s

L
V
E
R
JUBILEE

PRINCIPLES
PROCEDURES
1993

PROF.

DR.

KHAWAJA

AM

AD

SAEED
CHARTERED ACCOUNTANT COST AND
MANAGEMENT ACCOUNTANT

INSTITUTE OF BUSINESS MANAGEMENT

G.P.O. BOX

1164,

LAHOREPAKISTAN

&

II
JUBILEE

s=s

AUDITING
a
PRINCIPLES n
PROCEDURES d

PROF. KHAWAJA AMJAD SAEED

CHARTERED ACCOUNTANT COST AND MANAGEMENT ACCOUNTANT

INSTITUTE
MANAGEMENT

OF

BUSINESS

G.P.O. BOX 1164, LAHORE PAKISTAN


PREFACE

SILVER
EDITION

JUBILEE

. The book entitled Auditing: Principles and Procedures, was. first published in 1968. Its
revised version appeared in 1973. Since then many changes have taken place. The Companies
Ordinance 1984 was enforced. Several International Accounting Standards have been in
currency and wealth of literature on auditing has appeared in the world through changes in
auditing techniques and specially through the International Standard on Auditing. Besides,
courses and syllabi of various academic and professional examinations have undergone
changes.1 Some new laws on auditing have also come up. Various professional institutes have
issued several pronouncements and consequently the practical aspects of audit have undergone a
significant -'change.
I have been trying to update myself in respect of above developments through travel
abroad, visits to various professional institutes, at home and abroad, and have also benefitted
considerably from the excellent work produced by the International Federation of Accountants
(IF AC). I visited the headquarters of IF AC in New York in the year 1988, 1990, 1991 and 1992
and procured all available literature. I am on their mailing list and continue to stay updated. They
have published IF AC Handbook in 1992 containing Technical Pronouncements.
Current >edition is Silver Jubilee edition and has been written in the light of various
changes mentioned above and I do hope that it will serve the students pursuing higher academic
and professional qualifications including courses offered by Chartered Accountants of Pakistan
and the institute of Cost and Management Accountants of Pakistan. Three .additional chapters on
summary of 'International Standards on Audit' 'Computer and the Auditor* and Glossory of
Terms have been included in this edition. Changes introduced by Chartered Accountants ByeLaws 1983 have also been incorporated. Every Chapter has been re-written and expanded in the
light of current environments.
I am most grateful to the reading community for the excellent support received in the past
and do hope that, through gesture of goodwill in reading this edition, they will ornament
themselves with the modern techniques of auditing.
I am most grateful to International Federation of Accountants, New York, for their kind
permission to include appropriate material from the International and ends on Auditing ISAs
published by them. With-their permission ISAs have been cited and reproduced in this book.
I also thank Professor S. M. Naseer Ajmal for the logistical support extended which has
enabled the book to be neatly printed.

 remain grateful to Messrs Aftab Shabeen, Abdul Ghaffar Naeem and Nijat Hussain for
the useful support in getting the work printed.
I thank the readers for their kind support. Improvement is an on-going activity and
suggestions for improvement will be most gratefully acknowledged.
I appreciate the encouragement received by me from Dr. Muneer-ud-Din Chughtai, ViceChancellor, University of the Punjab, Lahore, for pursuing academic and research efforts.

Lahore,
February 12, 1993

Dr. Kftawaja Amjad Saeed

FCA; FCMA; FCIS; FICM; FITM
Chartered Accountant Cost &
Management Accountant.

PROFESSOR DR. KHAWAJA

AMJAD SAEED
Professor Dr. Khawaja Amjad Saeed holds Master Degrees in Commerce (M. Com.) from,
the University of the Punjab (1959) and in Business Administration (MBA) from the American
University of Beirut (1970). He is a Fellow Member of all the six professional Institutes of
Pakistan, ie. the Institute of Chartered Accountants of Pakistan (FCA 1966), the Institute of Cost
and Management Accountants of Pakistan (FCMA 1971), the Institute of Corporate Secretaries
of Pakistan (FICS 1974), the Institute of Marketing Management (FhMM 1986), the Institute of
Taxation Management (FITM 1988) and- the Institute of Chartered Secretaries and Managers.
Besides holding a Degree in Law (LL.B.) from the University of the Punjab <1976), he is a
holder of Diplomas in Industrial Accountancy from the British Tutorial Institute, London (1964),
in Project Analysis Industry and Infrastructure from the United Nations Asian Institute of
Economic Development and Planning, Bangkok (1971) and a certificate holder in teaching of
Project Analysis from the Economic Development Institute of the World Bank, Washington
(1979). He has also obtained Degree of Doctor of Philosophy in Business Administration (Ph.D)
from USA (1981).
He has been honoured with various Awards. Besides having seven years of field experience
in corporate finance, audit, accounting, taxation and business management, he has 28 years of
teaching experience at the Masters level in commerce, business administration, public
administration and economics and has also extensively taught in professional examination
courses. Several Management Development Programs have been conducted by him at home and
abroad.
He has authored 30 books in the areas of Income Tax, Auditing, Management, Financial,
Reports, Corporate and Mercantile Laws, Economics, Financial Institutions, Accounting and
Higher Accountancy. He is widely travelled and has contributed over 600 articles in journals of
national and international repute. Some of his articles have been abstracted by the Commerce
Clearing House Inc., New York.
He was awarded Appreciation Scroll by tile International Federation -of Accountants, New
York, for his contribution made to accounting profession on worldwide basis in 1990.
He has participated in several international conferences, contributed papers for the same
and has also conducted several research studies including research studies for International
Labour Organisation (ILO), King Abdul Aziz University, Saudi Arabia, ICFTU, Belgium,
TWARO, Tokyo and other international bodies. During the summer of 1984, he was on Visiting
Faculty assignment at the University of Hawaii and also visited 12 top business schools of USA.
During 1984, he delivered

()
tv^elvft'ftalks inynanagoment development programs in India under the auspices of the Institute
of Cost and Works Accountants of. India. He has presented several papers in international
conferences he'IH-iri USA, Japan, South Korea, Thailand, Switzerland, Sri Lanka, India, Nepal,
Australia, UK, Bangladesh and several other
countries. . .
. . . . . . . . . . . . ............... . . .
.. He presented a paper in 7th CAPA (1973) in Bangkok, Thailand, attended 8th (1976)
in Hong Kong, presented a paper in 10th A PA (1983) in New Delhi, India, Chaired a technical
session in 11th CAPA (1986) in Melbourn, Australia and contributed a paper for the 12th CAPA
(1989) held in Seoul, Korea. . .
His paper was accepted in the 5th International Conference on Accounting Education (1982)
held in Mexico and also presented a paper in the 6th above conference held in Koyoto, Japan
(1987).
Hehas also.served as representative on Finance.and Management Accounting Committee of
International Federation of Accountants (IFAC-FMAC) for three
years..
He is University Professor and Director of Institute of Business Administration, University
of the Punjab, Lahore arid is also serving ps Director (Planning and Development) of the
University of the Punjab.
He is also serving as Dean, Faculty of Arts, University of the Punjab*. Vice President of the
Institute of Cost & Management Accountants of Pakistan, Vice President of the Association of
Management Development Institutions of South' Asia (AMDE3A) and Member Board of
Studies, Institute of Chartered Accountants of Pakistan'and is holding several offices in national
and international bodies. He is Founder President of the Institute of Marketing Management,
Institute of Taxation Management and the Institute of Chartered Secretaries and Managers.


GUIDANCE NOTES
FOR READERS
1. Executives
Several executives are engaged in external and internal audit. Some are charged with the
responsibility of strengthening financial controls. They will find the reading of the hook
interesting from their functional point of view.
Since several ISAs have been reproduced, these are available for ready reference. However,
for quick reference they may read the summary on ISAs
included as a separate Chapter. t

2. Practising Chartered Accountants and Cost and

Management Accountants

They will find this book as Audit Manual and discussion included will assist them in using
modern audit techniques. However, for specific purpose, they may kindly refer to the exact
wording of relevant section of the Companies Ordinance, 1984 and other Statutes, IASs and
ISAs.

3. Professional Examination Students

They may consult their prescribed courses of reading and study the relevant
chapters.

4. Commerce/Public/Business Administration Students

(a) Please follow guideline at 3 above.
(b) Prescribed syllabus for B.Com. is given on the next page.

GUIDANCE NOTE FOR B. COM. M. COM. AND MBA

STUDENTS
Students may read the selected chapters relevant to their syllabus.' Summary
may l>e prepared wherever relevant ...
* - '.
''
._[-

()

PRESCRIBED
SYLLABUS FOR B.
COM.

UNIVERSITY OF THE PUNJAB

Auditing
Definition '
Scope and Objectives of Audit
Audit Programme
Audit Working Papers .
Standards and Procedures

.;

Types of Audit
Internal Control and Internal Audit
Audit of Journals, Subsidiary Books, Trial Balance, Profit and Loss Account and Balance Sheet
Vouchers
Verification of Balance Sheet

Audit of Textiles, Sugar, Hotel, Insurance, Banking and Newspaper Companies

Investigation of Accounts and Detection of Fraud
Conclusion of Audit
Audit Report
Rights, Powers, Duties and Liabilities of Audit
AuditofComputerised Accounting Records

COMPANY LAW AND PRACTICE IN

PAKISTAN
This book has been re-written in the light of the Companies
Ordinance, 1984, and the Comapnies Ruies, 1985, and will appear
in the market in the middle of 1993.

TABLE
STATUTES
S.JVo.

1.
2.
3.
4.
5.
6.
7.
8.
9

10.
11.
12.
13.
14.

15.
16.
17.
18.
19.
20.
21.
22.
23.

OF

Particulars Page
Societies Registration Act, 1860 ...................,..........................434
Contract Act, 1872..................................................................... 401
Companies Act of 1882 ............................................................ 18
Companies (Consolidation) Act, 1908....................................... 396
Companies Act, 1913.................................................................6,10,18,19,
.............................................. ...................................................20, 70
Income Tax Act, 1922................................................................ 20
Cooperative Societies Act, 1925................................................ 342
Partnership Act, 1932................................................................. 383
Auditor's certificate Rules, 1932............................................... 19
Insurance Act, 1938 .................................................................. 24, 317, 345,
................................................................................................... 347 , 348, 354,
................................................................................................... 429, 429
The Capital Issues (Continuance of Control) Act, 1947 344
Auditors' Certificates Rules, 1950 ............................................ 20
Insurance Rules, 1958................................................................ 348, 355
Chartered Accountants Bye-Laws, 1961 ...................................20
Chartered Accountants Ordinance, 1961 .................................. 3, 20, 41,
42,43, 292, 319,
361, 363
Banking Companies Ordinance, 1962 ...................................... 10, 24, 359
................................................................................................... 361,377
Banking Ordinance, 1962 ......................................................... 317
Exchange Control Manual, 1965......................;........................ 361
Cost and Industrial Accountants Act, 1966............................ 21, 363
Industrial Relations Ordinance, 1969 ....................................... 362, 363,449
Securities and Exchange Ordinance, 1969 ................................ 449
The Monopoly Control Authority Rules, 1971 ......................... 363
Banking Companies (Amendment) Act, 1972 .......................... 361
Economic Reforms Older, 1972................................................. 364

34*^

i ? & ^^O^nance, 1972 .................................................... ...f................. 20

f.g i t; i p* (Amendment) Act, 1972................................... 361

25.
26.
27.
28.
29.

30.
31.

People's Finance Corporation Act, 1972................................... 364

Income Tax Ordinance, 1979.................................................. 218, 428
Zakat and Ushr Ordinance, 1980 .............................................. 295,296,318,

.....ZZZLLl..............................____......... 320

Chartered Accountants Bye-Laws, 1983 ----------------.....-----43

Companies Ordinance, 1984.................................................... 21, 24, 60,
........................................................:..........;......:......_.............,293,
294,295,319, "'
345, 347, 359 361,
363, 364, 379, 383,
429
.. .CompameBRuIes, 1985....................................... ....................24
Companies (Invitation and Acceptance
of Deposits) Rules, 1987..................1.............365

()

\-Z
Appendix/
AnnexureNo.

1.1
1.2
1.3
2,1

4.1
4.2
4.3
5.1
5.2
6.1

7.1
7.2
7.3
9.1
12.1
12.2

12.3 .
12.4
T2;5
13.1
13 .2

13.3
13.4
13.5

??;<$

O^APPENDICES/ANNEXURES
Particulars Page

Examples of conditions or events which .'....................................................... 16

increase the risk of fraud and error
History of auditing profession in Pakistan .....;;..!':............................ 18
Examples of an ahdit engagement letter -.......:.........................................'..... 36
Schedule I ...:......;.:..i...1:;....:..1^.~,-..........;.:..^.,M....>..................................69
Schedule ..^.v.....................v......................................................................... 72
Schedule ..................................................................................................... 73
Factors influencing compliance test sample size ........................................... 150
Factors influencing substantive test sample size............................................ 151
Compliance test and substantive test risk matrix..........:,................................ 152
Example of an auditor's report on revised Financial Statements.... 174
Example of a management representation letter............................................ 177
Liability certificate.............................. ...................................................... 200
Stock certificate....................,-____.,...................................r ..... ..................... 222
Suggested format of letter for debtor's........................................................... 224
confirmation by direct communication
Suggestions for improving response rates ................................................... 225
International Standards on auditing and related services............................... 287
Example of an auditor's report with paragraph
emphasizing a going concern uncertainty............................................ 327
Example of an auditor's report qualified for
disagreement for inadequate disclosure of a going
concern uncertainty when on
adverse opinion is not appropriate ............................................... 328
Form of auditor's urujualified report............................................................. 337
Example paragraph emphasizing on uncertainty.............................................337
Examplesof opinions other than unqualified.................................................. 338
Examples of reports on financial statements prepared .
in accordance with an Other comprehansive basis-of accounting 373 .
Examples of reports on components of Financial Statements.........................373
Examples of reports on compliance given in a separate report
and in a report accompanying financial statements..................................375
Examples of reports on summarized financial statements..............................376
Working index relating to accounts and audit matters .................................. 377

Iwi)

LIST OF FORMS/CHARTS
S.No.

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.

Particulars Page
Organisation Chart of an Audit Firm................................................................ 58
A specimen of the audit programme- in respect of cash book ......................... 63
Standard request for bank report for audit purposes ..................................... 162
Specimen of representation letter in use in Pakistan...................................... 180
Auditors' Report on Share Transfer Audit...................................................... 194
International Standards on Auditing................................................................229
Current status of International Standards on Auditing....................................231
Summary of International Guidelines ........................................................... 233
on Auditing and related services
Form 35A Auditors' Report to the Members..........................................295, 319
Form of Auditors' Certificate ......................................................................... 308
Auditor's Form of the Report Illustrated........................................................ 312
Auditor's Report: Form of Qualification ....................................................... 321
Suggested proforma of Auditor's Report ....................................................... 331
under Section 362 of the Ordinance
International Accounting Standards and the Auditor ..................................... 339
The Capital Issues (Continuance of Control)................................................. 344
Act, 1947 - Auditor's Certificate

15.

Auditors'Report to the Shareholders in........................................................... 347

the case of an Insurance Company

16.

Auditors' Report to the Shareholders in ......................................................... 360

the case of a Bank
Auditors* Certificate under Exchange Control Manual, 1965 ...................... 362
Certificate of Auditors.................................................................................... 366
Auditors' Report to the Shareholders in ......................................................... 429
the case of an Insurance Company

17.
18.
19.
20.

Important Auditing Case-Law Tabulated in Summarised Form ... 452

LIST
OF
CITED

CASES

Case Page
Allen Craig & Co. (London) Ltd. (1934)......................................................................... 313, 460
Anns LS. Merton Borough Council (1978)........................................................................... 417
Apfe! (Trustee of) us. Annan Dexter & Co. (1926)........................................................
4, 380
Armitage vs. Brewer and Knott (1932)..................... ............................................. 113, 402, 457
Arthur E. Green & Co. vs. The Central Advance and
Discount Corporation Ltd. (1920)..........................................................402, 459
Arthur Francis Ltd.................................................................................................................... 298
Bond i s. Barrow Haematite Steel Co. Ltd. (1902)................................................................. 456
Burland vs. Earie(1902).............................................................................................- 396, 457
Candler vs. Crane, Christmas and Co. (1951)..................................'...............................411, 414
City Equitable Fire insurance Co. Ltd. (1924)............................................... 154, 161,405,458
Colmer vs. Merrett, Soh and Street (1914}.............................................................................. 441
Cox vs. Edinburgh and District Tramway Co. Ltd................................................................... 397
Crabtree vs. Crabtree (1912)............................................................................"..................... 455
Dehra Dun Mussoorie Electric Tramway Co. Ltd. (1929)....................................................... 458
Deny vs. Peek (18891............................................................................................................... 412
DeSavary vs. Hoiden Howerd and Co. (I960)..:............................................ ......................... 411
Diamond Manufacturing Ltd. vs. Hamilton (1968).................... _____................................... 415
Donoghue vs. Stevenson............................................................................................... 414, 415
Drown vs. Gnumont British Picture Corporation Ltd. (1938).................................................. 457
Findiey vs. Waddell (1910).................................................................................................... 65
Foster vs. New Trinidal Lake Asphalte Co. Ltd. 11900)..................................................393, 453
Grover Industrial Holding vs. Newsman Harris & Co......................................................----- 415
Guardian Insurance Co. of Canada vs. Sharpe, Milne and Co. (1941)................................. 411
Haigis. Bairifbrd <1976>.............................................................................'...................... 415
Hedley Byrne & Co. Ltd. vs. Heller and Partners Ltd. (1964)................................ 412, 415, 463
Henry Squire (Cash Chemists) Ltd. vs. Ball, Baker and Co. (1911).........................................461
Herbert Alfred Burligh vs. Ingram Clark Ltd. (1901)...................................................... 297, 452
Hoale, Smith and Field vs. Valentine Tingey (1926)....;..:.......................................:................. 65
Hoole vs. The Great Western Railways Co. (1965)...;......-.................................................... 457

Irish Woollen Co. vs. Tyson and others (1900)............................................. 157, 404,460, 463

^"#^er^rit&.3 ^arks^Bioo&i & Co. (1980)................................................. 413, 416, 417, 464

Kingston Cotton Mills Co. Ltd. (1896).'...............................................................-. 164,406, 460
Lahgunas Nitrate Co. vs. Shroeder(1901)................................................................................ 458
Lawless vs. The Anglo-Egyptian Cotton and Oil Co. Ltd. (1869)........................................... 409
Lee- us. Neuchatel Asphalte Co: Ltd. (1889).........................................................>......
392, 455
;
Leech vs. stockes and others (1937)............................................____.................................. 380
Leeds Estate Building & Investments Co. us. Shepherd (1887)...... 401, 403,404, 453
LeLievre and Dennes vs. Gould (1893)................................................................................... 414
Liverpool and Wigan Supply Association Ltd. (1907)......................_.................................... 401
. London and General Bank (1895)........:...................................................... 4, 65, 321, 406, 452
..London Oil Storage Co. Ltd. vs. Seear Hashluck &' Co. (1904)............................154, 403, 459
Lubbock vs. British Bank of South America Ltd. (1892)....................................... 392, 393, 454
Mckesson and Robbins (1939)............................................................................................... 155
McKesson and Robbins Investigation (1941).........................................._.......r...................... 461
Mead vs. Ball,.Baker & Co. (1911)........;........,.,.................................................................. 461
. JJewton vs. Birmingham Small Arms Co. Ltd. (1906)............................._......................401, 461
Republic of Bolivia Exploration Syndicate Ltd. (1913)...........................................................407
Jtese vs. Bishirgian and others (1936)........................................................................................441
ilex vs. Kylsant (1931).....................................................................-.................... 407, 441, 462
Ross us. Caunters(1979).......................:..........................................................................417
! Royal Mail Steam Packet Co. (1931).................................................______.................1 399,408
S. P. Catterson & Sons Ltd. (1937)........................................................................................... 405
Scott Group Ltd. vs. McFarlane.......................................................................................415, 417
.. Sham Dasani vs. Pochkhanwala (1927).................................................................................. .462
. Short and Compton vs. Brackett (1904)................'...........1.....................-..........'................... 441
[ Smith us. Sheard(1906).................,.................................................................................. 3,459
Sockockinsky vs. Bright Grahme and Co. (1938)......,.............................................. 65, 298, 459
: Stapley us. Read Bros. Ltd. (1924)________..........................................................._____202,394
. The Ammonia Soda Co. Ltd. us. Arthur Chamberlain and others (1918)......: 393,395
;
. .....
. . . . . . . . .'1'.':" 5;?
Towers ps. Afi-icanTug Co. (1904)...........,..4..,.................,...............................,..................... 458
. .Ultramares Coiporation vs. Touche, Nivenand Co. (1931)....v.......................-............ 412, 414
UnionBank of Allahabad (1925). ..................................................
_ . . - 452
,:Vefner us. General and Commercial Investment Trust Ltd. (1894)........................................ 392
. Weld Blundel us. Stephens (1920X.....,V...._.,.;.......;....;......'............................... 410
Westminster Road Consti-uction and Engineering Co. Ltd. (1932)............................. 407, 463
Wilmer vs. McNamara & Co. Ltd. (1895).....................'.................................................... 456

LIST
ABBREVIATIONS
Abbreviation

Act
AEL
B/d
B/f
Board
CA
CAATs
CCI
CCIE
C/d
CJF
Co.
CPA
DSQ
EDP
e.g.
FCA
FIFO
FOB
FOR
GDA
GRN
ISA
Ibid
ICQ
i.e
IFAC
IOU

Full Meaning .
Associate Member of the Institute of Chartered Accountants Gf
Pakistan.Companies Act, 1913
;:,
Audit Engagement Letters
Brought down
:=: :
Brought forward
Board of Directors
Chartered Accountant
Computer-Assisted Audit Techniques ; .
Controller of Capital Issues
Chief Controller of Imports and Exports
Carried down
Cost, Insurance and Freight
Company
Certified Public Accountant
Description System Questionnaire
Electronic Data Processing
For example
Fellow Member of the Institute of Chartered Accountants of Pakistan
First in First Out
Free on Board
Free on Rail
Government Diploma in Accountancy
Goods Received Note
International Auditing Standard
In the same place
Internal Control Questionnaire
That is
International Federation of Accountants
I owe you

OF

ISA
International Standard of Auditing
LTFO
Last in First Out
Ltd.
Limited
MO
Money Order
Ordinance
The Companies Ordinance, 1984
Op. cit.
P
PIDC
PM
PP
RA
Re
Rs.
Section
UK
VPP
%

In the work cited

Page
Pakistan Industrial Development Corporation
Per Month
Pages
Registered Accountant
Regarding
Pakistan Rupee
Section of the Companies Act, 1913, unless otherwise stated
United Kingdom
Value Payable Post
Per cent

(Xvit
)

BY THE SAME AUTHOR

MERCANTILE LAW
OF PAKISTAN
Contents

Contains detailed commentary in a layman's style in respect

of: Law of Contract; indemnity; Guarantee; Bailment and
Agency; Sales of Goods; Partnership; Negotiable Instruments;
Arbitration; Insolvency and Carriage of goods.
Readership

A practical guide for Business Executives, Personnel

dealing with Commerce, Trade and Industry and financial
institutions and students of Commerce, Business Administration and Professional examinations.
PRICE Rs. 35.00

COMPANY LAW AND

PRACTICE IN
PAKISTAN
This book has been, re-written in the light of the Companies
Ordinance.. 1984, and the Companies Rule, 1985, and will
appear in the market in the middle of 1993.

ixix)

BY Tl IE SAME AUTHOR

INCOME TAX LAW

Practical Problems
Contents
Covers an interesting exposition of Law governing Income Tax Ordinance. 1979 and
includes all available amendments introduced into the above Ordinance through circular?
issued by the CBR and till the enforcement of Finance Act, 1993- '
The book covers topics such as: Introduction; Capital and Revenue; Income Exempt from
Tax; Salient Features of the Finance Act. 1993 ; Income Tax Authorities; Appeals and
Revision; Salaries: Interest on Securities; Income from Property: Profits and Gains of
Business and Profession: Depreciation; Income from other Sources and Capital Gains: Self
Assessment Scheme of Income Tax; Assessment Procedure: Registration of Firms;
Computation of Income of Special Concerns; Method of Accounting: Set-off and Carryforward of Losses; Foreign Investment and Pakistan Taxation; Miscellaneous; Assessment of
Individuals; Assessment of Firms; Assessment of Companies; Set-off and Carry-forward of
Losses: Solutions to Typical Practical Problems; Index.

Readership;
: Income-tax Practitioners. Business Executives; Practising Chartered Accountants; Personnel
of Income-tax Department; Cost and'Management Accountants and Chartered Accountancy
Students; Business Administra* tion, Commerce: and allied fields.

PRIC
E

Rs.80.0
O

CONTENT
S

Chapter

Particulars Page

Foreword................................................................................. ......................................111
Preface........................................................................................................................ w
Bio-Data of the Author.................,............................................................................... vi
Guidance Notes for Readers.................................................................................... xiii
Prescribed Syllabus for B. Com., University of the Punjab.......................................... ix
Table of Statutes...........................................................................................-................. x
Table of Appendices/Annexures................................................................................... rii
List of Forms/Charts ...............,...................................................................................xiii
List of Cases Cited............................................................................................xiv
List of Abbreviations................................................................................................... xvi
,

PRINCIPLES OF AUDITING................................................................ ............-.... 1-22

Origin of Audit ...........,...................................................................................... 1
, Definitions of Audit.................................................................... ........................ 1
^Auditing DrfTerentiated from Accounting ......,................................................... 3
Qualities required in an Auditor......................................................................... 4
Objects of an Audit ............................................................................................ 6
, The detection and prevention of errors and mistakes................................... 6
Clerical Errors..........."............................................. ...........................
Errors of omission...........................................................................Errors of comrnisMon .................................. ..................................
Compensatory Errors....................................:..................................
Trial Balance Errors..........................................................................
Errors of Principle..............................I..,,.........,,..................................

6
6
6
7
7
7

ixix)

Incorrect allocation........................................................................... 7
Omission of Outstanding assets and liabilities................................. 7
Incorrect Valuation of assets............................................................ 7
Location of Errors.............................................................................
7
Trial Balance Checking..................................................................
7
Short cut Method............................................................................. 7
Extensive checking.............................................................. 8
The Detection and Prevention of Fraud...................................................... 8
Embezzlement of cash.......................................................................... S
Misappropriation of goods...............................................\...............

Fraudulent manipulation of accounts.................................................... 9

Expression of independent opinion on accounts................................................ 10
Moral check......................................................'....................................... 10
Responsibility for the detection of fraud and error............................................. 10
* Inherent limitations of an audit................................................................... 11
Risk of fraud and error....................................................................
12
Procedures when there is an indication
that fraud or error may exist.................................................................. 13
Other reporting responsibilities.................................................................. 13
History of auditing profession in Pakistan...................................................... 14
Auditor and accounting machine ."..................................................................... 14
Advantages.................................................................................................. 14
Disadvantages............................................................................................. 14
Auditor and the Computer................................................................................... 15

Fundamental Principles and Techniques of Auditing.......................................... 15

Examples of events which increase the Risk of Fraud or Error...........................16
History of Auditing Profession in Pakistan.................................................-.....:-18

/X

///A

AUDITING PROCEDURES............................................................................... 23-74

The Operation of Audit.........................................................v..................... 23
Ticking....................................................................................................... 23
Casting...............................................................................................:...... 23
Calling-over....................................".......................................................... 23
Vouching.............................................................................................. 24
Verification.....................................................................................24

Reporting.................................................................................................... 24
Procedures Affecting Audit................................................................................. 25
Compliance Procedures.......................................................................-..... 25
Substantive Procedures............................................................................... 25
Analytical Review Procedures............................................................ 25
Scope of Audit.................................................................................................... 25
Introduction......................................................................................................... 25
'Objective of an Audit........................................................................................... 26
Responsibility for the Financial statements......................................................... 26
f Scope of Audit........................................................................................................ 26
Ethics............................................................................'.............................; 28
Integrity, objectivity and Independence................................................................28
Confidentiality..................................................................................................... 28
/Professional comptence and due care and Technical standards............................ 28
Planning.........................................................................:............-.................... 29
Work performed by others................................................................................... 29
Documentation..................................................................................................... 30
v^^Audit Evidence.................................................................................................... 30
Audit Conclusion and Reporting......................................................................... 30
Conduct of Audit.................. .............................................................................. 31
^Continuous Audit........................................................................................ 31
Concept................................................................................................. 31
.Advantages............................................................................................. 31
Disadvantages....................................................................................... 31
J-'inal Audit.......................:............................:..................................-....... 32
' Interim Audit ............................................................................................... 33
Audit Engagement Letters .................................................................................. 33
Principal Contents....................................................................................... 34
Recurring Audits......................................................................................... 34
Audits of Components ................................................................................ 35
Using the Work of an Auditor...................................................................... 37
Introduction................................................................................................. 37
Acceptance as Principal Auditor................................................................. 38
The Principal Auditor's Procedures............................................................. 38
Documentation........................................................................ .................. 39
Cooperation between Auditors..............................;.................................. 39

Reporting Considerations............................................................................ 40
Division of Responsibility...............................-......-.................................. 40
Professional Conduct .......................................................................................... 40
Functions of the Council.................................................................................... 42
Duties and Obligations of a student and principal............................................... 42
Auditing Planning................................................................................................ 44
Knowledge of the Client's Business............................................................ 44
Development of an Overall Plan................................................................. 45
Developing the Audit Programme............................................................... 46
Audit Evidence .......................................................-........................-................. 47
Sufficient Appropriate Audit Evidence....................................................... 47
Method of Obtaining Audit Evidence......................................................... 49
Inspection.............................................................................................. 49
Observation........................................................................................... 50
Inquiry and Confirmation...................................................................... 50
Computation........................... .............................................................. 50
Analytical Review................................................................................. 50
Introduction.......................................................................... ................ 50
Observation of Inventory...................................................................... 51
Confirmation of Accounts Receivable.................................................. 53
Inquiry regarding Litigation and Claims................................................ 55
Long-Term Investments......................................................................... 56
Segment Information ..v-....................................................................... 57
Organisational Set up of an Audit Office ..:......................................................... 57
Organisation Chart of an Audit Firm................................................................... 58
Commencement of a new audit......................................................................... 59
' Audit Programme.......................................................................-......................... 61
Definition..............................................::.:................................................ 61
Preparation........................................................................r......................... 61
"Extent of Works...............................................:......................................... 62
Advantages................................................................................................... 62
'Limitations............'....................................................................................... 62
-Removal of Limitations ..'.................."....................:..........-..................... 62
Test Checking.......................................................................:.............................. 62
Audit Notebook.................................................__________ ............................... 64
Audit Programme........................................................................................'64

(24)

Audit Review Notes.................................................................................... 64

Audit Queries............................................................................................ 64
Important Balances.....................,..................................,......,.................. 64
Extracts from documents......................................................................... 64
Accounting Statistics.................................................................................. 64
t Working Papers.....................................................................................................65
Form and Content........................................................................................ 66
Ownership and Custody of Working Papers........................................... 67
Records of Progress of Audit............................................................................... 67
Schedule I..................................;........................................................................ 69
Schedule ........................................................................................................... 72
Schedule in ..:................................................................................................... 73
INTERNAL CONTROL.................................................................................. 75-111
- What is Internal Control....................................................................,.:............... 75
Internal Check, Internal Audit and Internal Control Distinguished... 75
Internal Audit....................................................................................................... 76
Concept.................................................... ................... ............................. 76
Scope........................................................................................................... 76
Role.......................................................................... ................................. 76
Forward looking approach to Internal Auditing.......................................... 77
Evaluation of Internal Control............................................................... 77
Review of Accounting Efficiency ............'............................................ 77
*
Appraisal of Performance of Organisation............................................... 77
Place of an Internal Auditor in the Organisation................................... 77
Internal Audit Report............................................................................. 77
Internal Auditing and External Auditing Dmerentiated ;..................................... 78
Cooperation between Internal and External Auditors................................. 79
Suggested Dimensions for Internal Auditors............................................... 79
Cooperation between Internal and External Auditor .................................. 79
Using the Work of an Internal Auditor...........................................................80
Introduction........................................'....................................................... 80
Scope and Objectives of the Internal Audit Function ................................. 81
Relationship between Internal and External Auditors................................. 81
General Evaluation of Internal Audit Function..................... ................ 82
Timing of Liaison and Coordination........................................................... 82

Evaluating Specific Internal Audit Work................................................... 83

Principles of Internal Control.............................................................................. 84

Review and Reliance of Internal Control by the Auditor................................ 85
Systems of Internal Control................................................................................. 85
Small concerns............................................................................................ 85
Manufacturing concerns.............................................................................. 86
CashReceipts............................................................................................... 87
Cash Payments........................................................--............................... 88
Petty Cash Transactions.............................................................................. 88
Purchases..................................................................................................... 89
Sales .................................."............................................................-.......... 90
Postal Sales..................................................................................... 90
Sales Over the Counter............................................................................. 91
Stores........................................................................................................... 91
Use of Statistical Records ............................................................-..................... 92
Methods of Evaluating Internal Control.............................................................. 92
Management Letter.............................................................................................. 93
Risk Assessment and Internal Control...........................-.....................................93
Introduction...........................................................................................................93
Inherent Risk.................................................................................................94
At the Financial statement level......................................................................... 94
At the Account balance and class of Transaction level.........................................95
Accounting and Internal Control systems........................................................... 95
Accounting system................................................................................................95
Control environment..........................................................................;-r............96
Internal control procedures...................................................................................96
Inherent Limitations of Internal Control...............................................................96
Understanding the accounting and internal control systems.................................97
Accounting system................................................................................................98
Control environment......................................................................................-.....98
Control Procedures...............................................................................................98
PreHmiriary assessment of control risk................................................................99
Documentation of understanding and assessed conatrol risk.............................100
Obtaining evidence from tests of control to support an
assessment of lower control risk................................................................101
Quality of evidence.............................................................................................101
Timeliness of evidence.......................................................................................102
Review of the Preliminary assessment of control risk........................................102
Relationship between the assessments of inherent and control risks..........................103'
Relating the assessments of inherent and control risks to detection

risk and their impact on substantive procedures........................................103

Internal control in the small business.................................................................104
Communication of weakness in internal control................................................105
Introduction........................................................................................................105
Organizational structure...................................................................................- 5
Nature of processing...................................................-.............. .....................106
Design and Procedural aspects...........................................................................107
Internal control in an EDP Environment............................................................107
General EDP Controls.......................................................................................108
EDP application controls ...,...............................................................................109
Review of General EDP Controls.......................................................................109
Review of EDP application controls.............................................................- 110
Evaluation.................................................................................................... 110

|,
'

VOUCHING......................................................................................................... - 112-152
Definition of Voucher........................................................................................ 112
Routine Checking.............................................................................................. 112
Definitions of Vouching.................................................................................
Extent of Vouching............................................................................................
Procedure of Vouching............,........................................................................
Technique of Vouching...................................................................................... 114
Cut-off Procedures.............................,.............................................................. 5
Audit Sampling................................................................................................... 115
Design of the Sample................................................................................ 116
Audit Objectives................................................................................. 116
Population..........................................................................................- 116
Risk and Assurance............................................................................. H7
Compliance Testing............................................................................ H7
Substantive Testing ............................................................................ 118
Tolerable Error.................................................................................... 118
Expected Error in the Population.................................................... 118
Stratification........................................................................................ H9
Selection of the Sample............................................................................ 119
Evaluation of Sample Results .................................................................. 120
Analysis of Errors in the Sample........................................................ 120
Projection of Errors............................................................................. 120
Assessing Sampling Risk.................................................................... 121
Conclusions............................................................................................... 121

Depth Test......................................................................................................... 121

Concept...................................................................-.............................. 121
Objectives................................................................................................. 122
Vouching of Cash Book Receipts Side......................................................... 122
Opening Balance...................................................................................... 122
Cash Sales................................................................................................ 122
Cash Received from Debtors...............................................................-- 122
Interest Income .............................................................................. ........ 123
Dividend Income.................................................................... ................. 123
Rents Received......................................................................................... 123
Commission Received.............................................................................. 124
-Subscriptions Received.......................................................-................... 124
Sale of Securities...................................................................................... 124
Bills Receivable..........................................................................-............ 124
Bad Debts Dividend........................................................................ 124
Insurance Claim Money Received............................................................ 124
Share Capital............................................................................................. 125
Sale of Fixed Assets..................................................-............................. 125
Miscellaneous Receipts............................................................................ 125
Vouching of Cash Book Payments Side....................................................... 125
Payments to Creditors ..'........................................................................... 125
Cash Purchases......................................................................................... 126
Wages........................................................................................................ 126
Time Records...................................................................................... 126
Piece-work Records............................................................................ 127
Preparation of Wages-sheets or Wages book...............................-..... 127
Payment of Wages............................................................................... 127
Payment of Salaries ................................................................................. 128
Capital Expenditure.................................................................................. 128
Freehold and leasehold property......................................................... 128
Plant and Machinery........................................................................... 129
Furniture and Fixtures..................................................................... 129
Motor Vehicles ................................................................................... 129
Investments............................................................................................... 129
Loans............................................................. .................................'.'...... 129
Payments under hire-purchase and instalment agreements...................... 130

(28)

Agent's and travellers' commission and expenses.................................... 130

Travelling Allowances......................................................................------ 130
Insurance Premiums................................................................................. 130
Bank Charges........................'................................................................... 131
Freight and Carriage............................................................................. 131
Deferred Revenue Expenditure................................................. .............. 131
Dividend Paid................................................................-.................132
Remuneration of Managing Agents.......................................................... 132
Custom Duties.....................................................,.................................. ;. 133
Postage.................................................................................................133
Telephone Expenses.................................................................................. 134.
Bill Payable............................................................................................... 134
Bill Receivable Dishonoured.................................................................... 134
Income Tax.and Super Tax, ...................................................................... 134
Partners Drawings..................................................................................... 134
Directors'Fee................................................................................135
Miscellaneous Expenses........................................................................... 135
Vouching by Petty Cash Book ......................................................................... 135
Vouching of Purchases Book..............................;___........................................ 136
Purchases Book .............................................. ........................................ 136
Purchases Invoices.................................................................................... 136
Allocation................................................................................................. 136
Receipt of Goods ,..................................................................................... 137
Inspection Reports.................................................................................... 137
Tenders and Quotations............................................................................. 137
Purchase Contracts.................................................................................... 137
Authorisation....................................................................;....................... 137
Statement of Accounts.............................................................................. 137
Forward Contracts..............................................;.................................... 137
Duplicate Invoices.................................................................................... 138
Provisional Purchases Invoices................................................................. 138
Insufficiently vouched purchase invoices................................................. 138
Casts and Postings.................................................................................... 138
Suppression of Purchases.......................................................................... 138
Inflation of Purchases'............................................................................... 139
Imports...................................................................................................... 139

Vouching of Sales Book ............................................:...................................... 139

Execution of Sales Order.......................................................................... 139
Sales Book.............................................................................................. 139
Sales Invoices........................................................................................... 139
Allocation................................................................................................. 140
Despatch of Goods................................................................................... 140
Sale Contracts........................................................................................... 140
Authorisations.......................................................................................... 140
Statement of Accounts.............................................................................. 140
Tenders and Quotations .....................................................,.................. 140
Exports.............................................................._...................................... 141
Forward Contracts.................................................................................... 141
Provisional Sale Invoices ........................................................................ 141
Insufficiently Vouched Sale Invoices....................................................... 141
Casts and Postings.................................................................................... 141
Suppression of Sales...........................;............................................ 141
Inflation of Sales....................................................................................... 142
Sale or Eetum Basis.................................................................................. 142
Sale on Consignment Basis...................................................................... 142
Heavy Sales........................................................................................... 142
Vouching of Purchases returns book................................................................. 142
Purchasing Returns Book.......................................................................... 143
Debit Notes .............................................................................................. 143
Allocation..................,.............................................................................. 143
Goods sent out ....................'.................................................................... 143
Reason for Return .................................................................................... 143
Casts and Posting...................................................................................... 143
Manipulation............................................................................................. 143
Statement of Accounts.............................................................................. 144
Vouching of Sales Returns Book....................................................................... 144
Sales Returns Book................................................................................... 144
Credit Notes.............................................................................................. 144
Allocation................................................................................................. 144
Goods for Return...................................................................................... 144
Casts and Postings.................................................................................... 144
Manipulation.................................-.......................................................... 144

(30)

Statement of Accounts.............................................................................. 145

Vouching of Bills Receivable Book........................_................................... 145
Vouching of Bills Payable Book....................................................................... 145
Vouching of Journal........................................................................................... 145
Opening Entries........................................................ ............................... 145
Closing Entries......................................................................................... 146
Transfer Entries......................................................................................... 146
Rectification Entries..........................................................................----- 146
Adjusting Entries ....................:...........;.............................................. 146
Transactions for which there is no other book of original entry 146
Audit of Purchases Ledger................................................................................ 146
Audit of Sales Ledger....................................................................................... 147
Auditing of General Ledger.............................................................................. 147
Casts ;.............................................................................................;.....:.- 148
Scrutiny..............................................................."................................. 148
Trial Balance............................................................................................. 148
Audit of Banks Statements................................................................................ 148
Debit side of cash book............................................................................ 148
Credit side of cash book.................................................................148
Casts............................................:........................................................... 148
Bank Reconciliation.................................................................................. 148
. Factors Influencing Compliance Test Sample Size.................................. 150
Factors Influencing Substantive Test Sample Size................................... 151
Compliance test and substantive test risk Matrix..................................... 152

VERIFICATION - GENERAL.......................................................:...............153-189
Need for Verification......................................................................................... 153
Six-rx>int Technique forVerification ..........................i.........................:,........... 153
Physical Existence.................................................................................... 154
Correct Valuation..................................................................:............... 154
Ownership................................................................................................. 155
Correct Disclosure ....................I.'..,.'......................................------...... 157

Assets suffering from a charge................................................................... 157^

Company's Register of Mortgage........................................................... 158
Registration with Registrar ...................................v........:............,........ 159
Fixed Charges....................:.............................................................. 159

(31)

Floating charges........................................................................................ 159

Mortgage ..:.............................................................................................. 159
Pledge....................................................................................................- 159
: Hypothecation....................................................................................---- 159
Proper Authorisation ...........................................................................159.
Verification of Assets not in Possession of Client.......................;................. 159
Banks accounts..........................................................................................163
Contingent Liabilities........................................_.............................164
Related Parties.......................................................".............,........................... 165
Definitions............................................,..............................................---- 166
. Existence of related parties...................................................................... 166
Transaction with related parties................................................................ 167
Examining identified related party transactions....................................... 168
Audit conclusions and reporting.................................................:........... 168
Events Occurring after the Date of Balance Sheet............................................ 169
Liabilities..............................................,.................................................. 169
Provision for Taxation ............................................................................. 169
. Fixed Assets.............................................................................................. 169
Debtors .................................................................................................... 169
Stock-in-Trade.......................................................................................... 169
Inroduction.........................................................................................................170
Dating, of the Auditor's "Report...........,.............................................................170
Events up to the date of the Auditor's report......................................................171
Events after the date of the Auditor's report but before the
Financial Statements are issued..................................................................172
Offering of Securities to the Public ...............................;;.v...-v.:n..............173
Discovery of facts after the Financial have been issued.....................................173
Example of an Auditor's report on revised Financial Statements...............................174
Representation Letter......................................;.*....:-.........>..................... 175
Representations by Management as Audit Evidence................................ 175
Documentation of Representations by Management..........................176
Written Representations................,.................................................... 176
Basic elements of a management representation letter......................... 176
Action if management refuses to provide representations....................... 177
Example of a Management Representation Letter................................,.......... 177
Responsibility for the financial statements and auditor............................ 179

Specimen -of Representation Letter in use in Pakistan...................................;. 180

Liabilities and commitments .....................................,...;..:.,.................. 181
Contingencies..........................................................................-............... 181
Analytical Review.......................................................................................... 182
Introduction......................................................................-----................. 1S2
Nature and purpose of Analytical Review Procedures ............................ 183
Analytical Procedures in Planning the Audit.....................................................183
Analytical procedures used as substantive test......................_...................:......184
Extent of Reliance on Analytical Review Procedures........................... 185
Investigating Unusual Fluctuations and items.......................................... 186
Analytical procedures used in the overall Review.............................................186
Quality of Audit Work...............................:..:............................................... 186
Control on individual audits..................................................................... 187
Delegation..........................................................J....;....:.....'..,................. 187
Supervision....................................................:..................................., 187
Review..................................................~.....<..-............................ 187
General quality controls............................................................................ 188
VERIFICATION - LIABILITIES ....................................................................... 190-200
Capital.............................................................................................................. 190
Share transfer audit................................................................................... 193
Reserves..............................................-......-.................................................. 194
Deferred Taxation............................t................................................................. 194
Debentures.....................................................................................................i.. 194
Loans _______.................................................^...T.^....>.;-............................ 196
. Secured..............................................................................................-...... 196
Unclaimed dividends ...............'...............,......:....'......................................... 196
Liabilities.......................................-.................................-,.............,................-~ 196
Bills payable........................... ..................J................:..v....................... 197
Provision for taxation............................................................................... 198
Proposed Dividends.................................................................................. 198
Unexpired Discounts.......................,........;....................................................... 198
Contingent Liabilities........................................................................................ 199
Liability Certificate........................................................................................... 200

(33)

()
X

VERIFICATION - ASSETS................................................................................... 201-225

Balance Sheet Audit.....................................................................................'.. 201
Fixed Assets.....................;................................................................................ 202
Goodwill................................................:................................................: 202
Freehold Land.....................'................................................................. 202

Leasehold Land....................................................................................... 202
Buildings....................................;............................................................. 202
Capital work in progress........................_................................................ 203
Assets Abroad.............................................................................. ........... 203
Railway Sidings........................................................................................ 203
Plant and Machinery................................................................................. 203
FauTuture and fixture............................................................................... 204
. Development expenditure ...............,........................................................ 204
Mines and Quarries.................................................................................
204
Patents .............................................................................................205
Trade marks and designs ............................................................205
Copyrights................................................................................................205
Vehicles..................................................................................................... 205
Interest paid out of capital ............................................................... 206
Assets acquired on hire-purchase system.............................................. 206
Preliminary expenses......................................................................................... 206
Commission on Shares and Debentures............................................................ 207
.. > Commission on shares...................................................'........................ 208
Commission on debentures....................................................................... 208
Brokerage............................................................................................... 208
Underwriting Commission.............................................................................. 209
Stores and Spare Parts .................',...........................:..............._...................... 209
Loose Tools.................................................................................................... .. 209
Live-Stock..............................................................--..................... ..:.v........ 209
Stocks ..........................................................._.........,...,.,^_:.-, ..................... 210
; Stock-in-trade.............................................................................................. 210
Examination of Stock-taking procedure..................... 210
Verification of Quantities of Stocks............................................... 211
Verification of Valuation of Stocks..................................................... 211
Stock-in-Transit.....................................................................................212
Work in Process...............:.............................................................. 212

()
Stock of Packages and Empties................................................................ 213
Stock of Goods sent on Corisignment...................................................... 213
Stock of Goods sent out on sale or return................................................. 213
Bills of Exchange..................,................,.................................................214
Book Debts.............................................................I......................................... 214
Advances.........,..........................................................................,.................... 216
Loans and Advances (as an Asset).................................................i......... 216
Loans against security of goods.......................................................... 216
Loans against insurance policy........................................................... 216
Loans against security of shares ........................:............................... 216
Loans against security of land and property....................................... 216
Deposits.................................................................................................... 217
Prepayments............................................................................................. 217
Recoverable Claims.................................................................................. 217
Investments..........................................................................................-............ 217
Principal.................................................................:................................. 217
Book values.................................................................::.,.:. ... 217
, !. Market values .................................................................................. 217
. ': Interest...................___.............:.................................................-i........... 218
. Contingent liability........................................................................... r i , ..... 218
Speculative transactions .............-............................................................ 218
Endowment policies................................................................................. 218
Interest accrued on investments............................................................... 218
Cash and Other Balances................................................................................. 218
'Cash..................;. .....:;.!;.. ...;..:...:..::...:::............................21s
Cash-m-Transit.........................................................................,..... 219
National Prize'Bonds ..................................................................... 219
Bank Balance........................................................................................... 219
Balance with Agents................................................................................. 220
Deferred Revenue Expenditure......................................................................... 220
Contingent Assets.............................................................................................. 220
Stock Certificate................................................................................................ 222
Suggested format of letter for debtor's
confirmation by direct communication.................................................... 224
Suggestions for improving response rates......................................................... 225

ixxxiv)
y>Z

%p

VERIFICATION - REVENUE ACCOUNT...........................................................226-228

Scrutiny of Trading Account............................................................................. 226
Scrutiny of Profit and Loss Account ................................................................ 227
ScmtinyofProfit and Loss Appropriation Account............................................ 227
INTERNATIONAL ON STANDARDS AUDIT GUIDELINES.........................229-290
J

Current status of International Standards on Auditing adopted by the Council of

the Institute of

Chartered Accountants of Pakistan......................................................... 231

International Federation of Accountants....................................................233
Summary of International Standards on Auditing
and related services......................................................................................... 234
Overview of Standards...................................................................................... 236
Framework of International Standards
on Auditing and related services.................................................................... 236
ISA 1: Objective and Scope of the Audit of financial statements . 236
AjcGl ^-^- ISA 2: Audit engagement letters..............................-.......................................... 236
l--->i_&- ,<- ISA 3: Basic principles governing an audit ................................................. 236
ISA 4: Planning............................................................................................... 237
ISA 5; Using the work of an other auditor.....................-.............................. 237
--^ GL(SU.O ISA6: Study and evaluation of the accounting system and
related internal controls in connection with an audit .................... 237
ISA 7: Control of the Quality of Audit Work................................................. 237
ISA 8: Audit evidence......................J.......................................................,... 238
Addendum: Additional guidance on Observation of
inventory, confirmation of accounts receivable
and inquiry regarding litigation and claims ................................................... 238
1
AJCGC (^: Documentation................................................................................................. 238
^^TSA 10: Using the work of an internal auditor................................................... 239
ISA 11: Fraud and Error............................................................................... 238
ISA 12: Analytical review....................................................................... 239

ISA 13; The auditor's report on financial statements........................................ 239

ISA 14: Other information in documents containing
audited financial statements .................'................................ 239
ISA 15: Auditing in a EDP Environment........................................................ 240
ISA 16: Computer-Assisted audit techniques.......................................... 239

ixxxv)

^KA17: Related parties............................................................................................ 240

ISA 18: Using the work of an expert................................................................ 240
ISA 19: Audit sampling..................................................................................... 240
D
AJ iCi~- olO^ ISA 20: The effect of an EDP environment on
the study and evaluation of the accounting
system and related internal controls.............................................. 241
<^C^ISA 21: Date of the auditor's report; events after the
balance sheet date; discovery of facts after the
financial statements have been issued ....................,.................... 241
ISA 22: Representations by Managements....................................................... 242
ISA 23: Going concern.................................................................................... 242
C< ISA 24: Special purpose auditor's re,x)rts........................................................ 242
ISA 25: Materiality and Audit risk................................................................... 242
ISA 26: Audit of accounting estimates............................................................. 243
ISA 27: The examination of Prospective Financial information...................... 243
ISA 28: First Year Audit Engagement - Opening Balances................................244
AjfjdL c/.^'-^ISA 29: Inherent and control risk assessments and
their impact on substantive procedures..........................................."244
ISA/RS 1: Basic principles governing review engagements......................... 244
ISA/RS 2: Review of financial statements..................................................... 244
ISA/RS 3: Engagements to perform agreed-upon procedures........................244
ISA/RS 4: Engagement to compile financial information...............................245
Audit Summary of Basic principles and essential procedures ..................... 245
Overall objective and scope..................................................................... 245
Basic principles General matters .................................................. 246
Integrity, objectivity and independence ..:.......................................... 246
Confidentiality................................................................................... 246
Skills and competence.............................................................................. 246
Basic principles and essential examination procedures ................................... 246
Planning.................................................................................................. 246
Audit Evidence......................................................................................... 249
General matters......................................................................................... 249
Sampling................................................................................................... 249
Computer-assisted audit techniques (CAATs).......................................... 251
Opening balances.......................,.........................................................251
Inventory, accounts receivable and Litigation and claims.........................252
Accounting system and internal control .................................................. 253

(37)

EDP...................................................................................................... 255
The assessments of inherent and control risk
and their impact on substantive procedures............................................256
Compliance procedures and audit conclusions............................... 257
Substantive procedures and audit conclusions......................................... 257
Materiality............................................................................................... 257
Fraud or Error........................................................................................... 258
Going concern.................................................................259
Accounting, estimates ..........,.................................................................. 260
Analytical review.................................................."................................. 261
Related party transactions.........................................................................!62
Subsequent events.................................................................................... 263
Management representations.................................................................... 263
Opening balance........................................................................................264
Work performed by others........................................................................ 264
Another Audit...................................................................................... 265
Internal Auditors....................................................................................... 266
Experts............................................................................................. 267
Documentation....................................................................................... 268
Basic principles and Essential reporting procedures................................... 268
General Matters....................................................................................... 269
Dating of report/Subsequent discovery of an error............................... 270
Other information in documents containing
audited financial statements.......................;:.........-................................. 271
Overall objectives and scope......................................'............................. 271
Consideration of other information.................V!.......... ......................... 271
Material inconsistencies........................................................................... 272
Material misstatements of fact ......................:......................................... 272
Availability of other information after
date of the auditor's report.................................................................. 273
Special purpose auditor's reports................................................:................... 273
Overall objective and scope..................................................................... 273
General matters........................................................................................ 273
Other comprehensive basis of accounting................................................ 274
Components of financial statements......................................................... 274
Compliance with contractual agreements................................................. 274

bcxxvii)

Summarised financial statements ............................................................ 275

Examination of Prospective Financial information................................. 275
Overall objective and scope ... ....................................276
General matters :.,:.....................................................................................276
Exanurmtion jnxicedures .............................i...^....,.:.:....;,....;............... 277
Reporting procedures .... -----------------..................................................277
Related services Summary of basic principles.....................................278
and essential procedures ..r.i~................................................................... 278
Overall objective and scope...................................................................... 278
General matters.................................................................................... 279
Integrity, objectivity
and
uidependentd
"
, :
' ',
279
Confidentiality
."
:
.
279"
Skills and cbmpetetice.............................................................................. 279
Basic principles and essential review procedures . ,
/_ 279
Planning ." .. .
.
- :--........................................... 279
Generalguidelines..................................................................................... 279
Work performed by others.............................................................. 280
Documentation.......................................................................................... 281
Basic principles and essentia! reporting procedures ........................................ 281
Engagement to perform agreed-upon procedures...............................................282
Overall objective and scope................:'.............................................................282
Basic Principles - Genereal................................,...................,..........................282
/mtegriW......^.........................................................................:...;......................-282
Objectivity ..:..;.;:....... :.....:,;..................^..:;..'.........:.....................;...........282
Confindentiality...;........................:....;..:....................................................282
Skills and competence:...:...................................................................................282
Basic Principles - Procedures.............................................................................282
Documentation......................................^.......^.................................................282
Planning..........................'.............................................. .....................................283
Evidence....................................................L......................................................283
Basic Principles - Reporting...............................................................................283
Engagement to compile financial information...................................................284
Overall objective and scope......................................................................... 284
Basic Principles-General...................:................................................................284
Integrity .................................................................................:......,.........;...... 284
Objectivity..........................................................................................................284
Confidentiality....................................................;...i.:i.^i.;:*.Vi^v.>.--^-- 284

()

Skills and competence........................................................................................284

Basic Principles-Procedures.............................................................'.................285
Documentation...................................................................................................285
Planning..............................................................................................................285
General guidelines..............................................................................................285
Basic Principles - Reporting...............................................................................285
International Standards on Auditing and related services...................................287

-4

%,

^| AUDITOR OF A LIMITED COMPANY .................................................... 290-300

Appointment of auditors.................................................................................... 290
First auditors............................................................................................. 290
Subsequent appointment......................................................................... 290
Casual vacancy..................................................................................... 291
No appointment......................................................................................... 291
Remuneration............................................................................................ 292
Qualification of auditors........................................................................... 292
Disqualification of auditors....................................................................... 292
Independence of an auditor................................................................................ 293
Powers and duties of auditors.................................................................. 293
Auditors' Report to the members Form........................................................ 295
Reading and inspections of auditors' report.............................................. 297
Signature of audit report.....................................................................,..... 297
Audit of cost accounts............................................................................... 297
Auditors' hen....................................................:................................... . 297
Status of Auditor.................................................................................. 298
As an agent of the members................................................................ 298
As an officer of the company.............................................................. 298
Audit committee........................................................................................ 299
Concept............................................................................................. 299
Scope of work..................................................................................... 299
Benefits...........................................................................:................... 299
Materiality to accounts and the auditor..................................................... 299
AUDITOR OF A COMPANY AND LEGAL DOCUMENTS ............. 301-305

Memorandum of association and auditor.......................................'................... 301

Articles of association and auditor ................................................................... 302

Prospectus and auditor ..................................................................................... 302

Minutes book and the auditor ........................................................................... 303
Statutory books and auditor ...................................................................-......... 304
<| ^AUDITORS' REPORTS ............................................'.................................................306-341
Certification of statutory report......................................................................... 306
Shares allotted and cash received there-against........................................ 306
Receipts and payments account................................................................ 307
Form of auditor's certificate...................................................................... 308
Report for irisertion in prospectus..................................................................... 308
Auditors' Report...............................................................-............... 310
Scope of Auditor's work................................ .......................................... 311
Auditor's Form of the report illustrated.................................................... 312
Annual Audit .................................................................................................. 313
Auditors' Report........................................................................................ 313
Circulation of Accounts................................ .......................................... 313
Laying accounts before general meeting for consideration...................... 314
Authentication of accounts....................................................................... 314
Filing of accounts...................................................................................... 314
Contents of report.............................,....................................................... 314
Submission of auditors'report to shareholders................................................... 319
Auditors'report to the members......................................................................... 319
Qualifications in an audit report................................................................ 320
Auditors'Report: Form of qualification............................................................. 321
Disclaimer............................................................................................... 321
Adverse opinion........................................................................................ 321
Subject to opinion..................................................................................... 321
Except opinion.......................................................................................... 321
Examples of qualifications........................................................................ 322
Auditor's report and going concern concept.......................:.............................. 322
The going concern assumption.....................".:......................................... 323
Financial Indications............................................*............................. 323
Operating Indications.......................................................................... 324
Audit evidence.......................................................................................... 324
The Auditor's Report................................................................................. 325
Paragraph emphasizing unresolved going concern questions....................326

()

Opinions expressing disagreement......................................................327

Example of an Auditor's report qualified for the
possible effects of a going concern uncertainty.................................. 327
Examples of on Auditor's report qualified for disagreement for
inadequate disclosure of a going concern uncertanity when
an adverse opinion is not appropriate..............................................................328
Audit conclusions and reporting....................................................................... 329
Report on the affairs of a company in support of a
director's declaration of the company's solvency .................................... 329
Verification........................................................"..................................... 330
Reason for winding up.............................................................................. 330
Reflectionof liabilities in the accounts..................................................... 330
Report....................................................................................................... 330
The auditor's report on financial statements ..................................................... 330
Suggested proforma of auditor's report
under Section 362 of the Ordinance ........................................................ 331
Basic elements of the auditor's report....................................................... 332
Types of opinions...................................................................................... 334
Circumstances that may result in other than
an unqualified opinion ....................................................................... 335
Limitation of scope............................................................................. 335
Disagreement with management......................................................... 336
Paragraph emphasizing on uncertainty............................................... 336
Form of auditor's rniqualified report ................................................................ 337
Examples of opinions other than unqualified............................................... 338
International Accounting Standards and the Auditor........................................ 339

/' '

///f/

AUDIT UNDER OTHER STATUTES............................................................... 342-378

Audit under the Cooperative Societies Act, 1925...................................................... 342
The Capital Issues (Continuance of Control) Act, 1947................................... 343
Facts.......................................................................................................... 344
Auditor's Certificate.................................................................................. 345
Audit under the Insurance Act, 1938.................................................................347
Auditors' Report to the Shareholders
in case of an Insurance Company....................................................... 347
Special Audit................................................................................................- 347
Audit under the Banking Companies Ordinance, 1962................................. 359

Auditors report to the shareholders in the case of a Bank ............................... 360

Certification by Auditor under Exchange Control Manual, 1965 .... 361
Auditors' Certificate.......................................................................................... 362
Audit of Accounts under the Industrial Relations Ordinance, 1969 362
The Monopoly Control Authority Rules, 1971................................................. 363
Audit of Companies taken over under
the Economic Reforms Order, 1972 .....................................................364
Audit under the People's Finance Corporation Act, 1972................................. 364
Special purpose Auditor's Reports..............................................................365
Audit under Companies (Invitation and Acceptance
ofDeposits) Rules, 1987 ............................... . .......;...... 365
Summarised financial position of the company as appearing in the Two Audited
balance sheets immediately
preceding ^ year's............................ ___________;....................366
Certificate of Auditor.........................................................................................366
Special purpose Auditor's report........................................................................367
Introduction....................................................................................................... 367
General considerations.......................................................................................367
Reports on financial statements prepared in accordance with
an other comprehensive basis of accounting.............................................369
Reports on components of financial statements.................................................370
Report on compliance with contractual agreements...........................................371
Reports on summarized financial statements.....................................................371
Examples of reports on financial statements prepared in accordance with an other comprehensive basis of accounting.......................... 373
Examples of Reports on components of financial statements............................374
Examples of Reports on compliance given in a separate report
and in a report accompanying financial statements...................................375
Examples of reports on summarized financial statements.................................376
Banking Companies. Ordinance, 1962.............................................................. 377

, 3s AUDIT OF SOLE TRADERS AND PARTNERSHIP CONCERNS ... 379-384

Auditor and Paitnership accounts...................................................................... 379
Types of partnership audits................................................................................ 381
Onbehalf of a sleeping partner................-................................................ 381
On behalf of a retiring partner or a

representative of a deceased partner........................:......................... 381

Advantage of audit to a sole trader................................................................... 382
Advantages of audit to a firm............................................................................ 382
Audit of partnership firm contrasted with
audit of limited companies...................................................,.................. 383
^| INDIVISIBLE PROFIT................................................................................................385-400
Importance of proper ascertainment of profits.................................................. 385
^The concept of the Profit ................................................................................. 385
Difficulties in the determination of profits...................................................,...386
Consequences of incorrect deterrnination of profit .......................................... 386
Legal provisions..................................................,............................................. 387
J Concept of divisible profit........................................................................... 387
Directors and payment of dividend............................................................... 388
Payment of dividend.......................................................................................... 389
Payment of interim dividend............................................................................. 390
Appropriation of Profits...............................................'.................................... 390
Legal cases..................................................................................................... 392
Depreciation of fixed and floating assets ................................................. 392
Capital Profits........................................................................................... 393
Past Losses................................................................................................ 393
Draft upon reserves open and secret.................................................... 394
Transfer to reserves................:............................................................... 396
Profit prior to incorporation...................................................................... 396
Capital losses............................................................................................ 398
Revaluation of fixed assets and the auditor ...................................................... 398
Secret reserve and auditor......................... ....................................................... 399
Sinking fond...................................................................................................... 400

4 A LIABILITIES OF AN AUDITOR...........................................................................401-419
Liability of an auditor appointed by a private concern.....................................
Auditors' liability for negligence..................................................^ . ..................
Auditors'liability for misfeasance......................................................................
Criminal liabilities and auditor..........................................................................
Auditors'liability for libel..................................................................................
Auditors' liability in dual appointments............................................................

401
401
405
407
409
410

Liability of an honorary auditor........................................................................ 410

Liability of an auditor to third parties .................... ......................................... 411
New professional negligence liability judgement..................................... 413
Narrower test of liability.....................................................-.................... 415
Drastic revision needed............................................................................. 416
Implications for accountants..................................................................... 418
What are reasonable grounds?.................................................................. 418
Auditor a Watchdog and not a Bloodhound.............................................. 419

/a X/

SPECIAL POINTS DIFFERENT CLASSES OF AUDITS ............420-439

Bank.......................................................................................................................... 420
Branches______...........;;................................................................................ 421
Brick Company.............................................................................................. 422
Bus Companies..........................................................................................-...... 422
Charitable Institutions....................................................................................... 422
Cinemas and Theatres....................................................................................... 423
Clubs.............................................................................................-................... 423
Collieries........................................................................................................... 424
Contractors........................................................................................................ 425
Doctor................................................................................................................ 425.
Educational........................................................................................................ 426
Electric Supply Company.................................................................................. 427
Executors' Accounts........................................................................................... 427
Hospitals............................................................................................................ 427
Hotels.................................................1............................................................. 428
Importing House................................................................................................ 428
Insurance Company Life ............................................................................. 428
Auditors' Report to the Shareholders in
the case of an Insurance Company...................................................... 429
Landed Estates................................................................................................... 430
Mail Order Business.......................................................................................... 431
Mining Company............................................................................................... 431
Motor Cab Company......................................................................................... 431
Newspapers and Periodicals.............................................................................. 432
Oil Producing Company.................................................................................... 432
Partnership Accounts......................................................................................... 432

Publishers......................................................................................................... 433
Railway companies........................................................................................... 433
Registered Society............................................................................................ 434
Retail Stores...................................................................................................... 435
Rubber Plantations............................................................................................ 435
Shipping Companies......................................................................................... 436
Stock Broker.........................................................._......................................... 437
Sugarcane Company ........................................................................................ 437
Water Company................................................................................................. 437
<4 |% BUSINESS INVESTIGATIONS............................................................................ 438-450

'Investigation defined.......................................s._.............................................. 438

'Audit and Investigation distinguished ............................'.................................. 438
v Objects of Investigation ................................................................................... 439
Qualities of an Investigating Accountant.......................................................... 440
< Scope of Investigation...................................................................................... 440
Investigating accountant and the case law......................................................... 441
/Fypes of Investigations..................................................................................... 441
Misappropriation of Cash......................................................................... 441
Misappropriation and Manipulating Stocks.............................................. 442
Investigation on behalf of an incoming partner........................................ 444
Investigation on behalf on a lender of money............................................444
Purchase of a controlling interest in the
share capital of a limited company ,................................................... 445
investigation under the Companies Ordinance, 1984 ..................................... 447
Interpretation of comparative trading profit and loss accounts ........................ 448
Enquiry under Securities and Exchange Ordinance, 1969 ............................... 449
^ ^AUDITING CASE-LAW............................................................................................451-464

Important Auditing Case-law Tabulated in Summarised Form......................... 451

^I^COMPUTER AND THE AUDITOR................................................................... 465-500

/A

'

Auditing in an EDP environment............................................................................... 465

Introduction................................................................................,............. 465
Skills and Competence............................................................................. 465
Work Performed by Others....................................................................... 466

Planning................................................................................................... 466
Accounting System and Internal Control................................................. 466
Audit Evidence......................................................................................... 466
Risk Assessment and Internal Control.......................................................-.......466
EDP environments - Stand-alone Microcomputers........................................... 467
Introduction....................................................................................................... 468
Microcomputer systems.................................................................................... 468
Microcomputer configurations.......................................................................... 468
Characteristics of Microcomputers................................................................... 469
Internal Control in Microcomputer environments............................................ 470
Management authorization for operating microcomputers............................... 470
Physical security - Equipment........................................................................... 471
Physical security - removable and non-removable media................................. 471
Program and data security................................................................................. 472
Software and data integrity................................................................................ 473
Hardware, software and data back-up.................................... .............. .......... 474
The effect of Microcomputers on the accounting system
and related internal controls...-^.... ........:............................ .......................... 474
General EDP controls - Segregation of duties ........"...."..:................ ............. 474
EDP application controls................................................................................... 474
The effect of a microcomputer environment on audit procedures.................... 475
EDP environments - On-line Computer systems.............................................. 476
Introduction..................................................................................................... 477
On-line Computer systems................................................................................ 477
Types of on-line computer systems................................................................... 478
On-line/real time processing............................................................................. 479
On-lins/batth processing.................................................................................... 479
On-line/Memo update (and subsequent processing)...................................... 479
Ori-line/inquiry................................................................................................. 480
On-line Downloading/uploading processing..................................................... 480
Characteristics of on-line computer systems..................................................... 480
Internal control in on on-line computer systems............................................... 481
Effect of on-line computer systems on the accounting system
and related internal controls............................................................................ 482
Effect of on-line computer systems on audit procedures.................................. 484
EDP environments - Database systems........................................ ................... 485

Introduction........................................................................................................486
Database systems............................................................................................... 486
Database system characteristics........................................................................ 486
Data sharing....................................................................................................... 486
Data independence from application programs................................................. 487
Data dictionary.................................................................................................. 487
Database administration.................................................................................... 487
Internal control in a database environment....................................................... 488
Standard approach for development and maintenance
of application programs....................................~........................................... 489
Data Ownership................................................................................................. 489
Access to the database....................................................................................... 490
Segregation of duties......................................................................................... 490
The effect of databases on the accounting system and
related internal controls......................................................................................491
The effect of databases on audit procedures..................................................... 492
Computer-assisted audit techniques.................................................................. 492
Description of computer-assisted audit techniques (CAATs)........................... 492
Audit software................................................................................................... 492
Test data.................................................... ....................................................... 493
Uses of CAATs.................................................................................................. 493
Consideration in the use of CAATs................................................................... 494
Computer knowledge, Expertise, and experience of the auditor...................... 494
Availability of manual tests.......................................................................... 494
Effectiveness and efficiency.............................................................................. 495
Timing...................................................................................................:........... 495
Using CAATs. .................................................................................................. 496
Controlling the CAAT application............................................................................. 496
Documentation........................................................................................................... 498
Using CAATs in small business computer environments...........................................498

GLOSSARY OF TERMS.............................. ................................................ 501-508

Accounting estimate....................................................................................................501
Accounting system......................................................................................................501
Agreed-upon procedures............................................................ ...............................501

Analytical procedures.................................................................................................501
Annual report..............................................................................................................501
Assertions...........................................................................................................501
Assurance.........................................................................................................502
Audit......................................................................................'............................502
Audit evidence....................................................................................................502
Audit program.....................................................................................-.............502
Audit risk...................________;........................................................................502
Audit sampling...........................................-.........................-............................502
Auditor association.............................................................................................502
Auditor's Engagement letter...............................................................................502
Auditor's reports.................................................................................................502
Scope paragraph............. ..................................................................................503
Opinion paragraph..............................................................................................503
Signature.............................................................................................................503
Complications................................................................-...................................503
Computation.......................................................................................................504
Control environment...............................-........................................................504
Control procedures.............................................................................................504
Control risk.....................................................................................................-504
Detabase................................................................:............................................504
Detection risk......................................................................................................504
EDP application conatrols.;................................................................................504
EDP environment...............................................................................................504
Financial statements............................................................-.............................505
Forecast.'.............................................................................................................505
Fraud.......................;..............................................................................505
General EDP controls.........................................................................................505
Going concern assumption.................................................................................505
Inherent risk.................................................................................................... 505
Internal auditing.................................................................................................505
Material weaknesses........................................................................................506
- Materiality,................................................................^........................................506
Misstatement.......................................................................................................506
. Non-sampling risk....................................-.......................................................506
Predecessor auditor.............................................................................................506

(/)
Principal auditor............................................................................................... 506
Projection............................................................................................................506
Prospective financial information....................................................................:. 506
Quality controls..................................................................................................506
Related party.......................................................................................................506
Representations by management....................................................................... 507
Reviews..........................................................................................,...................507
Special purpose auditor's report.........................................................................507
Subsequent events..............................................................................................507
System of Internal control...................................................
........................507
Tests of control...................................................................................................508
Tolerable misstatement.......................................................................................508
Working papers..................................................................................................508

INDEX.................................................................................................................509-518

PRINCIPLES
AUDITING

OF

ORIGIN OF AUDIT
The word 'audit' is derived from the Latin 1 word "audire" which means to hear. In the good
old days whenever the proprietors of a concern suspected a fraud, certain people were appointed
to hear verbal evidence of transactions of barter etc., and to judge the facts. They 'heard' the points
of view of those who maintained the accounts.
Lucas Pacialo who is commonly considered as the father of double entry bookkeeping
wrote his treatise on the double entry bookkeeping and described the duties and responsibilities
of an auditor in it. The roots of 'modem audit' lie deep in the birth of Industrial Revolution which
brought large-scale production in its wake. The rapid growth of banking, transport and insurance
development, use of mechanical appliances and computers in business concerns and gigantic
growth of joint stock companies have resulted in the growing importance of audit. The need of
audit became imminent when the management and ownership of business was divided among
different groups of people. Now, it has become necessary that those who are owners of a
business should know how their money is being utilised by those who manage the business. Fo>'
this purpose, independent auditor has become a necessity.

DEFINITIONS OF AUDIT
The word 'audit' has been defined by many distinguished authors and every one of them
has attempted to highlight one aspect or the other. Definitions of the word 'audit' given by
authorities on the subject are as foUows:
"An audit may then be said to be such an examination of the books, accounts and
vouchers of a business, as shall enable the auditor to satisfy . himself whether the
balance sheet is properly drawn up, so as to give a trae and fair view of the state of
affairs of the business, and that the profit and loss account gives a true and fair view of
the profit or loss for the financial period, according to the best of his information and
the

51

Auditing: Principles and Procedures

explanations given to him as shown by the books; and if not, in what respects he is not
satisfied."1
"An audit is an examination of accounting recc ds undertaken with a view to
establishing whether they correctly and completely reflect the transactions to which
they purport to relate.''2
A special committee of the American Institute of Accoun 'ants has defined the verm 'Audit'
in the Accounting Research Bulletin No.9 as follow :

(1)

"An examination of a claim for payment or credit snd of supporting evidence

for the .purpose ofodetermimng whether th-^ expenditure is properly authorised, has
been or should be duly made, d how it should-be treated in the accounts of the payer
hence 'audited voucher',
(2) An examination of similar character and purpose of an accouit purporting to
deal with actual transactions only, such as receipts and pay 'nents.
(3) By extension, an examination of accounts which purport to reflect not only
.. actual transactions but valuations, estimates, and opinions for the purpose
of determining whether the accounts are properly stated and fairly reflect the matters
with which they purport to deal.
(4) An examination intended, to serve as a basis for an expression of opinion
regarding
the
fairness,
consistency
and
conformity
with
accepted
accounting principles, of statements prepared by a corporation or other
entity for publication in this case more generally called 'examination'.
Perhaps the best way to define audit is to tell why it is done, as the action is presumably
such as to fulfil its puipose. In this context the definition of audit would
differ depending upon whether it is in the case of concerns which voluntarily get their accounts
audited or whether it is mandatory. ;
ISA1 entitled Objective and Basic Principles Governing an Audit has defined audit as
under:
"An audit is the independent examination of financial statements or related
information of an entity, whether profit oriented or not, and irrespective of its size, or
legal form, when such an examination is conducted with a view to expressing an
opinion thereon."
ISA 1 lays down that the auditor is responsible for forming and expressing his opinion on
the financial statements.. The term "Financial Statements" includes balance sheets, income
statements or profit and loss accounts, statements of changes in .financial position, notes and
other statements and explanatory material identified as part of financial statements.

1.
2.

W- W. Bigg, SpiueiwiulPeglcrs Practical Auditing (Lndi>n: H. F, L. PUWIKWI-S Ltd., 1953), p.3.

-Lawrence R- Diutaee', Auditing: Practical: Manual 'fur Audilum (L'mdoii: Gee mid Company ;
"(PiiblishB^)Lvd,, 1951), - '

Principles of Auditing 52

AUDITING DIF FERE NCI ATE D FROM ACCOUNTING

The features that distinguish auditing from accounting are tabulated here:
Accounting
It means maintaining the books of accounts.
The spade work is done by the accountant to
enable the auditor to give a finishing
touch.
The accountant prepares the financial
statements.
No

prescribed qualifications are legally

required to be possessed before
appointment of an accountant is made.

The job of an accountant is generally

entrusted to him by management and he
is expected to perform the same.

Auditing
It means examining the accounts and
' reporting on their accuracy. The auditor's
work begins, where the accountant's work
ends.
Audit entails preparation and submission of
report on the checking and examination
of the accounts etc.
It is mandatory that an auditor of a public
limited company must be a chartered
accountant (within the meaning of
Chartered
Accountants
Ordinance,
1961).1
The auditor of a public limited company is
appointed by shareholders.

Summary of the two important legal cases, highlighting the difference between auditing and
accounting, is given below:

1. Smith vs. Sheard (1906)

The cashier,, while in the. employment of one Mr. Smith, had embezzled sums amounting
to 700. The. auditor who was deputed to do certain work on the books, was charged with failure
to discover the embezzlements. The auditor argued that he was engaged for preparing a coirect
balance sheet rather than auditing it. He continued, however, that the word 'audit' crept into the
report by one of his mistakes and merely meant to imply an 'audit of the posting'.
The judge in his remarks to the jury said, "the whole question turns on what' was the
contract". The findings of the jury were that there was in fact a contract for a complete audit and
the auditor was held liable for damages.

I.

Chartered Accountants Ordinance, 1961 [X of 1961), Gazette (if Pakistan- Extraordimii-y, March 10, 1961.

53

Auditing; Principles and Procedures

2. Apfei (Trustee of) vs. Annan Dexter &

Co. (1926)

Mrs. Apfel brought an action against the auditors that she was defrauded by her two sons,
who acted as the managers of the firm. It was pointed out that had the auditors not acted
negligently, the fraud would have been detected and therefore damages amounting to 28,600
were claimed. The auditors (defendants) argued to prove that they were asked to prepare the
accounts and not to audit them, and therefore they were not responsible. The certificate given by
the auditors was worded:
"Prepared from the books of Mrs. Apfel and in accordance therewith." It was, therefore,
held that from the form of certificate it was clear that the work was that of accountancy and not
of auditing.
To avoid any confusion that might arise by the indiscriminate use of the words auditing and
accounting, it is essential that the auditor must obtain clear instructions in writing about the
nature of the work required to be performed by him.

QUALITIES REQUIRED IN AN AUDITOR

The qualities required in an auditor are summaiised below:

1.

Professional Competence. He must be well versed in the firndamental principles and theory
of all branches of accounting viz., general accounting and cost and management accounting etc.
He should possess a sound knowledge of the techniques of audit and be conversant with the
decided legal cases in the field of theory and practice of auditing. This store of knowledge must
be constantly replenished and kept up to date. He must possess a sound working knowledge of
taxation laws (income-tax, wealth-tax, gift-tax, sales-tax etc.) of his country. He should be quite
familiar with the company and mercantile laws. He should have a thorough training in business
organisation, management and finance. He should have an understanding of the general
principles of economics and business statistics.

2.

Integrity. The word 'integrity' implies complete honesty together with strength of mind.
Integrity and keeping its flag flying up should be kept by an auditor as a guiding inflexible rule.
He must be tactful and scrupulously honest. The concept of 'to be honest', has been lucidly
explained by Lord Justice Lindley in London and General Bank 1895 case: "An auditor must be
honest, i.e., he must not "ertify what he does not believe to be true, and he must take reasonable
care and skill before he believes what he certifies is true." He must possess qualities of
withstanding and resisting the influence (direct or mdireet) exerted by others in the cour se of the
discharge of his duties. He should not disclose the secrets of his clients. He should never
compromise his principles without being rigid in his altitude.
3.

General. He should be able to. grasp quickly the technical details of the

Principles
udiang

of A

it

nature of his clients' business. He must have the tact of putting intelligent questions to extract full
information. He must be prepared to hear arguments and decide on logical grounds. He should have the
ability to write his report in a concise, clear and correct manner. He will often be in need of patience,
both with people and with his professional problems.
ISA 3 has given emphasis on integrity, objectivity; independence, confidentiality, skills and
competence. In this respect relevant material is reproduced below:
"Integrity, Objectivity and Independence .
The auditor should be straightforward, honest and sincere in his approach to his professional work.
He must be fair and must not allow prejudice or bias to override his objectivity. He should maintain an
impartial attitude and both be and appear to be free of any interest which might be regarded, whatever its
actual effect, as being incompatible with integrity and objectivity.
Confidentiality
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.
Skills and Competence
The audit should be performed and the report prepared with due professional care by persons who
have adequate training, experience and competence in auditing.
The auditor requires specialised skills and competence which are acquired through a
combination of general education, technical knowledge obtained through study and formal
courses concluded by a qualifying examination, and practical expeiience under proper
supervision. In addition, the auditor requires a continuing awareness of developments including
relevant international and national pronouncements on accounting and auditing matters, and
relevant regulations and statutory requirements."

OBJECTS OF AN AUDIT
The dominant principle of audit is the examination by an independent person of the accounts or
statement made by an accountable party, with a view to reporting to the person to whom the account is
rendered on its truth or falsity. The discovery of errors, fraudulent or otherwise, although frequently
supposed to be the main object of audit and in practice of great importance, is only a pait of the general
purpose. In the Act, nowhere the question of discovery of fraud in relation to the auditor's responsibility
is discussed, although negligence on his part leading to the failure to discover defalcations would
normally render him liable in damages.

Principles of Auditing 55

Where an undertaking whose accounts are being audited is large, greater reliance has to be
placed on the system in use for the prevention and detection of misappropriations and errors.
Therefore, the auditor has to use test checking technique to ascertain whether the system is
satisfactory and is being efficiently carried out. In smaller audits, more detailed work will have to
be done as the system, of internal check would be lacking.
Subject to the above remarks, the objects of an audit are classified as under:

(1) The detection and prevention of errors or mistakes.

(2) The prevention and detection of loss to the client by reason of fraud or
(3)

misrepresentation resulting in the accounts being false or incomplete.

Expression of independent opinion on accounts: This depends upon the
terms of contract or legal provisions of the governing statutes (Companies Ordinace,
1984, Banking Companies Ordinance, 1962, Insurance Act, 1938, etc.) ensuring that
the object is to report that the accounts on which the auditor is submitting his report
show a true and correct view of the state of affairs of the company.

(4) Moral Check.

The above points are discussed below:

1. The detection and prevention of errors and mistakes

Clerical Errors

(a) Errors of Omission. These occur where the transaction has been either omitted wholly or
partially. Such errors do not affect the accuracy of the trial balance. A searching eye and a critical
scrutiny of the accounts only can uncover such errors. For example, scrutiny of salaries account
in the general ledger may indicate that salaries for only 11 months have been accounted for and
the outstanding amount for the 12th month has not been provided for.

(b) Errors of Commission. These consist of incorrect additions, wrong postings and entries.
Some of the examples of these are:
(i) Errors in additions, carry-forwards in the books of original entries or ledgers.
) Errors or incorrect postings debit amount posted to credit, wrong amount posted to
an account, an amount posted twice, omission to post an amount from a book of
original entry to the ledger.
(Hi ) Errors in taking out balances of the ledger accdunts.
The above errors will affect the agreement of the trial .balance.
Cheeking the arithmetical accuracy of books of original entries and ledger and postings
from the books of original entries to the ledgers would reveal the above errors.

56

Auditing: Principles and Procedures

(c) Compensatory Errors. It is an error which is counter-balanced by another error of same

amount in the opposite direction. For example, an over-casting of an account by Rs. 500 may be
counter-balanced by undercasting of another account to the same extent. Such type of errors will
not affect the agreement of trial balance. Checking.of the arithmetical accuracy of books of
accounts and posting would detect such errors.
(d) Trial Balance Errors. These may consist of casting error in the trial balance, omission of
a balance while extracting balance from the books of accounts or entering an amount incorrectly
or on the wrong side.
These errors would be spotlighted during the routine checking.

Errors of Principle
By and large there are three types of errors generally considered as errors of
principle. These are:' . .
Jkto/it

( a ) Incorrect >~ This occurs when correct distinction between revenue and

capital is not strictly maintained, e.g., capital expenditure charged to revenue expenditure and f
ice versa etc. .
( b ) Omission of Outstanding Assets and Liabilities. For example, prepayments are
ignored and the amount charged off to the profit and loss account, outstanding expenses in
respect of rent, salaries, commission etc., are ignored and not accounted for etc.
fc) Incorrect Valuation of Assets. Current assets are not valued at cost or market price
whichever is lower. Fixed assets are not valued at cost less depreciation etc., as required by the
Act.
The above errors can only be detected by an intelligent vouching and a complete
verification (including checking of valuations) of the assets and liabilities.

Location of Errors .
In an auditor has agreed to locate errors, the following steps should be taken by him. to
discover the difference in the trial balance:

(1) Trial Balance Checking

(a)
(b)
(c)
(d)

Check casts of the trial balance, lists of debtors and creditors.

Establish the amount of difference.
-Check balances from personal and impersonal ledger into the trial balance.
While checking the balances, care must be taken to ensure that the closing balances are
correctly entered in the right column.

(2) Short cut Method

(a) Look for an item of half that amount which might have been entered on the wrong
side.

Principles of Auditing 57

(b)

If the difference is divisible by nine, it may mean an error of transposition of

figures (69 written as 96 or 86 written as 68 etc.).
(c) If the difference is a round sum, it is probable that the mistake has been made
in totals of trial balance or cany-forward of its figures.
(d) If the difference is of a large amount, it is advisable to compare the trial
balance with that of the previous year, in order to ascertain whether the figures under
the different heads of account are very near the same as those of the previous year, and
whether the balances fall on the same side of the trial balance.
(e) If the difference happens to be of an amount which constantly recurs in the
books, all posting of this amount is to be reehecked.
(3) Extensive Checking
If all the above short cuts do not result in locating the difference, the following work should
be done:

(a)

Ascertain that all opening balances have been correctly brought forward in the
current year's books.
(b) Check casts, cross casts and -forwards of the various books of original
entries and ledgers.
(c) If the ledgers are self-balancing, the work would be restricted to checking the
balances, postings and casts of only that ledger the trial balance of which does not
agree.
id) The Journal and subsidiary books should be smitinised to see that the total debits and
credits of each entry tally and there were no unticked items.
(e) The postings from the various subsidiary books should then be checked into the
impersonal ledger.

2, The Detection and Prevention of Fraud

(a) Embe^lement of Cash. Msanprppriation of cash takes place by: omitting to enter
receipts or by entering fictitious payments or by undercasting the receipt side of the cash book or
by over-casting the payment side of the cash book or by committing a theft of the cash in hand.
Twelve instances in respect of fraudulent practices relating to cash are given below:

(i)

Cash received in respect of sales, accounts receivable previously written off as

bad debts and from other income accruing sources may be understated and the
unrecorded cash may be embezzled.
(ii) Cash refunds arising out of the invoice overpayments may not be recorded and
amount misappropriated.
(Hi ) Receivables may not be recorded and cash received against the same embezzled.

58

Auditing: Principles and Procedures

(iu) False credits may be passed in customers' accounts relating to discounts, returns,

allowances or bad debts and an equivalent cash received may be stolen.

Misappropriation of cash drawn in respect of wages may be done by either
inserting dummy names in the wages sheet or by overcasting the wages sheets.
(vi) Proceeds of bills discounted may be misappropriated and the bills still shown
on hand.
(vii) Cash received in respect of goods sent on sale or return or under VPP system
may be pocketed and goods shown having been returned.
(viii) Vouchers once approved and paid may be used in support of further reimbur
seme nts.

(v)

(ix) Cheques for personal purposes may be charged as business expenses.

(x) Fictitious purchases and expenses may be recorded with the motive of stealing
the corresponding cash.

(xi) Theft of unusual cash receipts, e.g., sale of waste etc., may be resorted to.
(xii) Cash balance may be understated by erroneous footing in the cash receipts and
disbursement records and cash equivalent to the extent of understatement may be
misappropriated.
A thorough vouching and the existence of a sound and effective system of internal conti-ol
would assist in bringing such frauds to light.

(b) Misappropriation of Goods. Goods purchased may be stolen or used for personal benefits.
Proper method of keeping accounts in respect of purchases, sales, consumption, stock-taking,
periodical-physical checking of stocks etc., and the checking thereof with the records would help
in preventing such losses.

(c) Fraudulent Manipulation of Accounts. This type of fraud is comparatively more difficult to
detect than those discussed above, as this is usually committed by directors or the management
with the object of either showing more profits or less profits than they actually are. With these
objectives, certain beneficial strings are linked. Some of the exaniples of such frauds are:

(i) Inflation or suppression of sales.

(ii) Inflation or suppression of purchases.
(iii) Over-valuation or under-valuation of assets and liabilities.
(io) Utilisation of secret reserves during a period when the concern has made
less or no profit, without disclosing this fact to the shareholders, (u) Not providing
any depredation or providing less or more depreciation.
The auditor must carry out the routine checking, vouching and verification, and make
searching enquiries intelligently to detect such fraudulent manipulations.

Principles of Auditing

59

3. Expression of independent opinion on accounts

After the audit has been completed, the auditor should submit his report, the contents of
which will depend upon the requirements of his clients, except in the case of limited companies
in which the contents of his report to the shareholders are laid down in Section 145(2) of the Act.
The Insurance Act, 1938 and the Banking Companies Ordinance, 1962 govern the inclusion of
additional matters in the auditors' report in the case of an insurance and banking company
respectively.

4. Moral check
The visits of an auditor have considerable moral check on the staff of the client, as they are
aware that the accounts will be checked. A regular audit, therefore, tends to keep the books of
accounts up-to-date, and assists in exercising a great moral influence on the staff so as to help in
preventing fraud and errors. ISA 1 contains objective of an audit. Related guideline in this
respect is explained below:
"The objective of an audit of financial statements, prepared within a framework of
recognised accounting policies, is to enable an auditor to express an opinion on such
financial statements.
The auditor's opinion helps establish the credibility of the financial statements. The
user, however, should not assume that the auditor's opinion is an assurance as to the
future viability of the entity nor an opinion as to the efficiency or effectiveness with
which management has conducted the affairs of the entity."

RESPONSIBILITY FOR THE DETECTION OF

FRAUD AND ERROR
ISA 11 deals with fraud and error. Besides giving definitions of fraud and error, pertinent
topics covered include responsibility for the detection of frauds and error, inherent limitations of
an audit, risk of fraud and error, procedures when there is an indication that fraud or error may
exist and other reporting responsibilities.
Relevant material contained in the above ISA is given below:
The term "fraud" refers to intentional misrepresentations of financial information by one or
more individuals among management, employees, or third parties. Fraud may involve:

(1) manipulatior,, falsification or alteration of records or documents;

(2) misappropribiion of assets;
(3) suppression or omission of the effects of transactions from records or
documents;

(4) recording of ransactions without substance; and

60

Auditing: Principles and Procedures

(5) misapplication of accounting policies.

The term "error" refers to unintentional mistakes in financial information, such as:

(1)

mathematical or clerical mistakes in the underlying records and accounting

data;

(2) oversight or misinterpretation of facts; or

(3) misapplication of accounting policies.
Responsibility for the Detection of Fraud and Error
The responsibility for the prevention and detection of fraud and error rests with
management through the implementation and continued operation of an adequate system of
internal control. Such a system reduces but does not eliminate the possibility of fraud or error.
The objective of an audit of financial information is to enable an auditor to express an
opinion on such financial information. In forming his opinion, the auditor carries out procedures
designed to obtain evidence that will provide reasonable assurance that the financial information
is properly stated in all material respects. Consequently, the auditor seeks reasonable assurance
that fraud or error which may be material to the financial information has not occurred or that, if
it has occurred, the effect of fraud is properly reflected in the financial information or the error is
corrected. The auditor, therefore, should plan his audit so that he has a reasonable expectation of
detecting material misstatements in the financial information resulting from fraud or error. The
degree of assurance of detecting errors would normally be higher than that of detecting fraud,
since fraud is usually accompanied by acts specifically designed to conceal its existence.
Due to the inherent limitations of an audit there is a possibility that material misstatements
of the financial information resulting from fraud and, to a lesser extent, error may not be
detected. The subsequent discovery of material misstatement of the financial information
resulting from fraud or error existing during the period eovered by the auditor's report does not,
in itself, indicate that the auditor has failed to adhere to the basic principles governing an audit.
The question of whether the auditor has adhered to the basic principles govermng an audit is
determined by the adequacy of the procedures undertaken in the circumstances and the suitability
of the auditor's report based on the results of these procedures.

Inherent Limitations of an Audit

The test nature of an audit of financial information involves judgment as to the areas to be
tested and the number of transactions to be examined. Furthermore, much audit evidence is
persuasive rather than conclusive in nature. Therefore, ihs ai'ditor's examination is subject to the
inherent risk that some maiariai misstatements of the financial information resulting from fraud
or error, if eitQa

61

A uditing: Principles and Procsdum

exists, will not be detected.

The risk of not detecting material misstatement resulting from fraud is grater than the risk
of not detecting a material misstatement resulting from error, because fraud usually involves acts
designed to conceal it, such as collusion, forgery, deliberate failure to record transactions, or
intentional misrepresentations being made to the auditor. Unless the auditor's examination
reveals evidence to the contrary, he is entitled to accept representations as truthful and records
and documents as genuine. However, the auditor should plan and perform his audit with an
attitude of professional skepticism recognising that he may encounter conditions or events during
his examination that would lead him to question whether fraud or error exist.
While the existence of an effective system of internal control reduces the probability of
misstatement of financial information resulting from fraud or error, there will always be some
risk of internal controls failing to operate as designed. Furthermore, any system of internal
control may be ineffective against. fraud involving collusion among employees or fraud
committed by management. Certain levels nf mpmwgomoint may be in a position to override
controls that would prevent similar frauds by other employees; for example, by directing
subordinates to record transactions incorrectly or to conceal them, or by suppressing irrformation
relating to transactions.
International Standard on Auditing Number 2, Audit Engagement Letters, recommends that
engagement letters include reference to the inherent limitations of an audit and the fact that
material misstatement may remain undiscovered.

Risk of Fraud and Error

In planning and performing his examination the auditor should take into consider-ation the
risk of material misstatement of the financial information caused by fraud or error. He should
inquire of management as to any fraud or significant error which has occurred in the reporting
period and modify his audit procedures, if necessary.
In addition to weaknesses in the design of the internal control system and noncompliance
with identified control procedures, conditions or events which increase the risk of fraud or error
include:

(1)
(2)
(3)
(1)

questions with respect to the integrity or competence of management;

unusual pressures within an entity;
unusual transactions;
^problems in obtaining sufficient appropriate audit evidence. Examples of these

conditions or events are set forth in the Appendix 1.1.

62

A uditing: Principles and Procedures

Procedures when there Is an

Indication that Fraud or Error may
Exist
If circumstances indicate the possible existence of fraud or error, the auditor should
consider the potential effect on the financial information. If the auditor believes the suspected
fraud or error could have a material effect on the financial information, he should perform such
modified or additional procedures as he determines to be appropriate. The extent of such
modifications or additional procedures depends on the auditor's judgment as to:

(1) The types of fraud or error that could occur;

(2) The relative risk of their occurrence;
(3) The likelihood that a particular type of fraud or error could have a material
effect on the financial information.

Performing modified or additional procedures will normally enable the auditor to confirm
or dispel a suspicion of fraud or error. Where confirmed, he should satisfy himself that the effect
of fraud is properly reflected in the financial information or the eiror is corrected.
However, the auditor may be unable to obtain audit evidence either to confirm or dispel a
suspicion of fraud. In this circumstance, the auditor should consider the possible impact on the
financial information and the effect on his report. The auditor will also need to consider- relevant
laws and regulations and may wish to obtain legal advice before rendering any report on the
financial information or withdrawing from the engagement.
Unless circumstances clearly indicate otherwise, the auditor should not assume that an
instance of fraud or error is an isolated occurrence. If the fraud or error should have been
prevented or detected by the system of internal control, the auditor should reconsider his prior
evaluation of that system and, if necessary, adjust the nature, timing and extent of his substantive
procedures.
When fraud or error involves a member of management, the auditor should reconsider the
reliability of any representations made by that person to the auditor.

Other Reporting Responsibilities

The auditor should communicate his findings to management on a timely basis
if:

(1)

He believes fraud may exist, even if the potential effect on the financial
information would be immaterial; or

(2) Fraud or significant error is actually found to exist.

In the latter circumstance, he should also consider his reporting responsibilities to
regulatory authorities.

Principles of Auditing

63

In determining an appropriate representative of the entity to whom to report occurrences of

possible or actual fraud or significant error, the auditor would consider all the circumstances
With respect to fraud, he would assess the likelihood of senior management involvement. In mot
cases involving fraud, it would be appropriate to report the matter to a leyel in the organisation
structure of the entity above that responsible for the persons believed to be implicated. When
those persons ultimately responsible for the overall direction of the entity are doubted, the
auditor would normally seek legal advice to assist him in the determination of procedures to
follow.

HISTORY OF AUDITING PROFESSION IN PAKISTAN

A note on the history of auditing profession in Pakistan is given in Appendix

1.2.
AUDITOR AND ACCOUNTING MACHINES
The fact that records of a client are made by accounting machines will not affect the
principles of audit. However, it may result in material alteration in the routine work. From the
view-point of the auditor, the following advantages and disadvantages arise from the use of
accounting macliines:

Advantages
(11 Greater reliance may be placed on the arithmetical accuracy of the records, and
therefore less attention need be paid to the checking of detail work. The auditor is thus able to
devote a greater proportion of his time to the more important aspects of the audit.

(2) The records are more easily capable of subdivision between members of the auditors' staff,
thus expediting the checking of detail work.

(3) The records are more legible than when written by hand, and the waste of time and risk of
error so often occasioned through bad figures are avoided.

Disadvantages

(1) Original records require to be examined more closely since an error made thereon will
pass automatically throughout the whole of the records, and will not be brought to light by the
failure of one set of figures to agree with another.
(2) Less detail is normally provided by records compiled by a machine than is the case with
hand-written records. Considerable research may, therefore, be necessary in. certain cases in
older to elucidate doubtful entries.
(3) There is a considerable danger of the loose sheets required by the mechanised system
becoming lost, destroyed or fraudulently substituted.

64

A uditing: Principles and Procedures

AUDITOR AND THE COMPUTER

ISA 5 is in respect of Auditing in an EDP Environment and ISA 16 deals with ComputerAssisted Audit Techniques. ISA 6 contains a lucid commentary on Risk Assesment and Internal
Control. A separate chapter has been included in the book covering foregoing aspects.

FUNDAMENTAL PRINCIPLES
AND TECHNIQUES OF
AUDITING
The fundamental principles of auditing are the principles on which is founded the whole art
of auditing and which govern the objects of audit. The techniques of auditing consists of the
methods adopted for achieving those objects. These principles are the decision of errors and
fraud and the verification of accuracy of accounts. They must remain unchanged whatever
technique is adopted to give effect to them.
Auditing is closely related to accountancy. Therefore any changes and improvements in
methods of accounting result in corresponding changes in the techniques of auditing. The
techniques of auditing are also affected by changes in the law, particularly in relation to the
accounts of the limited company. Such changes in the law usually impose increased duties and
responsibilities of auditors and require some revision in the method of his work.

65

A udiiing: Principles and Procedures

Appendix 1.1
EXAMPLES OF CONDITIONS OR EVENTS WHICH INCREASE THE RISK
OF FRAUD OR ERROR

1. Questions with respect to the integrity

or competence of management
Management is dominated by one person (or a small group) and there is no
effective oversight board or committee.
() There is a complex corporate structure where complexity does not seem to
be warranted.
(c) There is a continuing failure to correct major weaknesses in internal control where
such corrections are practicable.
()

(d) There is a high turnover rate of key accounting and financial personnel.
(e) There is significant and prolonged vmderstaffing of the accounting department.
(f) There are frequent changes of legal counsel or auditors.
2. Unusual pressures within an entity
(a ) . The industry is declining and failures are increasing,
(o) There is inadequate working capital due to declining profits or too rapid expansion.

(c)

The quality of earnings is deteriorating, for example, increased risk taking with
respect to credit sales, changes in business practice or selection of accounting policy
alternatives that improve income.
(d) The entity needs a rising profit trend to support the market price of its shares
due to a contemplated public offering, a takeover or other reason.
(e) The entity has a significant investment in an industry or product line noted for
rapid change.
i f ) The entity is heavily dependent on one or a few pr oducts or customers.
(g) Pressure is exerted on accounting personnel tc complete
statements in an unusually short time period.

financial

3. Unusual transactions
l a) Unusual transactions, especially near the year end, that have a significant effect on
earnings.
(b ) Transactions with related parties.
(e) Payments for services (for example, to lawyers, consultants or agents) that appear
excessive in relation to the services provided.

Principles of Auditing

66

4. Problems'in obtaining sufficient appropriate audit evidence'

(a) Inadequate records, for example, incomplete files, excessive adjustments to books and
accounts, transactions not recorded in accordance with normal . procedures and out of
balance control accounts.
) "- Inadequate documentation of transactions, such as lack of proper authorisation,
supporting documents not available and alteration to - . documents (any: of these
documentation problems assume greater sigruficance when they relate to large or
unusual'transactions).
(c) An excessive number of differences between accounting records and third
party confirmations, conflicting audit-evidence and unexplainable changes
;' in operating ratios. . . .
(d) Evasive or unreasonable responses by management to audit inquiries.
. Some factors unique to an EDP environment which relate to the conditions and events in 1
through 4 above include;

.'

Inability to extract information from computer files due to lack of, or noncurrent, documentation of record contents or programs.
Large numbers of program changes that are not documenteu, approved and tested.

Inadequate overall balancing of computer transactions and data bases to the

financial accounts.

67

Principles ofAuditing

Appendix 1.2,

HISTORY OF AUDITING PROFESSION IN PAKISTAN

This appendix is intended to introduce the readers of this book to the background on the
subject of auditing. For a logical analysis, the history has been subdivided into certain specific
periods and is described below:
- - 1. 1850-1881. The^-st Companies Act in the thenBritish India was enacted
in 1850. One of the provisions included in the said Act was a half-yearly audit and a
report on the accounts audited to be given by the auditor.]! n Indo-1 ' subcont i nent
there were a few British firms of accountants, but they were so busy that their
services were not available to the general public. The public Companies used to
appoint a European auditor for safeguarding the interests of the European
shareholders, and an Indian auditor with the objective of safeguarding the interests
of the Indian shai'eholders.T '
."

2.

IH82 1913. Then the Companies Act of 1882 was passed. Regulations 83-94 of Table 'A'
contained in the first : Schedule to the said Act provided for the audit of accounts of the.
companies adopting that Table and for the appointment, remuneration and duties of the auditors.
jlt was not necessary for a company auditor in those times to be an accountant himself. Some
companies in fact used to employ lawyers as their auditors^
3. 1913 1932. [The Companies Act, 1913, was passed to be effective as from 1st April, 1914.
No person could then act as the Auditor of a public limited company unless he held an auditor's
certificate granted by the government. The Provincial Governments were empowered to grant
Auditors' Certificates but, at the same time, the Central Government also reserved the right to
recognise members of certain professional bodies as qualified to function in the capacity of
company auditors without obtaining Auditor's Certificate from the government. Consequently
the members of the English, Scottish and Irish Institutes of Chartered Accountants and of the
English Society of Incorporated Accountants and Auditors were recognised as qualified
auditorsH .
Section 130 of the Companies Act, 1913, required that every company should cause to be
kept proper books of account with respect to: -

(a)

all sums of money received and expended by the company, and the matters in
respect of which the receipt and expenditure took place;

(b) all sales and purchases of goods by the company; .

(c) the assets and liabilities of the comparw.
Thus'in broad outlines, the maintenance of books of accounts was made mandatory under
the Company Law.
For some years after 1914 the Provincial Governments used to .grant Auditors' Certificate
to persons who possessed some knowledge of accountancy. (At that time

68

Auditing: Principles and Procedures

there was no- provision of any kind for the training and examination of the accountants.
Government of Bombay was the first Provincial Government to take a constructive step in the
direction of organising the profession. In I91S, it instituted the Government Diploma in
Accountancy (called GDA) and made regulations for the examination and'training of those who
wanted to obtain that Diploma and certificate to practise- -.'
The action taken by the said government received the approval of other
Provincial and 'Central Governments. The result was that GDA Diploma became
the requisite qualification for the grant of Auditors' Certificates throughout the
then British ihdia^An Accountancy Board was set up by the Government and was
attached to the Sydenham College of Commerce and Economics, Bombay. This
functioned till 1932. The -Board was required to register apprenticeships and
randuct the required examinations. The successful candidates were granted the
GDA Diploma and they could practise if they had previously received training as
apprentices with a practising accountant. The Accountancy Board was also required
to advise the Government on all matters relating to accountancy - and the
Government ' ','
:"
. ' . ".' .
4. \ 1932-Augtist 14, 1947. Till 1932 there was no centralised control b'ver the profession,
of accountancy, but. the necessity for such control was increasingly being felt because of the
changing requirements of the time ir d growing needs of the economy. Consequently the
Government framed Rules under Section 144 of the Companies Act. 1913,. cawed Auditor*
Certuifites Rules, 1932' The objectives of these Rules were broadly, as follows: *
(a ) Registering apprenticeships; : v
"'Conducting examinations;
-':[ '
. (c) Controlling and regulating the profession of auditing;

'.::,':':":' '

The. Accountancy profession was then being supervised and controlled by the Ministry of
Commerce of the Central Goyer-rrment.. With-.a view to helping the Government hi
rdiKehargirig the : necessary, responsibilities in. respect ' yf the accountancy profession, Indian
Accountancy Board was established. Til's Board consisted of officials and practising accountants
nominated to it" by the Government. Later, in'1939, appointment of a majority of the members on
the.Board was made oh the elective principle. The Board, was only an advisory body, .The
Auditors' Certificates Rules, 132, required the passing of two examinations Registered
Accountants first and final If further hud down the tenure of".the,"prescribed training which was
required to be completed during the pei'cd of apprenticeship. Provisions meant to regulate
and.control the profession were also "contained therein.
" 5. August 14( 1947-1972.|TJakistan emerged as a sovereign state on August 14, 1947, and
adapted the Auditors' Certificates Rules, 1932. Amendments were made in 1950 and the affairs'of
the accountancy profession were then^ administered under the Auditors' Certifyates Rule? 1950
These -.ere published in the Gazette of PaU. stan oil December : 30 "1950 for regulating- theaccountancy pj^Qfessron m

Principles ofAuditing

Pakistan: These Rules were generally based on the old rules with some amendments incorporated
therein. A person who passed the Registered Accountants, first and final examination and who
satisfied the Ministry of Commerce, Central. Government of Pakistan that he-had completed-the
prescribed practical training could:have his name placed on the register ma^ained by the said
Ministry and was entitled to use the designation 'Registered Accountant' (RA). The Companies
Act, 1913, as adapted by Pakistan allowed only a Registered Accountant to act as the auditor of a
public limited .company, although his services could also be utilised for the audit of private
companies, partnership concerns and sole traders. Under the law, as it stands now, it is not
compulsory for private limited companies to get their accounts audited by a. qualified
accountant.1
bi .1962, the Registered Accountants formed a private body known as "Pakistan Institute of
Aecountants'Nwith the object of looking after their own interest and taking up with the Ministry
of Commerce, Government of Pakistan, matters affecting the accountancy profession. It was
realised that the accountancy profession had hitherto been well nursed by .the Government, but
the Registered Accountants in the profession had in their mind the ultimate goal of having an
autonomous association in the country.
.'. The Government also realised that the profession was'rapidly-growing in'its stature and
importance andfin June 1959 the Department of Accountancy was established in the Ministry of
Commerce with a Controller of Accountancy to deal with the profession instead of a Section
Officer] -,
The Pakistan Institute of Accountants persisted with the idea of establishment of an
independent'body .jAn advisory body called the "Council of Accountancy" was set up under the;
Auditors' Certificates Rules, 1950,. which recommended the establishment of the Institute of
Chartered Accountants in Pakistan. The Government accepted the recommendations, and the
Department of Accountancy assisted by the officials; of the Institute and a number of its
members prepared the Draft Ordinance to be passed..
The Chartered Accountants Ordinance, 1961, received the assent of the President of
Pakistan on March 3, 1961, and was published in Part I of the Extraordinary Gazette of Pakistan
on March 10, 1961. The Institute, of Chartered Accountants of Pakistan came into being on July
1, 1961. A draft of the Chartered Accountants Bye-Laws was also prepared and published for
inviting public comments. The amended version called the Chartered Accountants Bye-Laws,
1961, was published in the Part I of the Extraordinary Gazette of Pakistan on July 1, 1961 and .
was enforced as on . that date. As of that date the Department of

1. However, under Section 13A of the Income Tax Act,.1922, all private limited companies, whose puld Up capital waB rupees two
million or more were required to get their accounts certified by a Chartered Accountant or an Industrial Accountant.

Noln' The above Act was replaced by the Income Tax Crdmanc-i, 1979 and Industrial Accountants were redesigned as Cost
and Management Accountants

69

Principles of Auditing

Accountancy and the Pakistan Institute of Accountants having served a very useful purpose were
liquidated."/
The Institute of Chartered Accountants of Pakistan is now a statutory
autonomous body and is administered by a Council 'of .thirteen. The Council is
assisted by : the three standing committees known as Executive Committee,
Examination Committee and Investigation Committee. The Chartered Accountants
Bye-Laws also provide for the formation of regional committees to look after the
interests of their members. At present there are two such committees; .one each in
Karachi and Lahore. The. members are divided into classes namely, Associates
and Fellows (, FCA).

The Pakistan Institute of Industrial Accountants .was registered in.the year

1951 by a group of Government and .business executives for the advancement of
Accounting and Cost Accounting. In July 1966, the National Assembly of Pakistan
passed an Act- entitled the 'Cost and Industrial Accountants Act, 1966' (XIV of
1966). This Act regulates the profession of Cost and Industrial Accountancy and the
Pakistan Institute of Industrial Reconstitution of Accountants for that purpose,
which was subsequent done.
..
The Finance Ordinance, 1972, empowered its members to certify the accounts of private
limited companies with paid up capital of Rupees two million or over for the purposes of Section
13A of the Income Tax Act, 1922.
6. 1984 Onward. In December 1984, the Companies Act, 1913 was replaced by Companies
Ordinance, 1984. Through this, consolidation of various laws in one company code was
undertaken. Salient features of the relevant legal provisions governing accounting profession are
summarised below:
()

Maintenance of accounting record was extended to mandatory provision

for cost accounting record in respect of manufacturing industries.
Currently the government is. considering prescribing cost accounting
records under Section 230(lXe) of the Companies Ordinance, 1984.
() Legal provisions also require cost audit and cost accounting records on
annual basis by a Chartered Accountant or Cost and Management
;
Accountant.
v.
' (c) The Fourth Schedule annexed to the above Oi^nance includes detailed requirements
governing information disclosure relating to preparation of balance sheet and profit and
loss account. For listed companies in Pakistan these requirements are very extensive and
listed companies are legally obliged to follow these. Total number of listed companies on
Karachi Stock Exchange as on. August. 14, 1989, was 418 with market capitalisation of
Rs.45 billion.
(d) The Fifth Schedule annexed to the Companies Ordinance, 1984, lays down .
requirements for preparation of financial statements in respect of unlisted companies.

71

Auditing: Principles and Procedures

(e). For listed companies the above Ordinance has also laid down that > National
Accounting Standards and other standards developed. and. notified by the Corporate Law
Authority, Ministry of Finance, Government of Pakistan, are mandatory. This has been a
good -step in extending the mandatory requirements for compHance of national
accounting standards and -various other standards prescribed by the Institute of
Chartered Accountants of Pakistan and the Institute of Cost and Management
Accountants of Pakistan.
(fl Preparation of funds flow statement has also been made mandatory in
respect of listed companies in Pakistan.
",.
(g) Release of half yearly unaudited financial statements is also the legal necessity for listed
companies in Pakistan.
() A prescribed form (Form 35-A) has been issued by the Corporated Law Authority,
Ministry of Finance, Government of Pakistan, Islamabad, as Auditor's Report for
limited companies.

AUDITING
PROCEDURES

THE OPERATION OF AUDIT

The audit work is operated with, the help of the following techniques:
1. Ticking. Ticking indicates the placing of a mark against an entry in the book todenote
that it has been examined by. the auditor for a certain purpose. Variously shaped marks are used
to denote checking of additions,1 posting, carryforward, tracing, extraction of balances etc. Ticks
are generally put in indelible pencil, although some auditors also use pen and ink for this
purpose.*1
To ensure consistency, most of the good auditors use a tick chart which is required to
bejcanit by heart by all the members of the audit staff.
2- Casting. Casting refers to the checking of additions of books of accounts and financial
statementsTlTis essential that arithmetical, accuracy be checked so Uiat frauds or errors' (if any)
may be detected. This job is normally done by a junior memBer^of audit staff. Most of the
auditors use mechamcal appliances or a3oung machines tq*cneCTF casting of the books of
accounts.
3. Calling-over. A sizable part' of the work of,audit .consists in the
comparison of entries in two or more books or of an entry a book with its
supporting evidence or voucher. This is. usually carried" out by two clerks; one
reading the item to the other. Care" ^! to see that' the whole of the
Important; details of each item is eheckVd and" not merely the amount Special care
m checking postings to personal ledgers is needed as to names and title of.account,
otherwise a wrong posting may remain undetected. Clarity in pronunciation is
esseTftiaT." There may be a confusion between ninety au^'mneteeri, , 'sTxly 'af^'sfxteen
etc. Thus it is advisable to pronounce ninety as'niiietie, sixty as sixtie and so on.
Similarly when calling out a figure as Rs. 80.90, there should be a pause Between
80 and 90, lest it should he understood as Rs. 89.
""
' '""

Some of the instances of ticks together with what they indicate are;'
""V = Vouched. T = Traced = Casts checked. ! = Posting checked. = Balance cbtcfcsd-

73

Auditing: Principles and Procedures

4.

VoucMng^The function of the voucher is to-authenticate an. entry' and the auditor must
BatisfxJrijnseTf "that it does this. !t_rn.usi .cprrespondln date^and accountT5"the entry in the
books.:It must be in respect of the client and the entry must be correctly passed in the books. The
cj. of vouching consists of checking the documentary evidence (mvoices, cash memos, bills,
receipts, vouchers, minutes,
"reference to legal documents etcj_as should establish the -accuracy and trutlifulness of ,
entries appearing in thebooksof account, and in those eases where it is not so, the matters are
note4"fbr chscussion and if the auditor still remains unsatisfied, the outstanding matters
arereported to the client.

5.

Vefification. When an auditor has vouched the entries, appearing in the

books of account, his.duty is not thereby fully ihscharged. If appointed for audit
under the Act, he has to report whether or not the balance sheet exhibits a true and
correct view of the state of affairs of the company. For this purpose, he should
satisfy hi msejf.o^ the following points:
; .
^Xa)

That each asset and liability is correctly valued and correctly stated in the
, balance sheet.

^ ' (b) That the assets actually existed at the date of the balance sheet.
\& That they are property of the business.
';.
-(d) That they are not suffering from a charge except that disclosed in the balance sheet.
The technique of audit.carried out to achieve the foregoing objectives is known
as'verification'.
"
.
- ....
.6. Reporting. After the^aboye^stensjmyejpeen carried out, the auditor will then be
r^^^Sr^sub^t his report. T^sorrn^and^e''c^^
several factors, e.g., the legal statu? of the appointing authority, the coru'xact'rorTne
scope of work to be done, wliether the audit is being conducted under the "Companies
Ordinance, 1984, Banking Companies Oidinance, 1962. Insurance Act, 19.38, etc.
Tiie'"points to be considered while drafting ^report in respect of sole traders and
partnership coiicerns will be dealt with a length in a separate chapter of this book.
However, the form of auditors' report to be submitted after the annual audit of
ai^iffits_of a company has beenpresmbedas Form 35 A annexed to the Companies
Rules, 1985"----------^-"'
* ~~
."
.-.-^
Modem trends follow the undernoteisequence:' " ^tl)
Examination ofthe accounting system. <f(2) Evaluation of
internal controls. JS) Sample checking of vouchers. <^(4)
Verification of assets and liabilities. ^={5) Submission of
auditors report.

2*i

Auditing: Principles and Procedures

PROCEDURES AFFECTING AUDIT Compliance

Procedures
These tests are designed to qbtainreasonable asjsurancejhat those, internal contro^bn'wTd'eh
auchtrejh^e is to be placed are in effect^

Substantive Procedures
These
are
designed
vah^fyof the daj^jprodui^^

to

obtain
evidence
as_to
system. These are of two types:

and

y.'(l) Tests of details of transactions and.balances. .

^ (2) Analysis of significant ratios and trends including the resulting investigation of
unusual fluctuations and items.

Analytical Review Procedures

. These are usfd to describe the analysis of significant ratios and trends including
investigation of unusual fluctuations and items. Details are available in International Standards
Auditing. Guideline No. 12, which was revised in October 1990.

SCOPE OF AUDIT
ISA 1 contains lucid discussion in respect of Basic Principles Governing an Audit scope of
audit. Related portions of the above revised until Octber 1991 are given below: .
Introduction

1.

An .audit is the independent exa mination of financial statements or related financial

information of an entity, whether' profit oriented or foot, and irrespective of its size, or legal
form, when such an examination is conducted with a view to expressing ah opinion thereon.

2.

This Standard describes the overall objective of an audit and basic principles which govern
the auditor's professional responsibilities and which should be complied with whenever an
audit of financial statements and other financial information is carried out.

3.

Other International Standards on AuditingCISAs) elaborate on the principles set out herein to
give guidance on auditing procedures and reporting practices. Compliance with the basic
principles recorires the application of auditing procedures and reporting practices appropriate
to the particular circmrrstances.

Auditing Procedures

75

Objective of an Audit

4. The objective of an audit of financial statements, prepared within a framework of

recognized accounting pohcies,1 is to enable an auditor to express an opinion 2 on such
financial statements.

5. The auditor's opinion helps establish the credibility of the financial statements.

The user, however, should not assume that the auditor's opinio: is., an
assurance as to the future viability of the entity nor an dpinion as to the
efficiency or effectiveness with which management has conducted the affairs of
the entity. .
,

Responsibility for the Financial Statements

6. While the auditor is responsible for forming and expressing an opinion on the financial
'statements, the responsibility for the financial statements is that of the management of the
entity. Management's, responsibilities include: the maintenance of adequate accounting
records and internal controls, the selection and application of accounting policies', and the
safeguarding of the assets of the entity. The audit of the financial statements does not
relieve management of its responsibilities.

Scope of Audit
7. The scope of an audit of financial statements is noi-mally determined by the
requirements of ISAs, relevant professional bodies, legislation, regulations, and where
appropriate the terms of the audit engagement; and reporting requirements.

8.

The audit should be organized to cover adequately all aspects of the entity as far as they are
relevant to the financial statements being audited. The. auditor should determine whether
the information contained in the underlying accounting records and other source data is
reliable and sufficient as the basis for the preparation of the financial statements.

9.

The auditor should obtain a svnTicient understanding of the accounting and internal control
systems to plan the audit and develop an effective audit approach. The understanding of the
accounting and internal control systems,
fundamental accounting assumptions and considerations governing tbe selection and application of accounting policies, as
well as other standards to be observed in the presentation of audited financial statements, are issued by the International
Accounting Standards Committee. Many national profesBlofial bodies also issue pronouncements on such matters.
Legislation or regulation within a country often contain further accounting and diaolosm e requirements.
There is a variety of terminology used in diSerant countries by aud itors in expressing an opinion on financial
statements_.T]ie actual woi-ding used reflects concepts determined by local legislation, by rules ieeued by professional bodies
or by the development of general practice within the country. Wordings frequently used to reflect these.ncept aie "present
fairly in accordance with generally accepted accounting principles," give a true and fair view, ;md "in uniformity with the
law" (see ISA 13, The Auditor's Beport on Financial Statements!

2*i

Auditing: Principles and Procedures

together with the inherent and control risk assessments and other considerations, enables
the auditor to:

identify the types of potential material misstatements that could occur in the
financial statements;
- consider factors that effect the risk of material misstatements; and .. design
appropriate substantive procedures.

10. Judgment permeates the auditor's work; for'example, in deciding the extent of audit

procedures and in assessing the reasonableness of the judgments and estimates made by
management in preparing the.'financial statements. Furthermore, much of the evidence
available to auditors is persuasive rather than conclusive in nature. Because of the above
factors; absolute certainty in auditing is rarely attainable.

11. In forming an opinion on the financial statements, the auditor carries out procedures

designed to ' obtain reasonable assurance that the financial statements give a true and fair
view or present fairly in accordance with the relevant national standards or International
Accounting Standards in all material respects. Because of the test nature and other inherentlimitations of an audit, together with the inherent limitations of any system of internal
control, there is an unavoidable risk that even some material misstatement may remain
undiscovered

12. The auditor, determines whether the relevant information is properly communicated by:

comparing the financial statements with the underlying accounting records and other
source data to see whether they properly summarize the transactions and events
recorded therein, and ' ,
considering the assertions1 that management has made in preparing the financial
statements; accordingly, the auditor assesses the selection and consistent application
of accounting principles, the manner .in which the
information has been classified, and the adequacy of disclosure.

13. Constraints on the scope of the audit of financial statements that impair the auditor's ability
to express an unqualified opinion oh such financial statements should be set' out in the
report, and a qualified opinion or disclaimer of Opinion should be expressed, as appropriate.

Ethics

14. In performing audits in accordance with ISAs, auditors should comply with the
Assetertions are representations by management that are emboidied in the financial stuttet^e^ .There are seven clurteifications
of financial statement assertions: exist-jote, tights and > oecurance, completeness, valuation, measurement, and
presentation and disclosure.

Auditing Procedures

Code of Ethics for Professional Accountants issued by the International Federation of

Accountants.

Integrity, Objectivity and independence

15. The Code of Ethics for Professional Accountants states that the auditor should be
straightforward and honest in performing professional work. .The auditor must be fair and
should not allow prejudice or bias or influence of others to override objectivity. The auditor
should maintain an'impartial attitude and both be and appear to be free of any interest which
might be regarded, whatever its actual effect, as being incompatible with integrity,
objectivity and independence. The auditor should be independent in fact and appearance.

Confidenthlity;
16". The auditor should, as stated in paragraph' 16 of the Code of Ethics for Professional
Accountants, "respect the confidentiality of information acquired during the course of
performing professional Services and should-not use or disclose any such information
without proper and specific authority or unless there is a legal or professional right or duty
to disclose."

Professional Competence and Due Care, and Technical Standards

17. Paragraph 16 of the Code of Ethics for Professional Accountants states that the auditor in
agreeing to provide professional services implies that there is a level of competence
necessary to perform professional services and that the knowledge, skill and experience of
the auditor will be applied with reasonable.. care and diligence. Auditors should therefore
refrain from performing any services which they are not competent to carry out unless
advice.and assistance is obtained to ensure that the services are performed satisfactory. An
auditor should perform professional services with due care, competence and diligence and
has a continuing duty to maintain professional knowledge and skill at a .level required to
ensure that a client or employer receives the advantage of competent professional service
based on up-to-date developments in- practice, legislation andtechniques.
18.. Paragraph 16 of the Code of Ethics for Professional Accountants also states that an auditor
should earry out professional services in accordance with the relevant technical and
professional standards. Auditors have a duty to carry out with care and skill, the instructions
of the client or employer insofar as they are compatible with the requirements of integrity,
objectivity and independence.

Planning
19. The auditor should plan to conduct an effective audit in an efficient and timely manner. Plans
should be based on a knowledge of the client's business. The

23

78

Auditing: Principles and Procedures

auditor should obtain sirfficient appropriate audit evidence through the performance of tests
of control and substantive procedures to enable the auditor to draw reasonable conclusions
therefrom on which to base an opinion on the financial information.
20 Plans should be made to cover, among other things:

obtaining a sufficient knowledge of the client's business and a sufficient . rniderstanding

of the accounting and internal control systems;

. assessing the lever of audit , risk which includes the risk that material misstatements will occur
(inherent risk), the risk that the client's system of internal control will not prevent or
detect such misstatements (control risk), and the risk that any remaining material
misstatements will not be detected by the auditor (detectionrisk);
determining and programming the nature, timing and extent of the audit procedures to
be performed; and
' considering of the going concern assumption regarding Xhc entity's ability
to continue in operation for the foreseeable future, generally for a period not to exceed
one year after the balance sheet date.

21. The auditor should Obtain a sufficient understanding of the accounting and internal control,
systems to plan the audit and develop an effective audit approach. After obtaining the
understanding, the auditor should consider the assessment of control risk to determine the
appropriate detection risk to accept for the financial statement assertions and to determine
the nature, tiniing and extent of substantive procedures for such assertions.

22. Where the auditor assesses control risk at a lower level, substantive procedures would
normally bo less extensive than would other-wise be required and may also differ.as to their
nature and timing;
23. Plans should be further developed and revised as necessary duringthe course of
the audit.

Work Performed By Others

24.

When the auchtor.delegates work to assistants, the auditor continues to be

responsible for forming and expressing an opinion on the financial statements and other
financial information and the auditor should carefully direct, supervise and review work
delegated tp assistants.

25.

When the auditor uses work performed'by other auditors Or experts*, the
auditor should obtain reasonable assurance that such work is adequate for the purposes, of
the audit.

23

Auditing Procedures

Documentation
26. The auditor should document matters which are important in providing -. evidence that the:
audit was .carried out in accordance with the principles of
ISAs,'...-.,. Audit

Evidence
27 Tests of control are performed to obtain evidence about the effectiveness of the desipx,Llhe.
accounting and internal contj^^sysfamr^^ cu'ieciivencss of the operation of the policies and
procedures applied
2S. S ibs1 mtiyo procedures are designed to obtain evidence as to the completeness,
.' accuracy \nd validity of the data produced by the accounting system They are
cf two.-types.
~
"~'
tests of dot-ids of transactions andl^ances;
. . anajvjas - J j t :.&^.rjaijpgi,Jand - trends. Jpaclucbr^ the i resulting .. niv
estigation of unusual flj^twatiuns-and items

Audit Conclusions and Reportirig

2, The auditor -should review and. assessthe conclusions drawn fr<;nr the audit evidence
obtained as tbi basis fur the ^. - - of an on .he financial informatics. This
review-and-assessment .nvebes considerrng whethei ;
.

- the financial statements have been prepared using acceptable accounting policies, wh;ch
"have"been-consistently appl'ted. " .... .the financial tnfoiniatien. complies, with
regulations .and.,statutory requirements relating to the prepai ?Uon of fir.iPial statements,
... . the view presented by -the-financial information as a whole.is consistent ithti e n-iditor s
fcr o-yledgo of the busmis* oi. W.io entity, and .
. .. there i.s adequate disclosure of all material matters relevant to. the.proper.
pj-e^eiii at i {<f the fin mcial nfoimat'pn.
-30. ' The audit-- should contain a clear-written expression of opiiiion'oh the
financial information. . unqualified opinion indicates the auditor's sahsi'aciicn in all
material respects with the ^natters;dealt, with in- paragraph
31. 'viie?.. a yuuiiliixi opimor1 adverse oprrisori of'a dis .l-inncr of cpvue
... --itbe; audit report should state in a clear and informative maimer--aH : of the

. .ijeasohs thcrefei. '

*.s given,

AuditingProcedures _
^

>

/ ,' L %, ,{ , ,/, 4 '

fc 31

CONDUCT OF AUDIT

From the point of view of the conduct of audit, it may be classified as

Crmfijmous_ audTt^^
These are now explained:

Continuous Audit
Concept
.It is also, known as 'Tanning audit'-. /Under such a type of audit, an auditor is required
to'visit fl business house at "lttrvals (which may be fixed or otherwise), during the financial year
and check the books to date as fai, as possible. This type of audit is practised: When it is desired
that the audited filial accounts should be ready immediately after the close of financial year as'in
the base of banking companies; when a business is extraordinarily large and numerous
transactions, are to be cheeked; when, in a business house, monthly or quarterly final accounts are
required Oifoughout the year "**"
.Advantages:- ;:

'...' >

. ' Easy rectification o f errors. As the books are" checked soon after the entries have been
made, enws'~c;ui be spotlighted as well as rectified more' quickly. Similarly, frauds can be
detected at an eaily stage
SH'f-*'' 0SjZyi'ds: imposes a check upon frauds because of the. reason that . books
are kept up-todate and -a inoral check n exerted on.the staff.
3. ' Quick JX)l!ipkti<Xn. The accounts are kept up-to-date and'the audit can be completed
more quickly and accounts can be presented to the shaieholders soon after the closing of the
financial year. .
" 4... Closer contoMjvith the business. The auditor, while practising this type of audit, can have
greater touch with the! transactions of a going: coheern, Inthis way, he can consider all tire:
important points and there is less likelihood of neglecting any important matter.

5. Proper attention. As the auditor has ample time before the finalization of
accounts, greater attention can be paid to the checldng.of accounts and detection of
errors and frauds.
' .'
.
.'
6. Interim dividend. When the directois of a company decide to pay interim dividend to the
sHarebolders, continuous audit will expedite the preparation of interim accounts without much
delay.
Disadvantages
1. Alteration i n figures. There is a possibility of alteration, in figures either ignorantly or
deliberately after they have been checked by an . auditor, fn this way, errors frauds cannot be
detected without further ^.checking which is carried but.

Auditing Procedures

2. Interruption in work: As the audit is conducted for several years, the auditor may lose
the thread of work and omit to follow up transactions completely which may navebeen left open
at the date of his last visit. ;
.3. Inconvenience. The frequent visits by an auditor and his frequent checking may dislocate
his client's work and causa inconvenience to him. The thread of the work is also likely to be lost.
4. Expensive^ This type of audit is comparatively more expensive as the auditor makes
several visits and performs detailed work involving more time being
The following m^cautions must be taken to reduce the above disadvantages to the
minimum .possiibie; '
The auditor must take special steps while conducting the audit on interim basis. These
steps should require the prohibition of the alteration of figures. Moreover, all the
corrections should be recorded through journal entries with full narration.
On his next visit, the auditor must glance through the altered figures. He should
enquire of the alterations and ensure that they were duly authenticated. In this way
frauds Can be miramized, At the end of each visit, the auditor should make a note of all significant totals and
other figures.
There must be a well developed programme so that the possibility of any loose
motives should be dealt with. .
Checking of a book must be completed at least in one visit while the cheeking of all
impersonal account should be postponed till all the books are at the disposal of the
auditor.'
All quarries must be noted in the audit note-book and complete record as to how they
were cleared should also be. maintained;
The system becomes indispensable in the following cases:
- (1) Where monthly financial, accounts are required throughout the period..(2). Where it is required to have the audited accounts ready immediately after the close of
the financial year, e.g., a bank or a financial institution.

(3) Where a satisfactory system of internal control is lacking.

(4) In big concerns requiring considerable detailed checking. . \-

A final or complete audit is one which is started after the close of the accounting year of a
business and it is carried out until completion, It is also called 'balance sheet audit' or 'periodical
audit'. The advantages of this type of audit are as follows:

81

82

Auditing: Principles and Procedures

(1) The auditor is supplied with the full facts relating to the year under review and he can
(2)
(3)

peruse the books and accounts duly completed in respect of that particular year.
There is less danger of manipulation and alteration of figures after they have been
checked.
Thread of the work is not likely to be lost, as the whole work is performed at one
stretch.

The final audit works satisfactorily in case of small concerns but in case of large businesses
it takes more time to check accounts and to submit the report to the shareholders.

Interim Audit
Ihteriro^u^tjie^midway betweeij finals to know 'the 'reliable trading results of a business for
a part of the year, the proprietor may arrange for the carrying out of _an,,interim audit to be
carried out during the year, i. ., montWy, Quarterlyorhalf-yearly. For example, if the directors of
a particular company desire to pay the interim dividend after a certain period, say nine months
after the date of financial closing, an interim audit may be conducted.
Interim audit has the following advantages:

(1) It enables the final audit to be completed soon.

(2) Auditor's suggestions can be implemented quickly in an interim audit than in the case
(3)

of a final audit. Threugh an interim audit, work can be satisfactorily done by staff
along with the advice of auditors.
In the audit of a large and important .concern, some form of interim "audit is almost
indispensable in order that' a sufficient amount of detailed checking may be done.

The type of audit to be adopted depends upon the magnitude and requirements of the
business.

AUDIT ENGAGEMENT LETTERS

ISA 2 deals with audit engagements letter. JlLl^adyisablg. .that the auditor should send an
engagement letter before. the commencement of engagement. This will help in avoiding
nusunderstandings^with respect to- the engagement.
There is an Appendix attached io the above ISA which presents an example of an Audit
Engagement Letter.
Important aspects contained in the said ISA are reproduced below:

83

Auditing Procedures

Principal Contents
1. The form and content of audit engagement letters may vary for each
client, but they should generally include reference to:
i d) The objective of the audit of financial information.
(6) Management's responsibihty for the financial information.
(c) The scope of the audit, induding reference to applicable legislation, regulations, or
pronouncements of professional bodies to which the auditor adheres.
(d) The form of any reports or other communication of results of the engagement.
(e) The fact that because ofthe test nature and other inherent limitations of anaudit,
togeTher with the inherent limitations of any system of internal controTTthere is an
"imaybidable risk that even some material misstatement may remain undiscovered.
(fi Access to whatever records, documentation and other information requested in
connection with the audit.

2.

The auditor may also wish to include in the letter (a)

Arrangements regarding the planning of the audit.

(o) Expectation of receiving from management written confirmation concerning
representations made in connection with the audit.
(c)

Request for the client to confirm the terms of the engagement

acknowledging receipt of the engagement letter.
(d) Inscription of any other letters or reports he expects to issue to the client.
" " Ce) Basis on which fees are computed and any billing aiTangements.

3.

by

When relevant, the following points could also be made:

(a) Arrangements concerning the involvement of other auditors and experts in some
"aspects of the audit.
Co) Arrangements cpncerning the involvement of internal auditors and other client sj^afi\_
(c) Arrange^entsAifany, to be made_with the predecessor auditor, in the case of an
initial^ audit.

(d) Any restriction of the auditor's liability when sueh possibility exists.
(e) A reference to any further agreements between the auditorand theclient.
Recurring Audits
1. On recurring audits, the audrtqr_maxdecjde not to ^enda new. engagement
letter^e^ch^year, However, the following factors mipht cause him to,decide to send a new letter:

84

Auditing: Principles and Procedures

(a) Any indication feat the client nusunderstands the objective

the .

. L'

scope of

(b) Any revised or special terms of the engagement:

(c) A recent change rjf management,,
i d ) A significant change in nature or size ofthe client's business., (e) Legal

requirements.
If the auditor decidesjanew engagement letter is unnecessary for any year.^he
remind tbe_client of the original letter.

wish to

Audits of Components

1. When the auditor of a parent is also the auditor of its subsidiary, branch or division
(component), he should consider such factois as the following in deciding whether to send a
separate engagement letter to the component:
(a) Who appoints the auditor of the component.
(o) Whether a separate audit report is to be issued on the component
(c) Legal requirements.
(d) The extent of any work performed by other auditors.
(e) Degree of ownership by parent.

<;

Auditing: Principles and Procedures

Appendix 1.3

EXAMPLE OF AN AUDIT ENGAGEMENT LETTER

The following letter is for use as a guide in conjunction with the considerationsOutlined in the Guideline, and should he varied according to individual
requirements and circumstances:
:.
To the Board of Directors or the appropriate representative of senior management:
You have requested that we audit the balance sheet, statements of income and
changes in financial position of. . . ......................................: . . . . as of and for the year
ending . .. . .
... . .
. i .". -:: . . We are pleased to confirm our
acceptance and our understanding of this engagement by means of this letter. Our audit
will be made in accordance with applicable authoritative
pronouncements in . . ... ..............................(name of country) with the objective of
our expressing an opinion on the financial statements.
In forming Our opinion on the financial statements, we will perform sufficient
tests to obtain reasonable assurance as to whether the information contained in
the underlying accounting records and other source data is reliable and
sufficient as the basis for the preparation of the financial statements. We will
also decide whether the information is properly communicated in the financial
statements.
,. '
Because of the test nature and other inherent limitations of an audit, together with-the
inherent limitations of any System of internal control, there is an unavoidable risk that
even some material misstatement may remain undiscovered.
In addition to our report on the financial statements, we expect to provide you with a
separate letter concerning any material weaknesses in internal control which come to our
notice.
May we remind you that the responsibility for the preparation of financial statements
including adequate disclosure" is that of the management of the company. This includes the
maintenance of adequate accounting records and internal controls, the selection and
application of accounting policies, and the safeguarding of the assets of the Company. As
part of our audit process, we will request from management written coi^firmation
concerning representations made to us in connection with the audit.
We look forward to full cooperation with your staff and we trust that they will make
available to us whatever records, documentation and other infortnation are requested in
connection with our audit.
Our fees, which will be billed as work progresses, are baaed on the time required by the
individuals assigned to the engagement phis direct out-of-

Auditing Procedures

86

pocket expenses. Individual hourly rates vary according to the degree of responsibility
involved and the experience and skill required.
This letter will be effective for future years unless it is terminated, amended or superseded.
Please sign and return the attached copy of this letter to indicate that it is in accordance with
your understanding of the arrangements for our audit of the financial statements.
XYZ&CO.

USING THE WORK OF AN AUDITOR

ISA 5 revised upto October 1991 contains useful'standards governing using the work of an
other auditor. In this respect relevant portion are given below:

introduction

1.

International Standard on Auditing 1, Objective and Basic Principles Governing an Audit

states:
"When the auditor delegates work to assistants, the auditor continues to be responsible
for forming and expressing an opinion on the financial statements and other financial
information. The auditor should carefully direct, supervise and review work delegated
to assistants.
When the auditor uses work performed by other auditors or experts, the auditor should
obtain reasonable assurance that' such work is adequate for the purposes ofthe audit."
The purpose of this Standard is to amplify the basic principle outlined above as
it relates to other auditors.
..

2.

This Standard applies when an independent auditor (referred to herein as the principal
auditor) reporting on the financial statements of an entity uses the work of another
independent auditor (referred to herein as the other auditor) with respect to the financial
statements of one or more divisions, branches, subsidiaries or- associated companies
(referred to herein as components) included in the financial statements ofthe entity. This
Standard also applies when the principal auditor reports on other financial information. For
the purposes of this Standard, offices of the principal auditor's firm in a different country,
affiliated firms, correspondents,, and unrelated auditors who are involved in the audit of
components of the entity are considered as other -auditors.

3.

This Standard does not deal with those instances where two or more auditors are appointed
as joint auditors nor does it deal with the arrditor's relationship with a predecessor auditor.

A uditing Procedures

2.

When the principal auditor concludes that the financial statements of a component are
immaterial, the procedures outlined in this Standard do not apply. When several
components, immaterial in themselves, are together material in relation to the financial
statements of the entity as a whole, the procedures outlined in this Standard should be
considered.

Acceptance as Principal Auditor

5.

The auditor should consider whether his own participation is sufficient to enable him to act
as the principal auditor taking into account:

a) the materiality of the portion of the financial statements which he has audited in
b)
c)

relation to the financial statements as a whole;

the principal auditor's detailed knowledge of the business of all components;
the performance of additional procedures as'set out in this Standard with, respect to
the components audited by the other auditor resulting in the principal auditor having
significant participation in such audit; anil

d) his assessment of the risk of material misstatements in the financial statements of the
components audited by the other auditor.

The Principal Auditor's Procedures

6.

When using the work of an other auditor, the principal auditor should ordinarily perform the
following procedures:
)

Obtain mformation regarding the professional competence of the other

auditor in the context of the specific assignment undertaken by the other
auditor. Some of the sources of this information could be common
membership of a professional organization or reference to the professional
organization to which the other auditor belongs, supplemented when
appropriate by inquiries through other sources such as other public
accountants, bankers, etc. and by discussions with the other auditor.

Advise the other auditor of the applicable independence requirements as

regards both the emity and the component and obtain representation as to
his compliance with them.
Advise the other auditor of the use that is to be made of his work and report. The
principal auditor should also inform the other auditor of other matters related thereto,
such as areas requiring special consideration, procedures for the identification of intercompany transactions that may require disclosure and the timetable for completion of
the audit. Therefore, he should make sufficient arrangements for the coordination of
their efforts at the planning stage of his audit.
Advise the other auditor of the applicable accounting, auditing and reporting
requirements and obtain representation as to compliance with them.

c)

d)

87

88

Auditing: Principles and Procedures

e) Consider the significant audit findings ofthe other auditor.

7.

The principal auditor should also perform procedures to obtain reasonable assurance that
the work performed by the other auditor is adequate for the principal auditor's purpose. For
example, the principal auditor might discuss with the other auditor the audit procedures
applied or review a written summary of the other auditor's procedures and findings (which
may be in the form of a completed questionnaire or checklist), or review sufficient working
papers of the other auditor. The principal auditor may wish to perform these procedures
during a visit to the other auditor. The princpal auditor's selected procedures will depend on
the circumstances of the engagement and the extent of his knowledge of the professional
competence of the other auditor. Tins knowledge may have been enhanced from his review
of other audit work ofthe other auditor.

8.

The principal auditor may, however, conclude that he need not apply the procedures
described in paragraph 7 because he has reasonable assurance that the other auditor
complies with acceptable quality control policies and procedures in the conduct of his
practice. The principal auditor and the other auditor may have a continuing, formal
relationship providing for procedures that give that assurance, such as periodic interfirm
review and compliance tests of operating policies and procedures and review of working
papers of
selected audits.

9.

The principal auditor may consider it appropriate to discuss with the other auditor and the
management of the component the audit findings or other matters affecting the financial
statements of the component. He may also decide that supplemental tests of the records or
the financial statements of the component are necessary. He may request the other auditor
to perform such tests or alternatively, he may request permission to perform them himself.

Documentation

10. The principal auditor should document in his working papers the components whose
financial statements were audited by other auditors, their significance to the financial
statements of the entity as a whole, the names of the other auditors. and any conclusions
reached that individual components are immaterial. He should also document how he
applied the procedures he performed, and the conclusions he reached. For example, he
should identify working papers of the other auditor that he has reviewed and record the
results of discussions with the other auditor. However, the principal auditor need not
document in his working papers the reasons for limiting the procedures in the
crrcumstances described in * paragraph 8, provided those reasons are sunimarized
elsewhere in documentation maintained by his firm.

Cooperation between Auditors

11. An other auditor, knowing the context in which his work is to be need by the

A uditing Procedures

89

principal auditor, should cooperate with that auditor and assist him actively. For example,
he should bring to the principal auditor's attention any aspect of his work that cannot be
carried out as requested. 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
other auditor's work.

Reporting Considerations

12. The principal auditor should qualify his report or disclaim an opinion when he concludes,
based on his procedures, that he cannot use the work of the other
auditor and has not been able to perform sufficient additional procedures with respect to the
financial statements of the component reported on by the other auditor.

13. In all circumstances, if an other auditor qualifies his report, the principal auditor should
consider whether the subject of the qualification is of such a nature and significance, in
relation to the financial statements of the entity on which the principal auditor is reporting,
that it requires a qualification of his Own report.

Division of Responsibility

14. While compliance with the guidance in the preceding paragraphs is considered desirable,
the local regulations of some countries permit a principal auditor to base his opinion on the
financial statements taken as a whole solely upon the report of an other auditor with respect
to the financial statements of one or more components. When the principal auditor does so,
his report should state this fact clearly and should indicate the magnitude of the portion of
the financial statements audited by the other auditor. When the auditor makes such a
reference in his report, he ordinarily limits his procedures to those described in paragraph 6
a) through d).

PROFESSIONAL CONDUCT
A profession has been defined to be a vocation in which a professed knowledge of some
department of learning is used in its application to the affairs of others. The three basic
characteristics of profession are:

(1)

It is based on preliminary study, training and examination on the general

principles of the pursuit.
(2) The profits which may be made from its pursuit do not preliminarily depend
upon the command of great qualities of capital.
(3) It is pursuit which is followed not solely as a livelihood but which is always
subject to the observance of a code of professional honour and in which the work
rendered should be in proportion to the clients' needs

90
Procedures

Auditing:

Principles

and

rather than in proportion to the reward received.

The Institute of Chartered Accountants of Pakistan aims at the elevation ofthe profession of
public accountants as a whole and stands to promote their efficiency and usefulness by requiring
the observance of strict rules of conduct as a condition of membersliip. Reference should be
made to the relevant provisions of the Chartered Accountants Ordinance, 1961,* Chartered
Accountants Bye-Laws2 and other directives3 and publications4 of the Institute of Chartered
Accountants of Pakistan.
Schedule I, and HI were inserted by Section 22 of the Chartered Accountants
(Amendment) Ordinance, 1983: Relevant parts are as under:
Part Title Schedule I
1 Professional misconduct, in relation to chartered accountants in practice.
2 Professional misconduct in relation to members engaged in management
consultancy.
3 Professional misconduct in relation to members of the Institute in service.
4 Professional misconduct in relation to members of the Institute generally.
Schedule
1 Professional misconduct in relation to chartered accountants in practice requiring
action by a High Court.

Professional misconduct in relation to members engaged in management

consultancy requiring action by a High Court-.

Schedule
Professional misconduct in relation to the students of the Institute. These
Schedules are given as Annexure 2.1.

Op. cit. Section 8.

Chartered Accountants Bye-Laws, 1983.
The Institute of Chartered Accountants of Pakistan, Member's Hand Book, Volume {Karachi: The Institute of Chartered
Accountants of Pakistan], June 1936.
The Institute of Chartered Accountants of Pakistan, Manual of Professional Ethics. (Karachi: The Institute of Chartered
Accountants of Pakistani, 1969.
Recommended for further reading: 1. D. V. House, "Professional Ethics": Summer Course ofthe Institute of Chartered
Accountants in England and Wales - September, 1956: Address presented at flw course (London: The Institute of Chartered
Accountants in England and Wales), -53-llS 2. J. P. PaUl, "Professional Conduct mid Ethics". Tile Pakistan Convention of
Chartered , 1963; Technical paper submitted to the convention. (Karachi: Thu Institute of Cbartcrft ?
of Pakistan, 1963), pp.1-35.

91

Auditing Procedures

FUNCTIONS OF THE COUNCIL

Based on Section 15 of the Chartered Accountants Ordinance, 1961, it will be the duty of
the Council to carry out the provisions of the above Ordinance, In particular and without
prejudice to the generality of the provision, contained in the above Ordinance the functions of
the Council include:

(1)

The examination of candidates for enrollment and the prescribing pf fees

therefor,

(2) the regulation of the engagement and training students;

(3) the prescribing of cmalifications for entry in the Register;
(4) the recognition of foreign qualifications and training for purposes of
enrollment;

(5) the granting or refusal of certificates of practice under the said Ordinance;
(6) the maintenance and publication of a Register of persons qualified to practise
as Chartered Accountants;

(7) the levy and collection of fees from members, examinee and other persons;
(8) the removal of names from the Register and the restoration to the Register of
names which have been removed;

(9)

the regulation and maintenance of the status and standard of professional

qualifications of the members of the Institute;

(10) the carrying out, by financial assistance to persons other than members of the
Council or in any other manner, of research in accountancy;

(11) the maintenance of a library and publication of books and periodicals relating
to accountancy;

(12) the exercise of such disciplinary powers over the members and servants of the
Institute as may be prescribed;

(13) the formation of such Striding Committees as may be prescribed;

(14) the constitution of an Investigation Committee consisting of such members as
may be prescribed; and

(15) such other powers as may be conferred on the Council by the Federal
Government.

92
Procedures

Auditing:

Principles

and

DUTIES AND
OBLIGATIONS OF A
STUDENT AND PRINCIPAL1
The duties and obligations of a student are:

(1) That he will throughout his term of training serve in his Principal's office on his
Principal's business of public accountant and he shall not chiring such term of training
practise as a public accountant or engage in any other business or occupation.
(2) That he will not at any time during the said term destroy, cancel, obliterate, spoil,
embezzle, spend, make away with or take copies of books, papers, plans, documents,
monies, stamps or chattels of the principal, his personal representatives or assignees or
of his partner or partners or of any of his clients or employers which shall be deposited
in his hands or which shall come to his care, custody or possession or allow any ofthe
said goods to be so treated by others if he can by the exercise of reasonable care
prevent it.
(3) That he will at all times keep the secrets of the principal and his partner or partners
and of his and their clients and employers and will not divulge the names and affairs
of such clients and employers.
(4) That he will readily obey and execute the lawful and reasonable commands of the
principal and will not depart or absent himself from the service or employ of the
principal at any time during the said term without his consent or that of his partners
first obtained but will at all times during the said term conduct himself with all due
diligence, honesty and propriety.
(5) That he will at all times well and faithfully serve the principal as a trainee student.
(6) That he will make good and fully inderrrnify the principal for any loss or damage
suffered or sustained by his (trainee student's) misbehavior or improper conduct.
The duties and obligations of the principal are:

(1) That he will by the beet ways and means in his power and to the utmost of his skill

(2)

and knowledge instruct or cause to be instructed the trainee student and afford him
such reasonable opportunities and work as may be required to enable him to acquire
the art, science and knowledge of accountancy.
That he will at the expiration of the said term use his best means and endeavours at the
request, cost and chargee of the trainee student to cause the trainee student to be
admitted on the Register of Members pursuant to

The discussion is based on relevant clauses of the '"Training Contract", the profnrma > been prescribed under the
Chartered Accountants Bye-Laws, 1983, as Form "R".

93

Auditing Procedures

(3)

(4)

the Chartered Accountants Ordinance, 1961 (X of 1961) and the Chartered

Accountants Bye-Laws, 1983: Provided always that the trainee student shall have well
and faithfully served his intended trainee and shall have passed the required
examinations and in all respects properly qualified himselfto.be admitted on the said
Register.
That if the principal shall die or cease to practise as a member or cease to be borne on
the Register of Principals maintained under the Chartered Accountants Bye-Laws,
1983 or shall in any way become incapable of continuing the intended employment of
the trainee student during the said term he or his representative shall make necessary
arrangements for the completion of the residue of the term as trainee student.
That he will allow the trainee student leave of absence for a total period not exceeding
six months in all and may allow to spend a period not exceeding six months in all in
such industrial, commercial or other suitable organisation as the Council may approve
and subject to such conditions and. control as the Council may impose or exercise..

AUDIT PLANNING
However, ISA 4 deals exclusively with planning. Relevant portions: are reproduced below:
(1) Planning should be continuous throughout the engagement and involves:

(a) developing an overall plan for the expected scope and conduct of the audit; and

(b) developing an audit programme showing the nature, timing, and extend of audit
procedures.
Changes in conditions or unexpected results of audit procedures may cause
revisions ofthe overall'plan and of the audit programme. The reasons for
/
significant changes should be documented.
^ -tr- t
^.>1-(2) Adequate audit planning helps to ensure that appropriate attention is devoted to important
areas ofthe audit, potential problems are promptly identified, and the work is
completed expeditiously. Planning also assists in proper utilisation of assistants and in
coordination of work done by other auditors and experts.

(3) The extent of planning will vary according to the size and complexity of the audit, the
(4)

auditor's previous experience with the client, and his knowledge of the client's
business.
The auditor may wish to discuss elements of his overall plan and certain audit
procedures with the client's management and staff to improve the efficiency ofthe
audit and to coordinate audit procedures with work of the client's personnel. The
overall audit plan and the audit programme, however, remain the auditor's
responsibility.

94

Auditing: Principles and Procedures

Knowledge of the Client's Business

The auditor needs to have a level of knowledge of his client's business and industry that will
enable him to identify the events, transactions, and practices that, in his judgment, may have a
significant effect on the financial information. The auditor can obtain such knowledge from:
-fl) The Ghent's annual reports to shareholders. v>.(2) Mmute_s_ of_ meetings of
stockholder's, board of directors and important committees.
W3) Internal financial management reports, for current and previous period.
-f4) The previous year's audit working papers and other relevant files.
(5) Fhm personnel responsible for non-audit sendees to the client who may be able to
provide .information on matters that may affect the audit;
v<6> Discussions with client's management and staff.
'-(7) The client's policy and procedures manual.
v^S) Trade journals or magazines.
V(9) Consideration of the state of the economy and its effect on the client's business.
(TO) 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 required special
consideration and decide whether1 they might affect the work to be done in the
current year.
..
.
.
Discussions with the client's management and staff might include such subjects as:
^ (1) Changes, in management, organisational structure, and activities of the client.
(2) Current government regulations affecting the client.

(3) Current business developments affecting the client.

(4) Current or impending financial diffkultiesor accounting jjioblems. (5> Existence of
related parties. .(6) New or closed premises and plant facilities.
(7) Recent or impending changes in technology, types of pruducts or services, and
production or distribution, nrethods. '""
' (8) Changes in the accounting system and in the system of internal control.
In addition to the importance of knowledge of *the client's business in establishing the
overall audit plan, such knowledge helps the auditor to identify areas for special audit
consideration, to evaluate .the reasonableness both of accounting estimates and management
representations, and to make judgments regarding the appropriateness of accounting policies and
disclosures.

Auditing Procedures

95

Development of an Overall Plan

The auditor should consider the following matters in

developing his overall plan for the expected scope and conduct
(1) ofthe audit:
(2)
(3)
(4)
(5)
(6)
C
D

(8)
(9)
(10)
(11)
(12)

The terms of his engagement and any statutory responsibilities.

The nature and timing of reports or other communication with
the client that are expected under the engagement.
The accounting policies adopted by the client and changes in
those policies.
The effect of new accounting or auditing pronouncements on
the audit. The identification of significant audit areas. The
setting of materiality levels for audit purposes.
Conditions requiring special attention, such as the possibility of
material .error or fraud or the involvement of related parties.
The degree of reliance he expects to be able to place on
accounting system and internal control.
Possible rotation of emphasis on specific audit areas.
The nature and extent of audit evidence to be obtained.
The work of internal auditors and the extent of their
involvement, if any, in the audit.

96

Auditing: Principles and Procedures

The involvement of other auditors in the audit of subsidiaries or

branches of the client.
The involvement of experts.
The auditor should document his overall plan. The form and extent of the documentation
will vary depending on the size and complexity of the audit. A time budget, in which hours are
budgeted for the various audit areas or procedures, can be an effective planning tool.

Developing the Audit Programme

The auditor should prepare a written audit programme setting forth the procedures that are
needed to implement the audit plan. The programme may also contain the 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 the work.
In preparing the audit programme, the auditor, having an understanding of the accounting
system and related internal control, may wish to rely on certain internal controls in deterrmning
the nature, timing, and extent of required auditing procedures. The auditor may conclude that
relying on certain internal controls is an effective and efficient way to conduct his audit.
However, the auditor may decide not to rely on internal controls when there are other more
efficient ways of

97

Auditing Procedures

obtaining sufficient appropriate audit evidence. The auditor should also consider the timing of the
procedures, the coordination of any assistance expected from the client, the availability of
assistants, and the involvement of other auditors or experts.
The auditor normally has flexibility in deciding when to perform audit procedures, as very few
of them have to be carried out within specific time limits. For example, procedures carried out on
transactions can be performed at any time after the transaction has been recorded. On the other
hand, the auditor may have no discretion as to timing, for example, when observing the taking of
inventories by client personnel.
The audit phjn^and, related programme should be reconsidered as the audit progresses. Such
consideration is based-on the auditor's review of internal control, "his preliminary evaluation
thereof, and the results of his compliance and substantive procedures.

AUDIT EVIDENCE
ISA 8 deals with audit evidence. Its salient features are reproduced below:

Sufficient Appropriate Audit Evidence

Sufficiency and appropriateness are interrelated and apply to evidence obtained from both
compliance .and substantive procedures. SmTrciency is the measure of the quantity of audit
evidence obtained; appropriateness of audit evidence relates to its relevance and reliability.
Normally, the auditor finds it necessary to rely on evidence that is persuasive rather than
conclusive. He may often seek evidence from different sources or of a different nature to support
the same assertion.
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.
The auditor's judgment as to what is sufficient appr opriate audit evidence is influenced by
such factors as:
(a) the degree of risk of misstatement. This risk may be affected by:
(i) the nature of the item;
(ii) the adequacy of internal control;
(Hi ) the nature of the business carried on by the entity;
(i v) situations which may exert an unusual influence on management, and

98

Auditing: Principles and Procedures

(v) the financial position of the entity;

(6) the materiality of the item in relation to the financial information taken as a whole;

(c) the experience gained during previous audits;

(d) the* results of-auditing procedures, including fraud or error which may have been
found; and

(e) the type of information available.

In obtaining audit evidence from compliance procedures, the auditor is concerned with the
following assertions:
Existence. the control exists
Effectiveness the control is operating effectively
Continuity the control has so operated throughout the period of intended reliance.
In obtaining audit evidence from substantive procedures, the auditor is concerned with the
following assertions:
Existence
an asset or a liability exists at a given date Eights and
. Obligations an asset is a light ofthe entity and a liability is an obligation ofthe entity, at a
given date
Occurrence a transaction or event took place which pertains to the entity
Completeness there are no unrecorded assets, liabilities or transactions
Valuation
an asset or liability is recorded at an appropriate carrying value
Measurement. a transaction is recorded in the proper amount and revenue or . expense is
allocated to the proper period Presentation and
Disclosure an item is disclosed, classified, and described in accordance with acceptable
accounting policies and. when applicable, legal requirements.
Obtaining evidence relevant to one assertion, for example, existence of inventory, will not
compensate for failure to do so with respect to another, for example, its valuation. The extent and
natur e of substantive procedures to be performed will vary with respect to each of the above
assertions.
The reliability of audit evidence is influenced by its source internal or external, and by
its nature visual, documentary or oral. While the reliability of audit evidence is dependent. on
the circumstance under which it is obtained, the following generalisations may be useful in
assessing the reliability of audit

99

Auditing Procedures

evidence:
External evidence (e.g., confirmation received from a third parryj is more reliable than
internal evidence.
(2) Internal evidence is more reliable when related internal control is satisfactory.
(3) Evidence obtained by the auditor himself is more reliable than thai obtained
fi'om the entity.
.- (4) Evidence in the form of documents and written representations is more reliable than
oral representations.
The Auditor may gain increased assurance when audit evidence.obtained from different
sources or of a different nature is consistent. In these circumstances, he may obtain a cumulative
degree of assurance higher than that which he attaches to the individual items of evidence by
themselves. Conversely, when audit. evidence obtained from one source is inconsistent with that
obtained from another, further procedures may have to be performed to resolve the inconsistency.
The auditor should be thorough in his efforts to obtain evidence and be objective in its
evaluation. In selecting procedures to obtain evidence, he should recognise the possibility that the
financial information may be materially misstated.'
There should be a rational relationship between me cost of obtaining evidence and the
usefulness of the information obtained. However, the matter of difficulty and expense involved in
testing a particular item is not in itself a valid basis for omitting a procedure.
When the auditor is in reasonable doubt as to any assertion of material sigmficance, he
should attempt to obtain sufficient appropriate evidence to remove such doubt. If he is unable
to obtain sufficient appropriate-evidence, he should not express an unqualified opinion.

Methods of Oblaining Audit Evidence

The auditor obtains evidence in performing compliance and substantive procedures by one
or more of the following methods:

(1)
(2)
(3)
(4)
(5)

inspection;
observation;
inquiry and confirmation:
computation; and
analytical review.

--

The timing of such procedures will be dependent, in part, upon the periods of time during
which the audit evidence sought is available.

100

Auditing: Principles and Procedures

Inspection
Inspection consists of examining records, documents, or tangible assets. Inspection of
records and documents provides evidence of varying degrees of reliability depending on their
nature and source and the effectiveness of internal controls over their processing. Three major
categories of documentary evidence, which provide different degrees of reliability to the auditor,
are:
(t) documentary evidence created and held by third parties; (ii) documentary evidence created by third parties and held by the entity; and
(iii) documentary evidence created and held by. the entity.
Inspection of tangible assets provides reliable evidence with respect to their existence but
not necessarily as to their ownership or value.

Observation
Observation consists of looking at a process or procedure being performed by others. For
example, the auditor may observe the counting of inventories by client personnel or the
performance of internal control procedures that leave no audit trail.

Inquiry and Confirmation

Inquiry consists of seeking appropriate information of 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 provide him with
corroborative evidence.
. Confirmation consists of the response to an inquiry to corroborate irubrmation contained in
the accounting records. For example, the auditor normally requests confirmation of receivables
by direct communication with debtors.

Computation
Computation consists of checking the arithmetical - accuracy of source documents and
accounting records or of perforating independent calculations.

Analytical Review
Analytical review consists of studying significant ratios and trends and investigating
unusual fluctuations and items, Addendum 1 to ISA 8, Audit Evidence, released in February 1991 dealing with Additional
Guidance on observation of Inventory, Confirmation of Accounts Receivable and Inquiry
regarding Litigation and claims is reproduced below:

Auditing Procedures

101

Introduction

1.

International standard on Auditing (ISA)8, Audit Evidence, states that tb degree of risk of
misstatement is one factor in the auditor's judgment of what, constitutes sufficient
appropriate audit evidence, Further guidance on risk is given in ISA 25, Materiality and
Audit Risk, and ISA 6, Risk Assessment and Internal Control.

2.

Factor which enter into the auditor's judgment of what constitutes sufficient appropriate
audit evidence also include:

the nature of the item;

the nature, sources, and resultant reliability of the evidence available; and

alternative available methods are not practicable.

3.

The purpose of this Standard is to provide guidance in relation to obtaining audit evidence
by means of observation of inventory, confirmation of receivables and inquiry regarding
litigation and claims, as these procedures are generally accepted as- providing the most
reliable audit evidence in relation to certain assertions.

4.

The auditor should assess the results of the observation, confirmation, and inquiry
procedures or (when such procedures are not practicable) alternative procedures and decide
whether they form an adequate basis for the opinion, the effect of this limitation of scope
on the report should be considered (for further guidance see ISA 13, The Auditor's Report
on Financial Statements).

Observation of Inventory

5.

Paragraph 13 of ISA-8 states that:

"Inspection consists of examining records, documents, or tangible assets... Inspection
of tangible assets provides reliable evidence with' respect to their existence but not
necessarily as to their ownership or value."

6.

Paragraph 14 of ISA 8 states that:

"Observation consists of looking at a process or procedure being performed by others.
For example, the auditor may observe the counting of inventories by client personnel
or the performance of internal control procedures that leave no audit trail."

7.

It is the responsibility of the management of an entity to ensure that inventories are fairly
stated in the financial statements of the entity. This will normally involve establishing
procedures under which inventory is physically counted at least once a year to serve as a
basis for the preparation of the financial statements or to ascertain the reliability of the
perpetual inverrrory system.

8.

When inventories are material to the financial statements, the auditor ^sjdjd.

102

Auditing: Principles and Procedures

obtain satisfaction as to their physical existence and condition by attendance-at - stocktaking

unless this is impracticable. Such attendance will enable the auditor to physically inspect the
inventory, to observe compliance with the operation of management's procedures for
conducting the count, and to gather evidence as to the reliability of management's procedures.
In plarming the audit, the audff^^shguld Consider:
the nature of the accounting and internal control systems used in respect of inventory;
inherent and control risks, and materiality related to inventory;
r

whether management is expected to establish adequate procedures and issue proper instructions
for physical inventory counting;
.

. the timing of the count;

^ the locations at which inventory is held; and
whether an expert's assistance is needed.

10. When inventory is situated in, several locations, the auditor should consider at
which locations attendance is appropriate, taking into account the materiality
of the inventory and the assessment of control risk at different locations.
11. If unable to attend the stocktakingj on the date planned due to unforeseen
chcumstances, the auditor should .take or observe so me'physical counts on an
alternative date., and when necessary, perform tests " of intervening
transactions. \Vbere^ftehdance at sToclrtakrng'is impracticable because ofthe
.nature and location of the inventories, the auditor' should consider whether
alternative procedures fe.g. evidence of the subsequent sale of specific inventory items
acquired or purchased prior to the inventory count date) provide satisfactory evidence of
physical existence and condition to conclude that he need not make reference to a limitation
on the scope of his examination.
12. *vVhen the quantities are to be..determined by a physical inventory count and
the auditor attends such a count, or wKerTthi entity" operates aT^elpetual
iffventory system" and the auditor" "attends the "stocktaking one or more times
during the year -, he should ordinarily observe count procedures and pertorm
test counts.

13. If the entity_uses procedures to estimate the physical quantity (such as esffinating a coal
'pile), the auditor"' sh6um"_s^isf^ the reasonablenessjjf those procedures.

14. The auditor should review management^s^sbj^or^.a^f

the apjjlieation of control procedures (e.g. in the case of a physical count, coTTection
of used stocksheets, accounting for unused stocksheets, and count and re-count
procedures);

Auditing Procedures

accurate identification of the stage of completion of inventory (e.g. work in

progress! "and of slow moving, obsolete or damaged items, or Inventory -owned by a
.third party (e.g. consignment);, and

whether appropriate arrangements are made regarding the movement of

mveriforieV between areas arid trie snipping and receipt of inventories before and after
the cut-off date.

15. To obtain assurance that management's procedures are adequately-implemented, the auditor

should observe employees' procedures and perform test counts. When

perfgrrnjng..these,.CQ.unt,jJhe auditor may tegt both the rornrdeteness_and the accuracy of
the count __tracing;.items selected from_thgse records to the physical inventoiy
and items selected from the plrysical inventoiy to the records. The auditoi' should determine
the extent to which he needs to collect a copy of such count recoids for subsequent testing,
and comparison. The auditor should also obtain details of movements of inventoiy just prior
to and after the count date so that the correct accounting for such movements may be
checked at a later date; the auditor should not overlook movements during the count.

16. For practical reasons and when internal control is evaluated as adequate, the physical
inventoiy count may be conducted at a date other than the balance sheet date. In. such
instances, the auditor should assess, through the performance of appropriate' procedures,
whether changes in inventoiy between these dates are correctly recorded.

17. When the entity operates a perpetual inventory system which is used to determine the year-

end balance, the auditor should assess, through the performance of appropriate procedures,
whether the reasons for any significant differences between the.physical count and the
perpetual inventory recoids are understood and the records are properly adjusted.

18. The auditor should test the final inventoiy listing to assess whether it accurately reflects
actual inventory counts.

19. When inventories are under the custody and control of a third party, the
auditor should ordinarily obtain direct confirmation from the third party as to
the quantities and quality of inventories held on behalf of the entity. The
auditor should also consider:
''
'. any apparent lack of integrity and independence of the third party;

observing, or arranging for another auditor to observe, the physical inventory

count;
' obtaining another auditor's report on the adequacy of the third party's internal controls
for ensuring that inventoiy is rorrectly counted and adequately safeguarded; or .

documentation as to inventory held by third parties (e.g. if warehouse

receipts are pledged as collateral).

104

Auditing: Principles and Procedures

Confirmation of Accounts Receivable

20. Paragraph 16 of ISA 8 states that:

21.

"Confirmation consists of the response to an inquiry to corroborate information

contained in the accounting records. For example, the auditor normally requests
confirmation of receivables by direct communication with debtors."
When accounts receivable are material to the financial statements, and when it is reasonable
to expect that debtors will respond, the auditor should normally plan to obtain direct
confirmation of accounts receivable balances or individual entries in an account balance
since this provides the most reliable audit evidence as to the existence of debtors and the
accuracy of their recorded account balances. However^_it_does not usually
pjraidfi_gyidence as to the collectibility of bal^nces npr^tp the existence of unrecorded
rej^iyj&Ie balances? WJienJtis_ expected thatthe debtor will^not_resrx)M,_the_auoHtor
should plan to perform alternative procedures such as examining subsequent cash receipts
relatedf 6 the specific account balance at year encf. _

22.

The &ceounts_tobe confnmied should be selected to enable the auditor to reach an

appropriate conclusion as to existence and accuracy of accounts receivable as a w .ole,
taking into account audit risks identified and other planned procd-rres (for further guidance
see ISA 19, Audit Sampling).

23.

Letters requesting confirmation should be sent by the auditor and debtors should be
requested to reply direct to the auditor. Such letters should contain
management^s_authorization to the debtor to disclose the necessary iirformation to the
auditor.

24- The request for confirmation of balances may take a positive form when the debtor is

asEecfto confirm agreement or to express disagreement with the recorde'd~Balance, or a

negative form when a reply is requested only in the event of disagreement with the
recorded balances.

25. Positive coiurrrrmtions will provide more reliable evidence than negative confirrnations.

The choicebetween"positive and negative forms of wrifirm~atiOn will depend .upon

the..circumstances, including the assessment of both' inherent and control risks. Thepositive form is preferred when inherent or control risk is assessed as high since with the
negative form, no reply may be due to causes other than agreement with the recorded
balance.

26. A combination of positive and negative forms may be used. For example, where

the total accounts receivable balance consists of a small number of large

balances and a large number of small balances, the auditor may decide that if
is appropriate to confirm all or a sample of the large balances with positive
confirmation, requests... and a sample of the small balances using negative
confirmation requests.
"" "" r
" "-

Auditing Procedures

27. When the positive form is used, the auditor should ordinarily send a to those
debtors who do not reply within- a reasonable time. If replies contain exceptions, these
should be fully investigated. If a reply is not received, alternative procedures should be
applied (e.g. examining evidence of subsequent cash receipts and examining sales and
dispatch documents). For items which cannot be confirmed and for which alternative
procedures have not been performed, the auditor should treat these items as errors for the
purpose of evaluating the audit evidence provided by the audit sample.

28. For practical reasons and when internal control is evaluated as adequate, the auditor may
decide to confirm accounts receivable balances at a date other than the balance sheet date
(e.g. when the audit is to be completed within a short time after the balance sheet date). In
these cases, the auditor should review and test intervening transactions as deemed
necessary to be satisfied that the amount recorded at the balance sheet date is not materially
misstated.

29. When management requests the auditor not to confirm certain accounts receivable balances,
the auditor should consider whether there are valid grounds for such a request. For
example, management may say that the particular account is in dispute with the debtor and
communication on behalf of the auditor may aggravate sensitive negotiations between
management and debtor. Before accepting a refusal as justifiedj the auditor should examine
any available evidence to support management's explanations (e.g. correspondence between
management and debtor), In such a case, alternative procedures should be applied to the
accounts receivable not subjected to confirmation.

Inquiry regarding Litigation and Claims

30. Litigation and claims involving an entity may have a material effect on the financial
statements and thus may be required to be disclosed and/or provided for in the financial
statements.

31. In order to become aware of any litigation and claims involving the entity which may have
material financial implications, among other procedures the auditor should:

make appropriate inquires of management including oMaining representations,

review board minutes and correspondence with the entity's lawyers,

examine legal expense accounts, and

use any information available in this respect about the entity's Irosiness
including information obtained from discussions with any in-house legal-department.
When litigation or claims have been identified or when the auditor believes they may exist,
the auditor should seek direct ccmmunication with the errthy's lawyers in order to obtain
satisfaction that all potentially material litigsiian

32.

105

106

Auditing: Principles and Procedures

and claims are known and also to obtain assurance as to the reliability of management's
estimates ofthe financial implications, including costs.

33. The letter, which should be prepared by management and sent by the auditor, should request
the lawyer to communicate directly with the auditor. When it is considered unlikely that the
lawyers will respond to a general inquiry, the letter should contain:

a list of litigation and claims as provided to the auditor by management;

management's assessment of the outcome of the litigation or claim and its

estimate ofthe financial implications, including costs involved; and

a request that the lawyer confirm the reasonableness of management's

assessments and provide the auditor with further information if the list is considered
by the lawyer to be incomplete or incorrect.;

34. The auditor should consider the status of legal matters up to the auditor's report date. In
some instances, the auditor may need to obtain updated information from lawyers.

35- In certain circumstances (e.g. where the matter is complex or there is disagreement between
management and the lawyer), it may be necessary for the auditor- to meet with the lawyer to
discuss the likely outcome of existing or pending litigation. In such circumstances, the
meeting should take place with management's peimission and preferably with a
representative of management in attendance.
36. Whenever management refuses to give the auditor permission to communicate with lawyers,
there would be a limitation on the scope of the audit sufficient to preclude an unqualified
opinion. Where the lawyer refuses to respond in an appropriate manner, arid the auditor is
unable to satisfy himself by applying alternative procedures, the auditor should consider
whether there is a scope limitation sufficient to preclude an unqualified opinion.
Addendum to International Standard on Auditing 8, Audit Evidence released in Februaiy,
1992 dealing with Additional guidance on long terms Investment and Segment information is
reproduced below:

Long-Term Investments
1. The auditor should carry out auditing procedures designed to provide a
v reasonable basis to conclude whether long-term investments are accounted for
in accordance with the applicable accounting principles..
2.

Such procedures would normally include considering evidence as to whether

the entity has the ability to continue to hold the investments on a long-term
basis, and discussing with management whether the entity will continue to
hold the investments as long-term investments and obtaining written
representations to that effect. Other procedures would normally include

Auditing Procedures

107

considering related financial statements and other information, such as market quotations,
which provide an indication of value and comparing such values to the carrying amount
ofthe investments up to the date of the auditor's report. If such values do not exceed the
carrying amounts, the auditor should consider whether a write down is required. If there is
an uncertainty as to whether the carrying amount will be recovered, the auditor should
consider whether the contingent loss has been appropriately disclosed. In each of these
situations, the related effect, if any, on the auditor's report should also be considered.

Segment Information

3.
4.

The auditor should carry out auditing procedures designed to provide a reasonable basis, to
conclude whether segment information is presented in accordance with the applicable
accounting principles.
The auditor should consider segment information in relation to the financial statements
taken as a whole, and is not normally required-to apply auditing procedures that would be
necessary to express an opinion on the segment information standing alone. However, the
concept of materiality encompasses both quantitative and qualitative factors and the
auditor's -procedures should recognize this.
5. Such procedures - would normally consist of analytical procedures and other
' audit tests which could also be used to audit segment information. The auditor
should discuss with management the methods used in determining segment information and
related disclosures and consider whether such methods are likely to result in the applicable
accounting standards' being met, and test the application of such methods. The auditor
should consider sales, transfers and charges between segments, elimination of inter-segment
amounts, comparisons with budgets and other expected results (e.g. operating profits as a
percentage of sales), allocation of assets and costs among segments, and consistency with
the prior periods or adequacy of the disclosures with respect to inconsistencies.

ORGANRATIONAL SET UP OF AN AUDIT OFFICE

An auditor is required to have a sound organisational set-up in his office. Suggested
organisational chart is given in this chapter. This organisational chart has been developed on the
assumption that the auditor specialises in the audit work only. However, the organisational set-up
will be different if the auditor were to deal in Tax, Management Consultancy and Cost
Consultancy also.
If the magnitude of work is big, the audit department will be divided into several sections.
Each section will be under the .charge of a qualified assistant (Le Chartered Accountant). An
audit manager is required to be there who will distribute the audit work amongst the staff in
liaison with the qualified assistants (generally called as Principals). Besides this, he should
maintain a record ofthe following:

109

Auditing Procedures

(1) Allocation of jobs amongst the senior in charge of the jobs.

(2) Daily posting of audit staff to various jobs.
(3) Audit work to be done (classified as monthly audit/inspection, quarterly, half yearly
and yearly audits).

(4) Details of jobs where targets are involved.

(5) Dates as and when cash count and physical stock check (annual/monthly or surprise)
are to be conducted. -

(6) Audit jobs to be started, in progress and completed.

In order to ensure that the above record is maintained efficiently, audit completion register
and audit work register should be maintained.
The audit manager should also maintain an up-to-date list of the clients. It is generally
advisable to review it periodically, specially marking new audit jobs undertaken. Generally one
or two jobs should be allocated to a senior (called audit job-in-charge) who would be assisted by
a semi-senior and a few junior members of the audit staff in the conduct of the audit work. The
senior would be accountable to the qualified principal for getting the audit work finalised who
would then submit his work to the auditor to go through in the synthesis of final stage and
reporting.
The auditor should also keep and use Job Completion Register. This should include a
snapshot of the total jobs on hand. From this register a periodical summary should be prepared
indicating jobs completed and jobs still in hand (marking separately in progress, to be shortly
taken up and arrears, if any).

COMMENCEMENT OF A NEW AUDIT

Before" the commencement of final audit, the following instructions must be given by the
auditor to his client:

(1) A complete list of books in use together with a list of employees engaged upon them
with their respective duties, a note on the system of bookkeeping in operation and a
statement of the system of internal control in practice should be provided to the audit
staff.

(2) All the books of original entry should be totalled and all the ledgers should be
balanced and ruled off. The final trial balance and the draft final account should be
kept ready for audit and examination.

(3) All supporting vouchers to all the books should be kept properly arranged.
(4) Supporting Schedules to the draft accounts, Schedule of debtors and creditors,
Schedule of bad and doubtful debts, Schedule of outstanding assets and liabilities in
respect of accrued income, unpaid expenditure, pre-paid expenses or income received
in advance, Schedule of investments, detailed inventory sheets, in respect of stock and
fixed assets, Schedule rf share capital etc.), should be prepared and kept in final form.

110

Auditing: Principles and Procedures

Before commencing the audit, some of the auditors prepare a job information sheet.
The auditor of a newly-established limited company should carry out the folio wing
preliminary work before commencing the actual audit:

1.

Appointment. He should ascertain whether his appointment is in order. He should obtain a

certified true Copy of the resolution of the Board of Directors or Shareholders (whichever is
relevant) and keep it in the permanent audit file. If an auditor is being appointed in place of the
retiring auditor he should see that the requirements of the Companies Ordinance, 1984, have
been complied with.

2.

Documents. A copy of the Memorandum and Articles of Association should be obtained

and studied carefully. Particulars affecting the auditor in relation to account books and internal
procedures relating to relevant matters should be noted.

3.

Prospectus. Relevant matters affecting the accounts and allied information should be
examined.

4.

Minute Books. He should go through the directors and shareholders' nrinute books and job
down notes of important decisions.

5.

Contracts. Service contracts concerning the terms of appointment and the scope of
authority in respect of officers of the company should be scrutinised. All material contracts
entered into by the company with the outsiders should be procured and studied (with vendor's,
undei-writers, managing agents etc.). Important matters should be noted.

6.

Technical Operations. He should acquaint himself as far as possible with the technical
operations of the company. It is advisable that he should visit works before starting the audit.

7.

List of Books. He should obtain a list of books statutory, statistical and accounting,
which are in use together with the names and duties tf various clerks who are to write them up.

8.

System of Accounting. A note on the system of accounting employed by the company

should be obtained.

9.

Internal Check. He should ascertain whether the internal check system in operation appears
in black and white in some accounting manuals. If so, he should go through the same and
car'efully note any loopholes. The system, whatever exists in practice, should be tested in all
practical aspects. -

10. Previous Years Audited Accounts and Reports. With the exception of a new company, the

auditor should examine the last balance sheet for the pur-poses of checking the opening entries
for the period under audit. The previous auditors' report should also be inspected and if any
qualifications are contained in it, the possibility of then - being applicable the year under audit
should be carefully

111

Auditing Procedures

examined:
11, Audit Programme. He should then draft an audit programme and commence the work of
audit.

AUDIT PROGRAMME
Definition. An audit programme is a written scheme of the exact details ofthe work to be
done by the auditor and his staff in connection with a particular audit. It is generally contained in
the audit notebook and is invariably in black and white. A space is also provided in the audit
programme against each item of the work to be done so that each audit clerk, responsible for any
portion of the particular work, may put down his signature or initial. One audit programme is
prepared for one audit. The details of the audit programme will depend upon the adequacy or
otherwise of the system of internal control, special provisions of Memorandum and Articles of
Association affecting the duties of an auditor and the nature of the business etc.

Preparation
The audit programme must be developed with due care and skill. Particular attention should
be given to the following:

(1)
(2)
(3)
(4)
(5)

Exact scope of the duties of an auditor.

Books of original entry and ledgers in use.
The system of book-keeping employed, and it weaknesses (if any).
System of internal check and the extent of its reliability.
Special provisions contained in the legal documents (Partnership Deed, Memorandum
and Articles of Association, etc.) affecting the duties of the auditor.

(6) General nature and routine ofthe business.

The audit programme should not be very rigid; it must be capable of being reviewed in view
of changing circumstances.
A similar audit programme is required to be prepared in respect of all books of original
entries and ledgers. The scope of the contents of the audit programme should cover all the routine
checking and vouching.

Extent of works
The extent of the. work to be .performed in respect of each item must be indicated-in the
audit programme for guidance ofthe audit staff. The extent may be a full checking or the
checking may be restricted to a test basis, the'extent of which (whether one month in a quarter,
one week in a month, one day in a week, etr.' must be clearly indicated in the audit programme..

A uditing: Principles and Procedures

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113

Auditing Procedures

Advantages
The use of the audit programme offers the following advantages:

(1) It is one of the basic instruments for training the staff and can be used as a guide for
(2)
(3)
(4)
(5)

the performance of the job.

Progress ofthe work can be watched periodically.
The audit can be divided amongst the staff.
Uniformity ofthe performance of audit work is ensured.
It is a legal proof for the work done as initials of those who have performed a
particular job are to be appended to it.

(6) The responsibility for the negligence can be fixed.

(1) It extends a useful help in supervising the work of the staff.
Limitations

(1) The audit work may become top mechanical.

(1) Initiative and the dexterity of an audit assistant is likely to be ost as he is required to
faithfully carry out the steps listed in the audit programme.
(3) . No rigid audit programme can be laid down for each type of work.

Removal of Limitations
However, these limitations can be easily overcome. The auditor should review and revise
the audit programme off and on. The auditor should make a flexible programme which could be
adjusted according to circumstances. He should not let it become mechanical and automatic.

TEST CHECKING
The concept of test checking in auditing is based on the "Law of Statistical Inertia" which
means the selection and checking of a representative number of entries of each class of
transactions instead of going through every entry. The basis of thought is that the whole matter
(vouchers, entries, etc.) will correspond to the samples, selected or checking during the audit.
Whether the auditor should resort to test-check or not depends upon several factors, viz., the
existence of a sound system of internal control or otheiwise, the existence of an efficient system
of internal audit or otherwise etc.
However, the following precautions must be taken by the auditor while carrying a test
check of the transactions:

(1) While making selection for test checks, every effort must be made to ensure that the
entries are representative ofthe whole set of books.

(2) The clients should not be knowing the period selected for the test i-bm-fc

114

Auditing: Principles and Procedures

(1) The months selected For test check should be different in the forthcoming year.
(2) The first and the last months of the period covered by the accounts may preferably be
checked in every case.
ISA 19 deals with Audit Sampling. Details in this respect have been included in chapter
Dealing with Vouching.

AUDIT NOTEBOOK
It is a book in which a permanent record is kept of the following:

1.

Audit Programme. It has already been explained at length earlier.

2.

Audit review notes. During the conduct ofthe audit, certain points do crop up which need
further elucidation and discussion with the management. Therefore notes are taken during the
conduct of work. A record of the progress of the disposal of audit notes is also maintained.

3.

Audit queries. During the conduct of the audit, all those vouchers which remain
insufficiently vouched are to be noted in the query list of the audit notebook. A complete record
as to how they were cleared and those which remained uncleared and reported to management is
maintained.

4.

Important balances. A note of the important closing balances particularly in respect of cash
and bank should be noted so that after the work has been done in alteration any the closing
balances may be made difficult.

5.

Extracts from documents. Extracts from Memorandum and Articles of Association,

Agreements, Contracts, Minutes of the proceedings ofthe Directors or Shareholders, etc., must be
noted in the audit notebook for ready reference.
6: Accounting Statistics. Statistics in respect ofthe pages of each book of original entry and
the number of the vouchers must be noted in this section. This serves two -poses. Firstly, it is
a check on the staff so that they may not indulge in wasting time. Secondly, it is intended to help
the auditor for requesting for increase in the audit fee if the comparison of accounting statistics of
the present year with the previous one reveals that the quantum ofthe work has gone up..
If the notes have been properly taken in the audit notebook, they might prove of great value
to the auditor subsequently, in case a suit is filed against him for negligence or misfeasance. The
importance of such an audit notebook was emphasised by Lord-Justice Vaughan Williams in the
London and General Bank case.

115

Auditing Procedures

WORKING PAPERSWorking papers are the connecting link between the client's records and the audited
accounts. These include all the evidence gathered by the auditor indicating what work has been
done by him and the procedure he has followed in verifying a particular asset or a liability. These
provide a permanent historical record logically arranged in order, in which each item appears in
the balance sheet. These also serve as a great guide to the staff to whom the work of audit has
been assigned after the previous year audit. These would come to the help of the auditor in future
in case the client files a suit against the auditor's negligence,
The question of lien in regard to the working papers arose in the case of Sockockinsky vs.
Bright Grakme and Co. (1938) in England. The vital' question involved in this case was whether
the auditors had a right to retain the working papers as if it were their own property even after the
payment of the audit fee. The learned Court gave the judgment in favour of the auditors On the
ground that they were independent contractors and not as agents of the clients.
However, the right of the auditor to retain the working papers must be distinguished from
the light ofthe auditor to retain the books of accounts, if his fees were not paid. It has judiciously
been held that the auditor has- right of lien on, the books of the company in respect of the
payment of their fees. \Hoate, Smith and' Field vs. Valentine Tingey (1926) and Fi ndl ey vs.
Wad del l (1910)1.
.ISA 9 is captioned "Documentation". Documentation refers to the working papers prepared
or obtained by the auditor and retained by him, in.eonnectipn with the performance of his audit.
Three benefits listed in the above ISA are given below:
(1) aid in the planning and performance of the audit; .
' (2) aid in the supervision and review of the audit work; _
(3) provide evidence of the audit work performed , to support the auditor's opinion.
Relevant material relating to Form and Contents and Ownership and custody of working
papers is reproduced below:

Form and Content

. Working papers "should record the auditor's planning, the nature, timing and extent of the
auditing procedures performed, and the conclusions drawn from the
Becommended for further reading: (a) S. M. Duncan, "An Accountant's Working Papers", SBBMO-Course of the Institute of
Chartered Accountants in England and Wales ~ September, 1 Aciinee presented at the course (London: the Institute of Chnrteied Accountants in England sad Wafe*^ pp.167-217. .
ft) Audit Guideline (AG 2) entitled: Audit Working Papers issued fay the InsutiEe (brae Accountants of Pakistan on
December 14,1986, pp. 1-5.

116

Auditing: Principles and Procedures

evidence obtained.
Working papers should be sufficiently completed and detailed for an experienced auditor to
obtain an overall understanding of the audit. The extent of documentation is a matter of
professional judgment since it is neither necessary nor pr&ctical for the auditor to document in
his working papers every observation, consideration or conclusion made. .
All significant matters which require the exercise of judgment, together with the auditor's
conclusion thereon, should be included in the working papers.
The form and content of working papers are affected by matters such as:

(1) The nature of the engagement.

(2) The form of the auditor's report.
(3) The nature and complexity ofthe client's business.
(4) The nature and condition.of the client's records and degree of reliance on
internal controls.
(5) The needs in the particular circumstances for direction,, supervision arid
review of work performed by assistants.
Working papers should be designed and properly organised to meet the circumstances and
the auditor's needs for each individual audit. The use of staridardised working papers (eg.,
checklists, specimen letters, standard organisation of working papers) may improve the
efficiency with which they are prepared and reviewed. They facilitate the delegation of work
while providing a means to control its quality.
To improve audit efficiency, the auditor normally plans with the client to utilise schedules,
analyses and other working papers prepared by the client. In such circumstances, the auditor
should satisfy himself that those working papers have been properly prepared.
Working papers normally include:

(1)
(2)
(3)
(4)

Information concerning the legal and organisational structure of the entity.

Extracts or copies of impoitant legal documents, agreements and minutes.
Evidence ofthe planning process ofthe audit and audit programmes.
A record ofthe study and evaluation of the accounting system and related internal
controls. This might be in the form of narrative descriptions, questionnaires or flow
charts, or some combination thereof.

(5) Analyses of transactions and balances.

(6) Analysis of significant ratios and trends.
(7) A" record of the nature, timing and extent of auditing procedures performed, and the
results of such piocedui-es.

Auditing Procedures

117

(8) Evidence that the work performed by assistants was supervised ^ reviewed.
(9) An indication as to who performed the audit procedures and when they were
performed.

(10) Copies of communications with other auditors, experts and other third parties.
(11) Copies of letters or notes concerning audit matters communicated to or discussed with
the client, including the terms of the engagement and material weaknesses in internal
control.

(12) Letters of representation received from the client.

(13) Conclusions reached by the auditor concerning significant aspects of the audit,
including how exceptions and unusual matters, if any, disclosed by the auditor's
procedures were resolved or treated.
(14) Copies of the financial information being reported on and the related audit reports.
En the case of recurring audits, some working paper files may be classified as permanent
audit files which are updat ed currently with infonnation of continuing importance to succeeding
audits, as distinct from current audit files which contain information relating primarily to the
audit of a single period.

Ownership and Custody of Working Papers

Working papers are the property of the.auditor. The auditor may, at his discretion, make
portions of or extracts from his working papers available to his client. They should not, however,
be a substitute for the client's accounting records.
The auditoi- should adopt reasonable procedures for safe custody and confidentiality of his
working papers and should retain them for a period of time sufficient to meet the needs of his
practice and satisfy any pertinent legal or professional requirements of record retention.

RECORDS OF PROGRESS OF AUDIT

The following steps should be taken to keep a record of the progress of each audit:

1.
2.
3.

Staff Engaged, Note names of principal, senior, semi-senior and junior clerks.
Checking colours used. These should be noted.
Record and Progress

(a) - Date when client's request received for commencement of audit.

(a) Acknowledgment date.

Auditing: Principles and Procedures

(a) Date of interim audit started.

(b) Date of interim audit ended.
(e) - List of queries sent to client.
(J) Date when final audit started.
ig) Exairnnation of Memorandum, Articles and previous year's working papers.
Draft accounts prepared/checked.
(0 Accounts approved by'partner.
..
(j) Account submitted to clients and approved by them. (k) Closing entries passed.
(0 . Clients advised in writing of weaknesses in internal control, (m) Taxation notes
prepared and checked with certified accounts.

119

A uditing Procedures

Annexure 2.1

'SCHEDULE I
(See Section 2 OA)
PART 1
PROFESSIONAL MISCONDUCT IN RELATION TO
CHARTERED"ACCOUNTANTS IN'PRACTiCE. .
A Chartei'ed Accountant in practice shall be deemed to be guilty of professional misconduct,
if he 0 ;
(1) allows any person to practise in his name as a chartered accountant,
unless such person is also a chartered, accountant in practice and is in
partnership with, or employed by, him;
(2) . pays or'allows or agrees to pay or allow, directly or indirectly, any share,,.
commission or brokerage in the fees or profits of his professional business to. any
person other than a member- of the Institute or a partner or a. retired partner or the
legal representative of a deceased partner;
Explanation: In

(3)

this clause, "Partner" includes a person residing outside

Pakistan with whom a chartered accountant in practice has
entered into partnership which is not in contravention of
clause (4) of this Part;
.;
accepts or agrees to accept any part of the profits of the professional work of a lawyer,
auctioneer, broker, or other agent who is not a member ofthe Institute;

(4) places his professional service at the disposal of, or enters into partnership
with, an unqualified person or persons in a position to obtain business of
the nature in which chartered accountants engage by means which are not
open to a member of the Institute:
"'. I'
Provided that this paragraph shall not .be construed as prohibiting a .
practising in a country outside Pakistan in association with a person who is entitled
under the law in force-in that country to perform functions similar to those a member
of the Institute is entitled to perform inPakistan;

(5) Solicits clients for professional work either directly or indirectly by

(6)

circular, adveitisement, personal communication or interview or-by any

other means;
'-;
advertises his professional attainments or services, or ' uses any
designation or expression other than chartered accountant on professional
documents, visiting cards, letter heads or sign boards, unless it be adegjree
of a University established by law in Pakistan or recognised by the
Federal Government or the Council;
. . 'i " "

Schedules inserted by Section 22 of the Chnrtei ed Accountants (Amendment) ^. 1363.

Auditing: Principles and Procedures

(7) accepts a position as auditor previously held by another member of the Institute
without first comm'irnicating with him in writing;
(8) accepts an appointment as auditor of a company without first ascertaining from it
whether' the requirements of sub-section (6) of Section 144 of the Companies Act,
1913 (VTJ of 1913), in respect of such appointment have been duly complied with; ;
(9) charges or offers to charge, accepts or offers to accept in respect of any
. professional employment fees which are based on a percentage of profits or
which are contingent upon the findings or results of such employment, except in cases
which are permitted under any law for the time being in force or by an order ofthe
Government;
(10) engages in any business or occupation other than the profession of chartered
accountants unless permitted by the Council so to engage:
".' Provided that nothing contained herein shall disentitle a chartered
accountant from being a director" of a company, unless he or any of his partners is
interested in such company as an auditor;
(11) accepts a position as auditor previously held by some other chartered
accountant in such conditions as to constitute undercutting;
(12) allows a person not being a member ofthe Institute or a member not being his
partner to sign on his behalf or on behalf of his firm; any balance sheet, pr ofit and
loss account, report or financial statement; or
(13) gives estimates of future profits for publication in a prospectus or
otherwise, or certifies for publication the statements of average profits over a period of
two years or more without, at the same time, stating the ' profits or losses for each year
separately.
PART 2
PROFESSIONAL MISCONDUCT IN RELATION TO MEMBERS ENGAGED IN
MANAGEMENT. CONSULTANCY
A member of Institute engaged in management consultancy shall be deemed to be guilty of
professional misconduct, if he
- (1) -advertises or solicits for work or issues any circular, calendar or publicity . ; material;
(2) issues brochur es, except to existing clients or in response to an unsolicited
request;
.
' (3) Uses designator^ letters indicating qualifications of the' directors and members of the
company on letter heads, note-papers, or professional cards ' except as provided in
clause (6) of Part 1 of this Schedule;
(4) refers to associated firms of Chartered Accountants on his letter heads, or professional
cards or announcements;

Auditing Procedures

121

adopts a name or associates himself as a partner or director of a firm or a company

whose name is indicative of its activities;
uses the term chartered accountants for his management consultancy firm or
company;
shares profits cf remuneration in a manner contrary to clauses (2) snd (3) of Part 1 of
this Schedule, except when he associates with non-members as stated in clause (10) of
this Part;
or his partner in any firm accepts auditing, taxation, or other conventional accounting
work from any client introduced to him for management consultancy services by the
client's own professional accountant;
uses the term "Management Consultant(s)" except in respect of a company engaged in
management consultancy field;
associates with non-members for the rendering of various management services
except as long as such non-member observes the bye-laws and code of professional
ethics of the Institute;
does not communicate with, the existing professional accountant or consultant, if a
member of the Institute, informing him of the special work he has been asked to
undertake in the event of an introduction for management consultancy work other than
through the existing professional accountant; or
under the guise or through the medium of a company or firm does anything which he
is not allowed to do as an individual.
PART 3
PROFESSIONAL MISCONDUCT IN RELATION TO MEMBERS
OF THE INSTITUTE IN SERVICE
A member ofthe Institute (other than a member' in practice) shall be deemed to be guilty of
professional misconduct, if he, being an employee of any company, firm or person,

(1) pays or allows or agrees to pay directly or indirectly to any person any share in the
(2)
(3)

emoluments ofthe employment undertaken by the member,

accepts or agrees to accept any part of fees, profits or gains from a lawyer, chartered
accountant or broker engaged by such company, firm-or person, or agent or customer
of such company, firm or person by way of commission or gratification; or
discloses confidential information acquired in the course of bis employment except as
and when required by law or except as permitted by the employer.

122

Auditing; Principles and Procedures

PART 4
PROFESSIONAL MISCONDUCT IN RELATION TO MEMBERS OF THE
INSTITUTE GENERALLY
' A member of the Institute, whether in practice or not, shall be deemed to be guilty of
professional misconduct, if he
. (1) includes in any-statement, return or form' to be submitted to the Institute any particulars
knowing them to be false;
(2) not being a fellow styles himself as a fellow;
(3) does not supply the information called for by the Institute or does not
comply with the requirements asked to be complied with or does not
. comply with any of the directives issued or pronouncements made by the Council or
any of its Standing Cemmittees;
(4) . generally, wilfully rnaligns the Institute, the Council or its Committee to

lower their prestige; or to interfere with performance of their duties in

relation to himself or others;

(5) has been guilty of any act or default discreditable to a member of the Institute; or'
(6) contravenes any of the provisions of the- Cadi nance or the bye-laws made thereunder.
SCHEDULE II
(See Sections 20A and 20D)
PART 1
. PROFESSIONAL MISCONDUCT IN RELATION TO CHARTERED ACCOUNTANTS >'. .
IN PRACTICE REQUIRING ACTION BY A HIGH COURT
A chartered accountant in practice shall be deemed to be guilty of professional
misconduct, if he
-.
...;
(1) 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;
(2) . certifies or submits in his name or in the name of his firm a report of an
examination of financial statements unless the examination of such statements and the
related records has been made by him or by a partner or an employee in hie firm or by
another chattered accountant in practice;
(3) permits his name or the name of his firm to be used in connection with
'' V any estimates of earnings contingent upon future transactions in a manner
-'.^vwhich may lead to the belief that he vouches for the accuracy of the * ' forecast;

Auditing Procedures

123

(4) expresses his opinion on financial statements of any business or any enterprise in

which he, his firm or a partner in his firm has a- substantial interest, unless he
discloses his interest in his report;

(5) fails to disclose a material fact known to him which is not disclosed in a financial
(6)
(7)
(8)
(9)

statement, but disclosure of whichis necessary to ensure that the financial statement is
not misleading;
fails, to report a material mis-statement known to him to appear in a financial
statement with which he is concerned in a professional capacity;
is grossly negligent hi the conduct of his professional duties;
fails to obtain sufficient information to warrant the expression 0f an opinion or his
exceptions are sufficiently mateiial to negate the expression of an opinion; or fails to keep moneys of his client in a separate banking account or fails to use such
moneys for purposes for which they are intended.

PART 2 PROFESSIONAL MISCONDUCT IN RELATION TO MEMBERS ENGAGED

IN MANAGEMENT CONSULTANCY REQUIRING ACTION BY A HIGH COURT
A member engaged in management consultancy shall be deemed to be guilty of
professional misconduct, if he

(1) discloses information acquired in the course of his professional engagements 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;

(2) is grossly negligent in the conduct of his professional duties; or

(3) fails to keep moneys of his client in a separate banking account or fails to use such
moneys for purposes for which they are intended.

SCHEDULE HI
(See Sections 20A and 20E) PROFESSIONAL MISCONDUCT IN
RELATION TO THE STUDENTS OF THE. INSTITUTE
A student of the Institute shall be deemed to be guilty of professional misconduct, if he
(1) contravenes any of the provisions of the Ordinance or the bye-laws made thereunder;

124

A editing: Principles and Procedures

(2) does not supply the iriformation called for by the Institute;
(3) does not comply with any requirements which he is asked by the Institute to comply
with;
(4) does not comply with any of the directives issued by the. Council or any of its
committees;
(5) discloses confidential information acquired in the course, of his training except as and
when required by law or except as permitted by his principal;
(6) includes in any statement or form to be submitted to the Institute, any particulars
knowing them to be false; or
(7) has been guilty of any act or omission discreditable to a student of the Institute.

INTERNAL
CONTROL

WHAT IS INTERNAL CONTROL

^orttrol indicates, the whole s^s^^^^^^^^t^^grrrpkj management JJI the (?
^^^8"ss?"[t memoes internalcn^kTinXeihal audit^and other forms 7:6'-1,. Its
efficient working in practical aspect is helpful not only for the management but also for the
external auditors. It includes all the methods followed by an organisation to:

(1)
(2)
(3)
(4)
(5)

Protect its assets against their improper disbursement.

Protect against the incurrence of improper liabilities.
Assure the accuracy and dependability of all the financial and operating information.
Judge operating efficiency, and
Above all, measure the adherence to established policies of the company.

INTERNAL CHECK, INTERNAL AUDIT AND

INTERNAL CONTROL DISTINGUISHED
The expressions 'internal audit', 'internal check' and 'internal control', have been used
indiscriminately and they are differentiated from each other as under:

1. Internal Check. It means a system under which the work relating to carrying out and
recording of transactions is allocated amongst various persons in such a manner that the work of
one person is automatically checked by another and thus possibilities of fraud or error or
irregularity are minimised, if not completely" eliminated.
2. Internal Control. By internal control is meant not only internal check and internal audit
but the whole system of controls, financial and otherwise. established by the management in
order to carry gn the business of the company bran orderly manner, safeguard its assets
amLsecui'f as far as possible the accuracy and reliability of its records.

Auditing: Principles and Procedures

126

Internal Audit. It is a continuous review .of operations and records, undertaken within the
business and is normally done by specially assigned staff. It should operate independently ofthe
internal check and in case should divest anyone of the responsibilities placed urxmliim. t

Thus it is apparent that internal control expression is used in a wide sense and includes
internal check and internal audit as well. , ,

INTERNAL AUDIT
Concept
The internal audit is a continuous review of operations and records undertaken
within the business and is normally done by specially assigned staff. It should
operate independently of all the internal check and in no case should divest.any one
ofthe respoimbiMies pl^d upoojum.
......
The Institute of Internal Auditors, USA, has defined internal audit as under:
"Internal Auditing is an independent appraisal activity within an '. organisation for
the review of operations as a service to management. It is a managerial control which
functions by measuring and evaluating the effectiveness of other controls."

Scope. ;
The above Institute has defined the scope of internal auditing as under:
"The examination and evaluation of the adequacy and effectiveness or the
organisation system of internal control and' the quality of performance in carrying out
assigned responsibilities."

Role
To achieve the said objective, the above Institute has identified the following five areas of
operation for review by an internal auditor:

(1)
(2)
(3)
(4)

Reliability and integrity of information.

Compliance with policies, plans, procedures, laws and regulations.
Safeguarding of assets. Economical and efficient use of resources.
(5) Accomplishment "of established objectives and goals for operations ox
programmes.

In the light of above points, it can be safely concluded that the current concept of internal
audit not only covers the hitherto traditional functions but also stresses' new arid modern areas
such as reviewing the economic and efficient use of resources and watching the organisational
performance.

127

Internal Control

Forward Looking Approach to Infernal Auditing

A check; list governing forward looking approach to internal auditing is suggested below:
1. Evaluation o f Internal Control
This should test the adequacy of accounting system from the following view points:

(a) information is adequate and accurate.

(b) Resources of business are protected against losses resulting from: .
(1) Theft,
(2) Embezzlement, or
(3) Carelessness.
(c) Control over all phases of operations.
2. Review o f Accounting Efficiency This
should cover the following aspects:

(a)
(b)
(c)
(d)
(e)

Procedures are effective.

Mechanical and/or electronic equipment is used.
Space is fully utilised.
Personnel is adequate.
An accredited programme is used for weeding out old records and retaining the
current and relevant ones.

3. Appraisal o f Performance o f Organisation

..

"Aspects to be covered include the following:

(o) Implementation of policies.

,'

(b) Compliance with procedures.

(e) Review of individual performance.
(d) Checking up of plan of organisation.

4. Place o f an Internal Auditor in the Organisation

Internal audit is a staff function rather, than a line one. Consequently an internal auditor
cannot exercise direct authority over other persons in the banking institutions. However, he
should be free to appraise and review policies, plans, procedures and records. He should enjoy
independence for ensuring objectivity. He .should receive support from management to enable
him to perform his job efficiently and effectively.

Auditing: Principles and Procedures

128

5. Internal Audit Report ' . .

- .

- ..

" . :

The benefits of internal auditor's work are to be accomplished through the medium of
reports on his findings and recommendations. The above report should be prepar ed in the light
of following aspects:
(a ) These should be carefully prepared and well written.
(&) These should be designed to catch and hold the attention of the person to whom it is
presented.

(c) Conclusions and recommendations must be clearly and succinctly written.

(d) Main ideas be included in the body of the report and supporting details be
included as exhibits.
(c) Rough draft of the report may be reviewed and discussed before final submission.

(f) Specific improvements need to be properly highlighted.

(g) Follow up is needed to ensure action on the findings and
recommendations.
(h) Guidelines included in the Bank Audit Manual be followed for an efficient
approach of work.

INTERNAL AUDITING AND EXTERNAL AUDITING

DIFFERENTIATED
There are some similarities of work of an infernal auditor and an external auditor.
However, there are several differences too.

These are tabulated

below:
Basic
PointInternal AuditorExternal
AuditorAppointmentAppointed by managementAppointed by
the shareholdersNatureHe is an employee of companyHe is an
outsiderMajor concernServing the needs of
managementCompliance of statutory requirementsBasic
JobReview of operations and internal controls for developing
improvements and ensuring compliance of policies and
proceduresExpression of an independent opinion on financial
state: mentsScope of WorkDetermined by
managementDeteimined by Statutes

Internal Control 129

Cooperation between Internal and External Auditors

It is high time that internal audit work be developed in consultation with external auditors to
pave the way for avoiding Unnecessary duplication of work. This will further lead to reduction
of the extent of details resulting in test check.
The external auditor should follow guidelines stated below:

(1)

The working papers and internal audit reports be reviewed to determine tests to
be undertaken.
(2) Internal audit manual be reviewed to ascertain the whole approach of work.
(3) Experience, qualifications and relevance of internal audit staff should be
carefully reviewed.
(4) As per (3) above, the position of chief of the internal audit department should
also be reviewed.
(5) Authority vested in the Chief of the Internal Audit Department and the level of
management to which, he is directly responsible should also be ascertained and
appraised.

Suggested Dimensions for Internal Auditors

There is no independent professional Institute of Internal Auditors in Pakistan requiring
acquisition of professional qualifications. It is high time that a ; serious thought may be given to
set up such an Institute in Pakistan'so that well trained, properly equipped and professionally
qualified interna! auditors may be produced in the country to achieve the goals of internal audit.
Until such time the foregoing suggestion is not implemented, the following suggestions are
offered to strengthen the internal audit work:

(1)
(2)
(3)
(4)

Internal auditors should be trained in human behaviour.

They should be motivated to serve as watch dogs rather than blood hounds.
Constructive approach for problem solving should be indoctrinated.
Internal auditors should be jewelled with modern concepts of audit.
(5) ' Special training should be imparted to i nternai'.-auditors for developing
thoughts on efficient and economic use of bank resources.
(6) An appraisal activity of their performance should also be undertaken by an
independent agency.
(7) The current status of internal audit manuals used in Banks should be reviewed
and these should be periodically updated.

Cooperation between Internal and External Auditor

Mutual assistance between both would lead to reduction of the exiraArf

130

Auditing: Principles-and Procedures

details. Test checks may resorted to.

Examples of coordinated work are:

(1) Reliance by statutory auditors on the system of internal check.

(2) Confirmation of accounts, verification of assets and liabilities and audit
working schedules.

It is for the statutory auditor to decide whether and to what extent, consistently with his
statutory responsibilities he can rely. on the work of the Internal Auditor.
Guiding principlesto be followed in this respect are:
(a) Extent .and efficiency of the internal audit reports. He should form his opinion by
reviewing working papers and reports of the internal auditors and decide the tests
considered fit to check internal auditors' work.
(o) Experience, qualifications of chief internal auditor and his staff.
(c) Authority vested in chief internal auditor and the level of management to which he is
directly responsible.

USING THE WORK OF AN INTERNAL AUDITOR

' deals with the above subject. Full text of this is reproduced below:
Introduction
Safeguarding of assets, refiahUity of fmancial records and. efficiency in
operations^-aj^basie-responsibiKties of management and are prime purposes of
1 end^<iBeist^ivHrom^
aware of the
advantages of bmmg**a&i*to&emaBl audit .function to assist,,in fulfilling such responsibilities.
International Standard on Auditing 6, Study and Evaluation of the Accounting System and
Related Internal Controlsin connection with an Audit, fttetes:
W.he'n anj^^^^^^a^rntern'al audit department, managementmay delegate-f|i)^
wiffirefbect to the review of mternal control. This particular internal audit function
constitutes a separate component of internal, control undertaken by specially assigned
staff within the entnV with the objective of determining whether other internal control
are well designed and properly operated."
While the independent auditor has sole responsibility for his report and for the
determination of the nature, timing and extent of his auditing procedures, much of the work of
the internal audit department may be useful to him in his examination ofthe financial
information.

Internal Control

Si

In this Standard "financial information" encompasses financial statements, and the term
"external auditor" is used, synonymously with "independent auditor".
The purpose of this Standard is to provide guidance as to the procedures which should be considered by : the external auditor in assessing the work of the internal auditor for the purpose of
using that work. When internal-audit personnel assist the external'auditor in carrying out
compliance and substantive procedures, they are not performing an internal audit function and
such instances are not dealt with in this guideline. .

Scope and Objectives of the Internal Audi* Functlojn.^ ^

The scope and objectives of internal audit vary widely and are-dependent upon" the size and
structure ofthe entity and the requirements of its management.
Normally however internal audit operates in one or more of the following areas:
(1) Review, of accounting system.; and related , .internal controls The
establishment of an adequate accounting system and the related controls
is the responsibility of management which demands proper attention on a
continuous basis. The internal audit function is often assigned specific
responsibility by management for reviewing the accounting system and
related internal controls, monitoring their operation and.recommending
improvements thereto.
(2) . Examination .for management of financial, and operating information. This
may include, review of the means used to identify, measure, classify and report such
information and specific inquiry into individual items including detailed testing of
transactions, balances and procedures.
(3) Examination of the economy, efficiency and effectiveness-of operations
including, non-financial controls of an organisation. Generally, the
external auditor is interested in the results of such audit work only when
it has an important bearing on the. reliability of the financial records.

Relationship between infernal and External Auditors

The role of the internal audit function within an entity is determined by management and its
prime objective differs from that of the external auditor who is appointed to report independently
on financial information.. Nevertheless some of the means of achieving their respective
objectives are often similar and thus much of the ; work of the internal auditor may be useful to
the external auditor in determining the nature, timing and extent of his procedures.
The external auditoi' should, as part of his audit, evaluate the internal audit function in so
far as he believes that it will be relevant in determining the nature, timing and extent of his
compliance and substantive procedures.
effective internal audit fenetaim will often justify a ledurtjqp the
performed by the external auditor1; but '?1?& them"

132

Auditing: Principles and Procedures

An internal audit fVrnction is part of the entity and irrespective of the degree of its
autonomy and objectivity cannot meet the prime criterion of independence which is essential
when the external auditor expresses his opinion on the financial information. The report of the
external auditor is bis sole responsibility, andr that responsibility is not reduced by any use he
makes of the internal auditor's work. Thus, judgments relating to the audit of the financial
information must be those of the external auditor.

General Evaluation of Internal Audit Function

&^;$&1&- general evaluation of the internal audit function will
influence his judgment as to the likely use which may be made ofthe work of the internal auditor.
The - external auditor should document his evaluation and conclusions in this respect. The
important criteria are as follo ws:
(1) 1 Organisational Status. The internal, auditor is part of the entity and
therefore cannot be totally indeppnrfcnt. of it TTowpv^r, b'" '^ qfobig
in the organisation can affect his ability to be objective in the performance of his
work. In the ideal situation he will report to the , highest level of management and
should be free of any other operating responsibility. Any constraints or restrictions
placed upon his, work by management should be carefully evaluated. In particular the
.internal auditor should be free_to communicate fully with the external auditor.

(2) Seope of Function. The external auditor should ascertain the nature and depth of
coverage of the assignments which the internal auditor discharges for management.
He should also ascertain whether management
. Considers, and where appropriate acts upon, internal audit'
recommendations and how this is evidenced.
(3) Technical Competence. The external auditor should ascertain that internal audit work
is performed by persons having adequate technical training and proficiency as
auditors. This may be accomplished by reviewing the policies for hiring and ta'aining
the internal audit staff, and their experience and professional qualifications,

(4) Z>ue\ Prpfessional^pre^ The external auditor should ascertain whether internal audit
work appears to be properly planned, supei-vised, reviewed and documented.. An
example of the exercise of due professional care by the internal auditor is the existence
of adequate audit manuals, work
programmes and working papers. .

Timing of Liaison and Coordination

Having decided in principle that he intends to use the work of the internal auditor, the
external auditor should ascertain the internal auditor's tentative plan for the year aei cuseuss it
with him at as early a stage as possible, to determine areas where-he believes he could use the
internal auditor's work. Where internal

Internal Control

auditor work is to be a factor in detmmnning the nature, timing and extent of the external
auditor"s procedures, it is desirable to agree in advance the timing of such work, the extent of
audit coverage, test levels and proposed methods of sample selection, documentation of the work
performed, and review and reporting procedures.
Liaison with the internal auditor is usually more effective when meetings are held at
appropriate intervals during the year. The external auditor should be advised of and have access to
relevant internal audit reports and in addition be kept informed, along with management, of any
significant matter that comes to the internal auditor's attention and which he believes may affect,
the work of the external auditor. Similarly, the external auditor should oro!inarily inform the
internal auditor of any significant matters which may affect his work.

Evaluating Specific Internal Audit Work

Where, following the general evaluation described above, the external auditor intends -tonse. specific internal audit work as a basis for modifying the nature, timing and extent of his
procedures, he should review the internal auditor's working papers to satisfy himself that:

(1) The scope of work and related audit programmes are adequate for the external
auditor's puiposes.
(2) The work was properly-planned and the work of assistants properly supervised,
reviewed and documented.

(3) Sufficient appropriate evidence was obtained to afford a reasonable basis for the
conclusions reached.

(4) Conclusions reached are appropriate in the circunistances and any reports
prepared are consistent with the results of the work performed.
(5) Any exceptions or unusual matters disclosed by the internal auditor's
procedures have been properly resolved.
The external auditor should document his conclusions in respect of the specific work which
he has reviewed.
The external auditor should also test the work of the internal auditor which he intends to use.
The nature, timing and extent of his tests will depend upon the external auditor's judgment as to
the mateiiality of the area concerned to the financial statements taken as a whole and the results
of his evaluations of the i internal audit function and of the specific internal audit work. His tests
may include examination of items already examined by the internal auditor, examination of other
similar items, and observation of the internal auditor's procedures.

133

134

Auditing: Principles and Procedures

PRINCIPLES OWNWRNAJ. CONTROL

- The hasic principles of financial internal control are explained below: (1)' Financial and accounting operations must be separated, i.e., the handling
of cash and the recording of the movement theieof should be done by . different
persons.
(2) Responsibility for-the peifOnnanee ofthe job must be clearly stated so that
there may be no room for dOubt or confusion subsequently.
(3) Too much confidence should not be pinned in one individual. Nearly ad frauds
have been committed by 'tmsted' officials or employees. It is interesting to note that
frauds have occurred owing to their being tmsted.
(4) Rotation principle relating to transfer of an employee from one job to anothershould be the inflexible guiding rule. This is an effective safeguard against collusion
and is recognised as an important canon of sound organisation." -

(5)

Mechanisation of the work wherever feasible and practicable; "should bo

resorted to. Mechanical devices such as cash register, recording time clocks,
calculation machines etc., should be introduced. A.system of control accounts should
elegantly be fitted in the book-keeping system.
(6) The work should be so arranged that work done by one employee should be
promptly checked by another independent employee. Such continuous and constant
checking goads moral control and the errors and the frauds
. cannot go undetected
,. . . . .
(7) The arrangement of the work should be. in such a manner that written reeord
of the part played by each employee should be maintained and the work should pass
through several hands in a well-defined manner.
(8)
. Clear and well defined rules should be laid down and practically followed
relating to dealing of the cash, ordering, receiving and issuing goods etc. Instiirctions
should be in writing in the form of accounting manuals.
(9) Employees must be in bond so that the tempted employee must be deterred from
committing fraud and employer be protected.
(10) Although not a substitute for protective financial internal control, yet double entry
system of accounting must be used.
Based on; the practical operational aspect of the problem, personnel must be segregated
with the following functions:

(1) Those initiating or authorising the transactions.

(2) Those connected with the execution of tr ansactions.
(3) Those having responsibility for asset, liability, expense or revenue resulting from the
trans actions.

135

Internal Control

Some of the examples of internal controls are as under

(1)
(2)
(3)

Clock cards, cash registers, etc.

Mechanical. Invoice typewriter, tabulating and computer machines.
Theoretical. Work of one employee is to be checked by another, cashier
abstaining from making entries in the ledgers etc.
Physical

REVIEW AND RELIANCE ON INTERNAL CONTROL BY

THE AUDITOR
Before starting the audit, the auditor should review the system of internal control for the
following considerations:

(1) To examine the weaknesses of system, if any.

(2) To consider the proposition of introducing, test check to be performed during the course
(3)

of audit.
Based'upon above (1) and (2), determine exactly the extent of work to be performed so
as to enable the auditor to express his opinion'..on .the given set of accounts.

The effectiveness of the system in practice should be tested to form an opinion

that whatever existed on the paper did exist in practical aspect also. proper and
effective system of internal control offers'advantages such as: saving of time for the
auditor, reduction in cost of conducting audit and assurance to.auditor of the^
reliability-of the-financial accounts, t ": ci.cX~'
^.c"' 'c.^- ^ U^hCU-tThe review ofthe system of financial internal control would involve either oral ' questioning
or use of written questionnaire for the audit ofeacfeaspeet oiibusmess.
It is advisable that the auditor should obtain a stateroenfein writing- abridging the details of
internal controls in practice. It is interesting to note that the existence of a good internal control
reduces to a great extent the work of the auditor, but does not reduce his liability. To what extent
should an auditor depend upon.the system will depend upon the circumstances of each particular
case and the efficiency of the audit will depend upon the skill, tact, experience, and, above all,
the judgment of the auditor.

SYSTEMS OF INTERNAL CONTROL

Systems of internal control in respect of small and manufacturing concerns and other aspects
of business are explained below:

Small Concerns
(1) (Vyfciv:>p(Vf>-p All incoming correspondence should be opened by responsible
official.

136

Auditing: Principles and Procedures

(2) &&&^. All remittances in the form of cheques, drafts etc., should
be crossed and marked 'Accounts Payee only', and deposited.
into the bank on the nest day.
(3) Payment Authorisation. All payments, should be sanctioned by responsible officials.
(4) W^& -and Salaries. Wages and salary sheets/book should be carefully checked and
payments made in the presence of persons knowing the iatourers and Clerks.
(5) 6eee5. A complete record of all goods received and sent out should. be_ mamtairted
and physical count should be carried out at regular intervals.

Manufacturing Concerns

. ~i>"> ' . '' ,

(1) Access to Ledgers. The cashier should have no access, to the Iedge.rs and the ledgerkeepers should not maintain the books of original entry. Correspondence. All
correspondence received should be daily opened by a responsible official.
/(3) Remittaiuxs. All remittances received in the form of cheques, drafts, etc., should "be
cross marked "Accounts Payee only", entered into a cash diary and handed over to the
cashier. (4) %:posit All receipts should be banked daily or on the next day and a periodical
bank reconciliation should be prepared.
Official printed pre-numbered forms should be used.for. issue of
receipts and signed by a responsible official. Unused stock of receipt books should be
kept under lock and key.

(6) ^asfoaggfefc Cash sales should be adequately supervised.

(6) Payment AuthnrisatU/iis. As far as possible, all payments should be made by crossed
cheques marked "Accounts Payee only".

(7) . Payments of wages should be carefully supervised.

(8) Cash, Petty cash book should be kept on the imprest system.
(7) Pmskmses, Purchases should be subject to proper control and alt inward invoices
should be checked.
(8) Credit Notes. Credit notes for returns, allowances and bad debts written off should be
authorised by a responsible official.
(9) Statements o f Accounts. Accounts rendered to customers should be examined by a
responsible official who should also attend to the overdue accounts.
(10) Control Accounts. Sundry creditors and debtors ledger should be checked by control
accounts in the general ledger.
(11) Mechanical Appliances. As far as possible, mechanical-appliances should be used.

Internal Control

(15) Stocks and Stores. Periodical physical cheek should be carried out by a responsible
official.

Cash Receipts

(1) Receipt Books. The following inflexible rules should be followed as a sound system
of internal check:

(a) Unused books should be kept under lock and kev.

(b) All receipts should be consecutively numbered.
. (c) The issue and custody of cash receipts should be under the control of a responsible
official.

(d) Originals of all spoilt and cancelled receipts should be retained and
countersigned by a responsible official.

(e) Acknowledgments of the recipients of the receipt book (to be consecutively

numbered) should be obtained so that he could be held

accountable for the utilisation of it.
(2) Acknowledsiment. For every amount received, official receipt must be issued.
(3) Remittances Received All correspondence received must be opened by a responsible
official. All remittances (drafts, cheques etc.) received must be crossed "Accounts
Payee only" entered in a daily cash diary and then handed over to the cashier. >(4) Deposits. All collections must be internally checked and then deposited into the bank
in tact the next day. Pay-in-slips should be filed and checked daily. The amount should
then be traced into the bank statements. All outstanding collections should-be
thoroughly scrutinised and steps should be taken to obtain a credit for the same.
Collection of overdue balances should be attended to.
(5) No Access to Ledgers. The cashier should not be allowed anv access to personal or
general ledgers.
(6) Teeming and'Lading. The following steps should be taken with a view to avoiding
teeming and lading:
(a) The amount recorded as having been received should be checked with the
corresponding amount mentioned in the statement of account received from each
ofthe debtor. ;
(b)
The debtors should be requested to give crossed cheques marked
'Accounts Payee only'.
(c)
All remittances received in the form nf rhqqnefi, drafts etc, must be
crossed and marked 'Accounts Payee only' after they have been received.
i d ) . The pay-in-slips should be ^ checked with t-hp ADH on the
carbon copy or counterfod receipts.
~

137

138

Auditing: Principles and Procedures

(7) Physical Count. Surprise inspection of cash should be done by a responsible

official.
(8) Segregation. collections must be segregated and kept separately from imprests.

Cash Payments

(1) Mode of PttyfTieRts. As far as possible, payments must be made by crossed

(2)

cheques marked 'Accounts Payee only' and official receipts should be

obtained.
.
,
..
$!&. All payments should be authorised by a responsible official duly vested
with these powers by the management. Proper verification should be done before the
payment is made. All payments of special nature should be minuted by the Board.

(3) . J^fiBseimgr All payments should be promptly recorded in the cash book.
(1) Voueliers. All supporting vouchers of payments should be serially .numbered and
filed in order to facilitate the subsequent checking by tlie
auditors.

(5) General:
(u) Arithmetical Accuracy. .Cabts, cross casts and cany forward of all amounts in the
cash hook should be checked
(6) Saak.Reconciliation. Periodical bank reconciliation statements should be prepared.
Bank confirmations should be obtained and all outstanding items should be
carefully., scrutimsed., 1

Petty Cash Transactions

(1)

Imprest. Petty cash book should be kept on imprest basis. The imprest should
be kept in line with the actual financial requirements. .
(2) Payments. Vouchers should he prepared and chocked for all payments which
should be authorised by a responsible official. The vouchers should also be filed in
serial order to facilitate subsequent checking by auditor's.
(3) Alkmttmn. Before authorising payment, allocations should' be checked
carefully and all vouchers should then be entered promptly in the petty cash book.

(4)

Reimbursement. Periodical- reimbursement of all payments should be claimed

and shortfall in imprest may be recouped.

(5)

Cash Count. Cash in hand should be physically counted on surprise basis by a

responsible official.
(6) Miscellaneous Receipts. No miscellaneous receipts should come into petty
cash account, but should be deposited into a bank.

Internal Control

Purchases

(1) Initiation o f Purchase. There should be established limits for order level, minimum

(2)
(3)

(4)

(5)

level and maximum level of stores and stocks to serve as a basis on which the
storekeeper should, .after following these limits, send material purchase requisitions to
enable the purchase department to initiate purchase.
Quotations and- -Tenders. Quotations or tenders should be called and decision made
to buy from a certain seller. The jniiding factor should be to buy at most economic
price.
Placing- Order. An order for' the purchase should then be sanctioned asking the buyer
to supply goods within a stipulated time. All copies of purchase orders should be
consecutively numbered and filed. These should then be entered into the purchase
order register.
Receipt o f Goods. All_goods received should be physically checked, counted or
weighed and a document called 'Goods Received Note' should be prepared and signed
by the store-keeper in token of having received. A copy thereof should be sent to the
accounts department. All goods requiring chemical analysis should be analyzed by the
chemist or quality control department at the time of receipt of goods.
Invoice. The invoice should be internally checked before payment. The following work
in this respect should be done:

(a) See that the dafe, of invoice falls in the year under review.'
(b) The quantity and description of goods should be checked with pur-chase order
and goods received notes to ensure that all quantities ordered and invoiced have
been received. Any discrepancies should be investigated.
The rates should he verified with the purchase order and/or any f contract.

(c)
(d) Extensions, casts and cross casts should be checked.
(e) .A rubber stamp should be affixed indicating the checking work done on each
(6)
(7)
(8)

invoice and should be signed by the staff member who performed that job.
Allocation. All vouchers with invoices should be serially numbered and filed to
facilitate its subsequent checking by auditors. The allocation of expenditure should be
verified.
Payment The payment of invoices should be passed by a responsible official who
should satisfy himself that work at number (5) above has been done.
Goods Returned. goods returned to supplier's should be recorded on goods
returned notes, a copy of which should be forwarded to accounts section. A credit note
should be obtained from the supplier and amouic

139

Auditing:
Procedures

14
0

Principles

and

adjusted in the books. (9) Purchases Book. All entries should be promptly recorded in
the purchases
book.

Sales
(1) Orders ReeeweS: An attempt must be made to obtain orders in writing. Confirmations in
writing should be obtained in respect of verbal orders. All orders received should be
entered in the Orders Receiye.d .
}J (2) ^&. The orders should then he executed within the desired J time and
marked off from the orders received book.
(3) JansSiefc Desired number of the copies of invoice should be prepared and
internally checked. Jn case of contract sales, original contracts should be studied and
basis of billing should be verified. Apart from this, a responsible official should mark
the rate at which goods are to be invoiced.
(4) 1&^-$&; All goods despatched should be recorded, inJ&eJSoods
Despatch Register. All quantitative movement shown on sales invoices should be
traCed into the above register.

(5) Allocation. The allocation of sales should be verified.

(6) limmptmf^ Money. A -eful watch over the collection of money against
credit sale should be kept and such a system should be installed whereby recoveries of
amounts are being made regularly.
(7) (SemdSirB&titipned. All goods returned by customere should be entered in the
goods inward book and a credit note should be passed by a responsible official and
prepared in duplicate for each return of goods or allowance granted. These should then
be recorded
(8)-------------------------------------------------------------------I^MA:
The
entiles
should
be
promptly
recorded
in
sales,
book
and
all
sale invoices should be serially arranged to facilitate their subsequent
checking by the auditors. -----------------------------------------------------(9) Access to Ledgers. The person making the sale should have nothing to do with
the office where sales ledger's are posted up, nor with the cashier's offiCe where the
cheques inpayment of customers' accounts are received.

Postal Sales
(1)

V.P.P. Register. A V.P.P. Register should be kept for recording the

particulars of goods sent by post. All cases against which cash is received
should be marked off. Consignments not paid for should be periodically
reviewed and efforts made to settle the cases.
(2) Cash Received, All amounts received should be entered into .the cash book.
t
(3) V.P.P. Articles Returned. A note of all V.P.P. articles returned by post office should also
be made in the V.P.P. Register.

Internal'Control

141

Sales Over the Counter

( ! ) Segregation ofsDuties. The work of selling goods and receiving cash should
be done by two different persons. (2) CasfeMemo- Preparation. The salesman should prepare
the cash memo, give the original to the customer and retain the carbon copy. He should send
the goods to the cashier and request the customer to approach the cashier's counter, pay the
money and take the delivery. All cash memos should be serially numbered. . (3) Cashier's
Record. The cashier, should mark the stamp 'paid' on the cash memo, collect the money and
give delivery of goods. At the end of the day, he should tally ttie" total cash received with the
total sales by the salesmen.
(4)
Cask Book, The amount should then be entered into the cash book and
banked
(5)
Mechanical Devices. .Mechanical cash register may also form an
important part in a system of internal check.

Stores
(1) Ordering level. The quantitative nunimum, maximum and ordering limits
I
should be fixed for each kind of material. When an ordering level of a
y/
" particular material is reached, the storekeeper should advise the buying
V,
^ ,
i f - department by means of a purchase requisition.
' V; -ir ; {2) Placing o f order. Official order forms (after proper sanction! should be sent
r~\ ^ ^
to suppliers in respect of the materials required. A copy of this should also
\
\
be sent to the storekeeper.
" .
t "^r
(3) Receipt o f materials. The materials received should be checked by the
V
storekeeper with copies of purchase orders and report as a quality, etc.,
should also be sent to the buying department.
(4)
Stoting^f materiels. All materials should be placed in appropriate racks,
bins, etc.. by the storekeeper, ^ne. quantities should be entered on bin cards attached
to each rack, bin etc., to provide a perpetual record of
materials received and issued.
(5)
Record o f materials. The storekeeper's report together with the invoices
relating to the materials should be passed by the buying department to the cost office.
The invoices should be posted to the debit of accounts in stores ledger, a separate
account being kept for each class of material held The entiles in the stores ledger may
be in quantities and values, or values may be excluded therefrom.
(6)
Payment for materials. All invoices for materials purchased should be
caiefully checked before they are authorised by a i-esponsible official inpayment.

142

Auditing: Principles and Procedures

(7)

Issue o f materials. Materials for use in production should be issued by the

storekeeper only on the authority of materials requisition signed by the works
manager or a responsible official duly authorised in this respect. The quantity issued
should be entered by the storekeeper to the credit of the relative bin card and the
requisition then forwarded to the" cost office.
(8) Return of materials. There should be a rule that any material issued which are
found to be surplus in a particular job should be returned to the stores and not
transferred to another job. Particulars of materials returned should be entered on a
stores debit note, a copy of which should be supplied to the cost office.
(9) C&ppgirig for materials. The cost office should price out the requisitions and
stores returned notes, and post the quantities and values of materials issued and
returned to the appropriate stores ledger accounts and also to the production orders
concerned.
(10) ^& of materials. The balances shown by the stores accounts
should be checked from time to time with the balances on the relative bin cards. It is
also advisable that the balances on the stores ledger should be tested with physical
stocks as frequently as possible in order that differences may be located and
investigated without undue delay.

USE OF STATISTICAL RECORDS

An intelligent use of the statistical records would impose a useful check. Examples of such
statistics are as under:

(1)

The percentage of gross profit to turnover should be computed for the year and
compared with that of the previous year. Any material differences should be
investigated into.

(2)

The cost of each process of manufacture, i.e., per ton of material passing
through process, either based on quantity or weight should be established.
(3) The cubic feet of gas made, sold and accounted for, in the case of gas
undertakings etc., should be calculated.
(4) Return on capital should be compared with companies carrying on similar
businesses.

(5) Net profit percentage of turnover.

METHODS OF EVALUATING INTERNAL CONTROL
There are four- methods of evaluating internal controls. These are briefly discussed below:
1. Oral Approach
Oral discussion is held to identify strengths and weaknesses.

143

Internal Control

2. Memorandum Approach
Full notes are taken dming -discussions governing evaluation of internal controls. Analysis
of weaknesses is undertaken and suggestions are offered through management letter for
improvement.

3. Internal Control Questionnaire (ICQ)

An ICQ consists of questions in respect of each element-of business: Answers are obtained
as yes's 'no' or 'not applicable'. Remarks column is used for raising questions and/or identifying
weaknesses of the existing internal controls with a view to removing these. Some firms use
improved and expanded .version of ICQ. This is known as Descriptive System Questionnaire
(DSQ).

4. Flow Charts
Flow charts of each business activity are reviewed and internal controls are evaluated.

MANAGEMENT LETTER
After evaluation of the internal controls, Management; Letter is issued. This is at times
called 'Weakness Letter', The objectives of this letter are as under:

(1) To identify any weaknesses in the internal control.

(2) To suggest adequate accounting control.
(3) To suggest improvements in the existing internal controls. .

-. - ;

There is no prescribed form of the above letter. Major aspects may be included in the letter
and minor weaknesses may be relegated to an annexure.

RISK ASSESSMENT AND INTERNAL CONTROL

ISA 6 deals with the above aspect.
Text of the above ISA is reproduced below:

Introduction
1. International Standaid on Auditing (ISA) 1, Objective and Basic Principles Governing an
Audit, states (paragraph 9): "The auditor should; obtain a sufficient understanding of the
accounting and. internal control systems to plan the audit and develop an effective audit
approach. The understanding of the accounting and internal control systems, together with
the inherent and control risk assessments and other considerations, enables the auditor to:

identify the types of potential material misstatements thatjcpuld occur in the financial
statements;

144

Auditing: Principles and Procedures

2.

consider factors that affect the risk of material misstatements; and

design appropriate substantive procedures."

ISA 25, Materiality and Audit Risk, states (paragraph 19):

"The audit should be planned so that audit risk is kept at an acceptably low level. After the
auditor has assessed the inherent and control risks, he should consider the level of detection
risk that he is prepared to accept and, based upon his judgment, select appropriate
substantive audit procedures.*'

3. The purpose of this Standard is to provide guidance to the auditor in obtaining an

understanding of and testing the internal control system; and assessing inherent and control risks,
and using such assessments to design substantive procedures which the auditor intends to
perform in order to restrict detection risk to an acceptable level.

4. In planning the audit, the auditor should use professional judgment to assess . the level of
audit risk that is appropriate. Audit risk includes:

the risk that material misstatements will occur (inherent risk),

the risk that the client's system of internal control will not prevent or detect such
misstatements (control risk), and

the risk that any remaining material misstatements will not be detected by the
auditor (detection risk).

Inherent Risk

5.

ISA 25, paragraph 13, states: (f^

"Inherent risk is the susceptibility; of an ac be material, individually or when aggregated
with misstatements in other balances or classes, assuming thafthcre were no related internal
controls,"

6.

In determining the overall audit strategy and the expected conduct and scope of the audit, the
auditor should assess inherent risk at the financial statement level. In planning the audit in more
detail, the auditor should relate such assessment to material account balances and classes of
transactions. In the absence of such an assessment at the account balance or class of transactions
level, the auditor should assume that inherent risk is high.

7.

To assess inherent risk, the auditor uses professional judgment to evaluate numerous factors,
examples of which are:

At theFhancial Statement level

the integrity of management:

management experience, knowledge and changes during the period (e.g. the
inexperience of management may affect the preparation of the

Internal Control

145

financial statements of the entity);

unusual measures on management (e.g. circumstances that imgH predispose management to
misstate 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,
the complex captital structure, the significance of related parties, and the number of
locations and the 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 accounts likely to be susceptible to misstatement (e.g. a financial statement

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 judgment 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
transaction not subjected to the normal processing mode. Accounting and

8. An accounting system supplemented by effective internal controls can provide management with
reasonable assurance that assets are safeguarded from unauthorized use or disposition and that
financial recoids are reliable to permit the preparation of financial information.

9. The system of internal control comprises the control environment and control procedures, and the

plan of organization and all the methods and procedures 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, the prevention and detection of fraud and error, the accuracy and completeness of the
accounting records, and the timely preparation of reliable financial information. The system of
internal control extends beyond those matters which relate directly to the functions of the
accouruing system.

Internal Control systems

146

Auditing: Principles and Procedures

Accounting System
10. An accounting system can be defined as-.the series of tasks in an entity when transactions are
processed as a means of maintaining financial records. Such a . system should recognize,
calculate, classify, post, summarize and report transactions.

Control Environment

1, Control environment refers to the overall attitude, awareness and actions of directors and

management regarding control and its importance in the entity.1 The environment in which
internal control operates has an impact on the effectiveness ofthe specific control procedures.
A strong control environment , (e.g. one with tight budgetary controls and an effective
internal audit function) can significantly complement specific control procedures. However, a
strong environment does not, by itself, ensure the effectiveness of the overall system of
internal control.

Internal Control Procedures

12.

Control procedures are those policies and procedures in addition to the control environment
which management has established to provide reasonable assurance that specific entity
objectives will be achieved.2

13.

Internal controls relating to the accounting system are concerned with achieving the
following objectives:

transactions are executed in accordance with management's general or specific

authorization,

all transactions are promptly recorded in the correct amount, in the appropriate accounts
and in the accounting period in which executed so as to permit preparation of financial
information within, a framework of recognized accounting policies and to maintain
accountability for assets,

access to assets is. permitted only in accordance with management's authorization, and
the recorded accountability for assets is compared with the existing assets at reasonable
intervals and appropriate action is taken with regard to any differences.

Fiitrtor reflected in the control environment include management's philosophy and operating style, t)ie entity's organizational
structure and methods of assigning authority and responsibility and management's control system, including the internal
audit function, the functions of tlie board of directors, personnel policies and procedures, and external influences.
Specific internal cor.:i P(-;;edures desifcud to achieve such ;!.'.iecv>ves could include recom,:llotions checking the
arithmetical accuracy of the records; controls over computer application and environment; the maintenance of control
accounts and trial" balances; approval and control of documents; comparison with external sources of information; comparing
tile results of cash. Hecurity and inventory eountti with accounting records; limiting direct physical access to assets and
records;

Internal Control 147

MHerent. LimitqiMjas.of

1 Gonfroto

14. Internal control can provide only reasonable assurance thai management's objectives are
reached because of inherent limitations of internal eoneoL such as:

management's usual requirement that a control be cost-effective (i.e. that the

cost of a control procedure not be disproportionate to the potential loss due to fraud or
error);

the fact that most controls tend to be directed at anticipated types of

transactions and not at unusual transactions;

the potential for human error due to carelessness, distraction, mistakes of

judgment or the misunderstanding of instructions;

the possibility of circumvention of controls through collusion with parties

outside the entity or with employees of the entity (e.g. a lack of segregation of duties
between computer programmers and operators);

the possibility that a person responsible for exercising control could abuse that
responsibility (e.g. a member of management overriding a control); or

the possibility that procedures may become inadequate due to changes in

condition and compliance with procedures may deteriorate..

Understanding the Accounting and Internal Control Systems

15. When obtaining the understanding of the accounting and internal control systems to plan the
audit, the auditor should obtain a s^ifficient knowledge of the design of the accounting and
internal control systems, and whether they have been placed in operation (e.g. 'by a walkthrough test' tracing a few transaction through the accounting system). When the
transactions selected are typical of those transactions that pass through the system this
procedure may be treated as part of the tests of control.

16. The nature and extent of the procedures performed by the auditor to obtain an
understanding of the accounting and internal control systems will vary with, among other
matters:

the type of policies or procedures involved,

materiality considerations,'
the size and complexity of the business,

the nature of the entity's documentation of specific policies a-nd procedures,

and

the auditor's assessment of inherent risk. .

and comparison of results with budget.

148

A uditing: Principles and Procedures

17. The auditor's undemanding is-: generally obtained through previous experiefe with the entity
and the following:
inquiries of appropriate management, supervisoiy and other client personnel at
various organization levels within the entity, together with reference to documentation
such as procedures manuals, jojr^deseriptions and flow charts, to gain knowledge
about the accounting and internal control systems which the auditor has identified as
significant to the audit;

inspection of documents and records; and

observation ofthe entity's activities and operations encompassing the EDP organization,
management, personnel and the nature of transaction processing.

. Accounting System

18. The auditor should obtain an understanding of the design of the accounting system sufficient
to plan the audit and should obtain sufficient knowledge of the design of the accounting
system to identify and understand:

the major classes of transactions in the entity's operations;

how such transactions are initiated;
the accounting records, supporting documents, and specific accounts in the financial
statements; and
the accounting and finahcial reporting process (from the initiation of a transaction to its
inclusion in the financial statements), including how data are processed electronically.

Control Environment

19. The auditor should obtain an understanding of the control environment sufficient to assess
directors' and management's attitudes, awareness and actions regarding control and its
importance in the entity.

Control Procedures

20. The auditor should obtain an

v, aderstanciing ofthe control procedures sufficient to plan the

audit. Because control procedures are integrated in the control environment and accounting
system, as the auditor obtains an understanding
of these items, some knowledge about control procedures is also likely to be obtained (e..
in obtaining an -understanding of the accounting system pertaining to cash, the auditor
usually becomes aware of whether bank accounts are reconciled). The auditor should
consider knowledge about the presence or absence f control procedures obtained from the
.understanding of the control environment and accounting system in determining
whether;any additional understanding of'control procedures is necessary to plan the audit.
Ordinarily, audit planning does not5 require an understanding of control

Internal Control

149

procedures for every relevant assertion in each account balance and transaction class.

21.

The auditor is not concerned with those policies and procedures within the
accounting and internal control systems that are,not relevant to the assertions in the
financial information. For example, policies and procedures coricernirig the effectiveness
and efficiency of certain management decision making processes (such as the determination
of the selling prices for its products or whether to make research and development
expenditures) although important to the entity, do not usually relate to the work of the
auditor.

Preliminary Assessment of Control Risk

22. ISA 25 paragraph 14, states;

"Control risk is the risk that misstatement that could occur in an account balance or
class transactions and that could be material individually or when aggregated with
misstatements 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 h'mitation 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.'"
23.
Assessing control risk is the process of evaluating the effectiveness of an
entity's accounting and internal control systems in preventing or detecting material
misstatements in the financial statements. After obtaining the understanding .of the
accounting and internal control systems," the auditor should make a preliminary assessment
of control risk for the relevant assertions in the financial statements.

24.

When planning the audit approach, the auditor should consider the preliminary
assessment of control risk (in conjunction with his assessment of inherent risk) to determine
the appropriate detection risk to accept for the financial statement assertions and to
determine the nature, timing and extent of substantive procedures for such assertions.
25. . The auditor ordinarily' assesses control risk at a high level for some or all
assertions where:

the entity's policies and procedures relating to an assertion are not effective, or
evaluating the effectiveness ofthe entity's policies" arid procedures would be inefficient.

150

Auditing; Principles and Procedures

26. The auditor may make a preliminary assessment of control risk at less than a high level
only when the auditor:

is able to identify policies and procedures of the accounting and internal ' control
systems relevant to specific assertions which are likely to prevent
or detect material misstatements in the financial statements; and

plans to perform test of control to support the assessment.

27. 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 they
may provide evidence about the effectiveness of both the design and operation of the
policies and procedures relevant to certain assertions and, consequently, serve as tests of
control (e.g. in obtaining the understanding of the system pertaining to cash, the auditor
may have obtained evidence about the effectiveness ofthe bank reconciliations process
through inquiry and observation),

28. When the auditor concludes that procedures performed to obtain the understanding of the

accounting and internal control systems also provide evidence about the design and
operating effectiveness of policies and procedures relevant to certain assertions, the auditor
may use that evidence, provided it is sufficient, to support a control risk assessment at less
than a high level. The auditor should consider the factors in paragraphs 35 through 38 in
judging the degree of assurance provided by such evidence.

29. After obtaining' the understanding of the accounting and internal control systems and

assessing control risk (by considering only the evidence about design and operating
effectiveness of the policies and procedures described in paragraph 27), the auditor may
seek to obtain more evidence about design and operating effectiveness to support an
assessment of control risk at a lower level for certain assertions and to also affect the
nature, timing and extent of substantive procedures. Then in such eases, the auditor should
consider whether audit evidence sufficient to support this assessment is likely to be
available and whether performing additional tests of control to obtain evidence would be
efficient (i.e. the audit effort saved by a reduction in the extent of substantive procedures).
In recuiring audits, the auditor may find it more efficient to plan the preliminary assessment
to obtain additional information about the design and effectiveness at the same time.

Documentation of Understanding and Assessed Control Risk

30. 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
judgment. Common techniques, used alone or in combination, are narrative descriptions,
questionnaires, check lists and flow charts. The auditor should document the understanding
obtained of the entity's accounting and internal control systems, and the assessment of
control risk.

Internal Control 151

When control risk is assessed at less than a high level, the auditor also should document the
basis for the conclusions. 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 procedures the auditor performed, the more extensive
the auditor's documentation.

Obtaining Evidence from Tests of Control to Support an

Assessment of Lower Control Risk

31. Tests of control are performed both to obtain evidence about the effectiveness of the design

ofthe accounting and internal control systems (i.e. whether they are suitably designed to
prevent or detect material misstatements) and to obtain evidence of the operating
effectiveness of such systems. These procedures may include tests requiring inspection of
documents supporting transactions to gain evidence that controls have operated properly
(e.g. verifying that the document has been authorized) and inquiries about and observation
of controls which leave no audit trail (e.g. determining who actually performs each function
not merely who is supposed to perfoi-m it). The auditor may perform the control again to
ensure that it was correctly performed by the client in the first instance.

32. Evidence of the effective operation of policies and procedures generally is concerned with
how they were applied, the consistency with which they were applied during the audit
period and by whom they were applied. The concept of effective operation recognizes that
some deviations may have occurred. Deviations from prescribed controls may be caused by
such factor's as changes in key personnel, significant seasonal fluctuations in volume of
transactions, and human error. The auditor should make specific inquiries concerning these
matters, particularly as to the timing of staff changes in key control functions. The auditor
should then ensure that the tests of control appropriately cover such a period of change or
fluctuation. Generally the lower assessment of control risk, the more support the auditor
needs to obtain that accounting and internal control systems are designed and operating
effectively.

33. In an EDP 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 effectiveness and
efficiency of tests of control in an EDP environment may be improved through the use of
computer-assisted audit techniques. The use of such techniques may be appropriate when
the system has no visible evidence documenting the performance of the controls. In such a
case, test data may be used to obtain evidence (e.g. that data access controls in on-line
systems are functioning as designed).

152

Auditing: Principles and Procedures

34. Based onthe results of the tests of control, the auditor should evaluate whether the internal

controls are operating effectively. The evaluation of the deviations found in performing
tests of control may result in the auditor concluding that the assessed level of control risk
should be increased. In this case, the auditor should modify the nature, timing and extent of
planned substantive procedures.

Quality of Evidence .

35. Certain evidence obtained by the auditor provides more assurance than other evidence (e.g.

the auditor might obtain evidence about the proper segregation of duties by observing the
individual who applies a control procedure and malting inquiries of appropriate personnel).
Generally, the auditor's observation provides more assurance than merely making inquiries
about that individual. 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 evidence about other periods of time.

Timeliness of Evidence

36. The auditor should inquire whether the internal controls were in use throughout the period.
If substantially different controls were used at different times during the period, the auditor
should consider each separately. A breakdown in internal controls for a specific portion of
the period would necessitate separate consideration of the nature, timing and extent ofthe
audit procedures to be applied to transactions of that period.

37. In determiiung the appropriate support for a conclusion about control risk, the auditor may

consider'the support obtained for control risk from previous examinations. In a continuing
engagement, the auditor will be aware of internal controls through work carried out
previously but vriU need to update the knowledge gained and consider the need to obtain
further evidence. Before relying on procedures performed in previous examinations, the
auditor should obtain .evidence as to the nature and extent of any changes in the entity's
accounting and internal control systems since such procedures. The auditor should consider
that the longer the time elapsed since the performance of such procedures the less assurance
may result.

38. The auditor may decide to perform some tests of control at an interim date.. i However, the
auditor cannot rely on the results of such procedures without considering the need to obtain
further, evidence relating to the remainder of the accounting period. Factors to be considered
include the results of the inteiim procedures; the length of the remaining accounting period;
whether any
--changes have occurred in the accounting and ! control systems during the remaining
period; the n?.ture and amount of the transactions or balances involved; the- auditor's
evaluation of the internal ecntrol environment,

153

Internal Control

especially supervisory controls; and the substantive procedures which the auditor intends to
carry out irrespective of the adequacy of internal contruls.

Review of the Preliminary Assessment of Control Risk

39. Before the conclusion of the audit, the auditor should consider whether the preliminary

assessment of control risk is confirmed If such assessment needs to be revised, additional

procedures will need to be performed. The auditor should document any revisions to the
preianiiriary assessment.

Relationship Between
Control Risks

the

Assessments

of

Inherent

and

40. In many cases, inherent risk and control risk are highly interrelated. Also management often

reacts to inherent risk situations by designing accounting and internal control systems to
prevent and detect misstatements. In such situations, if the auditor attempts separately tOiassess inrusEe^ jund control risks when' they are highly interrelatedj'there is a
possibilitypfinappropriate risk assessment. As a result, audit risk may be more appropriately
determined in such situations by making a combined assessment.

Relating the Assessments of Inherent and Control Risks to

Detection Risk and their Impact on Substantive Procedures

41. ISA 25 paragraph 15, states:

"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 per cent of the account
balance or class of transactions because, for example, the auditor may- select an
inappropriate' audit procedure, misapply an appropriate audit procedure or misinterpret
the audit results."

42. The auditor, in forming his opinion on financial irdbrmation, needs reasonable assurance
that transactions are properly recorded in the accounting records and that transactions have
not been omitted. Internal controls, even if fairly simple and unsophisticated, may
contribute to the reasonable assurance the auditor seeks. 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 to an acceptable
level.

43. To determine the required level of assurance provided from substantive tests, the auditor
should consider:
*

the nature of substantive tests (e.g.=-using' tests directed uwaed independent parties
outside the entity rather than tests taauii

154

'Auditing: Principles and Procedures

parties or documentation within the entity, or using tests of details for a particular
audit objective in addition to analytical procedures);
the timing of substantive tests (e.g. performing them at year end rather than at an earlier
date); or

the extent of substantive tests (e.g. using a larger sample size).

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 evaluation that controls were adequate.

44. As the Appendix to ISA 25 states:

"...there should be an inverse relationship between the combined degree of inherent
and control risks and the detection risk established by the auditor. For example, when
an auditor believes that inherent and control risks are high, acceptable detection risk
should be low to restrict audit risk to an acceptable low level. On the other hand, when
inherent and control risks are low, an auditor can accept a higher detection risk and
still restrict audit risk to an acceptably low level."

45.

The assessed levels of inherent and control risks cannot be sufficiently low to
eliminate the need for the auditor to perform any substantive procedures for significant
account balances and transaction classes. Consequently, regardless of the assessed levels of
inherent and control risks, the auditor should perform some substantive procedures.

46.

The auditor's assessment of the components of audit risk may change during
the course of an audit (e.g. 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 instances, the auditor
should change substantive procedures based on a revision of the assessed levels of inherent
and control risks for some or all of the financial statement assertions.

47.

The higher the assessment of inherent and control risk, the more assurance the
auditor must obtain from the performance of substantive procedures. When both inherent
and control risks are assessed at a high level, the auditor should also consider whether
substantive procedures will provide sufficient assurance to reduce detection risk to an
acceptable level. When the auditor determines that detection risk cannot be reduced to an
acceptable level, the auditor should either qualify or disclaim the opinion or, if this is not
practicable, withdraw from the engagement.

Internal Control in the Small Business

4S. The auditor needs to obtain the same degree of assurance in Older to give an

Internal Control

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 the small
business (e.g. in small businesses, accounting procedures may be performed by 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 eases, be offset by owner/manager supervisory controls which may
exist because of direct personal knowledge of the business and involvement in the business
transactions. In circumstances where segregation of duties is limited and 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 the performance of
substantive procedures.

Communication of Weakness in Internal Control

49. As a result of obtaining the understanding and testing of the accountant and internal control
systems, the auditor may become aware of weaknesses. The auditor should make
management aware, on a timely basis and at an appropriate level of seniority, of material
weaknesses in the design or operation of the accounting and internal control systems, which
have come to the auditor's attention. The communication should preferably be in writing but
if the auditor judges that oral communication is appropriate, such communication should be
documented in the working papers. It is important to indicate in the letter that it discusses
only weaknesses which have come to the auditor's attention as a result of the audit, and that
the examination has not been designed to determine the adequacy of internal control for
management purposes.
Addendum 1 to ISA dealing with EDP characteristics and consideration revised till October
1991 is reproduced below.

Introduction
1. An electronic data processing (EDP) environment is defined in International Standard on
Auditing (ISA) 15, Auditing in an EDP Environment, as follows:
"For purposes of International Standard on Auditing, an EDP environment exists when
a computer of any type or size involved in the processing by the entity of financial
information of significance to the audit, whether that computer is operated by the
entity or by a third party."
The introduction of all desired EDP controls may not be practicable when the size of the
business is small or when microcomputers are used hrespective of the size of the business.
Also, where data is processed by a third party- the consideration of the EDP environment
characteristics may vary depending en the degree of access to third party processing. A
series of Internati^g^

155

Auditing: Principles and Procedures

156

Statements on Auditing has been developed to supplement the following paragraphs. This
series describes various EDP environments and their effect on the accounting and internal
control systems and on auditing procedures.

Organizational Structure
2. In an EDP environment, an entity will establish an organizational structure and procedures to
manage the EDP activities. Characteristics of an EDP organizational structure include:

a.

b.

Concentration of functions. and knowledge although most systems employing EDP

methods will include certain manual operations, generally the number of persons
involved in the processing of financial information is significantly reduced.
Furthermore, certain data processing personnel may be the only ones with a detailed
knowledge of the interrelationship between the source of data, how it is processed and
the distribution and use of the output. It is also likely that they are aware of any
internal control weaknesses and, therefore, may be in a position to alter programs or
data while stored or during processing. Moreover, many conventional controls based
on adequate segregation of incompatible functions may not exist, or in the absence of
access and other controls, may be less effective.
Concentration of programs and data - transaction and master file data are often
concentrated, usually in machine readable form, either in one computer installation
located centrally or in a number of installations distributed throughout an entity.
Computer programs which provide the ability to obtain access to and alter such data
are likely to be stored at the same location as the data. Therefore,, in the absence of
appropriate controls, there is an increased potential for unauthorized access to, and
alternation of, programs and data.

Nature of Processing
3. The use of computers may result in the design of systems that provide less visible evidence
than those, using manual procedures. In addition, these systems may be accessible by a
larger number of persons. System characteristics that may result irom the nature of EDP
processing include:

a.

b.

Absence of input documents data may be entered directly into the computer system
without supporting documents. In some on-line transaction systems, written evidence
of individual data entry authorization (e.g. approval for order entry) may be replaced
by other procedures, such as authoriza tion controls contained in computer programs
(e.g. credit limit approval).
Lack of visible transaction trai - certain data may be maintained on computei' files
only. In a .aanual system, it is normally possible to follow a transaction through the
system t ' examining source documents, books of

Interna! Control

c.

d.

account, records, files and reports. In an EDP environment, however, the transaction
trail may be partly in machine readable form, and furthermore it may exist only for a
limited period of time.
Lack of visible output certain transactions or results of processing may not be
printed. In a manual system, and in some EDP systems, it is normally possible to
examine visually the results of processing. In other EDP systems, the results of
processing may not be printed, or only summary data may be printed. Thus, the lack
of visible output may result in the need to access data-retained on files readable only
by the computer.
Ease of access to data and computer programs - data and computer programs may
be accessed and altered at the computer or through the use of computer equipment at
remote locations. Therefore, in the absence of appropriate controls, there is an
increased potential for unauthorized access to, and alteration of, data and programs by
persons inside or outside the entity.

Design and Procedural Aspects

4. The development of EDP systems will generally result in design and procedural characteristics
that are different from those found in manual systems. These different design and
procedural aspects of EDP systems include:

a.

b.

c.

d.

Consistency of performance EDP systems perform functions exactly as

programmed and are potentially more reliable than manual systems, provided that all
transaction types and conditions that could occur are anticipated and incorporated into
the system. On the other hand, a computer program that is not correctly programmed
and tested may consistently process transactions or other data erroneously.
Programmed control procedures the nature of" computer processing allows the
design of internal control procedures in computer programs. These procedures can be
designed to provide controls with limited visibility (e.g. protection of data against
unauthorized access may be provided by passwords). Other procedures can be
designed for use with manual intervention, such as review of reports printed forexception and error reporting; and reasonableness and limit checks of data.
Single transaction update of ' multiple or data base computer files a single input to
the accounting system may automatically update all records associated with the
transaction (e.g. shipment of goods documents may update the sales and customers'
accounts receivable files as well as the inventory file). Thus, an erroneous entry in
such a system may create errors in various financial accounts.
Systems generated transactions certain transactions may be imitated by the EDP
system itself without the need for an input document. The authorization of such
transactions may not be evidence hy visible inpcs

157

Auditing: Principles and Procedures

158

documentation nor documented in the same way as transactions which are initiated
outside the EDP system (e.g. interest may be calculated and charged automatically to
customers' account balances on the basis of pre-authorized terms contained in a
computer program).
e. Vulnerability of data and program storage media large volumes of data and the
computer programs used to process such data may be stored on portable or fixed storage
media, such as magnetic disks and tapes. These media are vulnerable to theft, loss, or
intentional or accidental destruction.

Internal Control in an EDP Environment

5.

The internal controls over computer processing, which help to achieve the overall objectives
of internal control, include both manual procedures and procedures designed into computer
programs. Such manual and computer control procedures comprise the overall controls
affecting the EDP environment (general EDP controls) and the specific controls over the
accounting , applications (EDP application controls).

General EDP Controls

6.

The purpose of general EDP controls is to establish a framework of overall control over the
EDP activities and to provide a reasonable level of assurance that the overall objectives of
internal control are achieved. General EDP controls may include:

a.

Organization and management controls designed to establish an

organizational framework over EDP activities, including:
Policies and procedures relating to control functions.

Appropriate segregation of incompatible functions (e.g. preparation of input

transactions, programming and computer operations).

b.

Application systems development and maintenance controls - designed to

provide reasonable assurance that systems are. developed and maintained in an
authorized and efficient manner. They also typically are designed to establish control
over:

Testing, conversion, implementation and documentation of new or revised

systems.

Changes to application systems.

Access to systems documentation.
Acquisition of application systems from third parties.

Computer operation controls designed to control the operation of the system and to
provide reasonable assurance that:

The systems are used for authorized purposes only,

Internal Control

159

Access to computer operations is restricted to authorized rjersGnneL

Only authorized programs ar e used.
Processing errors are detected and corrected.

a\ Systems software controls designed to provide reasonable assurance that system

software is acquired or developed in an authorized and efficient manner, including:

Authorization, approval, testing, implementation and documentation

of new systems software and systems software modifications.
Restriction of access to systems software and documentation to authorized
personnel.

e. Data entry and program controls designed to provide reasonable assurance that:
An authorization structure is established over transactions being entered into the
system.
Access to data and programs is restricted to authorized personnel.

7. There are other EDP safeguards that contribute to the continuity of EDP processing.
These may include;

Offsite back-up of data and computer programs.

Recovery procedures for use in the event of theft, loss or intentional or accidental
destruction.

Provision for offsite processing in the event of disaster.

EDP Application Controls

8. The purpose of EDP application controls is to establish specific control procedures over
the accounting applications in older to provide reasonable assurance that all transactions are
authorized and recorded, and are processed completely, accurately and on a timely basis.
EDP application controls include:
A. . Controls over Input designed to provide reasonable assurance that:
Transactions are properly authorized before being processed by the computer.

B.

Transactions are accurately converted into machine readable form and recorded
in the computer data files.
Transactions are not lost, added, duplicated or improperly changed.
Incorrect transactions are rejected, corrected and, if necessary, resubmitted on
a timely basis.

Controls over processing and computer dat a files - designed to provide

reasonable assurance that:
Transactions, including system generated transactions, are prcperiy

Auditing; Principles and Procedures

processed by the computer.

Transactions are not lost, added, duplicated or improperly changed.
Processing errors are identified and corrected on a timely basis.

C. Controls over output -- designed to provide reasonable assurance that:

Results of processing are accurate.

Access to output is restricted to authorized personnel.
Output is provided to appropriate authorized personnel on a timely basis.

Review of General EDP Controls

. The general EDP controls which the auditor may wish to test are described in paragraph 6.
The auditor should consider- how these general EDP controls affect the EDP applications
significant to the audit: General EDP controls that relate to some or all applications are
typically interdependent controls in that their operation is often essential to the
effectiveness of EDP application controls. Accordingly, it may be more efficient to review
the design of the general controls before reviewing the application controls.

Review of EDP Application Controls

10. Control over input, processing, data files and output may be carried out by EDP personnel, by
users of the system, by a separate control group, or may be programmed into application
software. EDP application controls which the auditor may wish to test include:

A.

Manual controls exencised by the user if manual controls exercised by the

user of the application system are capable of providing reasonable assurance that the
system's output is complete, accurate and authorized, the auditor may decide to limit
tests of control to these manual controls (e.g. the manual controls exercised by the user
over a computerized payroll systern for salaried employees could include an
anticipatory input control total for gross pay, the test checking of net salary output
computations, the approval of the payments and transfer of funds, comparison to
payroll register amounts, and prompt bank reconciliation). In this case, the auditor may
wish to test only the manual controls exercised by the user.

B.

Controls over system output if, in addition to manual controls exercised by

the user, the controls to be tested use information produced by the computer or are
contained within computer programs, it may be possible to test Bath, controls by
examining the system's output . using either manual oT'computer-assisted audit
techniques. Such output may be in the
:
form.of magnetic media, microfilm Or printouts (e.g. the auditor may test controls
exercised by the entity over the reconciliation of report totals to the general, ledger
control accounts and may perform manual tests of those

Internal Control

161

reconciliations). Alternatively, where the reconciliation is performed by computer, the

auditor may wish to test the reconciliation by ^performing the control with the use of
computer-assisted audit techniques (see ISA 16, Computer-Assisted Audit
Techniques).
C. Programmed control procedures in the case of certain computer systems, the auditor
may find that it is not possible or, in some cases, not practical to test controls by
examining only user controls or the system's output (e.g. in an application that does
not provide printouts of critical approvals or overrides to normal policies, the auditor
may want to test control procedures contained within the application program). The
auditor may consider performing tests of control by using computer-assisted audit
techniques, such as test data, reprocessing transaction data or, in unusual situations,
examining the coding of he application program,

Evaluation
11. The general EDP controls may have a pervasive effect on the processing of transactions in
application systems. If these controls are not effective, there may be a risk that
misstatements might occur and go undetected in the application systems. Thus, weaknesses
in general EDP controls may preclude testing certain EDP application controls; however,
manual procedures exercised by users may provide effective control at the application level.
The, following three supplements were also issued and have been reproduced in later
Chapter:

1.

Supplement 1 to ISA 6 dealing with EDP Environment Stand Alone Micro

Computer was released in October 1987.

2.

Supplement 2 to ISA 6 dealing with EDP Environments-on-line Computer

System was released in February 1989.

3.

Supplement 3 to ISA 6 dealing with EDP Environment on Data Base System

was released in February 1989.
These are reproduced in Chapter 20 ofthe book.

VOUCHIN
G

DEFINITION OF VOUCHER
A voucher is a documentary evidence which proves the accuracy or otherwise of a
trans^tioh' appealing in the books of account. vouchers^ relevant to the Dvlsiness trans
action should be carefully filed aria' preserved to enable the auditor to carry out vouching. Some
o"f the examples of the" various types of the vouchers to be produced to the auditor for checking
are as under:
Cash Receipt............Carbon copies of the receipts issued, cash memo, correspondence,
etc.
Gash Paid................Oiiginal receipts of the payees supported by relevant documents
e.g., invoices, wages book, contracts, correspondence, etc.
Purchases.................Copies of the purchases order, original invoices, goods received
notes, correspondence etc.
Sales....... .................Orders received, carbon copies ofthe invoices, copies of goods out
slips, correspondence etc.
Purchases Return. .Credit notes received, copies of the goods sent out slips, correspondence etc.
Sales Return.............Debit notes received from customers, goods received notes and
correspondence etc.
Journal Entries.........Previous year balance sheet and other available relevant
documentary evidence.

ROUTINE CHECKING
Routine checking is carried out as under:
^ (1) Checking of casts, sub-casts, carry forward, and other calculations of the books of original
entries and ledgers.

Vouching

163

<C (2 ) Checking of postings in the ledger.

f "(3) Checking of ledger account with records, balancing and checking the amount on to the
trial balance.
For this purpose auditor ..usually uses different kinds of tick. The objects of the routine
checking are to verify arithmetical"'accuracy"oTthe enbiesTtcTascertain that postings from the
books of originaTentiy' Have' been made to the correct account in the ledgers, and to ensure that
ledger accounts have been correctly balanced.

DEFINITIONS OF VOUCHING
Vouching is the very essence of auditing. The^whole success of_the audit very much depends
upon the intelligence and" skill with which this part of the wojk^is performed. TypJ^hmg means
_and includes^ the_ examination of every,... business transaction with its supporting documentary
evidence^ the checking of which enables the ^auditor to satisfy himself that the transaction is*"m
order: that'.jffiKfi^.. been properly authorised: and that it has been correctly allocated and entered
in the"
book. ;"
,------"
If the auditor fails to vouch the item correctly, he may be considered negligent in the
performance of his duties, and may he guilty as was decided iri"ffie"case "oi'ArrnUagc vs.
Brewer and Knott , . ,

EXTENT OF VOUCHING - c & r A

The basis on which the extent of the vouching could be carried out are complete
check or test check. The extent of carrying out the vouching will depend upon many
factors. One^of themost important factor's is the existence or otherwise of sound
intemaFcontrol system in practice." If the system of internal control is"sound and
does operate in practice also, the auditor may consider it advisable in restricting the
youchrng to a test cheek basis rather than cariyihg out 'ffie voMrimg completely.
However,, if the'system of internal control is loose or theiedoesnpt exist _a system of
internal control at all, the auditor will be runmngfThe risk if he does not resort to
complete vou^chrng.
"' ~
"*"

... ..
The type of test check is the matter which is to be decided by the auditor while taking all the
facts into consideration.

PROCEDURE OF VOUCHING
In practice generally the job of vouching is done by two persons. A junior member of the
audit Staff calls out the particular* in respect of each of tf.o entry appearing 4h the" books such as:
date, particulars, accounts debited, credited and amount.

Auditing: Principles and Procedures

164

The senior member compares^ the. details called_ out with the documentary
evidefici^pdueed to him to satisfy himself as to the genuineness ofthe transaction. In practice,
either of the following procedure is followed for identifying the act of vouching on the voucher:

(1) The senior puts his initials on the voucher; or

(2)
upon
the
documents.

voucher

and

upon

A rubber stamp is put

its
supporting
'.

The object of cancelling the documents by above manners is to ensure that the same
documents 'are not produced again in support of other items.
If a transaction is satisfactorily considered to have been vouched,^distinctive tick
is~pTacod on the amount appearing in the book of original entry If an item, is considered to be
insufficiently vouched for certain reasons, a symbol viz., "Q" is put on the amount appearing in
the book of original entry and the relevant particulars ofthe vouchers which are insufficiently
vouched are noted on the query list.
A copy of the queries should be handed over to the management to give them th^j)^ortunify
and time to'get them cleared. On the production of acquired documentary evidence, the queries
would be cleared and consequently, objections raised against them would be chopped. At the
conclusion of the audit, a list of uncleared queries will be prepared and reported to. the
management or the shareholders, depending upon whether the queries are material or otherwise.

TECHNIQUE OF VOUCHING
At the time of conducting the vouching, the following points must be borne in mind:

1.

In order to ensure that valuable time is not lost in vouching, the client should
produce to the auditor all the vouchers arranged- in the order in which entries appear in
the books of account,
2.
The auditor must satisfy himself that the dates given on the vouchers which are
recorded in the books fall in the ear'under review.

3.

Satisfaction must be made in respect of the head of account debited or credited

fr om the available documentary evidence.
4.
While examining the documentary evidence it should be carefully seen that the
transaction pertains to the business. Care must be given to those vouchers which are m
the personal names of the partners, managers, secretajy, directors etc.

5.
6.

Every voucher has been passed by the authorised official.

Attention should also be paid to the point whether the voucher bears
proper revenue stamp. *

7.

Complete notes should be taken in respect of such items as require further

Vouching

165

clarifications or evidence (e.g.. Partnership Deed, Leases, Memorandum and Articles

of Association, Minutes Book, Contracts etc.).

8.

Attention should also be paid to the amount to ensure that it agrees both in
words and figures. JB**M*
9.
Any aHerat^onjiarticuIarly in respect of the figures on the receipts, and
vouchers etc., must be fully inquired into.

CUT-OFF PROCEDURES

( .

Cut-off procedures represent arrangements made for ensuring that at a particular point of
time, e.g., December 31, there will be agreement between the physical stock-in-trade and workin-process and the figures actually shown in the accounts, as obtained from the records of
purchases, sales, debtors and creditors.
For operationalising cut-off procedures, the following steps be taken;
Stocks relating to outsiders and held on their behalf be excluded from the stocks of
the enterprise.
Stocks owned by the enterprise, wherever situated, should be included in the closing
inventoiy.
Movement of goods in and out at the closing date should be carefully examined.
Goods sold but not delivered on the financial closing date, should be excluded from
the inventory.
f5.'

Good bought but not received should not only be included in purchases but also in stock
in-transit.

. AUDIT SAMPLING (

ISA 19 deals with audit sampling. In general parlance it is known as test check. The above
ISA is a comprehensive guidelines and main features are reproduced below:
Auditjsampli^^
substantiveprocedui'e to
less than 100% oTthe items within an account balance or class of transactions to enable., the
auditor to obtain and evaluate evidence of some ch iracterliiic ofthe balance or class and to. form
or assist in forming a conclusion concerning that characteristic.
It isjmportant to recognise that certain testing procedures do not come within the. definition
oT sampling. Tes^jjejiformed on 100% of the items witfiin~"a popuhationjio not
involyje^sanipling. 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

Auditing: Principles and Procedures

166

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 we 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.
This Standard applies, equally to both statistical and non-statistical sampling
methridsT^nth^r method, when, properly *ap^Ii^rcan~provide sufficient appropriate
audit evidence.' Both^ethr^
i^aWiSsrW^e^^^^^^ox^ judgment
in designing and selecting the sample, perlDrniing~nis audit procedures and evaluating the results
thereof.'

Design of the Sample

In designing an audit sample, the auditor applies judgment in considering:

1.
2.
3.
4.
5.
6.

audit objectives,
population,
risk and assurance,
tolerable error,
expected error in the population, and
stratification.

Audit Objectives
The gjrditor should first consider the specific audit objectives to be achieved to
enable him to determine the audit procedure or c'o'rnbiriatioh of procedures which is
Ekely to best achieve those objectives. In addition, when audit sampling is
appropriate, the nature ofthe audit evidence sought and possible error conditions or
oTflerTKKrac^terr^
evidence will assist the auditor in defining
wriat^qnstrtutes"^
what population should fee used for sampling. "For
example, when peirfoi'mingj^ompliance tests of a company's purchasing procedures', the"'
auditor"'wilT'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 infor mation.
Population
The population is the entire set of data from which the auditor wishes to sample in order to
reach a conclusion. The auditor should 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
received trial balance. On the other hand, if he were testing for understatement of accounts
payable, his population would not be the accounts payable tiial balance but could be

Vouching

subsequent, disbursements, unpaid 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.
Risk and Assurance
In planning the audit, the auditor uses professional judgment to assess the level of audit risk
that is appropriate.
Audit rtsk includes:
1. the risk that material errors will occur (inherent risk),
; 2. the risk that the client's system of internal control will not prevent or correct such errors
(control risk), and
t 3.

the risk that any remaining material errors will not be detected by the
auditor (detection risk).
-i ^'' '''t
<
Inherent nsk and control risk Xist irrcspecJ.iv.g.of audit sampling procedures. The auditor
should consider detection risk arising from the uncertainties due to sampling (sampling risk) as
well as those arising from factors other than sampling (non-sampling'nsk).
Non-sampling risk can arise when the auditor uses sampling or other auditing
procedures" .and includes, for example, the risk that the auditor -might use inappropriate
procedures or might misinteipret evidence andjh.us fail to recognise an error. The auditors
objective should be to reduce non sampling nsk to s. negligible level by appropriate planning,
direction, supervision and review.
SaniplhTg^risk, for. either compliance or substantive testing,.,.aidses-fmm >.the possibility
that. auditor's jconclusion,.basecTon a~saniple, may be different from the conclusion he
would reach if the entire population were_ subjected to the same audit procedure.
The auditor is faced with sampling risk in both compliance and substantive testing
aVfollows:
f f >) Compliance Testing
1.

Risk 6? Under Reliance the risk that, although the sample result
does not support the auditor's planned degree of reliance. on internal
control, the actual compliance rate does support such reliance.
2. Risk of Over Reliance the risk that, although the sample result

167

A uniting: Principles and Procedures

168

supports the auditor's planned degree of reliance on internal control, the actual
compliance rate does not support such reliance.
(bi Substantive Testing

..

1.

Risk of Incorrect Rejection the risk that, although the sample result supports the
conclusion thai the recorded account balance is materially misstated, in fact it is not
materially misstated.
2.
Risk of Incorrect Acceptance the risk that, although the sample result supports
the conclusion that the recorded account balance is not materially misstated, in fact it
is materially misstated.
The risk of under reliance and the risk of _ incorrect^ rejection are prirnarily concerned with
audit efficiency as they would normally. lead to additional work being performed by the auditor
or his client which would establish that the initial conclusions were incorrect. The__risk of over
reliance and the risk of incorrect acceptance are concerned with audit effectiveness; thus they are
more serious, since they are more likely to lead to an erroneous opinion on the financial
information.
Sample size is affected by the decree of audit assurance the auditor plans to obtain from the
results of the sample. The greater the assurance the auditor requires, the greater the .sample size
should be. In determining the assurance required, the auditor will be concerned with the risk
(complement of assurance) that the conclusions he will draw from his audit procedures might be
invalid.
Tolerable Error
Tolerable error is the maximum error in the popula tion that the auditor would
be wining to accept and still conclude thatTSie result from the sample* has achieved his audit
objective. Tolerable error rs^cqhsiHeied during the planmng stage and is related to the*auditor's
preliminmy judgment about materiality. The smaller the tolerable error, the larger the sample size
the auditor will require.
In compliance procedures, the tolei'able error is the maximum rate of deviation from a
prescribed control procedure that the auditor would be willing to accept without altering his
planned, reliance on the control being tested. In substantive procecurres, the tolerable error is the
maximum monetary erro'r^Tri an'account TSalahce or class of transactions that the auditor would
be willing to accept so that when _he .considers the results .of.ail audit procedures he is able to
conclude, with reasonable assurance, that the financial information is not materially in error.
Expected Error i n t he Population
If the auditor expects error to be present, he will normally have to examine a larger sample
to conclude either that the population value is fairly stated to within the planned tolerable error or
that the planned reliance on a relevant control is justified. Smaller sample sizes are justified when
the population is expected to be error free. In determining the expected error in a population, the
auditor should consider such matters as error levels identified in previous audits, changes in client

169

Vouching

procedures and evidence available from his evaluation of the system of internal control and from
results of analytical review procedures.
Stratification
Stratification is the process of dividing a population into subpopulations, that is a group of
sampling units, which have similar characteristics (often monetary value). The strata must be
explicitly defined so that each sampling unit can belong to only one stratum. This procedure
reduces the variability of the items within each stratum. Stratification enables the auditor to
direct his efforts towards the items he considers potentially contain the greater monetary error.
For example, the auditor might direct his attention to larger value items for accounts receivable
to detect material overstatement errors. In addition, stratification may result in a smaller sample
size. "

Selection of the Sample

Sample items should be selected 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:

1.
2.
3.

random selection,
systematic selection, and
haphazard selection.

Random selection ensures that all items in the population or within_ each stratum have a
known chance of selection, for example, by use of random number tables.
Systematic selection involves selecting items using a constant internal between selections,
the first interval having a random start. The interval might be based on a certain number of items
(e.g. every 20th voucher number) or on. monetary totals (e.g. every $1000 in the cumulative
value ofthe population). When using systematic selection, the auditor should 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 alternative to random selection provided that 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, he should guard against
making a selection that is biased, for example, towards items which are easily located, as they
may not be representative.

Auditing: Principles and Procedures

J 20

Evaluation of Sample Results

Having carried out, on each sample item, those audit procedures that are appropriate to the
particular audit objective, the auditor should:

1.
2.
3.

analyze any errors detected in the sample,

project the errors found in the sample to the population, and
assess the sampling risk.

Analysis of Errors i n the Sample

In analyzing the errors detected in the sample, the auditor should 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 his audit objectives. For example, in
substantive procedure relating to .the recording of accounts receivable., a misposting between
customer accounts doi;s 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 impact on other areas of the audit, such as the assessment
of doubtful accounts.
When documentation in support of specific sample items cannot be located, the auditor may
be able to obtain appropriate audit evidence through performing alternative procedures related to
the missing sample items. For example, if a positive confirmation has been circularised in respect
to a customer account receivable and no reply was obtained, the auditotmay be able to obtain
appropriate audit evidence that the customer receivable is valid by reviewing subsequent
payments from the customer. If the auditor does not or is unable to perform alternative
procedures related to the missing sample items {customer receivable), he should treat this item as
an error for the purpose of hie evaluation of audit evidence provided by the audit sample.
The auditor also should consider the qualitative aspects of the errors. These include the
nature and cause of the eiror and the possible impact of the error on other phases ofthe audit, for
example, the amount of planned reliance on internal control procedures.
In assessing the errors discovered, the auditor may conclude that many have a common
feature, for example, type of transaction, location, product line, period of time or other relevant
feature. 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 extend his
procedures in this area. He should then perform separate evaluations based on the items examined
for each sub-population.
Projection of Errors
The auditor should project the error results of the sample to the population from which the
sample was selected. There are several acceptable methods of projecting the eiTor results.
However, in all cases the method of projection should be

171

Vouching

consistent with the method used to select the sampling unit. When projecting error results, the
auditor should keep in mind the qualitative aspects ofthe errors found. When the population is
divided into two or more sub-populations (stratification), the projection of errors is done
separately for each sub-population and the results are added together.
Assessing Sampling Risk
The auditor should consider whether errors in the population might exceed the tolerable
eiTor. To accomplish this, the auditor should compare the projected population error to the
tolei'able error and also then compare the sample results to the evidence obtained from other
relevant audit procedures when forming his conclusions about an account balance, class of
transactions or specific control. The projected population error used for this comparison should
be net of adjustments made by the client. As projected error approaches tolerable error, the risk of
incorrect acceptance or over reliance increases. The auditor should therefore reconsider the
sampling risk and if he determines that the risk is unacceptable, he should consider extending hie
audit procedures or performing alternative audit procedures.
In compliance procedures, the evaluation of the errors may result in the auditor concluding
that the sample results do not support his planned degree of reliance on a control procedure. In
this case, he may ascertain that there is another appropriate control on which he might rely after
applying appropriate compliance procedures. Alternatively, he may modify the nature, timing
and extent of his substantive procedures.

Conclusions
Having evaluated the sampling results, the auditor should conclude as to the extent to which
he has obtained sufficient appropriate audit evidence in support of the particular characteristic of
the account balance or class of transaction with which he is concerned.
Appendices I and II of this Standard illustrate some of the factors influencing sample size.
Appendix III illustrates sampling risk for both compliance and substantive tests. These are given
at the end of this chapter.

DEPTH TEST
Concept
Depth tests are generally known as "cradle to grave" tests and involve taking a transaction
or a series of transactions and following them through the accounting system from start to finish.
The objective is to facilitate an auditor in form his opinion.

Auditing: Principles and Procedures

172

Objectives
Depth tests may be undertaken to accomplish the following objectives:

1.

To test the accuracy of his record of the client's accounting system! This will
generally involve checking of small number of transactions and is generally known as
"walk through checks".

2.
3.

To perform compliance tests.

To provide evidence of a substantive nature.

VOUCHING OF CASH BOOK - RECEIPTS SIDE

The technique of vouching in respect of the important items which usually appear on the
debit side ofthe. cash book is discussed here:

Opening Balance
It should be cheeked with the balance shown in the audited balance sheet of the previous
year. Reference should be made to the audit working papers to see if the closing balance of the
cash shown in the balance sheet is the result of many balances.

Cash Sales
The required evidence for vouching the cash sales would depend upon the procedure for
recording the cash sales in the book. Usually carbon copies of the cash memos or cash sales
invoices would support such entries which should be checked. Where automatic tills are in use
the entries in the cash book should be checked from the till records. If automatic cash register is
maintained, resort should be made to the summaries.
The basis of charging prices to the customers against cash sales should be inquired into and
documentary evidence in this respect must be examined. A test check, the extent of which will
depend on the efficiency or otherwise of the system of interna] control, with the goods outwards
book should also be carried out.

Cash Received from Debtors

The carbon copy receipts or counterfoil receipts in support of the entries appearing in the
receipt side of the cash book should be examined. The method of allowing the discount to a
customer against prompt payment should also be inquired into. Any unusual discount should be
noted and satisfactory explanation should be obtained from the responsible official. The test
check of tracing the amount received as per cash book into the statement of accounts received
from the debtor should also be done. Requisite amount of work should be done to uncover the
process of 'Teeming and Lading" or also called "Lapping". Under this method when the cash is
received, e.g., from Mr. Wahid, no entry is made in the cash book

173

Vouching

by the cashier and he makes a personal use of the same. Subsequently on receipt of remittance
from Mr. Ayub the amount is recorded as cash received from Mr. Wahid. Further when some
money is later on received from Mr. Qayyum, the amount is credited to Mr. Ayub and this
process continues. At the end of the month or the year the cashier generally replaces the money
he had so far used without the permission of the management and credits the account of the
debtor whose account has not been credited. In order to put an effective check so that the said
malpractice is checked, the following steps should be taken:

(1) The carbon copy of the receipt or the counterfoil receipt, as the case may be, should be

(2)
(3)

cheeked with the pay in-slip. Special attention should be given to the amount banked,
number ofthe cheque and corresponding amount. This is meant to ensure whether the
cheques which were received had been deposited into the bank.
The management must follow as an inflexible guiding rule that all bearer or other
cheques received are immediately crossed "Accounts Payee only".
The specimen of the acknowledgment against the receipt of money should provide for
the disclosure of the facts whether the amount was received in cash or by cheque. In
the case of payment by cheque, the cheque number must be stated on the carbon copy
receipt or the counterfoil receipt.

Interest Income
The evidence required to vouch the amount of income will depend upon the nature of the
interest. Interest received on account of fixed deposits in the bank should be checked with the
bank advice and the verification of the arithmetical accuracy of its calculation should also be
done. Interest on savings bank account should be vouched with the bank advices. Interest on any
loans granted should be Vouched with reference to the agreement with the borrower. The terms of
the agreement in respect of rate of interest, the date of the payment etc., should be carefully
scrutinised. Interest received on securities should be checked with reference to the securities,
correspondence exchanged, covering letter in respect of the receipt of the interest and
counterfoil'receipts issued.

Dividend Income
Dividend received should be vouched with the counterfoil or the upper portion of the
dividend warrant and with the letters with which the cheques for amount of dividend had been
received.

Rents Received
Lease deeds and agreements should be exarnined in respect of amounts of rent payable, the
due date, provision regarding repairs etc., counterfoil of the receipts or carbon copies receipts
should be checked. Rent received should also be checked with the rent rolls. If the collection of
the rent is done through an agent, the agent's

174

Auditing: Principles and Procedures

statement of account and details given therein must be carefully examined.

Commission Received
Counterfoil or carbon copy of the receipts should be checked with the amount in the cash
book. The accuracy of the amount should be verified with reference to the agreements with the
parties regarding rate of commission and its entitlement of receipt. Calculation of the amount
received and the basis of the working should be checked.

Subscriptions Received
The entitlement of the receipt of the subscription must be checked with the bye-laws of the
association or club. Subscriptions received should be checked with the counterfoil receipt or the
carbon copy receipt with the register of subscriber's. Any unusual amount of subscription should
be inquired into.

Sole of Securities
Broker sold notes should be vouched. The fact that the sale is "ex-dividend" or "cumdividend" should carefully be examined. In the case of cum-dividend sale, element of income in
respect of dividend and amount attributable to investments should be apportioned. Minutes ofthe
Board of Director's should also be examined, if the articles of association require that sales of
investment should be minuted by the Board of Directors.

Bills Receivable
The amount received against the bill receivable should be vouched^ with reference to the
bills receivable book. For the bills which are due for the receipt of money but against which the
amount has not been received, inquiries must be made against the same.

Bad Debts Dividend

Receipts from debtors who become bankrupt should be vouched with the dividend warrants
received from the Official Receiver or Assignee. The points to be examined are: total debt, rate
per rupee payable as dividend and correspondence exchanged between the debtor or the official
receiver and the client.

Insurance Claim Money Received

Amount received in respect of a claim from an insurance company should be vouched with:
correspondence exchanged with the insurance company, the account rendered by the insurance
broker or the company, the original claim actually lodged.

175

Vouching

Share Capital
Reference may be made to a separate chapter where the procedure for vouching the amount
of share capital has been dealt with at length.

Sale of Fixed Assets

The amount received should be vouched with the correspondence, auction notes (if any),
agreement of sale, and any other evidence supporting the sales transaction. Minutes of the
Directors should also be examined, if the articles of association require the minuting ofthe sale
ofthe assets.

Miscellaneous Receipts
For vouching miscellaneous receipts, resort must be made to correspondence, contracts or
any other documents which will be produced for substantiating the support of transaction
involved in respect ofthe miscellaneous receipts.

VOUCHING OF CASH BOOK - PAYMENTS SIDE

The objects of vouching the payment side of the cash book are: to ensure that the payments
were properly authorised, asceitain that they were entered under their - appropriate head of
account in the cash book, see that the payments relate to the business and are a proper business
charge, determine that the payments stated to have been made are supported by the required:
documentary evidence and determine the closing cash and bank balances correctly.

The following points should be carefully considered while

examining the evidence of payments:
(1
)

(2
)
(3
)

(5
! That

the name of client is stated as the payer.

That the date in the payee's acknowledgement agrees with the corresponding entry in
the cash book.

That the payee's name is correctly stated in the cash book.

That the amount of the payment together' with the head of account debited is correctly entered
in the cash book.

Auditing: Principles and Procedures

176

That the allocation in respect ofthe head of account is correctly done.

That the payment is duly authorised and is properly chargeable as business expenditure.
That it bear's a proper revenue stamp. The cash
payment will be vouched as follows:

Payments to Creditors
An enquiry .should be made to ensure that invoices have been internally

177

A uditing: Principles and Procedures

checked and initialled by the authorised officials and payments are authorised. Payee's
acknowledgements should be checked. Statements of account of the creditors should be
scrutinised. As far as possible, payments must be made through _ crossed cheques. It should be
noted that the name of the payee is correctly recorded in the cash book so that it could later be
traced in the sundry creditors' ledger to the account of the particular creditor- to whom payment
has been made.

Cash Purchases
These should be vouched with cash memos of the suppliers. For acquiring satisfaction that
goods have actually been received, the available evidence, such as, goods received notes (GRN),
goods inward book, or gate pass book etc., whichever is applicable, should be examined.
Allocation to the head of account debited should be verified.

Wages
Before vouching the amount of wages paid, an enquiiy should be made in respect of the
system of preparation of time-keeping and pay-roll records and the procedure of making
payments, and the adequacy or otherwise of the system of internal control.
A sound system of internal control requires the segregation of duties in respect of
preparation of wages records in three phases; each phase of work to be performed by separate
staff, i.e., compilation of time spent or the record of piece-work, computation of the account
payable as wages and payment of wages. If the system of internal check is sound, a test check of
the wages sheets or wages book may be done. However, if the. system of internal check is loose,
then the' auditor should carry out an exhaustive work of checking.
The chances of frauds or errors could be in the following areas:

(1) Possibility of a clerical error.

(2) Fraud or eirors in r espect of time and piece-work records.
(3) The inclusion of 'dummy names' or 'ghost labour-' in the wages sheets or wages book.
A brief sketch of a workable sound system to be followed relating to preparation of wages
sheets is as under:
1. Time Records. Where mechanical devices are not used, the gatekeeper should record
the time of arrival and departure of each worker. Another similar record should also be
maintained by the foreman. It gives two benefits firstly, it provides a framework of
the check of the records maintained by the gatekeeper arid the for eman (with the
exception of such case where there is a collusion between the both) and secondly, it
provides a check on the wastage of time by the workers. However, if the mechanical
devices aie intended to be used, then Time Recording Clocks should be

178

3.

Auditing: Principles and Procedures

installed at the gates of the factory. Each worker should be given a card which he
should put in the slot of the said clock to record the date and time of his arrival and
departure.
2.
Piece-work Records. A card should be given to each worker. On it should
be recorded the number of pieces produced or manufactured. It should also
be signed by the worker, foreman and the storekeeper to whom the
finished products are delivered. A record of any fine imposed due to
defective goods etc. should also be noted on it.
Preparation of wages-sheets or wages book. On the basis of the information
available from the time record or piece-work record, wages sheet or wages book
should be written down. The time factor or the number of pieces manufactured would
be multiplied with the rate applicable to determine the amount of gross wages payable.
After entering the deduction (contributions to provident fund, wages advance, fines
etc.) the net wages payable be determined. Each number of the staff doing a particular
job should indicate the nature of work performed in relation to the wages sheets and
sign against it. The whole wages sheets or the wages book should also be countersigned by a responsible authorised official.

4. Payment of wages. The wages sheets together with the exact amount drawn from
the bank be handed over to the cashier who should make the payment of wages "to the
workers in the presence of a foreman who must identify the workers before they
receive the amount. AH thumb impressions must be authenticated and eventually a
Certificate of payment of wages be appended on the wages sheets and signed by the
cashier and the foreman as well. A list of all amounts of unpaid wages should be
prepared and the remaining cash balance must agree with it.
The following steps should be taken for vouching the wages paid;

(1)

Casts and cross casts of the wages sheets or wages book should be checked
and the amount should be traced into the cash book.
(2) Calculations of the amounts should be checked. The extent of checking would
depend upon the adequacy or otherwise of the system of internal check.

(3)

The basis of payments (daily rates, or hourly rates or piece-work rates) should
be enquired into and it should be seen that it has been followed in practice.
(4) Time-keeping recoids and/or piece work records should also be checked with
the wages sheets or wages book.
(5) Payee's acknowledgements should be checked. In case of thumb impression,
the auditor should ensure that they were authenticated. In case of money order
remittances, M.O. (money order) acknowledgments should be cheeked. If the amount
has been credited to wage earners' accounts in a bank, advices ofthe bank should be
examined.

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Vouching

(1) All unpaid amounts should be traced into unpaid wages register and subsequent
payments out of them should be verified with the said register.

(2) The total amount of wages payable should be checked with the amount of the cheque
drawn.

(3) In order' to see that no dummy or ghost labour is included in the wages sheets book,
(4)

the names of some ofthe worker's as mentioned in the wages sheets/book should be
checked with the job cards, and gatekeeper's and the foreman's register.
The auditor should ensure'that the wages sheets/book has been properly .signed by a
responsible official. The part played by several persons in preparing or checking the
wages sheets/hook should be noted on it and signed.

(1) Allocation of wages paid should also be verified.

(2) A test check on suiprise basis to ensure the physical presence/ existence of the wageearners is also suggested.

Payment of Salaries
The salary book should be examined and the steps to be followed for its checking are:

(1)
(2)

Casts and cross casts of salary book should be checked and amount agreed
with the cash book.
Cheques drawn should be tallied with the salaries book.

(3)

The recipients' acknowledgement bearing a proper revenue stamp be checked.

(4) Authority for increments should be seen.

(5) In case of senior employees, reference should also be made to the service
contracts and the entitlements and subsequent payments should be verified with the
same.
(6) In case of new recruitments, -letters of appointment or minutes of director's
(whatever is applicable) should be examined. .

(7) It should be seen that the salary book has been signed by an authorised
official in token of the authority for' payment.

Capital Expenditure
The procedure adopted in vouching various items is as follows:
Freehold and leaseliold- property. The agreement for sale and conveyance together with
the title deeds should be vouched for the real property. If the purchase has been effected through
a broker, broker's sold note and/or his statement of account should be examined. If purchased in
an auction, auctioneer's note should be examined. It should be seen that all legal charges incurred
in connection with the

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Auditing: Principles and Procedures

acquisition of the property and brokerage paid have been capitalised, payee's acknowledgments
should be seen. If the building has been constructed, the architect's certificate, contract for
construction and the payee's acknowledgment should be examined. If the construction was made
by the staff of the organisation then the allocation of materials, labour of overheads should be
carefully checked so that correct amount is capitalised.
Plant and Machinery. The procedure for vouching will differ depending upon the nature of
acquisition of the plant and machinery . If it was got constructed under a contract, the actual
contract should be examined and the certificate for the completion of construction and erection
be seen. The amounts paid should be checked with the contract, bills rendered * by the contractor
and payee's acknowledgment. A careful scrutiny should be made to ensure that allocation is
correctly made to correct head of account. However, if the plant and machinery .has been erected
by the staff of the enterprise, allocation of materials, wages and overheads should be verified.
Proper distinction between capital and revenue should be checked. If the plant and machinery has
been bought or imported, complete documents (invoices, payee's acknowledgment, bank advice,
letter of credit, asset receiving reporting etc.) should be cheeked. The amount of expenditure
under this head should be properly authorised and correctly entered in the cash book,
Furniture and Fixtures. Similar considerations apply, as were discussed in the case of plant
and machinery.
Motor Vehicles. Contract for purchase, invoice, broker's note, payee's acknowledgment,
asset receiving report and the registration hook showing the ownership in the name of the client
should be examined.
Patents. If a patent has been purchased, the patent and the receipt acknowledging the
purchase consideration should be seen. If it was purchased through an agent, the statement of
agent's account should also be examined and his commission be capitalised. It should be seen
that renewal fees are not capitalised.

Investments
If the investments are purchased through a broker, Broker's Sold Note showing the exact
amount payable should be checked. The original investments should also be physically examined
to ensure their existence and for acquiring satisfaction that they stood in the name of the client. If
share certificates have not yet been issued, letters of allotment and banker's advice should be
seen. The terms of purchase (whether cum-dividend or ex-dividend) should be noted. In case of
cum-dividend purchase of investments, the auditor should see that the correct allocation between
the capital and revenue is done and interest/dividend is subsequently received.

Loans
Loan agreements should be checked. If the loan is against mortgage, the mortgage deed will
state the amount of the loan, and should be exaimned together

Vouching

181

with the title deeds and certificates. The payee's acknowledgment receiving the loan should be
inspected. If the loan is a secured one, the nature of security should be examined. The authority
for the loan, such as the minutes of board of directors or managing director's approval etc.,
whatever is applicable, must be seen. In case of loans to directors of a company, the auditor must
see that the provisions of the Companies Ordinance, 1984, are not contravened. In respect of
loans to employees, the loan account of each staff member should be scratinised to ensure that
regular recoveries are taking place.

Payments under hire-purchase and Instalment agreements

Actual hire-purchase- agreements, or agreemeTits to pay by instalments should be
examined. Vouchers for the payment of each installment should be seen. As each instalment will
include the proportion of interest: which should be charged to revenue, care must be taken to see
that interest is not debited to the" asset account but is charged off to revenue account.

Agents1 and travellers9 commission and expenses

The auditor should examine the terms of contract to see the rate of commission and, also,
the actual basis of calculation of commission (whether an amount of goods sold or an orders
procured etc.). After checking the calculation and payee's acknowledgment the amount should
agree with the cash book. If the agents were paid by cheque, the paid cheques should be seen.
Where the payment is made in cash, receipts signed by the travellers should be checked. Where
the travellers are allowed to charge their expenses, vouchers should be examined for it. All
unpaid commission and expenses should be brought into account at the end of the financial year.
It should be seen that expenses were authorised by a responsible official. If the commission has
been paid tc the managing agents of the company, it should be seen that the amount has been
determined on the basis ofthe principles laid down under Section 87-3(c). Managing Agent's
agreement should be examined and the calculation ofthe amount of commission should also be
checked.

Travelling Allowances
The travelling rules should be studied. The travelling allowance bills should be checked
with the rules and the calculations of the amount may be certified. Payee's acknowledgment
should be checked. Any advances given should be checked to ensure that a proper adjustment is
made at the time of payment.

Insurance Premiums
Insurance policy can either be new" policy or a renewal of old policy. Insurance premium
should be vouched in respect of a new policy in the following way:

(1) Examine the actual policy to ascertain its nature.

(2) Check up the demand note of insurance Company.

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Auditing: Principles and Procedures

- (3) See the official receipt of insurance company.

(4) If payment of premium is made to some small offices which issue only provisional
receipts, check the original receipts also.
(5) In case of first premium, where interim receipts have not been issued, the auditor
should examine the policies, which will contain a note of the premium paid.
(6) If the receipt bears a note of "under protest", further facts should be investigated.
If the policy is a renewal of the old one, the renewal receipt of the policy, which will be
accompanied by a demand note should be examined. It should be seen that the insurance paid
against the import of assets is capitalised.

Sank Charges
Vouching should be done with reference to bank statement and bank advices. Wherever
possible and necessary, calculations should also be checked. Nature and basis of charge of any
material amount should be enquired into. Bank charges in respect of import and acquisition of
fixed assets should be capitalised in the books.

Freight and Carriage

The railway freight should be vouched with railway receipt which would be issued by the
railway authority. If the payment has been made against railway receipt which indicates the
'freight paid', then the payment will not be a genuine one. Payments in respect of shipping charge
should be vouched with the statements of bills rendered by the shippers or carriers or clearing' or
forwarding agents together with their receipts. The documentary evidence enclosed with the bills
should be checked. The question of any rebates on prompt payment of freight of the ship should
be looked into. Allocation of capital and revenue expenditure should be verified.

Deferred Revenue Expenditure

The common instances of deferred revenue expenditure are:'
(1) Cost of removal of a business to a comparatively better locality.
(2) Exceptional repairs of non-recurring nature.
(Z) Abnormal advertisement expenditure the benefit of which will extend to years beyond
the financial year in which it is incurred.
(4) Heavy renovations and structural improvements to buildings.
It should be seen that such payments are capitalised temporarily and spread^, over the years
for which the benefit is anticipated to be enjoyed. Relevant documentary evidence to prove the
truthfulness of the transactions should be examined. The amount to be carried forward should be
shown in the balance sheet. If any item of expenditure, which may, in fairness, be distributed over
several years

183

Vouching

has been uicurred in any one year, the whole amount of such item should be stated with the
addition of reasons why only a portion of such expenditure is charged against the income of the
year.

Dividend Paid
It should be ascertained from the Company's Memorandum and Articles of Association that
the dividend paid is in accordance with the rights attaching to the share capital in question.
The mture of the dividend paid must then be inquired into. If it is interim dividend, the
articles of association ofthe company should be examined to ascertain whether the directors are
empowered to pay the interim dividend and whether the profits disclosed by the interim accounts
justify the payment. If it is final dividend, the resolution passed by the shareholders in the annual
general meeting should be examined. The following steps should then be taken to vouch the
amount:

(1) Check casts, cross casts and carry -forwards ofthe dividend book.
(2) Check dividend book with the returned endorsed dividend warrants.
(3) Check the amounts appearing in the dividend book with the bank statements and
(4)
(5)
(6)

reconcile with the bank account.

See that the total of the gross dividend column in the dividend book represents the
correct percentage of the dividend on the share capital on which it is paid.
Check the income-tax deducted and deposited into the State Bank of Pakistan with the
prevailing rates and the receipted challans.
Trace the unpaid amount into the unpaid dividend register. Any subsequent payment
out of the unpaid amount of dividend should be checked with reference to the said
register.

Remuneration of Managing Agents

The auditor should ensure that the following have been complied with:

(1) The remuneration of the managing agents is to be a sum based on a fixed percentage
of the net annual profits of the company, with provision for a
minimum payment in the case of absence of or inadequacy of profits, together with an
office allowance to be defined in the agreement of management.
.. .

(2) The authority of a special resolution is required for any stipulation for remuneration
additional to or in any other form than the remuneration specified in point above.
(3) The "Net Profits" are to be calculated after deducting the following:
: . (a) All usual'working charges.
(b) Interest on loans and advances.

Vouching ..................................................................................................................... 133

"

(c) Repairs and outgoings.. \

(d) Depreciation.
The following income should be excluded from determining the profits on which the
calculation of the said remuneration should be based:

(a)

Bounties or subsidies received from any Government or from a public body.

(b) Profits by way of premium on shares sold:

(c) Profits on sale-proceeds of forfeited shares.
(d) Profits from the sale of the whole or part of the undertaking of .the company.
. No deductions for the following are allowed:
(a) ' Income-tax or super tax, or any other tax or duty on income or revenue.
(b) Interest on debentures.
(c) Expenditure on capital account.
(d) Any other sum set aside each year for reserve or any other special fund.
The provision of Memorandum and Articles of the Association, Prospectus, Consent Order
issued by the Controller of Capital Issues, Government of Pakistan and Managing Agency
Agreement should be carefully perused. Any conditions of the consent order h'miting the
remuneration to managing agents should be carefully noted. ~
It should be seen that provision for the required amount has been made and if paid, the
payees' acknowledgment must be checked. The calculation of the amount must be verified- If the
managing agents have waived their remuneration either partially or fully, waiver letter received
by the company should be checked and Board Minutes examined in this respect.
Remuneration of managing agents be disclosed separately in the profit and loss account.

Custom Duties
If these have been paid by forwarding agents on behalf ofthe customer, the amounts
will be included in their monthly accounts which should be vouched and the official receipt
checked. The,supportings to the bill (bill of entry, wharfage receipts etc.) should be checked.
Where the custom duty is paid directly, receipted bill of entry should be examined.. The
allocation of custom duly, L e., whether it is a revenue or a capital expenditure, should also be
verified.

Postage
The auditor should examine the system of internal control in operation relating

Auditing: Principles and Procedures

185

to incurrence ofthe postage expenditure. Casts ofthe postage book .together will the drawings
received from cash or petty cash book should be checked. Postal receipts should be checked
against the registered letters. Telegram receipts supported with a signed copy of the telegrams
sent should'be checked. For despatches through air, receipts issued by the airline companies
should be inspected. The despatch register should be scrutinised to ascertain that , the charge of
postage is allocatable to the business and personal element is not included. (If so, the recoveries
must be checked against those). If a franking roachine is kept, the amounts deposited should be
traced into the Post Office Franking Deposit Book.

Telephone Expenses
Bill and receipt received from the telephone department should be checked. The trunk call
bill should be traced into the trunk call register to ensure that official calls are charged off to
revenue and private calls are debited to advances .and recoveries made against those. The period
of the rent of telephone must be noted and proper allocation be made to prepaid expenses, if it is
relevant.

Bill Payable
A good internal control system requires that all bills paid should be cancelled immediately to
avoid the possibility of fraud. Vouching of these should be carried out by checking payments made in
respect of bills payable with the actual bills returned duly cancelled. Payee's acknowledgments
should also be examined, The relevant entries should be traced into the bills payable register to see
that only the bills outstanding had remained uncancelled.

BHt Receivable Dishonoured

The auditor should examine the dishonoured bills, if they have not since been met or retired.
The expenses of discounting a bill should be vouched with the bank statement and charged to the
discount account. Noting expenses should also be vouched with bank statement in eases where the
bills were presented through the bank or with the receipt from the Notary Public if got noted by
him.

Income Tax and Super Tax

Payments against advance tax (under the Income Tax Ordinance, 1979) should be checked
with the receipted challans. Their calculations should be verified. Admitted tax liability should be
vouched with the receipted challan and the copy of the income-tax return filed. Payment against
the final assessment (of the Income Tax Ordinance, 1984) should be verified with reference to
receipted challan, assessment order and notice of demand.

Partners Drawings
The auditor should go through the partnership deed to examine the

186

A uditing: Principles and Procedures

entitlement of drawings, the maximum amount which can be drawn and the provisions of interest
chargeable therein. The receipts of the partner should be inspected and the relevant entries in the
partner's drawings book be scrutinised.

The Memorandum and the Articles of Association of a company should be examined for
payment of directors' fees to the receipt of fee. The amount paid must be checked with the
attendance register {to ensure the attendance) and receipts of the payees. Under the Act,
remuneration to directors is required to be shown separately. Hence there should be a separate
head of account to which the amount paid may be debited. If a director has forgone this fee, the
auditor should examine the waiver's letter.

Miscellaneous Expenses
Vouchers, receipts, bills, correspondence should be examined to satisfactorily vouch the
payments which are not covered by the above discussion.
The casts, cross-casts and carry-forwards of the cash book must be checked and-postings
also be checked into the general ledger. Some of the postings should also be checked into the
subsidiary ledgers.

VOUCHING BY PETTY CASH BOOK

Petty cash book is usually kept on the imprest system (also called 'float' or 'revolving fund').
The auditor should ascertain that the system of petty cash is maintained on the imprest system
and note the amount of imprest should be consistent and in line with the requirements of the
company, although It should not necessarily be rigid. . . .
After examining the adequacy or otherwise of the system of internal check, the following
should be performed for vouching the petty cash book:

(1) Check the amounts drawn for petty cash with reference to the cash book or bank
statement;

(2) Check the casts, cross-casts and carry-forwards of the petty cash book. '
(3) Test check exhaustively the petty cash vouchers with the supporting evidence. The
extent of checking should be full if the system of internal control is loose.

(4) It should be seen that the petty cash book has been signed by cashier at the end ofthe
month.

(5) Posting should be checked into the general ledger.

(6) A surprise count of the cash kept with the petty cashier is also suggested. As at the
date of financial closing, the cash on hand must be physically

187

Vouching

(Tj (8)

counted.
Allocation of expenditure should be properly verified.
It should be seen that payment vouchers are properly' authorised.

VOUCHING OF PURCHASES BOOK

It is highly essential that an efficient system of internal check must be in force for the
placing of an order, receipt of goods, checking of invoices etc., in order to prevent the errors and
frauds and with a view to ensuring that liability is accounted for only in respect of such cases
where goods were actually received. The auditor should take the following steps to vouch the
purchases book:

Purchases Book
It should be vouched with the invoices, bills or credit memos. The vouched documentary
evidence should be cancelled by a rubber stamp or initials of the auditor so that it may not be
produced again in support of another entry.

Purchase Invoices
While checking the purchase invoices special attention should be given to the following
points:
(a) It is made out in the name of the client.
( The name of the creditor as given on the purchase invoice agrees with the
purchase book.
(c) The date of the purchase invoices falls, within the financial period under
audit.
(d) The goods mentioned in the invoice are of a nature in which the business is
carried on.
(e) The trade discount (if. any) is to be deducted and the net amount of the invoice
is entered in the purchases book.
i f ) Any private account passed through the purchases book should be charged to the
individual accounts.
(g) It has been properly initiated by those who had internally checked. Brief description of
the internal checking carried out by the client's staff should also be given either on the
back of the invoice or a separate sheet should be attached to it.

Allocation
The allocation of expenditure should be checked. Careful attention should be paid to ensure
that proper distinction is maintained between capital and revenue.

Receipt of Goods
Purchase invoices must be checked with such documentary evidence (goods receipt notes,
goods inward register etc.), as will ensure the receipt of the goods by the company. A test check
of these documents is also suggested with the store records maintained by the client.

Inspection Reports
If the nature of the goods purchased is such as requires inspection (chemical analysis etc.),
inspection reports by the responsible official should be checked to ensure that liability is being
recorded for the right type of goods purchased. The value of defective goods or goods of bad
quality not approved by the chemists should be kept in suspense. This amount should then be
adjusted after proper verification.

Tenders and Quotations

The purchase invoices should also be checked with the tenders or quotations and purchase
orders. Terms of purchases should be verified with the above documents.

Purchase Contracts
Generally, for bulk purchases contracts are executed which must be checked to verify the
accuracy of the basis on which the invoices have been prepared. It must be checked to see that
any concessions available in the contract are fully availed of.

Authorisation
All entries before being made in the purchases book must be properly authorised by a
responsible official. Any entry for which the invoices have not been authorised, proper
authorisations should be obtained. Where proper authorisations for purchase transactions have
not been made, matters should be reported to the client.

Statement of Accounts
If regular statements of accounts are being received from the creditors, a test check of the
amount of purchase invoices with the entries appearing in the statement of the accounts is also
suggested. .

Forward Contracts
Forward contracts entered into for the purchase of goods must be scrutinised and their
eventual settlement should be checked in the light of conditions laid down in the forward
contracts. If the commitments' under the forward contracts are of abnormal amount, a disclosure
by way of footnote on the face of the balance sheet may have to be made. If the contracts are of
abnormal amount and it appears that

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Auditing; Principles and Procedures

there is probability that in connection with such contracts due to fluctuations in the market prices
etc., provision must be made against such a loss.

Duplicate Invoices
While examining the invoices, if the auditor comes across the invoices marked "true copy
of invoice" or "duplicate invoice", he should satisfy himself that they were obtained in respect of
only those invoices which have actually been lost or mislaid to avoid the same being accounted
for twice in the books. For acquiring such satisfaction he will have to scrutinise the relevant
account of the creditor in the personal ledger and a general scrutiny of the invoices lying to the
credit of the respective creditor is required to be made.

Provisional Purchases Invoices

If any invoice is marked "provisional", the auditor should see that the relevant adjustments
are made through the final invoices and correct liability is reflected in the book.

Insufficiently vouched purchase Invoices

A list should be made of all invoices which are missing, or which are not available or which
remain insufficiently vouched for some reasons. It should be handed over to the management for
settling the objections raised. Queries should be cleared with the document produced. Any
queries which eventually remain uncleared should be reported to the management.

Casts and Postings

The casts-cross casts and carry forwards of the purchases book should be checked Postings
to general ledger and some of the postings to the sundry debtor ledger should also be checked.

Suppression of Purchases
In order to get a clue to the suppression of purchase invoices the purchases book should be
checked with the goods received during the last two or three weeks of the accounting period as
recorded in the goods inward book. The invoices for the first few weeks ofthe next period should
also be checked to ascertain whether any of them relate to the period under audit and should thus
have been accounted for in the period under audit. A further independent check in this connection
is to compare the percentage of gross profit earned on the cost of goods sold with that of previous
period and if such a rate of gross profit has material variations, the reasons therefor must be
inquired into. There is a likelihood that one of the reasons for -the material variation in the gross
profit ratio may be that goods were taken into stock but the corresponding invoices were not
entered in the purchases book.

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Auditing: Principles and Procedures

Inflation of Purchases
A similar work as mentioned in respect of suppression of purchases, if carried out, is likely to
uncover any deliberate attempt for inflation of purchases-Imports
In case of imports, supporting documents such as letter of credit, foreign invoices, exchange
conversion rates, shipping bills, bills of entries, clearing and forwarding bills, freight and octroi receipts,
banker's advice, bills of exchange etc., should be examined. Goods physically received against imports
should also be verified from the assets receiving reports. The following are some of the errors and
frauds likely to be found in connection with the purchases:

(1) Fictitious purchases may be entered in the purchases book.

(2) The same invoices may be recorded twice.
(3) Goods purchased and received in one day may be omitted in that period and entered
in the next period.
(4) Goods against purchases debited in one period may be received in the subsequent
period and recorded as purchases but excluded from stock.

VOUCHING OF SALES BOOK

The existence of a second internal check in respect of sales is highly essential. The following work
should be done by an auditor for vouching the sales book:

Execution of Sales Order

He should examine the system of the execution of sales order and be fully satisfied that a
permanent record of all the sales orders received is available for checking with the sales invoices.

Sales Book
It should be checked with carbon copy of the invoices, which should be cancelled by a rubber
stamp or initials by the auditor so that it may be produced again in support:of another entry.

Sales Invoices
While checking sales invoices special attention should be given to the following points:
()
()

It is made out in the name of debtor. It must be remembered that in the

case of a company there cannot be any sale by a company to itself.
The name of debtor as given on the sales invoice agrees with the sales
book.

191

Vouching

(c) The date of sales invoice falls within the financial period under audit.
(d) The trade, discount, if any, has been deducted and the net amount of the invoice is
entered in the sales book. Authority for the trade discount must be examined.

(e) It has been properly installed by those who had internally verified the basis of the sale

and checked it. Initials of those who do the necessary checking together with the brief
description of the work done should be given either on the back of the invoices or on a
separate sheet to be annexed thereto.

Allocation
The allocation of the sales should be checked, carefully noting that sales of non-trading
items-(sales of assete etc.) is not mixed up with the normal sales.

Despatch of Goods
Sales invoices must be. checked with such documentary evidence (goods despatched notes,
goods outward register etc.) as will ensure the despatch of the goods by the company. A test
check of these documents with the finished goods register maintained by the client is also
suggested.

Sole Contracts
If any sale contracts have been executed, the terms oh the basis of which sale invoices were
prepared must be verified with reference to them. In the absence of any sale contracts, an inquiry
must be made as to the selling policy of the management and the selling price mentioned in the
sale invoices should be verified with reference to such policy.

Authorisations
The sale invoices should properly be authorised before being entered into the sales book.

Statement of Accounts
If statements of accounts are being regularly received from the debtors or sent to them by
the client, a test check of the amount of sale invoices with the entries appearing in the statement
of the accounts should also be done.

Tenders and Quotations

The sale invoices should also be checked with tenders or quotations, if called by the client.

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Auditing: Principles and Procedures

Exports
In the case of exports of goods. Supporting documents such as sale invoices, exchange
conversion rates, shipping bills, clearing and forwarding bills, octroi and freight receipts,
banker's advices for the negotiation of documents must be examined. The terms of the invoice,
i.e., F.Q.R., F.O.B., C.I.F., etc., must be checked with the sale contracts or export orders received.

Forward Contracts
The forward contracts for the sale of goods must be inspected and their eventual settlement
should be verified. The question of a possible loss on the supply of goods involving future
commitment must be discussed and a provision made therefor. Only the goods actually delivered
should be treated as sales; because it is not desirable to take a credit in advance in connection
with the transaction which is in the nature of forward sales.

Provisional Sale Invoices

If any invoice is marked provisional, the auditor should see that the relevant adjustments are
made through the final sale invoices and incorporated in the books.

Insufficiently Vouched Sale Invoices

A list should be made for all sale invoices which are missing or which are not available or
they remain insufficiently vouched for some reasons. It should be handed over to the
management for clearing the queries. Those queries which remain uncleared should be reported
to the management.

Casts and Postings

The casts, cross-casts and the carry-forwards of the sale book should be checked. Postings
to general ledger and some of the postings to the sundry debtor ledger should also be checked.

Suppression of Sales
In order to get a clue to the suppression of sale invoices, the sales book should be checked
with goods sent out during the last two or three weeks of the accounting period as recorded in the
goods outward book. The sale invoices for the first few weeks of the next period should also be
checked to ascertain whether any of them relate to the period under audit and should thus have
been reflected in the period audited. A further independent check is to compare the percentage of
gross profit earned on the cost of goods sold with that of the previous period and if such a rate of
gross profit has material variations, the reasons therefor must be inquired into. There is a
likelihood that one of the reasons for the material variation in the gross profit ratio may be that
goods were sent out, but the corresponding invoices were not entered in the sales book.

193

Vouching

Inflation of Sales
A similar work as mentioned in respect of the suppression of sales, if carried out, will
uncover any deliberate attempt for inflation of sales.

Sale or Return Basis

The auditor should see that goods sent by the client on sale or return basis are not recorded
through the sales book, unless the sales have been confirmed by the person to whom goods were
sent on sale or return basis. However, if goods on sale or return are treated like ordinary credit
sales by being entered through the sales book, the auditor should see that proper adjusting entries
are made in respect of unsold goods lying with customers. He should further see that such goods
are taken as stock and valued at cost or market price whichever is the lower.

Sale on Consignment Basis

A separate account of the sales in respect of goods received on consignment basis must be
maintained. They should not be mixed up with the normal sale ofthe. business. Only the
commission on sale of goods received on consignment basis should be reflected in the books.

Heavy Sales
In the event of there being any heavy sales at the close of the period, the auditor should
satisfy himself that all these goods were delivered prior to the date of the financial close and that
none of those goods were included in the closing stock.
The following are some of the errors and frauds likely to be found in connection with the
sale:
(!) Goods sent on approval or V.P.P. but not yet accepted by the customer, or goods sent to
the agent for sale but not yet sold, may be treated as sale.

(2)
(3)
(4)
(5)

Sales of fixed assets may be recorded as sale of goods.

Next year's sale may be treated as this years sale.
Sales of consignment inwards may be entered as on sale.
Fictitious sale may be recorded.

VOUCHING OF PURCHASES RETURNS BOOK

The following steps should be carried out for vouching the purchases return book which is
intended for recording entries in respect of goods returned as damaged or not up to sample and
also relating to allowances claimed on account of shortage in weight, Over-charges etc.

Voudiing

194

Purchases Returns Book

It should be vouched with the debit notes issued to the creditors.

Debit Notes
While checking the debit notes, special attention should be given to the following points:
(a) It is made out in the name ofthe client.
(ft) The name of the creditor as given on the credit note agrees with the
purchases returns books, (c) The date of the debit note falls within the financial
period under audit.
id) It has been internally checked by some member of the staff or the client and it bears his
initials in token of internal checking.

Allocation
The credit to the revenue account should be given in the books of client to that head of
account which was previously debited.

Goods Sent out

The entries for the goods returned should be checked with the goods outward book or with
gate out passes.

Reason for Return

The general reason ( e .g., goods not in accordance with samples or of inferior quality, etc.)
for the debit note should be enquired into. Correspondence on the subject should be carefully
read. This should be done in the cases of exceptional nature or where the auditor feels doubtful
about the accuracy of entries.

Casts and Postings

Casts, cross-casts and carry-forwards of the purchases returns book should be checked. The
postings to -the general ledger and some of the postings in the creditors' ledger should also be
checked.

Manipulation
The entries in the purchases returns book for the early part of the next period should be
examined carefully. There is a possibility of manipulation of accounts by including the fictitious
purchases during the year under audit and showing them as returned after the end of the
accounting period.

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Auditing: Principles and Procedures

Statement of Accounts
A test check of amount in respect of debit notes sent to creditors into the statement of
accounts (if received regularly) should also be done.

VOUCHING OF SALES RETURNS BOOK

The following steps should be taken to vouch the sales returns book:

Sales Returns Book

It should be vouched with the credit notes issued to the debtors.

Credit Notes
While checking the credit notes issued, particular attention should be given to the following
points:
() It is made out in the name of the client.
(6) The name of the debtor as given on the credit note 'agrees with the sales returns book.
(c) The date of the credit note falls within the financial period under audit.
id)

It has been internally cheeked by some member of the staff of the client and it bears
his initials in token of internal checking.

Allocation
The debit to revenue account should be given in the books of clients to that head of account
which was.previously credited.

Goods for Return

The general reason for the debit note (e.g., goods not in accordance with samples or of
inferior quality etc.) should be enquired into. Correspondence on the subject should be carefully
read. This should be done in cases of exceptional nature or where the auditor feels doubtful about
the accuracy of entries.

Casts and Postings

Casts, cross-casts and . carry-for wards of the sales returns book should be checked. The
postings to the general ledger and some of the postings to the debtor's' ledger should also be
checked.

Manipulation
The entries in the sales returns book for the early part of the next period should he
examined carefully. There is a possibility of manipulation of accounts by

Auditing: Principles and Procedures

14fi

including the fictitious sales during the year under audit and showing them as returned after the
end of the accounting period.

Statement of Accounts
A test check of amount in respect of credit notes into the statement of accounts (if received
regularly) is also suggested.

VOUCHING OF BILLS RECEIVABLE BOOK

The casts and carry-forwards ofthe bills receivable book should be checked. Posting to the
ledger account and to the individual customed account in the subsidiary ledger should also be
traeed. If any bill has been disbursed, it should be seen that amount has been debited to the
respective customers. The proceeds of discounted and matured bills should be traced into the cash
book/bank book. If any bills have been sent to bank for collection,' 3 certificate should be directly
received and subsequent realisations noted. Any bills which become overdue must be scrutinised
and fully discussed with the management. A note should be 'taken to show the amount of
contingent liability in respect of bills- not matured but are under discount as at the date of the
balance sheet. Bills on hand should be physically checked and the balance on the bills receivable
account in the general ledger should agree with the total of the bills not matured on hand.

VOUCHING OF BILLS PAYABLE BOOK

Casts, carry-forwards and postings ofthe bills payable book should be checked. Bills paid
during the year should be vouched with the cash book and the returned bills. The auditor should
see that the total of the bills not matured, as shown by the bills payable book, is in agreement with
the credit balance on the bills payable account in the ledger.

VOUCHING OF JOURNAL
.. Where in a concern there is ai network of several books of original entr ies, the journal is
principally used for recprding opening, closing and adjusting entries and also those transactions
as could not be recorded in any other book of original entry. The evidence to vouch the entries
would be in the form of voucher's", correspondence, contracts, minutes etc. The several classes of
journal entries would be vouched as follows."

Opening Entries
These should be checked with reference to previous year's audit working papers
or audited balance sheet.
.

197

Vouching

Closing Entries
These should be checked with reference to the audited closing balances ofthe general
ledger.

Transfer Entries
Authority should be seen for the transfer from one ledger account to another ledger account.
The auditor must see that direct transfer from one account to another is not made.

Rectification Entries
The details of actual mistakes should be scrutinised and transactions must be thoroughly
checked with reference to the available evidence. The necessary entries must be authorised by a
responsible official.

Adjusting Entries
The auditor should see that all outstanding liabilities in respect of expenses relating to the
period under audit; income received in advance .and income earned and not received are duly
made. Adjustments in respect Of expenses prepaid should also be closely scrutinised.

Transactions for which there is no other book of original entry

Reference must be made to correspondence, minutes of board/ shareholders and other
relevant documentary evidence to vouch the tr ansaction for which there is no other book of
original, entry e.g., bad debts, bills receivable dishonoured, acquisition of different assets or
liabilities taken over from the vendors.
The. auditor should also cheek the casts of the journal vouchers and journal entries and then
the postings to the respective ledger accounts should be checked.

AUDIT OF PURCHASES LEDGER

After the books of original entries have been vouched and postings therefrom fully
checked, the following further steps should be taken in connection with the audit of the purchases
ledger which is also called sundry creditors' ledger or accounts payable ledger:

Casts
The casts and carry-forwards of the purchases ledger should be checked.
List

of Balances
The list of closing balances of creditors should be checked with the purchases

14fi

Auditing: Principles and Procedures

ledger and the control account of the above ledger in the general ledger should be tallied with the
total of the list of balances. The casts of the schedule of creditors should also be checked.

Confirmations
The purchases ledger balances should be compared with the corifirmation or statement of
accounts received. Any differences must be sorted out and reconciled.

Old Balances
The amounts, which remained unclaimed for a long time, should be noted and those which
do not represent payable, should be suggested for write-off.'

Dispute Cases
If certain amounts due to the creditors are in dispute, it should be seen that they me shown
ae contingent liability and are adequately provided for in the accounts.

Debit Balance
In the case of debit balances on any of the accounts, the auditor must satisfy himself that
they are really recoverable.

Scrutiny
Scrutiny should be made to make sure that no item is left unticked on any of the ledger
accounts (except for the month for which no posting has been checked by the auditoi').

AUDIT OF SALES LEDGER

Sales ledger is also called sundry debtors' ledger or accounts receivable ledger. After the
books of original entries have been vouched and posting checked, similar work as explained
under the 'Audit of Purchases Ledgeis' should be carried out for the audit of the sales ledger;
Further, the list of debtors must be thoroughly scretinised. Any legally time-haired debts must be
written off. Steps should be taken to ensure that adequate and proper provision for doubtful
accounts. This matter is elaborately explained in the chapter on 'Verification'.

AUDIT OF GENERAL LEDGER

: After the postings into general ledger have been checked, the following work should be done
to audit the general ledger:

Auditing: Principles and Procedures

199

Casts
Casts and carry-forwards of the accounts of the general ledger should be checked.

Scrutiny
The general ledger should be scrutinised to ensure that no entry remains unticked. This
would assist in uncovering the cases of entries which did not exist in any ofthe books of original
entries.

Trial Balance
The closing balances of the general ledger must be checked with the trial balance.

AUDIT OF BANK STATEMENTS

The bank column of the cash book should be checked with the bank statements or bank
pass book according to the following procedure:

Debit Side of Cash Book

The amounts shown as deposits into the bank should be checked with the credit side of the
bank statement; The date entries in both the above records should be compared and it should be
noted that they do not materially differ from each other. For" outstanding lodgements, the
conesponding entries which do not appear - in the bank statement, pay-in-slips should be
examined to ensure that the amounts were in fact deposited into the bank.

Credit Side of Cash Book

All entries in respect of payment by cheques, dishonoured cheques relating to bank
collections, interest and bank charges, or any other amount charged by the bank should be
checked with the debit side of the bank statement.

Casts
A test check of casts, cross-casts and carry-forwards of bank statements is also suggested.

Bank Reconciliation
The bank reconciliation statement should be checked as under:
( a ) Bank balance as at closing date should be verified from the bank certificate directly

received from the clients' banker.

(ft) Amounts deposited but not credited by the bank should be verified from

200

Auditing; Principles anil Procedures

the pay-in-slips and with the subsequent realisations noted in the bank statements of
subsequent period. Entry,by debit to the respective debtor and credit to the hank
account should be made relating to those cases of dishonoured cheques which were
returned with the remarks of. 'insufficient funds' or 'refer to drawer' etc.
(c) Subsequent clearance of all cheques issued but not presented for payment as at
the closing date should be traced into the bank statement of subsequent period. '
(d) The closing balance in respect of cash book shown on the bank reconciliation
statement should be checked with the closing balance indicated on the cash book.

201

Vouching

Appendix 4.1

Factors Influencing Compliance Test Sample Size

-----------------__.------------------------._____________---------,----:-----------------------------------------------1------Factor

Conditions Leading to
Smaller Sample Size

'
iHarmed reliance on
' internal control (1)
i
Allowable rate of deviation
(tolerable error)

Allowable risk of over

reliance
Likely rate of population
deviation (2)
Number of items in
population small

Larger Sample Size

Lower reliance on internal

control

Higher reliance on internal

control

Higher acceptable rate of

deviation for planned reliance
on internal control

Lower acceptable rate of

deviation for planned reliance
on internal control

Higher risk of over reliance on

internal control

Lower risk of over reliance on

internal control

Lower expected rate

deviation in population

Higher expected rate

deviation in population

of

of

Virtually no effect on sample size unless population is

(1) Compliance tests are not performed when no reliance on internal controls is planned.
(2) Larger samples are necessary when deviation occur", in order to obtain more precise
conclusions. However, high deviation rates normally warrant little, if any, reliance on
internal controls and, therefore, compliance testing might be omitted.

Appendix 4.2

Factors Influencing Substantive Test Sample Size

Factor

Conditions Leading to
Smaller Sample Size

Larger Sample Size

Reliance on internal
control

Higher reliance on internal

control

Lower reliance on internal

control

Reliance on other substantive tests related to

same audit objective and
class of transactions

Higher reliance to be placed

on other substantive tests

Lower or no reliance to be
placed on other substantive
tests

Measure of tolerable error

for a specific audit objective

Larger measure of tolerable

error

Expected size and fr equency of errors

Smaller errors
frequency

Population value

Smaller monetary signi- Larger monetary significance to . the

financial ficance to the financial
information
information

Number of items in
population

Virtually no effect on sample size unless population is small

Overall
required

Lower over'all assurance

assurance

Stratification

or

Smaller measure of tolerable

error
..

lower
Larger errors
frequency

or

higher

Higher overall assurance

Stratification of the popu- No stratification of the lation, if

appropriate population

203

Auditing: Principles and Procedures

Appendix 4.3

Compliance Test and Substantive Test Risk Matrix

Compliance Test Risk Matrix

Relevant Internal Control is in fact:
Compliance test indicates
reliance on relevant internal
control should be:
Accepted
Rejected

Adequate for
Planned Reliance

Correct
Decision
Risk of
Under Reliance

Inadequate for
Planned Reliance

Risk of
Over Reliance
Correct
Decision

Substantive Test Risk Matrix

Relevant Account Balance is in fact:
Evidence indicates relevant
account balance should be:
Accepted

Rejected

Correct
Decision
Risk of
Incorrect
Rejection

Fairly Stated
Risk of
Incorrect
Acceptance
Correct
Decision

Nor Fairly Stated

4
Of

VERIFICATION
GENERAL

NEED FOR VERIFICATION

The process for vouching enables an auditor to confirm the acquisition of an asset or the
assumption of a liability on a stated date. After such a work has been done the value of such
items may have decreased, their ownership may have changed or they may have ceased to exist.
It is, therefore, essential to substantiate the items at the date of the balance sheet by various
means such as inspection, obtaining of certificates from the responsible officials or by such
documentaiy evidence as is necessaiy in the given set of cuxumstances.
Sub-section (3) of Section 255 of the Ordinance requires an auditor to submit his report to
the shareholders specifically mentioning whether or not the balance sheet exhibits a true and fair
view of the state of company affairs according to the best of his information and the explanation
given to him and as shown in the books of the company. Moreover, the auditor is required to
discharge his duties after due verification.
In order to discharge the above legal duties imposed on the auditor of a company it is
imperative that such work should be carried out as would enable him to submit his report
addressed to the shareholders to his entire satisfaction. This process is known as 'verification'.

SIX-POINT TECHNIQUE FOR VERIFICATION

In our modest contention the technique of verification revolves round the
following six points:

(1) Satisfaction as to the existence of an asset or liability;

(2) Ensuring that the assets and liabilities are correctly valued;
(3) Ascertaining whether the question of ownership ' is valid and true in respect of
an asset or liability;

(4) Satisfaction in respect of the fact that each item of asset and liability is

205

A uditing: Principles and Procedures

being properly disclosed as legally required under the Act;

(5) Finding out whether any of the assets of the company is suffering from a
charge or not an a disclosure to that effect;
(6) Seeing that there is a proper authorisation for any acquisition, or disposal or
any other form of movement in respect of assets and liabilities, as laid down in the
memorandum and articles of association of the company.
The above six points are discussed below:

Physical Existence
In order to. satisfy himself in respect of the physical existence of an item appearing in the
balance sheet of the company, an auditor generally will have to use two techniques. Firstly, a
stress is given on physical veiification of the- item by actual count, weighing or measurement.
Secondly, where the first step to be followed in ascertaining the physical existence of an asset is
impracticable or not feasible, reference must be made to such documentary evidence and
certified inventories duly signed by a responsible official of the company so as to enable the
auditor to- acquire a satisfaction as to the physical existence of the item stated in the balance
sheet. For example, for the physical existence of the cash in hand, cash must be counted by the
auditor as on the date of the balance sheet. What was held in London Oil Storage Co. Limited vs.
Seear Hashluek and Co. (1904) is as under:
"It cannot be disputed that where # an auditor returns to the shareholder an entry for
cash in hand he must have taken reasonable steps to ascertain that the cash was in
hand. He has the same duty to discharge in regard to the veiification of cash as he has
with regard to the verification of securities."
The physical existence of a bank balance is to be verified with reference to a certificate
obtained directly from the clients' banker. In accordance with generally accepted auditing tests to
be applied for verification, the auditor must obtain a certificate for the closing balance of the cash
at hand directly from the clients' banker.
Investments held must be physically examined. If they are kept with the clients' banker, a
certificate should directly be obtained confrrming that they were held by them, indicating the
purpose of their being held, ie., whether held for safe custody or as a cover against any credit
facilities sanctioned by the banker to his client. It was held in the case of City Equitable Eire
Insurance Co. Ltd. (1924):
. "That it is the duty of a company's auditor, in general, to satisfy himself that the
securities of a company in fact exist and are in safe custody cannot, I think, be
gainsaid."
The question in respect of the checking of the physical existence of the stocks, has a divided
opinion. One school of thought still believes in the Kingston Cotton Mills case wherein it was
held that it was no part of the auditors' duty to take stock.

Auditing; Principles and Procedures

206

However, the decision in the case of Mckesson and Bobbins in 1939 has changed the present
position and auditors' outlook. The present practice in regard to stocktaking has been given in
"Audit by Certified Accountants" published by American Institute of Accountants in 1950 as
under:
"The C.P.A. (Certified Public Accountant known as Chartered Accountant in our
country), is required by generally accepted auditing practice to be present at the
inventory-taking to observe the effectiveness of the counting procedures when it is
practicable and reasonable to do so and the amount ofthe inventoiy is significant."
In view of the above cited case-law, emphasis is being- laid on the physical taking of the
stocks by an auditor, because this fact now constitutes as a recognised auditing technique. In
practice, it may, in several instances, be impracticable to physically count the items of plant and
machinery, furniture and fixture etc. For getting satisfaction as to the physical existence of the
fixed assets (some of the examples of which are cited above) a certified inventoiy by a
responsible official of the company must be obtained. Similarly in order to ascertain whether a
liability exists physically or not recourse must be made to relevant documentary evidence.

Correct Valuation
In the Kingston Cotton Mills case it was held that an auditor is not a valuer. This case is
now considered as a bad law. It is the duty of an auditor to check the valuation of the assets as far
as possible with reference to any* evidence which may be available. In doing so where technical
knowledge is involved he is entitled to rely upon the information supplied to him by the skilled
and technical persons who may be expected to possess such knowledge. The auditor must apply
all possible tests to obtain satisfaction that the assets have been valued upon the generally
accepted accounting principles and in accordance with the legal provisions contained in the Form
F annexed to the Third Schedule of the Act and other provisions contained therein.
The basis on which the assets of a business are valued for balance sheet purposes, largely
depends upon the nature of the business and the objects for which these assets are held.
Consequently, different methods of valuation are employed for fixed and current assets a brief
discussion of which is given here:
(a) Fixed Assets. These are assets which are acquired for earning income and not for resale.
As a guiding general rule, they are valued at what is generally known as 'a going concern' or
'conventional' or 'token' value which Is the cost less" reasonable depreciation. In Pakistan fixed
assets are' valued at cost less depreciation. In valuing fixed assets, their market and break-up
value is totally ignored for the reasons indicated below:'.
(i) The market value of the fixed assets does not in any way affect their earning power;

207

Verification General

(ii) It does not affect the proprietor with the exception of those cases where a fixed asset
becomes worn-out and has to be replaced; and
(i i t i The ascertainment of the realisable values of used fixed assets is impracticable except
when they are actually placed on the market for sale.
Due to the continued rise in price levels, the method of determining the profit on the basis
of above principle of valuation has become controversial. It is generally argued that, at first, the
replacement value of the fixed assets be arrived at and then depreciation on that amount be
charged off to profit arid loss account. The method by which depreciation may be provided on
the basis of replacement costs is explained. The fixed assets are written up in the books to their
current replacement values. The appreciation disclosed by such revaluation is to be credited to
the capital reserve account. Thus the future annual charge for depreciation will be computed on a
basis which would write off the appreciated values over the remaining lives of the assets.
However, if it is not desired to write up the assets to their replacement value in the* books, the
annual provision for depreciation in excess of the amount computed on the basis of original cost
of the assets should be credited to a replacement reserve account.

(b) Current Assets. Current Assets are those assets in which the business deals and which are

required for the purpose of sale and their subsequent conversion into cash, e.g., stocks, book
debts, bank balances, cash on hand etc. The following points must be considered in respect of
valuing the current assets:

(i) The valuation must be done at cost or market price whichever is lower;
(ii) The principles of valuation adopted in one year must be consistently adopted in the
subsequent year's;
(Hi ) Any depreciation (decrease in the value of the current assets as at the date ofthe
balance sheet) must be provided for.
The current assets are, as a general rule, valued at cost or market price whichever is less at
the date of balance sheet. However, a temporary fall in the market prices in the value of the
current assets is generally ignored. In valuing current assets, an anticipated loss should be taken
into account, but an expected profit is to be disregarded. It would be wrong to anticipate a profit
which would never be realised.

(c) Wasting Assets. Wasting assets are those assets of a fixed nature which are gradually
consumed or exhausted in the process of earning ineome, e.g., a quarry, a mine etc. Frem a
general point of view it may be said that in order to replace the exhausted capital out of the
revenue, it is necessary to reduce the book value of the wasting assets to the extent of the
estimated amount hy which it has diminished in value.

Ownership
The verification of the ownership of the assets and the liabilities is a

Auditing; Principles and Procedures

208

fundamental aspect to which the auditor should devote his inquisitive attention. If a
certain value is associated in respect of an asset which is shown on the balance sheet, the auditor
must satisfy himself that the ownership in respect of that asset is vested in his client, The
techniques enabling the auditor to acquire a satisfaction on this point will differ depending upon
the nature of an asset or liability. For example, ownership ofthe investments is to be verified either
by physically seeing the name of the client on the share certificates etc. or physically examining
by the auditor or by seeing a confirmatory certificate directly obtained from the banker
mentioning that the securities held by the banker on behalf ofthe client, were held in the name of
the client. The ownership of a bank balance in the name of a client will be verified by reference to
the bank confirmation directly obtained from the client's banker-, clearly indicating that the bank
balance was held in the name of the client. Similarly, the amounts owned in respect of the
liabilities are required to be confirmed with the help of confirmation obtained from the creditors. It
was observed in the case of Irish, Woollen Co. vs. Tyson and others (10) that had the auditor
sent for the statements of account from the creditors, the manipulation and falsification resorted to
would have been disclosed. The judicial pronouncement has lent a backing support to the
circularisation of accounts which is being generally employed as a generally accepted auditing
technique. The ownership of the motorcar is to be checked with the registration book seeing that
the name of the client is stated' as the owner. Title deeds vesting the property in the name of the
client must be physically examined, to vouch that fact or alternatively a certificate from the
company's solicitor should be obtained which should clearly mention that the ownership ofthe
property is vested in the name ofthe client.
It would thus appeal- from the above discussion that the technique to be adopted by the
auditor in getting the satisfaction in respect of the ownership will differ depending upon the nature
ofthe asset or liability.

Correct disclosure
Satisfaction on this point involves .on the part of the auditor to verify whether the
information which is required by law has -in fact been given in the balance sheet on which the
auditor is submitting his report. In this respect the legal requirements are summarised here:
Co) Disclosure requirements govermng listed companies are contained in the Fourth
Schedule annexed to the Oidinance.
(b ) Disclosure requirement governing non-listed companies are contained in the Fifth
Schedule annexed to the Ordinance. .
(e) IAS 5 contains disclosure requirements governing financial statements.

Assets suffering from a charge

The ownership of an asset is of two types. Firstly, an absolute ownership which ' vests a
clean title in the name ofthe client in respect of a particular asset. Secondly,

209

A uditing: Principles and Procedures

an ownership suffering from a charge in respect of the assets of a company. Some of the type of
charges are Mortgage, Hypothecation, Pledge, Lien, Pawn and Assignment.
The duty of an auditor, in our opinion, in this respect is two-fold. Firstly, he should adopt
such ways and means whereby he ascertains whether an asset of the company is suffering from a
charge or not. The following steps should enable an auditor to find out whether an asst is
suffering from a charge or not:
(a) He must obtain a certificate from the management to the effect that the assets shown in
the balance sheet are free from any such encumbrances, the details of the same must
be obtained.
If any loan has been obtained from a bank or other financing institution, the auditor
should enquire as to the nature of the charge established against the fixed assets or
current assets of the company. In this respect he must obtain the details and the nature
of the charge from the financing institution or the bank which has extended the credit
facilities.
He must carefully, examine the object of holding, any securities from the
confirmations directly obtained from the bankers holding the securities. If the object
of holding the securities is not stated, a further enquiry from the concerned party must
be made so that it becomes-manifestly clear- whether the securities held were for safe
Custody or as a cover against the credit facilities enjoyed by the client.
The register of mortgages and charges as required to be maintained under Section 125
of the Ordinance must be carefully scrutinised. Information in respect of the facilities
granted relating to loans, overdrafts or cash credits, stating the .limit authorised and
the nature of charge, e.g., pledge, hypothecation etc., must be directly obtained by the
auditors from the client's banker. The auditor should also directly obtain from the
banker information in respect of all investments, bills of exchange or other documents
of title held, specifying whether those were held for safe custody or as security.
The second aspect of the auditor's duty in this respect is to see whether an asset of the
company is suffering from a charge; the nature of the charge must be indicated in the balance
sheet. However, if the management does not agree to mention the nature ofthe charge in the
balance sheet, he must qualify his report to the shareholders.
The auditor should give his special attention to the legal provision for the registration of
mortgages and charges created by the company. These are explained as follows:

Company's Register of Mortgages

Under Section 125 eveiy company is required to keep a register of mortgages

16)

Auditing: Principles and Procedures

and enter in it all charges specifically affecting the property of the company.and all floating
charges on its undertaking, giving in each case a short description ofthe property charged, the
amount of the charge and, except in the case of securities tc bearer, the names of the persons
entitled thereto. The non-registration of charge in the companies' own registers of mortgages will
not affect the validity of the charge, but there is a penalty of rupees five hundred on every
director or other officer ofthe company who is knowingly in default.

Registration with Registrar

Section 121 requires that the following mortgages and charges created by a company must
be registered with the Registrar:
()

a mortgage or charge for the purpose of securing any issue of debentures;

or

() a mortgage or charge on any uncalled share capital ofthe company; or

(e) a mortgage or charge on any immovable property wherever situate, or any interest
therein; or
(d ) . a mortgage or charge on any book debts of the company; or
(e) a mortgage or charge, not being a pledge, on any movable property of the
company; or
(f) a floating charge on the undertaking or property of the company, including
stock-in-trade; or

(e) a mortgage or charge on a ship or any share in a ship; or

(g) a mortgage or charge on goodwill, on a patent or licence under a patent, on a
trademark, or on a copyright or a licence under a copyright; or
(i) a mortgage or charge or other interest based on agreement for the issue of
any instrument in the nature of redeemable capital; or
(/) - a mortgage or charge or other interest based on a musharika agreement; or
(k ) a mortgage or charge or other interest based on a fiit-e-purchase or basing agreement
for acquisition of fixed assets.
The prescribed particulars of the mortgage or charge along with the instrument by which it
is created or its certified copy are required to be filed with the Registrar for registration within
twenty-one days after the creation of the charge.
The. nature of charges established against the property and assets of the companies and
their characteristics are discussed below:

Fixed Charges
This, is established on the definite property and prevents the borrower, from dealing with
that property without the consent of the holder of the charge.

211

Verification General

Floating Charges
This represents a charge on changing property and is often expressed to be a charge on
'undertaking' of the company. It is a charge on a class of present and future assets. The class of
assets is one which, in the ordinary course of business, is changing from time to time. Until some
steps are taken to enforce the charge, it is contemplated, that the company will continue to deal
with assets charged in the ordinary course of its business.

Mortgage
The mortgager retains possession ofthe property. The mortgage is given the light, in case of
non-payment of the mortgaged money, to have the property sold through the court and realise his
dues from the sale-proceeds. The mortgager undertakes that if the sale, proceeds of the property
are insufficient to repay the money due, he will remain personally responsible for the payment of
the debt.

Pledge
It is a bailment of goods as security for the payment of a debt. It can be made of moveable
property alone. The borrower must be in possession of the moveable property under a legal light.
If the borrower makes default in payment of the debt, the lender may sell the property pledged by
giving the borrower reasonable notice of the sale.

Hypothecation
It is charged without possession created on moveable property in favour ofthe lender as a
security. The possession of goods remains with the borrower.

Proper Authorisation
The auditoi' must acquaint himself with thy relevant clauses affecting the auditor as laid
down in the memorandum and articles of association. The foregoing constitution of the company
will generally specify that a resolution by shareholders or directors is required to be passed
before any transaction is properly authorised in its final shape. The auditor must examine and see
the documentaiy evidence which establishes a proper authorisation for complete verification of
the entries made in the books of account. The auditors generally require minutes of the board of
the directors for any additions to. or deletions from the fixed assets, acquisition of the
investments and their subsequent disposals etc.

VERIFICATION OF ASSETS
NOT IN POSSESSION OF
CLIENT
Sometimes it happens that certain assets or the documents of title thereto are not in the
possession of client. Consequently they cannot be produced to the auditoi'

16)

Auditing: Principles and Procedures

for verification. In such cases the auditor has to decide whether he will accept a certificate from
the person holding the assets in question which were held at the date of the balance sheet on
behalf of the client or whether he should call upon the person concerned and actually inspect the
documents.
The chief items in respect of which an auditor has recourse to client's banker for
verification are as follows:

(1)
(2)
(3)
(4)
(5)

Balances of Accounts held at the date of balance sheet favouring client.

Bills under discount and not matured.
Bills held by bankers for collection.
Title deeds, securities, investments, bill of exchange or other documents of title held by
the client's banker, specifying whether held for safe custody or as security.
Balances in respect of loans, overdrafts or cash credits, stating the limits authorised and
the nature of the charge, e.g. , pledge, hypothecation etc.

The necessary certificates should be obtained directly by the auditors. The chief certificates
normally obtained by auditors in support of the items appearing in a balance sheet of a company
are as under:

(1) From Officials

(a) Certified inventory of plant and machinery.
(b) Certified stock sheets. (a) Certified lists of bad or doubtful debts and certificate as to the provision
considered adequate.

(c) Certificate that all outstanding liabilities have been brought in.
(2) From third parties
(a) Bankers, as to balance of accountisJ, or overdraft(s) and details of securities held as
cover.
(a) Agents, for any cash balances held.
(c) Bankers, for title deeds or securities held for safe custody,
(a*) Mortgages, for title deeds, etc.
The question whether an auditor was justified in accepting a certificate fion^a third party that
he held assets belonging to the client came before the Courts in In. re: City Equitable Fire
Insurance Co. Ltd (1924). Certain securities belonging to-the company had been certified as being
held by their stockbrokers on its behalf, whereas in fact the stockbrokers had pledged such
securities to their own customers. In considering whether or not the auditors were guilty of
negligence iri relying on the certificate from the stockbrokers that they held the securities on
behalf of th -City Equitable Fire Insurance Co. Ltd., the following points were observed by the
judges:

Verification General

. (1) Banks in the ordinary course hold certificates or securities on behalf of their customers
and an auditor may in good faith accept the certificate of a reputable bank that it holds
such securities. The mere fact that the certificate is given by a bank is not conclusive
and the auditor must satisfy himself that it is in fact a reputable and tiTistworthy
institution.
(2) Securities may from time to time in the ordinary course of business be placed in the
hands of stockbrokers for the purpose of dealing with them in the course of their
business, and as long as the securities are in the hands of a respectable, trustworthy
and responsible person, the auditor can accept his certificate.
(3) An auditor "must take a certificate from a person who is in the habit of dealing with
and holding securities, and whom he, on reasonable grounds, rightly believes to be,
with exercise of his best judgment, a trustworthy person to give such a certificate."
Prescribed form for obtaining information requires nine types of information to be collected
from a bank. These are listed below:

1.
2.
3.
4.
5.
6.
7.
8.

Bank Accounts title and details.

Details of closure of all accounts.

Amount accrued but not changed or credited at the closing dates.
Interest charge, if not specified separately in the customer's statement of account.
Particular's of written acknowledgement of set off.
Details of credit facilities.
Details of security.
Contingent liabilities.
9. List of other banks, or branches with which relationship was established.
The prescribed format is given below:
The Manager

Dear Sir,
Standard Request for Batik Report for Audit Purposes

In accordance with your above-named customer's instructions given hereon, please send
direct to us at the above address, as auditors of your customer, the

213

214

Auditing: Principles and Procedures

following information relating to their affairs at your .branch as at the close of

business on.........................and, in the case of items-2, 4 and 9, during the period since
Please state against each item any factors which may limit the completeness of your reply;
if there is nothing to report, state none.
It is understood that any replies given are in strict confidence, for the purposes of audit.

Bank Accounts

1.

Full titles of all accounts together with the account numbers and balances thereon,
including nil balances:
() where your customer's name is the sole name in the title;
() where your customer's name is joined with that of other parties;
(cj where the account is in a trade name.

Notes:(i) Where the amount is subject to any restriction (e.g. a garnishee order or arrestment}
or exchange control considerations (e.g. 'blocked account') this information should be
stated. (i i ) Where the authority upon which you are providing this information does
not cover any amounts held jointly with other parties, please refer to your customer in
order to obtain the requisite authority of the other parties.

2.
3.

Full title and dates of closure of all accounts closed during the period.
The separate amounts accrued but not charged or credited as at the above date, of

(a) Interest and

(b) Provisional charges (including commitment fees).
4.

The amount of interest charge during the period if not specified separately in the
customer'- statement of account.

5.

Particulars (i.e. date, type of document and accounts covered) of any written
acknowledgement of set-off, either' by specific letter' of set-off, or incorporated in
some other document or security.
Details of loans, overdrafts, cash credits and facilities, specifying agreed limits and in
the case of term loans, date for repayment or review.

6.
7.

(a) Security. Please give:

(i) details of any security formally charged to the bank, including the date and type
(ii)

of charge (e.g., pledge, hypothecation etc.);

particulars of any undertaking to assign to the bank any assets. If a security is
limited to any boirowing, or if there is a prior, equal or subordinate charge,
please indicate.

215

Verification General

Investments, bills of exchange, documents of title or other assets held but not
charged. Please give details.
. ..

Contingent Liabilities
8.

All contingent liabilities, viz.,

(a) Total of bills discounted for your customer, with recourse;

(b) Details of any guarantees, bonds or indemnities given to you the customer in
favour of third parties;

(c) Details of any guarantees, bonds or indemnities given by you, on your customer's

behalf, stating where there is recourse to your customer and/or to its holding,
parent or any other company within the group;
(d) Total of acceptances;
(e) Total of forward exchange contracts;
(j ) Total of outstanding Uabilities under aceumentary credits;
(g) Others please given details.
9.- A list of other banks, or branches of your bank, where you are aware that
a relationship has been established during the period.
Yours faithfully,
XYZ
Disclosure authorised
For and on behalf of
(Customers Name) Signed in accordance
with the terms and conditions of the conduct
of the customer's bank account
IAS 10 is in respect of Contingencies and Events Occurring after the Balance Sheet Date.
Paras 27 to 29 deal with contingencies and are reproduced below:
"27. The amount of a contingent loss should be accrued by a charge in the income
statement if:

(a)

it is probable that future events will confirm that, .after taking into
account any related probable recovery, an asset has been impaired or a liability
incurred at the balance sheet date, and
(b)
a reasonable estimate of the amount of the resulting loss can be made.
28. The existence of a contingent loss should be disclosed in the financial statements if
either of the Conditions in paragraph 27 is not met, unless the possibility of a loss is
remote.

Auditing: Principles and Procedures

216

29. Contingent gains should not ; be accrued in financial statements. The existence of
contingent gains should be disclosed if it is probable that the gain will be realised."
Paras 30 to 34 deal with events occurring after the balance sheet data and are reproduced
below:
"30. Assets and liabilities should be adjusted for events occurring after the balance sheet
date, that. provide additional evidence to assist with.the estimation of amounts relating
to conditions existing at the balance sheet date or that indicate that the going concern
assumptions in relation to the whole or a part of the enterprise is not appropriate,

31. Dividends stated to be in respect of the period covered by the financial statements and
32.

33.

34.

that are proposed or declared after the balance sheet date but before approval of the
financial statements should be either adjusted for or disclosed.
Assets and liabilities should not. be adjusted for, but disclosure should be made of,
those events occurring after the balance-sheet date that do not affect the condition of
assets or liabilities at the balance sheet date, but are of such importance that nondisclosure would affect the ability of the users of the financial statements to make
proper evaluations and decisions.
If disclosure of contingencies is required by paragraph 28 or 29 of this statement, the
following information should be provided:
(o) the nature of the contingency, .
(6) the uncertain factors, that may affect the future outcome,
(c) an estimate, of the financial effect, or a statement that such an estimate cannot be
made.
If disclosure of events occurring after the balance sheet date is required by paragraph
32 of this statement, the following information should be provided:
(a) the nature of the event.
( an estimate of the financial effect, or a statement that such an estimate cannot be
made.

RELATED PARTIES
ISA 17 is entitled "Belated Parties". This contains definitions such as Related Party, Related
Party Transaction, Significant Influence. There is a lucid discussion in respect of existence, of
related parties, transactions with related parties, examination of identified related party
transactions and audit conclusions and reporting.

Verification ~ General

217

Related portions in. respect ofthe above aspects are reproduced below: Definitions
The following definitions are given in paragraph 4 of IAS 24, "Related Party Disclosures":
"Related party parties are considered to be related if one party has the ability to
control the other party or exercise significant influence over the other party in making
financial and operating decisions.
Related party transaction a transfer of resources or obligations between related
uarties, regardless of whether a price is charged.
Control ~ ownership, directly or indirectly through subsidiaries, of more than one half
of the voting power of an enterprise, or a substantial interest in voting power and the
power to direct, by statute or agreement, the financial and operating policies ofthe
management ofthe enterprise.
Significant influence participation in the financial and operating policy decisions of
an enterprise, but not control of those policies. Sigriificant influence may be exercised
in several ways, usually by representation on the board of directors but also by, for
example, participation in the policy making process; material intercompany
transactions, interchange of managerial personnel or dependency on technical
information. Sigruficant influence may be gained by share ownership, statute or
agreement. With share ownership, significant influence is presumed in accordance
with the definition contained in International Accounting Standard 3, Consolidated
Financial Statements."
In addition, paragraph 5 of IAS 24 sets out the related party relationships covered by the
Standard and paragraph 6 the circumstances where parties are deemed not to be related.

Existence of Related Parties

When gaining an appropriate level of knowledge of the entity's business the auditor also
obtains an understanding of the means by which management fulfills its responsibilities regarding
the financial information, control environment and the entity's accounting system. While these
procedures may help identify, the existence of certain related, parties, such as parent/subsidiary
relationships, specific audit procedures will be required to obtain reasonable assurance that no
other related parties exist by virtue of control or significant influence. Such procedures may
include one or more ofthe foUowing:
1. Inquiry of management as to the names of all related parties.
2-. Inquiry as to the affiliation of directors and officers with other entities.
3. Review of stockholder records to determine the names of principal stockholders or, if
appropriate, obtaining a listing of principal stockholders

Auditing: Principles and Procedures

218

from the stock registrar. 4. Review of minutes of the meetings of stockholders and board of
directors. . 5. Review of the prior year working papers for names of known related parties.

6.

Inquiry of other auditors currently involved in the audit, or predecessor auditors, as to

their knowledge of additional related parties.

7.

Review of the entity's income tax returns.

Transactions with Related Parties

The names of identified related parties should be provided to the audit personnel involved
in the audit of the entity and its components so that they will be alerted to recognise transactions
with such parties if they are encountered during the audit.
When performing a review and preliminary evaluation of the accounting system and related
internal controls on which he intends to rely, the auditor should consider whether adequate
procedures and controls exist over the authorisation and recording of related party transactions. If
such procedures and controls exist and the auditor intends to rely on them, he should perform
tests designed to gain evidence that they have operated properly.
The auditor should review any information which may be provided individually by directors
or key management personnel outlining related party transactions of which they are aware,
including those with themselves and their immediate families.
During the ordinary course of the audit, the auditor carries out procedures which may
identify the existence of transactions with related parties. Examples of such procedures include:
1.. Performing normal detailed tests of trans actions and balances.

2.
3.

5.

Reviewing minutes of meetings of stockholders and board of directors.

Reviewing accounting. records for large or' unusual transactions or balances, paying
particular attention to transactions recognised at or near the end ofthe reporting period.
4. Reviewing corkfirmations of loans receivable and payable and
confirmations from banks. Such a review may indicate the nature and relationship, if
any, of guarantors to the reporting entity.
Reviewing investment transactions, for example, pur-chase or sale of an
equity interest in a joint venture or another company.

While performing his normal audit procedures, the auditor should be alert for transactions
which appear unusual in the circumstances. Such transactions may indicate the existence of
previously unidentified related parties. Examples include:

Verification ~ General

1.

Transactions which have abnormal terms of trade, such as unusual prices, interest
rates, guarantees, and repayment terms.

2.
3.
4.

Transactions which appear to lack a logical reason for their occurrence.

5.

219

Transactions in which substance differs from form.

Transactions processed in other than the normal way for processing similar
transactions.
High volume or significant transactions with certain customers or suppliers as
compared with others.

In addition, the auditor should also consider whether related party transactions have
occurred that are not recorded, such.as the receipt or provision of management services at no
charge.

Examining Identified related Party Transactions

In examining the identified related party transactions, the auditor should apply the
procedures he considers necessary to obtain sufficient appropriate audit evidence as to the
purpose, nature and extent of these transactions.
However, evidence of a related party transaction may be limited, such as an instruction
from a parent company to a subsidiary to record a royalty expense. In these types of
circumstances, the auditor should consider performing additional procedures, such as:

1. .Confirming the terms and amount of the transaction with the related party or with the
related party's auditor.

2. Inspecting evidence in possession of the related party.

3. Confirming or discussing information with persons associated with the transaction,
such as banks, lawyers, guarantors and agents.

Audit Conclusions and Reporting

It may be necessary to obtain a written representation from management concerning related
party disclosure in the financial information.
In forming his opinion, the auditor should consider the effect of related party transactions
on the financial information including the disclosure of such transactions therein.
If the auditor is unable to obtain sufficient appropriate audit evidence concerning related
parties and transactions with such parties, he should describe in his report the limitation on the
scope of his work and express a qualified opinion or a disclaimer of opinion, as appropriate.
If the. auditor concludes that the related party disclosures "in the financial infonaation are
not in conformity with IAS 24, "Related Patty Disclosures", or relevant national standards, he
should express a qualified opinion or an adverse

220

Verification General

opinion, as appropriate.

EVENTS OCCURRING AFTER

THE DATE OF BALANCE
SHEET
The auditor has to report that the balance sheet exhibits a true and correct view of the state
of affairs of the company as at a particular date. In order to give such report it is necessary to take
assistance from the events occurring after the date of the balance sheet. Practical illustrations
indicating the events occurring after that date which may assist in the assessment of the position
as it existed on that date in respect of some of the items appearing in the balance sheet are stated
here:

Liabilities
Guidance may be sought from the developments taken place since the balance sheet date in
respect of determining the amount of contingent liabilities or a liability of which the exact
amount cannot be determined as at that date.

Provision for Taxation

The amount of provision for taxation may need to be correctly calculated in the light of rates
fixed by the Finance Act of a particular year which may be passed much later than the date of
accounts.

Fixed Assets
Where fixed assets were acquired and the consideration was not determined as at the closing
date, the subsequent events have to be examined to reflect in the balance sheet the amount which
would have been subsequently settled.

Debtors
The subsequent realisation and'adjustments to the book debts as at the financial closing date
are a source of guidance as to whether a debt is good or doubtful and assists the auditor in
determining an adequate amount in respect of provision for doubtful accounts. Further if the
amount at which the debt has to be reflected in the amounts has not been agreed as on the date, it
will be estimated, and the events occurring after the balance sheet date will help in establishing
the correct amount to be accounted for in the books as at that date.

Sfock-ln-Trade
If the stock-in-trade is valued by a client at the lower of cost or realisable value, it becomes
essential to establish the realisable value. This is possible only if events occurring after the date
of balance sheet are examined.

221

Auditing: Principles and Procedures

The readers are expected to study the recommendations given by the Institute of Chartered
Accounts (England and Wales) in respect of events occurring after the balance sheet date and their
treatment in accounts.
ISA 21 is in respect of Date of the Auditor's Report; Events after the Balance Sheet Date;
Discovery of Facts after the Financial Statements have been issued. This guideline
comprehensively deals with the following;
Events up to the date of the Auditor's Report.
(i>) Events after the date of the Auditor's Report but before the Financial Statements are
issued.
(a)

(c) Diseovery of Facts after the Financial Statements have been issued Full text of the
above ISA dealing with the above subject is reproduced below:

Introduction

1.

International Standard o n Auditing 13, The Auditor's Report on Financial Statements, states

(paragraph 13):
"The report should be dated. This informs the reader that the auditor considered the
effect on the financial statements and on his report of events of transactions about
which he became aware that occurred up to that date."

2.

International Accounting Standard (IAS) 10, "Contingencies and Events Occurring After the
Balance Sheet Date", issued by the International Accounting Standards Committee, deals
with the treatment in financial statements events occurring after the balance sheet date.

3.

The purpose of this Standard is to provide guidance on dating of the auditor report, the
auditor's responsibility in relation to significant events occurring after the balance sheet date
(hereafter described as subsequent events) and the . procedures the auditor should perform to
meet this responsibility. IAS 10 identifies two types of events:
"(1) those that provide further evidence of conditions that existed at the balance sheet
date, and
(2). those that are indicative of conditions that arose subsequent to the balance sheet
date."
This Standard also provides guidance on the auditor's responsibilities in connection with the
discovery of facts after the financial statements have been issued.

Dating of the Auditor's Report

4.

The auditor should date and sign his report as of the date he completes his examination,
which includes performing procedures relating to events

Verification General 222

occurring up to the date of his report. However, since his responsibility is to report on the
financial statements as prepared and presented by management, the auditor should not date
his report earlier than the date on which the financial statements are approved by
management.

5.

The auditor should obtain assurance that the financial statements were approved by
management (e.g. by obtaining a signed copy of the financial statements, or a
representation to that effect).

Events Up to the Date of the Auditor's Report

6.

The auditor is not expected to conduct a continuing review of all matters to which he has
previously applied procedures and reached satisfactory conclusions. However, the auditor
should perform procedures designed to satisfy himself that all subsequent events up to the
date of his report that may require adjustment of or disclosure in the financial statements
have been identified. These procedures are in addition to specific procedures which may be
applied to transactions occurring after the balance sheet date designed to obtain evidence as
to account balances as at the balance sheet date, for example, the examination of data to
ensure that transactions have been recorded in the proper period.

7.

The procedures to identify subsequent events should be performed as near as practicable to

the date of the auditor's report and generally include the steps listed below:
a) Read minutes ofthe meetings of stockholders, board of directors, and audit
, and executive committees for the period after the balance sheet date and
inquire about matters discussed at meetings for which minutes are not yefc available.
b) Read the entity's latest available interim financial statements and, as considered
necessary and appropriate, budgets cash flow forecasts and other related management
reports and make comparisons.
c) Inquire or extend previous oral or written inquiries of the entity's legal counsel
concerning litigation and claims.
d) Review the procedures that management has established to ensure that material
subsequent events are identified, and inquire of management as to whether any such
events have occurred which might affect the financial statements being reported on.
Examples of inquiries of management on specific matters are:

The current status of items that were accounted for on the basis of tentative,
preliminary or inconclusive data.

Whether commitments have been made (e.g. by way of new borrowings or

guarantees).

223

A uditing: Principles and Procedures

Whether the sale of assets or operating units has occurred or is planned.

Whether the issuance of new shares or debentures, or an agreement of merger of

liquidation has occurred or is planned.

Whether assets of the entity have been appropriated by government or destroyed (e.g. by
fire or flood)..

Whether there have been any significant developments relative to risk areas and
contingencies known to the auditor, whether inherent in the nature of the business or
revealed by previous experience.

Whether any unusual accounting adjustments have been made or are contemplated since
the balance sheet date.

Whether management is aware of any events which have occurred or are likely to occur
which will bring into question the appropriateness of accounting policies used in the
financial statements as would be the case, for example, if such events call into
question the validity of the going concern concept.
If the procedures identify events which could affect the financial statements, the auditor
should carry out further procedures to assess whether such events are appropriately
reflected in the financial statements. .

8.

In situations involving branches, subsidiaries, investees or associated entities, the auditor

should decide the locations at which the above procedures should be carried out. Where
such entities are audited by other auditors, the auditor should consider obtaining the results
of their procedures, for example, by discussions with the other auditors, written
confirmation or review of working papers.

Events After the Date of the Auditors Report

but Before the Financial Statements are
Issued

9.

The auditor does not have any responsibility to perform procedures to identify subsequent
events occurring after the date of the auditor's report. During the period from the date ofthe
auditor's report to the date the financial statements are issued, management has the
responsibility for informing the auditor of any events which may affect the financial
statements.

10. If the auditor becomes aware of events occuriing after the date of the auditor's report but
11.

before the financial statements are issued, the auditor should consider whether the financial
statements should be amended and should discuss the matter with management.
If management amends the financial statements, the auditor should carry out the procedures
necessary in the circumstances and report on the amended financial statements. After
carrying out such procedures, the auditor should date his. report not earlier than the date the
amended financial statements are approved and, accordingly, the procedures in paragraphs
7-8 should be extended to the date ofthe auditor's report.

Verificacion General

224

9. If management does not amend the financial statements in ch'cumstances where the auditor

believes they should be amended, his'action will be determined by whether his report has
been released to the client. If his report has not been released, the auditor should express a
qualified opinion or an adverse opinion, as appropriate. If his report has been released to the
client, the auditor should notify those persons ultimately responsible for the overall
direction of the entity that he will take action to prevent future reliance on his report. The
action taken will depend on the legal rights available to the auditor and the
recommendations of his legal counsel.

10. The guidance contained in paragraphs 9-12 applies equally to the subsequent discovery by
the auditor of facts that existed at the date of the auditor's report.

Offering of Securities to the Public

14. In eases involving the offering of securities to the public, the auditor should consider any

legal and related requirements applicable to the auditor in all jurisdictions in which the
securities are being offered. For example, the auditor may be required to carry out
additional audit procedures to the date ofthe final offering document. These procedures
would normally include caring out the procedures in paragraph 7 up to a date at or near the
effective date ofthe final offering document and reading the offering document to assess
whether the other information in the offering document is consistent with the financial
information with which the auditor is associated.

Discovery of Facts After the Financial Statements Have Been

Issued

15. After the financial statements have been issued, the auditor has no obligation to make any
continuing inquiry with respect to such financial statements.
16. If after the financial statements have been issued, the auditor becomes aware of a fact that
materially affects the financial statements on which he has previously reported and which
existed but was not known to him at the date of his report, he should discuss the matter with
management.
17. The auditor should review the steps taken by management to ensure that any
individuals in receipt of the previously issued financial statements together with the auditor's
report thereon are informed that they have been superseded. If management decides that the
financial statements should be revised, the auditor should carry out the procedures necessary
in the circumstances and he should issue a new report on the revised financial statements.
The auditor's ' report on the revised financial statements should have a new date and should
refer in an explanatory paragraph to the note to the financial statements that more
extensively discusses the reason for the revision to the previously issued financial
statements. The report should also refer to the earlier report issued by the auditor on the
financial statements and, when the auditor has restricted his subsequent examination to the
events that necessitated the revision, should contain a statement to that effect.

225

Verification General

18. If management does not take the steps referred to in paragraph 17, the auditor should notify
those persons ultimately responsible for the overall direction of the entity that he will take
action to prevent future reliance on his report. The action taken will depend on the legal
rights available to the auditor and the recommendations of his legal counsel.

19. It may not be necessary to revise the financial statements accompanied by the auditor's
report when issuance of financial statements for a later period is imminent, provided
management agrees that appropriate disclosure will be made in such statements.
Appendix 5.1

EXAMPLE OF AN AUDITOR'S REPORT ON REVISED

FINANCIAL STATEMENTS
The following is an example of an auditor's report on revised financial statements prepared
in accordance with paragraph 17 of this Standard.
AUDITOR'S REPORT TO................................................................................................................
We have audited the financial statements of ABC Company as of December 31 19X1 and
for the year then ended in accordance with International Standards on Auditing and rendered an
unqualified report dated March 1, 19X2 on those statements.
For the reasons fully described in Footnote X, the previously reported results of ABC
Company as of December 31, 19X1 and for the year then ended contained misstatements of
inventory, cost of sales, tax expense, net income, taxes payable and shareholders' equity.
(We have restricted our examination ofthe accompanying financial statements from March
1, 19X2 to the date of this report to an examination of the matter discussed in Footnote X.}1
In our opinion, the financial statements as revised give a true and fair view of (or present
fairly') the financial position of ABC Company at December 31, 19X1 and the results of its
operations for the year then ended in accordance with...
This report replaces our report dated March 1, 19X2 in which we originally reported on the
financial statements at December 31, 19X1 and for the year then ended.
June 1, 19X2 AUDITOR Address
This paragraph is to be used when the examination is restricted tu the events that necessitated the revision (see paragraph
17).

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Auditing: Principles and Procedures

REPRESENTATION LETTER
Representations by Management as Audit Evidence is a title of ISA 22. This standard
explains the rational, documentation, written representations, action to be taken if management
refuses to provide representation and also contains an example of a management representation
letter. Relevant provisions governing these aspects ate given below:

Representations by Management as Audit Evidence

The auditor should obtain evidence that management acknowledges its responsibility for
the appropriate presentation of the financial statements and that management has approved the
financial statements. The auditor can obtain evidence of management's acknowledgement of
such responsibility and approval from relevant minutes of meetings ofthe management board or
similar body or by obtaining a written representation from management or a signed copy of the
financial statements.
During the course of an audit management makes many representations to the auditor,
either unsolicited or in response to specific inquiries. When such representations relate to matters
which are material to the financial statements, the auditor should:

1.
2.

Seek corroborative audit evidence from sources inside or outside the entity.

3.

Consider whether the individuals making the representations can be expected-to be wellinformed on the matter.

Evaluate whether the representations made by management appear reasonable and

consistent with other audit evidence obtained, including other representations, and

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

investigate the circumstances and, when necessary, reconsider the reliability of other
representations made by management.
Representations by management cannot be a substitute for other audit evidence that the
auditor would expect to find. For example, a representation by management as to the original
cost of an asset is no substitute for the normal evidence of such cost that an auditor would expect
to find. If the auditor is unable to obtain sufficient appropriate audit evidence that he believes
should be available, this will constitute a limitation in the scope of his examination even if he
has a representation fr om management on the matter.
In certain instances a representation by management may be the only audit evidence which
can reasonably be expected to be available. For example, the auditor would not necessarily expect
that other evidence would be available to corroborate management's intention to hold a specific
investment for long-term appreciation. In such circumstances, provided that the auditor obtains
written

Verification General

227

confirmation of manage merit's oral representations, this may not constitute a limitation ori the
scope of his examination.

Documentation of Representations by Management

The auditor can document in his working papers evidence of management's representations
by summarising oral discussions with management, or by obtaining written representations from
management. Written representations can take the form of:

1.
2.

a representation letter from management, or

a letter from the auditor outlining his miderstanding of management's representations, duly
acknowledged and confirmed by management.

Written Representations
The possibiUty of misunderstandings between the auditor and management is reduced when
oral representations are confirmed by management in writing. Furthermore, as described above,
written representations from management should be obtained tb confirm oral representations
given to the auditor on matters material to the financial statements when other sufficient
appropriate audit evidence cannot reasonably be expected to exist. Matters which might be
included in a letter from management or in a coralrmatory letter to management are contained in
the example of a management representation letter in the Appendix.
Written representations requested from management may be limited to matters that are
considered either individually or collectively material to the financial statements. With respect to
certain items it may be necessary for the , auditor to provide management his understanding of
materialist.

Basic Elements of a Management Representation Letter

When a management representation letter is r equested it should be addressed to the auditor,
contain the information requested by him and be appropriately dated and signed.
A management representation letter should normally be dated the same date as the auditor's
report on the financial statements. However, in certain circumstances in respect to specific
transactions, a separate representation letter may also be obtained during the course of the audit.
A management representation letter should be signed by the members of management who
have primary responsibility for the entity and its financial aspects, usually the senior executive
officer and the senior financial officer, based on the best of then- knowledge and belief. In certain
circumstances, the auditor may wish to obtain representation letters from other members of
management. For example, he may wish to obtain a written representation about the completeness
of all minutes of the meetings of stockholders, directors, and important committees of

228

Verification General
directors from, the individual responsible for keeping such minutes.

Action if Management Refuses to Provide Representations

If management refuses to provide representations that the auditor considers necessary, this
will constitute a limitation in 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.
If management has provided an oral representation but refuses to confirm it in writing, this
will constitute a limitation in the scope of the auditor's examination unless he is satisfied that
there are valid and acceptable reasons for such refusal and that he can rely upon the oral
representation.

Appendix 5.2

EXAMPLE OF A MANAGEMENT REPRESENTATION LETTER

The following letter is for use as a general guide in conjunction with the considerations set
forth in this Guideline. It is not intended to be a standard letter because representations by
management will vary from one entity to another, and from one year to the next.
Date
(To Auditor)
This representation letter' is provided in connection with your audit of the financial
statements of ABC Company as of December 31, 19X1 for the purpose of expressing an opinion
as to whether the financial statements give a true and fair view of (or present fairly' ) the financial
position and results of operations in accordance with (indicate relevant national standards or
International Accounting Standards).
We confirm, to the best of our knowledge and belief, the following representations:

1. We acknowledge our responsibility for the fair - presentation of the financial

statements in accordance with (indicate relevant national
standards or International Accounting Standards) including the - appropriate
disclosure- of all information required by statute.

2. There have been no irregularities involving management or employees who have

significant role in the system of internal control or that could have a material effect on
the financial statements.

229
Procedures

uditing:

Principles

and

3.

We have made available to you all books of account and supporting

documentation and all minutes of meetings of stockholders and board of directors
(namely those held on March 15, 19X1 and September 30, 19X1, respectively).

2. The financial statements are free of material errors and omissions.

3. The Company has complied with all aspects of contractual agreements that could have
a material effect on the financial statements in the event of non-compliance with
requirements of regulatory authorities with respect to financial matters.

4. The following have been properly recorded and when appropriate, adequately
disclosed in the financial statements:

(a)
(b)
(c)
(a)

Balance and transactions with" related parties.

Losses arising from sale and purchase commitments.
Agreements to buy back assets previously sold.
Assets pledged:as collateral.

7. We have no plans or .intentions that may materially affect the carrying

value or classification of assets and liabilities reflected in the financial
statements. -8. We have identified all excess or obsolete inventoiy, and no inventories are
stated at an_amount in excess of net realisable value.

9. The Company has satisfactory title to all assets and there are no liens or
encumbrirnces on the company's assets, except for those that are disclosed in Footnote
X.

9. We have recorded or disclosed all liabilities, both actual and contingent, and have
disclosed in Footnote X the guarantees that we have given to all third parties.

10. Other than . . . . described in Footnote X to the financial statements,-there have been
:.

no events subsequent to the balance sheet date which .require

adjustment of or disclosure in the financial statements and related notes.

12. The

claim by XYZ Company has been settled for the total sum of
$XXXXX which has been properly accrued-in the financial statements. No
other claims in connection with litigation have been or are expected to be
received.

12. There are no formal or informal compensating balance aiTangements with any of our1
cash and investment accounts: Except as disclosed in Footnote X, we have noother
line. of. credit .arrangements.
14. We have properly recorded or disclosed in the financial statements the

Verification ~r General

230

capital stock repurchase options and. agreements and capital stock reserved for options,
warrants, conversions and other requirements.

(Senior Executive Officer)

(Senior-Financial Officer) The

above letter has the following benefits for an 'auditor:
1.
2,

He may cover himself in the event of any subsequent enquiries regarding

the audit ..work, undertaken.
Putting major responsibility on the directors, he may try to relieve himself '
from the responsibility, if he has performed his duties after applying
generally acceptable auditing techniques. '..

However, the mere fact that an auditor has obtained Letter of Representation does not relieve
him from the discharge of his duties as laid down in the law..It is. ah additional cover to remind
directors of.their responsibilities for the preparation of accounts. In this respect ISA 1 has
emphasised the responsibility for the financial statements. Relevant, aspects are "now discussed.

Responsibility for the Financial Statements.and Auditor.

ISA 1 clearly .indicates the responsibility of ah auditor and management in respect of
financial statements. In this respect portion of the above ISA dealing with this subject is stated
below: '
While the auditor is responsible for forming and expressing his bpinion on the -.financial
'statements, the responsibility for- their, preparation is" that of the management ofthe
entity..Management's responsibilities include the maintenance of adequate accounting records and
internal.controls,.the selection and application of accounting policies, and the safeguarding of the
assets of the entity. The audit of the financial statements does not relieve .management of its resp
risibilities.

Auditing: Principles and Procedures

231

Specimen of Representation Letter in use in Pakistan is given below:

(SPECIMEN OF REPRESENTATION LETTER TO BE OBTAINED FROM CLIENT'S
OFFICE ON THEIR LETTER HEAD)
To

Dear Sirs,
Messrs A.B.C. Limited Accounts for the Year Ended
We confirm to the best of our knowledge and belief the following information and opinions
given to you in connection with your examination of the company's accounts for the year ended
. . . . . . . . and in the light of the requirements of the
Companies Ordinance,. 1984 and corporate law authority.
ASSETS
General

2.

The assets shown in the company's books and accounts at...........................................were

owned by the company and were free from any charge except as mentioned in the company's
accounts for the year under review.
Land,-Buildings, Machinery, Equipments and other Assets

3.

The net book amounts at which the premises, machinery, equipments and other assets are
stated in the balance sheet are arrived at:

(a) After taking into account all capital expenditure on additions thereto, but no
(b)

expenditure properly chargeable to revenue.

After praviding for depreciation and obsolescence on bases and at rates calculated to
reduce the net book amount of each asset to its estimated residual value by the end of
its. probable useful life in the company's business-

Stores and Stocks

4.
The company's stores and stocks appealing in the accounts Note No. . . . . : . , ' . .
|and No........................at a total value of Rupees :...........................comprise: the whole ofthe
company's stores and stocks wherever situated. Stocks held on behalf of other parties have been
excluded. All executed sales orders (and completed contract work) have been invoiced to custom
ers~and the stocks relating to invoiced sales have been excluded.

J 82

Auditing: Principles'and Procedures

5.

The stores and stocks were ascertained in the following manner:

(a)

Stores and stocks are in accordance with balances on stock records which
were verified by a year-end stocktaking which covered all items.

(b) . Stores and stocks were verified at the annual stocktaking carried out on . .
.......................Quantities were detercnined by actual count, weight or
measurement or, where this was not practicable, the quantities were . . estimated on a
realistic basis by responsible officials.

6.

The stores and stocks have been valued at

determined on average-basis. "

. . . In general cost is

7.

Stocks are valued on the same basis and were ascertained in the same manner as at the end
of the previous financial period.
Other Current Assets

8.

On realisation in the ordinary course of the company's business the other current assets in
the balance sheet are expected, in the opinion of the directors, to produce at least the amounts at
which they are stated.

Liabilities and Commitments

9.
All known liabilities incurred up to the year end (other than forward purchase
commitments in the ordinary Course of business), and all losses expected to result
from events occurring and contracts entered into by the balance sheet date, have
. been fully provided for in the accounts, apart from contracts for capital expenditure
totalling to Rupees. . . . . . . . . . In addition, capital expenditure amount to Rupees . .
.............. . had been authorised by the board but was not committed.

Contingencies

10. The total of contingent liabilities not provided for in the accounts is estimated

provided for in the accounts is estimated at Rupees................................. . , including possible

liabilities for claims and complaints received, pending litigation, discounted bills, and guarantees
and indemnities given.
Taxation

11. The amounts included in the balance sheet in respect of taxation are adequate to cover all
unpaid taxation liabilities, agreed, or estimated, arising in respect of profits earned to the date of
the balance sheet.
Charges

12. There were no charges, securities or options exerciseable by third parties over the company's
assets other than those disclosed in the accounts.
Profit and Loss Account
13.. There were no material items affecting the results of an exceptional,

Verification General

233

recurring or prior year ' nature and no material effect from changes in accounting bases, other
than those disclosed in the accounts.
Subsequent Events .
14. Since the end of the financial year no events have occurred which materially affected the
results or financial position shown by the accounts.
Records and Minutes
16. All the company's accounting records and all minutes of shareholders' and directors'meetings
have been made available to you for the purposes of your audit.
: Veiy Truly Yours for
(A.B.C. LIMITED}
DIRECTOR

CHIEF ACCOUNTANT

........................................ .ei9...

ANALYTICAL PROCEDURES
Analytical review procedures are used to describe the analysis of significant ratios and
trends including the resulting investigation of unusual fluctuations and items. ISA 12 deals with
nature of analytical review procedures, objectives and timing of analytical review procedures,
planning analytical review procedures, extent of reliance on analytical review procedures and
investigating unusual fluctuation and items. '
The text of above ISA is reproduced below:

Introduction
1.' International Standard on Auditing (ISA) 1, Objective Basic Principles Governing an Audit,
requires an audit to be adequately planned so that the auditor obtains sufficient appropriate
audit evidence on which to base the expression of his opinion. Analytical procedures are
identified as a type of substantive procedures for obtaimng audit evidence. This Standard
requires the use of analytical procedures in the planning and overall review stages of all audits.
It also gives guidance on the use of analytical procedures as substantive tests. In this
Standard, the term "analytical procedures" is used to describe the analysis of significant ratios
and trends including the resulting investigation of unusual fluctuations and items. The term
''financial information" encompasses financial statements. ' ~

J 82

Auditing: Principles'and Procedures

Nature and Purpose of Analytical Procedures

2. Analytical procedures include comparison of financial information with:

comparable information for a prior or periods,

anticipated results, such as budgets or forecasts, and

similar industry infoiTnation, 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.

Analytical procedures also include study of relationships:

3.

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 peifonning 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 procedures, methods and level of application is a
matter of professional judgment.

4. 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 ofthe 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

5.

In the planning stage, analytical procedures assist the. auditor in understanding the client's
business and in identifying areas of potential risk1
The audtor's consideration of audit'risk i n the planning stage is also discussed in. paragraph 10 of ISA 25, Materiality and
Audit Kisk.

235

Auditing; Principles and Procedures

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."

6.

Analytical procedures in planning the audit use both financial data and non-financial
information, such as number of employees, square footage of selling space, volume of
goods produced, and similar information.

Analytical Procedures Used as Substantive Tests

7.

The auditor's reliance on substantive tests to reduce detection risk relating to specific
financial assertions may be derived from, tests of details, from analytical procedures, or
from a combination of both. The decision about which procedures or procedures to use to
achieve a particular audit objective is based on the auditor's judgment about the expected
effectiveness and efficiency of the available procedures.

8.

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.

9.

When the auditor intends to perform analytical procedures, he should consider the
following:

The objectives of the analytical procedures, and the extent to which he may be
able to rely on their results (paragraph 11-12).

The nature ofthe 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 ofthe 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 procedures and sells specialized
product.

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.

236

Auditing: Principles and Procedures

10. The auditor should consider the need for testing the controls over the preparation of nonfinancial 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-fmancial
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 these cii'cumstances,' the auditor could test the 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

11. 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.

12. 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 auditoi' does not rely only on analytical procedures informing 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 collectibility 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 result of analytical procedures can be

predicted, for example, the auditor will normally expect greater consistency in
comparing gross profit margins from one period to another than in comparing
discretionaiy expenses, such as research or advertising.

Evaluation of internal controls, for example, if the auditor has concluded

237

Verification General

that internal controls over sales order processing are weak, he may have to rely more
on tests of details of transactions an balances than on analytical procedures in drawing
his conclusion on sales.

Investigating Unusual Fluctuation and Items

13. 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.

14. The investigation usually begins with mquiries 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.

15. 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

16. 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 ofthe 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.

QUALITY OF AUDIT WORK

ISA 7 deals with quality of audit work. Fundamental objective is that the policies and
procedures are adopted by an audit firm to provide reasonable assurance regarding the quality of
audit work generally.
Excerpts from the above ISA are reproduced below for quick reference:

Control on Individual Audits

Delegation .
Any delegation of work to assistants should be in a manner that provides

238

Auditing: Principles and Procedures

reasonable assurance that such work will be performed by persons having independence and the
degree of skills and competence required in the circumstances.
The auditor and assistants with supervisory responsibilities should consider the skills and
competence of assistants in performing the work that is delegated to them in deciding on the
extent of direction, supervision and review appropriate to each.
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 ofthe entity's
business and possible accounting or auditing problems, that may affect the nature, timing and
extent of audit procedures with which they are involved.
A written audit programme is an important tool for the communication of audit directions.
Time budgets and planning memoranda :-are- also helpful in communicating audit directions.

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:
(c) Monitor the progress of the work to determine that: .

assistants appeal's 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 appropiiate.
(c)

Resolve any differences of professional judgment between personnel.

Review
The work performed by eaeh assistant should be reviewed by personnel of equal or higher
competence to determine whether:

(a) The woi'k has been performed in accordance with professional and firm standards'.
(b) The work performed and the results obtained have been adequately documented.

Verification General

239

(c) Any significant audit matters remain unresolved.

(d) The objectives of the audit procedures have been achieved and the conclusions
expressed as consistent with the results of the work performed and support the
auditor's opinion on the financial infoiTnation.

The following major review stages can often be identified in an audit:

(a) Review ofthe initial audit plan and the. audit programme.
(o) Review of the study and evaluation of internal control, including
compliance procedures, and ofthe 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 ofthe financial information and proposed auditor's report.

Review procedures may be augmented, particularly in the case of large complex audits, by
requesting personnel, not otherwise involved in the audit to perform certain additional review
procedures before issuance ofthe auditor's report.

General Qualify 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 International Auditing Guideline 3.
Quality control policies are objectives arid goals; quality control procedures are steps to be
taken to accomplish the policies adopted.
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. Personal Qualities
Personnel in the firm should adhere to the principles of Integrity, Objectivity, Independence
and Confidentiality, as stated in the IPAC code of Ethics for Professional Accountants.

B. Ski ll s and Competence

..

The firm should be staffed by personnel who have attained and maintain the skills and
competence required to enable them to fulfill then- responsibilities.

C. Assignment
Audit work should be assigned to personnel who have the degree of technical training and
proficiency required in the circumstances.

240

Auditing: Principles and Procedures

D. Direction and Supervision

There should be sufficient direction and supervision of work at all levels to provide the
firm with reasonable assurance that the work performed by the firm meets appropriate standards
of quality. Whenever necessary, consultation should be made witfi. those who have appropriate
expertise.

E. Acceptance and Continuance of Clients

The fhm 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 malting 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 ofthe client's management.

F. Inspection
The firm should monitor the effectiveness of its quality control policies and procedures.
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 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 individual firms
will vary, as will the extent of their documentation. Illustrative examples of quality control
procedures are presented in an appendix to this guideline. The specific procedures used by a firm
would not necessarily include all the illustrative examples or be limited to them, nor would all
procedures carry the same weight for all circumstances. In addition, many ofthe illustrative
examples may not be appropriate to smaller firms.

VERIFICATION
LIABILITIES

The technique of verification of each of the items appearing on the "Capital

and Liabilities" and "Property and Assets" sides of balance sheet will now be
broadly discussed. The auditor should satisfy himself about the correct disclosure of
information in respect of eveiy item of capital, liabilities and assets as required by
law and IAS.
- :

CAPITAL
The steps to be taken for verifying the share capital of the company covering several phases
are ejmnierat.eii as under: '
Check the 'Authorised' share capital with the relevant clause of the
(1)
Memorandum of Association. Scrutinise the minute book of. the shareholders to
ensure that no alteration was made during the year. If it was so done, the minutes
should be seen and altered amount may be shown in the accounts. :
Obtain a list of shareholders, check with the register of members, and verify
(2)
the control account.
Obtain a schedule showing the movement during the year in the above
account. Veiify entries in respect of the additions oh account of issue of
- new shares (calls, fresh issues, rights, bonus).
The following work in this respect should be carried out:
(a)
See that the allotment of the shares has been made complying with
legal previsions.
(3)

(b) See that the issued capital does not exceed the authorised capital.
(c)Where permission is necessary from the Controller of Capital Issues.
. see that it has been obtained and the presented conditions are full
complied with. Verify the terms of consent order with the Articles of
Association.
. ;.'
(d) Check the share applications with that Application and Allotment
. Book to establish that the shares allotted wore actually applied for.

242

Auditing: Principles and Procedures

(e) Examine Resolution of the Board in respect of allotment of the shares.

(f > Vouch the monies received on application and allotment with the counterfoil of
the receipt book, bank statements and advices or their relpvant available
evidence.

(g) Ifhny calls were made, see the minutes of Board, meeting.
(h)
Verify the total cash received on. account of share capital with the
amount credited to the account, after deducting any debit balance of the
allotment and share call accounts, if any indicated in the financial ledger.

(i)

If in accordance with the provisions of the memorandum and articles

of association and prospectus, the Directors are required to take up
their qualification shares,.-see that the company has received the
required amount.
<J) In a case where the shares were allotted for Consideration other than cash,
examine the contract constituting the allottee's title to the share and the
Directors* Minutes. The contract is required to be filed with Registrar along with
the return of allotment. If the contract is not in writing, see that the particular of
the contract duly stamped are filed.
(k ) If the shares are issued at a premium; see that the premium is shown separately
and not under the share capital.
(0 : If the shares were issued at a discount, the auditor should satisfy himself in respect
of the matters given below:
(i) The issue of the shares at a discount was authorised by a resolution
passed in a general meeting of the company and was sanctioned by the
court;

(ii) The resolution stated the maximum rate of the discount (not
exceeding tenper cent in any case) at which shares were issued;
(Hi ) Not less than one year' must, at the date of issue, have elapsed since the
date on which the company was entitled to commence business; and
(if) The shares to be issued at a discount must be issued within six - months after
the date on which the issue is sanctioned by the court or within such extended
time as the court may allow.
(4) In the case of forfeiture of shares, the auditor should satisfy himself on the following
points:
(a) That the procedure as laid down in the Articles relating to forfeiture of shares was
followed i.e., the .forfeiture was permitted by the Articles of company and the
Directors' resolution forfeiting the shares was passed. Such resolution should be
examined.
(o) Examine the entries in the books of account for the forfeiture of

Verification Liabilities

243

244

sha
res,
an
d
ens
ure
tha
t
the
nec
ess
ary
adj
ust
me
nts
we
re
ma
de
in
the
reg
iste
r of
me
mb
ers.
(c)
W
her
e
for
feit
ed
sha
res
we
re
sol
d
or
reiss
ue

Auditing: Principles and Procedures

d, see that the issue of such shares was authorised by the Directors and the
amount of discount (if any) did not exceed the amount already received thereon
" the defaulting shareholders.
(. Any capital profit on re-issue of forfeited shares should be transferred to capital
reserve.
45}

(6)

If shares were allotted to the for eign nationals, examine the permission given by the
State Bank of Pakistan for such allotment.
Where the company has issued redeemable preference shares, verify the terms on which
they were issued with prospectus. See that particulars of such shares must be included
in the balance sheet of the company, specifying what part of the issued capital consists
of such shares and the date on which the shares are due to be redeemed or, where no
definite date was fixed for redemption, the period or notice to be given for redemption
is mentioned. The shares cannot be redeemed unless they are fully paid, and they can be
redeemed only out of the proceeds otherwise available for dividend, or out of the saleproceeds of any property of the company. With the exception of the above, the
redemption may be made on such terms and in such manner as may be provided in the
articles ofthe company.

(7) Examine the rights attaching to the var ious types of shares in the articles of association
(8)

of the company. Obtain a schedule summarising the various rights in respect of each
type of share.
-Where the company has organised its share capital, the following steps should be taken
to verify the transactions:
(a) Pursue the shareholders' minutes recording the special resolution
{&) Examine the court's order sanctioning the scheme of recognition and see that a
copy of the above order has been filed with the Registrar, Joint Stock
Companies.

(c) Vouch the journal entries arising out of reorganisation.

(d) Check the cancelled share certificates with the counterfoils ofthe new share

certificates issued. Scrutinise the share Register to ensure that the necessary
adjustments have been made therein.

(9) If the company has reduced its share capital, the auditor should-work on the following
lines:
() Consult the articles of association of the company to check the
authority for reduction of share capital. Verify the special resolution
giving effect to such reduction from the minutes of the meeting of
shareholders.
() Follow the above points 8(b), (e) and i d).

Verification Liabilities

245

() See that the fact of such reduction is clearly indicated on the balance sheet with the
womV'And Reduced", for such a period as is required under the court's order.
(10) Note market quotations of shares ofthe client at the year-end and enquire into the
major fluctuations.

Share Transfer Audit

The audit of the share transfer is not compulsory under the Oidinance . However, at times
the auditor is asked to undertake this work with the objectives to ensure that there has been no
error or fraud in the office of the Secretary and that duplicate shares have- not been issued,
except in genuine cases only where the original ones were lost.
The following procedure should be adopted in carrying out the share transfer audit of a
limited company.

(1) Examine the articles of association in respect of the procedure'to be followed with
regard to the transfer of shares and ensure that the requirements were followed.

(2) See that the company sent notices of transfers to the transferers in the case of transfers

lodged by the transferees as law in respect of those transfers which were lodged, by
the transferers and were in respect of partly paid shares.
(3) Ascertain that the transfer fee as prescribed by the articles of association was received
and accounted for in the books.
' (4) See that the transfer deed was properly stamped. The transfers must be checked with
the members' register,
(5) Verify the signature of the transferer with the signature on the
application form.
(6) Ascertain that the old share certificates were cancelled and check up the - counterfoils
of the new certificates. The cancelled certificates should be
carefully examined.

(7) Examine the Directors' minutes approving the transfers.

(8) Where shares were transferred through transmission by operation of law, examine the
legal evidence (succession certificate, probate of will etc) indicating the title of the
transferee to the shares.
(9) Compare the total issued capital with the balances on the shareholders' account in themembers' register.
(10) The Auditor should ensure that legal provisions contained in Sections 76 to 81 dealing
with transfer of shares and debentures are complied with.

(11) A suggested proforma of the report to be sent to the Directors relating to the share
transfer audit is as under : -

246

Auditing: Principles and Procedures

AUDITORS REPORT ON SHARE TRANSFER AUDIT

"We have audited the share, books of................................... . . . . . . . . .
Company Limited for the year ended.......................... and
certify that all the transfers were correctly recorded therein; that the relative share
certificates were properly authorised and that the balances ofthe Register of
Members are in agreement with the issued share capital as shown in the balance
sheet."
Place.............................................................................................................
Date . . . . . . . . .
Chartered Accountants

RESERVES

(1) Obtain a movement schedule of each type of reserve and agree the closing balance of
the schedule with the balance sheet.

(2) The opening balance of each of the reserves should be checked with the
(3)
(4)
(3)
(4)
(5)

audit working papers of the previous year or audited balance sheet.

Scrutinise any addition to or deletion from the reserves carefully and ensure that they
are properly authorised by the articles of the company and the directors' and/or
shareholders' resolution.
The auditor should study the case-law and comply with the guidelines laid down in the
judicial pronouncements.
Note undisclosed secret reserves.
Note provisions in excess of requirements so as to constitute reserves.
See that all reserves required under the tax laws have been created.

DEFERRED TAXATION
It is created with a view to providing future tax liability which is deferred due to the
accelerated rates of depreciation under the Income Tax Ordinance and Rules, as compared to low
rate of depreciation charged in accounts. The auditor should check the computation. Verify the
r^vements during the year. The amount is either provided in the accounts or shown by way of a
footnote.

DEBENTURES
(1)" Examine the memorandum and articles of the company to ascertain its borrowing
powers and the extent and mode of borrowing. If the directors

Verification Liabilities

247

are empowered to borrow on behalf of the company, examine the Directors' Minutes
regarding the issue of debentures and the mortgage of the company's property.
(2) Exarnine the- debentures trust deed {if any) or an actual debenture bond and note
exact terms and conditions of issue of debentures. See that they were complied with.
(3) Upon a new issue of debentures, carry out the detailed debenture capital audit in the
same manner as in the case of share capital audit explained in detail earlier in this
chapter.
(4) Note carefully the provisions regarding the redemption of debentures and see that they
were compiled with. Note the redemption conditions and vouch any redemption of
debentures with debenture bonds and examine the Directors' Minutes authorising the
redemption.
(5) Obtain a schedule of debenture-holders and check it with the Register of Debentureholders which is a statutory book required to be maintained under the Ordinance. Tally
the amount with the control account and with the balance sheet.
(6) If various classes of debenture are issued, e.g., first and second mortgage debentures,
they should be separately shown on the balance sheet stating the nature of security.
The charges created on the company's assets should be entered in the company's
register of mortgages and necessary particulars should be filed with the Registrar -.
(7) The remuneration payable to the trustees of debenture-holders must be either paid or
provided for in the books in accordance with the Trust Deed.
- (8) If debentures are issued at a premium, consult the articles of the company and adhere
to its requirements.
(9) If debentures have been issued as collateral security for a loan, see that they are
properly shown in the balance sheet as a foot note. Examine loan agreement and
Directors' Minutes authorising the issue of such
debentures. Trace the entries in the Register of Mortgages and charges. Ascertain that
necessary particulars were filed with the Registrar of Joint Stock Companies.

(10) See that the interest has either been paid or provided in the accounts.
At times debentures are issued as a Collateral Security for a loan. The term "CoUateral
Security" means a security accompanying but subordinate and which can be realised by the
holder thereof, in the event of failure on the part of the company to repay the original loan is
repaid, the Collateral Security is automatically released. When debentures are issued as
Collateral Security, the fact should be distinctly disclosed i n the balance sheet by way of a
footnote under the item or loan against which they are so issued.

Auditing: Principles and Procedures

LOANS .

'aicirvii arl t 1o .

Secured
^^0^ borrowing powers with reference to the memorandum and articles o^assocmtionTSee
Board Resolution for the approval of exercising the borrowing, powers. Study, the contract for loan
noting the maximum limit sanctioned, rate of interest, plan of repayment, instalments payable) the
nature and extent of scrutiny fl&id type of charge (pledge, hypothecation, mortgage, etc.). Scrutinise
the account to find out ^instances where limits have exceeded and report such instances to
dlrectors^All interest on outstanding balance should either be paid or provided in accounts^Check
the value of the security and see that the loan is fully secured) See confirmation for the loan. In case
of difference, obtain a reconciliation statement. Examine that the charge on assets has been noted on
the register of charges and j^onfirm that it has also been registered by the Registrar, Joint Stock
Companies. Prepare a movement account during the year and tie up the opening and closing
balance of the loan.

Unsecured
See that unsecured loans have been classified in the prescribed manner.
Ascertain the company's borrowing powers and see that they are not exceeded. See
the Board Resolution in this respect. Scrutinise the conditions of loan. Obtain a
directr'-cbrifirmation of the closing balance. In case of a difference, obtain a
reconciliation statement. See that interest accrued and due on unreceived loans has
been &.
. is-fiT ztli rijiv - i- ,:----v:":1<: UNCLAIMED DIVIDENDS
HI

.-

'

. '-"fiism-J'ij.._

ifirii btaiaB&i a^sax^^ri^t^^i'iiimfeaa^^^ ihesa^daiimed dividends, account. Traee^ansfer

of^vr^nd3acec^intss3.vhiehf remairadiuhpaid^ to unearned divi&endk Tb&breaikd0wttf.tri&H
seiTitirdse^and'C^e$k^
Ifjianyifoirfeiture has
lerl>ima^TBe]&^hatsiich forfeiture' is^authbr^ecbfeyathe i^varafcolaims of the articles of
association and obtain a copy of the dh-ectors'si?eselntibh Exercising the powerjsfj
fpr^t^jur^erf^^^ie^esj For,-|anyti^$^
non-residents, see the approval of the State Bank of Pakistan.
nrieJ ariT \ a 'JOI \\19 Iji'tsJbtloO e n bssj a?. i as-ajinsdoh ssrnti AA
rbidw buss. eJeaifyitdua-ia-d gjiiy^iccinoKHS a enesai-"^ IB-ISJSIIOO"
edi id i'iiia adi no eiidmf lo
rsbloil aril yd ad nsa
?,[ wjj-ojasg 1*- e-xii ,& tsi (isnigi'm sd> vaqen cJ isift
& fcpf ^^ .^1$&1< ^^^^^
balances with the subsidiary ledgeilshari^-.agr^e^^
cases and ascertain whether they are in fact payable. "Other- things being equal, all time-barred
amount may be written back to profit and loss account. See that only

Verification Liabilities

those liabilities which actually exist are shown in the accounts. See thatqdabitf balance in
creditors' ledger are shown as assets in the balance sheet, under'thet appropriate head. Examine
the directors' minute book to ascertain the liabilities1 assumed or contracts made, if any.
The auditor should carry out the following steps to ascertain that all liabUitjej| have been
accounted for in the books:
L
(1) Obtain liability certificate (Appendix 6.1)

(2) Glance through the goods received notes for the last month of the firiarrciajk

(3)

closing and ascertain that for all goods received, invoices were rece^^edj
and reflected in the books.
.
Scrutinise the files of invoices, petty cash vouchers, payments- vouchers* and journal
vouchers for a reasonable period (say one month) subseqaenti to tKe closing date to
see whether any item should have been erdereaiBntO-during the year under review. He
must ensure that adequate ' being exercised by the client for prompt booking
of liabilities.

(4) Enquire into any special claims lodged against the company.

f! 93

(5} Examine the files for court cases against the debtors and establish an, opinion about the
doubtful debts. .
(6) Scrutinise the general'ledger and see whether charges accrued to Ihe^atet
of the balance sheet have been provided in accounts. Accounts of salaries
wages, bonus, rates, taxes, water charges, electricity expenses, convmission
etc., should be carefully checked to ensure that liability for the
has been reflected in the accounts.
(7) Compare schedule of liabilities with previous period and examj^^the
reasons for major fluctuations.
.", /.
ID biftqnn
(8) Check the provision for leave, retirement and gratuity benefits to^he .jSbjiJG
with terms of service.
Is somilsd
. (9) Ensure that interest on all loans and overdrafts accrued up to theTdateioI balance sheet is
either paid or provided in the accounts. .shrt'shr/ib
(10) Compare statements received from creditors with the balances shown on the accounts
and investigate differences.

Bills Payable
-

(To be shown as liabilities for 'acceptance')

-.

sinT
- ^
no aimjosaib

Obtain a schedule of bills payable. Check it with bills payable rhrj^Talig

control account. Check casts of the schedule. Examine the unpaid bills. 1^^$hejg
subsequent payments into the cash book of succeeding period. Verify tOjije^^a^asr
far as possible there are no bills payable left out and not entered in the book&jfj
account. Obtain confirmations from the parties to whom bills of large amount, if ay,
have been issued. Verify the calculation of the interest accrued on bills payable. If

Auditing: Principles and Procedures

250

bills payable are issued out of a regular counterfoil book, go through the running numbers of
bills issued and examine the counterfoils with the bills payable register. Originals of the
cancelled forms together with the counterfoils should be seen.

Provision for Taxation

Ascertain by discussion and study of tax files the stage up to which the assessments have
been completed. Enquire if any appeals are pending and peruse the relevant papers in respect of
appeals and watch their implications. Check the computation of taxable income and tax liability
bearing in niind the nature of organisation. See that income-tax and super-tax have been
calculated at appropriate rates. Scrutinise the claim for allowable tax depreciation. Discuss any
controversial issues in respect of madrnissible items. Account for any tax rebates and relief from.
Avoidance of Double Taxation Agreement, - See that provision is made for any penalty payable
under the Income Tax Ordinance. See that all reserves required under the tax laws have been
correctly created. See that correct adjustment has been made to the provision for taxation upon
completion of assessments and determination of actual tax liability. Ensure that the provision is
sufficient to cover all the liabilities for the year and to date of the balance sheet. Generally the
advance payment of tax is off-set against the prevision and net amount is. shewn, in the balance
sheet where provisional assessment under the Income Tax Ordinance has been made.

Proposed Dividends
Examine special provisions in the Memorandum of Association or Articles of Association in
respect of payment of dividends. Ascertain that it does not include unpaid dividends which must
be excluded from it and shown separately. See that the amount of proposed dividend
recommended by the Board may be stated in the balance sheet (in which case a mention of
proposed dividends will be given in the Directors' Report). See that sufficient profits exist for the
appropriation to. proposed dividends. "

UNEXPIRED DISCOUNTS
This item generally arises in the case of banks or financing companies whose business is to
discount bills of exchange on a large scale. See that proport&mate discounts on such bills as
remain unmatured at the date ofthe balance sheet should be transferred from the credit of discount
account .normally called 'Rebate on Bills Discounted' and- should then appear as a liability
under . the above head, representing discounts received during the current year but attributable to
the next year. :

19

Verification Liabilities

CONTINGENT LIABILITIES
A contingent liability is a liability which is contingent on the happening or not happening of
an event. It is not unusual to record contingent liabilities in the books of account. A reference is
made to them by way of a footnote on the balance sheet. If it appears that a loss is likely to arise
on a contingent liability becoming an actual liability, adequate reserve should be' provided in
accounts. Several types .of4 contingent liabilities together with the verification procedure are
explained:

1. Bills discounted. Check the amount of such bills with the bills receivable book and note
the date of maturity. Trace the subsequent realisations. See that a reserve is created for those bills
which are found dishonoured before the date of the audit.
2. Uncalled Capital on investments. Check it with reference to the share certificates and
with banker's receipts for payment of application and allotment of money.
3. Guarantees. In respect of guarantees of a debt owing by a third party,
examine the agreement for guarantees and enquire whether the third party has
deposited any amount by way of security. Ascertain from the creditor the amount of
the outstanding debt.
-"
4. Law Suits. Relating to claims not admitted as debt by the client, any pending law suits,
study the correspondence and developments of the case. If there is a likelihood of a loss see that
adequate reserve is provided for it.
5. Arrears of Cumulative Preference Dividends. Examine the mwisions ofthe articles of
association in respect of arrears of cumulative preference dividends. Note the period up to which
any dividend on such shares has not been paid and check the working of the amount;
6. Labour Disputes. Enquire if any labour disputes are going on in a court of law and
ascertain the amount of contingent liability involved.
IAS 10 deals with contingencies and discussion in this respect has already been held in an
earlier chapter.

252

Auditing: Principles and Procedures

Appendix 6.1
LIABILITY. CERTIFICATE
(To be signed by the client)
As at. . . . . . ;_______19 . . .
.............'......................................................................................................................Limited.
(Name of Company)
I hereby certify that to the best of my knowledge and belief all liabilities mcurred in or
relating to the year ended 19 have as at the said date been included in the books of account.
I further certify that except for undemoted items there-were no contingent liabilities or
claims against the company not admitted as debts outstanding as at the above date.
I farther certify that with the exception of undemoted liabilities there were
no mortgages or charges outstanding against the company's property and assets as at the above
date:
. (a) Particulars of contingent liabilities or claims against the. company not
admitted as debts.

(b) Particulars of mortgages or charges (if any)

Place............................................... '..................................................................................
Signature
D a t e . . . . ..................................... ......................................................................................
Designation

VERIFICATION
ASSETS

Before taking up the task of verification of-assets, the auditor should* satisfy himself in
respect of the following:

(1) That there is adequate control over the custody and handling of assets.
(2) That there is adequate control over the purchase, disposal and scrapping of
assets.
(3) That all assets are free from charges except those noted on the?-balance sheet.

(4) That the insurance cover is sufficient for all assets.

BALANCE SHEET AUDIT

The Balance Sheet Audit means that it is primarily confined to the verification of the existence of assets
shown in the balance sheet, because on account of the multitudinous character of the transactions of a bank,
it is not ordinarily possible to tSj
examine every one of them, not it is usually done except with
reference to matters, vfo^iL if any, which provoke enquiry. But the existence of the assets must be strictly
verified cash in hand by actual counting, cash in banks by reference to the PassBook or letters of
confirmation, securities by inspection and uncashed cheques by presenting them for being cashed. In the
case of securities, it has been said that if f^-? some of them are said to be in the hands of a third party
the Auditor has to see whether the alleged Custodian is a party in whose hands the securities might
normally be placed under the approved commercial practice or in the ordinary course of the banks business,
and if that condition is satisfied and the party is also a trustworthy party, the Auditor may accept a
certificate from him instead of verifying the existence of securities by actual inspection. But verification of
the existing assets in some satisfactory form is essential.
The verification procedure of different types of assets will now be explained.

254

Auditing: Principles and procedures

FIXED ASSETS
Goodwill
This asset does not appear, in the balance sheet except when it -is actually purchased, or in
the case of a partnership when it is brought into the boobs oh a change in the constitution of the
firm.
Ascertain the amount of goodwill from the purchase agreement or partnership agreement
and verify the amount. Goodwill may appear in the balance sheet at cost, less any amount written
off. It is not legally obligatory to depreciate it, but it is thought to be a prudent financial policy to
write off the value of the goodwill out of the profits. Where this is done, the auditor should see
the board's resolution. It was held in Stapley vs. Read Bros. Ltd (1924) that profits so applied
were not irrevocably allocated and might be brought, back later to the credit of the profit and loss
account and used for dividend purposes if goodwill had in fact.mamtained its value.

Freehold Land
' Examine registration deed indicating the name of client as the owner. Note the area covered
by it. Verify the basis of valuation and see that it is valued at cost. See that all acquisition
expenses (legal charges, brokerage paid, stamp duty for registration etc.) for the purchase of land
have been capitalised. In case of any doubt in respect of title deeds, obtain a certificate from the
company's solicitor stating that the ownership is vested in the client. If it suffers from a charge of
mortgage against overdraft or loan facilities, obtain a direct bank confirmation stating that the
title deeds were held by the bank as cover suffering from a charge of mortgage against any overdraft or loan facilities.

Leasehold Land
Study the lease deed noting the date of commencement of lease, area covered, period of
expiry, terms of termination, provisions affecting additions (subsequent construction thereon),
hiring out, ground rent etc. See that the provision for write off is made in accounts according to
the life of the lease.

Buildings

(1) When erected by the client. Verify that the direct materials, direct labour costs and a fair
attributable overheads have correctly been capitalised. Obtain the engineers' certificate stating
that the construction work was completed on or before the date of the balance sheet, otherwise
the cost incurred till the date of accounts should be shown as "capital Work in progress".

(2) When erected by a contractor. Verify the cost with reference to the terms of the contract.
Vouch the contractors' bills duly certified by a responsible official.

Verification ~ Assets

255

Examine the construction completion certificate.

(3). When purchased. Examine the sale, deed, for the purchase. Study the title-deeds and
verify the consideration involved in the purchase of building. See that all acquisition expenses are
capitalised. Vouch the vendors' bills and verify items with the title deeds. If there is a consolidated
purchase of land and buildings, ascertain, that it is reasonably allocated in the accounts and
separated under proper heads for balance sheet purposes'. In this respect, board's resolution
should be seen. All additions and deletions from the building should be vouched with supporting
evidence. Proper authorisation in this respect should be examined. Enquire whether the building
is suffering from a charge. If so, it must be stated in the balance sheet. Ensure that adequate
depreciation with consistent basis as compared to that of the previous year has been provided in
the accounts. .;

Capital Work in Progress

Verify the valuation with invoices, work orders and job cards. Examine the basis of charging
labour and overheads. Obtain progress report from the engineer in charge and verify subsequent
installation and completion with Architect's certificate on the basis' of which its transfer to the
fixed assets should be traced.
out c-\ G-voWi .-^-*

Assets Abroad
Inspect the documents relating to property in a foreign country, if they are kept at head
office, in the absence of which the clients should be asked to obtain a Certificate from the local
qualified auditor. It should be examined.

Railway Sidings
In our country railways are nationalised. Therefore, generally all the railway sidings are
constructed by the railway authorities. Study the contract with the Pakistan Railways to establish
the actual cost payable for laying the railway sidings with the bills received by the client. Verify
the valuation from factory premises. Ensure that the work has been completed before the date of
the balance sheet. Obtain an inventory of the railway sidings and verify its quantitative aspect
with the original contract. See that the maintenance expenses of railway sidings have either been
paid or provided in full for the year' and have been charged to the revenue account. Ensure that
adequate depreciation with a consistent basis as that ofthe previous year has been provided in the
accounts.,/

Plant and Machinery

Obtain a schedule of closing balances. Check it with asset register or asset cards indicating
the location of assets also. Tally the control account. Verify the casts of the schedule. Check the
valuation with invoices, import documents, acquisition charges (clearing agents bills, bills of
entry for customs duty and sales tax etc.). Ascertain whether imports were against investment
licences , or against

256

A uditing: Principles and Procedures

bonus vouchers. In case of imports against bonus vouchers bought for this purpose, see that the
cost of bonus vouchers is capitalised. If manufactured by the client, see that the account of direct
materials, direct labour and attributable amount of the overheads are properly capitalised. Also
inspect Architect's certificate in proof of completion of work. If the work is still in progress, the
expenditure up to the date of the balance sheet should be shown under "Capital work-inprogress". See that all repairs to plant and machinery are charged to revenue and not capitalised.
See that adequate depreciation calculated on a consistent basis as that of last year is provided in
books. Confirm that the basis of charge of depreciation is consistent with that ofthe previous year.
Vouch all additions to and deletions from the account with supporting evidence and examine
authorisations in this respect. See that on sale of furniture, adjustment of accumulated
depreciation included in the depreciation reserve is also made.

Furniture and Fixture

Obtain a schedule of closing balances. Check it with the asset register or with assets cards
and agree with control account- Verify casts of schedule. Check valuation with supporting
evidence of invoices and vouchers. Ascertain that there is an effective check on the physical
existence of the items included under furniture and fittings. All expenses of repairs should be
charged to revenue. See that adequate depreciation calculated on a consistent basis as that of last
year is provided in books. Confirm that the basis of charging depreciation is consistent with that
of the previous year. Vouch all additions to and deletions from the account, with supporting
evidence and examine authorisations in this respect. For sale of furniture, adjustment of
accumulated depreciation included in the depreciation reserve should be made in the books.

Development Expenditure
In the case of plantation, e.g:, tea, rubber, coffee etc., all expenses incurred during the period
of development and up to the time they begin to earn are capitalised and debited to Development
Expenditure. The annual accounts are usually prepared after the crop is sold out. Obtain a
certified inventory of the closing stock. The closing stock is valued at an expected sale price in
the subsequent year less the estimated expenses. Verify the expected sale price with reference to
the subsequently realised orrealisableprice and also determine the adequacy of the estimated
expenses by reference to the actual expenses subsequently incurred. Vouch the expenditure
debited to this account, seeing that expenditure has been properly allocated between capital and
revenue. Be sure that the amount of depreciation provided is adequate.

Mines and Quarries

Verify the costs on the occasion of first audit with Sale-deed and other documents. Inspect
the lease deeds. See that the assets are being written down from

Verification Assets

257

year to year, based on the depletion, failing which a quaiifying note should be put on the
accounts. When the lease for such assets has expired, see that they are completely written off in
the accounts.

Patents
Obtain a list showing the description of each patent, the registered number, date and
number of years to run. Examine the actual certificates issued by the patent office in respect of
patents granted. Where patents have been purchased from an individual or syndicate, inspect the
agreement for the purchase and note the age of various patents. See that all renewal fee has been
paid or provided in accounts and is charged to revenue. See that the patents which have expired
are written off. The cost of a patent should be written off in the course of its life. At time a patent
might become valueless due to obsolescence or failure to create a demand of the patented article.
In such cases the auditor should see that its value is written off even before the expiration ofthe
period covered by the patent.

Trade Marks and Designs

Examine the certificates issued by the Registrar. If the trade mark has been acqrrired by
assignment, vouch the amount paid therefor with the assignment (representing capital
expenditure). All costs of registration of trade, e.g., registration fees, payments to artists and
expenditure of salaries and overhead attributable to the time spent in developing designs of mark
should be capitalised. See that renewal fee has been charged to revenue. Examine the last
renewal fee receipt to ensure4 that the trade mark has not been allowed to lapse check the amount
of provision for depreciation.

Copyrights
The verification of this item will be on the lines similar to those described under patents. If
the copyright was acquired by the client, see the agreement under which it has: been assigned.
Look into the question of amortisation copyrights; it should be revalued at frequent intervals. See
that copyrights which have expired are written off where any publication ceases to command
sales, the copyright in respect thereof loses its value and therefore the cost of publication of such
work should be written off.

Vehicles
fioijGfbtsiin acetified ijavenjtiar^nfrall .vehicles preferably indicating the following
pagtjtsulafcgij tnrb bfnoifa loiifcrnj sdT -baniw

(2) Description of Vehicles.

(3) Engine number,

258

Auditing: Principles and Procedures

(2) Chassis number, and

(3) Amount,
Examine Registration Books and see that token tax fdf the year has either been paid or
provided in accounts. Inspect the insurance policies also. Checfcthe log books to verify the
existence and use of the vehicle. See that it is adequately depreciated on a consistent basis as
compared to that of the previous year.

Interest paid out of Capital

The auditor should carry out the following work for a proper verification of the payment of
interest out of capital:

(1)" See that the payment is authorised by the articles or by a special resolution.
. (S2) Confirm that the company obtained the sanction from the Federal Government and
payment is made only for such period as may be determined by the Federal
Government.
(3) Ensure that interest does not exceed four per cent in any case.
(4)
Ascertain that the interest paid and the share-capital on which it was paid '
are clearly disclosed in the balance sheet.
The interest thus paid out of capital is allowed to be capitalised as a part ofthe construction
cost of works Or building.

Assets acquired on Hire-Purchase System

The auditor should see that the asset is brought on to the record at its present value ( i. e .
cash basis and the additional amount resulting on account of deferred payment is Charged to
interest account. The whole of the interest as represented by the difference between the total
payments agreed to be made and present cash price ofthe asset should not be charged off to
interest account in the first year, but should be tempmarily debited to interest suspense account,
and a proportionate amount of interest applicable to-each year should be written off to revenue in
that year. The calculation of the annual depreciation should be based on the cash price of the
asset and not on the total instalment value.

PRELIMINARY EXPENSES
The statutory report (if applicable), memorandum and articles of association and prospectus
should be examined. The auditor should see that only items connected with the floatation and
promotion of the company are included under this he.ad of account. Broad details of amounts
constituting preliminary expenses flre.V

(1) Legal cost of registei'ing the company.

(2) Stamp duty and fees paid on the authorised capital.

Verification Assets

259

(1)

Fees and stamp duties paid on the documents filed with the Registrar of Joint
Stock Ckmipanies. -

(2) Cost of preparing and printing memorandum and articles of association,

(3) Cost of preparing all preliminary agreements including stamp duties.
(4) Cost ofpreparation, printing and publication of the prospectus.
(71 Engineer and valuer's fees for valuing assets intended to be acquired.

(8) Accountant's charges for certifying profits.

(9) Cost of preparing and printing share certificates, letters of allotment, debentures, trust
deed etc.

(10) Cost of the first set of books of accounts,: statutory and statistical books and
commoneeal ofthe company.

(11) All legal and professional charges in respect of . the promotion and formation of the
eompany;

Supporting documents (solicitor's receipted bills of cost for legal services rendered, receipts
from newspapers or advertising agents for advertising and distribution of prospectus, printer and
stationer's bills and receipts, certificate of incorporation for stamp duties and receipted bills of
cost from accountants engineers and values etc) should be seen.
The auditor should also refer to the contract with the vendors or promoters to ascertain if
they have to bear either the whole or a portion of these expenses. If so, the auditor should see
that the amount of preliminary expenses to be borne by the vendoror promoters are charged to
their account. He should refer to the prospectus to ascertain that the amount estimated therein is
not exceeded.
The amount under this head is required to be shown separately on the assets side of the
balance sheet, till such-time that it has been completely, written off.

COMMISSION ON SHARES AND DEBENTURES

Section 82 provides that it shall, be. lawful for a company to pay a commission
to any person in consideration of a subscribing or agreeing to subscribe, whether
absolutely or conditionally or any shares in the company, or procuring or agreeing
to procure subscription for any shares in the company, if:
..

(1) The payment of the commission is authorised by the articles,

(2) The commission paid or agreed to pay does not exceed the amount or rate so
authorised, and

(3)

The amount or the rate of commission payable is disclosed in the prospectus or

in a statement in lieu of prospectus or in a statement in the

260

Auditing: Principles and Procedures

prescribed form to. be filed with the Registrar.

These requirements apply only where any shares or capital moneys of the company are
applied in payment of the commission, and particulars of any sums to pay must be disclosed in
every balance sheet of the company, until the amount has been written off. If the commission is
being paid out of profits, no formalities are necessary. These provisions do not affect the
payment of brokerage on shares which it is customarily lawful to pay to brokers and bankers.
The auditor should take the following steps to vouch:

Commission on Shares
If the commission was paid;out of the capital moneys, it should be seen that the
requirements of Section 182 were complied with. The relevant provisions contained in the
articles of association of the company in respect of this item should be examined and if any
restrictions were placed it should be seen that they were adhered to. The underwriting agreement
should be inspected and the amount of commission should be vouched with the underwriters
receipt. The minutes of the Directors should be examined. If the commission was paid in the
shape of shares, it should be seen that the necessary contract was filed with the Registrar, Joint
Stock Companies.
If the shares under written were not fully subscribed for by the public it should be seen that
the underwriters took up the remaining shares and paid for the same. The amount of commission
or so much of it as has not been wiitten off should be shown as a separate item on the balance
sheet.

Commission on Debentures
Apart from the procedure noted under commission of shares above, it should be inquired by
the auditor that the particulars of the amount or rate of commission have been filed with the
Registrar- along with the particulars of mortgages and charges as required by Section 124.

Brokerage
The amounts paid in respect of brokerage should be vouched as under:

(a) The provisions of the articles of the association should be inspected.

(b) The relevant portion of the prospectus dealing with the item of brokerage
should be studied.

(c)

The entitlement should be verified by the study of the above documents and
with the application forms marked by the broker.
.. _

tJi

(d) The brokers' r eceipt should be checked and the directors' minutes should
be examined for authorisation ofthe payment.

Verification Assets

261

UNDERWRITING COMMISSION
The terms of underwriting commission should be verified from the articles of association,
prospectus and agr eement with the under-writerCs). It should be seen that the limits laid down
by the controller of capital issues in respect of underwriting commission are not exceeded. If the
said commission has been paid in cash, payee's acknowledgement and the calculation of the
amount should be checked. If shares have been allotted against the consideration of underwriting
commission, the relevant entries should be checked. The amount paid should be separately
shown in the balance sheet until written off.

STORES AND SPARE PARTS

Obtain a certified inventoiy of stores signed by. a responsible official and check it with
stores and spare parts ledger. Check the casts, cany forward and extensions. Check valuation
from invoices, vouchers etc. Test check receipts and issues and review the slow moving stores
and see that adequate provision is made for the loss arising out of obsolescence and unsuitable
spares not fit for use. Ascertain whether any physical count was carried out by the client. If so,
find out that the differences were investigated by a responsible official and adjusted in books. A
physical test check of closing balance by the auditor should also be preferably carried out. A
certificate from a responsible official should also be obtained indicating the basis of valuation
and total amount of store.

LOOSE TOOLS
If the company manufactures its own tools, see that the cost ol these is properly ascertained
and certified by the Chief Engineer. Obtain a certified closing inventoiy and check its valuation.
The closing balances should be checked with the loose tools register.

LIVE-STOCK
Obtain a certified inventoiy of the animals. Check it with the live-stock register and agree
the control account. See that they are revalued annually and any loss on the sale or death of
animal has been written off.

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Auditing: Principles and Procedures

STOCKS
Sfock-in-Trade1
1. Examination of Stock.Taking Procedure
. A. Examine clients' written instructions for stock-taking, e.g., office order defining the
specific duties to responsible officials.
B. Confirm that these instructions deal adequately with:

(a) The following requirements:

(i) If in stock, charged to purchases.
(ii) If in purchases (and not received) included in stock. (Hi ) If in stock, not in
sales.
( i v ) If in sales (and not despatched) not in stock. .

(b)

Exclusion from stock of customers' materials, goods received on

consignment or sale or return, suppliers' packages not charged to clients etc. .
(cJ Exclusion from stock or stores and materials bought for capital projects and
already charged to capital accounts.

(d)

Recording receipts and deliveries between the date ofthe count and the
end of the year.
(e)
Items not being included more than once or not being omitted
altogether where stocks in all departments are not taken simultaneous! e.g., if
the count goes on during working hours.
(/} Distinguishing slow moving, obsolete, redundant and damaged stocks from sound
stocks.

(g) Checking rough stock sheets against final stock sheets.

C.

(A) Retentionfor audit purposes of rough stock sheets.

(0 Arrangement for initiating the stock sheets by those taking part and for
countersigning by a responsible official.
(/) Reconciliation of physical stocks with book stocks and examination of differences
by a responsible official.
Verify that the written instructions are carried out by:

(a) Attending at a stock-taking date

(b) Subsequent enquiry:
D.

Was physical count of stocks made by staff other than those responsible for

. Recommended fur further reading;

Audit Guideline (AG ll entitled, Verijicathill of InuL-nturies, j^ued hy the Institute of ChartBrtd Accountant* of Pakistan on
December 14, 1930, pp:l-9.

Verification Assets

263

keeping stock recoi ds?

2. Verification of Quantities of stocks

(a)
(b)
(c)
(d)

Test check build-up of main stock sheets from rough stock sheets.
Test quantities of rough stock sheets with bin cards.
Test quantities shown on bin cards with quantities shown on stock cards.
Obtain explanation for material differences,
(c) Test check of accuracy of stock cards with purchase invoices, requisitions, sale
invoices etc.
(/) Test additions of permanent stock records.
(g) Test goods, inwards with permanent stock records -around balance sheet date.
(A) Test peimanent stock records with items passed through purchases
account around the balance sheet date, (i) Test goods outwards book into peimanent
stock records around balance
sheet date.
(j ) Test stock car ds with items passed through sales journal around balance sheet date.
' (k) Examine certificate from thhd parties for stocks held outside clients' premises.
() Compare quantities held in different categories "with quantities held in previous year,
and account for material differences.

3. Verification of Valuation of Stocks '.

() Examine clients' written instructions for pricing and indicate
departmentsfficial(s) responsible for pricing.
(W Prepare schedule showing basis of valuation of
(t) Raw material.
..

(ii) Consumable store.

(iii) Work in'progress, and'or partly manufactured goods..
(iu) Finished goods. ^. (u) Packages and containers.
(vi ) Loose Tools.
. .' {vi i ) Other Stock,
. ,(c) Note any change of basis, as compared with the previous year- and assets the effect of
change on the current year's profits.
{d) Verify-"from the purchase invoices the cost prices of stocks, stores, etc.
(e) _ - Consider whether replacement cost of balance sheet date is less than stock

264

Auditing: Principles and Procedures

sheet value and if so, whether reflected in the valuation of partly manufactured and
finished stock.
(fi Work in Progress
(i) Test build-up of cost records (materials, labour, over-heads).
(ii) Examine reconciliation of cost and financial accounts.
(iii) Test overhead rates and bases of allocation.
(iv)
Consider the volume of activity on which overhead rates have been
based.
(u) Ascertain that overhead In stock valuation excludes selling overheads.
(vi ) Consider any provision is necessary against anticipated losses on uncompleted
contracts.
ig) Finished Stock
Test valuation with subsequent selling prices (after allowing for selling cost).
(h) Test the obsolete, slow-moving, redundant or damaged stocks are written
down to realisable values.
(i) Test check extensions.
(J ) Addition of stock sheets.
(k ) Prepare summaries of stocks classified according to the nature of business with
comparative figures for preceding year'.
(7) Note value of stocks for insurance purposes.
(m) Note any pledge or lien in connection with stocks.
( n ) Compare values with previous year and account for significant variations, (o)
Consider forward commitments for the purchase of raw material, etc., in
relation to spot prices at balance sheet date, (p) Stock
certificate to be obtained as Appendix 7.1.

Stock-in-Transit
See that the basis of valuation is consistent with that of the previous year -. Check valuation
with invoices, bank advices, voucher's etc. Confirm that stock has been subsequently received.
See that adequate provision is made for any items received as damaged. If the market value of
the items in transit shows a material fall as compared to cost, see that the provision is made In
accounts. Ensure that liability for the stock in transit is reflected in the accounts.

Work in Process
Check the inventoiy of work in process. If the company does not have a cost system in
operation, ascertain that physical inventoiy of work in process was taken

Verification Assets

265

at the end of the account year and obtain a certified copy thereof. Extract an inventory from the
costing records if maintained. Note the basis of valuation and see that it is consistent with that of
the previous year in respect of treatment of overheads and other charges which should be
included in cost according to generally accepted accounting principles. Trace the subsequent
transfers to the finished stocks. Ensure that provision is made in accounts to cover:

(1) Exceptional losses in work in process.

(2) Fall in market value of raw material below cost.
(3) Fall in sale price of finished stocks below cost. This is particularly important where
production is against .specific orders.

Stock of Packages and Empties

Look into the method of recording these in the books of accounts. Where these are not
returnable, see that the cost of packages and empties should be included in the sale price. Where
these are returnable, obtain a schedule showing what amount of empties are still to be returned.
The auditor should check the records which must contain the details of incomings and outgoings
of the empties on containers in a separate register. Adjustments subsequent to the date of the
balance sheet should be scrutinised. The auditor should cmefully be scrutinised. The auditor
should carefully look into the question of depreciation. As these are likely to be handled roughly,
they would be subject to heavy depreciation. Hence the auditor should see that adequate
depreciation is provided in the books.

Stock of Goods sent on Consignment

Obtain stock ..certificate from the consignee as to the existence of stock and custody with
him. Scmtinise the certificate to ascertain the mention of any deteriorated or damaged stock. If
the certificate discloses the same, proper allowance for it must be made in the books. Ascertain
that no obsolete and unsalable stocks are included in the stock. Scmtinise the basis of valuation.
Ascertain the market price of such goods and see that it is not lower than the cost. Where goods
are sent out on consignment at proforma invoice price including a percentage. Above cost, see
that the necessary adjustment is made in respect of consignment of goods which remained unsold
at the balance sheet date to bring them at the actual cost, .

Stock of Goods sent out on Sqfe or Return

If the transactions relating to goods sent on "Sale or Return' 1' .have been entered as ordinary
sales in company's books, obtain a schedule .of goods not approved and lying with the
customers at the date of balance sheet and check it with accounting records. Confirm that
adjusting entiy by debiting sales account and crediting debtors' suspense account with the amount
of such goods has been passed See that after posting this entry, the goods in the hands of
customers are valued at

A uditing: Principles and Procedures

266

cost or market price whichever is lower and is shown in the trading account and balance sheet.

BILLS OF EXCHANGE
Obtain a schedule of bills receivable. Check casts of it and compare the individual balances
with the bill receivable book. Agree'the control account. Count all the bills on hand and note any
bills which are overdue. Trace the proceeds of all bills which matured subsequent to the date of
balance sheet into the cash book. Obtain direct confirmations from the parties for larger amounts.
Obtain a direct bank, certificate in respect of bills that may be in the process of collection. See
that adequate reserve has been made for any bills which are doubtful of recovery. Ensure that any
bills discounted but not matured as on the date of balance sheet are shown by means of a
footnote as a contingent liability.

BOOK DEBTS1
. Obtain a certified schedule of book debts. Check individual balances shown on the certified
schedule with the debtors ledger and agree the control account. Verify the casts of the schedule.
While scrutinising each debtor account, special attention should be given to the following
matters;

(1)

Whether the account is regularly settled? In -such a case the conclusion is that
the debt is good. .'

(1) . Whether the debt is outstanding beyond the period of credit allowed. If so,
(3)

it would normally mean that the debt may prove to be doubtful.

Whether the payments are on account and the balance payable by the debtor tends to
increase? If so, the inference is that the party's creditworthiness is doubtful.

(4) Whether the old balance is being carried forward and the new goods are being
(5)

supplied for cash? It will lead to mean that the old balance is disputed. One which
should thoroughly be looked into.
Whether- a cheque or a bill r eceived in payment of goods supplied has ever got
dishonoured? If so, it indicates that the party appears to be financially unsound and the
debt may prove to be bad some day.

(6) Whether any note, e.g., account stopped, in solicitor's' hand, in bankruptcy, in
liquidation, address not known, left without leaving any address etc., appears on the
ledger account? If so, the account should be thoroughly looked into. Also establish the
amount which is doubtful of recovery.
. Recommended for further readi ng:
Statement of Auditing Guideline (AG 31 entitled. Verification of Debtors' Balances by Direct Communication, issued by th=
Institute 'if Chartered Avcountunt* uf Pakistan, n.d., pp.1-9.

Verification ~ Assets

267

(7) Whether the debt is time-barred due to the provisions of Law of Limitation which

allows three years to recover a debt? If so, the amount is doubtful of recovery. . '
(8) Whether the bills of exchange or cheques are constantly being renewed? If so,
apparent conclusion is that the party is financially unsound and the debt may prove to
be doubtful of recovery.
(9) Whether the payments are irregular? In such a case, the debt may not be good and
some day it may become bad.
(10) Whether there are any unusual items of discount or allowances? Such cases should be
thoroughly scrutinised to see the proper- authorisation for such discount.
Major accounts should be scrutinised to see whether unusual financing of parties has been
carried out. See that debts due by directors and other officers ofthe companies are shown
separately. Ensure that the segregation of debts into seemed and unsecured is made and shown in
the balance sheet. Check the nature of securities and its value and ascertain that the debt is fully
seem ed. The aging of the debts should be done. All unsecured debts which are fairly old should
be treated as doubtful. Note subsequent realisations. Discuss fully the old outstanding not paid
even after the date of the balance sheet. Mar k all doubtful accounts and prepare a .separate list
for them. Selected number of debtors should be checked: Specimen of the circular to be sent is
given as Annexure 7.2. For any difference between the balance shown in the books and on the
confirmation} an enquiry should be made to straighten out the matter. Enquire that amount of
sales does not include any items of transactions for future delivery of goods. Pay special attention
to any big items of sales passed through at the close of the accounting year to ascertain that they
are genuine. See that such sales are not shown as 'sales returns' subsequent to the date of account.
If so, the amount should be deducted from the book debts and sales and included in stock at cost
or market price whichever- is lower'. Examine board resolution for bad debts written off during
the year 1 and see that the provision for doubtful debts is adequately made by considering'the
following:

(1)
(2)
(3)
(4)
(5)

The basis of providing bad and doubtful debts.

The amount of debts marked by the auditor- as doubtful of recovery.
Bad debts incidence in the few previous year's (say three).
Cases in legal hands.
Unexecuted decrees which lapsed.

Debts showing credit balances and appearing in the debtors schedule are liabilities and
should be included under habilities in the accounts.

Auditing; Principles and Procedures

268

ADVANCES
Loans and Advances {as an Asset)
Obtain a schedule. Check it with the subsidiary ledger and tally the control account.
Examine authorisations for sanction of loans or advances. Vouch confirmations. Ensure that the
subsequent recoveries of principal and interest are regular. Examine agreements, nature of loan
and security (if any). See that all interest receivable has been received or accounted for in the
books. See that adequate provision for amounts doubtful of recovery is made in the accounts.
Under the law loans to directors and managing agents respectively are for bidden. Scrutinise
major accounts to see whether unusual financing of-parties has been carried out by the client.
Various types of .secured loans together with the steps involved in their proper verification are
discussed below:
(1) Loans against security of goods. Where loan was advanced against a godown keeper's
receipt, examine such receipt." If goods were at docks or in bonded warehouse, examine dock
warrant or ware-house certificate duly endorsed in favour of the client, (hi the absence of these
documents delivery notes duly endorsed in favour of client should be examined). See that the
warehouse rent has either been paid by the borrower or if paid by the client is either recovered
from the party or debited to their account. If the money was advanced against goods in transit,
documents, viz., railway receipt or bill of lading, letter of hypothecation, insurance policy and
invoices duly endorsed in favour of the client should be inspected. Market valuation of goods
should be verified from market quotations, invoices etc., to establish the value of security.
'(2) Loans against insurance policy. Examine the last receipt for the payment of premium to
prevent the policy lapsing . Scrutinise the policy and the notice of assignment to the insurance
company. Ascertain the latest surrender value of the policy and see that the loan in secured with
reference to the amount.

(3) Loan against security of shares. Obtain a written confirmation of the loan from the
borrower. Inspect the share certificates with blank transfer deeds duly signed by the borrower.
Enquire whether lien has been got marked by the client in the share register of the company
whose shares in question are held as security. Verify the market value of the shares with reference
to the standard publications giving share quotations and see that the value of security gives : a
sufficient cover against the loan.
(4) Loans against Security of land and property. Obtain a confirmation of loan from the
borrower. Examine the duly executed .and registered mortgage deed if the land or property has
been moitgaged. Also examine the title deed ofthe property. If a second mortgage has been
created, see that the contract with the first mortgage provides that second charge can be created
and he has been infomed accordingly. In this case, the auditor should obtain a confirmation as to
the title and ownership of the property from the first mortgagee who may be holding the title
deeds. Obtain

269

Verification Assets

professional valuers' certificate and see that the loan is . secured. Ensure that all interest
receivable on loan has either been received or. accounted for. Inspect the insurance policy
covering comprehensive risk and see the latest premium receipt.

Deposits
Obtain a schedule of deposits. Check it with original receipts and confirmations. - Enquire
into the reason for the amount deposited.7 Scrutinise any subsequent adjustment.

Prepayments
Obtain a schedule and check it with demand notes, bills, vouchers, etc., noting carefully the
period, for which the prepayments is involved. Scrutinise their subsequent adjustments. Examine
necessary correspondence in this respect. Compare amount with the previous year and note
any'major fluctuations. Enquire into usual financing by the client.

Recoverable Claims
Obtain a schedule giving the details of the recoverable claims. Examine correspondence and
study the developments and possibilities of .recoverability of claims. Note subsequent
realisations. See the adequate provision is made for doubtful claims in the accounts.

INVESTMENTS
As authority for investments, study memorandum of association. Obtain a certified schedule
of all investments and cany out the following work for a proper verification:
1. Principal
{a) Face value and ownership. Examine the investments seeing that name of the client is
stated as the owner and note the face value. If these are held by the bank, obtain a
direct confirmation stating the object of holding it, i.e., for safe custody or as a cover
against loan.
(&} Book Values. Compare with the investment ledger and the previous year's
schedule."Vouch the purchases with brokers bought note and see the terms of purchase,
i.e., ex-dividend ox cum-dividend. And sales during the year should be verified with the
brokers' sold note. See Boar d resolution for the authority of the above purchase and
sale. A comparison of rates at which these were bought or sold with the published lists
<in reliable newspapers, stock exchange repoi"ts, etc) should also be done.
(c) Market Values. Cheek the market value with the quotation list at the date ofthe balance
sheet (or- with the latest available quotation list hear- the

Auditing: Principles and Procedures

270

balance sheet date). Any material loss resulting from the decline in the market value
compared to cost should be provided in the accounts. For unquoted investment,
examine latest available accounts.

2. Interest

(a)

Scrutinise each individual investment account to ensure that all interest has
either beenreceived or accrued in books.
(b) In case of the limited companies, enquire into the question of dividend income.
*3. Contingent Liability .

Note any amount of uncalled capital relating to shares held as investments and give a footnote of it in the balance sheet.

4. Speculative Transactions
Enquire into the. speculative transactions with particular reference to short-term purchases
and sales.

Endowment Policies
Endowment policies are sometimes taken out to make funds available for redeeming some
liability falling due at a later date (e.g., sinking fund policies for redemption of debentures). The
auditor should actually inspect the policies and confirm that the premium is being paid regularly
to ensure that the policy may not lapse.

Interest accrued on Investments

Obtain a certified schedule indicating the names of securities, their nominal values, due date
of interest and amount of accrued ^interest. Check the date of accrual with the market
publications and verify the basis of computation and calculations. Income-tax liability should be
checked with the current rates, applicable under the Income Tax Ordinance, 1979 also note
subsequent realisations.

CASH AND OTHER BALANCES

Cash
All cash on hand should be brought at one table and physically counted as on the closing
date and agreed with cash book and balance sheet. The last numbers of the Receipt book(s), Cash
memo bookts), Cheque payment vouchers, Cash payment vouchers, cheque(s) book and cheque
receipts should be noted.

Verification Assets

271

See that the collections are segregated and kept separately from imprest. At the time of
counting the cash, examine the pay-in slips for at least seven days prior to cash count and link up
the lodgement dates which cash receipts. Scnitinise bank statements subsequent to cash count for
any dishonoured cheque. Vouch all cheques drawn for cash during fourteen days prior to cash
count.
For LO.U.'s (I Owe You), see that the chits are signed by the recipients. Ensure that the
same is approved by a responsible official, preferably by the passing authority before advancing
money on LO.U's. Assess the materiality of the amount and get it transferred to book debts, if the
amount is of material nature. The practice of showing LO.U.'s as cash in hand should be
discouraged as it omits to record the transactions taking place from day to day.' Check the
exchange conversion into rupee element at official rate of exchange. Obtain agents' confirmations
for cash lying with them.
In case of branches, the client should be requested to deposit all the cash into bank as on
financial closing date. Alternately confirmations from the branches should be obtained for the
closing cash on hand, if it is not practicable for the auditor to count the cash.
Various objectives of standard request for banker's confirmation letter are explained below:

1.
2.
3.
4.

Confirmation of ail bank balances of the client at year end is obtained directly.
If any charges were not included or credit was not given for accrued interest/return by
the bank, the amount is ascertained and accounted for.
Contingent liabilities, if any, are identified for footnoting in the balance sheet.
Ascertaining details of any assets held on behalf of the client.

Cash-in-Transit
Compares the dates shown on the paying banker's statement and the receiving banker's
statement. Examine the advices of transfeiring bank and receiving bank. If no advices are
produced for scmtiny, enquire whether the transfer is on account of standing instructions.

National Prize Bonds

Obtain a schedule of National Prize Bonds as at the date of balance sheet. Physically inspect
the same and check the schedule with the investment book. See that the details of the series and
numbers are recorded in the investment book. In . the case of prize won, see the amount was
received from the State Bank of Pakistan.

Auditing: Principles and Procedures

272

Bank Balance
Obtain direct bank coiuirmations in support of the bank balances. A suggested proforma of
the letter to be written in this respect has been included in an earlier chapter. Obtain a bank
reconciliation and agree the balance of cash book as at the date of balance sheet with the balance
shown in the bank statement/bank certificate. Scrutinise all outstanding items and note their
subsequent adjustments. See that the above bank certificate indicates the name of the client in
whose account the money is lying in the books of the bank.
Examine the fixed deposit receipt for amounts lying in fixed deposits (apart from a direct
bank certificate). See that accrued interest to the date of balance sheet has been accounted for in
the books. Show the balances with the bankers on deposit or on current account separately. Veiify
conversion rates in the case of foreign exchange balances and disclose the exchange rate of
conversion as a footnote on the balance sheet. Any loss or gain arising due to devaluation must
be reflected in the accounts.

Balance with Agents

Ascertain the reason for balances kept by the agents and ensure that their size is in line with
the financial requirements. Obtain a schedule of all balances due from agents. Check it with the
ledger. Check casts ofthe said schedule. Obtain confirmations and tally the amount with the book
balances. In case of differences, obtain a reconciliation and verify it properly. Scrutinise
adjustments subsequent to the date of balance sheet. Any balance disputed by the agents must be
thoroughly looked into and provision may be created for balances which appear to be doubtful of
recovery. If any interest is recoverable under 'the' agreement with the agent, see that the amount
has either been received or a provision' therefor is made in the accounts.

DEFERRED REVENUE EXPENDITURE

Where any heavy expenditure in the nature of revenue is incurred, the benefit of which is
likely to extend beyond the financial year' in which it takes place, it is usual to allow such an
expenditure to be temporarily capitalised and to be spread equally over number of years for
which it is anticipated that benefit would be reaped by the business. The following are some
ofthe examples:

(1) Cost of removal of business to a more convenient place.

(2) Exceptional repairs of plant, buildings, etc., of non-recurring nature.
(3) Abnormally heavy amount of advertising expended in any one year to popularise a
new product.

273

Verification Assets

CONTINGENT ASSETS
The Companies Oidinance 1984 does not require that contingent assets should be disclosed
as a footnote on the balance sheet. Hence usually no mention is made at the foot of the balance
sheet of the contingent assets. Examples are: an option to apply for shares in another company
on favourable' terms, refund of octroi paid for goods which have been sent out later, claim for
money fr om a previous endorser of a bill recoverable which had been discounted but which
might be dishonoured, uncalled share capital of a company, a legal action for infringement of a
copyright etc.
However, it is fair to show the contingent assets as a footnote, provided they involve
material amount and their disclosure would assist in exhibiting a true and correct position of
balance sheet.

274

A uditing: Principles and Procedures

Appendix 7.1

STOCK CERTIFICATE
(To be signed by client)
Messrs Mohammad Hussain & Co.,
Chartered Accountants,
Shahra-e-Quaid-e-Azam,
Lahore.

Dated.............................19...

Dear Sirs,
Accounts for the year ended on 1993
We hereby certify that the inventory as at above date was taken under the supervision of the
responsible official and is summarised as follows:
Val ue

Mode of
Valuation
( ) Raw Materials .................................................................. .............................................
() Work-in-process .'............................................................. .............................................
(c) Finished Goods ................................................................................................................
I d ) Stores and Spare Parts....................................................................................................
(e) Loose Tools
' .-.......................................................................
(f > Others . . ....................................................................... ............................................
Total Rs.

We further certify that:

(2)

The inventory is the property of the company and. that there is no mortgage,
assignment or other lien upon any ofthe goods listed. (If there-is any charge, the same
may be stated).

(3) No goods received on consignment have fx-en included.

.(4)

The quantities listed were on hand and were determined by actual count, weight or
measurement.
(5).................................. Excess/shortages between, the physical inventories and
book
balances
amounting to Rs.....................have been adjusted in the books of account.

(6)

The liability for all goods included in the inventory has-been reflected in the
books, and . -

275

Verification Assets

(7)

Obsolete, unusable good's and slow-moving stocks have been reduced to their
net realisable value.
(8) These comprise the whole of the company's stocks, wherever situated, and that
stocks held on behalf of other parties have been excluded.
(9) All executed orders for sale have been invoiced to customers and stocks
relevant thereto have been excluded from the above stocks.
(10) There has been no material variation in the basis of valuation as compared
with that adopted in the previous accounting year.

Yours faithfully,
Signature
Designation

Auditing: Principles and Procedures

276

Annexure 7.2

SUGGESTED FORMAT OF LETTER FOR DEBTOR'S

CONFIRMATION BY DIRECT COMMUNICATION
(To be Typed on Client's Stationery)
DEBTOR'S NAME AND ADDRESS

Dear Sirs,
by our

, to
ask ..
As pail of their normal audit procedures, we have been as
requested
auditors (N ame) ........ ..........................of (f ul l address) :. : . ... .-. .'.
you to confirm direct to them your indebtedness to lis as at (dat e) .............................'.;
details in the enclosed statement.

In the statement is in agreement with your records, please sign in the space provided below
and return this letter directly to "our auditors.- ...
If the statement is not in agreement' with your' records, please notify our auditors directly
ofthe amount shown by your records and, if possible,, send them full particulars of the
difference.
For your reply to be of assistance to our auditors, please give this request your early
attention. .We enclose a prepaid envelope for your convenience.
Please do not send remittances to the auditors alongwith the confirmation.
Yours faithfully, Client's
Authorised Signatory
PLEASE DO NOT DETACH

No...................:...............................

(Client's Name)
Debtor's Name............................................

The balance shown on the statement at ( d a t e ) ...................................of Rs...........................due

from us is/wis not in agreement with our' records at (Date]....................................................The
details of discrepancies are aimexod.
'Delete as apprupritite.
............................Signature
.......................Title or Position

277

Verification Assets

' DEBTOR'S STAMP

Auditing: Principles and Procedures

278

Annexure 7.3

SUGGESTIONS FOR IMPROVING RESPONSE RATES

The efficiency of the audit procedure of debtors corrfirmation by direct communication is
influenced by both the willingness and ability of debtor to respond accurately to the information
presented on the letter of confirmation. Improving confirmation response rate may reduce the
extent of other audit procedures that the auditor may have planned to undertake. The following
are some suggestions for improving response rates:
{a) Use'of Preliminary N oti f i cat i on
The use of a brief letter, post card, or telephone call immediately before posting the letter
generally tends to increase responses as the debtor is less likely to ignore the letter having been
previously notified.
(6) Request Information the Debtor is able to Confirm
The confirmation request should include all the relevant detailed information required for a
response by the debtor.

(c) Use Clear Wording

The coiifirmation request should avoid technical jargons and should be written in simple
language to facilitate an early and effective reply.

(d) Set Deadlines

The confirmation should state deadline 's e.g., URGENT or REPLY REQUESTED
WITHIN 5 DAYS.

(e) Provide Return Envelopes

Return envelopes that have the firm's name and address printed in bold print are likely to
draw attention to confirmations and are likely to encourage debtors to respond.

(f) Provide Prepaid Postage

To facilitate responses, auditors normally
return envelope akmgwith each confirmation;..

(g)

.: .
include

stamped self-addressed
. _.

: Send Follow-up Reminders/Second Requests

Sending reminders/second request soon after sending the initial letter- are likely to increase
response rates, .

(*
-52^

ACCOUNT

VERIFICATION

REVENUE

SCRUTINY OF TRADING ACCOUNT

The rates of gross profit to turnover should be computed for the previous year and the
current year and then compared. An abnormal increase in the ratio of gross profit to turnover
may be due to any one ofthe cumulative results of the following:

1. Purchase price may have remained constant and the sale price enhanced during the
year; or the sale price may have remained constant, but the purchases may have been effected at
cheaper rates.
2. Sales may have been inflated; goods entered in books as sold but not delivered may
also be wrongly included in stock.
3. Stock might have been over-valued due to a different basis of valuation adopted during
the year or due to errors in inventories. A portion of some obsolete stock may have been written
off in the preceding year, but no such adjustment may have been effected in the current year.
Goods may have been taken into stock, but corresponding invoices may not have been entered.
An abnormal decrease in the ratio of gross profit may be due to any or more of the
following reasons:

1.

Purchases may have been inflated; goods entered as bought may not have been
received and thus not reflected in stocks.

2.

Sal e price of goods dealt in may have remained constant during the year as compared
to the previous year, but the purchase price may have increased; the sale price,
increased but the pur-chase price may have remained the same; goods sold and
actually delivered may not have been inadvertently reflected in accounts.

3.

Stock may have been under-valued; there may have been pilferings of stocks; the
accumulated, obsolete arid unusable stock may have all been written off or sold at a
loss during the year;'some of the items may have been omitted Inadvertently from the
inventory list.

Verification Revenue Account

280

The auditor should examine the possibility of above matters and obtain a satisfactory
explanation for the variation in the gross profit ratio to turnover.

SCRUTINY OF PROFIT AND LOSS ACCOUNT

The gross profit having been ascertained should then be transferred from the trading
account to the credit of the profit and loss account. Against this gros^profit would then be set off,
on the debit side all the various expenses incidental to the conduct of the business and relating to
the trading period under audit.
For a satisfactory verification ofthe profit and loss account the auditor should carry out the
following work:

(1)

See that the requirement of the Ordinance and IAS 5 in respect of the
disclosure of information have been complied with.

(2)

While examining the profit and loss account exercise care to ensure that a
strict distinction between capital and revenue is maintained.
(3) As the object of the profit and loss account is to exhibit the true profit or
. loss resulting from hading during any given period, it is highly essential
that the auditor should see that only expenses and income of the year under audit are
included in the account.

(4)

Ensure that various adjustments relating to outstanding expenses, income

received in advance, unexpired discounts, provisions for depreciation, unexpired reser
ve for doubtful debts etc, have been properly made.

(5)

See that all accrued and anticipated losses relating to the year- under audit
have been provided in the accounts. Credit has also not taken for the unearned
profits.

(6)

Ensure that profit and loss account items were computed on a consistent basis.
Make a note of any changes.

(7)

Compare expenditure with that of the previous year and note reasons for
material variations.

(8) Disclose correctly any transaction in respect of previous periods.

(9) Verify satisfactorily that dividend, investment income, commission earned etc.,
have been reflected in accounts.

SCRUTINY OF PROFIT AND

LOSS APPROPRIATION
ACCOUNT
The net profit disclosed by the profit and loss account is transferred to the credit of another
amount called "Profit and Loss Appropriation Account". The objective of this account is to
indicate the amount available for disposal and its

Auditing: Principles and Procedures

appropriations.
On tbe debit side of this account generally appear all such amounts representing
appropriations such as proposed, dividends, dividend equalisation reserve, reserve for deferred
taxation, debenture redemption fund, provision for taxation etc. On the credit side appeal's
amount of profits brought forward 'from previous years and net profit earned during the year.
The auditor should see that: -

. ...

(1)

All the appropriations of net profits are in accordance with the resolutions
ofthe shareholders-in general meeting and the provisions of memorandum and articles
of association and conditions of the consent order issued by the Controller of Capital
Issues.

(2)

All reserves required under tax laws or' any other legislation have been created.

(3) Dividend appropriation is out of 'divisible profits'.

(4) That ultimate net balance on this account is shown in the balance sheet.
(5) In the case of banking companies, the Banking Companies Ordinance, 1962,
requires that all appropriations must be shown on the balance sheet. The auditor
should see that this is done.

INTERNATIONAL
STANDARDS
ON AUDITING
Till the writing.of this book,' 29 International Standards on Auditing had been
issued. The following Chart shows the position in a summarised shape in respect of
the titles and their constituents: . . f . "
..
f'.
ISA
2
Objective and Basic Principles Governing an Audit
{Revised October 1991)

8; 4 5

Audit Engagement Letters .'

Withdrawn and superseded by 1 ..; ... :..
:

Planning

-, 7

Using the wovk of another Auditor (Revised October

1991) Risk .Assessment: and Internal Control
(Revised October 1991):
"
(For Supplements, see Sta e nerts Sector)
Control of Die Quality of Audit W oxk ,.:
'Audit Evidence
Do< trnentation
Using the work of an Internal Auditor
Fraud and'-Error

.'.

-Analytical Procedures (Revised October 1990)

-a. ?
:. to 1 11
!' 12 ; Tit}e

Parag
raphs 31

Appendi

x 16 '
14 '
49 +
Addend
um +
3
Supplem
ents
17
+
Appendi
x
18+,, 2
Adden
dum
13
14
19

16

230

Auditing:
Procedures

Principles

and

The Auditor's Report on Financial Statements

(Revised October 1990)

26 + Three
Appendix

Other Information in Documents containing Audited

Financial Statements (Revised February 1992)

20

15 16
17 18

Auditing in an EDP Environment

19

Computer - Assisted Audit Techniques

13 14

10
24

Related Parties
20 21

24

Using the work of an Expert

17

Audit Sampling
22 23
24
25 26

34 + Three
Appendix

(Withdrawn and Superseded by 6)

Date of the Auditor's-Report; Events after the Balance
Sheet Date; Discovery of Facts after the Financial
Statements have been Issued (Revised October 1991)

19 4- Appendix

Representations by Management

.27

15 + Appendix

Going Concern (Revised October 1989)

28

16 + Two

Special Purposes Auditor's Reports

Appendix

. 29

26 + Four

Materiality and Audit Risk

Appendix

Audit of Accounting Estimates

The Examination
InfoiTnation

of

Prospective

23 + Appendix
Financial

First year Audit Engagements-Opening Balances

(Withdr awn and Superseded buy 6)

24 "
35 + Appendix
15 + 2
Appendix

Source:

1FAC Handbook 1992 Technical Pronuuncuinenin, International Federation of Account ante. New York, 1992

2:il

International Standards on Auditing

The readers are suggested to procure a copy each of the above from the two professional
institutes of our country namely, The Institute of Chartered Accountants of Pakistan and Institute
of Cost and Managements Accounts of Pakistan.
Wherever relevant, we have included provisions of ISA in relevant chapters. Moreover
salient features of some ISAs have also been included at related places.
The International Federation of Accountants have also issued "Summary of International
Standards on Auditing and Related Services" in a booklet form. This contains a brief overview of
each ISA issued to date followed by summaries of the basic principles and essential procedures
extracted from ISAs 129 and ISA/RSs 14 representing ISAs issued till March 1991.
For quick reference and use by readers and professional accountants, text of the above is
reproduced below:
CURRENT STATUS OF INTERNATIONAL STANDARDS ON AUDITING ADOPTED
BY THE COUNCIL OF THE INSTITUTE OF CHARTERED ACCOUNTANTS OF
PAKISTAN

International
Standard >T A'& Subject
lumbers

onAudidng

ISA1AG 2Objective and Basic Principles Governing an

Audit1SA3(Superseded by ISA 1)ISA 4AGSPlanningISA 5AG
6Using the Work of an Other AuditorISA 6Risk Assessment
and Internal ControlISA 7AG 25Control of the Quality of
Audit WorkISA 8AG. 5Audit EvidenceISA 10AG 24.Using the
Work of an Internal AuditorISA 11AG 7Fraud and ErrorISA 12
' " > AG 8Analytical ProceduresISA 15AG 9 ; - Auditing in
an EDP EnvironmentISA 16AGIOComputer-Assisted Audit
TechniquesISA 17AG 11Related Parties

286
Procedures

ISA 18 ISA 19
ISA 20
ISA 21

Auditing:

AG 12

Using the Work of an Expert

AG 13

Audit Sampling

Principles

and'.

(Superseded by ISA $)
:; / ."
AG 15
Date of the Auditor's Report; Events After' the Balance
Sheet Date, Discovery of Facts After the Financial
Statements have heen issued
ISA 22
AG 16
Representations by Management
ISA 23
AG 17Going Concern
ISA 24
Special Purpose Audit Reports
ISA 25
AG.1.8
Materiality and Audit Risk
ISA 26
AG 19
Audit of Accounting Estimates
ISA 27
AG 20
The Examination of Prospective Information
ISA 28
First year Audit Engagements-Opening Balances
ISA 29
(Superseded by ISA 6)
In addition ICAP lias issued certain Statements of Standard Auditing Praet which have been
re-numbered as follows:
Sap 1
Bank Reports for Audit Purposes
Sap 2
Auditors' Report and Qualifications
Sap3
AG 21
Verification of Inventories
(Formerly AG-1)
Sap 4
AG 22
Audit Working Papers
(Formerly AG-2)

Sap 5

AG 23

(Formerly AG-S)

Verification of Debtors' Balances by Direct

Communication

IF AC has recently renamed the term 'Guideline', as 'Standard' and all its pronouncements
on Auditing have been renamed as 'ISA' instead of TAG.'
Source:

Letter dated September 23, 1992 iiddiesned to the author buy the Secretary, the Institute of Chartered AceontantB u1
Pakistan, Karachi.

International -Standards on A uditing

287

INTERNATIONAL FEDERATION OF ACCOUNTANTS .

. "SUMMARY! OF UNTERNATIONAL STANDARDS .
ON AUDITING. AND RELATED SERVICES . (ISAs 1-29 and ISA/RSs 1-4
March 31, 1991)
PREFACE
." The International Auditing Practices Committee (IAPC) has been given specific
responsibility and authority to issue, on behalf of the Council of the International Federation of
Accountants (), exposure drafts, Standards and Statements on auditing and.related services.
(Preface I, p.3) Related services comprise reviews, agreed-upon procedures and compilations.
(Framework, .
; . The. IAPC believes that the issue .of such Standards will help improve the degree of
uniformity of auditing practices and related services throughout the world. (Prefaee , p.4)
International Auditing Standards (ISAs) apply whenever an independent audited is carried
out and may also have application as appropriate, to other related activities of auditors. However,
ISAs do not override local r egulations governing the audit and related ser vices of financial
information in a particular- country. (Preface 11, p.11-12) '
, Standards are issued by the IAPC in two separate series, Standards on Audit Services in
International Standard Auditing (ISAs) and Standards on Related Services . in International
Auditing Standnrds/lielated Services (ISA/RSs) (Framework, p.14). For ease of refer ence, the
term ''auditor" is used throughout the Standards when describing both the auditing and related
ser vices which may be performed. (Framework, p.2). ISA/RS 4, however, uses the term
"accountant" to distinguish between an audit and a compilation engagement (RS 4,p.2)
This booklet contains a brief overview of each Standard issued to date followed by
summaries of the basic principles and essential pr ocedures extracted from ISAs 1-26 and
ISA/RSs 1-2, is being all Standards issued to December 31, 1991. The basic principles and
essential procedures have been cross-referenced to the particular Standard and paragraph
number. This booklet will be updated periodically.
Readers are reminded that the essential procedures have been extracted for the purposes of
this Summary and the Standards contain a great deal of background information and other
helpful standard. Accordingly, it will be necessary to refer to the individual Standards to obtain a
proper understanding of the recommended practice.

Auditing: Principles and Procedures

288

SUMMARY OF INTERNATIONAL STANDARDS ON

AUDITING AND RELATED SERVICES
(ISAs 1-26 and ISA/RSs 1-2 December 31, 1988) TABLE OF CONTENTS

1.
2.

OVERVIEW OF STANDARDS
AUDIT - SUMMARY OF BASIC PRINCIPLES AND ESSENTIAL
PROCEDURES
Audit of Financial Statements
Overall Objective and Scope
Basic Principles General Matters

Integrity, Objectivity and Independence

Confidentiality

Skills and Competence

Basic Principles and Essential Examination Procedures

Planning

Audit Evidence

Accounting System and Internal Control

Compliance Procedures and Audit Conclusions Substantive
Procedures and Audit Conclusions

Work Performed by others

Documentation
Basic Principles and Essential Reporting Procedures

General Matters

Dating of Repoi tYSubsequent Discovery of anError Other Information in Documents

Containing Audited Financial Statements

Overall Objective and Scope

Consideration of other Information

Material Inconsistencies

Material Misstatements of Fact

Availability of other Information after Date of Auditor's Report

International Standards on Auditing

Special Purpose Auditor's Reports

Overall Objective and Scope
General Matters
Other Comprehensive Basic of Accounting
Components of Financial Statements
Compliance with Contractual Agreements
Smrrmarised Financial Statements
3. RELATED SERVICES - SUMMARY OF BASIC PRINCIPLES AND
ESSENTIAL PROCEDURES
Review of Financial Statements

Overall Objective and Scope

Basic Principles General Matters

Basic Principles and Essential Review Procedures"

Basic Principles and Essential Reporting Procedures

APPENDIX - INDEX OF STANDARDS

289

Auditing: Principles and Procedures

290

1.

OVERVIEW OF STANDARDS

Framework of International standards

on Auditing and Related Services
Standards are issued in two. separate series,' auditing: (ISAs) .and related services
(ISA/RSs)'- which comprise reviews, 1 agreed upon procedures and cornpHations. The^Framework
describes .the services that auditors may be engaged to perform hi relation to the resulting level of
assurance. Audits and reviews are designed to enable the auditor to provide high and. moderate
levels of assurance, : respectively, that information; is free of : material, error. In an agreed-upon
procedures engagement, the auditor reports the factual findings of perforrorrig procedures which
have been - agreed with his client-but--lie does not express any assurance on assertions. In a
compdation engagement, the auditor uses his accounting expertise to collect, classify and
summarise financial information but he does not express any assurance on assertions, The
Framework also discusses the circumstances in which an auditor'- may accept a change in the
terms of an engagement and auditor , association with client financial information.

1SA1: Objective and Scope of the Audit otFinancial

Statements
The Standard describes management's responsibility for financial statements and the overall
objective and scope of the audit of financial statements of an enteity by an independent auditor,

ISA 2:

Audit Engagement Letters

An auditor's engagement letter' to the client is designed to document and confirm the
auditor's acceptance ofthe appointment, the scope ofthe auditor's work, and the extent of the
auditor 's responsibilities and the form of any reports. The Standard describes the principal
contents of an engagement letter, and the appendix contains an example of a letter.

ISA3:

Basic Principles Governing an Audit

This Standard describes the basic principles governing an auditor's professional

responsibilities which should be exercised whenever an audit is carried out. The basic principles
identified involve: integrity, objectivity and independence, confidentiality, skills and competence,
work performed by others, documentation, planning, obtaining audit evidence, reviewing
accounting systems and internal control, reviewing conclusions reached, and reporting. These
basic principles are the cornerstone of ail succeeding International Standards on Auditing.

International Standards on Auditing -

291

ISA 4: Planning
The guidance applies to the planning process of the audit of both financial statements and
other financial information. It is framed hi the context of recurring audits, identifies key elements
in the planning process and provides, practical examples of items which should be considered
when planning an audit. Adequate, audit planning helps to ensure that appropriate attention is
devoted to important areas ofthe audit, that potential problems: are promptly identified, arid that,
the work is completed expeditiously. Planning also assists in proper utilisation of assistants and in
coordination of work done by other- auditors and experts/ - ' ;.

ISA 5:

Using the Work of an Other Auditor

The auditor's considerations to be made when intending to use the work of

another: auditor are described-The guideline applies when an independent auditor
reporting , on the financial statements of an entity uses the work of another
independent auditor with respect to the financial statements of one or more
divisions, - branches, subsidiaries or associated companies included-in the financial
statements of the entity. For the purposes of this Standard, offices of the principal
auditor's film in a different country, affiliated firms, correspondents,.and unrelated
auditors who are involved in the audit of components of the entity are considered" as
other auditors.
''"['. -'-.:

ISA 6:

Study and Evaluation of the Accounting System and

Related Internal Controls in Connection with an Audit

Management is responsible for maintaining an adequate accounting system incorporating

various internal controls to the extent appropriate to the size and nature of the business. However,
the auditor needs reasonable assurance that the accounting system is adequate and that all the
accounting information which should-be recorded has, in fact, been recorded. Internal controls
normally contribute to such assurance. This Standard describes accounting systems, elements,
objective and limitations of internal control and the audit procedures for the study and evaluation
of internal control.

ISA 7:

Control of the Quality of Audit Work

Controlling the quality of audit work is essential in maintaining the high standards of the
profession. This Standard distinguishes between controls on individual audits and general quality
controls adopted by an audit firm. While recognising the interrelationship' of the two types of
controls, general quality controls "augment, and facilitate": controls on individual audits but do
not replace them. Controls over delegation of work to assistants on an individual audit in order to
comply with the basic auditing principles aie addressed,'and practical assistance is provided to an
audit firm in controlling the general quality of their practice. An appendix with examples of
procedures is provided to assist a firm in implementing quality control polices. . . .

292

ISA 8:

A uditing: Principles and Procedures

Audit Evidence

Audit evidence is information obtained by the auditor in arriving at the conclusions upon
which an opinion on the financial information is based. The nature and sources of audit evidence
are described as well as the sufficiency and appropriateness of audit evidence and the methods by
which it is obtained by the auditor in the performance of compliance and substantive procedures.

ISA : Addendum 1, Additional Guidance on - Observation of

Inventory, Confirmation of Accounts Receivable and
Inquiry regarding lifigalion and Claims
Guidance is provided on the application of audit evidence gathering procedures (attendance
at stocktaking, direct confirmation of accounts receivable and direct communication with a client's
lawyers) that are generally-accepted as providing the " roost reliable audit evidence in relation to
certain assertions. The Addendum outlines the circumstances when these procedures should be
applied and the matters to be considered in their implementation. Observation of inventory is
required (unless impracticable) when inventories are material to the financial statements in order
to obtain evidence of the physical existence and condition of inventory. Confirmation of accounts
receivable is required when accounts receivable are material, and provides evidence of the
existence of debtors and the accuracy of recorded balances. Guidance is given on the selection of
accounts to be confirmed, the use of positive and negative confirmations and the use of alternative
procedures when confirmation is inappropriate or replies to confirmations contain exceptions.
Direct communication with the entity's lawyer is required when litigation or claims have been
identified or are believed may exist. Guidance is given on the form and content of the
communication, and the need for the auditor'to consider meetings with the lawyer if matters are
complex or there is a disagreement.

ISA 9: Documentation
Guidance is provided on the general form and content of working papers as well as specific
examples of working papers normally prepared or obtained by the auditor. Ownership and custody
of working paper is also discussed,

ISA 10: Using the Work bt an internal Auditor ,

The internal audit function constitutes a separate component of internal control undertaken
by specially assigned staff within an entity. An objective of the internal auditor is to determine
whether internal controls are well designed and properly operated Much of the work ofthe internal
audit department may be useful to the independent auditor for the purpose of his examination of
the financial information. Guidance is provided as to the procedures that should be considered by
the independent auditor in assessing the work of the internal auditor.

International Standards on Auditing

239

ISA 11: Fraud and Error

The Standard defines fraud and-error, and indicates that the responsibility for the
prevention of fraud and error rests with management. The auditor should plan the audit so that
there is a reasonable expectation of detecting material misstatements resulting from fraud and
error. Suggested procedures are provided which should be considered when the auditor has an
indication that fraud or error may exist. An appendix sets out examples of conditions or events
which increase the risk of fraud or error.

ISA 12: Analytical Review

A description of the nature of analytical review procedures is provided as well as guidance on
the objectives, timing and extent of reliance to be placed on such procedures in performing an audit.
Also discussed is the auditor's investigation of unusual fluctuations.

ISA 13: The Auditor's Report on Financial Statements

Guidance is provided to auditors on the form and content of the auditor's report issued in
connection with the independent audit of the financial statements of an entity. The Standard includes
suggested wording to express an unqualified opinion and discusses circumstances that may result in
other than an unqualified opinion. An appendix sets forth examples of an unqualified, qualified, and
adverse auditor's reports and a denial of opinion.

ISA 14: Other Information in Documents Containing Audited

Financial Statements '
The Standard defines "other information" as financial and non-financial information included in
a document which contains an entity's audited financial statements together with auditor's report
thereon. An entity usually issues such a document on an annual basis which is frequently referred to
as the "annual report". In certain circumstances, the auditoi - has a statutoiy obligation to report on
other information and in other circumstances he has no such obligation. This guidance discusses the
auditor's consideration of other infoimation on which he has no obligation to report and the actions he
should undertake if a material inconsistency or material misstatement of fact is discovered. "

ISA 15: Auditing in a EDP Environment

Guidance is provided to auditors on the additional procedures necessary to comply with ISA 3,
"Basic Principles Governing an Audit" when auditing in an EDP environment. The skills and.
competence required of the auditor are described as well as his responsibility when he delegates such
work to assistants or uses work performed by others.

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ISA 16: Computer-Assisted Audit Techniques

This Standard provides 'guidance to the auditor when using computer-assisted audit
techniques (CAATs) paiticulaiiy audit software and test data. The ISA outlines instances when
CAATs may be used, factors to consider in deterniining whether to use a CAAT and the major
steps to be performed in CAAT application. In addition, special considerations when using
CAATs in a small business computer environment are highlighted. .

JSA 17: Related Parties

Discussed are the procedures to be considered in obtaining sufficient appropriate audit
evidence concerning the existence of an transactions with related parties. This Standard is
premised on the definition and disclosure requirements set out in International Accounting
Standard (IAS) 24, "Related Party Disclosures." ISA 17 provides guidance to assist auditors in
determining whether management of an entity .has properly disclosed related party relationships
and transactions' with such parties in accordance with the provisions of IAS 24.

ISA 18: Using the work of an Expert

This Standard provides guidance to the auditor in instances when using the work of an
expert (specialist) engaged or employed by the client or auditor. The ISA outlines examples of
cases when an auditor may need to use the work of an expert, and provides guidance on
considerations relating to the expert's skills competence and objectivity. ISA 18 outlines
considerations that should be made by the auditor for communicating with the expert and offer's
Specific guidance on evaluating the work of an expert.

ISA 19: Audit Sampling

The factors that an auditor should consider when designing and selecting an audit sample
and evaluating the. results of audit procedures are identified. The ISA applies to both statistical
and non-statistical sampling methods and provides fundamental yet practical guidance on such
matters as sampling risk, stratification, selection methods and projection of errors.

ISA 20: The Effects of an EDP Environment on the Study and

Evaluation of me Accounting System and Related
Internal Controls
This Standard addresses the study and evaluation of the accounting system and related
internal. controls in an EDP' environment and is an extension of the guidance contained in ISA 6,
"Study and Evaluation ofthe Accounting System and Related Internal Controls in Connection
with an Audit" and ISA 15, "Auditing in an EDP Envii-onment". It describes the common
characteristic of an EDP environment,.'including the factors that affect the organization and
structure, nature of processing and design and procedural aspects of the system of accounting and
internal control and diiferentiates and explains the interrelationship.of general

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EDP controls (those that affect the EDP environment) and EDP application controls (those that
affect accounting applications). It also explains to the auditor operating in an EDP environment,
the steps involved in (a) making a review and preUminary evaluation, (6) performing compliance
procedures, and (c) making a final evaluation of the accounting system and related internal
controls. The auditor is reminded to communicate to the client management weaknesses in EDP
internal' control and weakness that affect the safeguarding of data and continuity of processing.

Statement: EDP Environments Stand-Alone Microcomputers

This Statement is the first in a'series of supplements designed to help the auditor implement
ISA 20.'The Effects of an EDP Environment on the Study and Evaluation of the Accounting
System and Related Internal Controls. ISA 20 requires the auditor to understand and consider the
characteristics of the EDP environment when carrying out an audit of an entity where a computer
is involved in the processing of financial information of significance to the audit.

ISA 21: Date of the Auditor's Report; Events after the Balance
Sheet Date; Discovery of Facts after the Financial
Statements have been Issued
Guidance is provided on dating of the auditor's report; the auditor's responsibility in
relation to subsequent events, which are sigruficant events occurring after the balance sheet date,
and the auditor's responsibility in connection with the discovery of facts after the financial
statements have been issued. This Standard describes steps the auditor generally performs to
identify subsequent events, responsibilities in relation to events after the date of the auditor's
report hut before the financial statements- are issued, and discovery of facts after the financial
statements are issued. An appendix sets forth an example of an auditor's report on revised
financial statements.

ISA 22: Representations by Management

This Standard provid3.> guidance to the auditor on using management representations as
audit evidence, procedures the auditor should apply in evaluating and documenting them, and
circumstances in which written representations should be obtained. It indicates that with regard
to representations for material financial statement matters, the auditor should seek corroborative
evidence, evaluate the representations for reasonableness and consistency with other audit
evidence and other representations, and consider whether the individual making the
representation can be expected to be well-informed. ft also notes that representations can be
documented in the working papers by summarising oral discussions of by obtaining written
representation. The Standard also notes the conditions for obtaining a letter from management
and considerations ofthe auditor when management refuses to provide or confirm representations
on matters considered necessary.

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ISA 23: Going Concern

Guidance is provided to auditors in discharging their responsibilities in situations in which
the appropriateness of the going concern assumption as a basis for the preparation of financial
statements is in question. The Standard notes that an entity's continuance as a going concern is
assumed in the absence of information to the contrary. If this assumption is unjustified, an entity
may not be able to realise its assets at the recorded amounts and there may be changes in the
amounts and dates of maturity of liabilities resulting in the need for financial statements to be
adjusted. ISA 23 provides examples of indications that continuance as a going concern should be
questioned, outlines the standards for collecting audit evidence when such a question arises, and
describes the audit procedures that may be performed to obtain such evidence. In addition, it sets
out the auditor's reporting considerations in such circumstances. ,

ISA 24: Special Purpose Auditor's Reports

This Standard provides guidance to auditors that issue audit reports that are other than those
covered by ISA 13, notably, i d) financial statements prepared in accordance with a
comprehensive basis of accounting other than international accounting standards or relevant
national standards, (b) specific accounts, elements of accounts, or items of financial statements,
(c) compliance with contractual agreements, and i d) summarised financial statements.
Appendices contain illustrations of special purpose auditor's reports.

ISA 25: Materiality and Audit Risk

This Standard defines the concepts of materiality and audit risk, their interrelationship and
the application of these concepts by an auditor when planning and conducting an audit and
evaluating the results of his procedures. Materiality is defined as the magnitude or nature of a
misstatement including an omission of financial information either individually or in the
aggregate that, in the light of surrounding circumstances, makes it probable that, as a result of
the misstatement, the judgment of a reasonable person relying on the information would have
been influenced or his decision affected. The assessment of materiality is a matter of the auditor's
professional judgment and is considered at both an overall level and in relation to individual
account balances and disclosures. Audit risk is defined as the risk that an auditor may give an
inappropriate opinion on financial information that is materially misstated. Audit risk is
considered at the financial statement level and the account balance .and class of transactions
level. The three components of audit risk are discussed and their interrelationship explained. An
appendix illustrates this inter-relationship.

ISA 26: Audit of Accounting Estimates

Guidance is provided to auditors on the audit procedures that should be performed in order
to obtain reasonable assurance as to the appropriateness of

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accounting estimates contained in financial mformation. An accounting estimate is defined as an

approximation of the amount of an item in the absence of a precise means of measurement. It is
noted that management is responsible for making accounting estimates based upon its judgment
of the uncertain outcome of events that have occurred or are likely occur and that the auditor is
responsible for evaluating the reasonableness of such estimates. ISA 26 sets out the main steps
involved in the audit of accounting estimates and provides the auditor with guidance on the
evaluation of errors in accounting estimates. It is stated that, due to the approximation inherent in
accounting estimates, such an evaluation can be made more difficult than in other areas ofthe
audit.

ISA 27: The Examination of Prospective Financial Information

This Standard deals with the examination and reporting procedures where an auditor is
asked to report on prospective financial information being either a forecast, based on bestestimate assumptions, or a projection based on hypothetical assumptions. Recognizing the future
oriented nature of the engagement, the examination procedures recognize the speculative nature
of the evidence' available to the auditor, and while acknowledging a consistent audit objective,
differentiates between the evidence requirements and process for best-estimate as distinct from
hypothetical assumptions. Emphasis is given to the importance of adequate disclosure of
significant assumptions to an rnidei-standing of prospective financial information and the
auditor's role in ensuring this occurs. It is noted that an auditor cannot obtain a high level of
assurance that the information is free of material misstatement, but that a useful service can be
provided a moderate level of assurance as to whether the assumptions provide a reasonable basis
for the prospective financial information, and an opinion as to whether the information has been
properly prepared on the basis of the assumptions. A statement cautioning readers that the
auditor is not providing an opinion as to whether the results shown in the projected information
will be achieved is also recommended. Appendices illustrate reports on a forecast and a
projection.

ISA 28: First Year Audit ingagements - Opening Balances

This Standard provides guidance as to the auditor's responsibilities for opening balances
when the financial statements are being audited for the first time or were audited by another
auditor in the prior year. The ISA outlines the audit procedures by which sufficient appropriate
audit evidence may be obtained in both circumstances to determine whether the opening
balances were misstated, correctly brought forward or restated and appropriate accounting
policies consistently applied. The auditor's reporting considerations are set out where the auditor
is unable to obtain sufficient appropriate audit evidence and where the prior year audit report
was other than unqualified. Appendices contain illustrations of other than unqualified reports.

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Auditing: Principles and Procedures

ISA 29: Inherent and Control Pisk Assessments and their

Impact on Substantive Procedures
Guidance is provided to the auditor in assessing inherent and control risks and using such
assessments to determine the nature, timing and extent of substantive procedures so as to restrict
detection risk to an acceptable level. The Standard requires the auditor understand the internal
control and accounting systems and document that understanding. Guidance is then given on
using this information in conjunction with a preliminary assessment of control risks to plan the
audit approach and determine the appropriate detection risk. An assessment of control risk at less
than a high level reqiiires that the auditor plan to perform compliance procedures to corifirm the
assessment. The relationship between the assessments of inherent and control risks to substantive
procedures is described indicating that some substantive procedures should always be performed,
and should be reassessed as the components of audit risk change. In addition, reporting
considerations are discussed when substantive procedures do not reduce detection risk to an
acceptable level.

ISA/RS 1: Basic Principles Governing Review Engagements

ISA/RS 1 is a parallel document to ISA 3, Basic Principles Governing an Audit, setting out
the basic principles and general and reporting Standards for review engagements. A review
engagement is defined as an engagement in which an auditor is asked to carry out procedures
which provide a moderate level of assurance on financial information, being a lower level of
assurance than that provided by an audit. A review consists primarily of procedures that involve
inquiry and analytical review. The specific objective of a review is to give the auditor an
appropriate basis for stating whether anything has come to his attention that causes him to
believe that the information does not give a true or fair view (or "is not presented fairly") in
accordance! with the basis of accounting indicated. The style of reporting used is known as
negative assurance and is clearly distinguishable from an audit opinion.

ISA/R3 2: Review of Financial Statements

This Standard describes the procedures the auditor should consider when .engaged to
review financial statements and the form of the content of the report to be issued. The
procedures, consisting primarily of inquiry and analytical review, are performed to provide the
auditor with a reasonable basis for stating whether anything has come to his attention that causes
him to believe that the financial statements do not give a true and fair view (or "are not presented
fairly") in accordance withthe basis of accounting indicated. A sample engagement letter and a
listing of common review engagement procedures are set forth in appendices..

ISA/RS 3: Engagements to Perform Agreed-upon Procedures

This Standard describes the basic principles and general guidelines to .be followed then an
auditor is engaged to apply procedures, which the auditor and

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299

client have agreed on, to individual items of financial data, a financial statement or set of
financial statements. Guidance is also given on the types of procedures that may be applied and
the form and content of the report of factual findings to be issued. As the procedures are agreed
between the auditor and client to meet the client's needs for particular information, it is suggested
that the auditor meet with the client and other specified parties who will receive copies of the
report to ensure there is a clear understanding ofthe nature, purpose and extent of the engagement
and procedures to be applied. Furthermore, the auditor is only required to present the evidence
collected to the user, and the report of factual findings provides no assurance on assertions.
Appendices illustrate a sample engagement letter and report of factual findings including an
illustrative list of procedures.

ISA/RS 4: Engagement to Compile Financial Information

This Standard describes the basic principles and general guidelines to be followed when an
accountant undertakes an engagement to compile financial information, the types of procedures
that should be applied and the form and content of the accountant's report. The guidance is based
on the auditor using his accounting rather than auditing expertise. The guidance requires that the
accountant ensure there is a clear understanding between the client and accountant regarding the
nature and extent of the engagement. While there'is no requirement for the accountant to test the
assertions underlying the irTformation, the accountant should obtain a knowledge of the
business ana operations of the client, the accounting and reporting principles and practices of the
industry and the nature of the entity's business transactions. While the accountant is required to
consider whether compiled information is free from obvious misstatement, the procedures, are
not designed and are not sufficient to enable the auditor to express any assurance. Appendices
illustrates a sample engagement letter and compilation reports.

2. AUDIT - SUMMARY OF BASIC PRINCIPLES AND

ESSENTIAL
PROCEDURES
AUDIT OF FINANCIAL STATEMENTS Overall
Objective and Scope
The objective of an audit of financial statements, prepared within a framework of
recognised accounting policies, is to enable an auditor to express an orrimon on such financial
statements.
The audit should be organised to cover adequately all aspects of the entity as far as they are
relevant to the financial statements being audited. To form an opinion on the financial statements,
the auditor should obtain reasonable assurance as to whether the information contained in the
underlying accounting records and

Auditing: Principles and Procedures'

24G

other source data are reliable and sufficient as the basis for the preparation of the financial
statements. In forming his opinion, the auditor should also decide whether the relevant
information is properly communicated in the financial statements.
It is in the interest of both client and auditor that the auditor send an engagement letter,
preferably before the commencement of the examination, to help in avoiding rmsunderstandings
with respect to the engagement.
ISA 3 describes the basic principles which govern the auditor's professional responsibilities
and which should be complied with whenever an audit is carried out. Other ISAs elaborate on the
principles set out in ISA 3 to give guidance on auditing procedures and reporting practices.
[Set out below are the basic principles and essential procedures extracted from all ISAs issued to
date, broadly categorised according to the audit engagement process. As a result of their
importance, the basic principles in ISA 3 have been highlighted in bold print.]

BASIC PRINCIPLES GENERAL MATTERS

Integrity, Objectivity and Independence
The auditor should be straigh^rward, honest and sincere in his approach to his professional
work. He must be fair and must- not allow prejudice or bias to override his objectivity. He should
maintain an impartial attitude and both be and appear to be free of any interest which might be
regarded, whatever its actual effect, as being incompatible with integrity and objectivity.

Confidentiality
The auditor should respect the confidentiality of information acquired in the course of his
work and sheuld not disclose any such information to a third party without specific authority or
unless there is a legal or professional duty to disclose.

Skills and Competence

The audit should be performed and the report prepared with due professional care by
persons who have adequate training, experience and competence in auditing.

BASIC PRINCIPLES AND ESSENTIAL EXAMINATION

PROCEDURES Planning
The auditor should plan his work to enable him to conduct an effective audit in an efficient
and timely manner. Flans should be based on a knowledge of the client's business.

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301

Plans should be made to cover, among other things, (o) acquiring knowledge of the client's
accounting system, policies and internal control procedures, (b) establishing the expected degree
of reliance on internal control, (e) determiiiing and programming the nature, timing, and extent of
the audit procedures to be performed, and (d) coordinating the work to be performed.
The auditor needs to have level of knowledge of his client's business and industry that will
enable him-to identify the events, transactions, and practices that, in his judgment, may have a
significant effect on the financial information.
With respect to the previous year's audit working papers and other relevant files, the auditor
should pay particular attention to matters that required special consideration and decide whether
they might affect the work to be done in the . current year.
The auditor, should document his overall plan.
The auditor should prepare a written audit program setting forth the procedures that are
needed to implement the audit plan. The pr ogram should have sufficisnt detail of serve as a set of
instructions to the assistants involved in the audit and as a means to control the proper execution of
the work.
The auditor should consider the timing of the procedures, coordination of any assistance
expected from the client, the availability of assistants, and the involvement of other auditor's orexperts.
CWhen planning the engagement) the auditor should undertake an overall audit risk
assessment based on his knowledge of the client's business, industry, management, control
environment and operations. 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, audit risk should be considered by the auditor at (the account balance and class of
transactions) level taking into account the results of the overall audit risk assessment made at the
financial statement level.
When planning the audit, the auditor should consider what would make the financial
information materially misstated. The auditor's preliminary judgment of materiality should. be
related to specific account balances and classes of transactions. The audit should be planned so
that audit risk is kept at an acceptably low level.
When planning the audit, the auditor should consider the materiality of inventories and the
need to attend stocktaking. The auditor should consider the nature of the accounting and internal
control systems used in respect of inventory, inherent and control risks, whether management is
expected to establish adequate procedures and issue proper instructions for physical inventoiy
counting, the timing ofthe count, inventory locations and whether an expert's assistance is
needed. (6 Addendum, p.8-9).

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A uditing: Principles and Procedures

The auditor should nmmalfy plan to obtain direct confirmation of accounts receivable
balances when accounts receivable are material and it is expected that debtors will respond.
When it is expected that the debtor will not respond, the auditor should plan to perform
alternative procedures. (8 Addendum, p.21)
When planning and performing audit procedures and in evaluating the result thereof, the
auditor should be alert to the possibility that the going concern assumption on which the
preparation of the financial statements is based may be subject to question.
The auditor should plan his audited so that he has a reasonable expectation of detecting
material misstatements in the financial information resulting from fraud or error.
The auditor should plan and perform his audit with an attitude of professional skepticism
recognising that he may encounter conditions or events during his examination that would lead
him to question whether fraud or error exist.
In planning and performing his examination the auditor should take into consideration the
risk of material misstatement of the financial information caused by fraud or error. He should
inquire of management as to any fraud or significant error which has occurred in the reporting
period and modify his audit procedures, if necessary.
The auditor should gather information about the EDP environment that is relevant to the
audit plan. '
When planning the audit, the auditor should consider an appropriate combination of manual
and computer-assisted audit techniques.
The names of identified related parties should be provided (by the auditorj to audit personnel
involved in the audit of the entity and its components so that they will be alerted to recognise
transactions with such parties if they are encountered during the audit.
The determination of overall audit strategy requires consideration of inherent risk at the
financial statement level. In planning the audit in more detail such assessment should be related
to material account balances and classes of transactions. The auditor may assume that inherent
risk is high at the account balance and class of transaction level without first performing an
evaluation, but Rhtn^d gain an understanding of the inherent risk factor at the financial statement
level. (29, p.6-7)
The auditor should obtain a sufficient understanding of the internal control and accounting
systems to plan the audit and develop an effective audit approach (29, p. 10)
The auditor should obtain an understanding of the control procedures sufficient to plan
the .audit. The auditor should consider knowledge about the presence or absence of control
procedures obtained from his understanding of the control

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303

environment and accounting system in determining whether any additional uriderstanding of

control procedures in necessary to plan the audit. Ordinarily, audit planning does not require an
understanding of control procedures for every relevant assertion in each account balance and
transaction class. (29, p.15)
When planning the audit approach, the auditor should consider the preliminary assessment
of control risk in conjunction with the assessment of inherent risk to determine the appropriate
detection risk and the nature, timing and extent of substantive procedures. (29, p.18)
Plans should be further developed and revised as necessary during the course of the audit.
Planning should be continuous throughout the engagement. The reasons for significant
changes should be documented.
The audit plan and related program should be reconsidered as the audit progresses.

Audit Evidence
The auditor should obtain sufficient appropriate audit evidence through the performance of
compliance and substantive procedures to enable him to draw reasonable conclusions therefrom
on which to base his opinion on the financial information.

General Matters
The audit evidence should, in total, enable the auditor to form an opinion on the financial
information.
The auditor should be thorough in his efforts to obtain evidence and be objective in its
evaluation. In selecting procedures to obtain evidence, he should recognise the possibility that the
financial information may be materially misstated.
There should be a rational relationship between the cost of obtaining evidence and the
usefulness of the information obtained.
When the auditor is in reasonable doubt as to any assertion of material sigiuficance, he
should attempt to obtain sufficient appropriate evidence to remove such doubt. If (the auditor) is
unable to obtain sufficient appropriate evidence, he should not express an unqualified opinion.

Sampling
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 best achieve those
objectives.

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A uditing: Principles and Procedures

The auditor should determine that the population from which he draws the ' sample is
appropriate for the specific audit objective.
The auditor should define the sampling unit in order to obtain an efficient and effective
sample to achieve the particular audit objective.
The auditor should consider detection risk arising from the uncertainties due to sampling
(sampling risk) as well as those arising from factors other than sampling (non-sampling risk).
The auditor's objective should be to reduce non-sampling risk to a negligible level by
appropriate planning, direction, supervision and review.
In determining the expected error in a population, the auditor should consider such matters
as error levels identified in previous audits, changes in client procedures and evidence available
from his evaluation of the system of internal control and from results of analytical review
procedures.
Sample items should be selected in such a way that the sample can be expected to be
representative ofthe population.
When using systematic selection, the auditor should determine that the population is not
structured in such a manner that the sampling interval corresponds with a particular pattern in
the population.
When the auditor uses (haphazard sampling) he should guard against making a selection that
is biased, for example, towards items which are easily located, as they may not be representative.
Having carried out, on each sample item, those audit procedures that are appropriate to the
particular audit objective, the auditor should (a) analyze any errors detected in the sample, (b)
project the errors found in the sample to the population, and (c) assess the sampling risk.
In analyzing the errors detected in the sample, the auditor should determine that an item in
question is in fact an error.
If the auditor does not or is unable to perform alternative procedures related to the missing
sample item, he should treat this item as an error for the purpose of his evaluation of audit
evidence provided by the audit sample.
The auditor should also consider the qualitative aspects ofthe errors.
(When the auditor decides to produce a sub-population and extend his procedures) he
should then perform separate evaluations (of errors) based on the items examined for each subpopulation.
The auditor should project the error results of the sample to the population
from which the sample was selected. When projecting error results, the auditor should keep in
mind the qualitative aspects of the errors found.
The auditor should consider whether errors in the population might exceed the

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305

tolerable error. To accomplish this, the auditor should compare the projected population error to
the tolerable error and also then compare the sample results to the evidence obtained from other
relevant audit procedures when forming his conclusions about an account balance, class of
transactions or specific control. The auditor should therefore reconsider the sampling risk and if
he determines that the risk is unacceptable, he should consider extending his audit procedures or
performing alternative audit procedures.
Having evaluated the sampling results, the auditor should conclude as to the extent to which
he has obtained sufficient appropriate audit evidence in support of the particular characteristic of
the account balance of class or transaction with which he is concerned.

Computer-Assisted Audit Techniques (CAATs)

Regardless of the source of the {audit software) programs, the auditor should substantiate
their validity for audit purposes prior to use.
When test data are processed with the entity's normal processing, the auditor should ensure
that the test transactions are subsequently eliminated from the entity's accounting records.
The auditor should have sufficient knowledge to plan, execute and use the results of the
particular CAAT adopted.
The auditor should consider the availability of CAATs, suitable computer facilities and the
necessary computer-based accounting system and files. The auditor should have a reasonable
expectation that the computer facilities will be (properly) controlled (when the CAAT is
processed).
The use of a CAAT should be controlled by the auditor to provide reasonable assurance that
the audit objectives and the detailed specifications of the CAAT have been met, and that the
CAAT is not improperly manipulated by the entity's staff.
The auditor should have reasonable assurance that the entity's staff did not improperly
influence the results ofthe CAAT.
The working papers should contain sufficient documentation to describe the CAAT
application.

Opening Balances
The auditor should obtain sufficient appropriate audit evidence that opening balances do not
contain misstatements that could materially affect the current year's financial statements, that the
prior year's closing balances have been correctly brought forward or restated, and appropriate
accounting policies are consistently applied. The nature and extent of the audit evidence that the
auditor should obtain in relation to opening balances depends on the accounting policies
followed by the entity, whether the prior year's financial statements were audited,

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Auditing: Principles and Procedures

and if so whether the auditor's opinion was other than unqualified, and the nature of the accounts
and the risk.of misstatement in the current year's financial statements.(28.p.4-5)
The current auditor may be able to satisfy himself on opening balances by reviewing the
predecessor auditor's working papers. He should be consider the professional competence and
independence of the predecessor auditor. (28.p.7)
When the financial statements were not previously audited, or when the auditor is not able
to satisfy himself by reviewing the predecessor's working papers, sufficient appropriate audit
evidence may be obtained by examining the records underlying the opening balances and by
applying additional procedures as part of the current year's audit procedures. (28.p.9-ll)

Inventory, Accounts Receivable and Litigation and Claims

Observation of inventory, confirmation of receivables and inquiry regarding litigation and
claims are procedures generally accepted as providing the most reliable audit evidence in relation
to assertions concerning the physical existence and condition of inventory, existence of debtors
and the accuracy of their recorded account balances, and reporting of litigation and claims
respectively. (8 Addendum, p.3, 8,21 and 32)
The auditor should assess the results of observation, confirmation and inquiry procedures or
(when such procedures are not practicable) alternative procedures and decide whether-they form
an adequate basis for the opinion. If the auditor is unable to obtain sufficient evidence to support
the opinion, the effect of this limitation on the report should be considered. (8 Addendum, p. 4)
The auditor should consider at which inventory locations attendance is appropriate based on
materiality and the assessment of control risk at different locations: (8 Addendum, p. 10)
The auditor should be satisfied as to the reasonableness of procedures used to estimate
physical inventory quantities. (8 Addendum, p.13)
The auditor should review management's instructions for physical inventory counting and
obtain assurance that they are adequately implemented by observing employees' procedures and
performing test counts. (8 Addendum, p.14-15).
When internal control over the physical inventory count is evaluated as adequate, the count
may be conducted at a date other than the balance sheet date. (8 Addendum, p.16)
The auditor should assess whether the reasons for any significant differences between the
physical count and records under a perpetual inventory system are understood and properly
adjusted. (8 Addendum, p. 17)
The auditor should test the final inventoiy listing to assess whether it reflects actual
inventory accounts. (8 Addendum, p. 18)

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307

The auditor should ordinarily obtain direct corurrmation from a third party who has custody
and control of inventory. (8 Addendum, p. 191
Selection of accounts receivable for corifirmation should be selected by reference to ISA 19
so as to be able to reach a conclusion as to the existence and accuracy of accounts receivable as a
whole. (8 Addendum p.22)
Confirmation letters should be sent by the auditor requesting a reply direct to the auditor. (8
Addendum, p.23)
While the positive form of confirmation of accounts receivable balances will provide more
reliable evidence than negative confirmations, the choice will depend upon the audit evidence
objective and circumstances such as the assessment of inherent and control risks. (8 Addendum,
p.24-26)
The auditor should treat accounts receivable subject to positive corifirmations which cannot
be confirmed, and for .which alternative procedures have not been performed, as errors for the
purpose of evaluating the audit evidence provided by the audit sample. (8 Addendum, p:28)
The auditor should consider whether there are valid grounds and examine any supporting
evidence for a request from management not to confirm certain accounts receivable balances, and
apply alternative procedures to those accounts. (8 Addendum, p.29)
The auditor should apply procedures to become aware of any litigation and claims that may
have material financial implications and seek direct confirmation from the entity's lawyers when
litigation or claims have-been identified or when the auditor believes they may exist. (8
Addendum, p.31-32)

Accounting System and Internal Control

Inherent and control risk assessment and their impact on substantive procedures
The auditor should gain an understanding ofthe 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.
Some procedures performed to obtain an understanding of the internal control and
accounting systems may not have been planned as compliance procedures, but may serve as such
by providing evidence about the effectiveness of both the design and operation of the policies
and procedures relevant to certain assertions. That evidence may be used to support a control risk
assessment at less than a high level.(29, p.21-22)
The lower the assessment of control risk, the more support the auditor needs to obtain that
the internal control and aecounjmg systems are designed and operating effectively. The auditor,
should consider whether audit evidence to support an

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Auditing: Piinciples and Procedures

assessment at a lower level is likely to be available and whether performing additional procedures
to obtain evidence would be efficient. (29, p.24-25)
Before relying on procedures performed in previous examinations to support a
conclusion about control risk, the auditor should obtain evidence as to the nature
and extent of any change in the entity's internal control and accounting systems
since the performance of such procedures. The auditor should consider that the
longer the time elapsed since the performance of such procedures the less assurance
may result.
*
Compliance procedures performed at an interim date cannot be relied upon without
considering the need to obtain further evidence relating to the remainder of . the accounting
period. (29, p.30)
Together with the auditor's assessment of control and inherent risk, the auditor should
consider the nature, timing and extent of substantive procedures to determine the required level
of assurance provided by such procedures to reduce detection risk to an acceptable level (29,
p.34)
The auditor should perform some substantive procedures as the assessed levels of inherent
and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any
substantive procedures for significant account balances and transactions classes. (29, p.36)
When both inherent and control risks are assessed at a high level the auditor should also
consider whether substantive procedures will provide sufficient assurance to reduce detection
risk to an acceptable level. (29, p.38)
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. (3, p.20)
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.
When the auditor is relying 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.
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 auditor should inquire whether the internal controls were in use throughout the^reiiod
of intended reliance. If substantially different controls were
used at different times during the peiiod, the auditoi- should consider each

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separately.
The auditor's preliminary evaluation of the internal controls should he made on the
assumption that the controls operate generally as described and that they function effectively
throughout the period of intended reliance.
For the benefit of his client, the auditor should make management aware, on a timely basis,
of material weakness which have come to his attention (as a result of his study and evaluation of
internal control and other auditing procedures).
When perforrning a review and prehminary evaluation of the accounting system and related
internal controls on which he intends to rely, the auditor should consider whether adequate
procedures and Controls exist over the authorisation and recording of related party transactions.
If such procedures and controls exist and the auditor intends to rely on them, he should perform
tests designed to gain evidence that they have operated properly.

EDP
When auditing in an EDP environment, the auditor should have an understanding of
computer hardware, software and processing systems sufficient to plan the engagement and to
understand how EDP affects the study and evaluation of internal control and the application of
auditing procedures, including computer-assisted audit techniques.
The auditor should also have sufficient knowledge of EDP to implement the auditing
procedures, depending on the particular audit approach adopted.
During the review and preliminaiy evaluation of internal control, the auditor should
acquire knowledge of the accounting system to gain an understanding of the overall control
environment and the flow of transactions. If the auditor plans to rely on internal controls in
conducting his audit, he should consider the manual and computer controls affecting the EDP
function (general EDP controls) and the specific controls over the relevant accounting
implications (EDP application controls).
The auditor should understand and consider the characteristics of the EDP environment
because they affect the design of the accounting system and related internal controls, the
selection of internal controls upon which he intends to rely, and the nature, timing and extent of
his procedures.
The auditor should review the accounting system to the extent considered necessary to gain
an understanding of the overall control environment ani the flow of transactions. If the auditor
wishes to rely on internal controls in conducting his audit, he should also identify and make a
preliminary review of those internal controls eiVwhich it might be effective and efficient to rely.
The "auditor' should consider- how (the) general EDP controls affect the EDP applications
significant to the audit.

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Auditing: Principles and Procedures

The auditor should conduct a preliminary evaluation of those general EDP controls and EDP
application controls on which he believes it might be effective and efficient to rely in conducting
the audit.
The auditor may become aware of weakness in EDP internal controls during his study and
evaluation of the accounting system and related internal controls. These weakness should be
reported to management (on a timely basis). When the auditor become aware of significant
deficiencies in areas (relating to safeguarding data and continuity of processing), he should
communicate such information to management.

The Assessments of Inherent and Control Risk and their impact

on Substantive Procedures
When obtaining an understanding of the internal control and accounting systems to plan the
audit, the auditor should obtain a sufficient knowledge of the design of the internal control and
accounting systems and whether they have been placed in operation.
The auditor should obtain an understanding of the control environment sufficient to assess
directors, and management's attitudes, awareness and actions regarding control and its
importance to the entity.
The auditor should obtain sufficient knowledge of the accounting system to be able to
identify and understand the major classes of transactions and how they are initiated, the
accounting records, supporting documents and specific accounts in the financial statements, and
the accounting and financial reporting process.
After obtaining an understanding of the internal control and accounting systems, the auditor
should make a preliminary assessment of control risk for'the relevant financial statement
assertions. Control risk is ordinarily assessed as high, except where the auditor is able to identify
policies and procedures relevant -to' specific assertions which are likely to prevent or detect
material misstatements, and the auditor plans to perform compliance procedures to confirm the
assessment. (29, p. 17, 19-20)
The auditor should document the understanding of the entity's internal control and
accounting systems, and the assessment of control risk. When assessed at less than a high level,
the basis for the conclusion should be documented. (29, p.23)

Compliance Procedures and Audit Conclusions

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 auditor should make specific inquiries concerning these matters, . particularly as to the
timing of staff changes in key control functions. He should

International Standards o n Auditing

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then, ensure that his compliance procedures appropriately cover such a period of change of
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 his 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 comph'ance procedures normally should be applied to transactions selected
from those of the whole period under examination. When 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.
After obtaining an understanding of the internal control and accounting systems and
assessing control risk, the auditor may seek to obtain more evidence about design and operating
effectiveness to support an assessment of control risk at a lower level for certain assertions. As a
result, the auditor may change the nature, timing and extent of substantive procedures. (29,' p.25)
The evaluation of deviations found in performing compliance procedures may result in a
conclusion that the assessed level of control risk should be increased. In this case the nature,
timing and extent of substantive procedures should be modified, 129, p. 26)
Before the conclusion of an audit, the auditor should consider whether the preliminary
assessment of control risk is confirmed. If the assessment is revised, additional procedures
should be performed and the revision documented.(29, p.31)

Substantive Procedures and Audit Conclusions

The auditor should review and assess the conclusions drawn from the audit evidence
obtained as the basis for the expression of his opinion on the financial information.

Materiality
Because the nature of a misstatement may give rise to other concerns, the auditor should be
alert for detected errors of relatively small amounts that could have a material effect on the
financial information..
Materiality should be considered by the auditor when detennining the nature, timing and
extent of audit procedures, when evaluating the effect of misstatements on the measurement and
classification of accounts and when determining the

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A udiung: Principles and Procedures

appropriateness of the presentation and relevant disclosure in the financial information.

i.

After the auditor has assessed the inherent and control risks, he should consider the level of
detection risk that he is prepared to accept and, based upon his judgment, select appropriate
substantive audit procedures.
As identified uncorrected misstatements approach the materiality level, the auditor should
consider reducing this risk by performing additional audit procedures or by requesting that
management correct the identified misstatements.
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 misstatements should include the
auditor's best estimate of the total misstatement 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 misstatement and, if management refuses,
issue a qualified or adverse opinion.

Fraud or Error
In planning and performing his examination the auditor should take into consideration the
risk of material misstatement of the financial information caused by fraud or error. He should
inquire of management as to any fraud or significant error which has occurred in the reporting
period and modify his audit procedures, if necessary.
If circumstances indicate the possible existence of fraud or error, the auditor should consider
the potential effect on the financial information. If the auditor believes the suspected fraud or
error could have a material effect on the financial information, he should perform such modified
or additional' procedures as he determines to be appropriate.
Where confirmed, the auditor should satisfy himself that the effect of fraud is properly
reflected in the financial information or the error is corrected.
(When unable to obtain audit evidence either to confirm or dispel a suspicion of fraud), the
auditor should consider the possible impact on the financial information and the effect on his
report. The auditor will also need to consider relevant laws and regulations.
Unless circumstances clearly indicate otherwise, the auditor should not assume that an
instance of fraud or error is an isolated occurrence. If the fraud or error should have been
prevented or detected by the system of internal control, the auditor should reconsider his prior
evaluation of that system and, if necessary, adjust, the nature, timing and extent of his substantive
procedures.

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313

When fraud or error involves a member of management, the auditor should reconsider the
reliability of any representations made by that person to the auditor.
The auditor should communicate his findings to management on a timely basis, if (a) he
believes fraud may exist, even if the potential effect on the financial information would be
immaterial or (o) fraud or significant error is actually found to exist. In the latter circumstance,
he should also consider his reporting responsibilities to regulatory authorities.

Going Concern
When a question arises {as to the appropriateness of using the going concern assumption as
the basis for preparation of financial statements,} the auditor should gather sufficient appropriate
evidence to confirm or dispel the doubt regarding the entity's ability to continue in operation for
the foreseeable future, generally for a period not to exceed one year after the balance sheet date.
When analysing cash flow, profit, and other relevant forecasts, the auditor should consider
the reliability of the entity's system for generating such information. The auditor should also
consider the support for significant assumptions underlying the forecast and compare the
prospective data for recent prior periods with historical results, and the prospective data for the
current period with results achieved to date.
The auditor should consider and discuss with management its plans for future action the
outcome of which is expected to improve the situation. The auditor should obtain reasonable
assurance that these plans are feasible, are likely to be implemented and that the outcome of
these plans will improve the situation.
After the auditor has carried out the additional procedures he considers necessary, obtained
all the information which he has required and considered the effect of " any plans of
management and other mitigating factors, he should decide whether, the questions raised
regarding the going concern assumptions have been satisfactorily resolved.
- If the auditor determines that he has obtained reasonable assurance that going concern
assumption used for the preparation of the financial statements is appropriate, he should express
an unqualified opinion on the financial statements. If the auditor detennines that the going
concern assumption is appropriate because of mitigating factors, in particular management's
plans for future action, he should consider whether such plans or other factors should bedisclosed in the financial statements. If disclosure considered necessary by the auditor is not
made, he should qualify his opinion for lack of such disclosure.
If the auditor determines that the going concern questions are not resolved, he should
ensure there is adequate disclosure in the financial statements of the principal conditions that
raise doubt about the entity's ability to continue in operation in the foreseeable future. Provided
the disclosure is considered adequate

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Auditing: Principles and Procedures

the auditor should issue an unqualified opinion. If the auditor concludes that adequate disclosure
is not made, he should issue a qualified or adverse opinion for the lack of disclosure. (23, p.14)
When the auditor determines that the going concern matter is not resolved but there is
adequate disclosure, the auditor should add a paragraph (after the opinion paragraph) that draws
attention to the financial statement note. (23, p.15)
If, on tire basis of the additional procedures carried out by the auditor and the information
obtained by him, including the effect of mitigating circumstances, he is convinced that the entity
will not be able to continue in operation in the foreseeable future, he should conclude that the
going concern concept used for the preparation of the financial, statements is incorrect. If the
result of the incorrect assumption used in the preparation ofthe financial statements is so material
and pervasive as to make the financial statements misleading, he should issue an adverse
opinion; otherwise he should issue a qualified opinion.

Accounting Estimates
The auditor should obtain an understanding of the procedures and methods used by
management in making material accounting estimates, including an understanding of the control
environment relating to such procedures and methods.
The auditor should obtain reasonable assurance that the data on which the estimate is based
are accurate, complete and relevant. Where accounting data are used, they should be consistent
with the data processed through the accounting system.
The auditor should ascertain that management has ensured that the data collected are
properly analyzed and projected to form a reasonable basis for determining the estimate. Where
such analytical and projection procedures are computerised, the auditor should ensure that he
can rely on the results by applying appropriate audit procedures.
The auditor should consider whether the entity has a sufficient basis for the principal
assumptions used in the estimate, ,
In evaluating the assumptions on which the estimate is based, the auditor should consider,
among other things, whether they are reasonable in light of actual results in previous accounting
periods except when changes can be justified, consistent with those made for other relevant
accounting estimates, and consistent with management's plans which appear reasonable. The
auditor should pay particular attention to assumptions which are sensitive to variation and
subjective and susceptible to material error.
The auditor should review the continuing appropriateness of formulae used by management
in the preparation of accounting estimates. Such a review should reflect the auditor's knowledge
of the financial results of the entity in previous periods, practices used by other- entities in the
industry and the future plans of

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315

management as disclosed to the auditor.

The auditor should test the calculation procedures used by management.
When possible, the auditor should compare estimates made for a prior period with actual
results of that period to assist in obtamrng evidence about the general reliability of the entity's
estimating procedures, establishing where adjustments to estimating formulae may be required,
and ensuring that differences between actual results and previous estimates have been quantified
and that, where necessary, appropriate accounting action has been taken by the entity.
The auditor should determine that [the] review and approval is performed by the appropriate
level of management and that it is evidenced in the documentation supporting the determination
of the accounting estimate.
The auditor should determine whether reasonable assurance has been obtained as to the
appropriateness of the assumptions and accuracy of the calculation of the accounting estimate.
The auditor should also assess the reasonableness of the estimate based on his knowledge of the
entity and industry, and the degree of consistency with other evidence obtained during the audit.
The auditor should consider whether there are any significant subsequent events or
transactions which assist in establishing the reasonableness of the estimate or which affect the
data and the assumptions used in deterrnining the accounting estimate.
If the auditor believes the difference [between his estimate and the amount best supported
by the available evidence] is unreasonable, he should request that management correct the
estimate to an acceptable figure. If management refuses to correct the estimate, the difference
between the estimate and the closest reasonable estimate should be considered an error. The error
should be considered with all other errors when evaluating whether the Impact on the financial
statement is material.
- The "auditor should consider whether inaividual differences which he has accepted as
reasonable are consistently biased in one direction, so that, on a Cumulative basis, they may have
a material impact on the financial statements. In such circumstances, the auditor should
reconsider the estimates taken as a whole.
When the auditor is unable to obtain reasonable assurance as to the appropriateness of the
accounting estimate and is also unable to obtain audit evidence to support a different estimate, he
should consider whether a scope limitation exists and, if so, he should issue a qualified, opinion
or disclaim an opinion, as appropriate.

Analytical Review
Analytical review procedures should be applied to some extent in planning, as substantive
tests and in the final review.

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Auditing: Principles and Procedures

When the auditor is planning to perform analytical review procedures, he should consider
(a ) the objectives of the analytical review procedures and the extent to which he may be able to
rely on their results, (b ) the nature of the entity, (c) the availability, relevance and reliability of
financial and non-financial information, (d) the comparability of the information available, and
(e) the knowledge gained by the auditor during previous examinations.
The auditor should consider the need, if any, for testing the controls over the preparation of
non-financial information used in applying analytical review procedures.
When analytical review 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 (a) evaluate the adequacy of replies to such inquiries, and (b) 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.

Related Party Transactions

The auditor responsibility is to obtain sufficient appropriate audit evidence to enable him to
draw reasonable conclusions concerning the treatment of [related party transaction] disclosures
in the financial information.
The auditor should review any information which may be provided individually by
directors or key management personnel outlining related party transactions of which they are
aware, including those w:th themselves and their immediate families.
While performing his normal audit procedures, the auditor should be alert for transactions
which appear unusual in the circumstances and which may indicate the existence of previously
unidentified related parties.
The auditor should also consider whether related party transactions have occurred that are
not recorded.
In examining the identified related party transactions, the auditor should apply the
procedures he considered necessary to obtain sufficient appropriate audit evidence as to the
purpose, nature and extent of these transactions.
In forming his opinion, the auditor should consider the effect of related party transactions
on the financial information including the disclosure of such transactions therein.
If the auditor is unable to obtain sufficient appropriate audit evidence concerning related
parties and transactions wit;; such parties, he should describe in

International Standards on Auditing

317

his report the limitation, on the scope of his work and express a qualified opinion or
a disclaimer of opinion, as appropriate.
" " '-.
If the auditor concludes that the related party disclosures in the financial information are not
in conformity with relevant national or international standards, he should express a qualified
opinion or an adverse opinion, as appropriate.

Subsequent Events

The auditor, should perform procedures designed to satisfy himself that all subsequent events
up to the date of his report that may require adjustment of or disclosure in the financial statements
have been identified.
The procedures to identify subsequent events should be performed as near as practicable to
the date of the auditor's report. If the procedure identify events which could affect the financial
statements, the auditor should carry out further procedures to assess whether such events are
appropriately reflected in the financial statements.
In situations involving branches, subsidiaries, investees or associated entities, the auditor
should decide the locations at which the above procedures should be carried out.
If the auditor becomes aware of events occurring after the date ofthe auditor's report but
before the financial statements are issued, the auditor should consider whether the financial
statements should be amended and should discuss the matter with management.
If after the financial statements have been issued, the auditor becomes aware of a fact that
materially affects the financial statements on which he has previously reported and which existed
but was not known to him at the date of his report, he should discuss the matter with management.

.Management Representations
The auditor should obtain evidence that management acknowledges its responsibility for the
appropriate presentation of the financial statements and that management has approved the
financial statements.
When [management] representations [either unsolicited or in response to specific inquiries],
relate to matters which are. material to the financial statements, . 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. " a representation by
management is contradicted by other evidence, the auditor should investigate the cii-cumstances
and when necessary, reconsider the reliability of other representations-made by management.

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A uditing: Principles and Procedures

If the auditor is unable to obtain sufficient appropriate audit evidence that he believes
should be available, this will constitute a limitation in the scope of his examination even if he
has a representation from management on the matter.
Written representations from management should be obtained to confirm oral
representations given to the auditor on matters material to the financial statements when other
sufficient appropriate audit evidence cannot reasonably be expected to exist.
When_a management representation letter is requested it should be addressed to the
auditor, contain the information requested by him and be appropriately dated and signed.
A management representation letter should normally be dated the -same date as the auditor's
report on the financial statements.
A management representation letter should be signed by the members of
management who have primary responsibility for the entity and its financial aspects, usually the
senior executive officer and the senior financial officer, based on the best of their knowledge and
belief.
[When a scope limitation has occurred, as a result of management refusing to provide
representations the auditor* considers necessary}, 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.

Opening Balances
If, after performing [the suggested procedures], the auditor is unable to obtain sufficient
appropriate audit evidence concerning opening balances, he should qualify or disclaim his
opinion, due to the limitation in scope of his audit. (28, p.12)
The auditor should issue a qualified or adverse opinion if the auditor concludes that the
opening balances contain misstatements which could materially affect the current year's financial
statements, or the current year's accounting policies have not been consistently applied, and these
matters have not properly been accounted for and disclosed.(28, p.13-14)

Work Performed by Others

. The auditor should carefully direct, supervise and review work delegated to
assistants. ................. .
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.
...

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319

The auditor and assistants with supervisory responsibilities should consider the skills and
competence of assistants in performing the work that is delegated to them in deciding on the
extent of direction, supervision and review appropriate to each.
Appropriate direction should be given to assistants to whom work is delegated.
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
and that the work is being carried out in accordance with the audit program and other planning
documents, (b) become informed of significant accounting and auditing questions raised during
the audit, assess their significance, and modify the audit program where appropriate, and (c)
resolve any differences of professional judgement between personnel.
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, (6) the work performed and the results obtained have been
adequately documented, (c) any significant audit matters remain unresolved, 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.
An audit firm should adopt quality control policies that incorporate objectives [relating to
ethics, competence, proficiency, supervision, client evaluation and practice inspection] and
should implement appropriate procedures that provide reasonable assurance of achieving those
objectives.
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.
When he delegates work to assistants or uses work performed by other auditors or experts,
the auditor should have sufficient knowledge of EDP to direct, supervise and review the work of
assistants with EDP skills or to obtain reasonable assurance that the work performed by other
auditors or experts with EDP skills is adequate for his purpose, as applicable.
The auditor should obtain reasonable assurance that work performed by other auditors or
experts is adequate for his purpose.

An Other Auditor
The principal auditor should perform procedures to obtain reasonable assurance that the
work performed by the other auditor is adequate for the principal auditor's purpose.
The Principal auditor should document in his working papers the components whose
financial statements were audited by other auditors, their significance to the

320

A uditing: Principles and Procedures

financial statements of the entity as a whole, the names ofthe other auditors and any conclusions
reached that individual components are immaterial. He should also document how he, applied
the procedures he performed, and the conclusions he reached.
An other auditor, knowing the context in which his work is to be used by the principal
auditor, should cooperate with that auditor and assist-him actively. 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 other auditor's work.
The principal auditor should qualify his report or disclaim an opinion when he
concludes, based on his procedures, that he cannot use the work of the other auditor and has not
been able to perform sufficient additional procedures with respect to the financial statements of
the component reported on by the other auditor.
In all circumstances, if an other auditor qualifies his report, the principal auditor should
consider whether the subject of the qrjalification is of such a nature
and significance, in relation to the financial statements of the entity on which the principal
auditor is reporting, that it requires a qualification of his own report.
When the principal auditor '[bases his opinion on the financial statements taken as a whole
solely upon the report of another auditor with respect to the financial statements of one or more
components] his report should state this fact clearly and should indicate the magnitude of the
portion of the financial statements audited by the other auditor. Where [branches, subsidiaries, investees or associated entities] are audited by other
auditors, the auditor should consider obtaining the results of their procedures, for example, by
discussions with other auditors, written confirmation or review of working papers.
.

Internal Auditors
The .external auditor should, as part of his audit, evaluate the internal audit
function in so far as he believes that it would be relevant in deterrnining the nature, timing and
extent of his compliance and substantive procedures.
The external auditor should document his evaluation and conclusions with respect to the
use ofthe work ofthe internal auditor.
Having decided in principle that he intends to use the work of the internal auditor, the
external auditor should ascertain the internal auditor's 1 tentative plan for the year and discuss
it/with him at as early a stage as possible to determine areas where he believes he Could use the
internal auditor's work.
The external auditor should be advised of and have access to relevant internal audit reports
and in addition be kept informed, along with management, of any significant matter that comes
to the internal auditor's attention and which he

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321

believes may affect the work ofthe external auditor. Similarly, the external auditor should
ordinarily inform the internal auditor of any significant matters which may affect his work.
Where the external auditor intends to use specific internal audit work as a basis for
modifying the nature, timing and extent of his procedures, he should review the internal auditor's
working papers to satisfy himself that (a) the scope of work and related audit programs are
adequate for the external auditor's purposes, (b) the work was properly planned and the work of
assistants properly supervised, reviewed and documented, (e) sufficient appropriate evidence was
obtained to afford a reasonable basis for the conclusions reached, id) conclusions reached are
appropriate in the circumstances and any reports prepared are consistent with the results of the
work performed, and (e ) any exceptions or unusual matters disclosed by the internal auditor's
procedures have been properly resolved. The external auditoi' should document his conclusions
in respect of the specific work which he has reviewed.
The external auditor should also test the work ofthe internal auditor which he intends to
use.

Experts
When determining whether to use the work of an expert, the auditor should consider {at the
materiality of the item being examined in relation to the financial information as a whole, (b) the
nature and complexity of the item including the risk of error therein, and (c) the other audit
evidence available with respect to the item.
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
[qualifications] and experience and reputation in the field in which the auditor is seeking
evidence.
The auditor should also consider the objectivity of the expert.
If, when planning the audit, the auditor intends to use the work of an expert, he should
communicate with the expert to confirm the terms of the -expert's engagement.
The auditor should seek reasonable assurance that the expert's work constitutes appropriate
audit evidence in support of the financial information. 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 auditor should obtain an understanding of those assumptions-and methods [used by the
expert] 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.

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Auditing: Principles and Procedures

If 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.
If, after performing[the necessary] 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 appropriate audit evidence, he should express a qualified opinion, a
disclaimer of opinion qr an adverse opinion as appropriate.
When expressing an unqualified opinion, the auditor should not refer to the. work of an
expert in his report as such a reference might be misunderstood to be a qualification of the
auditor's opinion or a division of responsibility, neither of which is intended.
If, as a result of the work of an expert, the auditor decides to* express other than Qn
unqualified opinion it may in some circumstances benefit the reader of his report if the auditoi -, in
explaining the nature of his reservation, refers to or describes the work of the expert (including
the identity and the extent of the expert's involvement). In these circumstances, the auditor
should, if he has not already done so, obtain the pel-mission of the expert before making such a
reference. If permission is refused, and the auditor believes a reference is necessary, he should
seek the advice of legal counsel.

Documentation
The auditor should document matters which are important in providing evidence that the
audit was carried out in accordance with the basic principles.
Working papers should record the auditor's planning, the nature, timing and extent of the
auditing procedures performed, and the conclusions drawn from the evidence obtained.
Working papers should be sufficiently complete and detailed for an experienced auditor to
obtain an overall understanding of the audit.
All significant matters which require the exercise of judgment, together with the auditor's
conclusion thereon, should be included in the working papers.
Working papers should be designed and properly organised, to ;meet . the circumstances and
the auditor's needs for each individual audit.
[When the auditor utilises schedules, analyses and other working. papers prepared by the
client], the auditor should satisfy himself that those working papers have been properly prepared
The auditor should adopt reasonable procedures for safe custody and confidentiality of his
working papers and should retain them for a period of time sufficient to meet the needs of his
practice and satisfy any pertinent legal or professional requirements of record retention.

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BASIC PRINCIPLES AND ESSENTIAL REPORTING

PROCEDURES
The audit report should contain a clear written expression of opinion on the financial
information.
When a qualified opinion, adverse opinion or a disclaimer of opinion is given, the audit
report should state in a clear and informative manner all of the reasons therefor.

General Matters
The auditor's report should include (a) an appropriate title, such as "Auditor's Report", (&)
an appropriate addressee as required by the circumstances of the engagement and local
regulations, (c) identification of the financial statements that have been audited, including the
name of the entity and the date and period covered by the financial statements, id) indication of
the auditing standards or practices followed in conducting the audit by reference to international
Standard on Auditing or to standards or practices established within a country, (e) the auditor's
opinion on the presentation in the financial statements of the entity's financial position and the
results of its operations [and suggested reference to the accounting standards and in any situation
where it is not evident which country's accounting principles have been used, the country should
be stated], {/) signature in the name of the audit firm, the personal name of the auditor, or both,
as appropriate, (g) a specific location, which is usually the city in which the auditor maintains his
office, and (h) the report should be dated.
It should be clear which type [i.e., unqualified, qualified adverse or disclaimer] of opinion
is rendered.
Whenever the auditor issues a report that is other than unqualified, he should include a
clear description of all the substantive reasons in his report, and unless impracticable, a
quantification of the possible effect(s) on the financial statements. This information should
preferably be set out in a separate paragraph, preceding the opinion or disclaimer of opinion, and
may also include a reference to a more extensive discussion in a note to the financial statements.
A qualified opinion should be expressed as being "except for" the effects of the matter to
which the qualification relates.
When the limitations in the terms of a proposed engagement is such that the auditor
believes he would need to issue a disclaimer of opinion, he should not accept such a hunted
engagement as an audit engagement, A statutory auditor should not accept such an audit
engagement when the limitation infringes on his statutory duties.
In circumstances [when he is unable to carry out an audit procedures that he believes are
desirable], the auditor should attempt to carry out reasonable

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alternative procedures to obtain sufficient audit evidence to support an unqualified opinion.

When there has been a limitation on the scope of the auditor's work that he concludes
prevents him from issuing an unqualified opinion, the auditor's report should describe the
limitation and the wording of his opinion should indicate that it is qualified as to the possible
adjustments to the financial statements that might have been determined to be necessary had the
limitation not existed.
If a sigruficant uncertainty affecting the financial statements, the resolution of which is
dependent upon future events, causes the auditor to qualify his opinion or to disclaim an opinion,
his report should describe the uncertainty and make reference, when applicable, to the note to the
financial statements that more extensively discusses the uncertainty.

Dating of Report/Subsequent Discovery of an Error

The auditor should date and sign his report as of the date he complete his examination,
which includes performing procedures relating to events occurring up to the date of his report.
However, since his responsibility is to report on the financial statements as prepared and
presented by management the auditor should not date his report earlier than the date on which
the financial statements were approved by managements. The auditor should obtain assurance
that the financial statements were approved by managements.
If management amends the financial statements [as a result of the discovery of an error after
the date of the auditor's report but before the financial statements are issued], the auditor should
carry out the procedures necessary in the circumstances and. report on the amended financial
statements. After carrying out such procedures, the auditor should date his report not earlier than
the date the amended financial statements are approved and, accordingly, the procedures [to
identify subsequent events) should be extended to the date of the auditor's report. If management
does not amend the financial statements in circumstances where the auditor believes they should
be amended, his action will be determined by whether his report has been released to the client.
If his report has not been released, the auditor should express a qualified opinion or an adverse
opinion, as appropriate. If his report has been released to the client, the auditor should notify
those persons ultimately responsible for the Overall direction of the entity that he will take action
to prevent further reliance on his report.
[When the auditor becomes aware of a fact that materially affects the financial statements
on which he has previously reported and which existed but was not known to him at the date of
his report], the auditor should review the steps taken by management to ensure that any
individuals in receipt of the previously issued financial statements together with the auditor's
report thereon are informed that they have been superseded. If management decides that the
financial statements should be revised, the auditor should carry out the procedures necessary in
the

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circumstances and he should issue a new report on the revised financial statements. The auditor's
report on the revised financial statements should have a new date and should refer in an
explanatory paragraph to the note to the financial statements that more extensively discusses the
reason for the revision to the previously issued financial statements. The report should also refer to
the earlier report issued by the auditor on the financial statements and, when the auditor has
restricted his subsequent examination to the events that necessitated the revision, should contain a
statement to that effect. If management does not take the steps referred to above . the auditor
should notify those persons ultimately responsible for the overall direction ofthe entity that he will
take action to prevent future reliance on his report.

OTHER INFORMATION IN DOCUMENTS CONTAINING

AUDITED FINANCIAL STATEMENTS
Overall Objective and Scope
[The auditor] needs to give consideration to other information (such as that which may be
included in an "annual report"] when issuing his report on the financial statements as the
credibility of the audited financial statements may be undermined by inconsistencies which may
exist between the financial statements and other information. (ISA 14) provides guidance as to the
auditor's consideration of other information on which he has no obligation to report.
The auditor should make appropriate arrangements with his client to obtain such information,
prior to the date of his report on the ! statements. In these circumstances, the auditor
should follow the guidance set forth in paragraphs 16-20 (below). .

Consideration of other Information

While the auditor has no responsibility to perform audit procedures to determine that such
other information is properly stated, he should read the other information to determine that is not
materially inconsistent with the financial statements.

Material Inconsistencies
If on reading other information, the auditor becomes aware of a material'
inconsistency; he should determine whether the financial statements or other information need
revision and should advise the client accordingly.
If a revision is necessary in the financial statements and the client refuses to make the
revision, the auditor should express a qualified or adverse opinion," depending on the particular
circumstances.

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If a revision is necessary in the other information and the client refuses to make the
revision, the auditor should consider including in his report an explanatory paragraph describing
the material inconsistency, or performing other actions, such as withholding the use of his report
in the document or withdrawing from the engagement.

Material Misstatements of Fact

If on reading other information, the auditor becomes aware that the other information,
though not inconsistent with the financial statements, nevertheless appears to include a material
misstatement of fact, he should discuss the matter with his client. When discussing the matter
with his client, the auditor should consider that he may not be competent to evaluate the validity
of the other information or management's responses to his inquiries and that there may be valid
differences of judgment or opinion. If after discussion with the client, the auditor still believes he
has a basis for concern as to the validity of the other information, he should request the' client to
consult with some other party, such as the entity's legal counsel and he should consider the
opinion received.
If the auditor concludes that there exists a material misstatement of fact which the client
refuses to correct, he should consider such steps as notifying the client in writing of his concern
regarding the other information and obtaining legal advice as to further appropriate action.

Availability of other Information after Date of the Auditor's

Report
When all the other information is not available to the auditor prior to the date of his report
on the financial statements, he should read the other information at the earliest possibleopportunity thereafter to ensure that no material inconsistencies or material misstatements of fact
exist.
If, upon reading the other information, the auditor becomes aware of a material
inconsistency or a material misstatement of fact, he should consider whether the financial
statements and other information need revision and should follow the guidance set forth in
paragraph 9 or 12-14 [above], as applicable.
When the auditor determines that a revision is necessary in-either the financial statements
or other information and the client agrees to make the revision, the auditor should carry out the
procedures necessary under the circumstances including, if required, the issuance of a new report
on the revised financial statements, In this situation, the auditor should also review the steps
taken by management to ensure that the individuals in receipt of the previously issued financial
statements are informed that they have been superseded.
If the auditor believes a revision to the financial statements is necessary and the client
refuses to' make the specific revision, the auditor should obtain legal advice and take the steps
necessary to prevent future reliance upon his report.

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327

If the auditor believes a revision of the other information is necessary and the client refuses
to make the specific revision, the auditor should notify the client in writing of his concern and
obtain legal advice as to further appropriate action.

SPECIAL PURPOSE AUDITOR'S REPORTS

Overall Objective and Scope
[ISA 24] provides guidance to auditors on the form and content of an auditor's . report issued
in connection with the independent audit of financial information other than an auditor's report on
[historical] financial statements issued in accordance with ISA 13.

General Matters
Before midertaking [an engagement to give a special purpose auditor's report] it is important
that there be agreement with the client as to the exact nature of the engagement and the form and
content of the report to be issued.
In planning his work, the auditor should have a clear miderstanding of the purpose for which
the information being reported on is to be used, and who is likely to use it.
All special purpose auditor's reports should include a title, addressee, identification of the
financial information audited, reference to auditing practices followed, an expression or
disclaimer of opinion on the financial information, signature, the auditor's address and the date of
his report. The scope ofthe auditor's engagement and his opinion should be given in separate
paragraphs. '
When requested to report on financial information in a prescribed format, the auditor should
consider the substance and wording of the form of report and, when necessary, should make
appropriate changes, either by rewording the form or by attaching a separate report.
[When requested to report on provisions of an agreement], the auditor should ensure that
[any significant] interpretation is clearly disclosed in the financial information and make reference
to the note within the financial information that describes the interpretation.

Of her Comprehensive Basis of Accounting

When an entity's financial statements are prepared in accordance with an other
comprehensive basis of accounting the auditor should make reference in his report to the basis
used.
The auditor should ensure that the title of, or a note to, the financial statements would make
it clear to the reader that such statements are not prepared in accordance with relevant national or
international accounting standards. If, in

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the auditor's opinion, the financial statements are not suitably titled or the basis of accounting is
not adequately disclosed, he should express a qualified opinion.
In formulating his report, in addition to the [matters referred to under general matters
above] the auditor should include a statement indicating the basis of accounting used in the
preparation of the financial statements on which he is reporting or refer to the note to the
financial statements giving that information. The opinion should state whether the financial
statements "give a true and fair view (or 'present fairly') in accordance with" the basis of
accounting indicated.

Components of Financial Statements

[An engagement to express an opinion on one or more components of financial statements]
does not result in a report on the financial statements as a whole and accordingly, the auditor
should express an opinion only as to whether a component
of financial statements "gives a true and fair view of (or is presented fairly..............................in
accordance with" the basis of accounting indicated.
The auditor should recognise that many financial statement items are interrelated. In
deterrmning the scope of the engagement the auditor should consider those financial statement
items that are interrelated and which could materially affect the information on which he is
report.
The auditor should also-consider the concept of materiality in relation to a component of
financial statements.
To avoid giving the user the impression that the report relates to the entire financial
statements, the auditor should advise the client that his report on a component of financial
statements should not accompany the financial statements of the entity.
In formmating his report, in addition to the [matters referred to under general
matters] the auditor should include a statement that indicates the basis on which
the component is presented or refers to an agreement that specifies the basis. A
statement or a reference to the note within the financial information should
describe any significant interpretations of the relevant agreement. The opinion
should state whether the component "give a true and fair view of (or is presented
fairly').............in accordance with" the basis indicated.

Compliance with Contractual Agreements

Engagements to express an opinion as to an entity's compliance with contractual
agreements should be undertaken only when the overall aspects of compliance relate to
accounting and financial matters within the scope of the auditor's professional competence.
In formulating his report, in addition to the [matters referred to under general matters], the
auditor should include a reference to the note in the financial information describing any
significant interpretations of the agreement. The

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opinion should state whether the entity has complied with the particular requirements of the
agreement.

Summarised Financial Statements

Unless the auditor has audited and expressed an opinion, on the financial statements from
which the summarised statements were derived he will not be in a position to report on
summarised financial statements.
Such financial statements should clearly indicate the summarised nature of the information
and caution, the reader that, for a better understanding of an entity's financial performance and
position, summarised financial statements should be read in conjunction with the entity's most
recent audited financial statements which include all disclosures required by relevant national or
international accounting standards.
Summarised financial statements should be appropriately titled to identify the audited
financial statements from which they have been derived.
The auditor should refer to his opinion on financial statements and state whether the
summarised financial statements are consistent with the audited financial statements from which
they are derived.
In addition to the [matters referred to under general matters above) the auditor's report
should include (a) and identification of the financial statements on which an audit has been
performed and from which the summarised financial statements were derived, (b) a reference to
the date of his report on the audited financial statements and to the opinion given in that report,
(c) an opinion stating whether the information in the summarised financial statements is
consistent with the financial statements from which it is derived (When the auditor has expressed
a qualified or adverse opinion or disclaimer of opinion on. the audited financial statements, yet is
satisfied with the presentation of the summarised financial statements, he should state that,
although consistent with the financial statements, they were derived from financial statements on
which such an opinion or disclaimer of opinion was expressed.), and (d) a statement, or
reference to the note within the summarised financial statements, which indicates that for a better
understanding of an entity's financial performance and position, the summarised financial
statements should be read in conjunction with the entity's related audited financial statements.

EXAMINATION OF PROSPECTIVE FINANCIAL INFORMATION

Overall Objective and Scope
[ISA 27] provides guidance to auditors on the general procedure's to be performed and the
manner of reporting the results of an engagement to examine forecast (best estimate) or
projection (hypothetical assumptions) prospective

Auditing: Principles and Procedures

financial information. (27, p.7 and 11)

The auditor's examination and report on prospective information increases the credibility of
that information, Given that prospective financial information relates to events and actions that
have not yet occurred and may not occur, the evidence available to support assumptions is future
"orientated and speculative in nature. Given the type of evidence available the auditor cannot
obtain a high level of assurance that the information is free of material misstatement but can
provide a useful service by providing a moderate level of assurance and reporting, on the basis of
the evidence from the examination, whether anything causes the auditor to believe that
management's assumptions do not provide a reasonable basis for the prospective fmancial
information, and an opinion as to whether the information has been properly prepared on the
basis ofthe assumptions. (27, p.3-6)

Genera! Matters
Before accepting an engagement, the auditor should determine the intended use and
distribution of the information, the nature of the assumptions, the components to be included in
the information and the period covered: (27, p. 12)
The auditor should obtain a level of knowledge of the entity's business sufficient to evaluate
whether all significant assumptions have been identified, and also become familiar with the
entity's process for preparing prospective financial informatioa (27, p.14)
The auditor should consider the extent to which the entity's historical financial information
can be relied upon as an historical yardstick for considering management's assumptions. The
auditor should consider the impact of this on the approach to the examination of the prospective
financial information. (27, p.15)
The auditor should consider the reasonableness of the period of time covered by the
prospective fmancial information. (27, p.16)
The auditor should be satisfied that the form and content of the prospective financial
information meets relevant reporting requirements, and adequately discloses material
assumptions or assumptions subject to a high degree of uncertainty, and any changes to
accounting policy from that used in prior period historical financial statements. (27, p. 17-20)

Examination Procedures
The auditor should obtain sufficient evidence to determine whether management's
assumptions are reasonable, hypothetical assumptions are consistent with the purpose of the
informations, the prospective financial information is properly prepared on the basis of the
assumptions and properly presented and prepared on a basis consistent with historical financial
statements. (27, p.21)
The auditor should assess the source and the reliability of the of the evidence supporting
management's best estimate assumptions, and seek sufficient

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331

appropriate audit evidence supporting such assumptions. (27, p.23)

The auditor should ensure that all significant implications of hypothetical assumptions have
been taken into account, but need not obtain evidential support for the assumptions. The auditor
should ensure that the assumptions are consistent with the purpose of the prospective financial
information and have no reason to believe that they are clearly unrealistic. (27, p.24-25)
The auditor should be satisfied that the prospective financial information is properly
prepared from management's assumptions. (27, p.27)
The auditor should focus on the extent to which those areas that are sensitive to variation
will have a material impact on the prospective financial' information when considering the extent
to which appropriate evidence should be sought, and when evaluating the appropriateness and
adequacy of disclosure. (27, p.27)
The auditor should consider the guidance in ISA 24 when engaged to examine one or more
components of prospective nnancial information. (27, p.28)
The auditor should consider the extent to which he needs to apply procedures to historical
information when a portion of the prospective financial information period has elapsed. (27, p.29)
The auditor should obtain written representations from management concerning the intended
use of the prospective financial information, the completeness of assumptions and management's
responsibility for the prospective financial information. (27, p.30)

Reporting Procedures
Reports on prospective information should contain a) a title, b) an addressee, c)
identification of the prospective financial information, d) a reference to the standards or practices
followed in carrying out the engagement, e) a statement that .management is responsible for the
prospective financial information and the assumptions on which it is based, f) reference to the
purpose and/or restricted distribution when applicable, g) a statement of negative assurance as to
the reasonableness of the assumptions, h) an opinion as to whether the prospective information is
properly prepared on the basis of the assumptions and presented in accordance with relevant
standards or to a described comprehensive basis of appropriate caveats concerning the
achievability of the results, j) the auditor's signature and address, and k) the date of the report.
(27, p.31-32)
When additional facts come to the auditor's attention that existed at balance date but were
not known to the auditor at that time, and which may require adjustment or disclosure, the auditor
should update the report. (27, p.31)
A qualified or adverse opinion should be issued where the prospective nnancial information
departs from the presentation guidelines in this ISA. (27, p.33)
The auditor should issue an adverse opinion or withdraw from the engagement

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332

if the auditor believes that one or more significant assumptions do not provide a reasonable basis
for the prospective financial information. {27, p.34)
The auditor should disclaim an opinion or withdraw from the engagement if the auditor is
precluded from applying a procedure considered necessary. (27, p.35)

3. RELATED SERVICES - SUMMARY OF BASIC PRINCIPLES

AND
ESSENTIAL PROCEDURES
REVIEW OF FINANCIAL STATEMENTS
OVERALL OBJECTIVE AND SCOPE
A review engagement is one in which an auditor is asked to carry out procedures which
provide a moderate level of assurance on financial information, being a lower level of assurance
than that provided by an audit.
A review consists primarily of procedures that involve inquiry and analytical review. The
specific objective of the engagement is to give the auditor an appropriate basis for stating
whether anything has come to his attention as a result of his review that causes him to believe
that the information does not give a true and fair view (or "is not presented fairly") in accordance
with the bash; of accounting indicated (negative assurance). In both audit and review
engagements, the auditor expresses some assurance that the information subject to hie
exainination is free of material error. In a review, the auditor's objective is to provide a moderate
level of assurance on the reliabihty of the financial information. While reviews involve the
application of audit skills and techniques, they do not usually involve study and evaluation of
internal accounting controls, tests of accounting records and of responses to inquiries by
obtaining corroborating evidential matter through inspection, observation or confirmation and
certain other procedures ordinarily performed during an audit. A review engagement may bring
to the auditor s attention significant matters affecting the financial information, but it provides
less assurance that the auditor will become aware of all significant matters than would be
provided by an audit.
[Set out below are the basic principles and essential procedures extracted from ISA/RSs 12, broadly categorised according to the review engagement process. As a result of their
importance, the basic principles in IBA/RS 1 have been highlighted in bold print.]
BASIC PRINCIPLES - GENERAL MATTERS

Integrity
The auditor should be straightforward and honest in performing professional services.'

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333

Objectivity
An auditor shoud be fair and should not allow prejudice or bias or influence of others to
override objectivity.

Confidentiality
The auditor should respect the confidentiality of information acquired during the course of
perfoiroing professional services arid should not use or disclose any such information without
proper and specific authority or unless there is a legal or a professional right or duly to disclose.

Skills and Competence

A review should be performed and the report prepared with due professional care by
persons who have adequate training, experience and competence in auditing.
BASIC PRINCIPLES AND ESSENTIAL REVIEW PROCEDURES

Planning
The auditor should plan his work so that the review is conducted in an effective, efficient
and timely manner.
Plans should be based on the knowledge of the client's business relevant to the subject
matter ofthe engagement. Plans should be made to determine and program the nature, timing and
extent of the procedures to be performed and to coordinate work to be performed. Plans should
be further developed and revised as necessary during the course of the review engagement.

General Guidelines
The auditor should obtain sufficient evidence, primarily through inquiry and analytical
review procedures, to provide an appropriate basis for the moderate level of assurance
communicated in the report.
The auditor should perform procedures involving inquiry and analytical review as a
reasonable basis for stating whether anything has come to his attention that causes him to believe
that the information does not give a true and fair view (or "is not presented fairly" in accordance
with the basis of accounting indicated. The selection of specific review procedures to be applied
in any given engagement is a matter of the auditor's judgment.
If, based on his knowledge of the business and the results of his inquiry and analytical
review procedures, the auditor has reason to believe that the information on which he is reporting
may not give a true and fair view (or "be presented fairly'' in accordance with basis of accounting
indicated or is otherwise incomplete or

Auditing: Principles and Procedures

334

unsatisfactory, he should carry out additional or more extensive procedures as he deems

necessary to enable him to express negative assurance or to confirm that a qualification is
required.
When [the results of the auditor's procedures create doubts as to the completeness or
accuracy of the financial statements], the auditor should carry out additional procedures, as he
deems necessary, to enable him to express negative assurance or conclude that a qualification is
required.
In considering the effect of (significant matters affecting the financial information] when
undertaking a review engagement, the auditor should apply the same materiality considerations
as he would if he were giving an audit opinion on the same information.
It is necessary for the auditor to.consider, for example, whether any restrictions in the
scope of his work imposed by the client are of such significance that a moderate level of
assurance could not be provided. In such cases, the auditor should withdraw from the
engagement and consider whether he has an obligation to report the circumstances necessitating
his withdrawal to third parties.
To perform a review the auditor should possess or obtain a knowledge of the accounting
principles and practices of the industry in which it operates, possess or obtain an understanding
of the entity's business, carry out inquiry and analytical review procedures, and carry out such
additional or more extensive procedures (when the auditor has reason to believe that the
information on which he is reporting may not give a true and fair view (or "be presented fairly"}
in accordance with the basis of accounting indicated or is otherwise incomplete or
unsatisfactory],
[The auditor's] understanding of the client's business should include a knowledge of the
entity's organisation, accounting systems, operating characteristics and the nature of its assets,
liabilities, revenues and expenses. The auditor should possess an understanding of such matters
relevant to the. subject of the engagement to enable him to make relevant inquiries and design
appropriate procedures, as well as to assess the responses and other information obtained.
Based on the work performed, the auditor should assess whether-any information has come
to his attention which causes him to believe that the financial statements do not give a true and
fair view (or "are not fairly presented") in accordance with the basis of accounting indicated. If
so, he should request that the necessary revisions be made in the financial statements.

Work Performed by ethers

The auditor should carefully direct, supervise and review work delegated to assistants and
should make such inquiries as will satisfy him that work performed by other auditors or experts
is adequate for his purpoot.

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335

Documentation
.The auditor should document matters which are important in providing evidence that the
review was carried out in accordance with the basic principles for such an engagement and
supports the level of assurance provided.
The auditor should document in his working papers the work performed and the significant
results of the review procedures carried out and, in particular, the manner in which problems
which were resolved.
; BASIC PRINCIPLES AND ESSENTIAL REPORTING PROCEDURES
The report on a review engagement should describe the scope of the engagement to enable
the reader to understand the nature of work performed. Reports on review engagements should
normally contain (a) a title, (b) an addressee, (c) an identification of the financial information on
which the review has been performed, (d) an appropriate description of the work undertaken
such as a reference to guidelines for the engagement and a statement that a review is limited
primarily to inquiries and analytical review procedures, (e) a statement that an audit has not been
performed, that the procedures undertaken provide less assurance than an audit and that a audit
opinion is expressed, i f ) a statement of negative assurance, (g) the auditor's signature and
address, and (h ) the date of the report.
The statement of negative assurance expressed by the auditor should either, (a ) state that
nothing has come to his attention as a result of his review that causes him to believe that the
information does not give a true and fair view (or "is not presented fairly") in accordance with
the basis of accounting indicated, or (b) if such matters have come to his attention, describe the
matters that were not presented fairly in accordance with the basis of accounting indicated,
including the monetary effect of the matters or, if this is not readily determinable, a statement to
that effect and either express a qualification of the moderate assurance provided or give an
adverse statement that the information does not give a true and fair view (or "is not presented
fairly'') in accordance with the basis of accounting indicated.
If there has been a limitation in the scope of the auditor's engagement that he concludes
prevents him from providing moderate assurance, his report should describe' the limitation and
indicate that it is qualified as to the possible adjustments to the financial statements that might
have been determined to be necessary had the limitation not existed. There may be circumstances
when the possible affect of the limitation is so significant that the auditor will conclude that no
level of assurance can be provided and [the auditor] should not provide any assurance.
The report made by the auditor on a review should be prepared in accordance with
requirements of ISA/RS 1, paras. 19-22. The auditor should date his report as ofthe date he
completes his review, which includes performing procedures relating

Auditing: Principles and Procedures

336
to events occurring up to the date of his report.

An auditor -who, before the completion of his engagement, has been requested to change it
from an audit to a review or from a review to one in which he provides no assurance on
assertions should consider the principles set out in the Framework of International Standard on
Auditing and Related Services.
The auditor should inquire about events subsequent to the date of the financial statements
that may require adjustment of or disclosure in the financial statements. If the auditor becomes
aware of any events after the date of his report, he should be guided by ISA 21.
ENGAGEMENTS TO PERFORM AGREED-UPON PROCEDURES

Overall Objective and Scope

An agreed-upon procedures engagement is one which an auditor is engaged to carry out
procedures of an audit nature, to which the auditor and the client have agreed, in order to meet
the client's needs for particular information. {RS 3, p.2)
BASIC PRINCIPLES - GENERAL

Integrity
An auditor should be straightforward and honest in performing professional services. (RS
3, p. 7)

Objectivity
An auditor should be fair and not allow prejudice or bias or influence of others to override
objectivity. (RS 3, p.7)

Confidentiality
An auditor should respect the confidentiality of information acquired in the course of his
work and should not use or disclose any such information without proper and specific authority
or unless there is a legal or a professional duty to disclose. (RS 3, p.7) -

Skills and Competence

An agreed-upon procedures engagement should be performed and the report prepared with
due professional care by persons having adequate training, experience and competence in
auditing. Work delegated to assistants should be carefully directed, supervised and reviewed.
(RS 3, p.7) l

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337

BASiC PRINCIPLES-PROCEDURES

Documentation
The auditor should document matters which are important in providing evidence that the
engagement was carried out in accordance" with the basic principles for such an engagement.
(RS 3, p.7)

Planning
The auditor should plan the work so that the engagement is conducted in an effective,
efficient and timely manner. Plans should be based on a knowledge ofthe client's business
relevant to the subject matter of the engagement. (RS 3, p.7)
The auditor should arrange to meet with the client and, ordinarily, other specified parties
who will receive copies of the report of factual findings to ensure that there is a clear
understanding of the nature and purpose of the engagement, the nature of the elements, accounts,
items or'financial statements to which the procedures will be applied, the nature and extent of the
specific procedures to be applied and the extent of report distribution. (RS 3, p.8)

Evidence
The auditor should perform the procedur es agreed upon and use the evidence obtained as
the basis for the report of financial findings. (RS 3, p.7)
BASIC PRINCIPLES - REPORTING
The auditor's report of factual findings should be 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. (RS 3, p.12)
The report on an agreed-upon procedures engagement should describe the purpose and the
agreed-upon procedures in sufficient detail to understand the nature and scope of the work
performed,, set out the factual findings including srrfficient details of errors and exceptions
found. The report should make it clear that neither an audit nor a review has been performed and,
consequently, that no assurance on assertions is given. RS 3, p. 13)
The report on an agreed upon procedures engagement should normally contain a) a title, b)
an addressee, c) an identification of the financial information to which the procedures have'been
applied, d) a statement that the procedures performed were those agreed upon with the recipient,
e) reference to the standard under which the engagement was conducted, f) indentification of the
purpose for which the agreed-upon procedures were performed, g) a Usting of the specific
procedures performed, h) a description of the auditor's factual findings, i) a statement that neither
an audit nor a review has been performed and that no assurance expressed, j) a statement- that
other matters might have come to light and been reported had

Auditing: Principles and Procedures

338

additional procedures, an audit or a review been performed, k) a statement mdicating to whom

the report is restricted, ) a statement, when applicable, that the report relates only to the specific
financial information indicated and not to the entity's fmancial statements as a whole, m) the
auditor's signature and address, n) the date ofthe report. CRS 3, p.14)
ENGAGEMENTS TO COMPILE FINANCIAL INFORMATION

Overall Objective and Scope

A compilation engagement is one which an auditor is engaged to use accounting expertise
to collect, classify and summarize financial information. The procedures employed are not
designed and are not sufficient to enable the auditor to express any assurance on the financial
information. (RS 4, p.2)
The term 'accountant' is used to distinguish between an audit and a compilation
engagement. (RS 4,-.)
BASIC PRINCIPLES - GENERAL

Integrity
An accountant should be sti-aightforward and honest in performing professional services.
(RS 4, p.6)

Objectivity
An accountant should be fair and should not allow prejudice or bias or influence of others
to override objectivity. In situations where the accountant is not independent, his report should
state that fact. (RS 4, p.6)

Confidentiality
An accountant should respect the confidentiality of information acquired during the course
of performing professional services and should not use or disclose any such information without
proper and specific authority or unless there is a legal or professional right or duty to disclose.
(RS 4, p.6)

Skills and Competence

A compilation engagement should be performed and the report prepared with due
professional care by persons. who have adequate training, experience and competence in
accounting. When work is delegated to assistants, the accountant should carefully direct,
supervise and review their work. (RS 4, p.6)

International Standards on Auditing

339

BASIC PRINCIPLES - PROCEDURES

Documentation
The accountant should document matters which are important in providing evidence that the
engagement was carried out in accordance with the basic principles for such an engagement. (RS 4,
p.6)

Planning
The accountant should plan the work so that the engagement is conducted in an effective,
efficient and timely manner. Plans should be based on a knowledge of the client's business
relevant to the subject matter ofthe engagement. (RS 4, p.6)
The accountant should ensure that there is a clear understanding of the nature and scope of
the engagement, the nature of the infoiTnation to be supplied by the client and the fact
management is responsible for the completeness and accuracy of the financial information, the
basis of accounting to be used and that any departures therefrom will be disclosed, the intended
use and distribution of the compiled iirformation and the form of report to be issued when the
accountant's name is to be associated therewith. (RS 4, p.7)

General Guidelines
The accountant should obtain a general knowledge of the client's business and operations,
and be familiar with the relevant industry accounting principles, practices and report
requirements. The accountant should also possess a general understanding ofthe nature ofthe
entity's business transactions, form of accounting records and the accounting basis on which the
financial information is to be presented. (RS 4, p.9-10)
Additional information should be requested from management if the accountant becomes
aware that the infoiTnation supplied is incorrect, incomplete or otherwise unsatisfactory. If
management refuses, the accountant should withdraw from the engagement. (RS 4, p.ll)
The accountant should read the compiled information and consider whether it appears to be
appropriate in form and free from obvious material misstatements. If not, and appropriate
amendments cannot be agreed with the client, the accountant should withdraw from the
engagement. (RS 4, p.12-13)
The accountant should normally obtain management's acknowledgement of its
responsibility for, and approval of, the financial information. (RS 4, p.14)
BASIC PRINCIPLES - REPORTING
A report should be issued when an accountant's name is associated with financial
information compiled by the accountant. (RS 4, p,15)

340

Auditing: Principles and Procedures

The report on a compilation engagement should normally contain a) a title, b) an addressee,

c) reference to the guideline under which the engagement was conducted, d) identification of the
information compiled, e) a statement that management is responsible for the information
compiled by the accountant, f) a statement that neither an audit nor a review has been performed
and that no assurance is expressed, g) when applicable a statement that the accountant is not
independent of the client, h) when necessary a paragraph identifying material departures from
the basis of accounting, i) the accountant's signature and address, j) the date of the report. (RS 4,
p.16)

341

International Standards on Auditing

Appendix 9.1

INTERNATIONAL STANDARDS ON AUDITING AND RELATED

SERVICES
INDEX OF STANDARDS

No.

Title

Preface to International Standards on Auditing of the

International Federation of Accountants

Publication Date

July 1989

Framework of International Guidelines on February 1988 Auditing and

Related Services
ISAs
ISA 1
ISA

ISA3

ISA

ISA

ISA 6

ISA 7
ISA

ISA

ISA 10
ISA 11
ISA 12

Objective and Scope of the Audit of Financial

Statements

January 1980

Audit Engagement Letters

June 1980

Basic Principles Governing and Audit

September
1980-Revised
1990

Planning

February 1981

Using the Work of an Other Auditor

July 1981

Study and Evaluation of the Accounting System and

Related Internal Controls in Connection with an
Audit

July 1931Revised October

1990

Control ofthe Quality of Audit Work

September 1981
January 1982

Audit Evidence

January 1982

Documentation -

July 1982

Using the Work of an Internal Auditor Fraud

October 1982

and Error Analytical Review

July 1983Revised October

1990

No.

Title

Publication Date

ISA 13

The Auditor's Report on Financial Statements

October 1983Revised October

1939

ISA 14

Other Information in Documents Containing

Audited Financial Statements

February 1984

ISA 15

Auditing in an EDP Environment

February 1984

ISA 16.
ISA 17

Computer-Assisted Audit Techniques

Related Parties

October
1984
October 1984

ISA 18

Using the Work of an Expert

February 1985

ISA 19

Audit Sampling

February 1985

ISA 20

The Effects of an EDP Environment on the

Study and Evaluation of the Accounting System and
Related Internal Controls

June 1985

ISA 21

Date of the Auditor's Report; Events After the

Balance Sheet Date; Discovery of Facts After the
Financial Statements Have Been Issued

October 1985

ISA 22

Representations by Management

October 1985

ISA 23

Going Concern

June 1986Revised October

1989

ISA 24

Special Purpose Auditor's Reports

October 1986

ISA 25

Materiality and Audit Risk

October 1987

ISA 26

Audit of Accounting Estimates

October 1987

ISA 27

The Examination of Prospective Financial

Information

February 1987

ISA 28

First Year Audit Engagements Opening

Balances

July 1990

ISA 29

The Assessments of Inherent, and Control

Risks and Their Impact on Substantive Procedures

July 1990

No.

Title

Publication Date

ISA/RSs
ISA/RS 1

ISA/RS 2
ISA/RS 3
ISA/RS 4

Revised
October 1990
July 1988
February 1988-

Basic rririciples Governing Review Engagements

Engagements
Information

Review of Financial Statements

Engagements to Perform Agreed-upon October

1990 Procedures
to

Compile

Financial

October 1990

Statements
Inter-Bank Corifirmation Procedures

February

EDP
Environments

Stand-Alone
Microcomputers (Supplement No.l to ISA 20)

October 1987

2 34

EDP Environments On - line Computer Systems

(Supplement No.2 to ISA 20)

February 1989

56

EDP Environments

(Supplement No.3 to ISA 20)

February 1989

Database

Systems

1984

The Relationship Between Bank Supervisors and

External Auditors

July 1989

Particular Considerations in the Audit of Small

Businesses

October 1989

The Audit of International Commercial Banks

February 1990

THE AUDITOR OF A
LIMITED COMPANY

APPOINTMENT OF AUDITORS
The appointment of auditors of a company is made according to the provisions of Section
252 which are explained below:

1, First Auditors

[Section 252 (3)]

The first auditoifs) of a company shall be appointed by the directors within sixty days of
the date of incorporation of the company. The auditors) so appointed shall hold office until the
conclusion of the first annual general meeting.
Two provisos have ( been attached to . the above sub-section. Their salient features are as
under:

(1)
\

The company in a general meeting may remove any such auditors) and appoint
in his or their place any other person or persons who have been nominated for
appointment by any member of the company and of whose
nomination notice has been given to the members of the company not less
than fourteen days before the date of the.meeting.
(2) If the directors fail to exercise their powers, the company in general meeting
may appoint the first auditor or auditors.
Appointment of a partnership by the firm name to be auditors of a company shall be
deemed to be the appointment of all the persons who are partners in the firm of appointment.

2. Subsequent Appointment

[Sections 255 (1) 253 (1)]

Every company is required to appoint an auditors), at each general meeting, to hold office
from the conclusion of the next annual general meeting.
A notice is required for a resolution at a company's annual general meeting appointing as
auditor a person other than a retiring auditor. This notice is required to be given by a member of
the company to the company not less than fourteen days before the annual general meeting, and
the company shall forthwith send a copy of

The A iiditor ofa Limited Company

, 291

^ j..

such notice to the. retiring; auditor and shall also give notice thereof to the membrs not less than
seven days before the date fixed for the annual general meeting and, if the company is a listed
company, shall also publish it at least in one issue each of a daily newspaper in English language
and a daily newspaper in Urdu language having circulation in the Province in which the stock
exchange on which the company is listed is situated.
.A

It is further laid down in the law that where notice is given of such a resolution and the
retiring auditor makes with respect thereto a representation in writing to the company not
exceeding a reasonable length and requests its communication to the members of the company,
the company shall, unless the representation is received by it too late for it to do so. In any notice
of the resolution given to members of the company, the fact of the representation having been
made should be stated. A copy of the representat ion should be sent to every member of the
company to whom notice of meeting is sent whether before or after the receipt of the
representation by the company. However, if a copy ofthe representation is not sent as stated
above because it was received too late or because ofthe company's default, the auditor may,
without prejudice to his right to be heard in person, require that the representation shall be read
out at the meeting.
A proviso attached to the legal provision states that it shall not be necessary to send out or
to read out the representation at the meeting if, on the application either of the company or of any
other person who claimed to be aggrieved, the registrar ie satisfied that the rights conferred are
being abused to secure needless publicity for defamatory matter and the registrar may order, the
company's costs on an application to be paid in whole or in part by the auditor, notwithstanding
that he is not a party to the application.
Every company is required to send intimation to the registrar, within fourteen days from the
date of retirement, removal or otherwise ceasing to hold office of an auditor.
Moreover, every company shall, within fourteen days from the date of appointment of an
auditor, send to the registrar intimation thereof, together with the consent in writing of the
auditor concerned.

3. Casual Vacancy
The directors may fill any casual vacancy in the-office of an auditor. However, while any
such vacancy continues, the surviving or continuing auditorfs), if any, may act. Any auditor
appointed to fill in any casual vacancy shall hold office until the conclusion of the next annual
general meeting. -

4. No Appointment
The Corporate Law Authority may appoint an auditor to Ell the vacancy in the following
situations:

346

Auditing: Principles and Procedures

(a) Where appointment for the first auditor is not made within 120 days ofthe
date ef incorporation ofthe company, (o) Where at an annual general meeting no
auditors are appointed.
(c) Where auditors appointed are unwilling to act as auditor of the company.
(d) Where a casual vacancy in the office of an auditor is not filled within 30 days
after the occurrence of vacancy.
The company is required to give notice of the above to the Corporate Law Authority within
one week of the Authority's power exercisable by it as mentioned earlier.

Remuneration

[Section 252 (8)]

The remuneration ofthe auditors of a company shall be fixed as under:

Particulars

Appointing Authority

1.

If the auditor is appointed by the

directors or by the Corporate Law
Authority.

Directors or Corporate Law

Authority as the case may be.

2.

In all other cases

The company in general meeting or

in such manner as the general meeting
may determine.

Qualification Of Auditors

[Sect i on 254]

For appointment as an auditor of a public company or a private company which is a

subsidiary of a public company he must be a Chartered Accountant within the meaning of the
Chartered Accountants Ordinance, 1961..
A firm whereof all the partners practising in Pakistan are Chartered Accountants may be
appointed by its firm name as auditors of a company and may act in its firm name.

Disqualifications of Auditors

[Section 254]

The following persons stand disqualified to be appointed as an auditor of a company:

1.
2.
1.

A person who is, or at any time during the preceding three years was, a director, other
officer or employee of the company,
A person who is a partner of, or in the employment of, a director, officer or employee
of the company,
The spouse of a director of a.company,

The Auditor of a Limited Company

1.
2.

347

A person who is indebted to the company, and

A body corporate.

The terms "officer" or "Employee" used above are so construed as .not to include reference
to an auditor.
The above disqualifications extend to company's subsidiary or holding company or a
subsidiary of that holding company.
If after appointment as an auditor, he becomes subject to any of the disqualifications
mentioned above, he shall be deemed to have vacated his office as auditor with effect from the
date on which he become so disqualified.
A disqualified auditor may be fined up to Rs.5,000 if he acts as an auditor. His appointment
shall be void. If his appointment is made by a company, the Corporate Law Authority may
appoint a qualified person in place of auditor appointed by the company.

INDEPENDENCE OF AN AUDITOR
-To ensure credibility to the financial statements, an auditor must be independent of the
management. The Companies Ordinance, 1984, prohibits the appointment as auditor of the
company in specified circumstances. The objective is to pavjSthe way for an independent
examination of fmancial statements.
Independence has been divided into three categories which are briefly explained below:
Category of Independence

Salient Features

1.

Programming

2.

Investigative

An auditor may perform his duty the way he wants

to enable him to express his independent opinion. He
may decide the extent and types Of tests required to
be undertaken by him *
An auditor is vested with the right of access to all books,
accounts and vouchers.

Reporting

An auditor is free to express his opinion on financial

statements without any pressures being imposed upon him.

3.

Powers and Duties of Auditors

[Section 255]

The following powers are-vested in an auditor of a company:

1. A right of access at all times to the books, papers, accounts and vouchers of

2.
3.

4.

the company, whether kept at the registered office of the company or elsewhere.
He shall be entitled to require from the company and the directors and other officers
of the company such information and explanation as he thinks necessary for the
performance ofthe duties ofthe auditors.
In the case of a company having a branch office outside Pakistan, it shall be sufficient
if the auditor is allowed access to such copies of and extracts from the books and
papers of the branch as have been transmitted to the principal office ofthe company in
Pakistan.
An auditor is entitled to attend any general meeting ofthe company and to receive all
notices of and any communications relating to, and general meeting which any
member ofthe company is entitled to receive, and to be heard at any general meeting
which he attends on any part of the business which concerns him as auditor.

Proviso attached to sub-section (6) of Section 255 makes it obligatory for the auditor or a
person authorised by him in writing to be present in the general meeting in which financial
statements and auditors' report are to be presented in respect of listed companies.
To motivate companies to enable auditors to practically enjoy the above powers, there are
penal provisions. In this respect sub-section (7) of Section 255 is qgjted below:
"If any officer of a company refuses or fails, without lawful justification, the onus
whereof shall lie on him, to allow any auditor access to any books and papers in his
custody or power, or to give any such information possessed by him as and when
required, or otherwise hinders, obstructs or delays an auditor in the performance of his
duties or the exercise of his powers or fails to give notice of any general meeting to
the auditor, he shall be liable to fine which may extend to a five thousand rupees and
in the case of a continuing offence to a further fine which may extend to one hundred
rupees for every day after the first during which the default, refusal or contravention
continues."
No limitation can be placed upon the duties of the auditors either by the articles of
association of a company or by any resolution of the members. These can be increased but not
reduced. Any act on the part of the company, directors or shareholders which ultimately results in
the reduction of the powers of the auditors of a company is ultra vires ofthe Companies
Ordinance, 1984.
Sub-section (3) of Section 255 deals with the duty of an auditor for annual audit of
financial statements.
Form 35A is a prescribed form for Auditors, Report to the Members and is reproduced on
the next page:

FORM 35A
THE COMPANIES ORDINANCE, 1984 ..; [Section 255(3) and Rule
17-A]

AUDITORS' REPORT TO THE MEMBERS

We have audited the annexed balance sheet of. .____________. . . .

asset . . . . . . . . . . . . .

and the related *1 profit and loss account and changes in financial position, together with the
notes forming part thereof, for the year then ended and we state that 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 and after due verification thereof we report that:

(a) in bur opinion, proper books of account have been kept by the company as required by
the Companies Ordinance, 1984:

(b) in our opinion:

(i) The balance sheet and profit and loss account together with the notes thereon
have been drawn up in conformity with the Companies Ordinance, 1984, and are
in agreement with the books of account and are further in accordance with
accounting policies consistently applied
... *3 except for the changes as stated in note(s) with which we concur;
(ii) the expenditure incurred during the year was for the purpose of the company's
business; and
(Hi ) the business conducted, investments made and the expenditure incurred during
the year were in accordance with the objects ofthe . company;

(c) in our opinion and to the best of our information and according to the explanations,
given to us, the balance sheet, *1 profit and loss account and the *2 statement of
changes in fmancial position, together with the notes forming part thereof, give the
information required by the Companies Ordinance, 1984, in the manner so required
and respectively give a true
. and fair view of the state ofthe company's affairs as at................................and ofthe
*4 profit/floss) and the *5 changes in financial position for the year then ended; and
(d) in our opinion ?6 Zakat deductible at source under the Zakat and TJshr
- Ordinance, 1980, was deducted by the company and deposited in the
Central Zakat Fund established under Section 7 of that Ordinance.
Date
Place

Signature {Namefs) of
Auditors}

Notes
Where Applicable
*1 Substitute ''income and expenditure account" *2
Substitute "source and application of funds".
*3 Where there is no change in the accounting policy(ies) the portion "except
for the changes as stated in note(s)...............................
with which we concure"
may be delated.
*4 Substitute "surplus or (deficit)".
*5 Substitute "changes in source and application of funds".
*6 Where no Zakat is deductible, substitute "no Zakat was deductible at source under the
Zakat and Ushr Ordinance, 1980.
Where any ofthe matters referred to in the Auditors' Report is answered in the negative or
with a qualification, the report shall state the reason for such answers -alongwith the factual
position to the best of the auditors' information.
In the case of a non-listed company reference to the statement of changes in financial
position or source and application of fund and opinion thereon may be omitted.

und
er:

Major points to be considered in the Auditors Report on annual accounts are as

1
.
2
.
3
.
4
Information and explanations to be obtained. Books of accounts to be kept as required under
the Ordinance. The financial statements should be drawn up in conformity with law and are in
agreement with bqeks.
The financial statements should give a true and fair view.
Expenditure was incurred for the purpose ofthe company's' business.
' The business conducted, investments made and expenditure incurred were in accordance with
the objects ofthe company.
Zakat was deducted and deposited in Central Zakat Fund
If any of the answers to questions raised in the prescribed Audit Report is in the negative,
the audit report will be a qualified one and the auditors report should state the reasons for such
answer along with the factual position to the best ofthe auditor's information.

The Federal Government has the power to include a statement of additional matters as may
be so specified.
The above legal provisions also apply to auditor appointed for audit of the books of
accounts of a liquidator.

Reading and Inspections of Auditors1 Report

[Section 256]

The auditor' report is required to be read before the company in general meeting and shall
be open to inspection by any member of the company.

Signature on Audit Report

[Section 257]

Salient features in respect of signature on audit report are explained as under :

(1) The following are permitted to sign the auditors' report or sign or authenticate any other
documents of the company required by law to be signed or authenticated by the
auditor:
(o) Only the person appointed as auditor of the company, or
(b) Only a partner in the firm practising in Pakistan.
2. The auditors report shall be dated and indicate the place at which it is signed.

Audit Of Cost Accounts

[Section

258]

Salient features in respect of audit of cost audit are stated below:

1. This relates to audit of cost accounts of the company prescribed by the Federal
Government.
The Federal Government may direct that an audit of cost accounts ofthe company shall
be conducted in a specified manner.
Cost auditor may be a Chartered Accountant (within the meaning of the Chartered
Accountants Ordinance 1961) or a Cost and Management Accountants (within the
meaning of Cost and Management Act, 1966). Cost auditor has been vested with the
same powers, duties, and liabilities as an auditor of a company and such other powers,
duties and liabilities as may be prescribed.

AUDITORS' LIEN
It has been held that the auditors have no lien on the books of accounts which have been
audited by them. However, if they worked on the books of account in the capacity of an
accountant they have a right to exercise lien on the books. In the case of Herbeart Alfred Burligh
vs. Ingrim Clark Limited, it was decided that the auditor had no Uen on the books of account in
respect of audit work. But if the work was in the nature of accountancy, lien could be exercised.
The extracts from the judgement of Justice Joyce are given here:
"The affidavits filed show that the respondent claims a lien, not as auditor but as an
accountant. In my opinion the question of an auditor's lien did not arise, and had it
been so, I consider an auditor has no such lien; but that point I do not decide now. In
respect of the

Share Register, the accountant has no possible lien on that, but he is entitled to a lien
on such books as he had actually worked upon in respect of his proper remuneration
for work upon those books only."
In the case of Sockockinsk vs. Bright Grahame and Company 1938, it was laid down that
an accountant can exercise lien on the correspondence and working papers.
Justice Swinfen-Eddy in the case of Arthur Francis Ltd., ordered the auditors to hand over
such books of account on which they claimed lien in respect of accountancy and auditing charges
to the liquidators from the dues and charges of work of liquidations without prejudice to the right
of lien by the auditors.

STATUS OF AUDITOR
The status of an auditor under the Ordinance is discussed as follows:

As agent of the Members

An auditor is appointed by the shareholders, except in the Case of an auditor appointed by
the directors to fill the casual vacancy or to certify the statutory-report or by the Central
Government in a case where no appointment is made by the shareholders. He is required to
submit his report to the shareholders. It was laid down by Lord Cranworth in his judgement given
in the case of Spackman vs. Evans that:
'The auditor may be the agent of the shareholders so far as relates tc the audit of the
accounts. For the purpose of the audit the auditor will bind the members." *,
In the same case Lord Chelmsford is quoted as follows:
"It seems to me that it would be an unreasonable conclusion from the mode of
appointment of these officers that they were thereby constituted agents so as to
conclude the shareholders by their knowledge of any unauthorised act of the
directors".
From the above discussion it will be apparent that an auditor is an agent ofthe shareholders
so far as it relates to the audit of the account.

As an officer of the Company

The auditor of a company is not one of its officers except for the purposes of Sections 412,
417, and 418, the provisions of which are as follows:
Under Section 412, when a company is in liquidation, its past and present auditors are liable
to make good any loss sustained by the company on account of negligence on the part of auditors,
if misfeasance proceedings are instituted against them by the liquidator, any creditor or
contributory of the company.

Under Section 417 and 418, if a charge of falsification of accounts or forgery is brought
against the auditor by the liquidator of the company, the auditors are punishable with
imprisonment for a term which may extend to seven years and also with fine.
At times the auditor of a company is asked to advise on the matters of amalgamation of
companies,,reconstruction of the capital of limited company and reconstruction of a limited
company. Therefore the legal matters are discussed as follows:

AUDIT COMMITTEE
Concept
An audit committee consists generally of non-executive directors. The main objective is to
establish an effective link between the board of directors and management team which is
involved with day-to-day operations of the company, specially with regard to control and
auditing matters.

Scope of Work
Scope of work of audit committee may include the following:

1.

Reviewing management letter received from the auditor and making recommendations
on if.

2.
3.
4.
5.

Appraising the company accounting policies.

Identifying areas of improving audit efficiency.
Reviewing internal audit reports of a company.
Resolving any possible conflicts between the directors and the company.

Benefits
Benefits of audit committee are listed below:

1.
2.
3.

It serves as a communication link between the auditor and the executive board.
Efficient audit work is facilitated.
Given a good quality of people constituting the audit committee, the company can
gain a lot in terms of ensuring improvements.

MATERIALITY TO ACCOUNTS AND THE AUDITOR

The auditor must ensure that the concept of materiality is used positively. The following
guidelines be used to consider whether an item is material or not:

30U

Auditing:

Principles

and

Procedures

1. A comparison of the figure in percentage terms be made with the total of that group
items.

1.
1.
2.
3.

It is difficult to prescribe a cut off percentage to declare it to be material. However, it

is normally considered to be material if it is 10 percentage or more of a total amount.
The amount may be compared with the corresponding amount of the previous year.
The impact in terms of changing a profit figure into a loss one or L>ee versa be
carefully considered.
Particular circumstances be carefully considered.

AUDITOR
OF
A
COMPANY AND LEGAL
DOCUMNETS
MEMORANDUM OF ASSOCIATION AND AUDITOR
The auditor should examine the memorandum of association of the company
for the following objectives:

."

(1) To see weather the company is carrying on the work in accordance with the "Object

(2)
(3)
(4)

Clause" ofthe memorandum of association. If the company is carrying on its work

which is beyond the scope of the object clause, the transactions will be void and the
auditor must bring this fact to the notice ofthe shareholders, failing which he is likely
to be held guilty.
To satisfy himself that the issue of the share capital is within the "authorised capital"
and that only those classes of shares were issued which were mentioned in the
memorandum of association.
If any matters in respect of the "accounts" are dealt with in the memorandum, the
relevant clauses must be studied.
He must examine the capital clause of the company to ensure that if the capital
Structure has been changed, the procedure as laid down in the memorandum is
adhered to.

Suggested contents of memorandum of association contained in the First Schedule of the

Ordinance are indicated below:
Table Particulars

Memorandum of Association of a company limited by shares.

Memorandum and Articles_ of 'Association of a company limited by
guarantee and not having a share capital.

Memorandum and articles of association of a company limited by

guarantee and having a share capital.
Memorandum and articles of association of a unlimited company
having a share capital.

Auditor of a Company and Legal Documents

ARTICLES OF ASSOCIATION AND AUDITOR

The auditor should procure the latest copy of the articles of association and examine the
following matters:

(1) The issue of share capital.

(2) The payment of underwriting commission and brokerage on shares.
(3) The amount of minimum subscription upon which the company may proceed to allot
the shares.

(4) Terms and conditions governing the issue of shares, allotment, making of calls,
forfeiture of shares, transfer of shares, transmission of shares etc.
(5) Borrowing powers of the company and the directors.
(6) Reorganisation of share capital.
(7) Dividends and Reserves.
(8) Rights attached to the different classes of shares issued by the company.
(9) Appointment, qualification, remuneration, powers, duties and rotation of directors.
(10) Accounts and Audit. f
(11) Creation of reserves and disposal of profits.
(12) Appointment, remuneration, duties etc, of the managing agents (if any).
(13) Meetings and how they can be held,
(14) Voting powers of shareholders.
(15) Payment of interest out of capital.
Table A of the First Schedule annexed to the Companies Ordinance 1984 is in respect of
"Regulations for Management of a Company Limited by -Shares.'' which-represent contents of
Articles of Association. These Regulations may be adopted in toto.or partially under Section 26.
It has been held in the case of Leeds Estate Building and Investment Society Limited vs.
Shepherd (1887) that an auditor cannot escape the liability on the plea that he was unaware of the
articles of the company, or that he did not consult them.

PROSPECTUS AND AUDITOR

When a prospectus has been issued by the company, the auditor should note the fouowing
points contained in it:

(1) The amount of the share capital offered for subscription, the different classes of shares
(2)

and the rights attached thereto, if any.

The terms of issue, i.e., amount payable on application, allotment, future calls
whenever made. In Pakistan full amount is received alongwith

358

Auditing: Principles and Procedures

(3)
(4)
(5)
(6)
(3)
(7)
(4)

application for shares.

The amount of minimum subscription.
Particulars of any contracts entered into with the vendor.
Amount payable for underwriting commission on shares and brokerage.
The amount or estimated amount of preliminary expenses.
The qualification, remuneration and powers of directors and managing agents.

Particulars of any materials contracts entered into by the company.

The nature and extent of the interest of any director in the promotion of the company.
, (10) The issue of redeemable share, if any.
The Second Schedule (Part L , ) annexed to the Ordinance contains matters to be
specified in Prospectus and reports and statement in lieu of Prospectus to be set out therein.

MINUTES BOOK AND THE AUDITOR

Under Section 173 every company is required to keep proper minutes of all general
meetings of members and meetings of Directors. The auditor of the company possesses a
statutory right to inspect them.
Many transactions of a company require the Sanction of a resolution either of the members
in the general meeting or of the directors ofthe company. If this is not done the transaction
becomes ultra vires either of the company or of the directors. Therefore, the auditor must satisfy
himself as to the validity of such transactions and also examine the nunutes book for this
purpose. Under Section 216, the director who is interested in any contract with the company is
prohibited from voting at the time when such contract is considered by the Board of Directors.
The auditor should ascertain that his presence was not counted for the purpose of forming a
quorum at the time of such a vote. He should also refer to the Board's minutes recording the
declaration made by the interested director.
The minutes of the general meeting should be inspected by the auditor for the verification
of the following matters:

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

The passing and adoption of annual accounts.

Appropriation of profits by way of transfers to reserves and declaration of dividend.
Appointment and remuneration of directors and auditors.
Alteration and reduction of share capital.
Alteration ofthe articles of association ofthe company.
Reconstruction of the company.

Auditor of a Company and Legal Documents

The minutes of the directors' meetings should be examined for the confirmation and
verification of the following matters:

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

Issue of share capital.

Allotment of shares.
Calls made by the company, if any.
Forfeitures of shares.
Issue of debentures including the terms governing the redemption of debentures.
Appointment, remuneration, duties and powers etc., of managing agents and directors,
secretary and other officers.
(7) Payment of interim divided.
(8) Recommendations as to the declaration in respect of dividend.
(9) Additions/deletions -to fixed assets.
(10) Borrowing on behalf of the company.
(11) Authorising the use of company's seal.
(12) Authorising the directors travelling expenses and any other special remuneration.
(13) Aaopt ion of annual accounts to be published.
(14) Appointment of directors to fill the casual vacancy.
(15) Appointment of first auditors and of auditors to fill a casual vacancy.
(16) Appointment of the bankers to the company and the officers authorised to operate the
bank accounts.

(17) Adoption of contracts.

(18) Any other matter requiring the directors' sanction.
Committees' minute books which contain the proceedings of the meetings of the
eommittees appointed by the Board of Directors should also be examined.

STATUTORY BOOKS AND AUDITOR

Every limited company registered under the Act is required by law to maintain certain
books which are called statutory books. A list of these books is as under:

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

Register of Members (Section 147)

Index of Members (Section 147)
Annual Returns (Section 156)
Minute Books (Section 173)
Registers of Directors, etc. (Section 206)
Register of Contracts (Section 214)

Auditor of a Company and Legal Documents

360

(7) Register of Mortgages and Charges (Section 135)

(8) Register of Debenture Holders (Section 113)
(9) Books of Account (Section 230)
All these statutory books are of utmost miportance to the auditors, as they practically form the
basis of his work, supplying him with information regarding the authority of transaction carried on by
the company and incidental liabilities of the assets of the company. The auditor under the law is vested
with an unconditional access to any of the above books and any refusal or restrictions imposed by the
management would constitute an infringement of the statutory rights of the auditors conferred on him
under Section 255. He should refer to these books as and when necessity arises. In respect of books of
accounts, he should ascertain that they are kept according to Section 230.

AUDITORS'
REPORTS

CERTIFICATION OF STATUTORY REPORT

[Section 77(4)]

The work done by an auditor in respect of the certification of statutory report is generally
called "Statutory Audit". This term is generally applied to the audit to be performed by the
auditor, if appointed prior to the statutory meeting of the company. Under Section 77(1), it is
required that every company limited by shares and every company limited by guarantee and
having a share capital shall, within a period of not less than one months nor more than six
months from the date at which the company is entitled to commence business, hold a general
meeting of the members of the company. This meeting shall be called the statutory meeting. The
directors are required to forward a report (called statutory report) duly certified by the auditors
of the company to every member of the company at least twenty-one days before the day on
which the meeting is to be held.
The contents of the statutory report are governed by Section 157(3) of the Ordinance.
A private company is not required to hold a statutory meeting or to prepare the statutory
report.
The work to be performed by the auditor, under Sub-section (4) of Section 77, in
connection with the certification of points contained in the statutory report is tabulated below:
(1) Shares allotted and cash received there-against
(a) Terms of issue. Verify the terms of issue with 'the memorandum and articles of
association and prospectus. See that the issue is within the limits of the authorised and issued
share capital. Peruse the consent order issued by the Controller of Capital Issues. Ministry of
Finance, Government of Pakistan (if applicable).
(5) Allotment of shares or calls made. Inspect the minutes of the directors' proceedings for
the allotment of shares and calls made. Ascertain whether the

Auditors' Reports

362

return of allotment has been filed with the Registrar Joint Stock Companies. In the case of shares
allotted for a consideration other than cash, examine the contract showing the title of allottees to
such shares and see that the copy of such contract has been duly filed with the Registrar.

(c) Cash received against share capital. Vouch the issue of shares payable in cash with the
applications received, copies of allotment letters, application and allotment books, call books,
and register of members. The letter of regret and the receipts obtained must be checked in respect
of amount returned to the non-allottees. Verify the amount of forfeited shares, unpaid calls and
calls received in advance. The relevant entries in the books of account relating to the issue of
shares and cash received in respect thereof should be vouched.

(d) Register of members. Check the balances from the register of members to the schedules of
share capital and see that the control account agrees.
(2) Receipts and Payments Account

(a) Period of Account. Ensure that the abstract of receipts and payments ofthe company has
been prepared up to a date within seven days of the date of report.

(b) Contents. No proforma for the above abstract has been laid down in the Ordinance.
However, contents of the abstract, on a broad principle, have been mentioned in Section 157(3).
The auditor should see that the following information is invariably given in.the above abstract:
Receipts

(i) From shares.

(ii) From debentures. (Hi )
From other sources.
Payments
(i) The payments made thereout.
(it) Commission or discount paid on the issue or sale of shares.
(iii)
. On account of the preliminary expenses of the company of estimate of the
preliminary expenses of the company.

(iv) The balance remaining in hand.

(c) Vouching the cash receipts and payments. Vouch the cash received from the proceeds ofthe
shares, or debentures, etc. Check other' receipts such as sale proceeds of assets, interest on
investment etc., with the supporting documentary evidence, including contracts with the vendors
(if applicable). See that the commission, paid on shares and debentures is properly authorised by
the memorandum and articles of association, prospectus and the agreements with concerned
parties. Vouch the amount of preliminary expenses and the capital expenditure with the-suppliers'
invoices, receipts and other relevant vouchers etc. Examine in their respect the minutes of the
directors' proceedings. Other payments should be vouched in the

normal way.
(d) Cash and bank balances. The auditor should physically check the closing balance of
cash in hand. He should also reconcile the bank balance shown in the cash book with the
amount indicated in the bank staten-snt. Bank certificate for the closing balance should be
directly obtained from the client's banker.

Form of Auditor's Certificate

If the auditor is satisfied about the accuracy of the foregoing items, he should give his
certificate in connection with the correctness of the prescribed items given in the statutory
report. The form of auditor's certificate to be given at the foot of this report is as follows:
"We the undersigned, being the auditors of the company, hereby certify that so much
of this report as relates to the shares allotted, the cash received in respect of such
shares, and the receipts and payments cf the company is correct."

Place and Date

Chartered Accountants

REPORT FOR INSERTION IN PROSPECTUS

[Second Schedule]
A prospectus issued by a company which has been carrying on business prior to the issue
thereof must include an auditor's report and an accountant's report dealing with the specified
matters.
The Second Schedule annexed to the Companies Ordinance, 1984, contains provisions in
respect of prospect and related matters. These are briefly stated below:
Parti,
Matters to be specified in Prospectus and Reports to be set out therein.
Section 1: Matters to be Specified
1. Contents of memorandum
2. Nature and value of shares
3. Remuneration of directors: Articles of Association
4. Particulars of directors, CEO, Managing Agent and Secretary
5. Minimum subscription

6. Dates of opening and closing of subscription list -Source: Excerpted from
Second Schedule Part I o f the Companies Ordinance, 1984.

;.

364

Auditing: Principles and Procedures

uditon'
Reports

7.
8.
9.

309

Amount payable on application

Substance of any contract or agreement: Option or preferential right to subscribe for any
shares or debentures
Number, subscription and amount of shares and debentures issued in the past two
preceding years for consideration other than cash. -

10. Premium Paid or payable

11. Underwriting Names and directors option in respect of sufficiency to discharge the
obligations

12. Vendors Property and other details

13. Consideration paid within two preceding years: Other details re: Unclerwritir^.'sub14.
15.
16.
17.
18.

miderwriting, commission etc.

Preliminary expenses
Promoters or officer: Benefit paid and consideration thereof
Contract: CEO, managing agent or secretary
Auditors and Legal advisers names and addresses
Director or Promoter particulars and extent of interest: Promotion of company or
property acquired

19. Rights: Voting, capital, dividend

20. Restrictions of Articles: Powers of management, right to attend, speak or vote or right to
transfer shares

21.
22.
23.
24.

Length of time during which business the company was carried on

Capitalisation: Particulars and surplus from any revaluation: Company or its subsidiary
Reasonable time and place for inspection of balance sheets and profit and loss account
Principal purposes for using net proceeds of the issue

25. Shares issued for consideration other than cash details

26. A summary in columnar form of the earnings of the company or the company and its
subsidiaries consolidated or otherwise, as appropriate, for each of the last three financial
years of the company

27. Pending legal proceedings, other than ordinary routine litigation Section 2: Reports to be
set out
28. Auditors Report

Profi^^nd losses and assets and liabilities: 5 years: distinguishing itenfiof a toprecrrrring nature

Dividends
' paid
5 years

 Particulars of each, class of shares for which dividend was paid or not paid
If no accounts made up, a statement to this effect Information about subsidiaries
Combined position
Individual

29. A report of Auditor

If shares issued for purchase of any business
On profits or losses of business for 5 financial years and assets and liabilities of
the business at the last date to which accounts of the business were made up.

30. Acquisition of shares resulting into a subsidiary: A report of the auditor as

per 29 above.
Section 3: Provisions Applying to Section 1 and 2

31. Reference to signatories of memorandum and the shares subscribed for by them and
preliminary expenses: Inapplicability in some cases

32. Scope of being a vendor

33. Vendor melides lessor if property acquired on lease
34. Financial years to be less than 5 years if the company has been carrying on business for
less than 5 years

35. Adjustments in figures of profit

37. Auditors to be qualifies under the Ordinance.

Auditors' Report
The report of the auditor of the company must contain the following things:

(1) The profits of the company for each of the five financial years immediately preceding
the issue of the prospectus, supported by a properly classified profit and loss account,
showing clearly the trading results and all charges and expenses incidental thereto,
excluding profits not belonging to the peiiod covered and non-recurring profits, but
including profits appropriated for taxation or reserves.

(2) The rates of dividends (if any) paid by the company for each of the five years stating:
(o) the particulars of each class of shares on which dividends have been paid, that is to
say, the total paid-up share capital and the total number of the issued shares of
each class together with the amount of
each share;

(b) the source from which dividends have been paid; and
(c) the particulars of any class of shareb on which no dividends have been

Auditors' Reports

366

paid.
(3) If the latest available audited accounts of the company are more than three months old
on the date ofthe prospectus, a statement of that fact is to be made.
If the company has been carrying on business for less than three years and its account have
been made up only for two years or less, then the auditor's report must be confined only to that
period.
Where the company has a subsidiary company, similar information relating to the
subsidiary company must also be included in the auditor's report.

Scope of Auditor's Work

The auditor should perform the following work to nilfil the above legal requirements:

(1) Tabulated profit and loss account. See that a tabulated profit and loss account is prepared
distinguishing items of a non-recurring nature for each of the five financial years immediately
preceding the issue of the prospectus.

(2) Balance Sheet. Check assets and liabilities of the company at the last date to which the
accounts of the company were made up.

(3) Rates of Dividends. The particulars of each class of the shares on which the dividends have

been paid should be verified with the audited balance sheet, minutes of the proceedings of the
meeting of directors and shareholders. The sources from which dividends have been paid should
be verified with reference to the directors' report and audited accounts, and minutes of the
shareholders' meeting. The fact that no dividend have been paid on any class of shares should be
verified by the scrutiny ofthe minutes of the shareholders' meetings.

(4) Latest available audited account A statement of the fact that the latest available audited
accounts of the company are more than three months old on the date of the prospectus, should be
verified by looking into the time factor.
(5) Auditors' Report. It should be addressed to the directors ofthe company.

367

Auditors'Reports

AUDITOR'S FORM OF THE REPORT ILLUSTRATED

An example of the suggested form of the report to be submitted by the auditor to the
directors of a company is given here:
The Board of Directors, Naeem
Elahi & Co. Ltd. Lahore.
Gentlemen,
Pursuant to legal provisions contained in the Company Ordinance, 1984, we have to
report that the profits of the company (which has no subsidiary company) as disclosed by
its annual audited accounts for three years from July 1, 19 . . . .
to June 30, 19......................(the latter date being the last to which the audited
accounts have been made up) and the rates of dividends together with the source from
which these have been paid by the company and particulars relating to the share capital are
on the next page.

Profit and Loss Account

Particulars
Cost of goods sold
Establishment
charges Directors' fees
Interest Depreciation
Balance c/d
Provision for
Taxation Transfer to
general
reserve Balance (from
which
dividends have
been paid)
Rs.

1991 1992 1993 Particulars

1991 1992 1993
Sales
Interest on investments
Balance b/d Balance
b/f from last year
Rs

368

Auditing: Principles and Procedures

Statement of share capital and dividends paraYears ended

30th JunePaid-up share capitalNumber of shares of Rs.10
eachDividends paid199319921993Lahore
Date.............. Chartered Accountants

Details in respect of assets and liabilities be also

included in the report.
ANNUAL AUDIT

[Section

255 C3)]

Section 233(3) requires that the balance sheet and the profit and loss account of a company
shall be audited by the auditor of the company and the auditors' report shall be attached thereto.

Auditors' Report
The auditor of a company is required to make a report to the members of the company on
the accounts examined.by him. The requirements ofthe report are laid down under Section
255(3). After the report has been signed, the auditor should forward it to the office of the
company leaving it for the directors to convene the general meeting and send the accounts to the
members. It was held in the case of Allen Craig & Company (London) Ltd. (1934) that the duty
of the auditor was discharged when he fixed his signature to the report attached to the balance
sheet and sent that report to the secretary of the company. Based on this case, it is not the duty of
the auditor to send a copy of his report to each member individually.

Circulation of Accounts
Under Section 233(4), every company is required to send a copy of the audited balance
sheet and profit and loss account (or income and expenditure account) together with a copy ofthe
auditor's report and directors report to every member at his registered address, at least twentyone days before the meeting at which these are to be presented. This period is intended to give
the members an adequate opportunity for considering the accounts. Under Section 243, the
members of a company are also entitled to be furnished with copies of balance sheet and profit
and loss account and auditor's report on payment of such sum as the company may

Auditors'Reports

fix not exceeding the maximum amount prescribed.

Laying Accounts before general meeting for consideration

The directors of every company are required by Section 233(1) to lay before a general
meeting of members in each calendar year a balance sheet and profit and loss account (or an
income and expenditure account in the case of a company no trading for profits). The balance
sheet and the profit and loss account are referred to as final accounts and statement of accounts.
The first final accounts must be presented at some date not later than eighteen months after the
incorporation of the company and the subsequent accounts must be presented once at least in
every calendar year. In the case of a listed company the Authority, and in any other case the
registrar, may, for any special reason, extend the period far a term not exceeding three months.

Authentication of Accounts
Section 241 provides for-the signing of balance sheet and the profit and loss account or
income and expenditure account as the case may be. The account should be signed by the chief
executive and one director.
When the chief executive is for the time being not in- Pakistan, then the balance sheet and
profit and loss account or income and expenditure account of the company shall be signed by not
less than two directors for the time being in Pakistan, but in such a case there shall be subjoined
to the balance sheet and profit and loss account or income and expenditure account a statement
signed by such directors explaining the reasons for non-compliance with the provisions of subsection (1).
If a company makes default in complying with the requirement of this section, the
company and every officer of the company who is knowingly and wilfully in default shall be
liable to a fine not exceeding five thousand rupees.

Filing of Accounts
Section 242 requires every public company to file with the Registrar five copies in the case
of listed companies and three copies in the case of any other company of the balance sheet and
profit and loss account together with the auditor's report after those accounts have been laid
before the general meeting. The copies to be filed must be signed by chief executive, directors,
chairman or the auditors of the company or secretary ofthe company and filed within tliirty days
after the ordinary general meeting.

Contents of Report
According to Section 255X3), the auditors' report should contain the following clauses:

369

Auditors' Reports

370

First Clause
(a) Whether or not they have obtained all the information and explanations which to the
best of their knowledge and belief were necessary for the purposes of the audit An auditor is
vested with the right of access to the books, accounts and vouchers of the company and also to
require from the directors and the officers of the company such information and explanation as
may be necessary for the performance of his duties. This right has been given to him so that he
may exercise it-"and if he failed to obtain any information or explanation which he thinks are
vital for the performance of his duties, he may qualify his report. In the absence of any
suspicious circumstances, he is entitled to rely on the information supplied to him by the
responsible officers of the company.
Second Clause
Whether or not in their opinion proper books of account as required by the Ordinance
have been kept by the company. Section 230 requires that every company must keep proper
books of account for recording:

(a) all sums of money received and expended by the company and the matters
in respect of which the receipt and expenditure takes place;
(b) all sales and purchases of goods by the company;
(c) all assets of the company;
i d) all liabilities ofthe company; and
(e) in the case of a company engaged in production, processing, manufacturing or mining
activities, such particulars relating to utilisation of material or labour or to other inputs
or items of cost as may be prescribed if such class of companies is required by the
Authority by a general or a special order to include such particulars in the books of
accounts.
The law does riot prescribe any particular system of accounting, nor does it lay down any
particular language in which the accounts ofthe Company should be kept. The books of account
may be kept according to the English system of accountancy or the Pakistani system of
bahikhata, but the accounts kept must be complete and should maintain records fulfflling the
said requirements.
The books of account are to be kept at the registered office ofthe company or at such other
place as the directors may think fit. Where a company has a branch office, proper books of
account relating to the transaction effected by "the branch may be kept at the branch oince; hut
proper summarised returns made up-to-date at intervals of not more than two months must be
sent by the branch office to the head office for incorporation in the principal books of account.

371

Auditing: Principles and Procedures

Tnird Clause1
Whether or not i n their opinion the balance sheet and profit and loss account or the
income and expenditure account have been drawn up i n conformity with the Ordinance and are
in agreement with the books of accounts. In order to enable himself to report on the above
matter it is highly essential that the auditor should be fully conversant with the statutory
requirements in respect of the drawing up to balance sheet and profit and loss account. No
prescribed form of balance sheet and profit and loss account has been laid down in the
Ordinance. However, certain essential information is required to be given as provided in Fourth
Schedule for listed companies and Fifth Schedule for unlisted companies. The legal provisions
contained in Section 234 of the Ordinance be also noted.
The auditor should thoroughly acquaint himself with the provision contained in the
Ordinance in respect ofthe following:
Secfion Particulars

237

Balance sheet of holding company to include certain particulars as to

its subsidiaries.

237
238

Financial year of holding company and subsidiary.

Rights of holding company representative and members.
238 Balance sheet of Modaraba company to include to Modaraba
accounts.

Fourth Schedule
Fourth Schedule is annexed to the Companies Ordinance, 1984, and contains requirements
in respect of balance sheet and profit and loss account of listed companies. It consists of three
parts. Part I is entitled "General" and contains definition of terms, broad principles governing
disclosure in the financial statements and treatment to several matters for inclusion in the
financial statements. Part is entitled "Requirements as to Balance Sheet" and prescribes the
classification and disclosure requirements of assets and liabilities in the balance sheet. Part is
entitled "Requirements as to Profit and Loss Account" and prescribes disclosure requirements
governing various sources of income and expenditures.
Similarly Fifth Schedule prescribes the disclosure requirements in respect of balance sheet
and profit and loss account of non listed companies.
Fourth Clause
Whether or not in their opinion and to the best .of their information and according to the
explanations given to them, the said accounts give the information
Recommended for further reading:
Financial Statement Disclosures Chick List, issued by the Institute of Chartered Accountants of Pakistan, n.d., pp. 1-31.

Auditors'Reports

372

required by this Ordinance in the manner so required and give a true and fair view:

(0 in the case of balance sheet, of the state of the company's affairs as at the end of its
financial year;
(ii) in the case of the profit and loss account or the income and expenditure account or the
profit or loss or surplus or deficit, as the case may be, for its financial year; and .
(Hi) in the case of the statement of changes in financial position or sources and application
of funds of a listed company, of the changes in the financial position or the sources
and application o f funds for the financial year.
The generally accepted interpretation of the words "true and correct view" as was used
earlier, is that the financial position of the company must not be- less favourable than that
disclosed by the balance sheet, although it may be more favourable; and where the position of a
company is under-stated on the balance sheet owing to the existing of secret reserves, it is not
usually necessary for the auditor to qualify his report to the shareholders. Therefore it appears
that a balance. sheet may exhibit a true and correct view of the position of the company and yet it
may give misleading impression. The English Companies Act and the Indian Companies Act have
removed the weakness of audit by substituting the words "true and correct view" for "true and fair
view". The object of this change is to place a greater responsibility on the auditor to ensure that
the accounts do reflect a position which is not misleading by being under-stated or over-stated,
and a clean audit report cannot cover a material under statement of the financial position of a
company as disclosed by the balance sheet.
It may further be noted that the phrase "according to the best of the information and
explanations given to him" also limits the responsibility of the auditor. He will not be held
responsible if he acted on the information and explanations which he believed to be true but
which are in fact untrue, provided he exercised a reasonable skill and. diligence in testing the
information supplied to him.
In order to submit the above report, an auditor must examine the vouchers, their supporting
documentary evidence, correspondence, memorandum and articles of association, minutes of the
proceedings of the meetings of directors and shareholders. He must verify the arithmetical
accuracy of the books by routine checking. A complete verification of all assets and liabilities
must also be carried out.
In the case of banking company, legal provisions laid down under Banking Ordinance,
1962, also reqnire that the auditor should also state "whether or not the transactions of the
company which have come to his notice have been within the powers of the company and
whether or not the returns received from the branch offices ofthe company have been found
adequate for the purposes of his audit. Similarly, when auditing the accounts of the insurance
company, the auditor is required by the Insurance Act, 1938, to state in his report that "no part
ofthe assets

18

A udking: Principles and Procedures

of the life insurance fund has been directly or indirectly utilised in contravention of the provisions
of the Insurance Act, relating to the application and investment of life insurance fund and also that
he has verified cash balance and the securities relating to the company loans, reversions and life
interests and investment."
True and Fair
There is no statutory definition of the words "true and fair". However, true and fair has been
taken to mean the following:

1.
2.
3.
4.
5.

Free from prejudice or bias

Presentation of an objective picture
In accordance with generally accepted accounting principles
Consistent and having clarity
Not nrisleading but understable by the reader of financial statements.

To facilitate the role of an auditor to express his opinion, it is necessary that he should be
following the accounting and auditing standards. His effort should be to be as objective as is
possible.
Fifth Clause
Whether or not in their opinion:

(i)

the expenditure incurred during the year was for the purpose' of the company's
business; and

(ii) the business conducted, investments made and expenditure incurred during the
year were in accordance with the objects of the company.
The auditor must thoroughly read object clause of the Memorandum of Association of the
company and related provisions of the Articles of Association and ensure that the spirit of the
above clause is met. The purposes of the company business are found in the object clause of the
Memorandum of Association. The same clause also includes the details of business to be
undertaken, investments to be made and expenditure to be incurred.
Sixth Clause
Whether or not i n their opinion Zakat deductible at source under the Zakat and Ushr
Ordinance, 1980 (XVIII of 1980), was deducted by the company and deposited i n the Central
Zakat Fund established under Section 7 of that Ordinance.
There are two schedules attached to the Zakat and Ushr Ordinance, 1980. One deals with
compulsory deduction and the other one is in respect of voluntary, payment. The auditor must well
verse himself with the compulsory deduction of Zakat @ 2"% and after verification must ensure
that it was deducted and deposited in the Central Zakat Fund established under Section 7 ofthe
above Ordinance.

374

Auditors' Reports

SUBMISSION OF AUDITORS' REPORT TO SHAREHOLDERS

The auditor's report is addressed to the shareholders of the. company. After it has been
signed and dated by the auditors, it is sent to the office of the company. According to legal
provisions of the Chartered Accountants Ordinance, 1961, every member of the Institute of
Chartered Accountants of Pakistan should designate himself as 'Chartered Accountant'. When the
auditor is satisfied that the balance sheet and profit and loss account are in order, he should give
a clean report containing answer in the aflirmative of the questions posed by the law. An
example of clean report is now given.
FORM 35A THE COMPANIES
ORDINANCE, 1984
[Section 255(3) and Rule 17-A] AUDITORS'
REPORT TO THE MEMBERS

We have audited the annexed balance sheet of.....................................as at............................

and the related *1 profit and loss account and statement of *2 changes in financial position,
together with the notes forming part thereof, for the year then ended and we state that 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 and after due verification thereof we report that:

(a) in our opinion, proper books of account have been kept by the company as requiredby the Companies Ordinance, 1984;

(b) in our opinion

(i) the balance sheet and profit and loss account together with the notes thereon

(ii)

have been drawn up in conformity with the Companies Ordinance, 1984, and are
in agreement with the books of account and are further in accordance with
accounting policies consistently applied *3 except for the changes as stated in
note(s) with which we concur;
the expenditure incurred during the year was for the purpose of the company's
business; and

(Hi ) the business conducted, investments made and the expenditure incurred during
the year were in accordance with the objects of the company;

(c) in our opinion and to the best of our information and according to the explanations
given to us, the balance sheet, * 1 profit and loss account and the *2 statement of
changes in financial position, together with the notes forming part thereof, give the
information required by the Companies Ordinance, 1984, in the manner so required
and respectively give a true
and fair view of the state of the company's affairs as at..............................
and of
the *4 profit/floss) and the *5 changes in financial position for the year ended; and

375

Auditing: Principles and Procedures

(d) in our opinion *6 Zakat deductible at source under the Zakat and Ushr Ordinance,
1980, was deducted by the company and deposited in the Central Zakat Fund established
mider Section 7 of that Oirdinance.
Date........................... Signature
Place........................

Name(s) of Auditors

Notes
Where applicable:
*1. Substitute "income and expenditure account". *2.
Substitute "source and application of funds''.
*3. Where there is no change in the accounting policyfies) the portion "except
for the changes as stated in note(s).........................................with which we concur"
may be deleted.
*4. Substitute "surplus or (deficit)".
*5. Substitute "changes in source and application of fiinds".
*6. Where no Zakat is deductible, substitute "no Zakat was deductible at source under the Zakat
and Ushr Ordinance, 1980".
Where any of the matters referred to in the Auditors' Report is answered in the negative or with
a qualification, the report shall state the reason for such answers along with the factual position to the
best of the auditors' information.
In the case of a non-listed company reference to the statement of changes in finan-cial position or
source and application of funds and opinion thereon may be omitted.

Qualifications In an Audit Report

The auditor may, however, find it necessary to qualify his report in the following circumstances:
()

()

Where he has been refused an access to any books, accounts and vouchers
ofthe company, or where he has been unable to obtain any information or
explanations that he may have required from the directors and officers of
the company.

Where the balance sheet and the profit and loss account, on which report is
being given are notj m his opinion, drawn up in conformity with the law.
(c) Where the balance sheet does not exhibit a true and fair view of the state ofthe company's
affairs, as for example, where he has failed to verify the existence of certain assets, where the
assets are not properly valued, where the provision for depreciation is inadequate, where
any known loss or liability has not been provided for, or where an excessive or unjustified

376

Auditors'R eports

secret reserve exists etc.

(d ) Where proper books of account, as required by law, have not been kept by
the company for the period covered by the audited accounts.

'... -

If the auditor finds it necessary to insert a qualification in his report, he must state the
reason therefor. At the time of giving a qualified report he should be guided by the dictum of late
Lord-Justice Lindley (London and General Bank case).
"A person whose duty is to convey information to others does not discharge that duty
by simply giving them so much information as it calculated to induce them to ask for
more. Information and the means of information are by no means equivalent terms."

AUDITORS'REPORT: FORM OF QUALIFICATION

The way an auditor should deal with qualification in his report is explained below:

1. Disclaimer
In a disclaimer of opinion, the auditor states that he is unable to form an opinion as to
whether the nnancial statements give a true and fair view. .

2. Adverse Opinion *
In an adverse opinion, the auditor states that in his opinion, the financial statements do not
give a true and fair view.

3. Subject to Opinion
In a "subject to" opinion, the -auditor disclaims an opinion on a particular aspect of the
financial statements which is not considered fundamental.

4. Except Opinion
In an "except" opinion, the auditor expresses an adverse opinion on a particular aspect of
the financial statements which is not considered fundamental. Overall position is tabulated
below:
Nature of
Circumstances
Uncertainty
Disagreement

Fundamental
Disclaimer of Opinion
Adverse Opinion

Material but not

Fundamental
Subjeet to........................
Except..........................

Auditing: Principles and Procedures

Examples of Qualifications
Few instances of cmalifying clauses which an auditor might find necessary to insert in his
report on the accounts reported upon by him are as below:
Depreciation. The amount charged for depreciation on plant and machinery is,
in our opinion, insufficient to the extent of Rs...........................
No depreciation on fixed assets has been provided in the accounts, on the
ground that the whole of the assets of the company _ haw.- been efficiently
maintained out of the revenue. If depreciation would have been provided, it would
have amounted to Rs................
Lease-hold Property. The amount of lease-hold property is shown at original cost, although
half of the term for which the lease had been acquired has expired
Reserve f or bad and doubtf ul debts. In our opinion, the reserve for bad an
doubtful debts is inadequate by Rs. .......................
No provision has been made for the doubtful debts, although debts amounting to Rs.
. . . . . . . are statute-barred.
Investment The investments ofthe company have been valued at cost, which is
in excess of the present market value by a sum of Rs.............................
Stock-in-trade Stock-in-trade appearing in the balance sheet Rs................................., is an
estimated figure and is not supported by records or by physical stocktaking.
Provision for Taxation. No provision has been made for taxes payable to the
extent of Rs...................
Contingent Liability. There is a contingent liability in
discounted Rs,..................which has not been disclosed in the accounts.

respect

of

bills

Trade Mark. We were unable to form an opinion as to the value of trade mark.
Liabilities. A sum of Rs......................representing liabilities for the accounts under
review has not been accounted for in the books.

AUDITOR^ REPORT AND GOING CONCERN CONCEPT

ISA 23 deals with "Going Concern" concept, it assumptions, audit evidence and the e
impact on auditor's report. Relevant excerpts in this respect revised up to October 1989, are
reproduced below:

Recommended for further rending:

Statement of Standard Auditing Practices (SAP 2) entitled: Auditors' Report and Qualifications, issued by the Institute of
Chartered Accountants of Pakistan, n.d., pp.1-16.

Auditors'Reports

378

Introduction

1.

2.

InterTiatiorial Accounting Standard (IAS) 1, Disclosure of Accounting Policies, issued by

the International Accomiting Standards Committee Recognizes the going concern
assumption as one of the fundamental assumptions underlying the preparation of finaneial
statements. The going concern assumption is defined in IAS as follows (paragraph 7):
"The enterprise is normally viewed as a going concern, that is, as confirming in
operation for the foreseeable future. It i6 assumed that the enterprise has neither the
intention nor the necessity of liquidation or of curtailing materially the scale of its
operations."
International Standard on Auditing (TSA )1, Objective and Scope of the Audit of Financial
Statements, states (paragraph 3):
"The auditor's opinion helps establish the credibility of the
statements. The user, however, should not assume that the
opinion is an assurance as to the future viability ofthe entity......................"

3.

financial
auditor's

The purpose of this Standard is to provide guidance to auditors in discharging their

responsibilities in situations in which the appropriateness of the going concern assumption
as a basis for the preparation ofthe financial statements is in question.

The Going Concern Assumption

4.

An entity's continuance as a going concern is assumed in the preparation of financial

statements in the absence of information ic the contrary. Accordingly, assets and liabilities
are recorded on the basis tlsat the entity will be able to realize its assets and discharge its
liabilities in the normal courje of business. If this assumption is unjustified, the entity may
not be able to realize its assets at the recorded amounts and there may be changes in the
amounts and dates of maturities of liabilities. As a consequence, the amounts and
classification of assets and liabilities in the financial statements may need to be adjusted.

5.

Indications that continuance as a going concern should be questioned may come from the
financial statements or from other sources. Examples of such indications are listed below.
This listing is not all-inclusive nor does the existence of one or more always signify that the
going concern assumption needs to be questioned:

Financial Indications

a. Net liability or net current liability position.

b. Fixed-term borrowings approaching maturity without realistic prospects of renewal or
repayment, or excessive reliance on short-term borrowings to finance long-term assets.

c. Adverse key financial ratios.

379

Auditing; Principles and Procedures

d.
e.
f.
gh.

Substantial operating losses.

Arrears or discontinuance of dividends.
Inability to pay creditors on due dates.
Difficulty in complying with the terms of loan agreements.
Change from credit "to cash-on delivery transactions with suppliers.
Inability to obtain financing for necessary new product development or other
necessary investments.

Operating indications
j. Loss of key management without replacement.
k.. Loss of a major market, franchise, license, or principal supplier.
1, Labor difficulties or shortages of important supplies.

Other Indications
m. Noncompliance with capital or other statutory requirements.
n. Pending legal proceedings against the entity that may, if successful, result in judgments
that could not be met.
o.

Changes in legislation or government policy.

6. The significance of such indications can often be mitigated by other factors. For example,

indications that an entity may be unable to make its normal debt repayments may be
mitigated by management's plans to maintain adequate cash flows by alternative means,
such as by disposal of assets, rescheduling of loan repayments, or obtaining additional
capital. Similarly, the loss of a principal supplier may be mitigated by the availability of a
suitable alternative source of supply.

Audit Evidence

7. When planning and performing audit procedures and in evaluating the results thereof, the
auditor should be alert to the possibility that the going concern assumption on which the
preparation of the financial statements is based may be subject to question. When such a
question arises, the auditor should gather sufficient appropriate evidence to confirm or
dispel the doubt regarding the entity's ability to continue in operation for the foreseeable
future, generally for
a period not to exceed one year after the balance sheet date.
8. During the course of the audit, the auditor carries out audit procedures
. designed to obtain appropriate audit evidence as the basis for the expression of
his opinion on the financial stajten^snj&-When a question arises regarding the going
concern assumption, certain ofthese procedures may take on additional significance or it
may be necessary to'-employ additional procedures or to update information obtained
earlier. Procedures that are relevant in this

380

Auditors' Reports

connection may include:-

a.

Analyze and discuss cash flow, profit, and other relevant forecasts with
management at the latest practicable date before the date of the auditor's report.
b.
Review events after the balance sheet date for items affecting the entity's
ability to continue as a going concern.
c.
Analyze and discuss the entity's latest available interim financial statements.

d.

Review the terms of debentures and loan agreements and determine whether
any have been breached.

e.

Read minutes ofthe meetings of stockholders, board of directors and other

important committees for reference to financing difficulties.
f.
Request information on any material legal matters from the entity's legal
counsel.
g.
Confirm the existence, legality and enforceability of arrangements to provide
or maintain financial support with related and third parties and assess the financial
ability of such parties to provide additional funds.

h.
i.

Consider the entity's position concerning unfilled customer orders.

Obtain written representations from management concerning
future action the outcome of which is expected to improve the situation.

plans

for

9. When analyzing cash flow, profit, and other relevant forecasts, the auditor
should consider the reliability of the entity's system for generating such information. The
auditor should also consider the support for significant assumptions underlying the forecast
and compare the prospective data for recent prior periods with historical results, and the
prospective data for the Current period with results achieved to date.

10. The auditor should consider and discuss with management its plans for future action the
outcome of which is expected to improve the situation. Examples of plans that the auditor
should consider and discuss with management are plans to liquidate assets, borrow money
or restructure debt, reduce or delay expenditures, and increase capital. The relevance of
such plans to an auditor generally decreases as the time period for planned actions and
anticipated events increases. Particular emphasis ordinarily is placed on plans that might
have a significant effect on the entity's solvency within the foreseeable future. The auditor
should obtain reasonable assurance that these plans are feasible, are likely to be
implemented and that the outcome of these plans will improve the situation.

The Auditor's Report

11. After the auditor has carried out the additional procedures he considers necessary, obtained
all the information which he has required and considered

A uditors' Reports

381

the effect of any plans of management and other mitigating factors, he should decide
whether the questions raised regarding the going concern assumption have been
satisfactorily resolved.

12. If the auditor determines that he has obtained reasonable assurance that the going concern
assumption used for the preparation of the fmancial statements is appropriate, he should
express an unqualified opinion on the financial
statements.

13. If the auditor determines that the going concern assumption is appropriate because of
mitigating factors, in particular management's plans for future action, he should consider
whether such plans or other factors should be disclosed in the financial statements. If
disclosure considered necessary by the auditor is not made, he should qualify his opinion or
express an adverse opinion for lack of such disclosure.

14. If the auditor determines that the going concern questions are not resolved, he should
ensure there is adequate disclosure in the financial statements of the principal conditions
that raise doubt about the entity's ability to continue in op^ation in the foreseeable future.
The disclosure should:
describe the principal conditions that raise doubt about the entity's ability to continue in
operation in the foreseeable future.
state that there are doubts that the entity will be able to continue as a going concern and,
therefore, may be unable to realise its assets and discharge its liabilities in the normal
course of business.
state that the financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or to amounts and
classification of liabilities that may be necessary should the entity be unable to
continue as a going concern.
Provided the disclosure is considered adequate the auditor should not qualify his opinion
nor give an adverse opinion. If the auditor concludes that adequate disclosure is not made in
the. financial statements, he should qualify his opinion or express an adverse opinion for
the lack of such disclosure.

Paragraph Emphasizing Unresolved Going Concern Questions

15.

When the auditor determines that the going concern questions are not resolved but he
concludes that adequate disclosure is made in the financial statements, he should add a
paragraph (after the opinion paragraph) that draws attention to the note in the financial
statements that discloses the matters noted in paragraph 14.1

The auditor ie not precluded from issuing a disclaimer oi pinion for a going concern uncertainty.

382

Auditing: Principles and Procedures

Opinions Expressing Disagreement

16. If, on the basis ofthe additional procedures carried out by the auditor and the information
obtained by him, including the effect of mitigating circumstances, he is convinced that the
entity will not be able to continue in operation in the foreseeable future, he should conclude
that the going concern concept used for the preparation of the financial statements is
incorrect. If the result of the incorrect assumption used in the preparation of the financial
statements is so material and pervasive as to make the financial statements misleading, he
should issue an adverse opinion.
Appendix 12.1

EXAMPLES OF AN AUDITOR'S REPORT WITH

PARAGRAPH EMPHASIZING A GOING
CONCERN UNCERTAINTY

AUDITOR'S REPORT TO
(Scope paragraph)
We have audited the financial statements1 in accordance with International Standards on
Auditing.2
(Opinion paragraph)
In our opinion, the financial statements give a true and fair view of ('present fairly')
the financial position of. .......................at........................and the results of its operation for
the year then ended in accordance with............................: 3 (and comply with..........................4).
(Paragraph emphasizing a going concern uncertainty)
Without qualifying our opinion we draw attention to Note X in the financial statements. The
Company incurred a net loss of $... during the year ended December 31, 19XX and, as of that
date, the Company's current liabilities exceeded its current assets by $ . . . and its total liabilities
exceeded its total assets by
Provide suitable identification, such as by reference to page numbers or by identifying the individual statements.
or refer to relevant national standards or practices.
Indicate the relevant national standards or refer to International Accounting Standards. Refer to relevant statutes or law.

383

A uditors' Reports

$ .. . These factors, along with other matters as set forth in Note X, raise doubt that the Company
will be able to continue as a going concern,
AUDITOR
Date
Address

Appendix 12.2

EXAMPLE OF AN AUDITOR'S REPORT QUALIFIED FOR

DISAGREEMENT FOR INADEQUATE DISCLOSURE OF A
GOING CONCERN UNCERTAINTY WHEN AN ADVERSE
OPINION IS NOT APPROPRIATE

AUDITOR'S REPORT TO................................................................................................................

We have audited the financial statements 1 in accordance with International Standards on
Auditing.2
The Company has been unable to renegotiate its borrowings from its bankers. Without such
financial support there is a sigruficant uncertainty that it will be able to continue as a going
concern. Consequently adjustments may be required to the recorded asset amounts and
classification of liabilities. The financial statements (and notes thereto) do not disclose this fact.
In our opinion, except for the omission of the information included in the preceding
paragraph, the financial statements give a true and fair view of (present fairly') the
financial position of the Company at December 31, 19XX and the results of its
operations for the year then ended in accordance with..................................3 (and Comply with
................4).

Date AUDITOR Address

Provide suitable identification, such as by reference to page numbers or by identifying the Individual statements.
*. Qr-refer to relevant national standards or practices.
3

Indicate the relevant national standards or refer to In! national Accounting Standards. * Hefer to relevant

statutes or law.

384

A uditors 'Reports

AUDIT CONCLUSIONS AND REPORTING

The auditor should review and assess the conclusions drawn from the audit evidence
obtained as the basis for the expression of his opinion on the fmancial information. This review
and assessment involves forming an overall conclusion as to whether;

(a)

the financial information has been prepared using acceptable accountingpolicies, which have been consistently applied;

(b)

the financial information complies with relevant regulations and statutory

requirements;
(c) the view presented by the financial information as a whole is consistent with
the auditor's knowledge ofthe business of the entity; and
(d) there is adequate disclosure of all material matters relevant to the proper
presentation of the financial information.
The audit report should contain a clear written expression of opinion on the financial
information. An unqualified opinion indicates the auditor's satisfaction in all material respects.
When a qualified opinion, adverse opinion or a disclaimer of opinion is given, the audit
report should state in a clear and informative manner all of the reasons therefor,

REPORT ON THE AFFAIRS OF A COMPANY IN SUPPORT OF

A DIRECTORS' DECLARATION OF THE COMPANY'S
SOLVENCY
[Section 362]

If a limited company wishes to go into voluntary liquidation with a view to having a

members' voluntary winding up the directors ofthe company or a majority of them, if there are
more than two directors, are required by Section 362 to make a statutory declaration to the effect
that, after full inquiry into the affairs of the company, they have formed the opinion that the
company has no debts or will be able to pay all its debt in full within a period not exceeding 12
months from the commencement of the winding up.
The above declaration should be accompanied by a copy of the report of the auditors of the
company, prepared, so far as the circumstances admit, in accordance with the provisions of this
Ordinance, on the profit and loss account ofthe company for the period commencing from the
date up to which the last such account was prepared and ending with the latest practicable date
immediately before the making of the declaration and the balance sheet of the company made out
as on the last mentioned date and also embodies a statement of the company's assets and
liabilities as at that date.

A uditors' R eports

385

The auditor of the company is required to make a report on the company's affairs in support
of the directors' declaration of the solvency of the company. For this purpose he must perform
the following work:

Verification
Verify all assets and liabilities of the company as on the date of directors' declaration. Also
critically examine the accounts of the company since the close of the last financial year.

Reason for winding up

Enquire into the basic reasons for winding up. If it is due to the fact that the company's
affairs are getting involved, the examination of its affairs should be conducted with great care by
the auditor.

Reflection of liabilities in the accounts

He should see that all the liabilities including fixed, short term, actual or contingent are
taken into account. A liability certificate to the effect that all known liabilities in respect of the
company as on the said date has been accounted for should be taken from the directors. A
scrutiny of the accounts in the ledger particularly nominal ones should reveal any unaccounted
for liabilities.

Report
He should submit his report on the company's affairs in support of a director's declaration
ofthe company's solvency. Suggested format is on the next page.

THE AUDITORS' REPORT ON FINANCIAL STATEMENTS

ISA 13 deals with auditors' report on financial statements. Text of this ISA is reproduced
below:

Introduction
1.

International Standard on Auditing 1, Objective and Basic Principles Governing an

Audit, states (paragraphs 29 to 31):
"29. 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
information. This review and assessment involves considering whether:
the fmancial information has been prepared using acceptable
accounting policies, which have been consistently applied;

the financial information complies with regulations and statutory

requirements relating to the preparation of financial statements;

386

Auditing: Principles and Procedures

SUGGESTED PROFORMA OF AUDITOR'S REPORT UNDER SECTION 362

OF THE ORDINANCE .
Dated........................19
The Directors

Dear Sirs,
We have audited the accounts of your company from................................to.......................
and have signed the balance sheet together with the profit and loss.
We have obtained all the information and explanations we have required and, in our opinion,
balance sheet exhibits a true and fair view of the state of company's affairs, according to the best
of our information and the explanations given to us and as shown by the books ofthe company.
It will be seen from the accounts that the total habilities and total unsecured
debts were approximately Rs...........................................Against these, there were the
following assets:

( a ) Fixed assets
(o) Stocks
(c) Book debts
(d) Cash in hand and in bank

Rs...........................
...............................
...............................
............. .................
Total Rs........................................

Yours faithfully

Place and Date

Chartered Accountants

the view presented by the financial information as a whole is

consistent with the auditor's knowledge of the business of the entity; and

there is adequate disclosure of all material matters relevant to the

proper presentation ofthe fmancial information.
30. The audit report should contain a clear written expression of opinion on the
financial information. An rniqualified opinion indicates the

A uditors' R eports

387

auditor's satisfaction in ail material respects with the matters dealt with in
paragraph 29.
31. When a qualified opinion, adverse opinion or a disclaimer of opinion is given, the
audit report should state in a clear and informative manner all ofthe reasons
therefor."
The purpose of this Standard is to provide guidance to auditors on the form and
content of the auditor's report issued in connection with the independent audit
ofthe financial statements of any entity. Much ofthe guidance provided can be
adapted to audit reports on financial information other than fmancial
statements.

2.

Basic Elements of the Auditor's Report

3. The auditor's report should include the following basic elements:
" a. title,

b.
c.
d.
e.
f.
g.
h.

addressee,
identification of the financial statements audited,
a reference to the auditing standards or practices followed,
an expression or disclaimer of opinion on the financial statements,
signature,
the auditor's address, and
the date of the report.

A measure of mrnbrmity in the form and content of the auditor's report is desirable because
it helps to promote the reader's understanding. The auditor's unqualified report will usually
consist of a paragraph describing the scope of his audit and a separate expressing his
opinion.

Title

4.

An appropriate title, such as 'Auditor's Report', should be used. This help the reader to
identify the auditor's report and to easily distinguish it from reports that might be issued by
others, for example, by management.

Addressee

5.

The report should be appropriately addressed as required by the circumstances ofthe

engagement and local regulations. The report is usually addressed either to the shareholders
or the board of directors of the entity whose financial statements are being audited.

388

Auditing; Principles and Procedures

Identification of Financial Statements

6.

The report should identify the financial statements that have been audited. This should
include the name of the entity and the date and period covered by the financial statements.

reference to Auditing Standards or Practices

7.

The report should indicate the auditing standards or practices followed in conducting the
audit by reference to International Standards on Auditing or to standards or practices
established within a country. The reader needs this as an assurance that the audit has been
carried out in accordance with established standards or practices. Unless otherwise stated,
the auditing standards of practices followed are presumed to be those of the country
indicated by the auditor's address.

Opinion on the Financial Statements

8.

The report should clearly set forth the auditor's opinion on the presentation in the financial
statements of the entity's financial position and the results of its operations.

9.

Financial statements are based upon a framework of concepts determined by local

legislation, by rules issued by professional bodies and by the development of general
practice within the country, with an appropriate consideration of fairness. The phrases used
to express the auditor's opinion that the nnancial statements have been prepared accordingly
should be 'give a true and fair view' or 'present-fairly', which are equivalent terms. To advise
the reader of the context in which fairness is expressed, it is suggested that the auditor's
report indicate that his opinion is based upon such-a framework of concepts by using words
such as 'in accordance with (indicated relevant national standards or International
Accounting Standards)'. In any situation where it is not evident which country's accounting
principles have been used, the country should be stated.

10., Sometimes the auditor is required to give an opinion ae to 'conformity with the law.' Often
such conformity will also satisfy the requirements for the auditor to express the opinion
referred to above. However, when the application of accounting principles required or
allowed by local regulation does not result in a presentation which 'gives a true and fair
view of (or 'present fairly')...', this or similar phraseology should not be used by the auditor
when expressing his opinion as to 'conformity with the law.'

Signature
11. The report should be signed in the name of the audit firm, the personal name
of the auditor, or both, as appropriate.

Auditors'Reports

389

Auditor's Address

12. The report should name a specific location, which is usually the city in which the auditor
maintains his office.

Date of Report

13. The report should be dated. This informs the reader that the auditor considered the effect on
the financial statements and on his report of events or transactions about which he became
aware that occurred up to that date.

Types of Opinions .

14. The opinion expressed in the auditor's report may be:

unqualified,

qualified,
adverse, or
disclaimer of opinion

It should be "clear which type of opinion is rendered. This can best be achieved by adopting
a degree of uroformity in the wording of each type of opinion. Accordingly, this Standard
includes suggested wording to express an unqualified opinion as well as qualifying phrases
when expressing a qualified opinion. The appendices include a suggested form of an
auditor's report which expresses an unqualified opinion and examples of other types of
opinions which incorporate the principles set forth in this Standard.

15. An unqualified opinion is issued when the auditor is satisfied in all material respects with
the matters dealt with in paragraph 29 of Objective and Basic Principles Governing an
Audit as quoted in paragraph 1 above. The auditor's report should express this satisfaction
in a clear and affirmative manner.

16. An unqualified opinion indicates implicitly that changes in accounting principles or in the
method of their application and the effects thereof have been properly determined and
disclosed in the financial statements.

17. An auditor may not be able to express an unqualified opinion when any of the following
circumstances exist 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 his work; or
b. There is a disagreement with management in respect to the financial statements, for
example, whether a significant uncertainty has been adequately disclosed.
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. These circumstances are discussed

390

Auditing; Principles and Procedures

more fully in paragraphs 22 to 25.

18. A qualified opinion is issued when the auditor concludes that he cannot issue an unqualified
opinion but that the effect of any disagreement or limitation on scepe is not so material as to
require an adverse opinion or a disclaimer of opinion. A qualified opinion should be
expressed as being 'except for' the effects of the matter to which the qualification relates.

19. An adverse opinion is issued when the effect of a disagreement is so material and pervasive
to the financial statements that the auditor concludes that a qualification of his report is not
adequate to disclose the misleading or incomplete nature ofthe fmancial statements.

20. A disclaimer of opinion is issued when the possible effect of a limitation on scope is so
significant that the auditor is unable to express an opinion on the financial statements.

21. Whenever the auditor issues a report that is other than unqualified, he should include a clear
description of all the substantive reasons in his report and unless impracticable, a
qualification of the possible effectfs) on the financial statements. This information should
preferably be set out in a separate paragraph, preceding the opinion or disclaimer of
opinion, and may also include a reference to a more extensive discussion in a note to the
financial statements.

Circumstances That May Result in Other Than an Unqualified

Opinion
Limitation on Scope

22. A limitation on the scope of the auditor's work may sometimes be imposed by the client
(e.g. 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 he would need to issue a
disclaimer of opinion, he should not accept such a limited engagement as an audit
engagement. A statutory auditor should not accept such an audit engagement when the
\ limitation infringes on his statutory duties.

23. A scope limitation may be imposed by circumstances (e.g. when the timing of the auditor's
appointment is such that he is unable to observe the counting of physical inventories). It
may also arise when, in the opinion of the auditor, the client's accounting records are
inadequate or when he is unable to carry out an audit procedure that he believes is desirable.
In these circumstances, the auditor should attempt to carry out reasonable alternative
procedures to obtain sufficient audit evidence to support an unqualified opinion.
24. When there has been a limitation on the scope of the auditor's work that he concludes
prevents him from issuing an unqualified opinion, the auditor's

391

Auditing: Principles and Procedures

report should describe the limitation and the wording of his opinion should indicate that it
is qualified as to the possible adjustments to the financial statements that might have been
determined to be necessary had the Limitation not existed. As indicated in paragraph 20,
there may be circumstances when the possible effect of the limitation is so significant that
the auditor will decide to disclaim an opinion on the financial statements.

Disagreement with Management.

25. The auditor may disagree with management as to:

a)

The acceptability of the accounting policies selected;

b)
The method of their application, including the adequacy of disclosures in the
financial statements; or
c)
The compliance of the financial statements with relevant regulations and
statutory requirements.

Such disagreement would, if material, cause the auditor to express a qualified opinion or, in
the circumstances described in paragraph 19, express an adverse Opinion.

Paragraph Emphasizing An Uncertainty

26. If a significant uncertainty, the resolution of which is dependent upon future events, affects
the financial statements, the auditor should consider adding a paragraph (after the opinion
paragraph) to his report that draws attention to the note to the financial statements that more
extensively discusses the uncertainty1, (Appendix provides an illustrative example of
such a paragraph).

When the auditor decides to add a paragraph emphasizing a significant uncertainty this will normally adequately, serve users
of the financial statements. However, the auditor is not precluded irom issuing a disclaimer of opinion in situations involving
significant uncertainties.

Auditors'Reports 392

Appendix 12.3

FORM OF AUDITOR'S UNQUALIFIED REPORT

The following is an unqualified report incorporating the principles set forth in this Standard.
AUDITOR'S REPORT TO.............................................................................................................
We have audited the financial statements 1 in accordance with International Standards on
Auditing2.
In our opinion, the financial statements give a true and fair view of (or 'present
fairly') the financial position of.......................at............... .and the results of its operations
for the year then ended in accordance with..............................3 (and comply with....................4).
AUDITOR
Date
Address
Appendix 12.4

EXAMPLE PARAGRAPH EMPHASIZING AN UNCERTAINTY

In our opinion............................
Without qualifying our opinion we draw attention to Note X to the financial statements. The
Company is the defendant in a lawsuit alleging infringement of certain patent rights and
claiming royalties and punitive damages. The Company 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 financial statements.

Provide suitable identification, such as by reference to page numbers or by identifying the individual statements.
Or refer to relevant national standards or practices ' - Indicate the relevant national standards or refer to International
Accounting Standards. . Refer to relevant statutes or law.

A uditing: Principles and Procedures

Appendix 12.5
EXAMPLES OF OPINIONS OTHER THAN UNQUALIFIED
These examples incorporate the principles set forth in this Standard but are not intended to
suggest standard wording for particular circumstances.

Qualified Opinion-Scope Limitation

We have audited the financial statements in accordance with . . . . except as explained in
the following paragraph.
We did not observe the counting of the physical inventories as of 31st December 19X1,
since that date was prior to the time we were initially engaged as auditors for the Company.
Owing to the nature of the Company's records, we were unable to satisfy ourselves as to
inventory quantities by other audit procedures.
In our opinion, except for the effects of such adjustments, if any, as might have been
determined to be necessary had we been able to satisfy ourselves as to physical inventory
quantities ...
Qualified Opinion-Disagreement on
Accounting Policies-Inappropriate
Accounting Method

As discussed in Note X to the financial statements, no depreciation has been provided in

the financial statements which practice, in our opinion, is not in accordance with
International Accounting Standards. The provision for the year ended December 31, 19X1,
should be xxx based on the straight-line method of depreciation using annual rates of 5r/<
for the building and 20% for the equipment. Accordingly, the fixed assets should be
reduced by accumulated depreciation of xxx and the loss for the year and deficit should be
increased by xxx and xxx, respectively.
In O'T opinion, except for the effect on the financial statements of the matter
refeired to in the preceding paragraph, these financial statements..............................
Qualified Opinion Disagreement on
Accounting Policies-Inadequate Disclose
On January 15, 19X2, the Company issued debentures in the amount of xxxxx for the
purpose of financing plant expansion. The debenture agreement

394

Auditors' Repvrts

restricts the payment of future'cash dividends to earnings after December 31, 19X1.
In our opinion, except for the omission of the 'information included in the
preceding paragraph, the financial statements.........................
Paragraph Expressing
Adverse Opinion
In our opinion, because ofthe effects of the matters discussed in the preceding paragraph,
the financial statements do not give a true and fair view of [or present fairly'] the financial
position of XYZ Company at December 31, 19X1, and the results of its operations for the
year then ended in accordance with International Accounting Standards.
Paragraph
Expressing
Disclaimer of Opinion

Because of the significance of the- matters discussed in the preceding paragraph, we are
not in a position to, and do not, express an opinion on the fmancial statements.

INTERNATIONAL ACCOUNTING STANDARDS AND

THE AUDITOR
One of the mandatory requirements [Section 234(3)] for listed companies is compliance of
such International Accounting Standards and other standards as are notified in the official
gazette by the Corporate Law Authority.
Except for IAS 3, 6, 15, and 22 other lASs have.been adapted for mandatory compliance by
the Institute of Chartered Accountants of Pakistan. The following chart shows the names of IAS:
IAS Number

Title Paragraphs

Disclosure of Accounting Policies 23 (January 1975)

Valuation and Presentation of

Inventories in 36
the Context ofthe Historical Cost System
(October 1975)

Consolidated Financial Statements (June 1976) 52

Depreciation Accounting (October 1976) 19

395

Auditing: Principles and Procedures

Information to be Disclosed in Financial Statements

(October 1976) -

19

Statement of Changes in Financial Position (October

1977)

23

'8

Unusual .end Prior Period Items and Changes in

Accounting Policies (July 1978)

24

Accounting for Research and Development Activities

(July 1978)

25

10

Contingencies and Event Occurring After the

Balance Sheet Date (October 1978)

35

11

Accounting for Construction Contracts (March 1979)

49

Accounting for Taxes on Income (July 1979)

12 13
14
15
16
17 18 19

Presentation of Cur*ent Assets and Current Liabilities

(November 1979)

28

Reporting Financial Information by Segment (August

1981)

26

Information Reflecting the Effects of Changing Prices

(November 1981)

28

Accounting for Property, Plant and Equipment

(March 1982)

51

Accounting for Leases (September 1982)

Revenue Recognition (December 1982)

20

56

Accounting for Retirement Benefits in the Financial

Statements of Employers (January 1983)

21

Accounting for Government Grants and Disclosure of

Government Assistance (April 1983)

22 23 24

Accounting for the' Effects of Changes in Foreign

Exchange Rates (July 1983)
Accounting for Business Combination (November
1983)
Capitalisation of Borrowing Costs (March 1984)
Related Party Disclosures (July 1984)

64 + Appendix
52 + Appendix
52 + Appendix

44
39 56
30 28

396

Auditors' Reports

25

Accounting for Investments (March 1986) 56

26 Accounting and Reporting by Retirement 36 Benefit Plan (January

1987)

27 Consolidated Financial Statements and 38 Accounting for

Investments in Subsidiaries (April 1969)

28 Accounting for Investments in Associates 31 (April 1989)

29 Financial Reporting in Hyper irrflationary 43 Economies (July 1989)
30 Disclosures in the Financial Statements of 61 Banks and Similar
Financial Institutions (August 1990)

31 Financial Reporting of Intrests in Joint 5k Ventures (December

1990)
Source:

Handbook 1992 Technical Pronouncements Inernatiohal Federation of Accountants, New York, 1992.

Text of each standards is available from the Institute of Chartered Accountants of Pakistan
and the Institute of Cost and Management Accountants. The International Accounting Standards
Committee, London, has printed IAS 1 to 29 in a bound volume.
The auditor must acquaint himself with the provisions of the above IASs and ensure
compliance.

UNDER
STATUTES

AUDIT
OTHER

Apart from the audit Under the Companies Ordinance, 1984, an auditor is also required to
audit or certify the accounts under other statutes. The various types of work to be done by the
auditor under other statutes are discussed below:

AUDIT UNDER THE COOPERATIVE SOCIETIES ACT, 1925

The auditor should acquaint himself thoroughly with the relevant provisions of The
Cooperative Societies Act, 1925, affecting him and the preparation of accounts. The provisions
relating to audit are contained in Section 22 of the above Act. These are explained as under:

(1)

(2)

The Registrar
shall by himself or by some person authorised by him in
writing, by general or special order in this behalf, audit the accounts of
every society at least once in every year.
[Section 22(1)1
The audit, as explained above, should include:

(i) an examination of overdue debts, if any,

(ii) the verification of cash balance and securities, and
(Hi) a valuation ofthe assets and liabilities of the society.

[Section 22(2)]
(3)
The Registrar
or other person auditing the accounts of any society should
have free access to the books, accounts and vouchers of such society and
should be allowed verify its cash balances and securities. It is incumbent
upon the directors, managers and other officers of the society to furnish to
the Registrar or other person appointed to audit the accounts of a society,
all such information as to its transactions and working as the Registrar or
such other person may require.
[Section 22(3)]
(4) The Registrar and every other person appointed to audit the accounts of a
society'have been vested with the following powers:
(i) to summon at the time of his audit any officer, agent, servant or member of the
society who. he has reason to believe, can give valuable information in regard to
any transaction of the society or the management of its affairs, or

398

Audit Under Other Statutes

(ii) to require the production of any book or document relating to the

affairs of any cash or securities belonging to the society by the officer,
agent, servant or member in possession of such book, document, cash
or securities.
[Section 22(4)]
Under Section 22A it has been laid down that, where in the course of an audit under Section
22 as explained above, it appears to the Registrar that there exists any such ground as is specified
in Section 50A of the above Act he may, of his own motion or on the application of the person
authorised by him under Section 22, exercise the powers specified in Section 50A.

THE CAPITAL ISSUES {CONTINUANCE OF CONTROL)

ACT, 1947
Rem No.8 of the application form for issue of capital under the above Act requires a
disclosure of information in respect of 'Acquisition of assets of other companies'. Full details
ofthe assets of the Vendor Company in a situation where shares are being allotted on 'no cash
basis' for acquiring assets, with their value certified by a Chartered Accountant, or an Engineer or
Surveyor, as the case may be, should be furnished. The Auditor's Certificate should be on lines
indicated on the next page.
A certificate is required to be signed by an auditor and sent to the Controller of Capital
Issues in respect of capitalisation of profits.
A case is illustrated below:

Facts
The balance sheet of ABC Limited, a public company,, gives the following
information:
Particulars

Amount (million Rs. )

Paid up capital (one million

shares of Rs.10 each)
Revenue Reserves
Profit and Loss Account (credit balance)
Provision for deferred tax
Long-term loans
Current liabilities
Fixed Assets at book value
Preliminary Expenses
Current Assets
In addition, the notes disclose contingent liabilities of Rs.1.5 million. /Required
Draft an Auditor's Certificate to be issued to the Controller of Capital Issues in

10.00
8.00
12.50
1.00
56.00
18.00
90.00
0.50
15.00

399
Procedures

Auditing:

Principles

and

connection with the proposed capitalisation of profit of Rs.5.00 million by the issue of bonus
shares.
THE CAPITAL ISSUES (CONTINUANCE OF CONTROL) ACT, 1947

AUDITOR'S CERTIFICATE
We have audited the Profit and Loss Account together with the Balance Sheet
. . . . and report that we have obtained all the
infoiTnation and explanations we. had required and in our opinion the following
statement exhibits a true and correct state of affairs of the Company.
Assets. ......
Rs.
. , Liabilities.... Rs.
Machinery"'f
Creditors" """"
(Book value less.depreciation .
Loans and overdraft.
at Income-tax rate the
Income-tax should not imply
-special depreciation rates).
Building and Land
(Book value less depreciation)
" ' 'fax liability up to date of sale.
Unclaimed dividend.
Furniture and Fixture
(Book value less depreciation)
Liabilities to employees ofthe
... Company, if any.
Stock
(Book value or market value
Accrued expenses not paid.
whichever is lower)
Advances
(Considered Good)
Accrued (interest not paid)
Deposits
(Considered Good)
Other liabilities.
Investment
..
. (Considered Good)
Cash and Bank Balances
Other Assets
(The items to be specified)
Total
Total
(1) Total Assets
(2) Total Liabilities
Net Total
.. .. .
.-, .
also attached.
Place and Date

Chartered Accountants

Audit Under Other Statutes 345 Solution

The amount of bonus shares to be issued should not exceed 25% of the paid up capital. The
following chart will help in obtaining permission for the issue of bonus shares:
Particulars
Revenue Reserves 8.00
Profit and Loss Account (credit balance) 12.60
Less: Preliminary Expenses
Provision for deferred tax 1.00

Amount
(million Rs.)

0.50 12.00
21.00

Less: Contingent Liabilities 1.50

19.50
Lass: Proposed issue of bonus shares 5.00
14.50
Position of share capital will be as under: Paid
up capita! Proposed bonus shares

Since the net amount of accumulated profit and reserves (Rs.14.50 million) is more than
25% of total capital of Rs.15.00 million, bonus shares will be allowed to be issued.

AUDIT UNDER THE INSURANCE ACT, 1933

ANNUAL AUDIT

[Sections 11 and 12]

The balance sheet, profit and loss account, revenue account and profit and loss
appropriation account of every insurer1 in respect of the insurance business transacted by him,
and in the case of any other insurer in respect of the insurance business transacted by him in
Pakistan shall be audited annually by an auditor, unless they are subject to audit under the
Companies Ordinance, 1984. The auditor has been invested with the powers of exercise of
functions vested in, and discharge the duties and subject to the liabilities and penalties imposed
on him by Section 255 ofthe Companies Ordinance, 1984.
In accordance with the regulations contained in Part I of the First Schedule annexed to the
Insurance Act, 1938, a balance sheet should be on the prescribed
This has been defined in sub-clause ( a X t i ) or sub-clause lb) of clause (91 of Section 2 of the Insurance Act, 1938.

401

Auditing: Principles and Procedures

Form 'A' given in Part of the above Schedule. The auditor should ensure that the balance sheet
is drawn up in accordance with this Form or as near thereto as circumstances admit.
The following Forms have been prescribed in the Act;
Form

Particulars

The Second Schedule: Part II

Form Form
The Third Schedule: Part II FormD
Form DD
Form DTJD
Form DDDD

Form of Profit and Loss Account.

Form of Profit and Loss Appropriation
Account.

Form
E

Form of Revenue Account applicable to Life Insurance Business-Classified

statement of life insurance policies ofthe company. Additions to and deduction from
policies of the company.
Particulars of the policies forfeited or lapsed
in the last year under review and of policies
revived and reinstated for full benefits,
classified according to the year in which they
were issued. This was omitted by the
Insurance (Amendment) Act, 1944. Form of
Revenue Account applicable to Fire Insurance
Business, Marine Insurance Business and
Miscellaneous Insurance Business.

To ensure that the accounts are drawn up in conformity with

law, the auditor should ensure that the profit and loss, revenue
accounts etc. are prepared in accordance with the above Forms.
The auditor should acquaint himself with the provisions of
the Insurance Act, 1938, and Rules made therein which affect
his position and preparation of accounts, particularly in respect
of rates of commission prescribed in the Act, valuation surplus,
life insurance surplus, limitation of expenses of management
etc.1

402

Auditing: Principles and Procedures

As a result of legal requirements, the Auditors' Report to the shareholders will ordinarily
take the following shape:

For special points, please refer bo Chapter of this book entitled, "Special Points in Different Classes of Audits".

403

Audit Under Other Statutes

Auditors Report to the Shareholders iu case of

an Insurance Company
We have audited the above balance sheet of the.............................................
Company Limited, as at. . . ...................................19............., and the Revenue Accounts,
the Profit and Loss Account and the Profit and Loss Appropriation Account of the company for
the year ended on that date in which are incorporated the returns from the various Branches and
Agencies, and we report that:
(o) We have obtained all the information and explanation which we had required.
(6) In our opinion, the annexed Balance Sheet, Revenue Accounts, Prcfit and Loss Account
and Profit and Loss Appropriation Account are drawn up in conformity with the law.
(c) Such balance sheet exhibits a true and correct state of the company's affairs
according to the best of our information and the explanations given to us and as
shown by the books of the company.".
(d) In our opinion, the books of account have been kept by the company for the
year under report as required by Section 130 of the Companies Ordinance, 1984.
(e) We have verified the cash balances and investments by actual inspection or by
the production, of certificates or vouchers, and have also verified the securities
relating to the loans.
(f) No part of the assets of the Life Insurance Fund has been directly or indirectly
applied in contravention of the Insurance Act, 1938, relating to the application and
investment of Life Assurance Funds.
(g) All expenses of management incurred in respect of Life Assurance Business
and in respect of business other than the Life Assurance have been fully debited as
expenses in the respective Revenue Accounts.

Place and Date

Chartered Accountants

SPECIAL AUDIT

[Section 12A]

Section 12A was inserted in the Insurance Act, 1938, by the Act of 1958 under Subsection
of Section 12, the Controller of Insurance has been empowered to appoint every year an
auditor for conducting special audit, for making investigation and submitting such report as may
be prescribed. Proviso to sub-section lays down that the auditor or any of the auditors appointed
under Section 12A for any year of account shall not be the auditor or auditors employed by the
insurer for an audit under the Companies Ordinance, 1984, or under Section 12 of the Insurance
Act, 1938, for that year of Account.

(1)

404

A uditing: Principles and Procedure;

For enabling the auditor to perform his functions and duties under this section, the auditor
appointed under this section has been vested with the following rights under sub-section (2) of
the above section;

(1)

Access of all such books of account, registers, vouchers, correspondence and

other documents ofthe insurer, and
(2) Requiring from the directors and officers of the insurer such information and
explanations as may be necessary for the performance of his functions and duties
under the above section.
... Sub-section (3) requires that every report should be prepared by an auditor or auditors in
quadruplicate to the Controller of Insurance who may take such action thereon in accordance
with the provisions ofthe Insurance Act, 1938.
Sub-section (4) lays down that the said auditor shall be paid by the insurer such fees as
may be prescribed and in presenting such fees regard shall be had to the size of the insurance
and the class or classes of business transacted by him. The Controller of Insurance has been
empowered to specify the time within which the fee payable shall be paid.
Under Rule 42 of the Insurance Rules, 1958, an auditor appointed for special Audit is
required to investigate and report on the following matters:

(1) Rule 42
The compliance or otherwise by the insurer, of the requirements of sub-section (4) of
Section 3C of the Insurance Act, 1938, relating to payment of premium.
This sub-section requires that no insurer shall assume in Pakistan any risk in respect of
general insurance business unless and until the premium payable or such part thereof as may be
prescribed has been received by him or has been guaranteed to be paid by such person in such
manner and within such time as may be prescribed. Proviso to this sub-section requires that
nothing contained in the above sub-section shall apply to the insurance ofthe properties or
interests of the Central or a Provincial Government of such Government gives an undertaking to
pay the premium payable within such time and in such manner as may be prescribed.

(2)

Rule 42 ( H )

The compliance or otherwise by the insurer, of the requirements of sub-section 5 of Section

3C of the insurance Act, 1938, relating to refund of premium and the amount or amounts of
refund outstanding.
The above sub-section (5) requires that any refund of premium which may become due to
the insured on account of the cancellation of policy of general insurance or alteration in its terms
and conditions shall be paid directly to the insured by a crossed or order cheque or by money
order and a proper receipt shall be obtained from the insured, and such refund shall in no case be
credited to the account ofthe agent.

Audit Under Other Statutes

405

(3) Rule 42 (
The compliance or otherwise by the insurer of the recpiirements of sub-section (1) of
Section 3D relating to placing of facultative reinsurance outside Pakistan. The above sub-section
requires that no insurer shall reinsure outside Pakistan any insurance business or any part thereof
underwritten by him in Pakistan which is in excess of its treaty reinsurance arrangement unless a
certificate has been obtained from the controller to the effect that such excess cannot be placed in
Pakistan. The proviso to the above sub-section example the reinsurance by the Pakistan
Insurance Corporation from the above pi-ovision.

(4) Rule 42 (iv)

The compliance or otherwise by the insurer of the requirements of Sections 14 and 64 ofthe
Insurance Act, 1938, relating to keeping of books of accounts, registers and records and the
management of the affairs of foreign companies in Pakistan Section 14 lays down that every
insurer should maintain:
( Q)

a register or record of policies, in which shall be entered, in respect of every policy

issued by the insurer, the name and address of the policyholder, the date when the
policy was effected and a record of any transfer, assignment or nomination of which
the insurer has notice, and
(b) a register or record of claims, in which shall be entered every claim made together
with the date ofthe claim, the name and address of the claimant .- and the date on which
the claim was discharged, or, in the case of a claim which is rejected, the date of
rejection and the grounds therefore.

Section 64 requires that every insurer having his place of business or domicile outside
Pakistan shall manage its affairs in Pakistan at his principal office in Pakistan and shall keep
thereat all the records relating to the business of the insurer in Pakistan including such books of
accounts, statements and abstracts which he is required under the Insurance Act, 1938, to furnish
to the Controller of Insurance in respect of the insurance business transacted by him in Pakistan.

(5) Rule 42 (u)

The compliance or otherwise by the insurer ofthe requirements of Section 29 of the
Insurance Act, 1938, relating to grant of advances and repayments thereof. Subsection (1) of
Section 29 lays down that no insurer shall grant loans or temporary advances either on
hypothecation of property or on personal security or otherwise, except loans on life insurance
policies issued by him within their surrender value, to any director, manager, actuary, auditor or
officer ofthe insurer of a company, or where the insurer is a firm, to any partner therein, or to any
other company or firm in which any such director, manager, actuary, officer or partner holds the
position of a director, manager, actuary, officer or partner. These provisions do not apply to loans
made by an insurer to a banking company or to a subsidiary company or to any other company of
which the company granting the loan or advances is a subsidiary company. In sub-sections (2)
and (3) exceptions to the foregoing

406

A udixing: Principles and Procedures

provisions have been stated. Sub-section (4) requires the preparation of a statement, on the
prescribed form, showing the particulars of the various advances paid by every insurer and
outstanding against an employee, insurance agent or an employer of agents as on December 31
of every year and furnishing the same to the Controller of Insurance. Sub-section (6) specifies
that where any event occurs giving rise to circumstances the existence of which at the time of
the grant of any subsisting loan or advance would have made such grant a contravention of this
section such loan or advance shall, notwithstanding any contract" to the contrary, be repaid
within three months from the occurrence of such event, or within such further period as may be
allowed by the Controller of Insurance.
(6) Rule 42 (id)
The compliance or otherwise by the insurer of the requirement, of Section 32B of the Act
relating to employment of persons on salary-cum-cornmission basis and the employment of any
person without specific functions or without sufficient functions or work justifying the salary or
remmierationpaidtohim.
Provisions of Section 32B relating to managers etc. are:

(1) Notwithstanding anything to the contrary contained, in the Companies Ordinance,

(2)

1984, or articles of association of the insurer, if a company or in any contract or

agreement, no insurer shall after the expiry of one year from the oommencement of
the Insurance (Amendment) Act 1958, be directed or managed by or employ as
manager or officer or in any capacity, any person whose remuneration or any part
thereof takes the form of commission or bonus on the total insurance business or on
the total business of any class or sub-class of insurance business or on a part of any
class or sub-class of general insurance business transacted by the insurer.
No person shall have any right whether in contract or otherwise, to any compensation
for any loss incurred by reason of the operation of any provision of this Section.

Provided that nothing in the sub-section (1) shall be deemed to prohibit:

(1) The payment of commission to an insurance agent or employer of agents in respect of

(2)

any insurance business procured by or through him.

The employment of any individual in a clerical or other suterdinate capacity who as
an insurance agent, receives commission in respect of insurance business procured by
him.

(3) The employment as an officer of any individuaT who. receives commission in respect
of life insurance business procured by him in his capacity as insurance agent or as
employer of agents.

(4) The payment of a share In the profit of general insurance business.

(5) The payment of bonus in any year on a uriiform basis to all salaried
.." employers or any class of them by way of additional remuneration, such

Audit Under Other Statutes

407

bonus in the case of any employee not exceeding in amount the equivalent of his
salary for a period which in the opinion ofthe Central Government is reasonable
having regard to the circumstances ofthe case.
Broadly speaking, no manager or officer or any other person should be employed on
commission basis though there are several provisions which should be studied.
It appears that this will not apply to 1958 audits as the section specifies that no person
should be so employed after the expiry of one year after the commencement of the Insurance
(Amendment) Act, 1958, which means after 31.3.1959.
(7) Rule 42 (fit)
The compliance or otherwise of requirements of Sections 40 and 40A of the Act relating to
payment of convmission or remuneration.
Sections 40 requires:

(1)

No insurer shall, after the expiry of six months from the commencement of this
Act, pay or contract to pay any remuneration or reward whatever by way of
commission or otherwise for soliciting or procuring insurance business in Pakistan to
any person except an insurance agent or a person acting on behalf of an insurer who
for the purposes of insurance business employs insurance agents.
(2) No insurance agent shall be paid or contract to be paid by way of commission
or as remuneration in any form an amount exceeding, in the case of life insurance
business, 40% of the first year's premium payable on any policy or policies effected
through him and 5% of the renewal premium payable on such a policy or in the case
of business of any other class 15% ofthe premium.
Provided that insurers, in respect of life insurance business only, may pay, during the
first ten years of their business to their insurance agents 50% of the first year's
premium payable on any policy or policies-effected through them and 6% of the
renewal premium on such policies.
(2A) Save as hereinafter provided, no insurance agent shall be paid or contract to be paid
by way of commission or as remuneration in any form any amount in respect of any
policy not effect through him.
Section 40A is in respect of limitation of expenditure on commission and requires:
(1) No person shall pay or contract to pay to an insurance agent, and no insurance agent
shall receive or contract to receive by way of commission or remuneration in any
form in respect of any policy of life insurance issued in Pakistan by an insurer after
31st day of March, 1958, and effected through aninsurance agent an amount
exceeding;. ...
( a ) Where the policy grants an immediate annuity or a deferred annuity

408

Auditing: Principles and Procedures

in consideration of a single premium or where only one premium is - payable

on the policy, two per cent of that premium.

(b)

Where the policy grants a deferred annuity in consideration of more than

one premium, 7}&% of the first year's premium and 2%% of each renewal
premium payable on the policy, and
(c) In any other ease, 30% of the first year's premium 10% of 2nd year's
premium and thereafter 5% of each renewal premium.

(2) No person shall pay or contract to pay an insurance agent, and no insurance agent shall

receive or contract to receive by way of commission or remuneration in any form, in

respect of any policy of general insurance issued in Pakistan by an insurer after the
commencement of Insurance (Amendment) Ordinance, 1958, and effected through an
insurance agent an amount exceeding:
()

(3)

Where the policy relates to fire or miscellaneous insurance, 15% of

the premium payable on the policy, and
() Where the policy relates to marine insurance, 10% of the premium
payable on the policy.
No person shall pay or contract to pay to any employer or agent and no employer of
agent shall receive or contract to receive by way of commission, over riding
commission or any other remuneration in any form, in respect of any policy of general
insurance issued by an insurer in Pakistan after the commencement of Insurance
(Amendment) Ordinance 1958 and effected through an employer of agents an amount
exceeding:

(a) in case of (a) (2) 15% of premium payable on the policy and
(b) in case of (b) (2) 10% inclusive of any commission payable to any
insurance agent in respect ofthe said policy.

(4) No insurer shall pay or contract to pay outside Pakistan to any person any commission
in any form in respect of the insurance business transacted by such person in Pakistan
and no person shall receive or contract to receive outside Pakistan from any person any
commission in any form in respect of any business reinsured abroad.
(5) Without prejudice to the provisions of Section 102 in respect of a contravention of any
provisions of the preceding sub-section by an insurer an insurance agent or employer
of agents who contravenes any of provisions of sub-sections (1), (2), (3) or (4) shall be
punishable with fine which may extend to 1,000 rupees.
(6) An insurer incorporated outside Pakistan who receives or contracts to receive any
commission in respect of any business transacted in Pakistan and reinsured abroad
shall not be deemed to have contravened the provisions of sub-section (4) if all
amounts received by him outside Pakistan in this respect have been fully credited to
the Pakistan receive
. account..
= ..'*='..-'
-

Audit Under Other Statutes

409

Broadly speaking, these sections lay dowh the persons entitled to receive commission and
the rates of commission payable.
Only insurance agents or employers of agents are entitled to receive Mmmission. For
conditions of becoming an insurance agent or an employer of agents see Rules 18 to 23.
Roughly speaking, rates of commission are divided into policies taken out before 31.3.1958
(Section 40) and policies taken out after 31.3.1958 (Section 40A).
(8) Rule 42 (viii)
The compliance or otherwise of the requirements of Sections 42, 42A and 44A of the Act
relating to appointment or employment of persons without licences or certificates and also
payment of commission or claims in contravention of the said section.
Section 42 is reproduced below:

(1) The Controller of Insurance or an officer authorised by him in this behalf shall in the

(2)
(3)

prescribed manner and on payment of the prescribed fee which shall not be more than
Rs.3.00 issue to any individual making an application in the prescribed manner and
not suffering from any disqualifications hereinafter mentioned a licence to act as an
insurance agent for the purpose of soliciting or procuring insurance business.
A licence issued under this section shall entitle the holder to act as an insurance agent
for any registered insurer.
A licence issued under this section shall remain in force for a period of 12 months
only from the date of issue but shall if the applicant does not suffer from any of the
disqualifications hereinafter mentioned by renewed from year to year on payment of
the prescribed f=e which shall not be more than three rupees.

(4) Disqualifications are:

(a) that the person is a minor.
(b)
that he is found to be of in sound mind by a court of competent
jurisdiction.
. (c) that he has been guilty of criminal misappropriation or criminal breach of trust or
cheating or forgery.
(d) that in the course of any judicial proceeding relating to any policy of insurance or
winding up of an insurance company or in the course of an investigation of the
affairs of an insurer it has been found that he has been guilty of or has knowingly
participated in or corrfined at any fraud, dishonesty or misrepresentation against
an insurer Or an insured.
(5) If it be found that an insurance agent suffers from any of the foregoing
disqualifications without prejudice to any other penalty to which he may

410

Auditing: Principles and Procedures

be b'able the Controller of Insurance shall and if the agent has knowingly contravened
any provision of this Act may cancel the licence.
(6) The authority which issued any licence under tins' section may issue a
duplicate licence to replace a licence lost...................
Text of Section 42A which governs employer of agents to hold certificates is given below:

(1)

The Controller of Insurance or an officer authorised, by him in this behalf

shall, in the prescribed manner and on payment of prescribed fee, which shall not be
more-than Rs.50.00, issue to any person making an application, a certificate to act as
an employer of agents on behalf of an insurer for the purpose of procuring life
insurance business or general insurance business as the case may be if -

(a) in the case of an individual, who does not suffer from any of the
disqualifications mentioned in Section 42(4).
(b) in the case of a company or firm any of its directors or partners does not suffer
from any of the said cusqualifications.
(2)
A separate application shall be made and a separate certificate obtained for life
insurance business and general insurance business.
(3)

For the purpose of Sections 40 and 40A of this Act no employer of agents who
is certified to act as an employer of agents for life insurance business shall be deemed
to be employer of agents for general insurance business shall be deemed to be
employer of agents for life insurance business.
(4)
A certificate under this section shall entitle the holder thereof to act as an
employer of agents for any insurer.
(5)
A certificate issued under this section shall remain in force a period of one
year only from the date of issue but shall on application made in this behalf be
renewed from year to year if

(i) an application in the prescribed form for renewal of the certificate reaches the
issuing authority before expiry;

(ii) renewal fee Rs.50.0O;

(iii) any of the directors/partners does not suffer from any
(iv)
(6)

disqualifications;
applicant has procured minimum business and complied with conditions.

If any director/partner suffers from disqualification the Controller shall cancel

the certificate.
Section 44A deals with-the Insurance Surveyors to hold certificates, and is given below:.
"No person other than an insurance surveyor holding an appropriate certificate under
this section shall undertake the surveying,

Audit Under Other Statutes

411

assessment or adjustment of any loss in respect, of general insurance business and no

insurer shall pay for any claim in respect "bf general insurance business transacted by
him in Pakistan unless thaloss has been surveyed, assessed or adjusted, as the case
may be, by an insurance surveyor holding an appropriate certificate tinder-.this
section."
These sections deal with the appointment of:

1.
2.
3.

Insurance Agents
Employers of Agents
Insurance Surveyors.

.(9) Rule 42 (ix) *

Any other matter which may be specified by the Controller of Insurance.
In order to conduct the Special Audit under Section 12A of the Insurance Act, 1938 and
Rule 42 ofthe Insurance Rules 1958, the auditor should broadly carry out the following work:
Rule 42 (i): Section 3G (4)
There are three main ways of complying with the sub-section:

(1) By paying premium in advance.

(2) By making a deposit in cash.
(3) By bank guarantee.
Examine the policy register for all policies taken out:
(1) In the case of new policies, copies of policies should be examined to ascertain the
period of.risk. For all policies, copies of the premium receipt : should be examined to
ascertain that the premium was received before the risk was assumed.
' (2) In the case of renewals of policies, the renewals endorsement should be examined to
ascertain period of risk and once again the' copy ofipremium receipt should be seen to
ascertain that the premium was received before the risk actually commenced.
(3) Where premiums were not received in advance, it should be ascertained that
either the insured had lodged a deposit with the company to cover the full premium,
or the insured had lodged a guarantee with the company regarding the payment of
premium.
(4) Where premiums are not received in advance and guarantee or deposits have
not been lodged such instances should be noted and reported.
(5) A selection of the copies of premium receipt should be compared with the cash
book to ascertain that dates in the cash book agree with the dates on the receipts.

412

Auditing: Principles and Procedures

(6) Ascertain that no claims have been paid before premiums have been received.
(7.) Ascertain that all premiums outstanding at any time due from agents or from insured
are covered by deposit/guarantee.
Notes
(1) Where premiums are covered by a guarantee on behalf of the insured, the premium
must be paid by the end of the subsequent month.
(2) In case of agents issuing policies and receiving premiums the agent must have a
guarantee with the insurer to the extent of the premiums received
by him in any period. The agent sends copies of policies issued by him to the insurer
at the end of the month and the insurer bills the agent for the total premium less
commission. But the agent must deposit premium with the company within 24 hours.
(3) In the case of upcountry cheques, the risk can be assumed from the'date of posting the
cheque (not the date of receipt) similarly in the case of remittance by Money Order.
(4) Annual insurances in the case of marine and full risk may be covered if an amount of
not less than ~ of premium payable has been paid or guaranteed.
(5) For other information regarding collection of premiums please see Insurance Rules 44
to 50.
Rule 42 (ii): Section 3CX5)
It is necessary to generally see 'that:

(1) There is a good reason for refunding.

(2) Amount has actually been refunded.
(3) Refund has been paid to the correct person.
The following checking should be done:

(1)

Refunds of premium should be checked from premium register as well as from

cash book.
(2) Ascertain that all refunds are made by:
(a) Crossed Cheque, or
(fj) Order Cheque, or (c)
Money Order.

(3)

Ascertain that refunds have been made direct to the insured. For this purpose,
it will be necessary to compare the signature of the insured on the receipt for refund
with his signature in the proposed form and various coirespondence etc. with the
insured.
(4) Ascertain that a proper receipt has been obtained from the insured for the

Audit Under Other Statutes 357

refund received by him. Care should be taken in examining receipts to ascertain:

(a) Date..
(a) Nature of Payment,
(e) Amount.-

(d) Signature of Insured.

(e) Revenue Stamp.
Presumably a receipt from the insured on the insurer's receipt form will be in order at least
where the insured is a person not a company which has its own form of receipts.
Rule 42 (Hi): Section 3D (1)
(1J Examine the treaty arrangements with companies outside Pakistan and
ascertain the extent of risk that can be reinsured under the arrangement.
(A separate file will normally be maintained showing, the arrangements
made with companies outside Pakistan.) (2) Examine journal entries relating to
reinsurance under treaty
arrangements and ascertain that no risk has been reinsured in excess of
the treaty arrangements.
Rule 42 (iv): Sections 14 and 64

(1) Examine the register or record of Policies to ascertain that it is being properly written
up in accordance with Section 14.

(2) Examine claims register or record to see that it meets requirements of the Insurance
(3)

Act, 1938. In order to verify that all policies and claims have been entered, check
totals and agree with general ledger.
Ascertain whether the company has any branches in Pakistan, and whether the
branches are being managed and books and records relating thereto are being
maintained at Principal Office.

Rule 42 (v): Section 29

(1) Ascertain if any subsidiary book is maintained giving details of all loans or advances
(2)

(3)

made during the year.

Scrutinise the general ledger account for loans or advances. Examine each individual
advance made during the year. Ascertain that no loan or advance made to an officer
of. the company (apart from life loans). Ascertain that any loans or advances made to
employees' agents or employer of agents are in accordance with the Act.
Scrutinise other accounts in the ledger to which loans or advances may conceivably
be posted, e.g. suspense account.

414

Auditing: Principles and Procedures

Rule 42 (pi): Section 32B

(1)

Examine the contract or letters of appointment of manager and members of

staff to ascertain that.they are in accordance with the above section.

(2)

Examine the Pay-rolls and ascertain that payments are being made in
accordance with contracts, or letters of appointment.
(3) Pxamine Pay rolls to ascertain that no bogus names are entered. Also ascertain
that functions of the members of the staff appearing thereon.
(4) Examine commission account to ascertain to whom commission is being paid.
No commission to be paid to officers in any circumstances except as provided by law.
(5) In case of bonus payments, ascertain that bonus is reasonable and that it is paid
under necessary sanctions and On uniform basis.
Rule 42 (vii): Sections 40 and 40A

(1)
(2)

Examine commission account to ascertain to whom commission has been paid.

Ascertain that all persons receiving commission are properly authorised agents
of insurer. For the purpose of this settion insurer will properly maintain a register of
agents with the agent's licence number and date of expiry thereof. In some cases it
may be necessary to see the licence itself which will be with the agent.
(3) Ascertain that'rates of commission are in accordance with rates laid down
. under the Act.
(Note: There will probably be details of the agent and rates of his -commission, in the
premium register.)
\ ' (4) Check commission calculations and ascertain that these are in order. Rule 42 (oiii):
Sections 42, 42A and 44A
Work to be done:
(a) With regard to agents and employees of agents this has already been dealt with under
the preceding paragraph relating to their commission.
(i>) With regard to surveyors, a list of surveyors who do surveying for the insurer should be
obtained together with details of their certificate, date of issue, date of expiry etc. It
may be necessary to call for the certificate in cases.
Claim papers should be scratinised to ascertain that claims paid have been surveyed by an
authorised surveyor under the Act.
Rule 42 (ii)
The auditor should develop a specific. programme to conduct his checking depending upon
the matter which may be specified by the . Controller of Insurance.

Audit Under Other Statutes

415

AUDIT UNDER THE BANKING COMPANIES ORDINANCE, 1962

The Banking Companies Ordinance, 1962, was promulgated on June 7, 1362. The- auditor
should acquaint himself with the relevant provision of the above Ordinance affecting him and
the Accounts. To facilitate the matter, working index relating to accounts and audit is given as
Appendix 13.1,
Under Section 34 of the Ordinance, the following requirements have been laid down:
(1)

At the expiration of each calendar year, every banking company incorporated

in Pakistan, in respect of all business transacted by it, and every banking company
incorporated outside Pakistan, in respect of all business transacted through its
branches in Pakistan, shall prepare with reference to that year a balance sheet and
profit and loss account as on the last working day of the year in the forms set out in
the Second Schedule or as near there to as circumstances admit.2
(2)

The balance sheet and profit and loss account shall be signed:

(a)

in the case of a banking company incorporated in Pakistan, by the

manager or the principal officer of the company and where there are more than
three directors of the company, by at least three directors, by all the directors,
and
(b)
in case of a . banking company incorporated outside Pakistan by the
Manager or agent of the Principal office of the company in Pakistan and by
another officer nexxin seniority to the manager or agent.
(3) Apart from the fact that the proforma balance sheet of a banking company is
prescribed as Form 'A' annexed to the Second Schedule of the Ordinance, the
requirements ofthe Companies Ordinance, 1984, relating to the balance sheet and
profit and loss account of a company, in so far as they are not inconsistent with the
Ordinance, apply to the balance sheet or profit and loss account of a banking
company.
In accordance with the requirements of Section 35, the balance sheet and profit and loss
account of a banking company shall be audited by a person duly qualified under the Chartered
Accountants Ordinance, 1961, or any other law for the time being in force to be an auditor of the
companies. The provisions of Section 145 of the Companies Ordinance, 1984, dealing with the
powers, functions, duties, liabilities and penalties of an auditor also apply to the auditor of a
banking company. Based on sub-section (3)-of Section 35 Of the Ordinance read in conjunction
with sub-section (2) of Section 145 of the Companies Ordinance, 1984, an unqualified auditor's
report
Recommended for further reading: Statement of Standard Auditing Practices (SAP 1) entitled: Bank Reports for Audit
Purposes, issued by the Institute of Chartered Accountants of Pakistan, December 1982, pp.1-8.
Forms 'A' and U' are the prescribed forms for the balance sheet and profit and loss account respectively.

416

A uditing: Principles and Procedures

to the shareholders of a bank should be as given below.

Following the announcement of Banking Reforms in Pakistan by the Central Finance
Minister on May 19, 1972, the following amendments were announced in the above Ordinance:

(1) Auditors would be appointed by Banks from a panel on the approved list of
the State Bank of Pakistan.

(2) The tenure of office of the auditors would be for three years.
AUDITORS REPORT TO THE SHAREHOLDERS IN THE CASE OF A BANK
We have audited the Balance Sheet of. . . . . . . . . . Bank Limited as at 3.1st
December, 19 and also the Profit and Loss Account of the Bank for the year ended on that date
with the books and records maintained at the Head Office and with the returns submitted and
certified by the concerned officials of the branches as reviewed and amended at the Head Office
and report that:

(a)

We have obtained all the information and the explanations which we have required
and found them to be satisfactory;
(b) The, transactions Gf the Bank which have come to our notice have been within the
powers of the Bank;
(c) In our opinion proper books of account as required by law have been kept by the
Bank so far as it appears from the examination of the books and proper returns
adequate for the purpose of audit have been received from all the branches ofthe
Bank;
(tfi Such Balance Sheet exhibits a true and correct view of the state of the Bank's affairs
according to the best of our information and the explanations given to us and as
shown by the books and records of the Bank;
(e) Such Profit and Loss Account shows a true balance of profit for the year ended
31st December, 19 ; and
(f) In our opinion, the Bank's Balance Sheet and Profit and Loss Account are
drawn up in conformity with the lav;.

Place and Date Chartered Accountant

(3) No premature retirement of the auditors would be allowed without the prior approval of
the State Bank of Pakistan.
The banking reforms in respect of 'Audit of Bank' were registered through the

Audit Under Other Statutes

Banking Companies (Amendment) Act, 1972. Based on this the provisions of Section 35 of the
Banking Companies Ordinance, 1962, have been substituted by new provisions ofthe same
section which are summarised below:
Section 35(1). It is now provided that the balance sheet and profit and loss account
prepared in accordance with Section 34 should be audited by a person who is duly qualified
under the Chartered Accountants Ordinance, 1961 or any other law for the time being in force, to
be an auditor of companies and is borne on the panel of auditors maintained by the State Bank
for the purposes of audit of banking companies.
Section 35(2). An auditor, appointed in accordance with above provisions, should hold
office for a period of three years and should not be removed from office before the expiry of that
period except with the prior approval of the State Bank of Pakistan.
Section 35(3). The State Bank of Pakistan may, from time to time, lay down guidelines for
the audit of banking companies and the auditors shall be bound to follow those guidelines.
Section 35(4). The powers, functions, penalties etc. as are provided in Section 255 of the
Companies Ordinance, 1984, apply to the auditor subject to the provisions of above sub-section
(3).
Section 3545). In addition to the matters which, under the aforesaid Act and guidelines laid
d6wn by the State Bank of Pakistan under the above sub-section (3), the auditor is required to
state in his report, he shall also state:
()

Whether or not the information and explanations required by him have

been found to be satisfactory;

() Whether or not the transactions of the banking company which have come
to his notice have been within the powers of the banking company;
(c) Whether or not the returns received from branch offices of the banking company have
been found adequate for the purposes of his audit;
id) Whether the profit and loss account shows a true loss for the period covered by such
account; and
(e) Any other matter which he considers should be brought to the notice ofthe
shareholders of the banking company.

CERTIFICATION BY AUDITOR UNDER EXCHANGE

CONTROL MANUAL, 1965
Based on Para 90(b) of Chapter 10 of the Exchange Control Manual (Third Edition, 1965),
Scheduled banks were authorised without prior approval of the State Bank of Pakistan to
approve loans, overdrafts and credit facilities against goods intended for export from Pakistan to
companies and business houses controlled by

417

418

Auditing: Principles and Procedures

persons resident outside Pakistan. It was decided that the above facility will also now be
available for purchase of raw material and for meeting other expenditure relating to the purchase
of raw material etc., directly related to the production of goods intended solely for export from
Pakistan.1 The facility has been allowed subject to the condition that the borrowing
company/firm should produce to his banker a certificate from its auditors as per specimen given
below, clearly certifying that the funds in question have been utilised solely for production of
goods which have been exported. The following certificate is required to be furnished by the
borrowing company/firm not later than twelve months from the date on which the loan has
actually been utilised:
AUDITORS' CERTIFICATE
period from.............................to...........................in terms of F.E. Circular No.75, dated
the 18th July, 1972, has been utilised by the former solely for the purchase of raw material and
for meeting other expenditure (as per broad details given in the annexure) in connection with the
production of goods which have been exported by the company as per details hereunder:
Name of Country to
Description of goods
FOB value CTF value
which exported
Auditors

AUDIT OF ACCOUNTS UNDER THE INDUSTRIAL

RELATIONS ORDINANCE, 1969
The inserted sub-sections (10) and (11) of Section 23B of the above Ordinance require that
the Provincial Government, from a Panel of five persons (later reduced to three) who are
Chartered Accountants suggested by the collective bargaining agent, shall appoint one of such
persons to be an auditor for the persons of inspecting the accounts, record, premises and stores of
the factory on one occasion. It
Foreign Exchange Circular Nn.75, dated July 18, 1972, issued by the Senior Deputy Director, Exchange Control Department,
State Bank of Pakistan, Karachi.

A udit Under Other Statutes

419

is further provided that the fee of such auditor shall be determined by the Provincial
Government and paid by the management of the factory who shall afford him all faculties
necessary for the discharge of his functions.
Text of the inserted sub-sections (10) to (13) of Section 23B of the Industrial Relations
Ordinance, 1969, is given below:
"(10) The collective bargaining agent for an establishment which is a factory and number of
workers employed in it in any shift at any time during a year is fifty or more, may,
once during the period in which it is such a collective bargaining agent, apply to the
Provincial Government to nominate an auditor for the accounts of the factory relating
to the period ofthe firm only once and for that purpose to inspect the accounts,
records, premises and stores of the factory on one occasion.
(11)
An application under sub section (10) shall be accompanied by a Panel of five
persons Gater reduced to three) who are Chartered Accountants within the meaning of
the Chartered Accountants Ordinance, 1961 (X of 1961), and, on receipt of such an
application, the Provincial Government shall appoint one of such persons to an be
auditor for the purposes of that subsection.
(12)
The fee of an auditor appointed under sub-section (11) shall be determined
by.the Provincial Government and paid by the management of the factory who shall
also afford him all facilities necessary for the discharge of his functions.
(13)
This Section shall have effect notwithstanding anything contained in the
Companies Ordinance, 1984, or any other law for the time being in force or in any
agreement or contract or memorandum or articles of association.1

THE MONOPOLY CONTROL AUTHORITY RULES, 1971

Rule 8 entitles an 'Accountant', if authorised in writing, to represent his client before the
Monopoly Control Authority of Pakistan in connection with any proceedings under the
Monopolies and Respective Trade Practices (Control and Prevention) Ordinance, 1970. The
word 'Accountant' has been defined in sub-rule (a) of Rule 2 ofthe above Rules to mean:
(1)

a Chartered Accountant within the meaning of the Chartered Accountants

Orclinance, 1961 (X of 1961), or.
(2) an Industrial Accountant within the meaning of the Cost and
. Management Accountants Act, 1966 (XTV of 1966).

This amendment was effect through the Labour Law (Amendment! Ordinance, 1972, on April 13, 1972. .

420

Auditing: Principles and Procedures

AUDIT OF COMPANIES TAKEN OVER UNDER THE ECONOMIC

REFORMS ORDER, 1972 <P.O. No. 1 Of 1972)
Through the Economic Reforms Order, 1972, the Government of Pakistan, took over 32
industries in Pakistan in early January 1972. The Government is exercising control and
managing the companies through their appointed managing agents. The Board of Industrial
Management has been constituted to exercise the overall control. This Board appoints auditors
for auditing the accounts of taken over industries. Under sub-section l e ) of Section 6 of the
Development of Industries (Federal Control) Act, 1972, it provides that the Board is empowered
to remove an auditor of an establishment and appoint another person to hold that office, or
appoint an auditor in addition to the auditor of an establishment, for such period and on such
remuneration payable by the establishment as the Board may determine.
Section 4 of the above Act lays down that the Act overrides the provision of the Companies
Ordinance, 1984.
Section 10 of the above Act provides that in the case of an establishment owned or
controlled by a company, the general meeting of the company before which balance sheet is laid,
shall not, if the Federal" Government by order in writing so directs, have the authority to refuse
to adopt the balance sheet, but nothing in this section shall be construed as to prevent any
shareholders from expressing his views on the financial affairs of the establishment and a record
of the proceedings of such meeting shall be forwarded to the Federal Government not later than
fifteen days of the meeting.

AUDIT UNDER THE PEOPLE'S FINANCE

CORPORATION ACT, 1972
Section 24 of the above Act deals with the 'Accounts' and it is mentioned therein that the
corporation shall maintain its accounts in such manner as may be prescribed.
The main features of Section 25 which relate to the 'Audit1 are:

(1)

The accounts of the corporation shall be audited by two auditors who are
Chartered Accountants within the meaning of the Chartered Accountants Ordinance
appointed by the Federal Government in consultation with the Auditor-General, on
such remuneration, to be paid by the corporation, as the Federal Government may fix.
(2) The Auditor-General has been empowered to give directions to the auditors in
regard to the extent and method of their audit subject to the provisions of the
Companies Ordinance, 1984, and to prescribe forms of accounts to be maintained by
the corporation consistent with the

Audit Under Other Statutes

421

requirements of that Act.

(3) The Corporation is required to furnish each shareholder every year with a copy of its
audited accounts including balance sheet and profit and loss account, and a report on
the working of the Corporation.

SPECIAL PURPOSE AUDITOR'S REPORTS

LAG 24 deals with special purpose auditor's reports and its constituents are as under:

1.

Guidelines for the following types of reports:

(o) Reports on financial statements prepared in accordance with an other
comprehensive basis of accounting.
(b) Reports on components of financial statements.
(c) Reports on compliance with contractual agreements. . (tfj Reports on
summarised financial statements.
2.
Four appendices have been included in respect of each of the above reports.

AUDIT UNDER COMPANIES (INVITATION AND

ACCEPTANCE OF DEPOSITS) RULES, 4987
Two Forms have been annexed to the above Rules. Form I is in respect of matters to be
specified in the advertisement relating to invitation of deposits and Form is a prescribed Form
for return of deposits with companies other than banking companies to be filed annually.
Clause of Form I requires certification by the company auditor "A summarised fmancial
position of the company appearing in the two balance sheets immediately preceding the date of
the advertisement in the form prescribed therein". This is reproduced on the following page.

422

Auditing: Principles and Procedures

Summarised Financial Position of the Company as Appearing in the Two Audited

Balance Sheets Immediately preceding Financial Year's

Reserves and
Liabilities

Figures for
the latest
financial year
for which audited accounts .
are available
with date
2

Figures for
the financial
year preceding the year Assets
referred to
in column 2
with date
3
4-

Paid up-share
() Free reserves
(Hi Other reserves/
)
surpl use s/p rofits
( w Deposits
)
(
Secured loans/
finances
(vi) Unsecured loans/
finances
Current liabilities
and provisions

Figures for
the nnancial
year preceding the year
referred to
in column 5
with date
6

Fixed assets
Investments
dii) Current assets

ra

Nates:

Figures for
the financial
year for which
audited ac-
counts are
available
with, date
5

(iv) Miscellaneous () Loss for the year

toff-

Actumulated loss/
Deficit balance

(a) Brief particulars of contingent liabilities to be added by way of a footnote.

{61 A summarised financial position may not be incorporated in the statement in lieu of advertisement of private
company.

Certificate' of Auditors in respect of Form , i.e, Annual Return of Deposit to be filed with
the concerned Registrar Joint Stock Companies and a copy of the same to sent to the
Corporate Law Authority has been prescribed as under:
CERTIFICATE OF AUDITORS Certified that the information
contained in this return is. correct.

Dated..........................................................................................._______________
Place...................................
Chartered Accountants

Audit Under Other Statutes

423

SPECIAL PURPOSE AUDITOR'S REPORT

Introduction
1. International Standard oh Auditing (ISA) 13, The Auditor's Report on Financial Statements,
provides guidance to auditors on the form and content of the auditor's report issued in
connection with the independent audit of an entity's financial statements 1 prepared in
accordance with the relevant national standards or International Accounting Standards.
Much of the guidance in ISA 13 can be adapted to auditor's reports on financial information
other than financial statements.

2.

The purpose of this Standard is to provide guidance to auditors on the form and content of
an auditor's report issued in connection with the independent audit of financial information
other than an auditor's report on financial statements issued in accordance - with ISA 13.
Such reports are hereafter referred to as special purpose auditor's reports. In addition to the
guidance on special purpose auditor's reports in general, specific guidance is given in the
case of auditor's reports on:

3.

Financial statements prepared in accordance with a comprehensive basis of accounting

other than relevant national standards or International Accounting Standards.
Specified accounts, elements of accounts, or items Of a financial statement (hereafter
referred to as reports on a component of financial statements).

Compliance with contractual agreements.

Summarized financial statements.

An auditor may be engaged to prepare a special purpose auditor's report other than those
covered by. this Standard (e.g. reports on non-financial information, such as newspaper
circulation statistics) or to prepare a single report which incorporates features of more than
one of the particular reports above. This
Standard may provide useful guidance for many aspects of such engagements.

General Considerations

4.

The extent of work to be performed in an engagement to give a special purpose auditor's

report will vary with the circumstances. Accordingly, before undertaking such an
engagement it is important that there be agreement with the client as to the exact nature
ofthe engagement and the form and content of the report to be issued.

The term 'financial statements', as defined in t he Preface to Statements of International Accounting Standards, covers
balanee sheets, income statements or profit and loss accounts, statements of cash flows, notes and other statements and
explanatory material which are identified as being part ofthe financial statements.

424

Auditing: Principles and Procedures

5.

In planning his work, the auditor should have a clear understanding of the purpose for
which the information being reported' on is to be used, and who is likely to use it. To avoid
the possibility of the auditor's report being used for purposes for which it was not intended,
the auditor may wish to indicate in his report the purpose for which the report is prepared
and any restrictions on its distribution.

6.

ISA 13 describes the basic elements which should be included in the auditor's report on
financial statements prepared in accordance with relevant national standards or
International Accounting Standards. These basic elements apply to all special purpose
auditor's reports unless otherwise stated. All special purpose auditor's reports should
include:

a.
b.
c.
d.
e.
f.
g.
h.

title,
addressee,
identification ofthe financial information audited,
a reference to auditing standards or practices followed,
an expression, or disclaimer, of opinion on the financial information,
signature,
the auditor's address, and
the date of his report.

A measure of unifoiTnity in the form and content of the auditor's report is desirable because it
helps to promote the reader's understanding. Therefore, in an auditor's unqualified report the
scope of the auditor's engagement and his opinion should be given in separate paragraphs.

7. In the case "of financial information to be supplied by clients to government authorities,

trustees, insurers and other entities there may be a prescribed form of auditor's report. Such
prescribed forms may not conform to the applicable professional reporting standards. For
example, the prescribed report g may require a certification of fact when an expression of
opinion is appropriate, * may require an opinion on matters outside the scope of the audit or
may omit g essential wording. When requested to report on financial information in a 3
prescribed format, the auditor should consider the substance and wording form of report and,
when necessary, should make appropriate changes, either by rewording the form or by
attaching a separate report.

8.

When the information on which the auditor has been requested to report is based on certain
provisions of an agreement, the auditor needs to consider whether any significant
interpretations of the agreement have been made by management in preparing the
information. An interpretation is significant when adoption of another reasonable
interpretation would have produced a material difference in the financial information. The
.auditor should ensure that the interpretation is clearly disclosed in the financial
information and

Audit Under Other Statutes

425

make reference to the note within the financial information that describes the interpretation.

Reports on Financial Statements Prepared in accordance with

an Other Comprehensive Basis of Accounting

9.

A comprehensive basis of accounting comprises a set of criteria used .in preparing nnancial
statements which applies to all material items and which has substantial support. Financial
statements may be prepared for a special purpose in accordance with a comprehensive basis
of accounting other than a basis of accounting that is in accordance with relevant national
standards or International Accounting Standards and are referred to herein as prepared on an
'other comprehensive basis of accounting.' A conglomeration of accounting conventions
devised to suit individual preference does not meet the criteria for an other comprehensive
basis of accounting. Examples of other comprehensive
bases of accounting are:

A basis of accounting that an entity uses to file its income tax return.
A cash receipts and disbursements basis, of accounting.

A basis of accounting that an entity uses to comply with the requirements or

financial reporting provisions of a governmental regulatory agency to whose
jurisdiction the entity is subject and which differs in material respect from.that
normally applied by the generality of entities.

10. When an entity's financial statements are prepared in accordance with an other

comprehensive basis of accounting the auditor should make reference in his report to the
basis used.

11. When the basis of accounting used or required to be used is in accordance with relevant
national standards or International Accounting Standards the guidance in this ISA is not
applicable and the requirements of ISA 13 should be followed.

12. The auditor should ensure that the title of, or a note to, the financial statements would make
it clear to the reader that such statements are not prepared in accordance with relevant
national standards or International Accounting Standards. For example, a tax basis fmancial
statement might be entitled 'Statement of Assets and Liabilities - Income Tax Basis'. If, in
the auditor's opinion, the nnancial statements are not suitably titled or the basis of
accounting is not adequately disclosed, he should express a qualified opinion.

13. In formulating his report, in addition to the elements mentioned in paragraphs 5 and 6, the
auditor should include a statement indicating the basis of accounting used in the preparation
of the financial statements on which he is reporting or refer to the note to the financial
statements giving that information. The opinion should state whether the financial
statements 'give a true and fair view of (or 'present fairly')... in accordance with 'the basis of

426
Procedures

Auditing:

Principles

and

accounting indicated. Appendix I gives examples of auditor's reports on financial

statements prepared in accordance with an other comprehensive basis of accounting.

Reports on Components of Financial Statements

14. The auditor may be requested to express an opinion on one or more Components of

financial statements, or example, accounts receivable, inventory, an employee's bonus

calculation or a provision for income taxes. This type of engagement may be undertaken as
a-separate engagement or in conjunction with an audit of an entity's financial statements.
However, this type of engagement does not result in a report on the financial statements
taken as a whole and, accordingly, the auditor should express an opinion only as to whether
a component of financial statements 'gives a true and fair view of (or is 'presented fairly')...
in accordance with 'the basis of accounting indicated.

15. The auditor should recognize that many financial statements items are interrelated, for

example, sales and receivables, and inventory and payables. Accordingly, when reporting
on a component of a financial statement, the auditor will sometimes be unable to consider
the subject of his examination in isolation and will need to examine certain other financial
information. In determining the scope of the engagement the auditor , should consider those
financial statement items that are interrelated and which could materially affect the
information on which he is reporting.

16. The auditoi' should also consider the concept of materiality in relation to a component of

financial statements (e.g. a particular account balance provides a smaller base against
which to measure materiality compared with the financial statements taken as a whole).
Consequently, the auditor's examination will usually be more extensive than if the same
financial information were being audited in connection with a report on financial
statements.

17. To avoid giving the user the impression that the report relates to the entire financial
statements, the auditor should advise the client that his report on a component to financial
statements should not accompany the financial statements of the entity. If the auditor has
expressed an adverse opinion or disclaimed an opinion based on an audit of the entire
financial statements, he may report on components of those financial statements only if the
components to be reported on are not so extensive as to constitute a major portion of the
financial statements, thus overriding the report on the entire financial statements.

18. In formulating his report, in addition to the elements mentioned in paragraphs 5 and 6, the
auditor should include a statement that indicates the basis on which the component is
presented or refers to an agreement that specifies the basis. A statement or a reference to the
note within the financial information should describe any significant interpretations of the
relevant agreement. The

Audit Under Other Statutes

427

opinion should state whether the component 'gives a. true and fair view of (or is presented
fairly'}... in accordance with' the basis indicated. Appendix II gives examples of auditor's
reports on components of financial statements.

Report on Compliance with Contractual Agreements

19. The auditor may be requested to report on an entity's compliance with- certain aspects of
contractual agreements, such as bond indentures or loan agreements. Such agreements,
usually require the entity to comply with a variety of covenants involving such matters as
payments of interest, maintenance of predetermined financial ratios, restriction of dividend
payments and the use of the proceeds of sales of property.

20. Engagements to express an opinion as to an entity's compliance with contractual agreements

should be undertaken only when the overall aspects of compliance relate to accounting and
financial matters wifMn the scope of the auditor's professional competence. When there are
particular matters forming part of the engagement that are outside his expertise, the auditor
should consider using' the work of an expert and follow the guidance set forth in ISA 18,
Using the Work of an Expert.

21. In formulating his report, in addition to the elements mentioned in paragraphs 5 and 6, the
auditor should include a reference to the note in the financial
. information describing any significant interpretations of the agreement.. The opinion
should state whether the entity has complied with the particular requirements of the
agreement. Appendix III gives examples of auditor's reports on compliance given in a
separate'report and in a report accompanying financial statements.

Reports on Summarized Financial Statements

22. An entity may prepare financial statements summarizing its annual audited financial
statements, for example for the purpose of informing user groups interested in the highlights
only of the entity's financial performance and position. Unless 'the auditor has audited and
expressed ah opinion on the financial statements from which the summarized statements
were derived he will not be in a position to report on summarized financial statements.

23. Summarized financial statements are presented in considerably less detail than annual
audited financial statements. Therefore, such financial statements should clearly indicate the
summarized nature of the information and caution the reader that, for a better understanding
of an entity's financial performance and position, summarized financial statements should
be read in conjunction with the entity's most recent audited financial statements which
include all disclosures required by relevant national standards or International Accounting
Standards.

24. Summarized financial statements should be appropriately titled to identify the

428

Auditing; Principles and Procedures

audited financial statements from which they have been derived, for example, 'Summarized
Financial Information Prepared from the Audited Financial Statements for the Year Ended
December 31, 19X1'.
25- Summarized financial statements do not contain all the information necessary to 'give a true
and fair view of (or 'present fairly')... in accordance with' the basis indicated. Consequently
this or similar wording should not be used by the auditor when expressing an opinion on
summarized financial statements. Instead, the auditor when expressing an opinion on the
audited financial statements and state whether the summarized financial statements are
consistent with the audited financial statements from which they were derived.
26. In addition to the elements mentioned in paragraphs 5 and 6 [except for paragraph 6c) and
d], the auditor's report should include:

a.

An indentification of the financial statements on which an audit has been performed

and from which the summarized financial statements were derived, with an indication
as to the auditing standards or practices followed in conducting the audit, such as by
reference to ISAs or to standards or practices established within a country.
b. A reference to the date of his report on the audited financial statements and to the
opinion given in that report.
c. An opinion stating whether the information in the summarized financial statements is
consistent with the financial statements from which it was derived When the auditor
has expressed a qualified or adverse opinion or disclaimer of opinion on the audited
financial statements, yet is satisfied with the presentation of the summarized fmancial
statements, he should state that, although consistent with the financial statements,
they were derived from financial statements on which such an opinion or &selaimer
of opinion was expressed.
d. A statement, or reference to the note within the summarized financial statements,
which indicates that for a better understanding of an entity's financial performance
and position, the summarized financial statements should be read in conjunction with
the entity's related audited financial statements.
Appendix IV gives examples of auditor's reports on summarized financial statements.

429

Audit Under Other Statutes

Appendix 13.1

EXAMPLES OF REPORTS ON FINANCIAL STATEMENTS

PREPARED IN ACCORDANCE WITH AN OTHER COMPREHENSIVE
BASIS
OF ACCOUNTING
Financial Statements Prepared on Cash Receipts and Disbursements Basis
AUDITOR'S REPORT TO....................................................................................... .......................
We have audited in accordance with International Standards on Auditing 1 the cash receipts and
disbursements basis financial statements2.
The Company's policy is to prepare its financial statements on the cash receipts and
disbursements basis. On this basis revenue and the related assets are recognized when received
rather than when earned, and expenses are recognized when paid rather than when the obligation
is incurred.
In our opinion, the financial statements give a true and fair view of (or 'present
fairly') the assets and liabilities arising from cash transactions of.........................at.........and the
revenue collected and expenses paid during the year then ended on the cash receipts and
disbursements basis as described in Note X.
Date AUDITOR Address
Financial Statements Prepared on the Entity's Income Tax Basis
AUDITOR'S REPORT TO......................................................._......................................................
We have audited in accordance with International Standards on Auditing 1 the income tax basis
financial statements2.
In our opinion, the financial statements give a true and fair view of (or 'present fairly 1) the
financial position of..... at.... and its revenues and expenses for the year then ended, on the basis
of accounting used for income tax purposes as described in Note X.
Date AUDITOR Address

^
1
2

Or refer to relevant national standards or practices. .

Provide suitable identification, such as by reference to page numbers or by identifying the individual
statements.
Or refer to relevant national standards or practices.
Provide suitable identification, such as by reference to page numbers or by identifying the individual statements.

430

A uditing: Principles and Procedures

Appendix 13-2

EXAMPLES OF REPORTS ON COMPONENTS OF

FINANCIAL STATEMENTS
Schedule of Accounts Receivable
AUDITOR'S REPORT TO ......................................................................... ........... ......................
We have audited in accordance with International Standards on Auditing 1 the schedule of
accounts receivable2 at December 31,' 19X1.
In our opinion, the schedule of accounts receivable gives a true and fair view of (or
'presents fairly') the accounts receivable of................at..... in accordance with...............3.
Date AUDITOR Address

Profit Participation
AUDITOR'S REPORT TO...............................................................................................................
We have audited in accordance with International Standards on Auditing 1 the schedule of Mr.
ABC's profit participation2 for the year ended December 31, 19X1.
We have been informed that the document that governs Mr! ABC's profit participation is the
employment agreement between Mr. ABC and XYZ Company dated June 1, 19X0. "
In our opinion, the schedule of profit participation gives a true and fair view of (or 'presents
fairly') Mr. ABC's participation in the profits of ... for the year ended December 31, 19X1, in
accordance with the provisions of the agreement referred to in the preceding paragraph.
Date AUDITOR Address

Or refer to relevant national standards of practices.

Provide suitable identification, such as by reference to page numbers or by identifying the individual statements. '
Indicate the relevant national standards or refer to International Accounting Standards, the terms of an agreement or any
described basis of accounting.

431

Audit Under Otlm Statutes

Appendix 13.3

EXAMPLES OF REPORTS ON COMPLIANCE GIVEN IN A

SEPARATE REPORT AND IN A REPORT ACCOMPANYING
FINANCIAL STATEMENTS
Separate Report
AUDITOR'S REPORT TO ............................................................................................................
We have made an examination in accordance with International Standards on
Auditing1 with respect to ..................... compliance with the accounting and financial
reporting matters of sections XX to XX inclusive of the Indenture dated May 15, 13X1 withABC Bank.'
In our opinion,..............was in compliance with the accounting and financial reporting
matters of sections XX to XX inclusive ofthe Indenture dated May 15, 19X1 with
ABC Bank as at.................
Date AUDITOR Address
Report

Accompanying

Financial

Statements

AUDITOR'S REPORT TO......................................

We have audited in accordance with International Standards on Auditing the financial
statements2.
In our opinion, the financial statements give n true and fair view of (or 'present
fairly') the financial position of .... "at .... and the results of its operations for the
year then ended in accordance with...............3 (and comply with............4).
During the course of our audit we also made an examination with respect to ................................
compliance with the accounting and financial reporting matters of sections XX to XX inclusive
of the Indenture dated May 15, 19X1 with ABC Bank in accordance
with International Standards on Auditing.1 In our opinion, .........................
was in compliance
with the sections of the agreement referred to in the preceding paragraph.
Date AUDITOR Address

or refer to relevant national standards or practices.

indicate the relevant national standards or refer to Intuinational Accounting Standards. * refer to relevant

provide suitable identification, such as" by reference to page numbers or by identifying the individual statements.
statutes or law. .

432

Auditing: Principles and Procedures

Appendix 13.4

EXAMPLES OF
STATEMENTS

REPORTS

ON

SUMMARIZED

FINANCIAL

When an Unqualified Opinion Was Expressed on the Annual Audited Financial Statements
AUDITOR'S REPORT TO ....................................................................................................____
We have audited in accordance with International Standards on Auditing 1 the financial
statements2 and in our report dated March 10, 19X1 we expressed an unqualified opinion on
those financial statements.
In our opinion, the accompanying summarized financial statements are consistent with the
financial statements referred to above from which they were derived.
For a better miderstanding of the Company's financial position and the results of its operations
for the period, the summarized financial statements should be read in conjunction with the
related annual audited financial statements.
Date
Address

AUDITOR

When a Qualified Opinion Was Expressed on the Annual Audited Financial Statements
AUDITOR'S REPORT TO...............................................................................................................
We have audited in accordance with International Standards on Auditing 1 the
financial statements2 and in our report dated March 10, 19X1 we expressed an
opinion that those financial statements gave a true and fair view of (or 'presented
fairly')........except that inventory had been overstated by...................
In our opinion, the information set forth in the accompanying summarized financial statements is
consistent with the fmancial statements referred to above from which it was derived and on
which we expressed a qualified opinion.
For a better understanding of the Company's financial position and the results of its operations
for the period, the summarized financial statements should be read in conjunction with the
related annual audited fmancial statements.
Date
Address

AUDITOR

Or refer to relevant national standards or practices.

Provide suitable identification, such as by reference to page numbers or by identifying the individual statements.

BANKING COMPANIES ACT, 1962

WORKING INDEX RELATING TO ACCOUNTS AND AUDIT
MATTERS

Section 34
34(2)
34(1)
34 (1) & (3)
34(1)
10
18 .
35
35

35 (3)
34(2)
Accounts
Accounts
Accounts, Authentication of Accounts, closing date
of Balance Sheet, form of Profit and Loss Account,
form of
Assets
Assets, Non-banking
Floating Charge, Prohibition on
Audit and Auditors . Audit
Auditors, qualifications, powers and duties of Audit report^ contents of
Authentication
Accounts, Authentication of
Balance Sheet
Date of Form
of
Brokerage
Restriction on
Capital
Authorised, subscribed and-paid-up,

34(1)
34(1)&(3)
16

minimum requirements of Capital of

foreign banking companies Capital (paidup) and Reserve,
minimum requirements of UnpaidCapital, prohibition on charge of
Commission
Restriction on
.Directors
Loan to

14
13
13
17
16

Discount Disqualifications of Managing Directors

24

Restriction on

lldMc)
16

Dividends.
Restriction as to payment of

19,21 (1)

Investments
In other, companies, restriction on .........................

23 (2), (3)

Loans
To-Directors, individual etc., restriction on 24
Powers
Transactions within the power of that Company
J

Profit and Loss Account

Formof .34(1)

Reserve
Minimum requirements of 21 Reserve and Paid-up Capital,
minimum requirements of 13

7, 9

436

Auditing: Principles and Procedures

^?

TRADERS
r

A pA

CONCERNS

AUDIT

OF

AND

SOLE

PARTNERSHIP

The basic difference between the audit of a company and that of other organisations is that
the duties of an auditor have been clearly defined under the Companies Ordinance, 1984,
whereas the duties in other cases is a. matter to be agreed upon between the auditor and his
client. The duties ofthe auditor may vary according to the terms of the contract. The extent of the
. work to be performed would depend upon the precise nature of the instructions received from
the client. It is advisable to obtain the instructions in writing while adopting the technique and
extent of checking and subsequent reporting thereon, the following considerations should merit
in the mind ofthe auditor; .

(1) The capacity in which he performed the work.

(2) Reliability and adequacy or otherwise of the records in relation to the
business.

(3) The obtainment or otherwise ofthe information and explanations.

(4)

The

effect of the clients' instructions imposing material limitations on the

work to be undertaken.

-. . .

AUDITOR AND PARTNERSHIP ACCOUNTS

Under the Partnership Act, 1932, it is not legally obligatory to get the accounts audited.
However, because of the inherent advantages of audit, most of the firms get their accounts
audited. The duties, powers, privileges and scope of the work to be done is mutually settled
between the auditor and the firm. It must be clear whether the work to be done is of auditing
nature or accountancy nature or of the nature of preparation of income-tax returns.
The procedure to be followed by a newly appointed auditor of a paitnership is explained
below:

1.

Instructions. Definite instructions

performed by him must be obtained. '

2.

in

writing

as
.'.

to

the

work

to

be

Partnership Deed. He should carefully peruse the paitnership deed and note the following
matters as to their treatment:

(a) Powers and duties of each partners.

(a) Capital contributed by each partner, his withdrawls, loans to or by the firm, interest on
capital or drawings.

(b) Sharing of profit and loss.

(c) Salaries, commission, provision for reserves and depreciation etc.
3. Amalgamation. If the business has been amalgamated, he should check the entries and
examine the basis of valuation of the business amalgamated.
4. Contracts. He should examine contracts entered into by the firm with the third parties.
5. Minutes. Minute book of partners should be inspected. Resolutions passed for approval

of accounts should be exanuned.

6. Goodwill The procedure for computing the amount of goodwill in the case of admission
of a new partner, retirement of a partner or on the death of the partner should be noted.
Some of the important legal decisions in respect of partnership accounts are discussed here:

1.

Apfel vs. Annen Dexter & Co. (1926). The facts of the case were that the plaintiff brought
an action against the auditors that she was defrauded by her two sons who had acted as the
manager of the firm. It was argued that the auditor committed an act of negligence and failed to
uncover the fraud. A sum of 28,600 was claimed as damages.
The defendants (the auditors) argued that they were engaged to do the accounting work and
no audit was done by them. The certificate given was: "Prepared from the books of Mrs. Apfel
and in accordance therewith". The learned court gave the verdict that it was apparent from the
auditors' certificate that the nature of the work was that of accountancy and not auditing.

2. Maritime Insurance Co. Ltd. vs. William Fortune and Son. It was also held in this case
that the auditors were given material to prepare the accounts and not to audit them. They
(auditors) acted as accountants and therefore they were not responsible for the loss sustained by
plaintiff due to their alleged negligence.
3. Leech vs. Stokes and others (1937). In this case also the plaintiff argued that the
auditors were negligent ofthe performance of their duties. The defendants (auditors) pleaded not
guilty and stated that they were engaged "to prepare a report of profits for the Inspector of
Taxes" and that "there was no proper material, available for the preparation of a balance sheet"
It was held by the court that the defendants were not negligent in preparing a profit and loss
account from the material supplied to them and the instructions were given to them as to what
they were to do.

438

Auditing: Principles and Procedures

Audit of Sale Traders and Partnership

Concerns

381

TYPES OF PARTNERSHIP AUDITS

Auditors may be appointed by either of the following to conduct the audit:

(1) Sleeping partner.

(2) Retiring partner or a representative of a deceased partner.
Important steps to be taken for auditing in each of the above cases are separately discussed
below:
On behalf of a sleeping Partner
Other names for the sleeping partner is 'ostensible partner' or 'dormant partner'. He is that type
of a partner who is vested with every right of a partner except that he does not take an active part in
the operation of business. He may appoint an auditor to examine the accounts and ensure a safeguard
to his interest. The auditor must take all such steps as should protect all the interests of his clients.
Special attention should be paid to the following:
()

Allocation. Proper distinction is maintained between capital and revenue

so that correct profits are determined.
() Active Partner's Role The role of active partners must be watched:
(i)
to see that they do not indulge in speculative transactions which do not
form part of the firm's ordinary business;

(ii) they do not withdraw more money on account of profit or capital;

(c> Accounting. No excessive reserves should be created or too mueh depreciation should not be
charged off in the accounts. All prepaid expenses should he accounted for and proper
adjustment should be made for income accrued but not received.
On behalf of a retiring partner or a representative of a deceased partner
The object of getting the accounts audited by the retiring partner or the representative of a
deceased partner is to ensure that the correct account is prepared and the account due to him is
accurately determined. Special points to which attention should be given are:

1. Agreement. Clauses dealing with the normal retirement of a partner or by retirement on

account of the death of a partner and his entitlements must be read carefully and notes should also be
taken by the auditor.
2. Assets. Checking should be done to ascertain that they have been properly valued. All
outstanding assets must be accounted for.
3. Liabilities. It should be ascertained that the liabilities were correctly valued, and all
outstanding liabilities were reflected in the books. 4. Goodwill. In accordance with the method laid down in the partnership deed, the payable
amount should be correctly determined and credited to the

retiring or deceased partner's account. '*"*.'

5. Payment. The correct amount due to the retiring partner or the deceased partner
consisting or share of profit, goodwill share in the assets and liabilities etc., should be
determined. The terms of payments (whether in one instalment or in a series of instalments)
should be verified from the partnership deed. If the amount is payable in instalments, the balance
due should be transfeired to a Loan Account and the matter of interest payable should also be
looked into.

ADVANTAGE OF AUDIT TO A SOLE TRADER

. The following are the advantages accruing from the audit of accounts to a sole trader:

1. Income Tex. Audited accounts by the Chartered Accountants are generally accepted
by the Income-tax Officer and assessments are completed without too much difficulty and delay.
2. Proper Control. ~ The sole trader is assured that his accounts are properly maintained
and that he is not being defrauded by his employees. A regular audit also tends to keep the books
of accounts up to date.
3.. Comparison, The audited version of accounts can be compared with the last year's
results and thus the sole trader can examine the material fluctuations in the figures and look into
the matter.
4. Estate Duty. The audited accounts of a deceased are very useful and helpful to the
executors and administrators of such accounts for preparing the estate duty accounts.

ADVANTAGES OF AUDIT TO A FIRM

Important advantages accruing to a firm getting the accounts audited are herein given:

1. Satisfaction o f Partners. Generally, provisions exist in the partnership deed for

getting the accounts of a firm audited. To avoid the possibility of any dispute, audit is arranged
and it further indicates the agreement of all partners as the audited accounts are also signed by
them.
2. Reliance by outsiders. Audited accounts and statements are generally relied upon the
outsiders in respect of the following:
(a) For income-tax assessment,
(o) For borrowing money.
(c) For obtaining additional capital.
(d) For securing compensations in the case of compulsory removal or business

Auditxif Sole Traders and Partnership Concerns

440

or claims relating to a loss by fire.

(e
Y

W
(S
)
In the case of a proposed sale of the business.
In the case of conversion of a business into a joint stock company.
While computing goodwill on the admission of a partner.
When agreeing the share of a business due to the trustees of a deceased partner.

AUDIT OF PARTNERSHIP FIRM CONTRASTED WrTH

AUDIT OF LIMITED COMPANIES
There is a difference in principle between the audit of a partnership firm and that of a
limited company, and that difference lies in the following directions:

(1) The audit of a partnership is not required by any law; it may be required by the
partners. The audit of the accounts of a company is made compulsory by the Companies
Ordinance, 1984.
(2) The partners may limit the scope of the audit, but in that case the auditor should
obtain a written statement from his clients giving the nature and extent of the work to be done by
him, so that there may not be any dispute in future. The position of the auditor of a private firm
and the fact that his duties are dependent upon agreement between the parties, have been
considered by the courts, and it has been held that, otherwise agreed, the auditor should carry out
a complete audit, and is only freed from that'responsibility where there is a specific agreement as
to the limitations of the work which he would be normally expected to perform.
In the case of a company, however, the rights and duties of the auditor are laid down by the
Companies Ordinance, and these cannot in any way be restricted by the company's articles or by
the company in general meeting, although such duties can be enlarged.

(3) The accounts of a partnership are to be kept in accoidance with the express
instructions of the partners and their partnership agreement. It is only when there is no agreement
of any kind between them that the relevant provisions of the Partnership Act, 1932, apply to the
keeping of accounts. The auditor of a company must, however, see that not only the provisions of
the company's memorandum and articles of association and the resolution of the company and of
the directors but also the provisions of law affecting the accounts of the company have been duly
complied with.
(4) The auditor of a partnership firm reports to the partners by whom he is appointed,
while the auditor of a company has to make his report to the members of the company even
though he may have been appointed by the directors or by the Federal Government.

441
Procedures

Auditing:

Principles

and

(5) The auditor of a partnership may be held liable only for negligence, if any, on his
part; whereas the auditor of a company may be liable not only for negligence but also for
misfeasance and certain other offences in relation to the affairs of the company.
ISAs
Reference may be made to the following:

1.
2.

ISA 2 dealing with Audit Engagement Letters.

ISA 24 dealing with Special Purpose Auditor's Reports.

While agreeing on the scope of work, guidance may be sought from the above.

DIVISIBLE
PROFIT

IMPORTANCE OF PROPER ASCERTAINMENT OF PROFITS

In the case of business owned by individuals and partners, the proprietors may ascertain
their profits in any way they like, because other parties are not interested therein. However, the
position with regard to the limited companies is quite different. Apart from present shareholders
of the company, there are other persons such as the prospective shareholders, debenture-holders,
creditors, employees etc., who are interested in this profit. Therefore, it is important that the
profit of the company should be properly ascertained, failing which the various parties would be
affected as under:

(1)

If profits are understated, they result in depriving the present shareholders of their
dividends to which they are entitled. Further the market values of the shares also decline. .
- .-....

(2)

An exaggerated statement of the profits may result in an improper payment of

dividends.

(3)

Dividends may be paid out through an overstatement of the profit. Thus dividends
may be paid out of capital of the company and it may become insolvent and ultimately go into
liquidation.

(4)

An overstatement of the profits may result in increased remuneration payable to

managing agents, thereby causing a corresponding loss to the company.

THE CONCEPT OF THE PROFIT

The question of the < determination of the profits is of great importance. Its determination
affects several people in different walks of life, e.g., proprietors, income-tax authorities,
shareholders, directors etc. Consequently, it is a very important item in determining the^correct
profits of a concern. Authorities on the subject have defined the word "Profit" in different ways.

443

Auditing: Principles and Procedures

Profit may be defined as follows:

(1)

Generally speaking, the profit of the business during a given period is the
excess over the expenditure for the period.
(2) It is the excess of assets over the liabilities and the capital between the two
periods.

DIFFICULTIES IN THE DETERMINATION OF PROFITS

Some of the basic complications which he in the determination of profits are listed below:

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

How to value the assets at the close ofthe period?

How should the liabilities be valued?
Whether the previous losses must be written off before arriving at the correct profits?
Whether or not it is necessary that reserves, special provisions for depreciation etc., be
provided for?
The question of capital expenditure being treated as revenue expenditure and vice
versa, is to be given a careful consideration.
A careful consideration should be given to those expenses the benefit of which may be
derived in the subsequent accounting period.

CONSEQUENCES OF INCORRECT DETERMINATION OF

PROFIT
(if the profits are not correctly arrived at, it may result as explained below:

(1) Under statement of profit will lead to the following disadvantages: [ a ) Lowering

(2)

(3)

the value in the market.

(o) Depriving the shareholders of dividends to -which they are entitled, (c)
Reducing the convrnission on profits payable to the manager.
Over-statement of profit will result as follows:
(a) Distribution of capital in the form of dividend.
(o) Payment of managing agents as percentage of profit in excess of the entitlement.
Over-valuation or under-valuation of assets and liabilities would result in
misrepresentation of the balance-sheetJ

444

Divisible Profit

LEGAL PROVISIONS
Legal provisions governing dividends and manner and time of payment thereof are
contained in sections 248 to 251 of the Ordinance. Subjects covered include certain restrictions
on declaration of dividends, dividend to be paid only out of profits, dividends not to be paid
except to registered shareholders, period for payment of dividend.
In case the dividend after having been declared is not paid within the period specified, the
Chief Executive of the Company . shall be punishable with imprisonment for a term which may
extend to two (2) years and with fine which may extend to one million rupees.

CONCEPT OF DIVISIBLE PROFIT

' term 'divisible profit' means all profits that can be legally distributed to the shareholders
of the company. Section 249 of the Ordinance reads as under:
"No dividends shall be paid by company otherwise than out of profits ofthe
company."
No dividends shall be declared or paid by a company for any financial year out of the
profits of the company made from the sale or disposal of any immovable property or assets of a
capital nature comprised in the undertaking or any of the undertakings of the company, unless the
business ofthe company consists, whether wholly or partly, of selling and purchasing any such
property or assets, except after such profits are set off or adjusted against losses arising from the
sale of any such immovable property or assets of a capital nature^'
The Company Law does not lay down the manner in which the profit of the company is to
be ascertained. It alsp does not define as to what profit can be distributed for dividend purposes.
The question then is:
What are the guiding principles to be applied in determining whether a particular
profit is available for distribution in the form of dividend or not?
The following guiding principles must invariably be kept in mind:

(1) In no circumstances a dividend can be paid out ofthe capital.

(2) In every case the requirements of the memorandum and articles of association
ofthe company must be faithfully complied with.
(3) The provisions of Section 248 of the Ordinance which are given below must be
adhered to:
"The company in general meeting may declare dividend; no dividend shall exceed the
amount recommended by the directors."

(4) Provisions of Section 249 ofthe Ordinance be adhered to.

Auditing: Principles and Procedures

In the following cases dividends will be considered to have been paid out of the profits:
(a) If any expenditure allocatable to revenue is charged to capital with a view to swelling
the profit ofthe company improperly.
(t>) If a company paid a dividend in spite of the fact that the profit and lose account
indicates the loss and there are no other undistributed profits.
(c) If a company distributes the^ sale-proceeds of one of its fixed assets.
The reasons as to why the Company Law prohibits the payment of dividend out of the
capital are briefly narrated below:

(i)

The payment .of dividend out of the capital tantamounts to voluntary reduction
of capital without the permission of the court. Such an act is illegal under Section 961
(ii) If the payment of dividend out of capital is authorised by the memorandum or
articles of association, it is illegal, as it is ultra vires the Ordinance.

DIRECTORS AND PAYMENT OF DIVIDEND

Directors who knowingly pay dividends out of capital are jointly arid severally liable to
make good the amount of such dividends to the company with interest.. Where, however, such a
payment had been made in the faith of a bona fide valuation of the assets of the company, which
subsequently proved to be an overestimate, the directors were not liable. The directors are also
entitled to rely,: in the absence of suspicious circumstances, on the accounts prepared by the
trusted officials of the company, even though such accounts proved to be incorrect. Moreover,
under Section 488, the court may relieve from liability a director who has been guilty of
negligence or breach of trust, but who, in the opinion of the court, .has acted honestly and ought
reasonably to be excused. If the shareholders know that a dividend is being paid out of capital,
the amount so paid may be recovered from them, and shareholders receiving dividend out of
capital with full knowledge of the facts cannot compel the directors to make good the amount of
such dividends.
The following considerations should weigh with the directors in recommending the
dividend:

(1)

It is very desirable chat the dividend paid year after year should as far as
possible be urtiform.

(2)

The present liquid resources of the company should be considered because it

would not be wise to pay the dividend although there may be sufficient profits, if such
payment is likely to reduce the working capital of the company below Its normal
requirements.
(3) The future financial needs of the company should not be over-looked.

Divisible Profit

(4)

The rate of dividend in a really stable and wel] managed company is not
increased unless the directors have satisfied themselves that in ah probability a later
decrease will not become necessary.

(5)

A reasonable proportion of the disposal of profits should be carried forward as

a precautionary measure.
(6) In a new company there need not be any hurry to start paying dividend and the
rate of the dividend should be fairly low in order to provide against any future
contingency.
(7) If the profit of a particular does not justify the payment of the usual
dividend and if there is no certain hope of future improvement in the profits of the
company there should be nb hesitation in curtailing the dividend.

PAYMENT OF DIVIDEND
The following work should be done by the auditor in respect of
dividend:

ghfrcltiTig

the payment of

1.

Articles to be seen. Ascertain that the dividend paid is in accordance with the rights attached
to the stock or share capital in question, by examining the memorandum and articles of
association of the company,

2.

Profits are sufficient. Ascertain from the accounts of the company that the profits permitted

the dividends to be paid.

3.

Minutes. Inspect the directors' or shareholders' minutes authorising the payment ofthe

dividend.

4.

Bank account transfer. Check the transfer of the total amount of the dividend from the
general bank account to the dividend bank account.

- 5. Dividend warrants. Vouch the net dividend' column in the dividend book with the returned
endorsed warrants.

., 6. Bank reconciliation to be cheeked. Check the figures in the column with the dividend pass
book, and agree that total of the outstanding warrants with the balance shown by the pass book.
7.. Certificate to be obtained. Verify the balance of the dividend account by obtaining the
confirmation, of the bankers for balance in the bank account.

8. Verification of total dividend. See that the total of the 'gross dividend' column in the
dividend book represent the correct percentage of the dividend on the share capital on which it
is-paid, and that the income-tax at the prevailing rate accounts for the difference between the
gross and net dividend columns.
9.

Arithmetical accuracy. Check the additions and cross additions of the dividend book.

Divisible Profit

8.

Balance to be tallied. Agree each year the balances of the old dividend bank accounts, by
seeing the returned endorsed warrants which have come in during the year, agreeing those still
outstanding with the balances on the accounts, and confirming such balances with the bankers.
.4
9.

Basis for payment. Ascertain that the amount appearing in the profit and loss account
includes the dividend (if any) which the directors propose to pay for the period, and that the basis
of payment with regard to income-tax is correctly described.

PAYMENT OF INTERIM DIVIDEND

1. Interim accounts to be prepared. The profits made by the company must be carefully
estimated. For this purpose it is advisable to prepare interim accounts for the half year. Where,
however, the business is of such a nature that the percentage of gross profit on turnover is more
or less constant year by year and there are no unusual factors during the currant year which may
affect the figure of profits, it may be possible to dispense with the taking of stock and the
preparation of the interim accounts, because the gross profit for the half year can be computed at
the usual percentage on the sales for the period; and then by deducting from the gross profit the
actual expenses and the necessary provision for outstanding liabilities, depreciation and
contingencies, the net profit for the period may be estimated.
2. Remainder period conditions to be anticipated. A careful inquiry should be made into the
conditions of trade and prospects for the remainder of the year, because it is quite possible that
the profit earned during the first half year may be swallowed up by a loss in the second half year.
3. Cash position to be watched The cash position of the company should be-examined since
it would be inadvisable to pay an interim dividend, although there may be profits, if such
payment may unduly deplete the working capital of the company. In this connection it is
important to ascertain whether the company has any future financial commitments, e.g., funds
may be required in the near future for the payment of liabilities, for financing capital expenditure,
etc. If so, the payment of an interim dividend would not be justified.
4. Rate to be lower than final dividends. If it be decided to pay an interim dividend,-the rate
fixed should preferably be lower than the estimated rate for the whole year, because it is better
that the final dividend may be higher than the interim.

APPROPRIATION OF PROFITS
The power to decide how the profits of a company are to be disposed of is given by law to
the directors, because they are the persons who are responsible for the successful working ofthe
company. In a private business, the whole of the profits

448

Auditing: Principles and Procedures

may be withdrawn by the proprietors from the business, but in a limited the
shareholders cannot claim that the entire available profitB should be distribute to them.
The directors also usually possess (by virtue of powers vested in them hy articles of
association) an absolute power for making appropriations, = recoinmending the amount
of profits to be distributed among the shareholders, tc set aside out of the profits of the company
such sums as they think proper as a reserve or reserves which may be required for the purpose of
the company. The practice with regard to the disposal of profits of a company is, therefore, as
follows:

(1) Transfers to reserves, if any, are made by the directors with their own authority
(2)

(3)
(4)

without the consent of the shareholders, and such appropriations are shown in the
profit and loss account of the year out of whose profits they are made.
Dividends to shareholders are to be legally recommended by the directors and are to
be finally approved by the shareholders in ordinary general meetings; and the
shareholders have no right to increase the amount of dividends recommended by the
directors, though they may reduce it if they so desire. In practice, however, the
dividends as recommended by the directors are never reduced by the shareholders^
because if they did so their own pockets would be touched.
The dividends proposed by directors out of the available profits of a particular year are
net recorded in the account of the year out of whose profits they are to be distributed,
because they are not a legal liability of the company until the ordinary general meeting
of the company has been held (and this is held during the rxt year) and the curectors'
recommendations with regard to dividends have been formally approved by the
shareholders. Therefore, the dividends declared are recorded in the profit and loss
account of the next year; This is the old . method of accounting. But the modern
method of recording proposed dividends is to show the proposed appropriation for the
dividend in the current year accounts.
The interim dividends, if any, are usually declared by the directors because they are so
authorised by the articles. Interim dividends-are, therefore, recorded in the profit and
loss account of the year, on account of whose profits they are distributed. "
In a few companies in which the directors are not authorised by articles of association
even to transfer the reserves are recommended by the directors and are finally
approved by the shareholders in ordinary general meetings.

Divisible Profit

LEGAL CASES
In the absence of adequate statutory provisions on the subject of profit, difficulties have
arisen from, time to time in practice with regard to this question. The difficulties that have arisen
in the disputed cases are in respect of the true meaning of the term profits, i.e., what can be
legitimately included in profits available for dividends and what losses must be made good out
of those profits before they can be distributed. The question of divisible profit can be answered
after considering the following facts in the light ofthe case-law.

Dopreciation of fixed and floating assets

Some of the leading judicial cases in this respect are briefly discussed in the following
pages.

1. Verner vs. General and Commercial Investment Trust Ltd. (1894). It is necessary to
make good any loss or depreciation of floating assets before arriving at profits available for
distribution.
This case was decided in the Court of Appeal on the 7th April 1894. The decision was to
the effect that an injunction to restrain a company from paying a proposed dividend out of
current profits, on the ground that the capital of the company is not intact, must be refused if the
company is solvent and acting within its articles. -

2. Lee vs. Neuchatel Aspkalte Company Limited (1889). A company is under no legal
obligation to make good the depreciation of its fixed assets, provided:
(a) there is nothing in its articles requiring it to do so, and ...
(b) that it retains sufficient assets to discharge its liabilities.
This case was decided in the Court of Appeal on 9th February 1890, where it was held that
a company, if allowed by its articles of association, may provide for the distribution of profits
arrived at before making good the depreciation of fixed assets.
,. The Court dismissed,the: appeal, refusing to grant an injunction to restrain the
proposed dividend being paid.
.....
.. #
'3. "Lubbock vs. British Bank of South America Ltd. (1892).: Where it is
proposed to pay a dividend out of realised capital profits, the depreciation of both
fixed arid floating assets must be made'good.

.... This case was decided'by Mr. Justice Chatty, in the Chancery Division, on 1st April, 1892,
where it was held that if a Company's articles of association so provide, a profit made on the sale
of a part ofthe undertaking is available for dividend.

450

Auditing; Principles and Procedures

Capital Profits
Ordinarily capital profits are not available for distribution as dividends. However, they
could be distributed as dividends provided:

(1) the profit is a realised one,

(2) if the profit remains after the whole of the other assets have been valued, and
(3) if the distribution of a dividend out of such profit is permitted by the articles of

association of the company .

However, the capital profits, whether realised or not, can always be distributed in the form
of bonus shares, since the assets are not thereby reduced in any way.Some of the leading cases in this respect are briefly discussed below: -

1.

Lubbock vs. British Bank of South America Ltd, (1892). The company had sold its
business in Brazil and had realised upon this sale a profit of 2,00,000. It was held that this profit
was available for distribution as dividend. For full facts of the case, the reader may refer to
earlier discussion.

2. Foster vs. New Trinidad Lake Asphalte Co. Ltd. (1900). Trie company upon its
formation had taken over, amongst other assets, a debt of 1,00,000, this debt being deemed to be
of no value. Subsequently this debt realised 26,258 and it was sought to treat this sum as a capital
profit and make it available for distribution as dividend. It was held that this sum could not be
distributed, as dividend without having regard to the results shown by the accounts as a whole.
This case was decided by Mr. Justice Byrne, in the Chancery Division, on the 28th November,
1900.
It was held that a profit made on realisation of an asset included in the undertaking acquired
by a company en bloc at its inception was not available for dividend, but that before any profits
so made could be rendered available for dividend regard must be had to the value of the assets as
a whole.

Past Losses
Based on sound financial policy, if there are past losses and profit has been made in the
current year, no dividend should be declared until the past losses have been wiped off:- J;
: The directors may, in the honest exercise of their discretion and subject to the articles of
association ofthe company, divide a profit arising in the period of account even though the losses
of period remain unabsorbed.

In this respect the sound case-law from which guidance can be sought is described herein:
The Ammonia Soda Co. Ltd vs. Arthur Chamberlain and others (198>. In the year 1910,
the company's profit and loss account showed a debit balance of 12,970.

Divisible Profit

451

For the purpose of the balance sheet issued by the company as on 31st July, 1911, the value of
the company's land was appreciated by 20,542, as a result of revaluation, and this helped to wipe
off the debit balance on the profit and loss account. The company made profits subsequent to
31st July, 1911, and paid dividends therefrom.
An action was brought by the plaintiff company against the defendants who were the
former directors of the company, seeking to make the directors liable to refund the dividends
already paid It was contended by the plaintiffs that the revaluation was not a genuine one, but
was made simply with a view to wiping off the past debit balance on the profit and loss account,
which should have been written off first out ofthe subsequent profits prior to the payment of
dividend.
It was held that a company may write up the value of its assets as a result of a bona fide
valuation and may distribute current profits without first making good the past losses.
Based on the judgment given in the-above case, it is clear that a company is not bound to
make good previous debit balance on the profit and loss account before dividing current profits.
The payment of dividend out of current profits, without making good past losses not necessarily
amount to payment of dividend out of capital. From the viewpoint of sound finance, it may seem
desirable to apply current year's profits in making up lost capital; but legally, if it is not So
applied and utilised in payment of a dividend, it will not amount to a reduction of capital. There
is thus no legal obligation to provide for lost capital out of current profits.

Draff upon Reserves - Open and Secret

Where a company holds secret reserves credited by over-depreciation of its fixed assets,
such secret reserves may be utilised for dividend purposes provided:

(1) the procedure is not contrary to the provisions of memorandum and articles of
association, and

(2) the value to which the fixed assets are written up is not in excess of their true value. '
Stapley vs. Read Brothers Ltd. (1924). Held that a company that has written down its assets
excessively out of profits may subsequently write them up again to the extent of such excess and
apply the amount thereof in payment of dividends.
This was a motion for an injunction to restrain the defendant company-(1) from distributing
in dividend the credit balance ofthe profit-and-loss account at 31st December, 1923, or any part
thereof until the debit balance on the profit and loss account at 31st December, 1922, had been
discharged: and (2) from treating as profits available for dividend (a) any profits originally
applied in writing off or down the book value of any of the assets, and subsequently written back
on the ground that such assets stood in the Company's books at less than their true value; (6) any
unrealised profit arising from an- estimated increase in the value of any capital

452

Auditing; Principles and Procedures

asset.
Until 1906 the balance sheets of the company contained an item of 140,000 for goodwill.
Between 1906 and 1917 various amounts were written off out of profits, and in 1917 the
goodwill had been written down to 51,000. In the meantime a reserve fund of 61,000 had been
built up out of profits, and in 1917 the goodwill account was eliminated from the balance sheet
by writing it off against the reserve fund, which was thus reduced to 10,000, the goodwill
disappearing altogether from the assets side of the balance sheet. In 1920 the reserve fund
amounted to 25,000, and there was also a sum of 33,000 balance of profits brought forward from
the previous year. The company then capitalised the reserve fund and 15,000 of the balance of
profits by issuing 4*0,000 1 bonus ordinary shares. In the two following years the company
made a loss of 20,060, and the debit balance of profit and loss account at 31st December, 1922,
was 20j504. In 1923 the company made a profit of 13,000. The preference dividends for'lB21,
1922 and 1923 were unpaid, and the directors, in their report for 1923, first pointed out that a
sum of 180,000 which might have been distributed in dividends had been retained in the business
by writing off the sum of 140,000 at which the goodwill had stood-originally in the balance
sheet, and by the issue in 1920 of 40,000 bonus 1 shares, and then recommended that the three
years' arrears of preference dividends up to 31st December, 1923, should be paid out of the
current year's profits, and that the debit balance of 20,504 should be carried to a suspense
account, and written off against a reserve of 40,000 to be created by writing to bank to reserve
40,000 out of the profits previously applied in writing off part of the goodwill.
As regards the first part ofthe motion, Russell, J., pointed out that it in no way depended on
the question of restoring the goodwill as an asset in the balance sheet and writing back profits to
reserve. The sole question was whether profit and loss was to be treated as a continuous account,
so that no dividend could be declared out of one year's profits until any debit to profit and loss in
respect of prior years had been made good. His lordship said that his point was covered by the
decision in Ammonia Soda Co. Ltd vs. Chamberlain (1918) 1 Ch. 226, and he, therefore, refused
to grant the injunction.
In dealing with the second part of the motion his lordship said that the point was not
covered by direct authority, had the company retained goodwill as an asset in. the balance*sheet,
and, instead of writing off its value out of profits, had carried those profits to a goodwill
depreciation reserved fund, it would have distributed those profits at any time to the extent by
which the amount of the reserve -fund exceeds the amount of actual depreciation. It was admitted
that the value of the goodwill was at least 40,000 and if, therefore, there had been 40,000 to the
credit of that reserve fund, the company could have distributed 40,000 of that reserve as profits.
The question was whether it made any difference that the company, instead of placing its profits
to reserve, had purported to apply them in writing off a corresponding amount of the value ofthe
goodwill. The answer to that Question

453

Auditing: Principles ami Procedures

depended on whether the company had finally and unreservedly capitalised those profits so as to
disentitle itself for ever from restoring them to reserve and treating them as profits. The accounts
which showed the particular method adopted had been approved each year by the shareholders at
the annual general meetings, but his lordship said that he was not satisfied that the shareholders
had thereby intended to bind themselves for all time to give up their claim to those profits, and to
treat them as capital only. In his opinion the shareholders might, if they thought fit, write back to
the profit account the 40,000 which was admitted to be the amount by which the depreciation
written off goodwill exceeded the proper requirements. There was no provision in the Companies
(Consolidation) Act, 1908, or in the constitution of the company, to prevent this course, which
was furthermore not prejudicial to creditors.
He, therefore, refused to grant this injunction also. The question raised in (2) [6) of the
motion did not fall for decision. . . .

Transfer to reserves
If the directors are authorised by the articles to make reserves, the profits available for
dividends are the profits remaining after such reserves have been set aside. Even if no such
power is contained in the articles, it has been held that the directors have the right to carry a part
of the profit to the next year and the shareholders cannot compel them to divide whole of the
profit (Burland vs. Earle, 1902).
The articles of association of a company must be seen to ascertain whether such a provision
exists or not.

Profit prior 1o incorporation

Legally the shareholders have no right to share such profits as were made by the company
at a time when it had not come into existence. Therefore, distribution of dividends out of profits
prior to incorporation is illegal. However, profits prior to incorporation are always available for
distribution in the form of bonus shares.
The profits made prior to incorporation are not available for distribution in the
form of dividends, for to distribute them to the shareholders would really amount to
apaymentof dividends out of capital, it being presumed that the equivalent of such
has beep paid to the vendor as part of the purchase price.
..
. _ .,
Where the vendor is entitled to interest on the purchase price until such time as it is actually
paid; such interest should be a first charge on theprofits earned prior to incorporation. The
balance of the profits should then be transferred to a capitalreserve or be used for writing off
depreciation of fixed assets purchased by the company or for reducing the value of goodwill.
... Strictly speaking, profits made prior to incorporation must be.ascertained by taking stock
and by preparing the final accounts on the date of incorporation. But .since this method is very
inconvenient, they are calculated apportioning the profits

 Auditing: Principles and Procedures

454

of the first trading year between the pre-incorporation and post-incorporation period either
according to time or according to turnover. Where profits accrue more or less evenly throughout
the year, the time basis of apportionment is quite suitable, but in the case of fluctuating sales the
apportionment should be based on the turnover.
For example, a company incorporated on 15th February, 1966 takes over a business as from
1st January, 1965. The profits for the first years are Rs.60,000; the turnover from 1st January to
15th February, 1966, is Rs.75,000 and that for the remainder of the year is Rs.6,00,000; on the
basis of time the pre-incorporation profit is 3/24 of Rs.56,00,000 or Rs.7,500, but on the basis of
turnover it would be Rs.6,667 i,e, 75,000/ 6,76,000 of Rs.60,000.
. The appointment based entirely on time or on turnover cannot give an accurate result.
Therefore, whenever sufficient information is available, a combination of both time and turnover
should be used, whereby the gross profit for the year is apportioned between the two periods
according to turnover and the expenses on the basis of time or turnover whichever is more
appropriate according to the nature of the expenses. The reason for this differential treatment lies
in the fact that gross profit varies directly with the turnover, while expenses vary according to
other circumstances irrespective of the turnover in those periods. The items in the Profit and Loss
Account Should then be apportioned according to the' rules 6s mentioned below:

(1)

Items such as directors' fees, auditors' fees, debentui-e interest, managing

agents' remuneration, etc., which relate solely to the post-incorporation period must be
charged thereto.
(2) Items such as partners' salaries, interest on capital, etc., which are applicable to
the pre-incorporation period, should be charged to that period.
(3) The remaining expenses are divided into two classes, namely, those that vary
according to time and those that vary with the turnover. These should then be charged
to the two periods on an appropriate basis.

(4)

Should there by any expenses of a seasonal nature, these should be charged to

the period in which they have been incurred.
The balance of the profit earned prior to incorporation may be utilised in writing off
goodwill, or, if there be no goodwill, in writing off the fictitious e.g., preliminary expenses,
underwriting commission brokerage on shares, discount on share and debentures etc., or may be
carried forward as Capital Reserve not available for dividend.
The auditor should carefully consider the above guiding rule at the time of vouching and
verifying the pre- and post-incorporation profits of a company.

Divisible Profit

455

Capital Losses
Notwithstanding any Capital Loss, dividend may be paid out of current profits. Therefore,
it is not necessary to take into account the capital losses while deternuning the profits available
for distribution to shareholders. However, if it is proposed to pay a dividend out of realised
capital profits, capital losses must be made good.

(1) Cox vs. Edinburgh and District Tramway Co, Ltd The company had switched over its
system from horse to cable traction and in this process had incurred a heavy loss of capital. The
court decided that such loss need not be made good before declaring dividends out of current
working profits.
(2) Verner vs. General & Commercial Investment Trust Ltd The company was
established to acquire and hold investments and its holdings had in the subject of depreciation but
it had an excess of current income over the current expenditure out of which it was proposed to
pay a dividend, while ignoring the depreciation of investments. The Court of Appeal decided that
it was not necessary for the company to make good the loss of capital before paying the dividend.
REVALUATION OF FIXED ASSETS AND THE AUDITOR
Section 235 of the Ordinance deals with the treatment of surplus arising out of revaluation
of fixed assets. Salient features ofthe above section are given below:

1. Where a company revalues its fixed assets, the increase in, or sums added by writing up
of, the value of such assets as appearing in the books of accounts of the company shall be
transferred to an account to be called "Surplus on Revaluation of Fixed Account" and shown in
the balance sheet of the company after capital and reserves.
2. Except and to the extent actually realised on disposal ofthe assets which are revalued,
the surplus on revaluation of fixed assets shall not be applied to set off or reduce any deficit or
loss, whether past, current or future, or in any manner applied, adjusted or treated so as to add to
the income, profit or surplus of the-company, or utilised directly or indirectly by way of dividend
or bonus:
Provided that the surplus on revaluation of fixed assets may be applied by the company in
setting off or in diminution of any deficit arising from the revaluation of any other fixed
asset of the company.

3. The requirements of sub-sections (1) and (2) shall also apply to any amount representing
any increase in or addition to the value of any asset as a result of any revaluation of any fixed
assets done before the commencement of this Ordinance, howsoever described, to the extent of
the amount thereof appearing in the books of account ofthe company on such commencement.

456

Auditing: Principles and Procedures

3. After revaluation as aforesaid, depreciation on the assets so revalued shall be provided

with reference to the value assigned to such assets on revaluation.
4. If default is made in complying with any requirements of this action, the directors of the
company who are knowingly and wilfully in default shall be punishable with fine not exceeding
twenty thousand rupees and shall also be jointly and severally liable to the company for any loss
sustained by the company on account of such default.
SECRET RESERVE AND AUDITOR
() A secret reserve is a reserve the existence of which is concealed from the
balance sheet. That is to say, there is a Surplus of assets over capital and liabilities
and that surplus is not disclosed. When there is a secret reserve, the actual Financial
position of the business is better than what is shown by its balance sheet.
The existence of a secret reserve is justified in the case of companies particularly banks,
insurance companies and other financial institutions, which depend for their success on public
confidence. Theoretically perhaps secret reserves may not be defended as the function of the
balance sheet is to show' the true financial position ofthe company; but in practice the necessities
of modem business demand the exercise of reasonable prudence on the part of those responsible
for the management of companies.
In some instance the existence of a secret reserve may be quite apparent from the balance
sheet, although not specifically disclosed upon it. This will be the case where a valuable assets
appears in the balance sheet at a nominal value.
() A secret reserve may be created: (i) by providing too much depreciation on
fixed assets or by writing down an assets altogether; (ii) by undervaluing floating
assets such as stores, stocks or investments; (Hi) by making excessive provision for
bad debts, outstanding liabilities and contingencies; (iv) by overstating liabilities; or
( v ) by charging capital expenditure to revenue.
(c) The existence of secret reserves is beneficial to the company and its members, because:
(i) they are a source of strength to the company and enable it in times of depression to preserve
its credit and maintain dividends and so to avoid violent fluctuations in the market prices of its
shares; and (ii) profit can be concealed from trade rivals thereby promoting the interests of the
company.
On the other hand, secret reserves are open to objection on the ground that (i) the published
accounts ofthe company become misleading and the shareholders and the public cannot obtain
therefrom a full knowledge of its affairs; in) losses arising out of bad management may be
concealed from shareholders; and (iii) improper practices on the part of directors and managing
agents of a company are made possible, e.g., manipulation of profits for the sake of fraudulent
dealings in shares.

457

Auditing: Principle} and Procedures

id) The auditor's duty in connection with secret reserves is a difficult one, and the Royal
Mail Steam Packet Company case decided in 1931 has thrown upon him a greater responsibility
in this respect. Where secret reserves exist, the auditor should thoroughly examine the whole
question and refer to the company's articles to ascertain that the directors have the power to.
make reserves. If he is satisfied that the existence of a secret reserve is necessary in the interest
of the company, that it is being utilised properly for the benefit of the company as a whole, and
that amount involved is not considerable, he may not report oti its existence.
But if secret reserves are not justified by the nature of the company's business or they are
being improperly used by the management or they being drawn upon for paying dividends or for
meeting losses without disclosing the fact in the published accounts, it is his obvious duty to
report the matter in detail to the shareholders.

SINKING FUND
A Sinking Fund is a reserve created out of profits and usually invested outside the business
in readily marketable securities and shares. The object is to establish this fund for providing
definite Periodic sum at a definite date for the purpose of repayment of liability or replacing a
wasting assets.
Accumulated Sinking Fund grows each year with the aid of periodical contribution and
interest. It is built up by setting aside a Certain yearly and half yearly instalments out of profit
and by investing it at compound interest outside the business in order to produce a required sum
at the end of a given period.
When money is needed for repaying the liability or replacing the assets, the investments are
sold out and out ofthe sale proceeds, the liability is repaid or the new. asset is purchased. This
amount cannot be used for paying a dividend to shareholders.

LIABILITIES
AUDITOR

OF

AN

LIABILITY OF AN AUDITOR APPOINTED BY A

PRIVATE CONCERN
The auditor must oMain instructions in writing from, his client in the case of a private
concern relating to the scope of his duties so that he may not be held responsible for work which
he never undertook to perform. If the auditor does not faithfully comply with the instructions
and performs his work in a manner so as to result in negligence and consequential loss to the
client, he may be held responsible for it. If he fails to perform his duties as laid down in the
agreement whieh was entered into between him and his client, he may be sued under the
Contract Act, 1872.

AUDITORS' LIABILITY FOR NEGLIGENCE

An auditor to a limited company is an agent of the shareholders. He is required to exercise
reasonable care and skill in the performance ofthe work entitled to him, and if he fails to do, then
the question of his liability with reference to the negligence arises. This matter is discussed in
the light of legal provisions as under:
(1) Where an auditor is proved to be negligent but no loss is sustained by his
client arising put of his negligence, he is not liable. This thought has the
support of judicial pronouncement given in the case of Liverpool and
Wigan Supply Association Ltd, 1907.
(2) An auditor cannot restrict his liability by entering into an agreement as
. his duties are defined and laid down in the Companies Ordinance, 1984,
: and therefore any such agreement (if executed) would be against the law
and will be void. He will be liable for damages in spite of such an agreement, as was
held in the case of Newton vs. Birmingham Small Arms Co. Ltd, in 1906.
(3) An indemnity clause inserted in the articles of a company, by which the
directors, managing agents, auditors and other officers of the company are

Liabilities ofan Auditor

relieved from liability has been declared void by Section 194. However, the court may
relieve an auditor of liability for negligence, or misfeasance if it is proved that he
acted honestly and reasonably.
?4) If the auditor fails to perform his job with reasonable care and skill and consequently
his client suffers a loss due to his negligence, he is liable to make good the loss on an
action being taken against him by the company .
(5). Action against the auditor for negligence can be taken any time during the life-time of
the company Some of the leading decided cases in which the auditor has been held
liable for damages on account of negligence are:

1. Newton vs. Birmingham Small Arms Co. Ltd. (1906). The defendant company passed
special resolution to alter the company's articles of association whereby the auditors of the
company were authorised to examine the . internal reserves and to see that the disclosure of such
reserves was prohibited to be indicated to the shareholders,
It was held that provisions in the Articles of the company limiting the powers of the
auditors were ultra vires.

2. Armitage vs. Brewer and Knott (1932). The facts of the case are that Miss Harwood, the
book-keeper, had embezzled a large sum of money by manipulating the wages sheets. She was in
charge of the books, vouchers, wages sheets and other documents. There was no system of
internal check. The auditors were appointed to conduct a continuous and a detailed audit. The
charge against them was that they failed to exercise reasonable care and skill in the course of
examination of documents, e.g., wages sheets, that is, they failed to vouch and verify book
entries. The auditors put forth the defence that the frauds could not have been detected by the
exercise of ordinary and reasonable care.
The case was decided in favour- of the plaintiff and the auditors were ordered to pay
damages amounting to 1,259 to the plaintiff.

3. Arthur E. Green and Co. vs. The Central Advance and Discount Corporation Ltd.
(1920). The firm of auditors (Plaintiffs) claimed their fees due to them by the defendants. There
was a counter suit by the defendants, a money lending company, claiming damages from their
auditors in not providing sufficie*nt amount for bad and doubtful debts and consequently
inflating profits whereby more commission on profit was paid to the manager. Furthermore,
some of ihe debts were time-barred, and the auditors did not point out this to the 'hareholdeis.
The defendants, thus, contended that the auditors were negligent in the performance of their duty
and therefore liable for damages.
The plaintiffs' plea was that although some of the debts were time-barred, they did not point
out this fact as from past experience they found that the customers did pay the time-barred debts.
It was held that the auditors were negligent in the performance of their duty in not pointing
out to the shareholders regarding the insufficient provision for bad and

459

460

Auditing: Principles and Procedures

doubtful debts..
4. Leeds Estate Building and Investments Co. vs. Shepherd (1887). The articles of association
of the company provided that, the directors were to be paid bonuses in proportion to the dividends
paid and that both dividends and bonuses were to be paid out of'profits. The articles further:
provided that the auditor of the company was to state whether in his opinion the balance sheet was
a full and fair balance sheet, properly drawn up so as to exhibit a true and correct view of the state
of the company's affairs.
. The company (established in 1862) made no profit except in the year 1876, and went into
liquidation. During the course of liquidation proceedings, it was discovered that the company had
made no profits, and that by including fictitious items, it was shown that the company had made
profits and therefore dividends were declared and bonuses paid. The articles of the company were
not shown to the auditor.
. The auditor was sued for damages. The defence put forth by the auditor was that he was
unaware of the existence ofthe Articles of Association and that the actions was time-barred by the
Law of Limitation.
It. was argued by the liquidator that the'auditor was negligent in the performance of his
duties. Had he referred to the Articles, he Could have seen that the directors were to be paid bonus
in. proportion to the dividends paid. In this case there were no profits and hence no dividends or
bonuses to directors could be paid. Moreover, the balance sheet did not exhibit a true and correct
view of the state of the company's affairs.
It was held that the auditor was liable to pay damages. He ought to haye seen what
exceptional duties were cast upon him. Ignorance of the provisions of the Articles was no excuse
to relieve him of any responsibility. In regard to the plea of Law of Limitation, relief was given to
some extent.
<5. London Oil Storage Co. vs. Seear, Hasluck & Co. (1904). The auditors failed to verify
petty cash in hand which amounted to. 796, but actually only 30 were physically in hand. The
clerk of the auditor compared the petty cash with the accounts where it was shown as 796, but he
failed to verify the actual petty cash in hand, andvdifference of 766 had been misappropriated.
It was argued on behalf of the company that had the auditor verified the petty cash in hand,
the fraud would have been detected.
The defence put forth by the auditor was that it was mainly due to the negligence on the part of the
directors by keeping such large sums of money with the petty, cashier and in not checking the
petty cash book from time to time that the : fraud had been committed and, therefore, the directors
were responsible for the damage and not the auditors.

Liabilities ofan Auditor

Lord Alverstone, C. J., while delivering judgment held that it was not valid argument to say
that the directors were guilty of negligence and hence the auditors were free from their liahility.
His Lordship said that by omitting to verify petty cash in hand, the auditors committed a breach
of duty and hence were liable to pay damages. But only nominal damages of five guinea as were
awarded as the directors were considered to be also guilty of gross negligence and were a
contributory cause of the loss.
6 Irish Woollen Co. vs. Tyson and others (1900). In this case, the accounts of the
company had been manipulated and falsified in the foUowing respects:

(a) The stock had been over-valued;

(b) The book debts had been over-valued; and
(c) The trade liabilities had been understood by suppressing the purchase invoices
and carrying them to the following period while intruding the goods in the stock of the
current year.
As a result of the above, profits were over-stated and dividends were paid out of capital.
The auditor had entrusted the work of audit to his assistant and he himself did
very little work.
It was argued by the company that on account of the negligence on the part of the auditor,
fraud had been committed. It was stated:
(a) had the auditor taken care that the stock was properly valued;
(o) had the auditor seen that sufficient provision was made for bad and doubtful debts;

(c) had the auditor himself done the major part of audit work; and
(d) had the auditor Sent for statements of accounts from the creditors.
the fraud would have been discovered. It
was said in the judgment:

(a) It was no part of the duty of an auditor to take stock unless there was something to
arouse his suspicion as was heldin the Kingston Cotton Mills case;

(b) there was no ground for alleging negligence against the auditor;
(c) it was considered that an auditor was entitled to get the work done by his assistant;
(d)

and
it was held that the auditor was negligent in the performance of his duties in not
getting statements of accounts from the creditors. Had he done so, the fraud would
have been discovered.
On the last score, the auditor was held guilty and was asked to pay damages.

461

Liabilities of an Auditor

462

7. In Re S.P. Catterson & Sons Ltd. (1937, 81 Acct L.R.62) where considerable defalcations
by a servant of the company had not been revealed, by the audit, the auditors were acquitted of
liability for negligence on the ground that they had pointed out to the directors that the system of
recording certain sales was unsatisfactory, and had recommended improvements, but these
recommendations were not adopted. Mr, Justice Bennett, in reviewing the responsibility of the
auditors, stated that the primary responsibility for the accounts of a company is with the directors
and in this case they were not a satisfactory team. He stated, "I have no doubt as to where the
primary responsibility for finding out the defalcations of this man spicer lies. It lies upon the
shoulders of the man whose duty it was as a director of this company to collect from spacer the
cash that he received. If that man had done his duty in any degree at all, the frauds could not
have been perpetrated in the way in which they were perpetrated." He came to the conclusion
that the auditor was an honest man trying to do his duty, and that in view of all facts of the case
and the audit notes, the applicant had quite failed to satisfy him that there was any negligence in
respect of the matters charged.

AUDITORS' LIABILITY FOR MISFEASANCE

After a company has gone into liquidation, misfeasance proceedings can be instituted
against the auditor by:

(1) The hquidator, or

(2) The creditor, or
(3) A contributory of the company.
The term 'misfeasa..ce' means breach of duty involving the company in a loss. Under
Section 412, when a company is in liquidation, its past and present directors, promoters,
managing agents and auditors are liable to make good all losses sustained by the company on
account of negligence of duty or breach of trust if misfeasance proceedings are initiated against
him within the prescribed time. Some of the leading decided cases in this respect are explained
below:
1. City Equitable Fire Insurance Co. Ltd. (1924), - In this case the Official Receiver as
liquidator4 sued the directors and auditors in respect of alleged misfeasance.
The following claims were made against the auditors:

(a)

That in the balance sheets sums due from Ellis & Co. (Stock-brokers) and
Mansell (the company's General Manager) were misdescribed by being included under
"Loans at call or short notice Loans." Part of the debt of Ellis & Co. was described as
"Cash at bank and in hand."
(b) That in fact the sums actually due from Ellis & Co. were larger than were so
included.

Auditing: Principles and Procedures

(e) That some ofthe company's securities were in the custody of Ellis & Co., and the
auditors failed to detect and report to the shareholders that these had been pledged by
that firm to third parties.
In the Court of Appeal Mr. Justice Romer's judgment was upheld. Lord Justice Sargant
described the duty of an Auditor as "verification and not detection."
Lord Justice Warrington said: "The duty of an Auditor is to verify the facts which it is
proposed to state in the balance sheet and to verify them using ordinary and reasonable care and
skill."
As a matter of fact, the auditors were protected by an Article of the company indemnifying
the directors, auditors and officers of the company against damages incurred in carrying out their
duties unless incurred by wilful neglect.

2. London and General Bank Ltd (1895). Held that an: Auditor is guilty of misfeasance
who, whendissatisfied with the accounts of a company, does not plainly draw attention to the
grounds for his dissatisfaction in his report.
This was an appeal by one of the auditors against a judgment by Vaughan Williams by
which the auditors were declared liable for the payment by the company of certain dividends out
of capital, it having been decided by the Court of Appeal in the previous action in connection
with this hquidation that the auditor of a limited company is an officer of the company and
therefore liable for misfeasance proceedings. The auditor had neglected to' bring-to the notice of
the shareholders that the assets shown in the balance sheet of the company were over-valued
leading to a payment of dividends out of capital.
The auditor was ordered to pay the amount of a dividend, wrongfully paid, with interest.

3. The Kingston Cotton Mills Company Ltd. (1896). The facts ofthe case are that the
accounts of the company had been falsified by its manager by overvaluation of stock-in-trade for
a number of years and thus profits were inflated and consequently dividend was paid out of
capital.
The auditor of the company was charged of negligence for having relied upon stock sheets
are prepared by the officers of the company, which were signed by the manager of the company.
The contention of the auditor was that there was nothing to arouse his suspicion and that he
relied upon, the stock sheets which were signed by a reasonable official ofthe company viz., the
manager. He further pleaded that while he signed the balance sheet he put the remark "as per
manager's certificate".
It was held that it was no part of the auditor's duty to take stock and that in the absence of
suspicious circumstances he could not be regarded guilty of negligence for having accepted the
certificates of responsible official of the company.

Liabilities ofanAuditor

464

4, Republic of Bolivia Exploration Syndicate Ltd (1913). The company was incorporated
in March, 1907, and had no special Articles of its own and, therefore, Table A ofthe Companies
Act applied. Thus the directors had no power to enter into contract with the company but they did
so and payments were made to them by the -company under these contracts^ The company went
into liquidation and the liquidator took out summons against the auditors for having committed
negligence or misfeasance or breach of trust for having certified certain payments in respect of
commission and profit-Costs which payments were alleged to be ultra vires. The alleged wrongful
payments were as under;
(a) Payment for commission (not to a director) for placing shares, for 338.10s.
(i)) Payment of profit-costs to a Solicitor-Director for 160.
(c) Payment to a director not accounted for by him amounted to 36.
As regards (a), the auditor did not point out such a payment in his report ofthe fust year, but
with regard to the balance sheet of the second year he stated "Cc^nnnssion paid for obtaining
subscribed for shares, 338.10s." But no qualification was appended to the auditor's certificate.
No question regarding the payment was raised in the first meeting. In the second meeting an
objection was raised to such a payment. The auditor admitted that the Companies Act did not
permit such a payment but the memorandum of company so and the matter was not pursued any
further by the shareholders.
^5. Westminster Road Construction and Engineering Co. Ltd (1932). The auditors did not
point out to the Shareholders that the work in progress was a overstated and the liabilities were
understated. Hence profit shown as 3,458 while actually they amounted to 297. Therefore the
dividend was paid out of the capital.
It was held that the duty of the auditor was to see that no invoice pertaining to the period
under review was omitted. If he did not do so, he failed to perform his duty and was, therefore,,
guilty of misfeasance.
In regard to the valuation of "Work-in-progress" it was held that the duty of the auditor was
"to check the figures at which work-in-progress was brought into balance sheet."
The auditors were found guilty of misfeasance and were ordered to refund the amount of
dividend with interest to the company.

CRIMINAL LIABILITIES AND AUDITOR

An auditor may be guilty of a criminal offence under the following sections the summary
of which follows:

465

Auditing: Principles and Procedures

Section
Extent of Liability
270 As the result of a public prosecution initiated, an auditor may be held criminally liable.
260 An auditor may be liable to a fine up to Rupees 2,000 if his report does not comply
with the requirements of Sections 167, 255 and 257.
If the auditor's report is made with the intent to profit such auditor or any other
person or to put another person to a disadvantage or loss or for a material
consideration, the auditor shall, in addition to the penalty provided be punishable
with imprisonment for a term which may extend to six months and with fine
which may extend to Rs.2,000.
417
If a charge of falsification of accounts or forgery is brought against an
auditor, he may be liable to imprisonment for a term which may
extend to two years or also to a fine which may extend to Rs.20,000, or with
both.
418
An auditor may be prosecuted if it is proved that he has been guilty of
any criminal offence in relation to the company.
492 If an auditor makes a false statement in any report, certificate, balance sheet etc.,
knowing it to be false he is liable to imprisonment for a term which may extend
to three years and also to a fine not exceeding Rs.20,000.
Rex vs. Kylsant (1931) or the Royal Mail Steam Packet Company is in respect of criminal
liability and is more commonly known as Royal Mail Steam Packet Company case.
The facts of the case are that the company created excessive secret reserves in boom years
under the heading "Taxation Reserves" and such reserves were not shown on the face of the
balance sheet. Subsequently the company suffered heavy losses for several years, and during
these years the losses were concealed and instead it was shown as if the company had made
profit by utilising the secret reserves. Thus the shareholders were made to believe that the
company was rurming profitably,
. The Chairman of the Company, Lord Kylsant, and the auditor, Mr. Moreland, were
criminally prosecuted on the ground that the Chairman issued false annual reports with the
intention of deceiving the shareholders and that the auditor of the company aided and abetted in
the issue of false reports and accounts.
The company was, in fact, running at losses for the past several years. The accounts were
manipulated to show considerable profits. During the years from 1921 to 1927, the profit and
loss account was credited with 5,00,000 after adjustment of "Taxation Reserve", which they
showed had been accumulated in the past and which they did not require. These "Taxation
Reserves" were actually Secret Reserves which had not been shown in the books of accounts.

466

A uditing: Principles and Procedures

The contention of the auditor was that the auditor need not disclose the fact that the Secret
Reserves had been utilised in order to augment the profit of the lean years, and that if he did so
the object of creating secret reserves would be frustrated. It was further argued that as a matter of
fact secret reserve is created to fall upon in lean years, especially in banking, financial and
insurance companies where there is the question of public confidence. Hence, if the auditor did
not disclose the fact that secret reserve was being utilised to augment the profit, he was not .
guilty of a criminal offence. But now it is a settled fact that if Secret Reserves are utilised, such a
fact must be disclosed.
The position of the auditor relating to the secret reserve is very delicate. If he does not
disclose the fact that secret reserve has been utilised to augment profits, he will be guilty of
issuing a false statement or certifying an incorrect balance sheet. On the other hand, if he
discloses the fact, the object of creating secret reserve is frustrated.
In this case the accused were acquitted in the criminal case against them. However, the
auditor who had committed a breach of duty in connection with the accounts of the company
was made liable under civil liabilities to pay damages for the dividends which were paid out of
capital. The lesson drawn from this case is that if excessive reserve is created or where there is a
suspicion that such a reserve will be improperly utilised it would be the same way, if excessive
amount is drawn upon such reserve to conceal losses, the shareholders must be informed of the
fact. Of course, each case will have to be considered on its own merits.

AUDITORS' LIABILITY FOR LIBEL

At times it so happens that an auditor in the course of his duties and in his audit report finds
it necessary to criticise the actions of officers of a company or the other undertaking, he should
submit his report in a manner which may not result in exposing him to action on grounds of
defamation.
The audit report is considered as a privileged document. It is not likely to result in Hability
for libel, provided the following ingredients are in it:
(1) It does not misstate facts.
(21 It is not actuated by malice.
(3) It does not go beyond what is relevant to its subject.
(4) The statement made is bona fide.
The following two cases are of interest in this connection;
1. Lawless vs. The Anglo-Egyptian Cotton and Oil Co. Ltd (1869). The plaintiff worked- as
a manager of the factories of the company and the auditors of the company appended to their
report the following statement:

Liabilities ofan Auditor

467

"The shareholders will observe that there is a charge for 1,306 for . deficiency of stock
for which the manager is responsible. His accounts have been badly kept, and have
been rendered to us very irregularity."
The directors after getting the said audit report printed, circulated it to the shareholders. The
plaintiff brought an action for libel against the company. It was found that there was no evidence
of malice for the Jury.
2. Weld Blundel vs. Stephens (1920). The plaintiff claimed damages against the defendant
for breach of duty or negligence in the performance of his duty in the capacity of accountant or
auditor. In the course of certain investigations by the defendant into the affairs of a company in
which Mr. Weld Blundell was interested, the latter wrote a letter of instruction which contained
defamatory matter relating to two individuals connected with the management ofthe company.
The contents of the letter came to the knowledge of the individuals concerned apparently owing
to the letter having been taken to the offices, of the company by the partner of Mr. Stephens and
lost there. A libel action was brought by the individuals named in the letter against Mr. Weld.
Blundell, the client, and the action cost the latter 1,689 in damages and costs. The-client then
brought an action against the accountant, and the jury in "the lower court returned a verdict in
favour of Mr. Weld Blundell, awarding him 650 damages. It was said that the letter out of which
the action arose was written and published on a privileged occasion but the jury found that it was
written and published with malice in the legal sense. They also found that the defendant
neglected his duty in regard thereto. In the King's Bench Division the decision went in favour of
the defendant, but on appeal the decision was in favour of the plaintiff, with -nominal damages
only; finally, in the House of Lords judgment was in favour of the plaintiff, was damages of 650
and costs.

AUDITORS' LIABILITY IN DUAL APPOINTMENTS

When two auditors are appointed to audit the accounts of a concern and to submit a report
on the accounts, each is jointly and severally liable, unless the contrary is clear from the terms of
the appointment.

LIABILITY OF AN HONORARY AUDITOR

An honorary auditor cannot relieve himself of liability on the plea that the agreement
between him and his client was not supported by consideration and hence it was. void. It is
generally believed in the profession that if he wishes to relieve himself of the liability, he should
not commence the work.

468

A uditing: Principles and Procedures

LIABILITY OF AN AUDITOR TO THIRD PARTIES

Another aspect of studying the concept of liability in relation to auditor is whether an
auditor can be held liable for damages to third parties, if they have suffered any loss by relying
on any balance sheet or any statement signed by him. The audited accounts- are being generally
relied upon by tax authorities while passing assessment order, by banks while advancing loans,
by insurance companies while settling claims etc. The foregoing authorities rely on the
information conveyed to them, through the^ figures of audited balance sheet and profit and loss
account. The question is whether the auditor is liable if the third parties rely on the audited
statements and suffer a loss.
It is generally argued that there is no privity of contract between the auditor and the third
parties and therefore he cannot be held liable. It is contended that he is never appointed by the
third parties and consequently he has nothing to do with them.
The following leading cases will present, an interesting reading in this matter:

.. 1. Candler vs. Crane, Christmas and Co. (1951). It was judiciously established that the
auditor owed no duty of care to anybody but his client, and he cannot be held responsible for any
loss suffered by third parties through reliance on accounts which have been audited by him even
though negligence may be proved.
2.

Be Sauary vs. Holden Howerd and Co. (1960). In this ease, the learned judges have also
approved .and followed the guidelines of case of Candler vs. Crane, Christmas and Co. and it
was held that he owned no duty of care to any third party outside his contractual relationship
existing between those who instruct him to audit the accounts and himself.

3.

Le Lievre and Dennes vs. Gould (1893). If there is no fraud it would appear that an auditor
cannot be held liable in respect of a loss sustained by a third party. The above case was not in
connection with an auditor, but with a negligent surveyor. Extracts from the judgment are quoted
below:
"The question of liability for negligence cannot arise at all until it is established that
the man who has been negligent owed some duty to the person who seeks to make
them liable for his negligence. What duty is there when there is no relation between
the parties by contract? A man is entitled to be as negligent as he pleases towards the
whole world if he owes no duty to them."

4.

Guardian Insurance Co. of Canada vs. Sharpe, Milne and Co. (1941). The facts of the case
were that Claude Neon Co. Ltd., lost money as a result of defalcations of an employee. This was
not discovered by the company's auditor. The company had an insurance policy covering such
losses. The insurance company possessed a "Subrogation Receipt" duly signed on and behalf of
the company. This insurance company sued the auditor, although there was no privity ofthe
contract.

Liabilities of an Auditor

The auditors were not found negligent, and the question whether the insurance company had the
right to claim damages from the auditor was not settled.

5. Ultramares Corporation vs. Touche, Niven and Co. (1931). In the above case, a banker
advanced loan to the company on the strength ofthe audited balance sheet of a company. The
lender lost the money as the balance sheet showed the firm to be financially sound when in fact it
was insolvent. The auditor through negligence had failed to discover falsification and fictitious
debtors. Subsequently the banker sued the auditor for damages. The case was however
compromised. But late Justice Cardozo created the concept that gross negligence resulted in
constructive or technical fraud and if fraud is present, a right of action for damages is open to
anyone who suffered because he relied upon the auditors' report. In order to establish fraud.there
need be no contract between the auditor and the third parties whom the auditor has never seen
and whom he does not know.
6. Derry vs. Peek (1889). It was held that if a third party wanted to hold the auditor liable
for damages in tort, it should prove the following;
(o) That the statement or balance sheet signed by the auditor was materially untrue;
(6) That the auditor knew that the statements etc. were untrue;
(c) That the statements etc. were made with an intent that a third party should act on it;
i d) That the third party did act upon such statement etc., and consequently suffered loss.

7. Hedley Byrne & Co. Ltd vs. Heller and Partners Ltd, (1963). Before entering into a
transaction with X, the plaintiffs sought a reference as to X's standing from X's bankers. The
bankers provided the reference, but stated therein that they accepted no responsibility for its
accuracy. The reference proved to be misleading and the bankers had been negligent. The
plaintiffs suffered loss and sued the bankers for damages for negligence.
The House of Lords held that (1) the bankers could be held liable for negligence contained
in a reference, but (2) the disclaimer of liabihty in the reference exonerated them from liability
on the particular facts of the case.
The principles involved relating to third party liability are summarised below:

1. There has to be negligence on the part of the person preparing the document.
2. The third party must suffer financial loss.
3. The financial loss must arise solely due to the reliance by the third party on the
negligency prepared document.

4. The document must be prepared in full knowledge of the purpose.

469

470

Auditing: Principles and Procedures

Several cases dealing with third party liabilities have been summarised earlier. One of the
recent case is that of Jeb Fasteners Ltd, vs. Marks Bloom & Co. Its most significant aspect is the
finding ofthe existence of a legal duty of care owed by auditors to a stranger at the time of the
audit.
A commentary contributed by Clifford Baxter and published in Accountancy (August 1981,
pp.98-100) is reproduced below:

New Professional Negligence Liability Judgement

If you think you know where the liability for professional negligence of an auditor begins
and ends, perhaps you had better think.again. For the existing, well-understood body of law
(including the MgMy-significant Hedley Byrne case) appears to have been drastically affected by
a recent High Court decision. Mr. Justice Woolf, in the case of Jeb Fasteners Ltd vs. Marks
Bloom & Co., gave a decision substantially extending the hitherto accepted limits of auditor's
liability. It established for the first time in English law the proposition that an auditor can be
liable for the pecuniary loss caused by his careless auditing of a company's accounts to a stranger
of whom he knew nothing at the time of his audit, and in respect of a transaction of which he had
no knowledge.
An accountant seeks legal advice as to his liability in the following circumstances
. . . . . . He recently carried out an audit of a company's accounts in
accordance with the provisions of the Companies Acts, and gave an unqualified report thereon.
Thereafter, a person unknown to the accountant at the time of that audit subsequently relied on
those audited accounts and engaged upon a significant transaction with the company (taking the
form of extending credit facilities to it, or making a substantial investment in it, or even acquiring
its entire share capital). At the time of the audit, the accountant had no knowledge that his
accounts and report would be relied on for this purpose.
That stranger now complains that the accounts did not give a : true and fair view ofthe state
of the company's financial affairs, and were negligently prepared. As a result, he has suffered a
substantial pecuniary loss, for which it is alleged that the accountant is liable in negligence.
The accountant acknowledges to his legal adviser that there was a lack of care on his part in
carrying out the audit, and that his financial statements did present a misleading picture as to the
state of the company. (This want of care may have taken the form of an omission of sales and
purchases, an incorrect valuation of stock, of fairing to pursue an enquiry after being put on
notice by observed discrepancies as to the company's assets; or of failing to discover that a
substantial payment to the company, recorded in the books as being in respect of a completed
contract was, in fact, an advance payment in respect of a series of contracts which the company
was obliged to perform and which had not yet even begun.)
The facts postulated above represent the essence of those cases which have come before the
courts concerning accountants' liability to third partiee unidentified

Liabilities of an Auditor

and unknown to the auditor at the time of audit. There have been such cases in England,
America, Canada and New Zealand, and they will be mentioned in the course of argument below.
On the basis of such authorities, the legal advice which the, above-mentioned (hypothetical)
negligent accountant would have received up to the end of 1980 (and prior to the High Court
decision which prompted this article) would have been a source of comfort to both him and his
professional indemnity insurer. That advice would have indicated that it is a basic principle of
English law that the mere fact that a man is injured by another's negligent act does not, of itself,
give the injured person a cause of action against, the wrongdoer, and it is an essential preliminary
to maintaining an action in negligence for the plaintiff to show that he was owed a duty of
care.by the defendant.
Although the leading duty of care case, Donoghue vs. Stevenson [1932] AC562 based the
existence of such a duty on the test of reasonable foresight, this has not been applied to negligent
auditors. For social policy reasons, and in particular the fear of placing an unlimited liability on
accountants and encouraging a multiplicity of actions against them, the courts of England and
other English-speaking jurisdictions have sought to restrict those to whom a negligent accountant
is liable.
The origin of this social utility rationale (an expression applied in American cases) derives
from the famous American judgement of Chief Justice Cardozo in Ultramares vs. Touche [1931]
174 NE 441: 'If Lability for negligence exists, a thoughtless slip or blunder, the failure to detect a
theft or forgery beneath the cover of deceptive entries may expose accountants to a liability in an
indeterminate amount for an indeterminate time to an indeterminate class. The hazards of a
business conducted on these terms are so extreme as to enkindle doubt whether a flaw may not
exist in the impliaation of a duty that exposes to these consequences. '
, Consequently, in this" case, an accountant who had negligently prepared and certified a
balance sheet was held not liable to a stranger unidentified at the time of the audit, and whose
purpose in relying on the accounts was likewise unknown. The English counterpart of the
Ultramares case was Candler vs. Crane Christmas & Co. [1951] 2'KB 164. There, the majority
ofthe Court of Appeal held that the plaintiff's action against a negligent accountant must fail on
the broader proposition (applicable at that time, but since altered see below) that pecuniary
loss, caused by careless misstatements, were not actionable in negligence.
TJenning L.J. (as he then was) dissented from this general proposition holding that
accountants 'owe the duty, of course, to their employer or client, and also I think, to any third
person to whom they themselves show the accounts, or to whom they know their employer is
going to show the accounts so as to induce him to invest money or to take some Other action on
them. I do not think, however, the duty can be extended still further so as to include strangers of
whom they have heard nothing and to whom their employer without their knowledge may choose
to show their accounts. Once the accountants have handed the accounts to their employer, they
are not, as a rule, responsible for what he does with them without their knowledge or consent,' .

471

472

Auditing: Principles and Procedures

The House of Lords, in Hedley Byrne vs. Heller and Partners Ltd [1964] AC
465, overruled the majority decision in the above case, holding that, in some
circumstances, negligent misstatements are actionable. However, their Lordships
specifically declined to base liability on the ordinary Dqnoghue vs. Stevenson
principle of reasonable foresight because of the prospect - of the indeterminate
liability of. defendants, and the multiplicity of actions,. such a course would
engender. In the words of Lord Pearce: 'Words . . . are dangerous and can cause vast
financial damage : . . If the mere hearing or reading of words were held to create
proximity, there might be no limit to the persons to whom the Speaker or writer
would be liable/
..

Narrower test of liability

Thus, such spectres as haunted Cardozo C- J. in the Ultramares case 41 years
previously, led'the House of Lords to consciously make the test of liability for
negligent misstatement. for narrower than that of reasonable foresight, and to
confine that liability' only to those cases where a 'special relationship' exists
between the party making the negligent statement and the party to whom it was
made.

'
The essence of this'concept is that of an assumption of responsibility by the party making the
statement, and reliance on it by the recipient; the party seeking information or advice must have
trusted the other to exercise a degree of Care as; was reasonable and required by the
circumstances, and the party giving the information or advice must have known, or ought to have
known,-that the inquirer = was relying on him. Beyond this, the Law Lords in Hedley Byrne
appeared to take a divergence of views on the scope of the duty of care and such uncertainty
caused the Council of the EnglishTnstitute to take legal advice on the implications of that
decision.
In-summary, that opinion advises that a prerequisite of an auditor's liability is that he must
have known, or ought to have known, that his financial statements were being prepared for the
specific purpose or transaction which ultimately gives rise to the loss. Accountants are riot liable
to third parties to whom negligently-prepared accounts are shown without the accountants'
knowledge.
As such, Lord Denning's formulation of the accountants' liability in the Candler case was
considered to represent the iaw after Hedley Byrne, and this fact is confirmed by several
subsequent decisions. There is little point in reciting the detail of each, since they are broadly
encompassed by the hypothetical problem situation which introduced this article. The most
important of such decisions are the New Zealand cases of Diamond Manufacturing'Ltd vs.
Hamilton [1968] NZLR 609; Scott Group Ltd. vs. McFarlane [1978] 1 NZLR 553; and the
Canadian case of Haig vs. Bamfbrd [1976] 3 WWR 331. Additionally, there is an unreported
English QBD decision of Stocker L.J. in Grover Industrial Holdings vs. Newsman Harris & Co.

Liabilities of an Auditor

The common features of all ofthe above are that:

1.

No duty of care was to be found between the auditor and the party who relied on the
audited accounts in the absence of a special relationship being in existence between
those parties; the party making the statement must have assumed a responsibility to the
plaintiff, and this could only be the case where the auditor knew, or ought to have
known, that his statements would be made available to, and would be relied on by, a
particular person or class of persons for the purpose of a particular transaction.

2.

Conversely, accountants or auditors who certify the accounts of a company are not
under a liability to third parties for negligence in the preparation or certification of
such accounts simply because such third parties fall into the category of persons who
can be foreseen as likely to sustain damage if carelessness exists; no duty of care can
be owed by an auditor to a third party unknown to him at the time of the audit, and
who subsequently relied on the accounts for a purpose uncontemplated at the time of
audit by the auditor.

Drastic revision needed

The legal advice given above must now be drastically revised in the light ofthe decision of
Mr. Justice Woolf in the QBD of the High Court in Jeb Fasteners Ltd, vs. Marks Bloom & Co.
heard on 19 December 1980 but as yet unreported.
In this case, the plaintiff accpiired the entire share capital of a company called B.G.
Fasteners in June 1975. In so doing, he claimed to have relied on the audited accounts of that
company for the year ended 31 October 1974, prepared by the defendant auditors, a firm of
chartered accountants. The plaintiff alleged that such accounts, to which an unqualified certificate
had been given by the defendants, did not give a true and fair view of the state of the company,
and consequently, the. plaintiff had suffered substantial loss and damage as a result of the
purchase of the company.
The court accepted as a fact indeed it was common ground between the parties that at
the time the accounts were audited, the defendants did not know of the plaintiff, or his purpose,
or that a takeover of the company from any source was contemplated. At the outset of his
judgement Mr. Justice Woolf acknowledged that there was no direct English authority on the
question whether a defendant can owe a duty of care to a plaintiff in these circumstances.
It was held that:

1.
2.

A duty of care was owed by the defendant auditors to the plaintiff.

3.

These accounts did not show a true and fair view ofthe company, and were

The plaintiff, in reaching his decision as to the takeover had relied on the nnancial
statements and unqualified report of the defendants.

473

Liabilities ofan Auditor

474

negligently prepared in that some sales and purchases had been omitted there had
been a failure to make provision for interest due on the company's over drawn
account, and there was a valuation of stock at a figure in excess of cost of
approximately 13,500. Consequently, whereas the certified trading and profit and loss
account had shown a net profit of 11, the reality was a loss in excess of 13,000. .
4. Judgement would be given for the defendant auditors, but by reason one of the fact that
on the evidence before the court, the plaintiff would have acted no differently and
would still have gone ahead with the takeover even had the true position of the
accounts been known to him. Thus, on the facts, the defendants' negligence was not
the cause of the plaintiff s loss.
The most significant aspect of the Jeb Fasteners decision is, of course, the finding of the
existence of a legal duty of care owed by auditors to a stranger at the time of the audit, and half
of the judgement is devoted to this one issue.
Mr. Justice Woolf, in so finding, derived, considerable support from a recent House of
Lords authority (not concerning accountants and whose facts bore no relationship to the case in
hand) in Anns vs. Merton Borough Council [1978] AC 728, where it had been held that: (i) to
establish that a duty of care arises in a particular situation, it is not necessary to bring the facts of
that situation within those of already decided cases in which a duty of care has been held to
exist; (II) prima facie, a duty of care arises if, as between defendant and plaintiff, there is a
sufficient relationship of proximity or neighbourhood such that, in the reasonable contemplation
of the former, carelessness on his part may be likely to cause damage to the plaintiff; (Hi ) that
prima facie position will stand unless there are any policy considerations which ought to
negative, reduce or limit the scope ofthe duty, or the class of person to whom it is owed, or the
damages to which a breach of it may give rise.
After citation of a recent authority on solicitors' negligence in Ross vs.
Counters 11979] 3 WLR 605, and the dissenting judgement of Cooke J. in the New
Zealand Court of Appeal case of Scott Group Ltd. vs. McFarlane, supra, Mr. Justice
Woolf went on to consider the liability of auditors; the appropriate test for
establishing whether a duty of care exists.is whether the defendant auditors knew,
or reasonably should have foreseen at the time the accounts were audited, that a
person might rely on those accounts for the purpose of deciding whether or not to
take over the company, and therefore, could suffer loss if the accounts were
inaccurate.
: :
This approach was said to place a h'mit on those entitled to contend that there had been a
breach of a duty owed to them by auditors. First, they must have relied on the accounts; and,
second, they must have done so in circumstances where either the auditors knew that they would,
or ought to have known, that they might so rely.
If the situation was One whereit would not be reasonable for the accounts to be

475

Auditing: Principles and Procedures

relied on, then, in the absence ofthe auditors' express knowledge, the auditor would be under no
duty. In any event, there was a limit to the period for which audited accounts can be relied on.
The longer the period which elapses prior to the accounts being relied on, from the date on
which the auditor gave his certificate, the more difficult it will be to establish that the auditor
ought to have foreseen that his certificate would, in the circumstances', be relied on.

implications for accountants?

That the decision may be expected to cause some concern among the profession there can
be no doubt, since it results in a significantly larger number of potential plaintiffs to whom the
auditor could be liable in damages, if negligent, than hitherto. What the case has done is to free
the law of much of its previous self-imposed restraints, founded on policy considerations, and
which have had the effect of tightly limiting the negligent auditor's liability.
A position has been adopted between two unacceptable extremes. On the one side is the
pure uiiqmilified test of an auditor's liability, based on reasonable foresight; unacceptable
because it was felt to render the auditor vulnerable to an unlimited liability and a multiplicity of
legal actions.
At the other extreme, was a test of liability dependent upon (as in the law prevailing
hitherto) the existence of a 'special.relationship' between the parties, as conceived in Hedley
Byrne; unacceptable because it limits too closely that number of injured persons entitled to bring
an action against the negligent auditor.
The position now is that auditors' liability depends on a qualified test of reasonable
foresight. That is to say, liability in 1981 depends on a principle whereby negligent accountants
owe a duty of care to those who can be foreseen as likely to sustain damage to succeed in his
action, must establish that if carelessness exists, but with the important qualification that any
prospective plaintiff, it was in the circumstances for him to rely on the audited accounts.
Thus, an objective limitation has again been introduced by the courts with the object of
protecting the auditor against an indeterminate liability and a multiplicity of suits, but it is a far
less stringent limitation than existed previously. The reality would seem to be that accountants'
habihty is now significantly advanced to an extent much greater than could ever have been the
case when dependent on the prerequisite of a special relationship being in existence between the
parties.

What are reasonable grounds?

It remains to be seen, as future cases develop the newly cpnstituted principle, what
circumstances do constitute reasonable grounds for reliance on audited accounts but it is
submitted that it would not seem unduly speculative to anticipate the following:
Given that the legislative philosophy of disclosure (which requires the annual

Liabilities of an Auditor

476

return of companies and the financial reports which are a component thereof, to be filed at the
Companies Registry, to be available for public inspection at a nominal fee) is based on the belief
that the public should be given financial iranrmation about companies in which they are
prospective investors or creditors, then it would seem axiomatic, since the Jeb Fasteners
decision, that a negligent auditor will be liable in damages to any member of the public who
carries out the appropriate search at the Registry in order to ascertain the financial position of a
particular company, and in reliance upon recent unqualified accounts found there, pursues a
transaction with that company, sustaining loss as a result.
In those circumstances, the defendant auditors will no longer be able to escape liabihty with
the plea that they did not owe the plaintiff a duty of care since they did not know of his existence
at the time of their audit, or his prospective transaction in relation to the company.
Again, an auditor who is aware of the financial difficulties of the company whose accounts
are being audited, and of the fact that the company is going to need financial support from
outside, will be treated by the courts as being in a position whereby he ought to have realised that
his accounts could be relied on (until such time as a further audit was performed) by the
commercial firms of whom the company would look for financial assistance.
This was the position in the Jeb Fastener case, and the court confirmed that in those
circumstances the fact that the defendant auditor did not then know who precisely would provide
the financial support, or what form that financial support would take, was an insufficient factor
to exclude the duty of care.

AUDITOR A WATCHDOG AND NOT A BLOODHOUND

In the course of judgment Re Kingston Cotton Mi l l Company Limited, Lord Justice Lopes
gave utterance to this phrase 'an auditor is a watchdog and not a bloodhound'. The auditor,
like the watchdog, is employed to protect the interests of those who appointed him. While he
would be entitled to assume that trusted servants of the company were honest, he could only rely
upon their statement provided he took reasonable care and used his normal skill. In adopting the
attitude of watchdog, he would not be exonerated from his responsibilities if he took everything
for granted. He must perform his duties with the normal degree of skill and care. In case of
suspicions he must thorougldy investigate into the matter and assume the role of a detective, also
he is not expected to have a suspicious mind unless the ebrumstances of the case aroused his
suspicions.
However, the law is restricted from imposing upon an auditor responsibilities which the
circumstances of his office would not warrant. He is not likely to be held reliable resulting from
a fraud which could not be uncovered by the application of normal skill and reasonable
examination of the books of accounts produced to him. However, an auditor must not be a
sleeping watchdog.

SPECIAL POINTS IN
DIFFERENT CLASSES OF
AUDITS

BANK

1. Internal Check. Ascertain the adequacy of internal check system. In considering the
efficiency of the system, the auditor should hear in mind the following;
(a) The duties of clerks should be frequently changed.
(fcO No ledger clerk should be permitted to make entries in any book from which ledger
postings are made.
(c) All unusual entries and transfers should be authorised by a responsible official.

2. Banking Companies Ordinance, 1962. Acquaint yourself with the provisions of the
above Ordinance affecting the accounts and audit matters.
3. Attendance at the close of Business. The auditor should attend the bank at the financial
closing date and physically check cash in hand, foreign currency notes, cheques, drafts etc. on
hand; Travellers' cheque register. Bills in hand should be scrutinised and explanations for
overdue bills should be obtained; gold ornaments against which loans were given should be
physically checked.
4. Accounts. See that profit and loss account and balance sheet are drawn up according to
the requirements ofthe Banking Companies Ordinance, 1962.
5. Branches. See that certified branch returns in the case of country or foreign branches
have been correctly incorporated in the Head Office Books.
6. Audit. Provisions of Section 35 of the above Ordinance should be noted.
7. Reserve Fund. See that twenty per cent of the amount of profits is
transferred to the Reserve Fund until it is equal to the paid up capital of the bank.
8. Secret Reserves. Examine entries affecting secret reserves which may be in existence,
9. Deposits. Verify the closing balance with ledgers. Test check

Special Points in Different Classes of Audits

478

confirmations. Verify the Control Accounts.

10. Bank Balances. Obtain direct bank confirmations for all accounts with other banks and
with the State Bank of Pakistan.

11. Investments. Examine all investments physically; Enquire into the basis of valuing the
bank's investments for balance sheet purposes and ascertain the market price from standard
publications; check the schedule with investment register; Ascertain that all income on each
investment has been reflected in books.

12. Loans, Advances and Overdrafts. Bills Purchased and Discounted Check balances of the
above accounts with ledgers; Examine securities and other documents obtained as cover against
secured loans etc.; prescribed classification should be checked carefully. Verify control accounts.
See that adequate provision has been made against doubtful accounts.

13. Dividends. See that no dividend is paid until all the intangible assets have been written off..
14. Income, Test check the correctness of interest earned; Ensure that irrecoverable interest is
fully provided for in the books and rebate on bills discounted and on unmatured bills is carried
forward.
Readers are encouraged to read the Audit of International Commerial Banks, issued by TP
AC in February 1990.

BRANCHES

1. System, Examine the system of accounting maintained by the branch or branches and
ascertain that uniform system of accountancy is employed by all the branches.
2. Certification. See that the returns from the branches are certified by the branch
manager or by a responsible official.
3. Returns' Incorporation. See that branches' returns are properly incorporated in the head
office books; conversion into home currency should be made in accordance with the set rules in
the case of foreign branches; if the goods supplied to branches are at market prices (proforma
invoices are being sent), it should be seen that proper adjustments are made to arrive at the
correct profit or
loSS. ! ' '

4. Debtors. Obtain a certified schedule of branch debtors and scrutinise it noting doubtful
accounts.
5. In Transit Ascertain that goods and cash in transit have been incorporated in the books
of account.
6. Attention. Proper attention should be given to the question of depreciation, reserves for
bad and doubtful debts, repairs and renewals, assets and liabilities.

Special Points'in Different Classes of Audits

BRICK COMPANY

1. Inspect leases and agreements relating to royalty payable to owners.

2. Vouch rent receivable in respect of field workmen's cottages etc.
3. An enquiry into the method of recording and paying wages and valuing stock of bricks
on hand should be done.

BUS COMPANIES

1. Purchase of buses. See agreement with the sellers; enquire into the nature of purchase
(eg., instalment sale or hire-purchase) and see that interest payable with the instalment is
charged off to revenue.
2. Verification. Verify closing balance of stock of stores, petrol, tyres, tubes
etc.

3. Expenses. See that a proper system of payment of salaries, wages (to engineers, clerks,
drivers, conductors etc.), and purchase and issue of petrol, tyres, tubes, parts etc. exists.
.. 4. Repairs and Renewals. If the repairs and renewals are of variable nature, it is advisable
that repairs and renewals reserve is maintained; see that all repairs after proper certification by
the engineer are debited to revenue. a

5. Depreciation. See that adequate depreciation on the value of motors and buses is being
provided in the accounts.
6. Income, Study the method of collection of fares from passengers; compare the
conductors' way bills with traffic book and test check entries with the passengers' receipts;
vouch the receipts from advertisements with the returns from the agents and examine the
relevant contracts.
CHARITABLE INSTITUTIONS

1. Rules and Regulations. Study Rules and Regulations particularly in respect of accounts
and auditing matters.
2. Accounts. See that the accounts are drawn up in accordance with the regulations.
3. Funds. See that funds earmarked for specific purposes have been dealt with

accordingly.

4. Assets and Liabilities. Vouch day to day and normal expenses with supporting
documents; verify purchase of instruments and physically examine them if they are available or
alternatively obtain, a certificate direct from the bank.

479

480

Auditing: Principles and Procedures

1. Income. Vouch - receipts of donation and subscriptions with supporting evidence; vouch
investment income from investments register; vouch receipt of rents from properties (if any)
with tenancy agreements, rent roll etc.
5. Minutes. Check minutes book of the trustees of Managing Committee for important
payments.
CINEMAS AND THEATRES

1. Internal Check. Examine the system of internal check and verify the daily receipts of
tickets for reserved and unreserved seats.
2. Liabilities. See that all liabilities in respect of purchase of materials, advertising posters
etc. have been accounted for.
3. Capital Expenditure. Verify allocation between revenue and capital and scrutinise items
lying in capital expenditure. The total cost of each production should be spread over the income
of such production.
4. Valuation of Films. This should receive the auditor's careful attention.
5. Valuation of Copyrights of Productions. The valuation of copyrights of productions

should be most thoroughly scrutinised.

6. Depreciation. Ensure that adequate depreciation in respect of wardrobe materials,

dresses, scenery, furniture and fittings has been charged in accounts.
7. Touring Company. Vouch receipts and travelling expenses in the case of a touring
company and see that these are duly approved by the touring manager.
8. Income. Test vouch counterfoils of tickets with daily returns of tickets sold and trace
the amounts into cash book; see that the amount received on advance bookings is properly
carried forward; Vouch advertisement sales with advertisement contracts.
9. Agreements. Inspect agreements for purchase, hire and sub-letting of films.
CLUBS

1. Constitution, Study the constitution and by-laws particularly relating to

powers of ~3icials, operation of bank accounts, accounts and audit, 'j i
2. Verification. Verify assets, particularly stock, and liabilities in the normal manner.
3. Expenditure. Vouch payments, particularly of purchase of crockery, furniture,
provisions, salaries to staff etc. Ensure that proper distinction is made between capital and
revenue expenditure.
4.

Income. Vouch receipts on account of admission fees, mbscriptions etc.

481

Special Points'in Different Classes of Audits

with a list of members and counterfoil carbon copy receipts. Ensure that life memberships are
spread over a number of years; See that subscriptions received in advance or arrears are properly
appropriated and accounted for; Enquire into the system of supplying meals, refreshments,
drinks etc. to the members and vouch the receipts of cash.
5.

Minutes. Examine minute book.

COLLIERIES

1. Liabilities. See that all liabilities under any contracts for supplies are reflected in
accounts.
2. Capital Expenditure Scrutinise capital expenditure incurred on:
(a)
(b)
(c)
(a)

Construction of surface railway lines

Underground tramways
Workmen's residential accommodation
Plant and other assets . . .
(e) Pit-Sinking
If wagons have been bought on liire-purchase basis, see that the instalments have been
correctly apportioned between, capital and revenue; Ascertain that adequate depreciation has
been charged in accounts on fixed assets; satisfy that correct allocation has been made between
revenue and capital.
3. Development Expenditure. The" above expenditure will ordinarily
distributed over the period during which such expenditure is expected to
remunerative.

be
be

4. Short Workings. These would be shown as assets in the balance sheet; The question of
recouping short working out of future royalties should also be looked
into.5. Minimum Rent. Inspect necessary lease and agreements and look into the question of
minimum rent and royalties.
6. Unsold Stock. Examine the basis of valuation of unsold stock; if the selling price is less
than the cost, it would be sold at the realisable value.
7. Wages. Examine the actual system applicable in respect ofthe preparation of wage
sheets and subsequent payments.
8. Sales. Verify sales with sale agents accounts, contracts with railway authorities and
other consumers; and enquire into the rates charged.
9. Comparison, Compare the total quantity of output and the cost of output per ton.
Compare with the figures of previous year and obtain satisfactory explanations for any material
fluctuations.

Special Points in Different Classes of Audits

482

5. Quantity Reconciliation. Obtain a quantitative reconciliation starting with opening

balance adding to it production and deducting sales including losses of screening etc. and finally
terminating with closing figure.
10. Articles of Association. Examine the articles of association and study the question of
providing depreciation on leases and nrining concessions etc.
CONTRACTORS
(including controcting companies, buildings, engineers,
shipbuilders etc.)

1. Cost Accounts System. The auditor should ascertain the system of dealing with wages
and expenditure on stores, materials etc., and treatment of indirect expenditure and test its
efficiency.
2. Work i n Progress Value. He should verify the items of the schedule showing how the
value has been arrived at in respect of work-in-progress. Value of this should be compared with
the latest available architect's, surveyor's or engineer's certificates.
3. Contract Ledger. Careful consideration should be given to the question of liabilities to
sub-contractors. The contract ledger for the succeeding period should be examined to see
whether any expenditure has been incurred in respect of contracts treated as completed at the end
of the previous year, and that if such expenditure has been incurred, provision was made for it at
the date of balance sheet.
4. Wages. He should examine carefully the system of internal control in relation thereto.
Wages sheets should be tested exhaustively. He should pay surprise visit at the sites when wages
are being paid.
5. Claims. Claims by the contractor arising out of prolonging the contract by the customer,
the impossibility and difficulties of obtaining essential materials and stores etc., should be
carefully looked into.
6. Profit on Uncompleted Contracts. The conservative principle is not to take any profit
until completion, but where profit is taken into account, the auditor should examine the method
by which the estimated figure is arrived at, and see that ample margin is allowed for
contingencies.
7. The provision of IAS 11 should be read in terms of application to contractors.
DOCTOR
1. Income.. Check, the amount of visiting fees received and examine the system of
recording visits. Vouch the amount received from sale of prescriptions with the patients register
and ensure that an efficient check is done on compounders

Auditing: Principles and Procedures

483,

regarding receipt of cash from patients.

2. Expenditure. VOAV&V e-s^emliUire ani see final all liabilities have been
accounted for. Verify capital expenditure on the purchase of instruments, apparatus, etc., and see
that adequate depreciation is provided on these.
3. Stock. Verify the stock of drugs in hand at the date of the balance sheet and see that -it is
properly valued.
4. Motor Car. If a motor car is used for practice purposes, see that a . reasonable proportion
of its running and maintenance charges and its depreciation is charged to revenue account,
5. Medicines. If medicines are also provided, their accounts be scrutinised.
EDUCATIONAL

1. Constitution. Ebtamine the rules, regulations, trust deeds, charters etc. (whichever is
applicable) relating to accounts, audit and matters in respect of management.
2. Budget Procure a copy of sanctioned budget and peruse it.
3. Income. Vouch receipts on. account of fees etc., with counterfoil carboncopy receipts and

register of students; examine authority for writing off irrecoverable fees; fees outstanding or paid in
advance must be adjusted and accounted for; Ascertain the .system of recovery of fines and extras
e.g. examinationfees, duplicate copies of diplomas, hostel rent, electricity charges etc., and their
treatment in accounts; vouch the income of landed property, endowments, securities etc.

4. Expenditure. See that proper distinction between capital and revenue has been
maihtaiHed; examine the internal check system regarding the purchase of pmrisiohs,- linen etc. for
the boarding-house and test its adequacy; see that a donation for a particular purpose is spent
specifically for it; vouch capital expenditure in the usual manner but examine the sanction; check
payments of salaries.
5. Verification. Verify closing stock of linen, fVrrrdture, stationery outstanding assets,
liabilities, balances of bank and cash.
6. Investments. See that investments representing prize endowment funds are kept apart and
not mixed up with ordinary investments.
7. Government Grants. Check Government grants with correspondence and see that it is
utilised only for the purposes for which it has been given.
8. Accounts. See that annual accounts prepared for submission to governing body are in
accordance with the Rules and are signed by the head of institution.

Special Points m Different Classes of Audits

484

ELECTRIC SUPPLY COMPANY

1. Study memorandum and articles of association.

2. Examine the system of internal check and test its adequacy.
3. Vouch income from consumers, special contracts, public lighting, meter rents with
meter books and other allied documents.

4.
5.
6.
7.
8.
9.

Verify hire-purchase or sale of meters with meter register.

Vouch all important proper allocation is being made between capital and revenue.
Check receipts from consumers with consumers ledger.
Test check postings into ledger.
Verify cash and bank balance, depreciation and reserves, and stocks.

Enquire into arrears and ascertain that adequate provision has been made
for doubtful accounts and all outstandings are accounted for.

10. Check and examine share capital account and payments of dividends.
EXECUTORS' ACCOUNTS

1. Examine the will of the deceased noting provisions affecting the executors' accounts.
2. Examine Estate Duty Affidavits and the supporting schedules to ascertain the assets and

liabilities of the decreased.

3. See that the correct amounts of estate duties and other death duties have
been paid.

4.
5.

Verify income of all investments.

Vouch purchase and sale of securities, real property etc.

HOSPITALS

1. Income. Vouch receipts with counterfoil carbon copy receipts; Donations and
subscriptions should be vouched with correspondence, register of subscribers, counterfoil carbon
copy receipt and any available documentary evidence; vouch receipt of rent, dividend etc. in the
usual manner.
2. Expenditure, See that/the grants from Government or local authorities are properly
spent; voucl 'purchase of linen, furniture medicines, provisions, salaries. All other payments
should be vouched with available documentary evidence.

485

Auditing: Principles and Procedures

3. Ref und of Income . Any income-tax deducted at source on interest on securities

received should be exarnined for refund, if the hospital is exempt from the payment of income
tax under the provisions of Income Tax Ordinance, 1979.

HOTELS

1. Internal Check. Test the system of internal check in force regarding the ordering,
receipts and payments of provisions, wines, stores etc., the receipt of cash and the accounting
thereof by the waiters and cashiers and quantity records of wines, spirits, provisions and other
stores; see that the system ensures that all charges incurred by visitors are duly debited to them
in the 'Day Book' or 'Personal Ledger'.
2. Cellar Accounts. Examine the system of keeping the cellar accounts in respect of
receipt and issue of wines and spirits shown to be on hand by periodical stocktaking and
compare it with the quantities shown in the cellar records.
3. Vouching. Check receipts from visitors from the cash book, vouch bar and billiard room
receipts. Verify purchase invoices and check their allocation. See that salaries and wages are
properly certified Scmtinise all items of capital expenditure.
4. Depreciation. Ascertain that adequate depreciation on hotel plant, furniture, fittings and
fixture has been charged in accounts.
5. Valuation Exaniine the accuracy of the method of valuing stocks of food stuff, wine,
linen, napery, plates, cutlery, kitchen utensils, etc.
6. Stocks. Check the system of ordering, receiving and paying for provisions and wine;
See that a system of sound nnancial control exists over stocks and stores. Compare the
inventories of stocks actually taken with the stock ledger by way of tests.
IMPORTING HOUSE

1.
2.
3.
4.
5.
6.

Examine the system of internal check.

Vouch cash book.
Check invoices of goods imported and sold with purchases and sales book.
Vouch credit and debit notes with the relevant books.
Trace postings with the general ledger.
Verify closing stock and bank balances.

INSURANCE COMPANY - LIFE

1. Internal Check. Examine the system of internal check and test its adequacy and
efficiency.

486

Special Points in Different Classes of Audits

Auditors' Report to the Shareholders in the case of an Insurance

Company
As a result of legal requirements, the Auditors' Report to the shareholders will ordinarily take
the following shape:
We have audited the above balance sheet of the . . ,..........................................Company
Limited, as at.............................19...............and the Revenue Accounts, the Profit and
Loss Account and the Profit and Loss Appropriation Account of the company for the year ended
on that date in which are incorporated the returns from the various Branches and Agencies, and
we report that:
(a) We have obtained all the information and explanations which we have required.
(&) In our opinion, the annexed Balance Sheet, Revenue Accounts, Profit and Loss
Account and Profit and Loss Appropriation Account are drawn up inconformity with
the law.
(c) Such balance sheet exhibits a true and correct view of the state of the
company's affairs according to the best of our information and the explanations
given to us and as shown by books ofthe company.
(d) In our opinion, the books of account have been kept by the company for the
year under report as required by Section 230 of the Companies Ordinance, 1984.
(e) We have verified the cash balances and investments by actual inspection or by
the production of certificates or vouchers, and have also verified the securities
relating to the Loans.
(_f ) No part of the assets of the Life Assurance Fund has been directly or indirectly
applied in contravention ofthe Insurance Act, 1938, relating to the application and
investment of Life Assurance Funds.
(g) All expenses of management incurred in lespect of Life Assurance business and in
respect of business other than the Life Assurance have been fully debited as
expenses in the respective Revenue Accounts.

Date

Chartered Accountants

2. Income. Vouch premium received with counterfoils of the receipt book, new policies
and renewal policy register; verify that total outstanding premium receivable has been accounted
for in books, vouch receipts of interest and dividends in investments and rents. See that accrued
interest is accounted for.
3. Expenses. Vouch commission payable to agents, noting that it does not exceed the rates
prescribed by the Insurance Act, 1938. See that unpaid commission as at the closing date has
been debited in the accounts and charged off to the revenue; surrenders should be checked with
the policies duly endorsed and returned

487

A uditing: Principles and Procedures

by the insured with receipts of payees.

4. Loans. Check loans to policy-holders against policies with receipts from policy holders
and see that they are within the surrender value ofthe policy.
4. Reinsurance. This should be checked carefully.
5. Annuities. Vouch amounts paid and see that unpaid annuities are duly accounted for in

the books of accounts.

6. Claims. Vouch claims paid and ensure that claims admitted and not paid have been
provided for in the accounts.
5.

Investments. Verify investments and check their valuation.

7. Valuation Surplus. Verify the valuation surplus by referring to the Actuary's Report and
see that it is properly allocated to the shareholders and policyholders.
8. Life Insurance Fund. See that the prescribed legal requirements of Insurance Act, 1938
in respect of insurance investments of life insurance fund have been complied with.
9. Accounts and Audit. See that accounts are prepared in the prescribed form and submit
the auditors' report also on the prescribed form.
10. Miscellaneous. Scrutinise the agency register and check the closing balance and
vouch the bonus paid in cash with bonus register.
LANDED ESTATES

1. Estates. For acquisitions see conveyance deeds and solicitors' bills of costs; for
leaseholds see leasehold agreements; for sales see corresponding sale-deeds.
2. Rent Income Vouch collection of rent; Tally arrears of rent with the list. Inspect leases
or agreements with tenants. See that outstanding rents are carried forward to the next year.
3. Expenses. Vouch municipal taxes, insurance etc. and scrutinise repairs to buildings.
4. Soles of Produce Adjacent to Building or Land, See that sale proceeds are properly
brought on and recorded and outstanding amount of sale of produce is properly brought into the
accounts.
5. General. Enquire into property unlet; vouch miscellaneous receipts (sale of timber,
livestock etc.); Enquire into the method of paying wages, ordering, receiving and paying for
materials.

Special Points in Different Classes ofAudits

488

MAIL ORDER BUSINESS

.1, Orders Received Check the orders received and see that on despatch of goods the
necessary particulars are entered in the VPP Register from the copies of invoices.

2. Cash Received Check cash received through the post office end the date of receipt in
the VPP Register. Trace the daily total of cash entered into the Cash Book.
3. Returns. Scrutinise the VPP Register in respect of any parcels returned and ensure that
it is taken into stock.
4. Outstanding Amount. Examine the VPP Register in respect of which payments have not
been received. All goods in transit at the date of balance sheet but subsequently returned should
be included in stock at cost less reasonable depreciation for damages in transit.
MINING COMPANY

1. Obtain a clear idea ofthe nature of operation, viz., heating of minerals or washing of
minerals.
2. Ascertain how mineral sold is reconciled with mineral produced
3. Other matters. System of recording and paying wages; depreciation of plant; basis of
apportioning expenditure as between development and working; Verification of amounts in
respect of royalties; Method of keeping records of stores and of checking and vouching stores in
hand.

MOTOR CAB COMPANY

1. Enquire into the system and ensure that takings are controlled and checked via the taxi-

meter.

2. See that the daily totals of takings were banked..

3. Ascertain the basis of division of receipts between the company and the drivers.
4. See that adequate depreciation has been accounted for.
5. Vouch upkeep expenses.
6. Check receipt and issue of the stores used for repair and maintenance of the cab.

Special Points in Different Classes of Audits

489

NEWSPAPERS AND PERIODICALS

1. System of Issue. Enquire into the system of issue of paper to newspapers, news-agents
and subscribers and the system of returned newspapers^
2. Receipte. Vouch the receipts on account of subscription and advertisement charges; see
that the unexpired subscription or advertisement charges already paid are reflected in the balance
sheet.
3. Payments. Payments made to contributions should be vouched.
4. Depreciation. Examine the basis on which depreciation of plant and machinery, motors,
carts etc. is calculated and ensure that it is adequate.
. 5. Liabilities. Ensure that all outstanding expenses are accounted for
especially in respect of accounts due to contributors; enquire whether any libel or
other actions are pending against the newspaper, in respect of which necessary
provision is to be made. Enquire whether there is a Uability in connection with
competitions in which prizes are offered. If so, see that it is provided for in the
accounts.
' -

OIL PRODUCING COMPANY

1. Carry out a general examination of the returns from the oil field, certified by the local
officials.

2. Give a careful consideration to the rates of depreciation applied to well-casing,

derricks, engines, boiler and other plant and machinery on the field.
3. Enquire into the system of apportioning expenses between capital and revenue.
4. Obtain a reconciliation of oil output and sale and scrutinise it.
PARTNERSHIP ACCOUNTS
1. Ascertain the exact nature and scope of work with reference to the
appointment details.
2.

See partnership deed and carefully note the following:

(a) Period covered.

C6) Capital provided by each partner.

(c) Method of determining the annual profits.

(d) The proportion in which the profits or losses are shared among the partners.

490

Auditing: Principles and Procedures

(c)
(d)
(e)
(f)

Interest on partners'capital. .

(i)

Arrangements of withdrawal from the firm and interest to he charged on

the drawings.

Special provisions for partners' loans.

Entitlement to the rate of drawing each partner.
Any salary entitlement provision.

(j ) Arrangements of termination of partnership.

3. Acquaint with the provision of the Partnership Act, 1932, particularly in respect of
matters affecting the partnership accounts.
4. Verify assets and liabdities. Check material items appearing in profit and loss account.
5. Verify partners current accounts and see that profit distribution is in accordance with the
partnership deed.

PUBLISHERS

1.
2.

Agreements. Examine agreements with authors and royalties payable to them.

Cost of Cash Book. Check the accounts showing cost of each book; see that the closing
stock of books on hand is valued at the lower of cost or realisable value.
-3. Liabilities. See that all royalties payable to authors have been provided for; also see that
proper provision is made for libel or infringement of copyrights, in case the suits against the
company are still pending at the date ofthe balance sheet.

4. Copyright Valuation, Copyrights should be revalued from time to time.

5. Advertisement Cost. If heavy expenses have been incurred in advertising a book, it
should be seen that such expenses are capitalised and charged off to revenue over a reasonable
period.
6. Valuation, Check the valuation' of books for illustration.
RAILWAY COMPANIES

1. Constitution, Study Special Act of the Assembly and note provisions affecting the
accounts, audit and management.
2. Internal Check. Enquire into the system of internal check and internal audit and test its
adequacy.

Special Points in Different Classes of Audits

491

1. Traf f i c Receipts. Check entries relating'to traffic receipts with monthly traffic
summary book and see that it is certified by the Station Masters as to its accuracy; Test check
monthly summaries in respect of passengers, goods, minerals and other receipts. Trace the
amounts shown on returns of cash remitted by the stations with entries in the subsidiary cash
books and then into the main cash book.
3. Capital Expenditure. Ascertain that allocation between capital, and revenue is being
done on correct basis; verify the capital expenditure with the certificates of engineers arid other
responsible officials.
4. Revenue Expenditure. Test check major items of revenue expenditure with the oiiginal
vouchers.
5. Verify. Securities, inventories of stocks and stores, outstanding traffic accounts,
outstanding liabilities, and fixed assets.
6. Liabilities. See that the unearned amount in respect of unexpired periods of season
tickets is duly carried forward; see that interest on all loans or debentures is duly provided in
accounts; verify redemption of loans or debentures.
7. Comparison. Compare the items of the Revenue Account with the figures of previous
year and obtain satisfactory explanations for material fluctuations.
8. Final Accounts. See that the Final Accounts are prepared in the form required by the
Statutes.

REGISTERED SOCIETY
The audit ofthe accounts of a registered society is not made compulsory by the Societies
Registration Act, 1860, but it may be required by the rules of the society. Where it is so
required, the auditor is to be appointed by the govermng body.
In auditing the accounts of a society, the auditor should proceed as follows:

(1) Read carefully the society's memorandum of association and the. rules; and note the
provisions relating to accounts and audit.

(2) Peruse the minute book of the govermng body in order to vouch the transactions of
the society.

(3) Vouch the cash book and other accounts in the usual way.
(4) Verify the assets and liabilities of the society.
The audit report must be addressed to the governing body of the society, and it may be
worded as follows:

492

Auditing: Principles and Procedures

The Members of the Governing Body,

X Education Society,
Karachi.
Gentlemen,
I have audited the balance sheet ofthe X Education Society as on June 30,19
. , . and its income and expenditure account of the year ended on that date. I have received all the
information and explanations that I had required. The balance sheet exhibits a true and fair view
of the state of affairs of the society and the income and expenditure account shows a true and fair
view of the excess of income over expenditure, according to the best of my information and
explanations given to me. and as shown by the books ofthe Society.
Place and Date

. .

Chartered Accountant

RETAIL STORES
' 1.' Cash Sales. Carbon copy of the cash memos should be checked with the abstracts
prepared by each salesman. Their totals should be traced into the Cash Book.

2. . Credit Sales. Carbon copies of bills should be checked with the sales journal.
2. Purchases. Invoices for purchase of goods should be checked and allocations to various
departments should be verified.
3. Stock Valuation. In cases where departments are charged with goods at selling price, or
at a stipulated percentage above cost, the auditors should ensure that stocks of such departments
are reduced to cost before incorporating the value of stock in the final accounts. .
RUBBER PLANTATIONS
1. . Properties. Verify the properties with reference to the title deeds and other
documents and by study of the above documents ascertain the terms and conditions.
2. Capital Expenditure. Scrutinise carefully all items of capital expenditure;
Ensure that proper allocation has been made between capital and revenue; see that
the expenses in the nature of maintenance and cultivation of areas and expenses
relating to the manufacture of rubber charged off to the revenue.
3-

Quantitative Reconciliation' Obtain a quantitative reconciliation starting

Special Points in Different Classes of Audits

493

with opening balance adding to it production and deducting sales including losses of screening
etc., and finally terrmnating with closing figure.

4. Allocations. See that the general basis of allocation of expenditure between capital and
revenue is in proportion to the ratio that the acreage of the areas in bearing and that of areas not
in bearing, bear to the total acreage of Estate.
5. Stock Valuation. Examine the basis of valuing stock of rubber on hand at the date of

closing.

6.

Advances. See that adequate provision is made in respect of irrecoverable advances to

workmen.

7. Monthly Summary. Examine the monthly summary of the Estate Manager's transactions
and trace it to the journal entry.
SHIPPING COMPANIES
1, Internal Check. Enquire into the system of internal check and test its
adequacy and efficiency.
2. Voyage Account. See that a separate account is kept for each voyage;
Examine each voyage account to see that all expenses relating to each voyage are
properly charged to it; see that this amount is credited with its legitimate freight
and passage money; ensure that at the end of voyage, each voyage account is
credited with the value of stores in hand and it is debited to the succeeding voyage
account. Ascertain that all outstanding liabilities in respect of each voyage are
reflected in the accounts; See that insurance premium attributable to each voyage is
properly charged to such voyage account.
3.. Ships. See that a separate ledger is maintained for each ship and adequate depreciation
is written off during the year.

4. Foreign Exchange Look into the question as to how the foreign exchange transactions
have been dealt with the books.
5.

Insurance Fund See that it is kept on a proper level and corresponding amount is

specifically invested.

6. Capital Expenditure. Scrutinise the capital expenditure; See that repairs and renewals
are charged off to revenue and any heavy amount spent on overhauling a vessel may be spread
oyer a reasonable number of voyages.
7. Unearned Money. Ascertain that unearned moneys received on account of return
passages not utilised are properly carried forward.
8. Scrutiny. Scrutinise agents' accounts, statements received from insurance brokers,
tradesmen and average adjusters and for repairs and reconditions and ensure that they are duly
incorporated in accounts.

494

Auditing: Principles and Procedures

STOCK BROKER

1.

Check jobbers' ledgers and enquire into accounts not settled at settlement

2.
3.
4.
5.
6.

Check posting to client ledgers and check schedule of balances.

date.
Examine bought and sold continuation books.
Trace posting of stamps and interest to general ledger.
Examine dividend account.
Verify client's own investments and those held on behalf of clients.

SUGARCANE COMPANY

1. Internal Check. Examine the system of internal check in operation at mill and
agricultural farm.
2. Farm. See that farming operations are adequately supervised; vouch farm expenditure
and receipts; verify records of cane grown on company's own farm and use in factory; verify
farm assets, e.g. land,- livestock, implements etc.
3.
4.
5.
6.
7.

Advances. Check advances to cultivators against supply of sugarcane.

Old Outstandings. See that irrecoverable outstanding are written off.
Light Railway or Tramways. Vouch the expenses.
Expenses. Vouch excise duty, cane cess and dead season expenses.
Contingent Liabilities. These should be noted at the foot of the balance sheet.

WATER COMPANY

1. Constitution. Study and note provisions in respect of share capital, debentures and
limitation of dividends, accounts, audit and management.
2. Water Rental Ledger. Test check with the certified property valuation list.
3. Consumers' Ledger. Test check postings; vouch allowances, irrecoverables, written off
and arrears carried forward; check apportionment of amount paid in advance.

4. Metered Consumption Check with meter readers' books.

5. Expenditure, Examine analysis of expenditure.

BUSINESS
INVESTIGATIONS

INVESTIGATION DEFINED
An investigation involves enquiry into the facts behind the books and accounts, into the
technical, financial and economic position of the business or its organisation. It is a searching
enquiry into the accounts of a concern with a particular object in view. It involves limited or
extended scope of work depending upon the purpose for which it is conducted and the terms
mutually agreed between an investigating accountant and his client.

AUDIT AND INVESTIGATION DISTINGUISHED

The difference between audit and investigation is tabulated here:
Points

Audit

1. Object

Whether the balance sheet

exhibits a true and correct
view of the state of the
company's affairs

2. Period covered

Covers one year

3. Conduct

Conducted on behalf of
shareholders in the case of a
company and proprietors in
the case of private concerns.
Investigation
There can be many objects,
e.g. to ascertain profit earning
capacity of a business, to
prove frauds, to advise the

parties to buy a concern or

not, or to invest the capital or
not etc. Generally covers
several years ranging from
one to several years. It may be
conducted- on behalf of
shareholders or proprietors,
but generally it is conducted
on behalf of outsiders who
intend to purchase the
business or lend money etc.

496

Business Investigations

Points

Audit

Investigation

4. Legal Binding

The annual accounts of a

company must be audited.

5. Extent of cheeking

Test checking may be done

provided the auditor can rely
upon the adequacy of the
system of internal control.
The expression of opinion is
based on the examination of
books,
and
receipt
of
information and explanations
from the officers of the
company.

There are no legal provisions

to
make
investigation
obligatory to be carried out
like a regular feature.
It involves a thorough
examination of the books of
accounts for a particular year
or years.

6. Basis for Report

7. Sequence of work

It rarely happens that investigation is done earlier to

the audit.

To finalise the report, the

Investigation Accountant has
to go beyond the books of
accounts and make an
exhaustive and close survey
of the varied factoi's of the
past success or failure of the
business. It relates to books
which have already been
audited.

OBJECTS OF INVESTIGATION
An investigation ofthe accounts of a business may be necessary in many cases. However, the
following are the principal objects for which investigations are-usually undertaken on behalf of;

(1) A person who intends to buy an established business.

(2) A company which proposes to purchase a business as a going concern and
requires a certificate of the past profits of such business for insertion in its prospectus.

(3) A person who intends to join an established business as a partner.

(4) A person who is approached by the proprietor of a business for a loan.
(5) A proprietor where fraud is suspected.
(6) The proprietor of a business where there are abnormal fluctuations in profits.
. .

(7) The Central Government where it is alleged that a company is being

mismanaged, as provided in the Companies Ordinance 1984.
(8) The proprietor of a business where he has to submit a return required by
the Government under control regulations.

44i)

Auditing: Principles and Procedures

QUALITIES OF AN INVESTIGATING ACCOUNTANT

The work of investigation is a highly technical one and requires a considerable amount of
knowledge and experience. Senior members ofthe accountancy profession with vast experience
generally undertake this work. Qualities required to be possessed by an investigating accountant
are: tact, patience, quick understanding, character, searching ability, ability to state candid facts
without fear or favour, sound knowledge of accountancy and auditing, vast experience of
professional field. Where it is desired he should obtain professional valuer's certificate for
market value of fixed and other assets.

SCOPE OF INVESTIGATION

1. Scope, The Investigating Accountant must obtain clear instructions in writing in respect
of object of investigation, period to be covered {if any) imposed upon the extent of his enquiry,
special points to be dealt with and so on. Having obtained this information he should then
proceed to do his job and decide the extent of his work.
2. Findings. The Investigating Accountant must arrive at his findings on the basis of the
work done, rather than jump to conclusions without substantiating them. He must preserve his
working papers so that when he is called to explain the matter, he is able to furnish the desired
information. Certain types of investigations may' give rise to a legal action, and the investigating
accountant may be called to give evidence in civil or criminal proceedings. In such
circumstances, the need to preserve working papers cannot be over-emphasised.
3. Report Contents. The contents of his report will depend upon the facts of the case and
will differ depending upon the object of investigation, r^uirements of his clients etc. But it
should generally cover the following:
(o) A reference to instructions received. (6) A
statement of work done.
(c) A statement of results obtained supported by facts and figures (synopsis of accounts
examined should also be annexed to report).

(d) A statement of conclusions reached.

The report should be written in such a clear style and language as is not interpretable to
several meanings.

498

Business investigations

INVESTIGATING ACCOUNTANT AND THE CASE LAW

Some of the leading cases heard in the courts relating to the position of the Accountant who
undertook to carry out investigation are described below:

1. Calmer vs. Merrett, Soh and Street (1914). The plaintiff wished to invest money in a
particular company of which the defendants were the auditors. A few months earlier, the auditors
prepared the first accounts of the company indicating a profit. It was subsequently discovered
that it was due to a large over-valuation of stock that the plaintiff asked him to prepare up to date
accounts to ascertain the current position before he'made the proposed investments. As the time
was short (around three days being available) the plaintiff agreed that an approximate statement
of affairs would serve his purpose. Consequently detailed audit was not carried out. The plaintiff
made the decision to invest on the basis of the profit reflected by the said approximate statement
of affairs. Subsequently several errors were discovered which ultimately resulted in a loss of over
1,900 to the plaintiff. The jury assessed the damages at 250.
2. Rex vs. Bishirgian and others (1936). The defendants were charged with a criminal
offence under Section 84 of Larceny Act, 1861 in respect of making a false statement in a
prospectus with the intention of inducing persons to become shareholders in a company. The
important falsity in the prospectus was - the omission of any reference to certain facts, viz that
the businesses acquired were involved in very heavy commitment for the forward purchase of
pepper. The case was against the directors of the Company and not against the Accountant. It is
however of interest to the Accountants who are asked to give a certificate for inclusion in the
prospectus.
3. Short and Campion vs. Brackett (1904). The defendant was sued for fees in respect of
services rendered in preparing certain , accounts from his books to determine the amount of the
profit and goodwill. After the completion of the work, the defendant discovered that one of the
clerks was deficient in his accounts. It was argued that the failure of the plaintiff to discover that
had resulted in a loss to him. However, the court did not accept his view and he was ordered to
pay the fees. It was held that an Accountant making an investigation of accounts for an mcoming
partner is entitled to assume that the books were correct.
TYPES OF INVESTIGATIONS
The procedure involved in carrying out major types of investigations is herein explained.

Misappropriation of Cash
Book debts and advances should be circularised under his control and supervision and
direct confirmations should be obtained. The confirmations

Business Investigations

obtained should be cheeked with closing balances and all cases where differences are found,
should be scrutinised carefully and investigated further. Lists of bad debts should be obtained
and cases be examined to ensure that they are in fact bad and thus written off.
The system of internal control in respect of cash receipts should be critically studied.
Probing into the loopholes obtaining in the internal control relating to cash sales should be done.
The possibilities of misappropriation of cash by 'teeming and lading' should be looked into and
steps discussed in the chapter of 'Internal Control' in this respect should be practically1 followed.
Full vouching of all cash receipts and all payments must be done intelligently. In the case of
cancelled or spoilt, receipts, originals must be seen. Special attention should be given to the
checking of serial number of all supporting numbers establishing the correctness of entries
recorded as receipts and payments.'
Receipt of cash on account of unusual receipts (sale of waste materials, bad debts
recovered, allowances received etc.) should be looked into. Generally collection of amount
against the foregoing receipts is reflected in accounts and misappropriated amount.
All the bank transactions should be carefully checked and all cash collections may be
traced into the bank statements. All outstanding items. in the bank reconciliation should be
enquired into and then subsequent realisations, noted. Arithmetical accuracy of all books
recording details of receipts and expenditure should be carefully verified.

Misappropriation and Manipulating Stocks

() General Considerations, Ensure that there is an adequate system of
internal control in operation as regards receipts, issues and custody. Ascertain that
proper stock records are maintained on a day to day basis. If this is not being done,
see that the closing stock is physically verified and incorporated in the inventories.
See that independent stock records are maintained by the storekeeper and the
accounts department separately and periodic reconciliations of the following are
prepared:
(r) Stock control accounts with inventories.
(it) Bin cards and stock department Cards with accounts department records. (i i i ) Physical
with book balances.
. The stocks checked by company officials should be independent of the storekeeper, and this
should be done on a surprise basis, at fixed periodic intervals and at closing dates.
() Movements during t he year. Check opening balances-. Test check receipts
with invoices and voucheis and finished products with production records. Test
check issues with sales and issue vouchers. See that write off and distributions have

499

500

Auditing: Principles and Procedures

been properly sanctioned.

(c) Physical verification. Cany out surprise checks during the year and ensure that the results
are satisfactory. Attend to the stock-taking on closing date. Check the final inventories with
physically checked lists, rough inventories and stock records. Obtain satisfactory explanations for
differences. Ensure that non-trading items have been excluded from stock.
(d) Val uat i on. Check the basis of valuation and see that it is stated on the balance sheet,
The stock, according to generally accepted principles, should be valued at- lower of cost and
market value. Confirm that the basis of valuation is consistent with that of the previous year
applied consistently for receipts and issues during the period fcost on UFO, FIFO, average etc.
basis). Check inventory valuations with purchase invoices, stock cards and cost records for
finished stocks. Examine the basis of allocation of overheads and other "charges. See subsequent
sales invoices, price lists, and quotations for assessing a material decline as compared to the
market value.
(e) Provisions. Review of stocks should be made to determine obsolete slow-moving and
deteriorated items. Ascertain the aging of stocks and ensure that all
- obsolete, and slow-moving items are segregated. See that the provision for slow-moving stocks is
adequately made in the accounts.
(f) Precautions to be t aken. Corafirm that all the stocks of the company have been included
in the closing figure. See that the stocks on consignment and stocks not belonging to the company
have been excluded. Ensure that liabilities relating to all stock items have been booked and all
items should have been excluded from stocks. For this examine purchase and sale transactions
around balance sheet date. Check casts, carryforward, surnmary and extensions of certified stock
inventories. Check stock records with insurance returns.
(g) Principal error to be guarded against. The auditor must guard against the following
principal errors while verifying the stock:
(i) Incorrect additions and extensions.
(ii) Deliberate inclusion of items in the summary of stocks. (Hi ) Incorrect prices
and valuation.

(iv) Omission of stock held at docks, or in warehouses or with agents etc.

(iv) Omission to provide depreciation in the case of damaged, out of fashion,
obsolete or otherwise unusual stock.

(v) Inflation in the value of stock by including non-trading items (e.g. Plant,
Furniture, Tools etc.) which already appear as assets.
(h) Quantitative reconciliations. Verify the accuracy of closing stock figure by:

(i) Quantitative reconciliation of production and sales.

(ii) Gross profit percentage: Ascertain the percentage of wastage in

Business Investigations

production in handling and sales as compared to that of the previous year.

Investigation on behalf of an incoming partner

1.

Reason, Ascertain the reason why a new partner is to he admitted.

1.

Replacing of a deceased or retiring partner. If the new partner is taken in place of a

deceased or retiring partner, the extent of the loss which the business is likely to suffer for want
of skill, experience or influence of the deceased or retiring partner should carefully be gauged.

2.

Financial Position. The financial position of the proprietor, partner or partners who wish to
admit him as a partner should be examined carefully, bearing in mind that the concept of
unlimited liability applies to the firm's partners.
4. . Computation of Profit. Salary of the outgoing partner should be considered
while determiriing the profits of the business.
b. Goodwill The question of calculating the amount of goodwill to be paid on admission as
a partner should be considered and it should be seen whether the amount is reasonable.
6. Capital Contribution, The object of utilising the capital contributed should be enquired
into i.e., whether it will be used for working oepital or for paying off any liability.
1: Share of Profi t . The question of the reasonableness or otherwise of the profit should.
be examined in the light of capital and labour put in by other partners.
8. Partnership Deed, The old and the proposed partnership deeds should be carefully
perused to ensure that they do not adversely affect the interests of his client.

Investigation on behalf on a Lender of Money

While conducting an investigation on behalf on a lender, the accountant should make an
enquiry into the following matters:

(1) Enquire into the reason as to why the additional finance is required.
(2) Ascertain the channels in which the loans will be utilised.
(3) Find out whether any party in the past has refused to give the loan. If so,
discuss the reasons.

(4)

Determine the true value (cost or market whichever is the less) and consider
whether security offered is sufficient to cover the loan requested for.

(5)

Ensure that the statement of assets and liabilities is prepared to ascertain the
net value of the assets and is delivered to the lender.

501

502

Auditing: Principles and Procedures

(1) Note the ratio of current liabilities to hquid resources (Acid Test Ratio).
(2) Study the normal earning capacity of the borrower by scrutinising the profit and loss
account for the past few years. There are greater chances of loan being repaid in time
if the earning capacity of the borrower is satisfactory.

(3) Make enquiries about the credit worthiness of the borrower.

Purchase of a controlling interest in
the share capita! of a limited
company
The investigating accountant may be asked to investigate the accounts and records of the
company before deciding to give an offer for the purchase of controlling interest in the share
capital of a limited company carrying on considerable manufactujing and trading activities. The
steps to be taken in carrying out the above investigations are:

1. Obtain a copy of memorandum and articles and carefully study .matters such as
objects, share capital and rights of different classes of shares, borrowing power, appointment and
remuneration of directors and any special powers.
2. Audited Accounts. Procure copies of audited accounts for the past five years. Scrutinise
the auditors' report to ascertain whether they contained any qualifications or not.
3. Trading, Profit and Loss Account. Prepare tabulated statement generally called 'analysis
of working'. Percentages to turnover of the different items of expenditure in Trading, Profit and
Loss Account should be worked out.
4. Balance Sheet. Synopsis of the balance sheets should be prepared in a tabulated
manner, as per the following details:
(a) Capital and Liabilities
Paid-up Capital. Reserves and
Surpluses. Long term Liabilities.
Current Liabilities. Contingent
Liabilities (if any).

(b) Property and Assets

Fixed Assets. Current Assets.
Intangible and other Assets.
Contingent Assets (if any).
(5) Examination of Accounts
(a) Turnover. Examine the general trend of the business in respect of turnover. Obtain
explanations for marked fluctuations from a normal trend.

Business Investigations

Xb) Cost o f Sale. Study critically the percentage in different years of the cost Of the
sales to sales.
.(c) Stocks. Find out the basis on which stocks and work in progress have been valued.
i d) Gross Profit Ratio. Ascertain the percentages of gross profit to turnover. Enquire
into material variations from year to year and compare them, if possible, with
those of similar other businesses.
(e ) Depreciation. Verify that adequate depreciation was provided in the books.
i f ) Bad Debts. Note the trend of the amounts written off during the last five years.
(g ) Abnormal Items. Take note of any abnormal item of non-recurring nature.
(ft) Taxation, Note the effect of any changes in the taxation of profits which may have
taken place and ensure that adequate provision has been made in the accounts in
respect of taxation.
i i ) Dividend Study the past dividend policy.

6.

Scrutiny of Balance Sheet.

(a) Capital. Study the capital structure and the gearing ratio.
(b) Debentures. Ascertain their nature, conditions, rate of interest, terms of
redemption and whether a sinking fund for the redemption exists.
(c) Secured Liabilities. Look into any other secured liabilities and note, the nature of
security offered as a cover against them.
' i d) Current Ratio. Ascertain the current ratio (current assets compared to current
liabilities) and enquire into any marked fluctuations. Pay special attention to the
liquid position at the latest date.
is) Investments. Note the values at which they appear in the balance sheet and
compare with market value.
i f ) Intangible. Examine the nature and amount of any assets such as
good-will, patents, trade marks, copyrights, preliminary expenses,
commission or brokerage on shares and discount on the issue of the
shares.
ig) Ratio o f Fixed to Current Assets. Study the relationship between the
fixed and current assets.

7. Important Matters. The following matters should also be carefully investigated:

(a ) Future Prospects of the Business. Note contracts and orders on hand, any future
commitment for capital expenditure etc.

503

504

Auditing: Principles and Procedures

(b)

Manageinent. Ascertain the existence of any agreement with senior

officials.

(c)

Taxation Trends and Political Developments. The general nature of

business should be considered in relation to the effect which political
developments and taxation trends are likely to have their important bearing upon
it.

INVESTIGATION UNDER THE COMPANIES ORDINANCE, 1984

Section 263 of the Ordinance provides a means of investigation into the affairs of a
company by inspectors appointed by the Corporate Law Authority.
On the conclusion ofthe investigation, the inspectors are required to send their report to the
Authority, a copy to the Registrar, a copy to the company, and a copy to the applicants for
investigation.
Powers o f Inspector. All pej-sons, who are or have been officers of the company, are
required to produce to the inspector all books and documents in their custody relating to the
company. An inspector may examine on oath any such person in relation to the company's
business: If any person refuses to produce any book or document or to answer any question
relating to the affairs of the company, he shall be liable to a fine.
Method of Investigation. The procedure to be followed by the inspector will be determined
by the terms of .his instructions, but in any case the following are the points to which he should
give his special attention:
*

1. Cost of management,

i.., remuneration paid to directors, managing agents and other

responsible officials ofthe company.

2. Any -direct or indirect interest of directors and managing agents in any concern with
which the company has business dealinps.
3. Loans given to directors and other officers of the company, interest charged thereon and
whether with or without security.
4. ' Important contracts entered into by the company, then- terms, the persons
with whom they are made, and whether such persons arerinany way connected with
the company's management,

5.

Fixed capital expenditure incurred on behalf of the company and whether this has been
profitable-.

6.

Expenses incurred in carrying on the business of the. company and whether there has been
sufficient control over them.
;' 7- . Investment of the company's funds and whether it has been made in the best interests of
the company.

505

Audmrg: Principles and Procedures

8. Adrninistration of the company's earnings with special reference to the dividends

declared on the class of capital which is principally held by the management and their friends.
9. Liquid resources ofthe company.
Sections 263 tc 282 of the Ordinance contain comprehensive details govermng
investigation of affairs of company on application by members or report by registrar, application
by members to be supported by evidence and power to call for security, investigation of
company's affairs in other cases, inspector to be a court for certain purposes, power of inspectors
to carry investigation into affairs of associated companies, duty of officers etc., to assist the
inspectors, inspector's report, prosecution, power of Authority to initiate action against
management, effect of court's order, no compensation to be payable for annulment or
modification of contract, no right to compensation for loss of office, application for winding up
of company or an order under Section 290, proceedings for recovery of damages or property,
expenses of investigation, inspector's report to be evidence, imposition of restrictions on shares
and debentures and prohibition of transfer of shares or debentures in certain cases, saving for
legal advisers and bankers,, enquiries and investigation not to be affected by winding up etc., and
application of Sections 261 to 281 to liquidators and foreign companies.

INTERPRETATION OF COMPARATIVE TRADING

PROFIT AND LOSS ACCOUNTS
When examining a set of comparative trading and profit and loss accounts of a business
with a view to interpreting the figures appearing therein, attention should be paid to the matters
given below:

1. Sales. It is obvious that the fatal disease in the business world is declining of sales. The
sooner this element of weakness is detected the better as otherwise the whole business may
encounter some danger.
2. Stocks. Accumulating stocks point to the need for investigation not only into the sales
policy of the business but also into its purchasing policy. Needless to say how essential it is for
the health of a business that the capital should not be locked up unnecessarily in stock, and the
control of the rates of stock turnover is perhaps the most important element that the capital
should not be locked up unprofitably in stock, and in the success of a business.
3. Percentage of gross profi t on turnover. This acts as a check upon stock, record of
purchases, sales and returns, direct expenditure, methods of production, efficiency of plant, and
leakages.
4. Expenses. This causes of variations in expenditure may indicate the
advisability of disbanding a particular department, replacing an obsolete machine
or effecting economies in other directions.

Business Investigations 506

5. Depreciation and Reserves. The depreciation and reserves policy pursued would
indicate prudent or imprudent conduct of the business.
5. Percentages of Net Profit. The trend of the percentage of net profit on turnover and on
the capital employed in the business should be noted. If possible, it should also be compared
with that of other business of a similar nature.
ENQUIRY UNDER SECURITIES
AND EXCHANGE ORDINANCE,
1969
Through Eighth Schedule annexed to the Companies Ordinance, 1969, Section 21 of the
Securities and Exchange Ordinance, 1969, was amended as per following redeeming features:

1.

The Federal Government may, on its own motion or on representation of not

less than one fifth in number of the members of the Stock Exchange or, in the case of
business or any transaction mentioned above, on the representation of the Stock
Exchange or any person interested in or affected by such business or transaction, at
any time by order in writing, cause an enquiry to be made by any person appointed in
this behalf into the affairs of, or dealings in, any Stock Exchange, or the dealings,
business or any transaction in securities by any broker, member, director or officer of
a Stock Exchange.
2.
Where any enquiry has been undertaken every past or present member,
director, manager or other officer of the Stock Exchange to which the enquiry relates,
and every other person who has had any dealing in the course of his business with
such stock exchange or with the director, manager or officer thereof, shall furnish such
information and documents in his custody or power or within his knowledge relating
to or having a bearing on the subject matter of the enquiry as the person conducting
the enquiry may require.
3.
Where the Federal Government has directed that any of its powers and
functions shall be exercised or performed also by any specified authority,' such
authority may, by notification in the official gazette, direct that any of the said powers
and functions may, subject to such limitations, restrictions or conditions, if any, as it
may from time to time impose, be exercised or performed by any officer ofthe
authority specified by it.

507

Auditing: Principles and Procedures

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THE

AUDITING IN AN EDP ENVIRONMENT

ISA, 15 was released in February 1984 and is entitled "Auditing in an EDP Environment. It
is divided into seven parts namely: Introduction, Skills and Competence, Work Performed by
Others, Planning, Accounting System and Internal Control and Audit Evidence. Relevant
portions causing these aspects are reproduced below:

Introduction
The purpose of this Guideline is to provide additional guidance necessary to comply with
these basic principles when an audit is conducted in an electronic data processing fEDP)
environment. For purposes of International Standards on Auditing, an EDP environment exists
when a computer of any 'type or size is involved in the processing by the entity of financial
information of significance to :the audit, whether that computer is operated by the entity or by a
third party.
The overall objective and scope of an audit does not change in an EDP environment.
However, the Use of a computer changes the processing and storage of financial information and
may affect the organisation and procedures employed by the entity . to achieve adequate internal
control. Accordingly, 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 bis other
audit procedures may be affected by an EDP environment. Separate International Auditing
Guidelines will give further guidance on auditing procedures appropriate to an EDP
environment.

Skills and Competence

When auditing in an EDP environment, the auditor should have an understanding of
computer hardware, software and processing systems sufficient to plan the engagement and to
understand how EDP affects the study and evaluation of internal control and the application of
auditing procedures, including computer-assisted audit techniques.

528

Auditing: Principles and Procedures

The auditor should also have sufficient knowledge of EDP to implement the auditing
procedures, depending on the particular audit approach adopted.

Work Performed by Others

The auditor is never able to delegate his responsibility for forming important audit
conclusions or for forming and expressing his opinion on the financial information. Accordingly,
when he delegates work to assistants or uses _ work performed by other auditors or experts, the
auditor should have sufficient knowledge of EDP to direct, supervise and review the work of
assistants with EDP skills or to obtain reasonable assurance that the work performed by other
auditors or experts with EDP skills is adequate for his purpose, as applicable.

Planning
The auditor should gather information about the EDP environment that is relevant to the
audit plan, including information as to:

1.
2.

How the EDP function is organised and the extent of concentration or

distribution of computer processing throughout the entity.
The computer hardware and software used by the entity.
3.
Each significant application processed by the computer, the nature of the
.processing (eg., batch, on-line), and data retention policies.

4.

Planned implementation of new applications or revisions1 to existing

applications.
When considering his overall plan the auditor should consider matters, such as:
1. Determining the degree of reliance, if any, he expects to be able to place on the EDP
controls in his overall evaluation of internal control. - 2. Planning how, where and when
the EDP function will be reviewed including scheduling the work of EDP experts, as
applicable.
3. Planning auditing procedures using computer-assisted audit techniques.

Accounting System and Infernal Control

During the review and preliminary evaluation of internal control, the auditor should acquire
knowledge of the accounting system to gain an understanding of the overall control environment
and the flow of transactions. If the auditor plans to rely on internal controls in conducting hie
audit, he should consider the manual and computer controls affecting the EDP function (general
EDP controls) and the specific controls over th^ relevant accounting applications CEDP
application controls).

Audit Evidence
An EDP environment may affect the application of compliance and substantive

-529

Computer and the Auditor

procedures in several ways. .

Hie use of computer assisted aut ^hques iriay be required because: ,-

1 The absence of input "documents ( e .g., order entry in on-line systems) or the generation of7
. accounting' transactions by computer programs ( e .g., automatic; calculation of discounts)

may preclude the auditor from examiningdocumentary evidence. The lack of a visible audit trail will preclude the auditor from visually following transactions
through the computerised accounting system.
The lack of visible output may necessitate access to data retained on files readable only by the
computer.

. The: timing of auditing procedures may be affected because data may not be retained in
computer files for a sufficient; length of time for audit use, and the auditor may have to make
specific arrangements to have it retained or copied.
. . The effectiveness and efficiency of auditing procedures may be improved through the use of
computer-assisted audit techniques in obtaining and evaluating audit evidence, for example:
1. . Some transactions may be tested more effectively for a similar level of cost by using the
computer to examine all or a greater number of transactions than would otherwise be
selected.,
2. In applying analytical review procedures, transaction or balance details may be reviewed
and reports printed of unusual items more efficiently by using the computer than by
manual methods.

SUPPLEMENTS TO ISA 6
The three supplements to ISA 6, Risk Assessment and Internal Control-; are reproduced
below:
INTERNATIONAL STATEMENT ON AUDITING
Issued as Supplement *4
to International Standard on Auditing (ISA). 6
(October 1937) .. ... '
'" .
EDPEnvironmonts Stand-alone Microcomputers - r
This International Statement on Auditing was approved by the International Auditing
Practices Committee in June 1987 for publication in October 1987.
>

The auditor should understand and consider the characteristics ofthe EDP environment
because they affect the design of the accounting system and related" internal controls, the
selection of internal controls-upon which he intends to rely, and the nature, timing and extent of
his procedures.

530

Auditing: Principles and Procedures

This Statement is issued as a supplement to ISA 6, Risk Assessment and Internal Control. It
does not form a part of ISA 6 or Addendum 1 to ISA 6, EDP Characteristics and Considerations,
and is not intended to have the authority of an ISA.
This Statement forms part of a series intended to help the auditor implement ISA 6 and
Addendum 1 to ISA 6 by describing various EDP environments and their effect on the
accounting system and related internal controls and on audit procedures.

Introduction

1.

The purpose of this Statement is to help the auditor implement ISA 6 and Addendum 1 to
ISA6 by describing microcomputer systems used as stand-alone work-stations. The
Statement describes the effects of the microcomputer on the accounting system and related
internal controls and on audit procedures.

Microcomputer Systems

2.

Microcomputers, often referred to as 'personal computers' or 'PCs,' are economical yet

powerful self-contained general puipose 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.

3.

Microcomputers can be used to process accounting transactions and produce reports that
are essential to the preparation of financial statements. The microcomputer may constitute
the entire computer based accounting system or merely a part of it.

4.

Generally, EDP environments in which microcomputers are used are different from other
EDP environments. Certain controls and security measures that are used for large computer
systems may not be practicable for microcomputers. On the other hand, certain types of
internal controls need to be emphasized due to the characteristics of microcomputers and
the environments in which they are used.

Microcomputer Configurations

5.

A microcomputer can be used in various configurations. These include:

A stand-alone workstation operated by a single user or a number of users at different

items;

a workstation which is part of a local area network of microcomputers; and e

a
workstation connected to a central computer.

6.

The stand-alone workstation can be operated by a single user or a number of users at

different times accessing the same or different programs. The programs and data are stored
in the microcomputer or in close proximity and,

Computer and the Auditor

531

generally, data are entered manually through the keyboard. The user of the stand-alone
workstation who processes accounting applications may he knowledgeable about
programming and typically performs a number of functions, (i.e. entering data, operating
application programs and, in some cases, writing the computer programs themselves). This
programming may include the upe of third-party software packages to develop electronic
spreadsheets or database applications.

7.

A local area network is an arrangement where two or more microcomputers are linked
together through the use of special software and communication lines. Typically, one of the
microcomputers 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 a distributed sy stem.

8.

Microcomputers can be linked to central computers and used as part of such systems, for
example, as an intelligent on-line workstation or as part of a distributed accounting system.
Such an arrangement may be referred to as an on line system. A microcomputer can act as
an intelligent terminal because of its logic, transmission, storage and basic computing
capabilities.

9.

Since control considerations and the characteristics of the hardware and software are
different when a microcomputer is linked to other computers, such environments are
described in other Supplements to ISA 6. However, to the extent that a microcomputer
which is linked to another computer can also be used as a stand-alone workstation, the
information in this Statement is relevant.

Characteristics of Microcomputers

10. Although microcomputers 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 microcomputer
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 microcomputer 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.

11. Software for a wide range of microcomputer applications can be purchased from thirdparty vendors to perform (e.g. general ledger accounting, receivable accounting and
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.

532

Auditing: Principles and Procedures

10. The operating system software, application programs and data can be stored on 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 unauthorized
users. Software, programs and data can also be stored on hard disks that are
:
not removable,~,

lnternal_Control in Microcomputer Environments .

13. Generally, the EDP environment in which microcomputers are used is less structured than a

centrally-controlled EDP: 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 (e.g. adequate documentation) and
operations (e.g. 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 microcomputer 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
microcomputer. Since microcomputers 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 microcomputer, without appropriate controls, programs and data
stored on non-removable storage media by one user may be susceptible to unauthorized
access, use, alteration or theft by other users.

14. In a typical microcomputer environment, the distinction between general EDP controls and
EDP application controls may not be easily ascertained-Paragraphs 15-32 describe security
and control procedures that can help improve the overall level of internal control.

Management Authorizatbn for Operating Microcomputers- .

15. Management can contribute to the effective operation of stand-alone microcomputers by

prescribing and enforcing policies for their control and use. Management's policy statement
may include:

management responsibilities;
instructions on microcomputer use;
training requirements;
authorization for access to programs and data;
policies to prevent unauthorized copying of programs and data;
security, back-up and storage requirements;

Computer and the Auditor 533

application development and documentation standards;

standards of report format and report distribution controls;
personal usage policies;
data integrity standards;
responsibility for programs, data and trror correction, and
appropriate segregation of duties.

Physical Security Equipment

16. Because of their physical characteristics, microcomputers are susceptible to
theft, physical damage, unauthoi'ized access or misuse. This may result in the
loss of information stored in the microcomputer, for example, financial data
vital to the accounting system.
17, One method of physical security is to restrict access to microcomputers when
not in use by using door locks or other security protection during non-business
hours. Additional physical security over microcomputers can be established, for
example, by;
.

locking the microcomputer in a protective cabinet or shell;

using an alarm system that is activated any time the microcomputer is

disconnected or moved from its location;
fastening the microcomputer to a table; or

installing a locking mechanism to control access to the on/off switch. This may
not prevent microcomputer theft, but many be effective in controlling unauthorized
use.

Physical Security - Removable and Non-Removable Media

18; Programs and data used on a microcomputer can be stored on removable storage media or
non-removable storage media. Diskettes and cartridges can be removed physically from the
microcomputer, while hard disks are normally sealed in the microcomputer or in a standalone unit attached to the . microcomputer. When a microcomputer 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 authorization or destroyed.
19. 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 internal controls
help ensure that removable storage media are not lost, misplaced or given to unauthorized
personnel. Physical control over non-removable storage media is probably best established
with locking devices.

534

Auditing: Principles and Procedures

20. 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 fireproof 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

21. When microcomputer are accessible to many users, there is a risk that programs and data
may be altered without authorization.

22. Because microcomputer operating system software may not contain many control and
security- features, there are several internal control techniques which can be built into the
application programs to help ensure that data are processed and read as authorized and that
accidental destruction of data is prevented. These techniques, which limit access to
programs and data to authorized personnel, include:

segregating data into files organized under separate file directories;

using hidden files and secret file names;
employing passwords; and
using cryptography.

23. The use of a file directory allows the user to segregate information on removable and nonremovable storage media. For critical and sensitive information, this technique can be
supplemented by assigning secret file names and 'hiding' the files.

24. When microcomputers are used by multiple users, an defective internal control technique 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
most instances it will be purchased. In either case, internal controls can be strengthened by
installing software that has a low likelihood of being thwarted by users.

25. Crypotography can provide an effective control for protecting confidential or sensitive
programs and information from unauthorized access and modification by users. It is
generally used when sensitive data are transmitted over communication lines, but it can
also be used On information processed by a microcomputer. Cryptography is the process of
transforming programs and information into an unintelligible form. Encryption and
decryption 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.

26. Directories and hidden files, user authentication software and cryptography can be used for
microcomputers that have both removable and non-removable storage media. For
microcomputers that have removable storage media, an

Computer and the Auditor

535

effective means of program and data*ecurity is to remove diskettes and cartridges from the
microcomputer and place them in custody of the users responsible for the data or the file
librarians.

27. An additional access control for confidential or sensitive information stored on nonremovable storage media is to copy the information to a diskette or cartridge and delete the
files on the nonremovable storage media. Control over the diskette or cartridge can then be
established in the same manner as over other sensitive or confidential data stored on
diskettes or cartridges. The user should be aware that many software programs include an
'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's
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

28. Microcomputers 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 unauthorized manipulation (i.e. that
authorized data are processed in the prescribed manner).

29. Data integrity can be strengthened by incorporating internal 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 and error trapping facilities. . For
user developed software, including electronic spreadsheet templates and database
applications,: management may specify in wilting the. procedures for developing and
testing application programs. For certain critical applications, the person 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.

30. Adequate written documentation of applications that; are processed on the microcomputer
can strengthen software and data integrity "controls further. Such documentation may
include step-by-step instructions, a description of reports prepared, source of data
processed, a description of individual reports, files and other specifications, such as
calculations.

31. If the same accounting application is used at various location, application software
integrity and consistency may be improved when application

536

A uditing: Principles and Procedures

programs are developed and maintained at one place rather than by each user dispersed
throughbutan entity. ,'

Hardware, Software and Data Back-Up

. '

32. 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 microcomputer 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 1 microcomputers. It is
particularly important to establish back-up procedures for users to perform on a
regular1 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 Microcomputers on the Accounting System and

related Internal Controls
33. The effect of microcomputers on the Accounting system and the associated risks
. will generally depend oh:

the extent to which the microcomputer is being used to process accounting

applications; -

the type and significance of financial transactions being processed; and the
nature of files and- programs utilized in the applications.

34. The characteristics of microcomputer system, described earlier in this Statement, illustrate

some of the considerations in designing cost-effective control.procedures for stand-alone

microcomputers. A summary of some of the key considerations and their effects on general
EDP and EDP application controls is described below.

General EDP Controls Segregation of Duties

35. In a microcomputer environment, it is common for users to be able to perform two Or more
of the following functions in the accounting system:

initiating and authorizing source documents;

entering data into the system;
operating the computer;
changing programs and data files;
using or distributing output; and
modifying the operating systems.

In other EDP environments, such functions would normally be segregated through

appropriate general EDP controls. This lack of segregation of functions

Computer and the Auditor

'

537

in a microcomputer environment may;

allow errors to go undetected; and '

. permit the perpetration and concealment of fraud.

EDP Application Controls -

36. The existence and use of appropriate access controls over software, hardware and data

fileSj combined with controls over input, processing and output of data may, in
coordination with management policies, compensate for some ofthe weaknesses in general
EDP controls in microcomputer environments. Effective controls may include: -

a system of transaction logs and batch balancing;

direct supervision; .and
reconciliation of record counts or hash totals.

Control may be established by an independent function which would normally:

receive all'data for processing; .

ensure that all data are authorized and recorded;
follow up all errors detected during processing; ~
verify the proper distribution of output; and .
restrict physical access to application programs and data files.

The Effect of a Microcomputer Environment on Audit

Procedures

37. In a microcomputer 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.

38. 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 EDP controls or EDP 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. -

39. 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.

538

Auditing: Principles and Procedures

40. In certain circumstances, however, the auditor may- decide to take a different approach.

These circumstances may include microcomputer 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 transaction on a
stand-alone microcomputer may establish- control procedures which reduce control risk;
the auditor may decide, on the basis ^ preliminary review of controls, to develop an
audit approach which includes testing of those controls on which he intends to rely.

41. The following are examples of control procedures that an auditor may consider when he
intends to rely on internal accounting controls related to stand-alone microcomputers:

a.

Segregation of duties and balancing controls:

- Segregation of functions as listed in paragraph 36.
Rotation of duties among employees.
Reconciliation of system balances to general ledger control accounts.

Periodic review by management of the processing schedule and reports which

identify individuals that used the system.

b.

Access to the microcomputer and its files:

Placement of the microcomputer within sight of the individual

responsible for controlling access to it.

The use of b y locks on the computer and ternimals-

The use of passwords for access to the microcomputer's programs and data files.
Restriction on the use of utility programs.

c.

Use of third-party software:

Review of application software prior to purchasing, including functions,

capacity and controls.
Adequate testing ofthe software and the modifications to it prior to use.
Ongoing assessment of adequacy of the software to meet user requirements.
INTERNATIONAL STATEMENT ON AUDITING issued as Supplement'2
to International Standard on Auditing (ISA) 6 (February 1989) EDP

Environments

On-line

Computer Systems

This International Statement on Auditing was approved by the International Auditing

Practices Committee in October 1988 for publication in February 1989.
The auditor should understand arid consider the characteristics of the EDP

Computer and the Auditor

539

environment because they affect the design ofthe accounting system and related internal
controls, the selection of internal controls upon which he intends to rely, and the nature, timing
and extent of his procedures.
This Statement is issued as a supplement to ISA 6, Risk Assessment and Internal Control. It does not form a part of ISA 6 or Addendum 1 to ISA 6, EDP Characteristics and
Considerations, and is not intended to have the authority of an ISA.
This Statement forms part of a series intended to help the auditor implement ISA 6 and
Addendum 1 to ISA 6 by describing various EDP environments and their effect on the
accounting system and related internal controls and on audit procedures.

Introduction

1.

The purpose of this Statement is to help the auditor implement ISA 6 and Addendum 1 to
ISA 6 by describing On-line computer systems. The Statement describes the effects of an
on-line computer system on the accounting system and related internal controls and on
audit procedures.

On-line Computer Systems

2.

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 microcomputers structured in a network
environment.

3.

On-line systems allow users to initiate various functions directly. Such functions include:

entering transactions (e.g. sales transactions in a retail store, cash withdrawals in a

bank and shipment of goods in a plant);

making inquiries (e.g. current customer account or balance information);

requesting reports (e.g. a list of inventory items with negative 'on hand ! quantities); and
updating master files (e.g. setting up new customer accounts and changing general
ledger codes).

4.

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:

Basic keyboard and screen - used for entering data without any validation .withinthe terminal and for displaying data from the computer system on the screen.
For example, in entering a sales

540

Auditing: Principles and Procedures

order, the product code is validated by the main computer and the result of the
validation is displayed on the terminal screen. 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.
Microcomputers - 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 microcomputer.
b.

Special Purpose Terminals, such as;

.'
'.- Point of sale devices - used to record sales transactions as 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.
Automated teller machines - used to initiate, validate, record,' transmit and
complete various banking transactions. Impending 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.

5.

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
he 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 and software which monitors on-line
terminal devices,. .

6.

In addition to the users of these systems, programmers may use the on-line 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

7.

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

Computer and the Auditor

541

are classified as follows: ,

On-line/Real Time Processing :.

On-line/Batch Processing
On-line/Memo Update (and Subsequent Processing)
On-line/Inquiry

On-line Downloading/Uploading Processing On-line I

Real Time Processing

8.

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 customer's accounts. The results of such
processing are then a-- . able immediately for inquiries or reports.

On-line/Batch Processing

9.

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 validated on-line and kept on a
transaction file, with the general ledger 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 Upydate (and Subsequent Processing)

10. On-line input with memo update processing, also known as shadow update, combines online/real time processing and on-line/batch processing. Individual transaction 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. Inquiries are made from
this memo file. These same transactions are added to a transaction file for subsequent
validation and updating ofthe 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.

542

A uditing: Principles and Procedures

On-line I inquiry
11. On-line inquiry restricts users at terminal devices to making inquiries of master flies. In such
systems, the master files are updated by other systems, usually on a batch basis. For
example, the user may inquire ofthe credit status pf 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 unauthorized
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.

Computer and the A uditor

543

17. Programmers may have on-line access to the systems that enables them to develop new
programs and modify existing programs. Unrestricted access provides the programmer with
the potential to make unauthorized changes to programs and obtain unauthorized access to
other parte 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 authorized to change the operational programs. In such cases, formal
control procedures would be followed subsequent tc the emergency situation to ensure
appropriate authorization and documentation of the changes.

Internal Control in an On-Line Computer System

18. Certain general EDP control are particularly important to on-line processing These include:
Access controls procedures designed to restrict access to programs and data.
Specifically, such procedures are designed to prevent or detect:

unauthorized access to on-line terminal devices, programs and data:

entry of unauthorized transactions',
unauthorized changes to data file;
use of operational computer programs by unauthorized personnel; and
use of computer programs that have not been authorized.

These access control procedures include the use of passwords and specialized access
control software such as on-line monitors that maintain control over menus,
authorization 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.

Controls over passwords procedures for the assignment and maintenance of passwords

to restrict access to authorized users.

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,
Programming controls procedures designed to prevent or detect improper changes to
computer programs which are accessed: through online terminal devices. Access may
be restricted by controls such as the use of separate operational and program
development libraries and the use of specialized program library software It is
important for on-line changes to programs to be adequately documented.

Transaction logs reports which are designed to create an audit trail for

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Auditing: Principles and Procedures

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 EDP application controls are particularly important to on-line

processing. These include:

Pre-processing authorization permission to initiate a transaction, such as the use of

a hank card together with a personal identification number before making a cash
withdrawal through an automated teller maehine.

Terminal device edit, reasonableness and other validation tests program.- med
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.
Cut-off procedures procedures which ensure that transactions are processed in the
proper accounting period. These are particularly necessary in systems which have a
continuous flow of transactions. For example, in on-line systems where sales orders
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.
File controls procedures which ensure that the correct data files are used for online processing.
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.
Balancing the process of establishing control totals over data being submitted for
processing through the on-ljne 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 Accounting System and Related Internal Controls

20.

The effect of an on-line computer system on the accounting system and the
associated risks will generally depend on:

the extent to which the on-line system is being used to process accounting
applications;

the type and significance of financial transactions being processed; and

the nature of files and programs utilized in the applications:

Computer and the Auditor

183

21. Risk of fraud or error in on-line systems may be reduced in the following
circumstances:

If on-line data entry is performed at or near the point where transactions originate,
there is less risk that the transaction will not be recorded.
If invalid transactions are corrected and re-entered immediately, there is less risk that
such transaction will not be corrected and re-submitted on a timely basis.
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 eiTors than when it
is performed by individuals unfamiliar with the nature of the transactions.
If transactions are processed immediately on-line, there is less* risk that they will be
processed in the wrong accounting period.

22. Risk of fraud or error in on-line computer systems may be increased for the following
reasons:

If on-line terminal devices are located throughout the entity, the opportunity for
unauthorized use of a terminal device and the entry of unauthorized transactions may
increase.
On-line terminal deviees may provide the opportunity for unauthorized uses such as:

modification of previously entered transactions or balances;

modification of computer programs; and
access to data and programs from remote locations.

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 the recovery may not be accurate and complete.
On-line access to dr.ia and programs through telecommunications may provide greater
opportunity for access to data and programs by unauthorized persons.

23. On-line computer systems may also have an effect on internal controls. 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:

There may not be source documents for every input transaction.

Results of processing may be highly summarized; for example, only totals, from
individual online data entry devices can be traced to subseqaeni
processing.

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Auditing: Principles and Procedures

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-Une Computer Systems on Audit Procedures

24. The following matters are of particular importance to the auditor in an on-line computer
system:

Authorization, completeness and accuracy of on-line transactions.

Integrity of records and processing, due to on-line access to the system by many users
and programmers.
Changes in the performance of audit procedures including the use of CAAT's (see ISA
16, Computer-Assisted Audit Techniques), due to matters such as:

the need for auditors with technical stills in on-line computer

systems; .

the effect of the on-line computer system, on the timing of audit

procedures;

the lack of visible transaction trails;

procedures carried out during the audit planning stage (see paragraph
25);

audit procedures performed concurrently with on-line processing (see

paragraph 26); and

procedures performed after processing has taken place (see paragraph

27).

25. Procedures carried out during the planning stage may include:

The participation on the audit team of individuals with technical proficiency in on-line
computer systems and related controls.
Preliminary determination during the risk assessment process of the impact of the
system on the audit procedures. Generally, in a well-designed and controlled on-line
computer system, it is likely that the auditor will place greater reliance on internal
controls in the system in determining the nature, timing and extent of audit
procedures.

26. Audit procedures performed concurrently with on-line processing may include compliance
testing ofthe controls over the on-line applications. For example, this may be by means of
entering test transactions through the on-line terminal devices 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

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Computer and the Auditor

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:

Compliance testing of controls over transactions logged by the on-line system for
authorization, completeness and accuracy.
Substantive tests of transactions and 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.
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 torequest 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.
INTERNATIONAL STATEMTEMENT ON AUDITING
issued as Supplement *3 to International Standard on Auditing
(ISA) 6 (February 1989) EDP Environments - Database

Systems

This International Statement on Auditing was approved by the International Auditing

Practices Committee in October 1988 for publication in February 1989.
The auditor should understand and consider the characteristics of the EDP environment
because they affet the design of the accounting system and related internal controls, the selection
of internal controls upon which he intends to rely, and the nature, timing and extent of his
procedures.
This Statement is issued as a supplement to ISA 6, Risk Assessment and Internal Control. It
does not form a part of ISA 6 or Addendum 1 to ISA 6, EDP Characteristics and Considerations,
and is not intended to have the authority of an ISA.
This Statement forms part of a series intended to help the auditor implement ISA 6 and
Addendum 1 to ISA 6 by describing various EDP environments and then-effect on the
accounting system and related internal controls and on audit procedures.

48 (i

Auditing: Principles and Procedures

Introduction

1.

The purpose of this Statement is to help the auditor implement ISA 6 and Addendum 1 to
ISA 6 by describing data base systems. The Statement describes the effects fo a database
system on the accounting system and related international controls and on audit procedures.

Database Systems

2.

Database systems are comprised principally of two essential components -- the database
and the data base management system (DBMS). Database systems interact with other
hardware and software aspects of the overall computer system.

3.

A database is a collection of data that is shared and used, by a number of 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 utilized by their applications.

4.

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.

5.

Database systems may reside on any type of computer system, including a microcomputer
system. In some microcomputer 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

6.

Database systems are distinguished by two important characteristics: data sharing and data
independence. These characteristics require the use of a data dictmory (paragraph 10) and
the establishment of a database administration function (paragraph 11-14).

Data Sharing

7.

A database is composed of data which are set up with defined relationships and are
organized 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.

Computer and the Auditor

549

Data Independence from Application Programs

8.

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.

9. 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 too) to maintain standardized documentation and definitions
of the database environment and application systems.

Database Administration

11. The use of the same data by various application programs emphasizes the importance of
centralized coordination of the use and definition of data and the maintenance fo 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 database, 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 pot part'of a
centralized database administration group. Where the tasks of database administration are
not centralized, but are distributed among existing organizational units, the different tasks
still need to be coordinated.

13. Database administration tasks typically include:

Defining the database struture determining how data are defined, stored and accessed
by users of the database in order to ensure that all tbeir requimients are met on a timely
basis.

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Auditing: Principles and Procedures

Maintaining data integrity, security and completeness developing, implementing

and enforcing the rules for data integrity, completeness and access. Responsibilities
include:
defining who may access data and how the access is accomplished (i.e. through
passwords and authorization tables);
preventing the inclusion of incomplete or invalid data;
detecting the absence of data;
securing the database from unauthorized access and destruction; and
arranging total recovery in the event of a loss.

Coordinating computer operations related to the database assigning responsibility

for physical computer resources and monitoring their use relative to the operation of
the database:
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.
Providing administrative support coordinating and liaising with the vendor of the
DBMS, assessing new release issued by the vendor of the DBMS and the extent of
their impact on the entity, installing new releases and ensuxing 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:

adequate linkage exists between database;

. coordination of functions is maintained; and
in different databases are consistent.

data contained

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 1114, and how they are performed.

16. Due to data sharing, data independence and other characteristics of data-base systems,
general EDP controls normally have a greater influence than EDP application controls on
database systems. General EDP controls over the database, the DBMS and the activities of
the database adrninistration 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:

standard approach for development and maintenance of application

Computer and the A uditor

551

programs;
data ownership;
access to the database; and
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 formalized, 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 programs 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 authorized 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 rhanging 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
authorized 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 auth rizat i n_

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Auditing: Principles and Procedures

19.

User access to the various elements of the database may be further controlled
through the use of authorization tables. Improper implementation of access procedures can
result in unauthorized 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 who are
authorized to change individual pay rates in the database.

The Effect of databases on the Accounting

System and related Internal Controls

22.

The effect of a database system on the accounting system and the associated
risks will generally depend on:

the extent to which databases are being used by accounting applications;

the type and significance of financial transactions being processed;

the nature of the database; the DBMS (including the data dictionary), the
database administration tasks and the applications (e:g. batch or on-line update); and

the general EDP controls which arc particularly important in a database

environment.

23.

Database systems typically provide the opportunity for greater reliability of

data than non-datahaso systems. This can result in reduced risk of fraud or
error in the accounting system where databases are used. The following factors, combined
with adequate controls, contribute to this improved reliability of data:

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 updated at different times and by different programs.
Integrity of data will be improved by effective use of facilities included in the DBMS,
such as recovery, restart routines, generalized edit and validation routines, and
security and control features.

Other functions available with the DBMS can facilitate control and audit
procedures. These functions include report generators, which may be used to create
balancing r eports, and que^y languages, which may be used to identify
inconsistencies in the data.

Computer and the Auditor

553

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 principally 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
utilize 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;

the DBMS and the significant accounting applications using the database:

the database administration function;

the standards and procedures for development and maintenance of application

programs using the database;
job descriptions, standards and procedures for those individuals responsible for
technical support, design, administration and operation of
the database;
the procedures used to ensure the integrity, security and completeness of the financial
information contained in the database; and
the availability of audit facilities within the DBMS.

27 During the risk assessment process, in determining the extent of reliance on internal controls
related to the use of databases in the accounting system, the auditor may consider' how the
controls described in paragraphs 17-21 are used in the system. If he subsequently decides
to rely on these controls, he would design and perform appropriate compliance tests.
28. Where the auditor decides to perform compliance or substantive tests related to the database
system, audit procedures may include using the functions ofthe DBMS (see paragraph 23)
to:

generate test data,

provide an audit trail;
check the integrity of the database;
provide access to the database or a copy of relevant parts of the database

554

Auditing; Principles and Procedures

for the purpose of using audit software

(see ISA 16, Computer-Assisted Audit Techniques); or

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 determines he cannot rely on the controls in 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 audit procedures in advance of their use.

COMPUTER-ASSISTED AUDIT TECHNIQUES

ISA 16 was released in October 1984 and is entitled "Computer-Assisted Audit
Techniques". The purpose of this ISA is to provide guidance in the use of CAATs. It applies to all
uses of CAATs involving a computer of any type or size. Major aspects covered include
Description of Computer-Assisted Audit Techniques, Using CAATs and Using CAATs in Small
Business Computer Environment. Relevant portions of the above ISA are reproduced below:

Description of Computer-Assisted Audit Techniques (CAATs)

This Standard describes two of the more common types of CAATs; audit software and test
data used for audit purposes. However, the guidance provided in this standard applies to all types
of CAATs.

Audit Software
Audit software consists of computer programmes used by the auditor, as part of his auditing
procedures, to process data of audit significance from the entity's account-ing system It may
consist of package programmes, purpose-written programmes, and utility programmes.
Regardless of the source ofthe programmes, the auditor should substantiate their validity for
audit purposes prior to use.
1. Package programmes are generalised computer programmes designed to perform data
processing functions which include reading computer files, selecting information,
performing calculations, creating data files and

Computer and the Auditor

2.

3.

555

renting reports in a format specified by the auditor.

Purpose-written programmes are computer programmes designed to perform audit
tasks in specific circumstances. These programmes may be prepared by the auditor, by
the entity -or by an outside programmer engaged by the auditor. In some cases,
existing entity programmes may be used by the auditor in their original or in a
modified state because it may be more efficient than developing independent
programmes.
Utility programmes are used by the entity to perform common data process-ing
functions, such as sorting, creating and printing files. These programmes are generally
not designed for audit purposes and, therefore, may not contain such features as
automatic record counts or control totals.

Test Data
Test data techniques are used in conducting audit procedures by entering data fair., a
sample of transactions) into an entity's computer system, and comparing the results obtained
with predetermined results. Examples of such uses are:

1. Test data used to test specific controls in computer programmes, such as on-line
2.

password and data access controls.

Test transaction selected from previously processed transactions or created by the
auditor to test specific processing characteristics of an entity's computer system. Such
transactions are generally processed separately from the entity's normal processing.

3. Test transactions used in an integrated test facility where a "dummy" unit (eg., a
department or employee) is established, and to which test transactions are posted
during the normal processing cycle.
When test data is processed with the entity's normal processing, the auditor should ensure
that the test transactions are subsequently eliminated from the entity's accounting records.

Uses of CAATs
CAATs may be used in performing various auditing procedures, including:

1.

Tests of details of transactions and balances for example, the use of audit software
to test all (or a sample) of the transactions in a computer file.
2. Analytical review procedures for example, the use of audit software to identify
unusual fluctuations or items.
3. Compliance tests of general EDP controls for example, the use of test
. data to test access procedures to the programme libraries.
4. Compliance tests of EDP application controls for example, the use of test
data to test the functioning of a programmed procedure. _-.

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Auditing: Principles and Procedures

Considerations in the Use ot CAATs

When planning the audit, the auditor should consider an appropriate combination of manual
and computer-assisted audit techniques. In determining whether to use CAATs, the factors to be
considered include:
1-

2.
3.
4.
5.

Computer knowledge, expertise and experience of the auditor.

Availability of CAATs.and suitable computer facilities.
Impracticability of manual tests.
Effectiveness and efficiency.
Timing.'

Computer Knowledge, Expertise, and Experience o f the Auditor

ISA 15 deals with the level of skill and competence the auditor should have when
conducting an audit in an EDP environment and provides guidance when delegating work to
assistants with EDP skills or when using work performed by other auditors or experts with such
skills. Specifically; the auditor should have sufficient knowledge to plan, execute and use the
results of the particular CAAT adopted. The level of knowledge required depends on the
complexity and nature of the CAAT and of the entity's accounting system. Accordingly, the
auditor should be aware that the use of CAATs in certain circumstances may require significantly
more computer knowledge and expertise than in others.
Availability o f CAATs and Suitable Computer Facilities
The auditor should consider the availability of CAATs, suitable computer
facilities and the necessary computer-based accounting systems and files. The auditoi' may plan
to use other computer facilities when the use of CAATs on the entity's computer is uneconomical
or impractical for example, because of an incompatibility between the auditor's package
programme and the entity's computer. The auditor should have a reasonable expectation that the
computer facilities will be controlled.
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 ofthe CAATs on the
entity's system, and to provide copies of data files in the fontiat required by the auditor.
impracticability o f Manual Tests .
Many computerised accounting systems perform tasks for which no visible evidence is
available and. in these circumstances, it may be impracticable for the auditor to perform tests
manually. The lack of visible evidence may occur at different stages in the accounting process
for example:
1.

Input documents may be non-existent where sales orders are entered on

Computer and the Auditor

557

line. In addition, accounting transactions, such as discounts and interest calculations,

may be generated by computer programmes with no visible authorisation of
individual transactions.
2. The system may not produce a visible audit trail of transactions processed through the
computer. Delivery notes and suppliers' invoices may be matched by a computer
programme. In addition, programmed control procedures, such as cheeking customer
credit limits, may provide visible evidence only on an exception basis. In such cases,
there may be no visible evidence that all transactions have been processed.
3. Output reports may not be produced by the system. In addition, a printed report may
only contain summajy totals while supporting details are retained in computer files.

Effectiveness and Efficiency

The effectiveness and efficiency of auditing procedures may be improved through the use
of CAATs in obtaining and evaluating audit evidence for example:

1.

Some transactions may be tested more effectively for a similar level of cost by using
the computer to examine all or a greater number of transactions than would otherwise
be selected.

2.

In applying analytical review procedures, transaction or balance details may be

reviewed and reports printed of unusual items more efficiently by using the computer
than by manual methods.
The use of CAATs may make additional substantive procedures more efficient than
reliance on controls and related compliance procedures.

3.

Matters relating to efficiency which may need to be considered by the auditor include:
1. The time to plan, design, execute and evaluate the CAAT.
1. Technical review and assistance hours.
3- Designing and printing of forms (e.g., confirmations).
4. Keying and verification of input.
' 5. Computer time.
In evaluating the effectiveness aud efficiency of a CAAT, the auditor may consider the life
cycle of the CAAT application. The initial planning, design and development of a CAAT will
usually benefit audits in subsequent periods.

Tsivng
Certain computer files, such as detailed transaction files, are often retained aly for a short
time, and may not be available in machine-readable form when required by the auditor. Thus, the
auditor will need to make arrangements for the

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Auditing: Principles and Procedures

retention of data required by him, or he may need to alter the timing of hie work which requires
this data.
Where the time available to perform an audit is limited, the auditor may plan to use a :
CAAT because it will meet his time requirement better than other procedures.

Using CAATs
The major steps to be undertaken by the auditor in the application of a CAAT are to:
(a) Set the objective ofthe CAAT application.
(fc) Determine the content and accessibility of the entity's files.
(c) Define the transaction types to be tested.
(d) Define the procedures to be performed on the data.
(e) Define the output requirements.
(f) Identify the audit and computer personnel who may participate in the design and
application of the CAAT.
(?) Refine the estimates of costs and benefits.
(ft) Ensure that the use ofthe CAAT is properly controlled and documented
(i) Arrange the administrative activities, including the necessary skills and computer
facilities.
(j) Execute the CAAT application.
( k ) Evaluate the results.

Controlling the CAAT Application

The use of a CAAT should be controlled by the auditor to provide reasonable assurance that
the audit objectives and the detailed specifications ofthe CAAT have been met, and that the
CAAT is not improperly manipulated by the entity's staff. The specific procedures necessary to
control the use of a CAAT will depend on the particular application. In establishing audit
control, the auditor should consider the need to:
(a) Approve the technical specifications, and carry out a technical review of the work
involving the use ofthe CAAT.
' (b) Review the entity's general EDP controls which may contribute to the integrity of the
CAAT for example, controls over programme changes and access to computet'
files. When such controls cannot be relied upon to ensure the integrity of the CAAT,
the auditor may consider processing the CAAT application at another suitable
computer facility.
tc)
Ensure appropriate integration of the output by the auditor into the audit
process.

Computer and the Auditor

559

Procedures carried out by the auditor to control audit software applications may include;
(a) Participating in the design and testing ofthe computer programmes.
(o) Checking the coding ofthe programme to ensure that it conforms with the detailed
programme specifications.
(c) Requesting the entity's computer 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 on the main data files.
(e) Ensuring that the correct files were used for example, by checking with external
evidence, such as control totals maintained by the user.
(/) Obtaining evidence that the audit software functioned as planned for example,
reviewing output and control information.
(g) Establishing appropriate security measures to safeguard against manipulation of the
entity's data files.
The presence of the auditor is not necessarily required at the computer facility during the
nmning of a CAAT to ensure appropriate control procedures. However, it may 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.
Procedures carried out by the auditor to control test data applications may include:

(a) Controlling the sequence of submissions of test data where it spans several processing
cycles.

(b) Performing test runs containing small amounts of test data before submitting the main
(c)

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.

(d) Confirming that the current version of the programmes was used to process the test
(e)

data.
Obtaining reasonable assurance that the programmes used to process the test data
were used by the entity throughout the applicable audit period.

When using a CAAT, the auditor may require the cooperation of the entity's staff who have
extensive knowledge of the computer installation. In such circumstances, the auditor should have
reasonable assurance that the entity's staff did not improperly influence the results ofthe CAAT.

560

Auditing: Principles and Procedures

Documentation
The standard of working papers and retention procedures tor a CAAT should be consistent
with that on the audit as a whole. It may be convenient to keep the technical papers relating to
the use of the CAAT separate from the other audit working papers.
The working papers should contain sufficient documentation to describe the CAAT
application, such as:
(a) Planning

1.
2.
3.
4.

CAAT objectives.
Specific CAAT to be used.
Controls to be exercised.
Staffing, timing and cost.

(o) Execution

1.
2.
3.
4.

CAAT preparation and testing procedures and controls.

Details ofthe tests performed by the CAAT.
Details of input, processing and output.
Relevant technical information about the entity's accounting system,
such as computer file layouts.

(c) Audit Evidence

1.
2.
3.

Output provided.
Description of the audit work performed on the output.
Audit conclusions.

(d) Other
Recommendations to entity management.
In addition, it may'be useful to document suggestions for using the CAAT in future years.

Using CAATs in Small Business Computer Environments

The general principles outlined in this Guideline are applicable in small business computer
environments. However, the following points should be given
special consideration in these environments:
(a) The level of general EDP controls may be such that the auditor will place less reliance
on the system of internal control. This will result in:
1. Greater emphasis on tests of details of transactions and balances and analytical
review procedures, which may increase the effectiveness of certain CAATs,
particularly audit software.

Computer and the Auditor

(b)
(c)
(d)

561

2. The application of audit procedures to ensure the proper functioning ofthe CAAT
and validity of the entity's data.
In cases where smaller volumes of data are processed, manual methods may be more
cost effective.
Adequate technical assistance may not be available to the auditor from the entity, thus
making the use of CAATs impracticable.
Certain audit package programmes may not operate on small computers, thus
restricting the auditor's choice of CAATs. However, the entity's data files may be
copied and processed on another suitable computer.

562
Auditing: Principles and Procedures

GLOSSARY
TERMS

OF

as of October 1991

Glossary of terms as of October 1991 related to in their Handbook 1992 is as under:

Accounting Estimate An approximation of the amount of an item in the absence of a precise
means of measurement.
Accounting System The series of tasks in an entity when transactions are processed as a means
of maintaining financial records. Such a system should recognize, calculate, classify, post,
swrrmarize and report transactions.
Addressee (See auditor's reports).
Adverse Opinion (See auditor's reports).
Agreed-Upon Procedures An engagement consisting of procedures of an audit nature which
the auditor and client have agreed upon in order to meet the client's needs for particular
information.
Analytical Procedures The analysis of significant ratios and trends including the resulting
investigation of unusual fluctuations and items.
Annual Report A document which an entity usually issues on an annual basis which includes
its nnancial statements and the auditor's report.
Assertions The representations by management that are embodied in the financial statements.
There are seven classifications of financial statement assertions, existence; rights and
obligations; occurrence; completeness; valuation; measurement; and presentation and disclosure.
Existence The control exists, or an asset or liability exists at a given date.
Rights and Obligations A right is an asset of the entity and an obligation is a liability of
the entity, at a given date.
Occurrence A transaction or event took place pertaining to the entity. " Completeness
There are no unrecorded assets, liabilities or transactions. Valuation An asset or liability
is recorded at an appropriate carrying .

564

Auditing: Principles and Procedures

Measurement A transaction is recorded in the proper amount, and revenue or expense is

allocated to the proper period.
Presentation and Disclosure An item is disclosed, classified, and- described in
accordance with acceptable accounting policies and, when applicable, legal requirements.
Assurance The auditor's satisfaction as to the reliability of an assertion being made by one
party for use by other parties.
Audit The independent examination of financial statements or related financial information of
an entity, whether profit oriented or not, and irrespective of its size, or legal form, when such an
examination is conducted with a view to expressing an opinion thereon.
Audit Evidence The information obtained by the: auditor in arriving at the conclusions on
which the audit opinion is based.
Audit Program A list of procedures that are needed to implement the audit plan. The program
may also contain the 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 the work.
Audit Risk The risk that an auditor may give an inappropriate opinion on financial
information that is materially misstated.
Audit Sampling The application of a compliance or substantive procedure to less than 100%
of the item within an account balance or class of transactions to enable the auditor to obtain and
evaluate evidence of some characteristic of the balance class and to form or assist in forming a
conclusion coMerning that characteristic.
Auditor Association An auditor is associated with financial information when the auditor
attaches a report to such information or consents to the use of one's name in a professional
connection.
Auditor's Address (See auditor's reports).
Auditor's Engagement Letter A document in which an auditor confirms to the client
acceptance ofthe appointment, the objective and scope ofthe audit, the extent of the auditor's
responsibilities to the client and the form of any reports.
Auditor's Reports A written report prepared by the auditor which comprises the foUowing
elements:
Auditor's Address A specific location identified inthe auditor's report.
Date' of the Report The auditor's report should be dated "in order to inform the reader
that the auditor considered the effect on the financial statements and on the report of events
or transactions about which the auditor became aware that occurred up to that date.
Addressee The person or persons to whom an audit report is addressed as

Glossary of Tenuis

565

required by the circumstances ofthe engagement and local regulations.

Scope Paragraph The paragraph which identifies the financial statements audited and
refers to the auditing standards or practices followed.
Opinion Paragraph The paragraph which sets forth the auditor's opinion on the
presentation in the financial statements of the entity's financial position and results of its
operations, or disclaimer or opinion on the financial statements.
Signature The auditor's report should be signed in the name of the audit firm, the
personal name ofthe auditor, or both, as appropriate.
Auditor's reports comprise opinions:
Unqualified Opinion An opinion which is not qualified is issued when the auditor is
satisfied in all material respects.
Modified Report Auditor's reports can be modified by issuing:

qualified opinions,
disclaimer of opinions,
adverse opinions, or
emphasis of matter paragraph(s)

Qualified Opinion An opinion issued when the auditor concludes that an unqualified
opinion cannot be issued but that the effect of an disagreement (e.g. whether a significant
micertainty has been adequately disclosed), or limitation on scope is not so material as to
require an adverse opinion or a disclaimer of opinion. A qualified opinion should be
expressed as being 'except for' the effects of the matter to which the qualification relates.
Disclaimer of OpinionAn opinion issued when the possible effect of a limitation on
scope or uncertainty is so significant that the auditor is unable to express an opinion on the
financial statements.
Adverse Opinion- An opinion issued 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.
Emphasis of'Matter Certain circumstances, while not affecting the auditor's opinion, may
require that the auditor add an explanatory paragraph (or other ; explanatory language) to the
standard report.
Compilations Ah engagement in which the auditor uses accounting expertise as opposed to
auditing expertise to collect, classify and summarize financial information.
Compliance Procedures (See tests of control).

566

A uditing: Principles and Procedures

Computation The checking of the arithmetical accuracy of source documents and accounting
records or of performing independent calculations.
Confirmation A response to an inquiry to corroborate information contained in the accounting
records. Control Environment The overall attitude, awareness and actions of directors and
management regarding control and its importance in the entity. The factors reflected in the
control environment include management's philoBophy and operating style, the entity's
organizational structure and methods of assigning authority and responsibility and management's
control system, including the internal audit function, the functions of the board of directors,
personnel policies and procedures, and external influences.
Control Procedures Those policies and procedures in addition to the control environment
which management has established to provide reasonable assurance that specific entity
objectives will be achieved. Generally, they are; procedures related to the proper authorization of
transactions, segregation of duties, design and use of adequate documents, safeguards over
assets, and independent checks on performance.
Control Risk The risk that misstatement that could occur in an account balanee or class of
transactions and that could be material individually or when aggregated with misstatements in
other balances or classes, will not be prevented or detected on a timely basis by the system of
internal control.
Database A collection of data that is shared and used by a number of different users for
different purposes.
Date of the Report (See auditor's reports).
Detection RiskThe 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.
Disclaimer ofOpin'.^n (See auditor's reports). "
Documentation The working papers prepared or obtained by the auditor and retained, in
connection with the performance of the audit.
EDP Application Controls The specific controls over the relevant accounting applications
maintained by the computer. The purpose of EDP application controls is to establish specific
control procedures over the accounting applications in order to provide reasonable assurance that
all transactions are authorized and recorded, and are processed completely, accurately and on a
timely basis.
EDP Environment The environment when a compute'- of any type or size is involved in the
processing by the entity of financial information of significance to the audit, whether that
computer is operated by the entity or by a third party.

Glossary of Terms

567

Emphasis of Matter (See auditor's reports).

Error The unintentional mistakes in financial information, such as: a) mathematical or clerical
mistakes in the underlying records and accounting data; b) oversight or misinterpretation of
facts; or c) misapplication of accounting policies.
Expert A person or firm possessing special skill, knowledge and experience in a particular
field other than accounting and auditing. An 'expert' is synonymous with 'specialist'. \
Financial Information The complete financial statements or segments of financial statements,
or supplementary information.
Financial Statements The balance sheets, income statements or profit and loss accounts,
statements of changes in financial position (which may be presented in a variety of ways, e.g. as
a statement of cash flows or a statement of funds flow), notes and other statements and
explanatory material which are identified as being part of the financial statements.
Forecast The prospective financial information prepared on the basis of assumptions as to
future events which management expects to take place and the actions management expects to
take as ofthe date the information is prepared (best estimate assumptions).
Fraud The international misrepresentations of financial information by one or more
individuals among management, employees or third parties. Fraud may involve: a) manipulation,
falsification or alteration of records or documents; b) misappropriation of assets; c) suppression
or omission of the effects of transactions from records or documents; d) recording of transactions
without substance; or e) intentional misapplication of accounting policies.
General EDP Controls-The establishment of a framework of overall control over the EDP
activities and to provide a reasonable level of assurance that the overall objectives of internal
control are achieved.
Going Concern Assumption The assumption that an enterprise will continue in operation for
the foreseeable future (generally for a period not to exceed one year after the balance sheet date)
and that the enterprise has neither the intention nor the necessity of liquidation or of curtailing
materially the scale of its operations.
Inherent Risk The risk that an account balance or class of transactions is susceptible to
misstatement that could be material, individually or when aggregated with misstatements in other
balances or classes, assuming that there were no related internal controls.
Inquiry The seeking of appropriate information of knowledgeable persons inside or outside
the entity.
Inspection The examining of records, documents, or tangible assets.
Internal Auditing An appraisal activity established within an organization as a

568

Auditing: Principles and Procedures

service to the organization- It is a control which functions by examining and evaluating the
adequacy and effectiveness of other controls.
Materiel Weaknesses The weaknesses in internal control that could have a material-effect on
the financial statements.
Materiality The magnitude or nature of a misstatement (including an omission) of financial
information either individually or in the aggregate that, in the light of surrounding
circumstances, makes it probable that the judgment of a reasonable person relying on the
information would have been influenced or one's decision affected, as a.result of the
misstatement.
Misstatement A mistake in financial information which could arise from errors andfraud. -
Modified Report (See auditor's reports).
Non-sampling Risk The risk that the auditor will make errors such as using inappropriate
sampling techniques or auditing procedures that may produce and incorrect inference from the
sample.
Observation The looking at a processor procedure being performed by others. : Opinion
Paragraph (See auditor's reports).
Predecessor Auditor An auditor who was previously the auditor of an entity and who has been
replaced by another (successor) auditor.
Principal Auditor An independent auditor reporting on the financial statements of an entity
using the work of another independent auditor with respect to the financial statements of one or
more divisions, branches, subsidiaries or associated' companies (components) included in the
financial statements of the entity.
Projection The prospective financial information prepared on the basis, of hypothetical
assumptions about future events arid management actions which are not necessarily expected to
take place. Such information illustrates the possible consequences as of the date the information
is prepared if the events and actions were to occur and is commonly referred to as a 'what if
scenario.
Prospective Financial Information The financial information which relates to events and
actions that have not yet occurred and may rot occur.
Qualified Opinion (See auditor's reports).
Quality Controls 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 Objective
and Basic Principles Governing an Audit, as set but in International Standard on Auditing (TS A)
1.
Related Party - The parties are considered to be related if one party has the ability to control
the other party or exercise significant influence (participation in the financial and operating
policy decisions of an enterprise, but not control of those

Glossary of Terms

569

policies) over the other party in making financial and operating decisions.
Related Services The reviews, agreed-upon procedures and compilations.
Representations by Management A document the auditor includes in the working papers as
evidence of management's representations by summarizing oral discussions with management, or
by obtaining written representations from management. The written representations can take the
form of a representation letter from management, or a letter from the auditor outlining the
understanding of management's representations, duly acknowledged and confirmed by
management.
Reviews An engagement consisting primarily of procedures that involve inquiry and
analytical procedures. The specific objective of the engagement is to give the auditor an
appropriate basis for stating whether anything has come to the auditor's attention as a result of
the review that causes the auditor to believe that the information does not give a true and fair
view (or 'is not presented fairly') in accordance with the basis of accounting indicated (negative
assurance).
Sampling RiskThe risk that the sample will not be representative of the population.
Scope Paragraph (See auditor's reports).
Signature (See auditor's reports).
Special Purpose Auditor's Report-A report issued in connection with the independent audit of
financial information other than an auditor's report on financial statements issued in accordance
with ISA 13. Auditor's reports on: financial statements prepared in accordance with a
comprehensive basis of accounting other than relevant national standards or International
Accounting Standards; specific accounts, elements of accounts, or items of a financial statement
(reports on a component of financial statements); compliance with contractual agreements;
summarized financial statements.
Subsequent Events The significant events occurring after the balance sheet date which may
have a material effect on the financial statements. Two types of events can be identified: a) those
that provide further evidence of conditions that existed at the balance sheet date and b) those that
are indicative of conditions that arose subsequent to the balance sheet date.
Substantive Procedures The tests designed to obtain evidence as to the completeness,
accuracy and validity of the data produced by the accounting system. They are of two types: tests
of details of transactions and balances, and analysis of significant ratios and trends including the
resulting investigation of onusual fluctuations and items.
Successor Auditor An auditor who replaces the previous (predecessor) auditor.
System o f Internal Control The plan of organization and all the methods and procedures
adopted by the management of an entity to assist in achieving

570

A uditing: Principles and Procedures

management's objective of ensuring, as far as practicable, the orderly and efficient safeguarding
of assets, the prevention and detection of fraud and error, the accuracy and completeness of the
accounting records, and the timely preparation of reliable financial information. The individual
elements of the system of internal control are referred to as internal controls and are collectively
known as internal control.
Tests o f Control The tests performed to obtain evidence about the effectiveness of the design
ofthe accounting and internal control systems and to obtain evidence of the operating
effectiveness of the policies and procedures applied.
Tolerable Misstatement 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.
Unqualified Opinion (See auditor's reports).
Working Papers The auditor's record of the plarining and performance of the audit, the
supervision and review of the audit work, and providing evidence of the audit work performed to
support the auditor's opinion.

INDE
X

Accounting differentiated from

auditing, 2 Accounting efficiency, review
of, 77 Accounting estimates, audit of, 242,
261 Accounting machines, advantages of, 14
Accounting machines, disadvantages of,
14
Accounting profession, salient features of, 21
Accounting system, 60, 95,96, 237, 254, .466!
Accounting system, evaluation of, 237, 241, .
Accounting system, study of, 237, 241
Accountants, implications for, 418 Accounts,
allocation of, 143, 144 Accounts,
authentication of, 315 Accounts balance, risk
of, 94 Accounts, circulation of, 313 Accounts,
filing of, 314 Accounts, fraudulent
manipulation of, 9 Accounts, implication for,
418 Accounts, manipulation of, 143 Accounts,
moral check of, 210 Accounts, statement of,
137, 140,144 Accounts receivable,
confirmation of, 53 Adjusting entries, scrutiny
of, 146 Advances, 216
Agents commission, examination of, 130
Agents expenses, examination of, 130
Amortisation copyrights, question of,
205 -Analytical review, 42, 182, 201
Analytical review, introduction of, 182
Analytical review, procedures, nature
of; 240
Analytical review, procedures, planning
of, 262, 280 Analytical review,
procedures, results
of, 185

Assessed control, risk documentation of, 100

Article of association, provision of, 113
Assets abroad, 203
Assets not possession of client, verification of,
159 Assets smTering from a charge, 157
Assets, incorrect valuation of, 7 Assets,
omission of outstanding of, 7 Assets,
verification of, 159, 201 . Ascertainment of
profits, importance of, 384
Association, articles of, 302 Association,
memorandum of, 301 Audit committee,
benefits of, 299 Audit coramittee, concepts of,
299 Audit conclusion, 30 Audit engagement
letters, 33, 236 Audit engagement letters,
contents of, 33
Audit engagement letters, principal contents,
34
Audit engagement letters, example of, 36
Audit procedures, cut-off, 1.15 Audit
committee work, scope of, 299 Audit
report, qualification of, 320 Audit
conclusions and reporting, 30,
168,257, 329 Audit work, quality
of, 186 Audit of financial
statements,
documents on,S4Q,'272t Audit of financial
statements, objective
of, 236, 272, 279 '

572

Audit of firJBnH! etatemerits, scope of,

236, 273* 279 Audit evidence, 30, 31,
237, 250, 324,
466
Audit evidence, appropriate of, 47 Audit
evidence, suffering of, 47 Audit note-book,
definition of, 64 Audit office, organisational
set up of, 57 Audit planning, 44, 236,466
Audit programme, definition of, 61 Audit
programme, developing of, 45 Audit
programme, advantage of, 62 Audit
programme, limitations of, 62 Audit
programme, preparation of, 61 Audit
programme, specimen of, 64 Audit to a firm,
advantage of, 382 Audit to a sole traders,
advantage
of, 382 Audit sampling, 115, 241 Audit
software, consists of, 491 Audit, conduct of,
31 Audit, casting of, 23 Audit, definition of, 1
Audit, final of, 33 / Audit, inherent limitations
of, 11 Audit, interim, 33 Audit investigation,
points Of, 437 Audit under other statutes, type
of. 342 Audit, objects of, 5, 25, 116 Audit,
origin of, 1 Audit, operation of, 23 Audit
procedures, Audit procedures, affecting of, 25
Audit, recurring, 34 Audit, scope of, 26
Audit, special points in different classes, 419
Audit, test checking of, 62:
Audit, ticking of, 23
Audited accounts, working papers of, 65
Auditing differentiated from
accounting, 2 Auditing profession in
Pakistan, history
of, 14,18.
Auditing, iundamental principles of, 15
Auditing, principles of, 1 Auditing,
techniques of, 15 Auditor articles of, 302
Auditor and the computer, 15 Auditor
appointed by private concern, liability of, 401
Auditors, certificate of, 366 Auditor and
partnership accounts,
procedures of, 379 Auditor-experience of,
493 Auditor lien, 297 Auditor's reports, 310,
313, 325 Auditor'* reports, basic elements of,
332 Auditor's report, dating of, 170, 171
Auditor's reports, event upto the date
of, 170, 241 Auditor's reports, general
matters of,
261;
Auditor's reports, introduction of, 306
Auditor's reports, inspection of, 297 Auditor's
reports, reading of, 297 Auditor's reports,
signature on, 297 Auditor's reports, special
purpose of,
242,273 Auditor's reports on financial

Auditing: Principles and Procedures

statements, 240, 241, 331 Auditor's report

on revised Financial
statements example of, 174 Auditor,
appointment of, 60, 290 Auditor, compliance
procedures, 81 Auditor, disqualification of,
292 Auditor, duties of, 293 Auditor,
independence of, 293 Auditor, qualification
of, 292 Auditor, qualities required in, 4
Auditor, powers of, 293 Auditor, status of,
298 Auditor, memorandum of, 301 Auditor,
criminal liabilities for, 407 . Auditor, labilities
of, 401 Auditor, liabilities for misfeasance,
405 Auditor, liabilities for libel, 409 Auditor,
liabilities for negligence, 401 Auditor report,
form of, 321 Auditor report to members, in
case of
bank, 319 Auditor report to shareholders,
in case
of banfe, 360 Auditor report to shareholders,
submission of, Auditor report', special
purpose of, 365 Auditor to third parties,
liabilities of,
411
Auditor, using the work of, 37 Auditor work,
scope of, 311 Authorisation for complete
verification of, 159

573

Index

Authorisation for purchase of, 137

Authorisation for sale, 140

Bad debts dividend, 124

Balances, list of, 146
Balance sheet, events occurring after
the date of, 169 Bank balance, 219
Bank charges, vouching of, 131 Balance
with agents, ascertain the
reason, 220 Bank report for audit
purposes,
standard request for, 162 Bank
reconciliation statement, checking
of, 148
Bank statements, audit of, 148
Bank, audit of, 420
Bank, internal check, 420
Basic principles of auditing, summary
of, Basic principles reporting, 286,
247,279,283, 284, 285 Bills payable,
checking of, 134 Bills payable book,
vouching of, 145 Bills payable, schedule of,
197 Bills receivable book, vouching of, 145
Bills receivable dishonoured,
examination of, 134 Book
debts, schedule of, 214 Branches of
book, audit of, 421 Brick company,
audit of, 422 Bus companies, audit
of, 422 Business investigations,
437

Capital, 190
Capital and liabilities, 190 Capital
expenditure, 128 Capital losses, 397 Capital
profit, 392 Capital, interest paid out of, 206
Capital work in progress, 203 Cash and other
balances, verification of, 218
Cash book, credit side of, 148 Cash book,
debit side of, 148 Cash book, vouching of,
122, 125 Cash, embezzlement of, 8 Cash-intransit, 219 Cash purchases, 126 Cash
received from debtors, checking of, 122
Cash sales, 122
Cash, misappropriation of, 441 Cast, 148,
Cast and postings, 138, 141, 143, 144 Casual
vacancy, 291 CAATs, uses of, 493,
Considerations in the use of, 494 CAATs,
availability of, 494 Charges, fixed, 159
Charges, floating, 159 Charitable institutions,
audit of, 422 Checking, trial balance, 7
Cinema and theatres, audit of, 423 Client's
business, 44 Club, audit of, 423 Collieries,

audit of, 424 Commission, errors of, 6

Commission received, checking of, 124
Commission, underwriting, 209 Contractual
agreements report on, 371 Computer assisted
audit techniques, 491 CAATs, description of,
491 Comparative trading profit and loss
accounts, interpretation of, 449
Compensatory errors, 6 Competence and
skills, 5 Compile financial information,
engagement to, 284
Components, audit of, 35
Computation, 50
Computer assisted audit techniques,
. 240, 252, 491 . Computer assisted audit
techniques,
controlling of, 496 Computer assisted
audit techniques,
description of, 492 Computer assisted
audit techniques,
uses of, 492 Computer and the auditor,
466 Computer system, on-line, 477 Computer
knowledge, 493 Conduct of auditing,
planning of, 247 Confidentially, 28, 28 285
Contractor, audit of, 425 Contractual
agreements, compliance
with, 275 Considerations, reporting
of, 40 Contingent liabilities, 164,181,199
Contingent, assets, 220 Continuous audit,
advantages tsf, 31 Continuous audit,
concepts of. 31

574

A uditing: Principles and Procedures

Continuous audit, disadvantages of, 31

Control environment, 96, 98 Control
procedures, 98 Control risk, preliminary
assessment, 99
Control risk, assessment of, 102, 103
Cooperation between auditors, 39 Correct
disclosure, points of, 157 Correct valuation,
154 Cost accounts, audit of, 296 Council,
functions of, 42 Credit notes, checking of, 144
Creditors, payments to, 125 Criminal
liabilities and auditor, 407 Current assets, 156
Custom duties, 133

Database systems, 486 Characteristics, 486

Database administration, 487 Database
en\dronment, internal control, 488
Data dictionary, 487
Database independence from application
programs, 486 Data sharing, 486 Data
ownership, 489 Database, access to, 489
Database on accounting system, effect
of, 490
Database audit procedures, effect of, 491 Data
entry and programmes controls,
.designed to, 412 Debentures, 194
Debentures, commission on, 208 Debit
balance, 147 Debit notes, checking of, 143
Deferred revenue expenditure, instances
of, 131, 220 Deferred taxation, 194
Deposits, schedule of, 217 Depth test, concept
of, 121 Depth test, objectives of, 122 Design
and procedural aspects, 107 Development
expenditure, period of, 204 Different classes
of audits, special points
in, 49 Directors'
fee, 135
Directors'declaration of the company's
solvency, report .of, 329
Dishonoured bills, examination of, 134
Dividend, payment of, 388, 389
Dividend income, checking of, 123
Dividend paid, rights of, 132
Dividend, proposed, 198
Divisible profit, 384
Divisible profit, concept of, 387
Doctor, audit of, 425
Documentation, 30, , 39, 239, 269, 281,
283,285,498 Draft upon reserves, 394
Drastic revision needed, 416 Dual
appointments, auditors' H ability
in, 410
Duplicate invoices, examination of, 138
Duties, regregation of, 474, 490

EDP application controls, purpose of, 109,

475
EDP application controls, review of, 110 EDP
environments, 241, 242 EDP environments,
auditing in, 240, 465
EDP environments on the study, effects of,
241
EDP environments, stand-alone
microcomputer, 467 EDP environments
on-line computer
systems, 476 EDP environments-database
system,
485
EDP environments, internal control of, 107
Educational institutions, audit of, 426
Effectiveness and efficiency of, 495 Electric
supply company, audit of, 427 Endowment
policies, 218 Enquiry under Securities and
Exchange
Ordinance, 449 Entries, closing of, 146
Entries, opening of, 145 Entries, transfer of,
145 Entries, verification of, 24 Error in the
population, expected to, 118 Error in the
sample, analysis of, 120 Error may exist,
indication of, 12 Errors and fraud, 259 Errors
and fraud, in sale of, 222 Errors,
compensatory of, 6 Errors, detection of, 6, 10,
239

575

Index

Errors, location of, 7

Errors, prevention of, 6
Errors, projection of, 120
Errors, risk of, 12, 15
Errors, trial balance, 6
Errors, subsequent discovery of, 271
Essential examination procedures, basic
principles of, 247 Essential procedures of
audit, summary
of, 246
Essential reporting, procedures, basic
principles of, 269, 282 Essential review
procedures, basic
principles of, 280 Ethics, 28
Evaluating internal control, methods of,
92,110
Evidence, quality of, 101, 284 Evidence,
timelines of, 102 Exchange, bills of, 214
Executors' accounts, audit of, 427
Expenditure, allocation of, 136 Experts, work
of, 268, 494 Extensive checking, 7

Facts after the financial statement

issued, discovery of, 173, 241 Final audit,
commencement of, 59 Financial statement
and auditor,
responsibility for, 26, 179 Financial
statement, audit of, 246 Financial statement,
components of, 275,370
Financial statement, identification of, 232
Financial Statement level, risk of, 94
Financial statement, opinion on, 232
Financial statement, review of, 245, 279
Financial statement, summarised of, 275
Fixed and floating assets, depreciation of,
3.92
Fixed assets and the auditor,
revaluation of, 398 Fixed assets, closing
date of, 169 Fixed assets, freehold land, 202
Fixed assets, goodwill, 202 Fixed assets,
leasehold land, 202 Fixed assets, resale of,
155 Fixed assets, sale of, 125 Forward
contracts, condition of, 137,
141
Freehold and leasehold property, 128
Freight and carriage, vouching of, 131
Fraud, check on; 31
Fraud, detection of, 10, 11, 239
Fraud and Error, risk of, .16
Fraud may exist, indication of, 13
Fraud, prevention of, 8, 11
Fraud, risk of, 12, 16
Fraud, terms of, 10
Furniture and fixture, sale of, 204

General, 4
General gu^elines, 286 General, EDP
controls, purpose of, 108, 475
General ledger, audit of, 147 General, quality
controls, 188 General, verification, 153 .
Going concern, appropriatness of, 241, 260
Goods for return, reason of, 144 Goods sent
on consignment, stock of, 213
Goods sent out on return basis, stock of, 213
Goods sent out on sale, stock of, 213 Goods,
despatch of, 140 Goods, exports of, 141
Goods, heavy sales of, 142 Goods,
misappropriation of, 9 Goods, receipt of, 137
Goods, sale on consignment basis, 142
Goods, sale or return basis of, 142
Governing on audit, basic principles of, 236
Governing review engagements, basic
principles of, 245

Hardware and data back-up, 474 Hire

purchase, payments of, 130 Hire purchase
system, assets^acquired on,206Honorary auditor, hability of, 410
Hospital, audit of, 427 Hotels, audit of,
428 Hypothecation, 159

A udiring: Principles and Procedures

576

Imports entries, checking of, 139

Importing house, audit of, 428
Incoming partner, investigation of, 444
Incorrect allocation, 7
Incorrect determination of profit, consequences of, 386
Independence, 4, 28
Independent opinion on accounts, expres-sion
of, 10
Individual audit, control of, 187
Information after date of auditors' report,
availability of, 235
Inherent, assessment of, 103
Inherent risk, 94, 103
Inquiry and confirmation, 50
Inquiry regarding Litigation and . Claims, 55
Insertion in prospectus, reporting of, 308
Inspection, 49
Inspection reports, checking of, 137
Instalment agreements, payments of, 130
.Insurance company-life, audit of, 428
Insurance premium, renewal of, 130
Integrity, 28, 283, 285
Interim audit, 33
Interim audit, advantages, 33
Interim dividend, 31
interim dividend, payment of, 390
Internal and external auditing differentiated,
78
Internal auditor in the organisation, place of,
77
Internal auditor, discussion of, 79
Internal auditor, using the work of, 239, 267
Internal and external auditors, cooperation of,
79
Internal and external auditors, relationship of,
81
Internal audit, concept of, 76
Internal audit function, general evaluation of,
82
Internal audit function, objectives of, 81
Internal audit function, scope of, 81
Internal audit report, 77
Internal audit, role of, 76
Internal audit, scope of, 76
Internal audit work, evaluating of, 82
Internal auditing, forward looking
approach, 77 internal check, 75 Internal
control, 75 Internal control distinguished, 75
Internal control, evaluation of, 77, 466
Internal Control in microcomputer
environments, 470 Internal control, operation
of, 254 Internal control, principles of, 84
Internal control, reliance on, 85 ' Internal

control, review oh, 85 Internal control, system

of, 85, 95 Internal control system of, cash payments, 88
Internal control system of, cash receipts, 87
Internal control system of,
manufacturing concerns, 86 Internal
control system of, small
concerns, 85 International accounting
standards,
compliance of, 339 International Audit
Standards 229, 406 International Standards on
auditing,
summary of, 234 International Standards
on auditing,
framework of, 236 International Standards
on related
services, summary of, 234, 236, 287
Interest accrued on investments, date of,
218 '
Introduction. 25, 37, 50, 93, 105, 170,
367,46?,477, 485 Inventory, observation
of, 51 Investigation account, position of, 440
Investigation accounts, qualities of, 441
Investigation defined, 43,7 investigation under
the Companies
Ordinance, 447 , Investigation, objects of,
438 Investigation, scope of, 440 Investigation,
types of, 441 Investments, interest of, 218
Investments, principal of, 217 Investments,
purchase of, 130

J
Journal, vouching of, 145

Index

577

Landed estates, audit of, 430 Lander on

money, investigation of, 386 .Liabilities,
169,'.196-Liabilities and commitments, 355
Liabilities in the accounts, reflection of, 330
Inabilities, contingent, 164, 199 Liabilities,
narrower'test of, 415 Liabilities, omission of,
7 Liabilities, verification, 190, 330 Liaison
and coordination, timing of, 82 Libel, auditors'
liability for, 409 Limitations, removal of, 62
Limited company, auditor of, 290 Live-stock,
inventory of,-210 Loans and advances,
sanction of, 216 Loans, against insurance
policy, 216 Loans, against security of goods,
216 Loans, against security of shares, 216
Loans, against security of land and
property, 216 Loans, agreements of, 130
Loans, secured, 196 Loans, unsecured, 196
Long terms investments, 56 Loose tools, cost
of, 209 Lower control risk, assessment of, 101

M
Mail order business, audit of, 431
Managements, competence of, 16
Managements, integrity of, 16 Managements,
letters, 93 Managements, representation of,
241, 264
Management authorization for
operating microcomputers, 470'
Managements representation letter,
basic elements of, 176 -Managements
representation letter,
example of, 176 Managements to provide
representation,
refusal of, 177 Managing agents,
remuneration of, 132 Manipulation, 143,144
Manipulation, stock of, 442 Mlal tests,
impracticability of, 494 Material
mconsistencies, aware of, 272 Hssrnal
misstatements, facts of, 272
Materiality and audit risk, concept of, 242
Materiality to accounts, concept of, 299
Materiality to auditor, concept of, 299
Materiality, misstatement of, 258
Memorandum of association, provision
of, 133 Method, short cut of, 8
Microcomputer systems, 466 Microcomputer
configuration, 468 Microcomputer,
characteristics of, 469 Microcomputer
environments, internal
control, 470 Microcomputer environment
on audit
procedures, effect of, 474 Mines and
quarries, cost of, 204 Mining company, audit

of, 431 Minutes book and the auditors, 302

Miscellaneous expenses, 135 Miscellaneous
receipts, 125 Misappropriation, stock of, 442
Misfeasance, auditors' liability for, 405
Mistakes, detection of, 6 Mistakes;
prevention of, 6 Modern trends, verification
of, 24 Mortgages, 159
Mortgages, company's register of, 158
Motor cab company, audit of, 431

Negligence liability judgement, new

professional of, 413 Negligence,
auditors' liability for, 401 New audit,
commencement of, 59 Newspapers and
periodicals, audit of,
432

Objectivity, 4, 28, 283, 285 Observation. 50

Obtaining audit evidence, methods of, 49
Obtaining audit evidence, problems of, 17
Oil producing company, audit of, 432
Omission of outstanding assets, 7 Omission
of outstanding liabilities, 7 Omission, errors
of, 6 Operating microcomputers,
management authorisation fir, 470
Opinions, types of, 334

578

Auditing: Principles and Procedures

Organisational sfaucture, 105 Overall

objective and stope of, 283, 284 Overall plan,
development of, 45 Ownership, verification
of, 155

Packages and empties, stock of, 213

Packages programme, function of, 416
Partners payment drawings,
entitlement of, 135 Partnership accounts,
audit-of, 432 Partnership audit, types of, 381
Partnership concerns, audit of, 379
Partnership firm contracted with audit
of limited company, audit of, 383 Patents,
description of, 205 Payments side, vouching
of, 125 Performance of organisation,
appraisal
of. 77
Performed agreed upon procedures,
engagement to, 283 Petty cash book,
vouching of, 135 Petty cash ttansactions,
88 . Physical existence, 154 Physical
security-equipment, 471 Physical security
non-removable media,
471 Physical security removable media, 471
Piece-work records, checking of, 127 Plant
and machinery, acquisition of,
129,203 Pledge,
159 Postal sales, 90
Population, 116
Postage expenditure, incurrence of, 133
Preliminary assessment, review of, 102
Preliminary expenses, 206
Previous years audited accounts, examination
of, 61
Previous years audited reports, examina-tion
of, 61
Principal, duties of, 42
Principal, obligations of, 42
Principle, errors of, 6
Procedures, analytical review, 25
Procedures, compliance of. 25
Procedures, substantive of, 25
Profession, basic characteristics of, 40
Professional competence, 4, 28
Professional conduct, 40
Professional misconduct, chartered
accountants of, 69, 72 Professional
misconduct, members of,
69,70,71. Professional misconduct,
students ofthe
institute, 73 Profit and loss account,
scrutiny of, 227 Profit and loss appropriation
account,

scrutiny of, 227 Profit, appropriation of,

390 Profit, concept of, 384 Profit, difficulties
in the determination
of, 386
On-line computer system on the
accounting system, effecting of, 481
On-line computer system on audit procedures,
effect of, 483
On-line/batch processing, 479
On line down loading/uploading . processing,
480
On line/inquiry, 479
On line/memo update, 479
Online/real time processing, 478
Profit, prior to incorporation, 396
Program and data security, 481
Progress of audit, records of, 67
Prospectus and auditor, 302
Publishers, audit of, 433
Purchase contracts, checking of, 137
Purchase ledger, audit of, 146
Purchase returns book, vouching of, 142
Purchase, inflation of, 139
Purchases, 89
r\irchases book, vouching of, 136 Purchases
invoices, checking of, 136, 138
Purchases suppression, 138

Qualifications, examples of, 322 Quality of

audit work, control of, 238 Queries, audit, 64
Quantity of stocks, verification of, 211

Railway companies, audit of, 433 Railway

sidings, expenses of, 203 Receipts and
payments account, abstract of, 307
Receipts side, vouching of, 122 Record,
inspection of, 49

579

Index

Recoverable claims, details of, 217

Rectification entries, checking of, 146
Registered society, audit of, 436 Related
internal control of audit,
evaluation of, 238 Related internal control
of audit, study
of, 238
Related parties, definition of, 166 Related
parties, existence of, 166 Related parties,
transactions with, 168, , 263
Related parties, transactions, examining
identified, 168
Reliance on analytical review procedures,
extent of, 185
Rents received, checking of, 123
Report, contents of, 314
Report, dating of, 271
Representation by management as audit
evidence, 175
Representation by management, documentation of, 176
Representation letter, 175
Reserve, 194
Responsibility, division of, 40 Retail stores,
audit of, 435 Revenue account, verification of,
226 Risk and assurance, 117 Risk assessment
and internal control, . 93,467
Routine checking, vouchers of, 112 Rubber
plants, audit of, 435
s

Sales, 91
Sales book, vouching of, 139 Sales
contracts, terms of, 140 Sales invoices,
checking of, 139, 141 Sales ledger, audit
of, 147 Sales order, execution of, 139
Sales over the counter, 91 Sales returns
book, vouching of, 144 Sales, allocation
of, 140 Sales, inflation of, 142 Sales,
suppression of, 141 v . Salaries, payment
of, 128 Sampling risk, assessing of, 121
Sample results, evaluation of, 120
Sample, design of, 116 Sample, selection
of, 119 Schedule I, 69
Schedule . -72
Schedule , 73
Scrutiny, 147
Secret reserve and auditor, 398
Secret reserve, over depreciation of, 326
Securities, sale of, 124
Segment information, 57
Securities to the public, offering of, 1 ?3
Reports on financial statement,

components of, 370 Reports on financial,

smnmarized of,
371
Reports on contractual agreements,
compliance with, 371 Reports on
components of financial
statement example of, 374 Reports on
summarized financial
statement, example of, 376 Selection,
random, 119 Selection, haphazard, 119
Selection, systematic, 119 Share capital of
limited company,
purchase of, 445 Share transfer audit, 193
Shares and debentures, commission on,
207
Shipping companies, audit of, 436
Sinking fund, 400
Skills and competence, 283, 285
Small business computer environments,
using CAATs of, 498 Small business,
internal control of, 103 Software and data
integrity, 473 Software and data back-up, 474
Sole traders, audit of, 379 Special audit, 347
Standards, overview of, 236 Special purpose
auditor's reports, 367 Standard request for
banker's,
objectives of, 219 Statistical records, use
of, 92 Statutory books and auditor, 304
Statutory report, certification of, 306 Stockin-trade, examination of, 210 Stock-in-trade,
value of, 169 Stock broker, audit of, 437
Stock in transit, value of, 212 Stores and
spare parts, inventory of, 209 Stores, checking
of, 91 Straffii cation, 119
Student, duties and obligations of, 42

580

Auditing: Principles and Procedures.

Subscriptions received, checking of, 124

Sugarcane, audit of, 437

Valuation of stocks, verification of, 211 Vehicles,

inventory of, 205 Verification, 24 Verification,
need for, 153 Verification, techniques for, 163
Vouch the amount, steps of, 132 Vouched sale
invoices, missing of, 141 Voucher, definition
of, 112 Vouching, 23, 112 Vouching, definition
of, 113 Vouching, extent of, 113 Vouching,
procedure of, 113 Vouching, technique of, 114

Taxation, provision for, 169, 198 Teerning

and lading, 122 Telephone expenses, charges
of, 134 Tenders and quotations, checking of,
137,144 Test data, techniques
of, 493 Testingj compliance of, 117
Testing, substantive of, 118 Ticking,
23
Time records, checking of, 126 Timing, 495
Tolerable error, 118 Trade account, scrutiny
of, 226 Trade marks and designs fee, renewal
of, 205
Transaction level, risk of, 95 Travellers'
commission, examination of,
130 v Travellers' expenses, examination
of,
130
Travelling allowances, checking of, 130

Unclaimed dividends, 196 Understanding,

documentation of, 100 Underwriting
commission, 209 Unexpired discounts, 198
Unqualified opinion, circumstances of, 337
Unusual items, investigation of, 186 Unusual
fluctuations, investigation of, 186
Unusual pressures within an entity, 16
Unusual transactions, 16 Use of CAATs,
application of, 496 Use of CAATs,
consideration of, 494 Utility programmes,
493 . .

w
Wages, 126
Wages book, preparation of, 127 Wages paid,
vouching of, 128 Wages sheets, preparation
of, 127 ' Wages, payment of, 127 Wasting
assets, 132 Watchdog, auditor, 416 Water
company, audit of, 438 Weaknesses in internal
control, commu-. mention of, 84, 415 Work in
process, inventory of, 212 Work of an expert,
using of, 241 Work of internal auditor,
introduction of, 80
Work performed by others, delegate, 265,281,
466
Work to assistants, delegation of, 187
Working paper, custody of, 67
Working paper, form and content, 65, 66
Working paper, ownership of, 67
Works, extent of, 62

Written representations from

management, 176