the form of audit working papers
Evaluation of the internal control system with the help of compliance procedures
Checking that the books are giving true & fair view
Vouching of the documents & transactions
Checking arithmetical accuracy by examination of the books of accounts
Verification of assets & liabilities
Carrying out analytical review procedures wherever required and ensuring overall accuracy & reliability of the books & financial statements
Ensuring the disclosure requirements has been met.
4) AUDIT REPORT
Forming an opinion on the basis of audit conducted
Drafting an audit report on the true & fair picture of the financial statements
Ensuring that the audit report complies with the statutory requirements
Preparing the report on timely basis
Communicating the report to appropriate authority


(27) Describe Audit Planning.
► AUDIT PLANNING: Auditor should plan his work to conduct audit effectively, efficiently and in time. Plans should be based on knowledge of client’s business and should be further developed  and revised as necessary during the course of the audit.

► OBJECTIVE OF AUDIT PLANNING is to:
ensure that appropriate attention is devoted to important areas of the audit
ensure that potential problems are promptly identified
ensure that the work is completed expeditiously
utilise the assistants properly
co-ordinate the work done by other auditors and experts
► KNOWLEDGE OF THE CLIENT’S BUSINESS: The auditor must obtain the knowledge of the client’s business in order to adequately plan the audit. The auditor can obtain such knowledge from:
Discussion with client: It includes such subject as change in management, technology, products, business, accounting procedures and government legislations, etc.
Other sources: It includes discussion with client’s staff & other people within & outside entity, client’s annual results, minutes of meeting, previous year’s audit working papers and visits to client’s premises and plant facilities.
► PLANNING INVOLVES developing:
an overall plan for the expected scope and conduct of the audit; and
an audit programme showing nature, timing and extent of audit procedures.
► DOCUMENTATION: Auditor should document his overall plan.


(28) Describe Audit Programme along with its advantages & disadvantages.
► MEANING: An audit programme is a detailed plan of applying the audit procedures, along with the instructions for appropriate techniques to be adopted to obtain sufficient evidence to enable the auditor to express opinion.
► POINTS TO CONSIDER: Auditor should consider following points in making audit programme:
1. It should meet the objective & cover scope of audit.
2. It should be in writing & communicated properly to the assistants.
3. It should contain audit objectives for each area and a set of instructions to the assistants for proper execution of work to complete audit efficiently, effectively and in time.
4. There should be co-ordination between the procedures to be applied to related items. In assembling procedures & methods, if related items are grouped together, the programme becomes purposeful and easy to coordinate.
5. Audit programme should be reviewed periodically so that inadequacies or redundancies may be removed.
6. Every assistant should follow the instructions as stated in the programme, unless the programme is not officially changed by the principal.

► ADVANTAGES OF AUDIT PROGRAMME:
1. Set of instructions: It provides clear set of instructions to assistants to carry out the work.
2. Job allocation: It facilitates in selection of assistants on the basis of capability.
3. Systematic Audit: Audit can be carried out systematically covering all important aspects & areas, without the chance of ignorance.
4. Responsibility: The responsibility for the work assigned can be fixed & traced easily.
5. Review: It helps to supervise & control the work of assistants.
6. Future Audits: It serves as a guide for audits to be carried out in the succeeding year.
7. Auditor’s Defense: It serves as evidence in the event of any charge of negligence being brought against the auditor.
► DISADVANTAGES OF AUDIT PROGRAMME:
1. Mechanical: The work may become mechanical and may be carried out without any understanding of the object.
2. Rigidity: The programme often tends to become rigid and inflexible despite changes in business an old programme may still be carried on.
3. Shelter for inefficient assistants: Inefficient assistants may take shelter behind the programme to defend deficiencies in their work
4. Lack of initiative: A hard and fast audit programme may kill the initiative of efficient and enterprising assistants.
► PRECAUTIONS to avoid disadvantages:
1. Periodic Review: Audit program should be reviewed periodically & updated accordingly..
2. Participating approach: Suggestions for improvements should be invited from assistants.
3. Explanation to assistants: regarding the objective, scope, etc. of audit in detail.

(29) What is final audit? Give its advantages & disadvantages.
► MEANING: A final/completed/periodical audit is an audit which begins after the books have closed at end of accounting period & thereafter is carried on continuously until completed.
► ADVANTAGES of final audit are:
1. Work can be carried on continuously in a single sitting, without affecting regular work flow of client
2. Possibility of alteration of figures after audit is avoided.
3. Allocation of work for staff becomes easier.
4. It is suitable for small size concerns
► DISADVANTAGES of final audit are:
1. Detailed checking not possible so chances of overlooking material misstatements exists
2. Excessive pressure for timely completion of audit
3. Timely rectification of errors not possible, all rectification entries are passed in year end
4. Not advisable for large size concerns

(30) What is continuous audit? Give its advantages & disadvantages.
► MEANING: A continuous audit is one in which the auditor’s staff is engaged continuously in checking the accounts of client the whole year round or when staff attends audit at intervals during the financial period. The audit staff is present at client’s premises almost during the entire accounting period. It is also known as detailed audit or running audit.
► ADVANTAGES of continuous audit are:
1. Timely rectification: earlier detection & rectification of errors is possible
2. Moral check: attendance of the audit staff acts as a moral check on client’s staff
3. Up-to-date accounts: the client’s accounts are always kept up-to-date.
4. Detailed checking: auditor has more time for detailed checking of the accounts
5. Early Final Audit: the final accounts can be prepared and reported upon much earlier
6. Knowledge of client’s affairs: auditor remains constantly in touch with the client’s affairs
7. Less yearend pressure: auditor has to face less pressure at year end
8. Interim reporting: Interim financial reporting is also facilitated to a great extent
9. Beneficial for large sized concerns or entities with weak internal controls
► DISADVANTAGES of continuous audit are:
1. Tampering: audited records may be altered either innocently or fraudulently
2. Time consuming: it may involve waste of time and effort
3. Interruption of work: continuous presence of audit staff may affect regular work flow
4. Small size concerns: it may not be suitable for small size concerns
5. Failure to keep track: audit staff may overlook a matter not examined on last visit
► PRECAUTIONS to avoid disadvantages:
1. At the end of each visit, important balances should be noted down and the same should be compared at the time of the next visit
2. The visits should be at irregular intervals of time including the surprise elements.
3. Special attention should be placed on altered figures, if any.
4. Minimum interference should be done in the client’s regular work flow

(31) Write a note on Audit Working Papers.
► MEANING: As per SA 230, audit working papers refers to the documentation consisting of the record of audit procedures performed, relevant audit evidence obtained and conclusions the auditor reached. It constitutes the link between auditor’s report and client’s records.
► PURPOSE OF AUDIT DOCUMENTATION:
1. To provide Auditor with the basis for conclusion about the audit.
2. To ensure that audit was planned & performed as per SAs and applicable legal & regulatory requirements.
3. To assist the engagement team to plan and perform the audit.
4. To retain records for future audits.
► BASIC REQUIREMENTS OF WORKING PAPERS:
1. Auditor should prepare audit documentation on timely basis.
2. Audit documentation may be recorded on paper or electronic or other media.
3. The documentation is not limited to records prepared by auditor but may include other appropriate records such as minutes of meetings prepared by the entity’s personnel and agreed by the auditor.
4. Assembly of final audit file should be done on timely basis (approx. not more than 60 days after the date of auditor’s report).
5. Working papers should be retained for atleast 7 years from the date of auditor’s report.
6. Ownership of Audit Documentation: Audit documentation is the property of the auditor and he should maintain confidentiality of his working papers. Auditor may, at his discretion, make portions of or extracts from the working papers available to his client.
► CONFIDENTIALITY OF WORKING PAPERS:
The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose.
As per SA 230 “Working papers are the property of the auditor & he may, at his discretion, make portions of or extracts from his working papers available to his client”. Thus, the client does not have a right to access the working papers of the auditor.
Chartered Accountants Act, 1949, provides that “A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he discloses information acquired in the course of his professional engagement to any person other than his client, without the consent of his client or otherwise than as required by any law for the time being in force.”

(32) Explain Permanent Audit Files & give its contents.
Permanent audit files refer to audit working papers containing matters which do not change very often and can be referred in future audits. It should be updated from time to time. It includes:
Information  relating  to  the  legal  &  organisational  structure  of  the  entity. For e.g.: for a company, this includes the Memorandum and Articles of Association.
Copies of important legal documents, agreements and minutes relevant to the audit.
Copies of audited financial statements for previous years.
Record of communication with the retiring auditor, if any.

(33) Explain Current Audit Files & give its contents.
Current audit files refer to audit working papers containing matters primarily relating to audit of a single period. It includes:
Correspondence relating to acceptance of annual reappointment.
Extracts of important matters in the minutes of Board Meetings and General Meetings.
Analysis of transactions and balances.
Record of nature, timing & extent of auditing procedures performed, and there results.
Copies of communication with other auditors, experts and other third parties.
Letters of representation or confirmation received from the client.

(34) What do you mean by Audit Sampling/Test Checking? What are the methods to select sample?
As per SA 530, "Audit sampling" means the application of audit procedures to less than 100% of the items within an account balance or class of transactions to enable auditor to obtain and evaluate audit evidence in order to form a conclusion concerning the population. The auditor should select sample items in such a way that the sample can be expected to be representative of the population.

There are two major methods which help in determining the size and components of the sample:
1) Judgmental sampling
2) Statistical sampling
1) JUDGMENTAL SAMPLING: Under this method, the sample size and its composition are determined on the basis of the personal experience and knowledge of the auditor. It is a traditional method of sampling. For e.g.: March & June may be selected in year one and different months would be selected in the next year.
Advantages of Judgmental Sampling:
It is simple to operate.
Easy to understand.
Auditor’s past experience can help him to make better evaluation of sample. Disadvantages of Judgmental Sampling:
It is neither objective nor scientific
The risk of personal bias in selection of sample items cannot be eliminated.
Sample may not truly represent population.
In case of a new audit the sample selection may be difficult for the auditor.
2) STATISTICAL SAMPLING: An approach to sampling that has the following characteristics:
(i) Random selection of the sample items; and
(ii) Use of probability theory to evaluate sample results
Under this method, the sample size and its composition are determined on the basis of mathematical laws of probability. It has wide application in case of homogenous population.

Advantages of Statistical Sampling:
It is more scientific.
There is no personal bias.
It is more reliable due to use of mathematical & statistical tools. Disadvantages of Statistical Sampling:
It is complex to operate.
Suitable in case of large organizations, where there is large number of homogenous transactions.
It may be time consuming.
Not suitable when there are variety of transactions without any sequence.
Audit staff needs to be educated about the statistical techniques first.
Statistical Sampling Methods
A) Random Sampling
    A1) Simple Random Sampling - Random selection of samples
    A2) Stratified Random Sampling -  Random selection of samples

B) Interval/systematic Sampling
    B1) Block Sampling - Defined block of consecutive items
    B2) Cluster Sampling -  Random selection of clusters


► RANDOM SAMPLING
Random selection ensures that all items in the population or within each stratum have a known chance of selection. It may involve use of random number tables. It is of two types:
1. Simple Random Sampling: Each unit of the whole population has an equal chance of being selected. Selection may be made by choosing numbers from:
 • table of random numbers
 • by computers
 • picking up numbers randomly from a drum.
This method is appropriate in case of homogenous population consisting units falling within a reasonable range. For e.g. debtors balances falling within the range of Rs. 5,000 to Rs. 25,000 and not in the range between Rs. 25 to Rs. 2,50,000.
2. Stratified Random Sampling: This method involves dividing the whole population into different groups called strata. Each stratum is treated as if it was a separate population and sample is selected from each of these stratums. The number of groups into which the whole population has to be divided is determined on the basis of auditor’s judgment. For e.g. in the above case, debtors balances may be divided into four groups as follows:-
 • Group1 : Debtors > Rs. 1,00,000
 • Group2 : Rs. 75,000 < Debtors < Rs. 1,00,000
 • Group3 : Rs. 25,000 < Debtors < Rs. 75,000
 • Group4 : Debtors < Rs. 25,000
From Group1 the auditor may examine all the items; from Group2: 25% of items; from Group3: 10% of items and from Group4: 2% of items may be selected. It helps in focusing attention on more material items. It is useful for heterogeneous or diversified population.
► INTERVAL/SYSTEMATIC SAMPLING:

Items are selected using a constant interval between selections, the first interval having a random start. The interval might be based on:
 Certain number of items (for e.g. every 20th voucher) or
 Monetary totals (e.g. every increase of Rs. 1,000 in cumulative value of population).
When using systematic selection, the sampling interval should not follow a particular pattern in the population. The multiple random starting points should be taken to minimise the risk of interval sampling pattern with that of the population being sampled. It is of two types:
1. Block Sampling: Selection of a defined block of consecutive items. For e.g. first 200 sales invoices in the month of September.
2. Cluster Sampling: Dividing the population into groups of items known as clusters. A number of clusters are selected randomly. For e.g. 500 to 540, 2015 to 2055 etc. The first item i.e. 500, 2015 is randomly selected from random number tables. The items of selected cluster can either be checked completely or a randomly selected proportion of them can be examined.

(35) What are the factors affecting sample size?
The auditor should consider the following while determining the sample size:
1) Sampling Risk: Sampling risk arises from the possibility that auditor's conclusion, based on a sample, may be different from conclusion that would be reached if entire population were subjected to the same audit procedure. The lower the sampling risk the auditor is willing to accept, the greater the sample size will need to be.
2) Tolerable Error: Tolerable error is the maximum error in the population which would be acceptable & will not affect the conclusions drawn from sampling. It is considered during the planning stage. The smaller the tolerable error, greater the sample size will need to be.
3) Expected Error: If the error is expected to be present in the population, a larger sample is required. Smaller sample sizes are justified when the population is expected to be error free. In determining the expected error, auditor would consider such matters as errors identified in previous audits, changes in the entity's procedures & evidence available from other procedures.

Sampling Risk : The lower the sampling risk the auditor is willing to accept, the greater the sample size will need to be.- Inverse
Tolerable Error : The smaller the tolerable error, the greater the sample size will need to be - Inverse
Expected Error : If the error is expected to be present in the population, a larger sample is required. - Direct

(36) Write a note on audit risk.
► Audit risk means the risk that auditor gives an inappropriate audit opinion when financial statements are materially misstated. It is the possibility of deriving an inappropriate opinion by relying on tampered financial statements.
► Audit risk has three components: inherent risk, control risk and detection risk.
Audit Risk Components

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

Detection Risk - Risk that any remaining material errors will not be detected by the auditor

Basis
Inherent Risk
Control Risk
Detection Risk
Definition
Inherent risk is the susceptibility of an account balance or class of transactions to misstatement that could be material.
Control risk is the risk that misstatement that could occur in an account balance or class of transactions will not be prevented or detected on a timely basis by system of
internal control.
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.
Type of risk
Risk that material errors will occur
Risk that the client’s system of internal control will not prevent or correct
such errors
Risk that any remaining material errors will not be detected by the
auditor
Controllability
It will always be present in an audit and can’t be
controlled by auditor
It will always be present in an audit and can’t be
controlled by auditor
It can be controlled by following         adequate
audit procedures
Existence
It exist independently of an        audit    of    financial
information
It exist independently of an         audit    of     financial
information
There is no existence of detection    risk    if    no
audit is conducted


(37) What is the relationship between various components of audit risk?

► Management minimises inherent risk by designing accounting and internal control systems to prevent/detect and correct misstatements, thus inherent risk and control risk are highly interrelated. Hence, audit risk may be more appropriately determined by making a combined assessment of inherent and control risk.
► The auditor’s combined assessment of control & inherent risk, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk.
► There is an inverse relationship between detection risk and combined level of inherent and control risks. For example, when inherent and control risks are high, acceptable levels of detection risk need to be low to reduce audit risk to an acceptably low level. On the other hand, when inherent and control risks are low, auditor can accept a higher detection risk and still reduce audit risk to an acceptably low level.

Practical Questions - Chapter 3: Preparation for an Audit

Question No. 1: Mr. Chintan who was auditor of AB Corp. for the financial year 2009-10 was reappointed as auditor for F.Y. 2010-11. Should he send a new engagement letter for 2010-11?
Question No. 2: M/s. Health Zone, a partnership firm running a nursing home have decided to discontinue you as an auditor for the next year and requests you to handover all the relevant working papers of the previous year. Comment on the above situation.
Question No. 3: Xavier, the auditor of Sarah Ltd. decided to destroy the audit working papers after the audit of Sarah Ltd. was complete and the annual report was signed & circulated. Comment, stating why he should carefully preserve the audit working papers?
Question No. 4: State whether true or false:
a. When inherent & control risk are low, an auditor can accept a lower detection risk.
b. Audit procedure & audit technique are not one and the same thing.
c. Audit working papers should be kept at least for three years.
d. Audit Planning means developing an overall audit plan to do audit.
e. Audit programme should not be changed.