A STUDY OF :
SA – 501 : AUDIT EVIDENCE – ADDITIONAL CONSIDERATIONS FOR SPECIFIC ITEMS AND SA – 505 : EXTERNAL CONFIRMATIONS.
The profession of Chartered Accountancy is changing very fast in our country. Be it in the field of work, the style of work, the responsibility of doing the work or the knowledge behind accomplishing the work, everything is getting changed with every passing day. Hardly ever in the history of our profession, the Chartered Accountants had to get along with so many happenings around them. The financial sector in our country has suddenly started moving too fast. Rarely, we find a leisure Sunday morning to defragment our hard discs as a number of regulations or a proposed financial legislation, an Act or a Revised Standard keep hovering around it to enter. Sometimes I wonder, how much and how far capacity addition to our hard discs shall be going on. Just see the upcoming events that would be seeking berth in our hard discs in the near foreseeable future, The new Companies Bill, this time with class action suit provisions, the new draft Direct Taxes Code, convergence of Indian Accounting Standards with complex IFRS, the newly enacted Limited Liability Partnership, the newly revised auditing and assurance standards in line with the international auditing and assurance standards, the much-talked goods and services Tax, the newly emerged forensic audits and the routine revisions and amendments to statements and statutes. All these will undoubtedly open new vistas for chartered accountants but opportunities bring threats along with. The threats that cant be ruled out are:
The rate of knowledge obsolescence ; and
Drifting below the break-even point in the cost benefit analysis where cost represents resources to gather knowledge and benefit represents the professional opportunities.
But come what may, CAs are always expected to get through any situation and get ahead in their career. So before the "Chinton Boithok" starts for all the new happenings, let's find out sometime for our basics, the basics of Auditing.
My subject today is SA-501: Audit evidence – Additional consideration for specific items and SA-505: External Confirmations, the erstwhile AAS 34 and 30 respectively.
But before I jump to my topics for discussion, I would like to get an impression, in retrospect, of the structure of Auditing Standards in our country.
HISTORICAL BACKGROUND OF AUDITING STANDARDS IN INDIA
The Institute of Chartered Accountants of India constituted the Auditing Practices Committee (APC) on 17th September, 1982 to review the existing auditing practices in India and to develop statements on Standards Auditing Practices. The APC issued statements on Auditing Standards commonly known as SAP. In July2, 2002 , the Council of the Institute in its 226th meeting approved certain recommendations of the APC. The Auditing Practices Committee was renamed as Auditing and Assurance Standard Board (AASB) and the SAPs were renamed as Auditing and Assurance Standards (AAS). The Auditing and Assurance Standard Board, in 2007, adopted the revised preface to Standard on quality control, Auditing, Review, other assurance and related services. When one starts reading the present auditing standards, one would find a preface first, “Preface to the Standards on Quality Control, Auditing,Review, Other Assurance and Related Services”. This preface has not been revised. What has been revised is the erstwhile preface to the statement on SAPs issued in 1983. This revised preface paves way for total revamp of the existing structure of the Auditing and Assurance Standards (AASs) issued by the Institute on the lines of the International Standards issued by the International Auditing and Assurance Standards Board (IAASB). In terms of the revised preface, the AASs are now renamed based on the types of engagements undertaken by a member and are called Engagement Standards. They are : Standard on Auditing (SAs), Standard on Review engagements(SREs), Standard on Assurance Engagements(SAEs) and Standard on Related Services(SRSs). Apart from these, there is a mother Standard called Standard on Quality Control which applies to all practicing firms in respect of all their services falling under the Engagement Standards. This new scheme of auditing Standards was made effective from April 1, 2008. So, from April 1 , 2008 , the erstwhile AASs are renamed as Engagement and quality Control Standards. To save this in our hard disc forever, let us think that The Standard on Quality Control, i.e., SQC is the mother who has four daughters – SA, SRE, SAE & SRS. These four daughters, collectively known as Engagement Standards while their mother is known as Quality Control Standard and whose rules apply to all four daughters. In addition to these, each daughter has been allotted a numerical series so as to remember her own child. Here "Hum DO Hamara DO" rule does not apply, instead, the number of child are so many that numerical series had to be allotted to remember the child. Today I will discuss about two child, i.e., SA-501(Erstwhile AAS 34) on Audit evidence-Additional consideration for specific items & SA-505 (Erstwhile AAS 30) on External Confirmations.
Let me take first SA-505 : External Confirmations – Child no 20 of First daughter , Standard on Auditing.
SA-505 deals with " External Confirmations" . It was made effective from accounting periods beginning on or after Ist April, 2003.
The purpose of this Standard on Auditing (SA) – 505 is to establish standards on the auditor's use of external confirmations as a means of obtaining audit evidence.
SA-200 " Basic principles governing an audit" (Erstwhile AAS-1) states that, "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."
This is the basics of Auditing. In an audit, we should obtain sufficient appropriate audit evidence in order to give our opinion on the financial information. Now how much is sufficient and what is appropriate shall depend on the assessed level of inherent and control risk because we have to keep the audit risk at an acceptably low level. To assess the level of control risk, we exercise compliance procedures and based on the findings of the compliance procedures and other considerations like materiality etc., we decide the nature and extent of substantive procedures to be performed. External Confirmation is a substantive procedure used to obtain audit evidence.
The auditor should determine whether the use of external confirmations is necessary to obtain sufficient appropriate audit evidence to support certain financial statement assertions. In making this determination, the auditor should consider materiality, the assessed level of inherent and control risk, and how the evidence from other planned audit procedures will reduce audit risk to an acceptably low level for the applicable financial statement assertions. The auditor should employ external confirmation procedures in consultation with the management.
Please note that the assessed levels of inherent and control risk cannot be sufficiently low to eliminate the need to perform any substantive procedures. These substantive procedures may include the use of external confirmations for specific financial statement assertions. In this regard, it would be pertinent to read the paragraph 20 of SA-330 "The Auditors response to assessed risks". It reads as follows :
"Irrespective of the assessed risks of material misstatement, the auditor shall design and perform substantive procedures for material class of transactions, account balance, and disclosure". This requirement reflects the fact that : 1. The auditor's assessment of risk is judgmental and so may not identify all risks of material misstatement and 2. there are inherent limitations to internal control, including management override. So, it appears that obtaining external confirmations is a must for auditors at least in those cases where control risk is high. But if the assessed level of inherent and control risk is low, the auditor may limit the extent of substantive procedure. For example, an entity may have a loan that it is repaying according to an agreed repayment schedule, the terms of which the auditor has confirmed in previous years. If the other work carried out by the auditor (including such tests of controls as are necessary) indicates that the terms of the loan have not changed and has lead to the level of inherent and control risk over the balance of the loan outstanding being assessed as low, the auditor might limit substantive procedures to testing details of the payments made, rather than again confirming the balance directly with the lender.
The higher the assessment of inherent and control risk, the more audit evidence the auditor needs to obtain from the performance of substantive procedures. Consequently, the auditor designs substantive procedures to obtain more evidence, about a financial statement assertion. In these situations, the use of confirmation procedures may be effective in providing sufficient appropriate audit evidence.
In the audit of very small entities, the assessed level of inherent and control risk will always be high as there will be practically no control or little control and as such we need to exercise substantive procedures to the highest extent and external confirmation can prove to be a very good procedure to obtain audit evidence for certain assertions in the financial statement. Let me read paragraph A18 of SA-330 "The Auditors response to assessed risks". It says " In the case of very small entities, there may not be many control activities that could be identified by the auditor, or the extent to which their existence or operation have been documented by the entity may be limited. In such cases, it may be more efficient for the auditor to perform further audit procedures that are primarily substantive procedures."
External confirmation is the process of obtaining and evaluating audit evidence through a direct communication from a third party in response to a request for information about a particular item affecting assertions made by management in the financial statements.
The process of external confirmations, ordinarily, consists of the following:
i. Selecting the items for which confirmations are needed.
ii. Designing the form of the confirmation request.
iii. Communicating the confirmation request to the appropriate third party.
iv. Obtaining response from the third party.
v. Evaluating the information or absence thereof.
Selection of items for which confirmations are needed is very important .
The relevance of external confirmations to auditing a particular financial statement assertion is also affected by the objective of the auditor in selecting information for confirmation. For example, when auditing the assertion regarding the completeness of accounts payable, the auditor also needs to obtain evidence that there is no material unrecorded liability. Accordingly, sending confirmation requests to an entity's principal suppliers, asking them to provide copies of their statements of account directly to the auditor, even if the entity’s records show no amount currently owing to them, will usually be more effective in detecting unrecorded liabilities than selecting accounts for confirmation based on the larger amounts recorded in the accounts payable subsidiary ledger.
When obtaining evidence for assertions not adequately addressed by confirmations, the auditor considers other audit procedures to complement confirmation procedures or to be used instead of confirmation procedures.
Timing :
The auditor may request external confirmations either as at the date of the financial statements or as at any other selected date which is reasonably close to the date of financial statements. The date may be, alternatively, settled by the auditor in consultation with the management. Where the auditor decides to request for confirmations as at date which is other than the date of the financial statements, the auditor would need to examine the movement in the concerned account(s) that occur between the date of the confirmations and the date of the financial statements.
Positive and Negative Confirmations :
A positive external confirmation request asks the respondent to reply to the auditor in all cases either by indicating the respondent's agreement with the given information, or by asking the respondent to fill in information. The use of a positive confirmation is preferable when individual account balances are large, or where the internal controls are weak, or where the auditor has reasons to believe that there may be a substantial number of accounts in dispute or inaccurate or irregular. A response to a positive confirmation request is ordinarily expected to provide reliable audit evidence. There is a risk, however, that a respondent may reply to the confirmation request without verifying that the information is correct. The auditor is not ordinarily able to detect whether this has occurred. The auditor may reduce this risk,
however, by using positive confirmation requests that do not state the amount (or other information) on the confirmation request, but ask the respondent to fill in the amount or furnish other information. On the other hand, use of this type of "blank" confirmation request may result in lower response rates because additional effort is required of the respondents.
A negative external confirmation request asks the respondent to reply only in the event of disagreement with the information provided in the request. However, when no response has been received to a negative confirmation request, the auditor remains aware that there will be no explicit evidence that intended third parties have received the confirmation requests and verified that the information contained therein is correct or that the confirmation was sent by the respondent but not received by him.
Accordingly, the use of negative confirmation requests ordinarily provides less reliable evidence than the use of positive confirmation requests, and the auditor considers performing other substantive procedures to supplement the use of negative confirmations.
Negative confirmation requests may be used to reduce audit risk to an acceptable level when:
(a) the assessed level of inherent and control risk is low;
(b) a large number of small balances is involved;
(c) a substantial number of errors is not expected; and
(d) the auditor has no reason to believe that respondents will disregard these
requests.
The auditor may use positive or negative external confirmation requests or a combination of both.
The External Confirmation Process
When performing confirmation procedures, the auditor should maintain control over the process of selecting those to whom a request will be sent, the preparation and sending of confirmation requests, and the responses to those requests. Maintaining control means maintaining direct communications between the intended recipients and the auditor to minimize the possibility that the results of the confirmation process will be biased because of the interception and alteration of confirmation requests or responses. The auditor may give a list of accounts selected for confirmation to the management for preparing requests for confirmations, which should be properly addressed and stamped, alternatively, the auditor may request the management to furnish duly authorised confirmation letters and fill in the names, addresses and other relevant details relating to the accounts selected by him. The auditor should, however, ensure that it is the auditor who sends out the confirmation requests, that the requests are properly addressed, and that it is requested that all replies and the undelivered confirmations are delivered directly to the auditor. The auditor considers whether replies have come from the purported senders.
No Response to a Positive Confirmation Request
The auditor should perform alternative procedures where no response is received to a positive external confirmation request. The alternative audit procedures should be such as to provide the evidence about the financial statement assertions that the confirmation request was intended to provide.
When using a confirmation request other than a negative confirmation request, the auditor, generally, follows up with a second and sometimes third request to those parties from whom replies have not been received or, alternatively, contact the recipient of the request to elicit a response. Where the auditor is unable to obtain a response, the auditor would need to use alternative audit procedures. The nature of alternative procedures varies according to the account and assertion in question.
Management Requests
When the auditor seeks to confirm certain balances or other information, and management requests the auditor not to do so, the auditor should consider whether there are valid grounds for such a request and obtain evidence to support the validity of management's requests. The auditor should also ask the management to submit its request in a written form, detailing therein the reasons for such request. The management, for example, might make such a request on the grounds that due to a dispute with the particular debtor, the request for confirmation might aggravate the sensitive negotiations between the entity and the debtor. The auditor, in such a case, would examine any available evidence to support management’s request, say, examining the correspondence between the management and the debtor. If the auditor agrees to management's request not to seek external confirmation regarding a particular matter, the auditor should document the reasons for acceding to the management’s request and should apply alternative procedures to obtain sufficient appropriate evidence regarding that matter.
If the auditor does not accept the validity of management's request and is prevented from carrying out the confirmations, there has been a limitation on the scope of the auditor's work and the auditor should consider the possible impact on the auditor's report. The auditor should, however, in this case also, document the request made by the management along with the reasons given by the management therefore as well as his own reasons for not acceding to the management’s request.
This is all about External Confirmations as per SA-505.
Now, I turn to
SA-501 : AUDIT EVIDENCE- ADDITIONAL CONSIDERATION FOR SPECIFIC ITEMS. (Erstwhile AAS-34)
SA-500 deals with "Audit Evidence" in general while SA-501 deals with audit evidence with respect to certain specific items – amaounts and disclosure - in the financial statement . These items are : Inventory, Litigation and claims, Long-term investments and segment information. The introduction of this standard says that " The purpose of this Standard on Auditing (SA) is to establish standards on the auditor’s responsibilities, audit procedures and provide additional guidance to that contained in SA - 500, “Audit Evidence”, with respect to certain specific financial statement amounts and other disclosures. A reading of the title as well as the “Introduction” paragraph of this standard makes it clear that this Standard have to be read in conjunction with the requirements of SA - 500, Audit Evidence. SA – 501 has, accordingly, been divided in the following four parts:
Part A: Attendance at Physical Inventory Counting
Part B: Inquiry Regarding Litigation and Claim
Part C: Valuation and Disclosure of Long Term Investments
Part D: Segment Information
Part A: Attendance at Physical Inventory Counting :
The Institute had issued in November 1994 Guidance Note on Audit of Inventories. The Guidance Note dealt with the duties, responsibilities as well inventories and covered areas such as internal control evaluation, verification, considerations in case of work in progress etc., not withstanding the fact whether he is required to attend the physical inventory count or not. Attendance of the auditor at physical count of inventory by management has, however, been discussed in brief in the Guidance Note. The focus of SA - 501, however, is narrower in the sense that it restricts only to discussing the principles defining the duties and responsibilities of the auditor with respect to attendance at physical inventory counting when the auditor is so required to do. Now I discuss the Standard:
The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence during his attendance at physical inventory counting.
Physical verification of inventories is the responsibility of the management of the entity. Management ordinarily establishes procedures under which inventory is physically counted at least once in a year (end of the year, generally, or as near the end of the year as possible) to serve as a basis for preparation of the financial statements or to ascertain the reliability of the perpetual inventory system.
When inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by attendance at physical inventory counting unless impracticable, due to factors such as the nature and location of the inventory.
So, unless impracticable, the auditor should attend the physical inventory counting.
If unable to attend the physical inventory count on the date planned due to unforeseen circumstances, the auditor should take or observe some physical counts on an alternative date and where necessary, perform alternative audit procedures to assess whether the changes in inventory between the date of physical count and the period end date are correctly recorded.
Where attendance at the physical inventory counting is impracticable, the auditor should consider whether alternative procedures provide sufficient appropriate audit evidence of existence and condition of inventory to conclude that the auditor need not make reference to a scope limitation.
In planning attendance at the physical inventory count or the alternative procedures, the auditor would consider the following:
The nature of the accounting and internal control systems used regarding inventory.
Inherent, control and detection risks, and materiality related to inventory.
Whether adequate procedures are established and proper instructions issued for physical inventory counting.
The timing of the count.
The locations at which inventory is held and its nature.
Whether an expert’s assistance is needed.
When inventory is situated in several locations, the auditor would consider at which locations attendance is appropriate, taking into account the materiality of the inventory and the risk of material misstatement and the assessment of inherent and control risk at different locations.
The auditor would also consider cut-off procedures including details of the movement of inventory just prior to, during and after the count to ensure that such movements are appropriately included and/or excluded, as applicable from such inventory. For example,
(a) goods purchased but not received are included in the inventories; and
(b) goods sold but not despatched are excluded from the inventories.
When the quantities are to be determined by a physical inventory count and the auditor attends such a count, or when the entity operates a perpetual inventory system and the auditor attends a count one or more times during the year, the auditor would ordinarily observe count procedures and perform test counts.
For practical reasons, the physical inventory count may be conducted at a date other than period end. This will ordinarily be adequate for audit purposes only when the control risk is assessed at less than high. The auditor would assess whether, through the performance of appropriate audit procedures, changes in inventory between the count date and period end are correctly recorded.
When inventory is under the custody and control of a third party, the auditor would ordinarily obtain direct confirmation from the third party/arrange with the entity for sending requests for such confirmation as to the quantities and condition of inventory held on behalf of the entity.
The auditor should obtain a written representation from management concerning:
(a) the completeness of information provided regarding the inventory; and
(b) assurance with regard to adherence to laid down procedures for physical inventory count.
Audit conclusion and Reporting :
If the auditor is unable to obtain sufficient appropriate audit evidence concerning the existence of inventory or adequacy of procedures adopted by the management in respect of physical inventory count the auditor should make a reference to a scope limitation in his audit report. If the inventory is not disclosed appropriately in the financial statements, the auditor should issue a qualified opinion.
PART B : INQUIRY REGARDING LITIGATION AND CLAIMS
SA-501 speaks of auditor’s duties & responsibilities with respect to audit of litigation and claims. 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.
You might be aware that the Institute, in December 1995, issued a Guidance Note on Audit of Liabilities, containing detailed procedures with respect to audit of liabilities, such as loans and borrowings, trade creditors and other current liabilities as well as contingent liabilities including claims.
SA-501 assists the auditor as to how to identify claims, how and when to seek direct communication with the entity’s lawyers, factors to consider in the direct confirmation letters, situations of disagreement between entity’s management and entity’s lawyers, refusal of management to permit auditors to communicate with the entity’s lawyers, management representations with respect to litigation and claims.
The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity which may have a material effect on the financial statements. Such procedures would include the following:
Make appropriate inquiries of management including obtaining representations.
Review board /committee minutes and correspondence with the entity’s lawyers.
Examine legal and other relevant expense accounts.
Use any information obtained regarding the entity’s business including information obtained from discussions with in-house legal department, if any.
When litigation or claims have been identified by the management or when the auditor believes they may exist, and are likely to be material, the auditor may seek direct communication with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims. Such communication will assist in obtaining sufficient appropriate audit evidence as to whether potentially material litigation and claims are known and management’s estimates of the financial implications, including costs, are reliable.
The letter seeking direct communication with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims should be prepared by management. The auditor should maintain control over the process of preparation and sending of the letter. The letter should request the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims to communicate directly with the auditor.
In certain circumstances, for example, where the matter is complex or there is disagreement between management and the entity’s lawyers, it may be necessary for the auditor to meet with the entity’s lawyers to discuss the likely outcome of litigation and claims. Such meetings would take place with management’s permission and, preferably, with a representative of management in attendance.
If management refuses to give the auditor permission to communicate with the entity’s lawyers, this would constitute a limitation on the scope of the auditor’s work that requires expression of a qualified opinion or a disclaimer of opinion as the case may be. Where a lawyer or a professional refuses to respond in an appropriate manner and the auditor is unable to obtain sufficient appropriate audit evidence by applying alternative procedures, the auditor would consider whether there is a scope limitation which may lead to a qualified opinion or a disclaimer of opinion.
Management Representations
The auditor should obtain a written representation from management concerning the completeness and adequacy of information provided regarding the identification of litigation and claims, estimates of financial implications, including costs, etc.
Part C: Valuation and Disclosure of Long-Term Investments :
The Institute had issued in November 1994 a Guidance Note on Audit of Investments. The Guidance Note contained comprehensive procedures for audit of investments – whether long term or current – such as the internal control evaluation, verification of transactions, physical verification of investments, analytical review procedures, management representations, documentation requirements etc.
SA-501 assists the auditor to audit of long term Investments, whether quoted or not or in a form other than securities, management representations regarding valuation and disclosure and audit conclusion and reporting.
The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence for valuation and disclosure of long term investments when they are material to the financial statements.
Definition of long-term investments is given in Accounting Standard 13, "Accounting for investment" and is adopted for the purpose of this standard. As per AS – 13, Current Investment is an investment that is by its nature readily realizable and is intended to be held for not more than one year from the date on which such investment is made. A long term investment is an investment other than a current investment.”
Audit procedures regarding long-term investments ordinarily include obtaining audit evidence with respect to their ownership and existence 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 ordinarily include:
(a) In the case of quoted securities, 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 of the securities up to the date of the auditor’s report.
(b) In case of unquoted securities, ascertaining the method adopted by the entity for determining the value of such securities as at the year end. The auditor should examine whether the method adopted by the entity is one of the recognized methods of valuation of securities such as Profit Earning capacity Value method, break-up value method, capitalization of yield method, yield to maturity method, etc.
(c) In the case of investments other than in the form of securities, ensuring that the market value has been ascertained on the basis of authentic market reports, and /or based on expert’s opinion, if warranted.
If such values do not exceed the carrying amounts, the auditor would consider whether a write-down is required. If there is an uncertainty as to whether the carrying amount will be recovered, the auditor would consider whether appropriate adjustments and/or disclosures have been made.
Management Representations
The auditor should obtain a written representation from management regarding :
(a) the completeness of information provided regarding valuation and disclosure of long term investments;
(b) the valuation of long term investments in the financial statements including adequacy of provision for diminution in such values, wherever required; and
(c) the intention of the management to continue to hold long-term investments as long-term investments.
Audit Conclusions and Reporting
If the auditor is unable to obtain sufficient appropriate audit evidence concerning the existence, valuation of long term investments or concludes that their disclosure in the financial statements is not adequate, the auditor should express a qualified opinion or a disclaimer of opinion in the audit report, as may be appropriate.
PART D : Segment Information :
This part applies to enterprises which are listed or in the process of being listed on a recognized stock exchange and all enterprises whose turnover exceeds Rs. 50 crores for the accounting year and hence this is not of much importance to us except for academic interest . I skip this.
Dear members, you might have noticed that many a places in the above two standards, alternative procedures and additional procedures are repeated. Now, what are alternative and additional procedures have not been explained because this is not simply feasible and hence somewhere some examples are cited. In this regard, SA – 520 which deals with "Analytical Procedures" may be of much use to an auditor. The fact is that Auditing is not a Science. Much depend on the skill, ability and judgment of the Auditor in handling a particular situation. Hence, Auditing Standards cannot be rule based, it must be principle based. This is a fact and shall remain so, so much ever one argues and so much ever one makes an effort to equalize professional negligence with criminal offence.
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