CAtestseries.

org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 1

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concept Notes

Chapter -1

NATURE, OBJECTIVE AND SCOPE OF AUDIT

INTRODUCTION

Auditing is a critical process in the modern business environment that provides confidence
and assurance to a wide range of users, including investors, shareholders, banks,
governments, trade unions, and insurance companies, by examining and verifying financial
statements. Its nature and scope involve the examination of financial records, internal
controls, and compliance with laws and regulations. Auditing has limitations, and it does not
involve making financial decisions or providing absolute guarantees of financial success.

ORIGIN OF AUDITING

Auditing has a long history, with references found in ancient texts like Kautilya's Arthshastra
from the 4th century BC. The term "audit" comes from the Latin word "audire," meaning "to
hear," reflecting the early practice of auditors listening to accounts being read. In modern
history, the first Auditor General of India was appointed in 1860, and the Institute of
Chartered Accountants of India was established as a statutory body in 1949 to regulate the
profession of Chartered Accountancy in the country.

MEANING AND NATURE OF AUDITING

Auditing is a process where an independent expert reviews the financial information of any
organization, whether it's a for-profit business or not, regardless of its size or legal structure.

CATESTSERIES.ORG
The purpose of this examination is to provide an expert opinion on the accuracy and reliability
of that financial information.

An incisive analysis of above meaning of auditing brings out following points clearly:

A. Independence is Crucial: Auditing means checking financial information, and the auditor
must be independent. This means their judgment isn't influenced by anyone related to the
entity being audited. For example, if your brother is a Chartered Accountant, he can't audit
your business because his family ties might affect his judgment.
B. Applies to All Types of Entities: Auditing isn't just for profit-focused businesses. It can also
be done for non-profit organizations like NGOs or charities. Plus, it's not limited by the size or
legal structure of the organization. It can be done for small businesses, big corporations,
partnerships, limited liability partnerships (LLPs), private companies, public companies,
societies, and trusts.
C. The Goal is to Give an Expert Opinion: Auditing's main purpose is to provide an expert's
opinion on financial statements. This opinion ensures that the financial information in those
statements is accurate and reliable. It's like having a referee in a game to make sure the rules
are followed.

He has to see that financial statements would not mislead anybody by ensuring that: -
• Accuracy: Auditors make sure that the financial statements match the company's actual
records.

• Evidence Backing: They check that all the numbers have proper proof and documentation.

• No Missed Entries: Auditors ensure that nothing important is left out when creating the
financial statements.

 Clarity: They confirm that the financial information is clear and easy to understand, not
confusing.

• Follow the Rules: Financial amounts are categorized, described, and disclosed as per
accounting standards

CATESTSERIES.ORG
• True and Fair Picture: Auditors guarantee that the financial statements show a real and
honest view of the company's financial health.

INTERDISCIPLINARY NATURE OF AUDITING RELATIONSHIP WITH DIVERSE SUBJECTS

Auditing is a multidisciplinary field that incorporates principles from accounting, law,

behavioral science, statistics, economics, and financial management. Auditors require a solid
understanding of accounting principles for financial statement examination and compliance
assessment with business and taxation laws. Interaction skills, statistical methods, economic
comprehension, financial management knowledge, and awareness of financial markets are
crucial elements in performing comprehensive audits.

Data
Processing

Behavioural Financial
Science Management

Auditing
Economics Production

Law Accounting

1. Auditing and Accounting: Auditing checks financial statements, which are the result of the
accounting process
2. Auditing and Law: Auditors need to know business laws that affect the entity they're
auditing
3. Auditing and Economics: Auditors should understand the economic environment that
influences their client's business.
4. Auditing and Behavioral Science: Knowledge of human behavior is crucial for auditors to
do their job effectively.

CATESTSERIES.ORG
5. Auditing and Statistics & Mathematics: Auditors use statistics and math to draw
meaningful conclusions and verify inventories.
6. Auditing and Data Processing: Electronic Data Processing (EDP) auditing is becoming its
own field of expertise.
7. Auditing and Financial Management: Auditors need to understand financial techniques
like managing working capital, funds flow, ratio analysis, and capital budgeting.
8. Auditing and Production: A good auditor grasps their client's business functions, including
production, cost systems, and marketing, for a comprehensive audit.

OBJECTIVES OF AUDIT

The objectives of an audit, as defined by SA-200 "Overall Objectives of the Independent

Auditor and the Conduct of an Audit in Accordance with Standards on Auditing," can be
summarized as follows:

a) To obtain reasonable assurance about the accuracy of the financial statements: The
primary objective of an audit is to assess and provide reasonable assurance that the financial
statements are free from material misstatements, whether they result from fraud or error.
This reasonable assurance enables the auditor to express an opinion on whether the financial
statements, taken as a whole, are prepared in accordance with the relevant financial
reporting framework.
b) To report on the financial statements and communicate findings: The auditor is
responsible for reporting on the financial statements and communicating their findings in
accordance with the requirements set forth in the Standards on Auditing (SAs). This
communication may include any significant issues, findings, or concerns that the auditor
identifies during the audit process, which may be relevant to the users of the financial
statements.

An analysis of above brings out following points clearly: -

CATESTSERIES.ORG
 Auditor's Objective: The auditor's main goal is to provide "reasonable assurance" that
financial statements are free from significant mistakes, whether caused by fraud or errors.
This is not a complete guarantee but a high level of confidence.
 Fraud or Error: Misstatements in financial statements can happen because of fraud, error,
or both. The auditor's job is to make sure the financial statements are accurate overall.
 Expressing an Opinion: When the auditor is reasonably sure that the financial statements
are free from significant errors, they can express an opinion on whether the statements follow
the rules of the financial reporting framework.
 Reporting the Opinion: The auditor shares their opinion through a written report,
following the auditing standards. This report communicates their findings to stakeholders.

SCOPE OF AUDIT-WHAT IT INCLUDES

The scope of an audit refers to what the audit covers. Audits aim to increase the trust of
financial statement users, like shareholders, employees, and regulators. This trust is built
through the auditor's opinion on whether the financial statements follow the established
rules. In simpler terms, the scope of an audit is what the audit checks to make financial
statements more trustworthy.

The following points are included in scope of audit of financial statements

a) Coverage of All Aspects: Auditors must examine all aspects of the company relevant to the
financial statements. For instance, they check not only the sales and expenses but also things
like employee payroll, inventory, and loans.
b) Reliable Information: Auditors need to be reasonably sure that the data in the company's
accounting records and other documents, like bills and vouchers, is dependable and enough
to create accurate financial statements. For example, they check that sales and expenses are
recorded correctly.
c) Proper Disclosure: Auditors also ensure that all the necessary information is correctly
presented in the financial statements, and they consider legal requirements. For instance,
they check if the company properly reports things like changes in accounting policies.

CATESTSERIES.ORG
d) Historical Financial Information: Financial statements are like a history book of the
company's financial activities. For example, when you see a sale listed on the financial
statement, it's a record of a past event – the sale that happened in the past.

SCOPE OF AUDIT-WHAT IT DOES NOT INCLUDE

The scope of audit is general and broad, focusing on obtaining reasonable assurance about
the overall accuracy and reliability of financial statements. Auditors are not expected to
possess expertise in specific areas outside their domain, such as assessing the physical
condition of machinery or determining the suitability and lifespan of buildings. They also do
not authenticate documents or conduct official investigations into alleged wrongdoing. In
contrast, investigation is a focused and specific examination often prompted by suspicion of
fraud, involving a critical examination of accounts with a specialized purpose. The key
distinction lies in the broad and general nature of audit, seeking assurance on the financial
statements as a whole, compared to the specific and narrow focus of investigation on
particular concerns or allegations.

INHERENT LIMITATIONS OF AUDIT

Certainly, in simple terms, there are inherent limitations in the audit process that prevent
auditors from being absolutely certain that financial statements are completely free from
errors or fraud. These limitations are due to several factors:

1. Nature of Financial Reporting: Financial statements involve judgments and uncertainties.

Auditors can't guarantee that there are no significant mistakes in the statements due to fraud
or errors. For example, if employees collude to fake purchase records, internal controls may
fail.
2. Nature of Audit Procedures: Auditors use procedures to collect evidence, but practical and
legal limits mean they can't examine every transaction. Management may not provide all

CATESTSERIES.ORG
information, and sometimes, they might be involved in fraud, making it hard for auditors to
detect.
3. Not an Investigation: Audits are not official investigations, so they can't uncover all fraud
or errors.
4. Timeliness and Relevance: Information can become outdated, and auditors might rely on
old data that's no longer accurate. This means auditors have to balance information reliability
with the cost of obtaining it.
5. Future Events: Unexpected events can severely affect a company, and auditors can't
predict or prevent these events.

WHAT IS AN ENGAGEMENT

An engagement, in the context of auditing, is a formal agreement between an auditor and a

client. This agreement is documented in an engagement letter and outlines the auditor's
commitment to provide auditing services. It's like a contract specifying what the auditor will
do for the client.

EXTERNAL AUDIT ENGAGEMENTS

In simple terms, external audit engagements are formal agreements where external auditors
review a company's financial statements to increase the confidence of the people who rely
on those statements. This is typically done to provide reasonable assurance that the financial
statements are accurate. For example, in India, companies are legally required to have their
annual financial accounts audited by an external auditor. Even non-corporate entities may
opt for external audits to enjoy the advantages of this assurance. It's like a financial check-up
conducted by an independent expert to ensure everything is in order.

CATESTSERIES.ORG
BENEFITS OF AUDIT-WHY AUDIT IS NEEDED

1) High-Quality Information: Audited accounts provide reliable and top-quality information.

They follow global auditing standards, giving users confidence in the data's accuracy.
2) Shareholder Confidence: Shareholders, who may not be involved in daily company
operations, need assurance that financial information is trustworthy. An audit safeguards
their interests by providing an independent review.
3) Preventing Fraud: The fear of being caught in an audit acts as a deterrent for employees,
reducing the likelihood of fraud.
4) Tax Determination: Government authorities use audited financial statements to calculate
tax obligations.
5) Lending Decisions: Lenders and bankers rely on audited statements to decide whether to
lend money to a company or not.
6) Fraud Detection: Audits can uncover fraud or errors that may have occurred.
7) Controls Evaluation: Audits assess the effectiveness of various controls within a company,
highlighting any deficiencies that need attention

AUDIT- MANDATORY OR VOLUNTARY

Audits are not always legally mandatory. Some entities, like companies, are legally required
to have their accounts audited, while non-corporate entities may need audits due to tax laws.
Others, like schools, may choose to get audits to secure government grants. However, many
entities voluntarily opt for audits because they see the benefits of the process and may have
internal rules in place that require audits for those advantages.

WHO APPOINTS AN AUDITOR

Auditors are typically chosen by the owners of a business or, in some cases, by government
authorities as required by laws and regulations. For example, in companies, shareholders
appoint auditors at the Annual General Meeting. Government companies might have auditors
appointed by the Comptroller and Auditor General of India, an independent constitutional

CATESTSERIES.ORG
authority. In the case of a partnership firm, the partners appoint the auditor. There are also
situations where government authorities appoint auditors, such as under tax laws. The key is
that auditors are selected based on specific rules and responsibilities outlined in various laws
and regulations.

MEANING OF ASSURANCE ENGAGEMENT

An "assurance engagement" is when a professional (practitioner) provides a conclusion to
increase the confidence of users (other than the responsible party) regarding the accuracy of
specific information compared to certain criteria. In simple terms, it's a service where an
expert offers their opinion to give users greater confidence in the reliability of certain
information, helping them make more informed decisions with reduced risk of errors.

ELEMENTS OF AN ASSURANCE ENGAGEMENT

a) Three-Party Relationship: In an assurance engagement, there are three main parties

involved: the practitioner (the one providing assurance), the responsible party (responsible
for the subject matter), and the intended users (who receive and use the assurance report).
b) Appropriate Subject Matter: This refers to the information that the practitioner will
examine. For example, in financial audits, it's the financial information in the statements.
c) Suitable Criteria: These are the standards or benchmarks used to evaluate the subject
matter. They can be laws, rules, regulations, or industry standards.
d) Sufficient and Appropriate Evidence: The practitioner collects evidence to support their
conclusions. "Sufficient" refers to having enough evidence, and "appropriate" means the
evidence is of good quality.
e) Written Assurance Report: The outcome of an assurance engagement is a written report
that conveys the practitioner's conclusion about the subject matter. This report provides
assurance to the intended users.

CATESTSERIES.ORG
MEANING OF REVIEW; AUDIT VS. REVIEW

An audit gives a higher level of confidence, called "reasonable assurance," by thoroughly

examining financial statements. On the other hand, a review provides a lower level of
confidence, termed "limited assurance," by conducting fewer checks and gathering less
evidence. Both audit and review focus on historical financial information in financial
statements.

TYPES OF ASSURANCE ENGAGEMENTS- REASONABLE ASSURANCE ENGAGEMENT VS.

LIMITED ASSURANCE ENGAGEMENT

Assurance engagements offer varying degrees of confidence to users. An audit, like a

reasonable assurance engagement, provides a high level of confidence. In contrast, a review,
which is a limited assurance engagement, offers a moderate level of confidence, lower than
an audit.

Aspect Reasonable Assurance Limited Assurance

Engagement Engagement
Level of Assurance Provides a high level of Provides a lower level of
assurance assurance compared to
reasonable assurance
engagement
Procedures Involves elaborate and Performs fewer procedures
extensive procedures to compared to a reasonable
obtain sufficient assurance engagement
appropriate evidence

Conclusions Draws reasonable Involves obtaining sufficient

conclusions based on appropriate evidence to
sufficient appropriate draw limited conclusions
evidence.

CATESTSERIES.ORG
 Examples An example of a reasonable An example of a limited
assurance engagement is an assurance engagement is a
audit engagement. review engagement
.

QUALITIES OF AUDITOR

An auditor plays a vital role in reporting on financial matters of businesses and institutions,
navigating the challenges of human errors and fraud. Essential qualities for auditors include
tact, caution, integrity, patience, and expertise in accounting principles. These traits, coupled
with technical training, enable auditors to critically review financial statements and maintain
a position of trust. Comprehensive knowledge of accounting principles is fundamental for
effective auditing.

ENGAGEMENT AND QUALITY CONTROL STANDARDS: AN OVERVIEW

The following Standards issued under authority of ICAI Council are collectively known as
Engagement Standards:

 Standards on Auditing (SAs) are used for auditing historical financial information, ensuring
high-quality standards and guidance for financial statement audits.
 Standards on Review Engagements (SREs) apply to the review of historical financial
information, setting quality standards for review engagements.
 Standards on Assurance Engagements (SAEs) are used for assurance engagements other
than audits and reviews of historical financial information, providing guidance for various
assurance services.
 Standards on Related Services (SRSs) apply to services such as agreed-upon procedures,
compilation engagements, and related service engagements, establishing standards and
guidelines for these activities.

CATESTSERIES.ORG
STANDARDS ON AUDITING

Standards on Auditing are guidelines for independent auditors when auditing financial
statements. They set high-quality benchmarks for auditing financial information, particularly
historical data. These standards cover various aspects of the audit process, such as the
auditor's objectives, documentation, risk assessment, planning, sampling, gathering
evidence, and forming opinions for reporting on financial statements. In short, they provide
a framework for conducting thorough and reliable financial audits.

 SA 200 (Overall Objectives): It outlines the core goals for auditors and how audits should
be conducted in line with auditing standards.
 SA 230 (Audit Documentation): This standard emphasizes the importance of maintaining
organized records of audit procedures, findings, and conclusions.
 SA 315 (Risk Assessment): It guides auditors in identifying and evaluating the risks of
significant errors or fraud in financial statements by understanding the entity and its
environment.
 SA 500 (Audit Evidence): This standard explains the types of evidence that auditors should
collect to support their audit conclusions.
 Revised SA 700 (Opinion and Reporting): It sets guidelines for auditors to form opinions
based on audit findings and effectively report those opinions on the accuracy and reliability
of financial statements.

STANDARDS ON REVIEW ENGAGEMENTS

Standards on review engagements are used when reviewing financial statements. Reviews
provide a lower level of assurance compared to audits because they involve fewer
procedures. However, even in a review, the auditor obtains sufficient appropriate evidence,
as seen in cases like reviewing interim financial information for reliability.

Examples of Standards on Review engagements are:

 SRE 2400 (Revised) - Guidelines for Reviewing Historical Financial Statements
 SRE 2410 - Reviewing Interim Financial Information Conducted by the Independent Auditor
of the Entity

CATESTSERIES.ORG
STANDARDS ON ASSURANCE ENGAGEMENTS
Standards on Assurance Engagements (SAEs) are a set of guidelines used in assurance
engagements that deal with subject matters other than historical financial information. These
standards apply when the assurance engagement does not involve the "audit" or "review" of
historical financial information. For example, SAEs are used for assurance engagements
related to prospective financial information or providing assurance on non-financial matters
such as the design and operation of internal controls in an entity.

Examples of Standards on Assurance Engagements are:

 SAE 3400 - Examining Future Financial Information
 SAE 3420 - Assurance for Pro Forma Financial Information in a Prospectus

STANDARDS ON RELATED SERVICES

Related services standards pertain to tasks like performing agreed-upon procedures on
specific financial data or assisting in preparing historical financial information. For instance,
these standards cover engagements involving individual financial items, balance sheets, or
complete financial statements. They clarify that these tasks are not assurance engagements
and no opinions are expressed. Examples of related services standards include SRS 4400 for
agreed-upon procedures and SRS 4410 (Revised) for compilation engagements. These
standards, along with auditing, review, and assurance standards, collectively form the
Engagement Standards.

STANDARDS ON QUALITY CONTROL

Standards on Quality Control (SQC) outline a firm's responsibilities for maintaining a system
of quality control when conducting audits, reviews, and other assurance and related service
engagements. SQC 1 is a key standard in this area, requiring auditors and practitioners to
establish quality control systems that ensure compliance with professional standards and
legal requirements. The primary goal is to maintain quality and ensure the issuance of
appropriate reports when providing services covered by engagement standards.

CATESTSERIES.ORG
WHY ARE STANDARDS NEEDED
Standards are like rules that help auditors perform audits up to global standards. They
enhance the quality of financial reporting, making it easier for users to make informed
decisions. Standards also bring consistency to the audit process, ensuring that all audits follow
the same rules. They provide professional accountants with the knowledge and skills they
need to do their job well and, most importantly, they ensure that audits are of high quality

CATESTSERIES.ORG
 CAtestseries.org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 2

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concepts Notes

Chapter -2

AUDIT STRATEGY, AUDIT PLANNING AND AUDIT PROGRAMME

AUDITOR’S RESPONSIBILITY TO PLAN AN AUDIT OF FINANCIAL STATEMENTS

SA 300 (Standard on Auditing 300) outlines the auditor's responsibility to plan an audit of
financial statements. Its main goal is to ensure the audit is conducted effectively. The
standard emphasizes the importance of careful planning to achieve a thorough and
successful audit process.

WHY PLANNING AN AUDIT IS NECESSARY? - ITS BENEFITS

Planning an audit is essential to conduct it efficiently and on schedule. It not only ensures
that the audit follows professional standards but also aids in the effective execution of the
audit engagement.

Adequate planning benefits the audit of financial statements in several ways, including
the following:
1. Focus on Important Areas: Planning helps the auditor pay attention to crucial parts of
the audit.
2. Problem Identification and Resolution: It helps spot and solve issues in a timely manner.
3. Efficient Organization: Planning ensures the audit is well-organized and runs smoothly.
4. Team Selection and Work Assignment: It helps in picking the right team members and
assigning tasks effectively.
5. Team Direction and Review: It makes it easier to manage the team's work and review
their progress.
6. Coordination with Others: In some cases, it assists in coordinating work done by external
experts or parties involved in the audit.

CATESTSERIES.ORG
NATURE OF AUDIT PLANNING- A CONTINUOUS AND ITERATIVE PROCESS
Audit planning is not a one-time event; it's an ongoing process that begins shortly after the
previous audit and continues throughout the current engagement. It involves considering
the timing of specific activities and procedures that must happen before further audit steps.
Here are some key aspects of planning with specific examples:

A. Analytical Procedures: Auditors use financial analysis to identify unusual patterns. For
example, they might compare this year's sales figures to previous years to spot unexpected
changes.
B. Legal and Regulatory Compliance: Auditors ensure the company follows laws and
regulations. For instance, they check if a healthcare company complies with healthcare
regulations in its operations.
C. Materiality Determination: Auditors decide what financial errors are significant. For
example, a mistake in a large corporation's financial statement might be considered minor,
but the same error in a small business could be important.
D. Involvement of Experts: Experts are brought in for specific technical matters. For
instance, an engineering expert might assess the value of a construction company's assets.
E. Other Risk Assessment Procedures: Auditors perform various checks, like interviewing
management or examining internal controls. For example, they might assess the risk of
inventory theft in a retail business.

PLANNING PROCESS- ELEMENTS OF PLANNING

The elements of planning can be categorized as under: -

(I) Preliminary engagement activities

(II) Planning activities

CATESTSERIES.ORG
PRELIMINARY ENGAGEMENT ACTIVITIES

The auditor assesses whether it's appropriate to maintain a professional relationship with
the client and whether the client complies with ethical requirements, specifically ensuring
independence. In essence, the auditor evaluates whether it's still suitable to work with the
client and if ethical standards are being upheld.
A. Checking if it's appropriate to continue the client relationship.
B. Ensuring compliance with ethical standards, including independence.
C. Clarifying the terms and conditions of the engagement.

Preliminary engagement activities include the following: -

(A) Performing procedures regarding the Continuance of Client Relationships and Audit
Engagements Acceptance and Continuance of Client Relationships and Audit Engagements
The auditor needs to follow proper procedures when accepting or continuing client
relationships and audits. It stresses the need to gather essential information, considering
factors like integrity and team competence. Additionally, when there's a change in auditors,
communication with the predecessor is highlighted for a smooth transition.
(B) Evaluating compliance with ethical requirements including independence
The auditor's responsibility to continuously assess compliance with ethical requirements,
particularly independence. Independence means that the auditor's judgment isn't
influenced
by someone who engaged them. The engagement partner must stay vigilant throughout the
audit, watching for any signs of ethical violations by the audit team. If such issues arise, the
engagement partner, with input from others in the firm, decides on the appropriate action.

In determining compliance with independence requirements, the engagement partner

must:
1. Gather Information: Obtain relevant information from the firm to identify and assess
circumstances and relationships that could threaten independence.
2. Evaluate Breaches: Assess breaches, if any, of the firm's independence policies to
determine if they pose a threat to independence for the audit engagement.

CATESTSERIES.ORG
3. Take Action: Take necessary steps to eliminate or reduce identified threats to an
acceptable level. This may involve applying safeguards. If the threats persist, withdrawing
from the audit might be considered, where allowed by law. Any unresolved issues should be
promptly reported to the firm for appropriate action.
(C)Establishing an understanding of terms of engagement
Before starting an audit, it's important for the auditor to send an audit engagement letter to
the client. This letter helps prevent misunderstandings between the auditor and the client
about what the audit will involve. It's like a clear agreement that lays out the terms of the
engagement, ensuring both the company being audited and the auditor are on the same
page and avoid any confusion. This helps establish a mutual understanding and sets the
stage for a smoother audit process.

PLANNING ACTIVITIES

1) Establishing the overall audit strategy

2) Developing an audit plan

(A) Establishing the overall audit strategy- Assistance for the auditor

The auditor needs to create an overall audit strategy. This strategy decides what areas to
focus on, when to do it, and how to approach the audit. It helps figure out things like:

1) Who Does What: Decides which team members, especially experienced ones, should
handle high-risk areas, or if experts are needed for complex matters.
2) How Much Resources: Determines how many team members are needed for tasks like
counting inventory or reviewing other auditors' work in group audits. Also, it sets the audit
budget for high-risk areas.
3) When to Deploy Resources: Decides when to use these resources, like during an interim
audit or at specific key dates.
4) Management and Supervision: Plans how to manage, direct, and supervise resources.
This includes scheduling team briefings and debriefings, deciding when reviews by the

CATESTSERIES.ORG
engagement partner and manager happen (on-site or off-site), and whether engagement
quality control reviews should be completed.

Factors to be taken into consideration by auditor for establishing audit strategy

(a) Identify the characteristics of the engagement that define its scope

It is important for auditors, figuring out the scope of the audit is crucial. It helps in creating a
solid audit strategy. The scope is defined by various characteristics, including:

 Financial Reporting Framework: Understanding the rules and standards that apply to the
entity's financial reporting.
 Nature of Business Segments: Knowing which parts of the business will be audited, and if
any specialized knowledge is needed for those segments.
 Industry Reporting Requirements: Considering specific reporting rules set by industry
regulators that the entity must follow.
 Use of Previous Audit Evidence: Understanding how evidence from previous audits will be
used in the current one.
(b) Ascertain the reporting objectives of the engagement to plan the timing of the audit
and the nature of the communications required.
When the auditor figures out what the reporting objectives are for the engagement, it helps
in planning when and how different audit tasks should be done. Here are some examples:
 Entity's Reporting Timetable: Knowing when the company plans to release its reports.
 Organizing Meetings: Setting up meetings with the management to discuss the nature,
timing, and extent of the audit work.
 Discussing Report Types and Timing: Talking with management about the kind of reports
expected and when they should be issued, including the auditor's report.
 Communication on Audit Status: Discussing with management how and when updates
on the audit progress will be shared.
 Communication within the Team: Planning how the audit team will communicate,
including the nature and timing of team meetings and when work reviews will happen.
(c) Consider the factors that, in the auditor’s professional judgment, are significant in
directing the engagement team’s efforts

CATESTSERIES.ORG
The auditor needs to focus the engagement team on things that are crucial in their
professional judgment. Identifying important classes of transactions and account balances
early on helps in setting the overall audit strategy. More attention should be given to
significant matters for better outcomes. Examples include:
 Transaction Volume: Assessing the volume of transactions to decide whether relying on
internal controls is more efficient.
 Industry Developments: Keeping an eye on significant changes in the industry, like new
regulations or reporting requirements.
 Financial Reporting Framework Changes: Noticing important changes in the financial
reporting rules, such as updates in accounting standards.
 Other Relevant Developments: Being aware of other significant changes, like shifts in the
legal environment that could impact the entity.
(d) Consider the results of preliminary engagement activities and, where applicable,
whether knowledge gained on other engagements performed by the engagement partner
for the entity is relevant
This content emphasizes the importance of leveraging past audit experiences and
knowledge gained from similar engagements when establishing an effective audit strategy.
Key points include:
1. Previous Audit Results:
 Examining outcomes of past audits helps in understanding the effectiveness of internal
controls.
 Analyzing identified deficiencies and actions taken provides insights for improving
current audit processes.
2. Emphasis on Professional Scepticism:
 The auditor stresses the significance of maintaining a questioning mind set to the
engagement team.
 Encouraging professional scepticism ensures thorough gathering and evaluation of audit
evidence for a more robust and reliable audit process.
(e) Ascertain the nature, timing and extent of resources necessary to perform the
engagement.
1) Team Selection:
 Choose experienced team members.

CATESTSERIES.ORG
 Assign them to areas where mistakes are more likely (higher risk).
2) Budgeting and Time:
 Allocate more budget and time to risky areas.
 Focus resources where there's a higher chance of errors.

RELATIONSHIP BETWEEN AUDIT STRATEGY AND AUDIT PLAN

The audit strategy outlines the general approach for the audit, determining its scope,
timing, and direction. On the other hand, the audit plan is a more detailed document that
addresses specific matters identified in the strategy. It describes how the strategy will be
implemented, detailing the nature, timing, and extent of audit procedures to be performed
by the engagement team. While the strategy provides the overarching framework, the plan
focuses on efficient execution. Although not strictly sequential, changes in one can influence
the other, highlighting their interconnected nature in achieving audit objectives through
effective resource utilization.

OVERALL AUDIT STRATEGY AND THE AUDITPLAN- THE AUDITOR’S RESPONSIBILITY

The auditor is solely responsible for creating both the overall audit strategy and the detailed
audit plan. While the auditor can discuss certain planning elements with the entity's
management, this collaboration should not undermine the audit's effectiveness. Ultimately,
the auditor maintains control to ensure a thorough and unbiased audit process.

CHANGES TO PLANNING DECISIONS DURING THE COURSE OF AUDIT

The auditor has the responsibility to update and adjust the overall audit strategy and plan as
needed during the audit. Unexpected events, changes in conditions, or new audit evidence
may require modifications. This is crucial for aligning the planned audit procedures with the

CATESTSERIES.ORG
revised assessment of risks. For instance, if detailed checks reveal information that
significantly differs from what was initially planned based on internal control testing, the
auditor may need to adapt the audit strategy and plan accordingly.

PLANNING SUPERVISION AND REVIEW OF WORK OF ENGAGEMENT TEAM MEMBERS

The auditor is responsible for planning how to guide, supervise, and review the work of the
engagement team. This plan depends on:

 Entity Size and Complexity: Larger and more complex entities may require more direction
and supervision.
 Audit Area: The nature, timing, and extent depend on the specific area being audited.
 Risk Assessment: Higher risks of mistakes may necessitate more thorough direction and
supervision.
 Team Competence: The plan considers the skills and competence of individual team
members.

DOCUMENTATION
(a) Overall Audit Strategy:
 A record of key decisions for proper audit planning.
 Communicates important matters to the engagement team.
(b) Audit Plan:
 A record detailing the planned nature, timing, and extent of audit procedures.
 Serves as a pre-approved guide for audit procedures.
(c) Significant Changes:
 Records any important changes to the overall audit strategy or plan during the audit.
 Explains reasons for changes, details adjustments to planned procedures, and justifies the
final adopted strategy and plan.

CATESTSERIES.ORG
 These records ensure transparency, proper planning, and appropriate responses to
changes throughout the audit process.
AUDIT PROGRAMME
An audit program is like a checklist for auditors, especially in larger audits. It's a structured
list of steps for examination and verification. The program is carefully designed to show how
each step relates to the others, considering the assertions in financial statements or an
assessment of the client's accounting records. Essentially, it guides auditors through the
audit process, ensuring a thorough and systematic examination of the client's financial
information.

EVOLVING ONE AUDIT PROGRAMME- NOT PRACTICABLE FOR ALL BUSINESSES

Businesses differ in various aspects like nature, size, and structure. One-size-fits-all audit
programs aren't feasible due to these variations, as well as differences in internal controls
and the specific audit requirements. Despite this, it's crucial to detail the audit program to
specify the work to be done. This prevents wasted time on irrelevant matters and allows for
addressing unique aspects of each assignment effectively.

THE ASSISTANT TO KEEP AN OPEN MIND

An auditor starts with a standard program, considering the business's nature, size, and
internal controls. This program can be adjusted based on experience to include overlooked
aspects or remove unnecessary ones. Assistants are encouraged to stay open-minded,
reporting any significant matters beyond the program to seniors or the audit firm's partners.
This adaptability ensures the audit program remains effective and responsive to the specific
needs of the business being audited.

CATESTSERIES.ORG
PERIODIC REVIEW OF THE AUDIT PROGRAMME

Regular reviews of the audit program are essential to ensure it stays relevant for obtaining
necessary knowledge and evidence about client transactions. Neglecting these reviews
could lead to auditing based on outdated information, potentially resulting in legal
consequences for the auditor. The audit program's effectiveness is maintained through
periodic reviews, which help identify and eliminate any inadequacies or redundancies.
Although the program includes specific tasks and instructions, it's not rigid as long as it
undergoes periodic updates to reflect changes in the client's business policies. Encouraging
assistants to observe and report on key aspects of the client's accounting functions further
enhances the program's utility.

CONSTRUCTING AN AUDIT PROGRAMME

Audit planning ideally starts right after the previous year's audit, with ongoing modifications
based on the auditor's review of internal controls, preliminary evaluations, and procedure
results. The development of an audit program involves considering the efficiency of relying
on internal controls, timing of procedures, client assistance, staff availability, and
collaboration with other auditors or experts. The auditor has flexibility in deciding when to
perform procedures, but in some cases, timing is non-negotiable, such as when observing
inventory or verifying year-end securities and cash balances.

For the purpose of programme construction, the following points should be kept in mind:

a) Adherence to Scope: Stay within the defined scope and limitations of the audit
assignment.
b) Written Audit Programme: Prepare a written audit program detailing procedures to
implement the audit plan.

CATESTSERIES.ORG
c) Identify Best Evidence: Determine the evidence reasonably available and select the most
effective evidence.
d) Useful Steps and Procedures: Apply only steps and procedures necessary for verification
in the specific situation.
e) Audit Objectives and Instructions: Include audit objectives and detailed instructions for
assistants to control proper execution.
f) Consider All Errors: Anticipate and consider all possibilities of error during the audit
process.
g) Coordinated Procedures: Coordinate procedures for related items to ensure a
comprehensive verification process.

AUDIT PROGRAMME- DESIGNED TO PROVIDE AUDIT EVIDENCE

Evidence forms the basis for an auditor's opinion, and the audit program is designed to
prescribe procedures for gathering this evidence. The auditor's expertise guides the
selection of the best evidence for testing the accuracy of various assertions. Transactions
vary, so the prescribed procedures depend on the auditor's prior knowledge of what
evidence is reasonably available for each transaction. The auditor considers and weighs
multiple pieces of evidence for each assertion, identifying the evidence that provides the
highest satisfaction regarding the appropriateness or accuracy of the assertion.

An auditor picks up evidence from a variety of fields and it is generally of the following
broad types:

1) Documentary Examination: Reviewing written records and documents related to the

audit.
2) Physical Examination: Physically inspecting assets, inventory, or other tangible items.
3) Statements and Explanations (Management, Officials, and Employees): Obtaining
information through discussions with individuals within the organization.
4) Statements and Explanations (Third Parties): Seeking information and clarifications from
external sources or third parties.

CATESTSERIES.ORG
5) Arithmetical Calculations by the Auditor: Performing mathematical analyses to verify
accuracy.
6) State of Internal Controls/Internal Checks: Assessing the effectiveness of internal
controls and checks in place.
7) Inter-relationship of Accounting Data: Examining connections and relationships among
various accounting data.
8) Subsidiary and Memorandum Records: Reviewing supplementary records and notes
supporting main accounting documents.
9) Minutes: Examining official records of meetings for relevant information.
10) Subsequent Actions by Client and Others: Assessing actions taken by the client or
external parties after the audit period.

ADVANTAGES OF AUDIT PROGRAMME

A) Clear Instructions: Provides clear instructions for the audit assistant's tasks.
B) Total Perspective for Major Audits: Essential for major audits to give a comprehensive
view of the work.
C) Ease in Assistant Selection: Simplifies the selection of assistants based on their
capabilities.
D) Prevents Oversight: Helps avoid oversight by providing a systematic plan, reducing the
risk of missing books and records.
E) Individual Responsibility: Assistants accept individual responsibility by signing the
program.
F) Progress Monitoring: Allows the principal to control audit progress by examining
initiated programs.
G) Guide for Future Audits: Serves as a guide for audits in subsequent years.
H) Evidence of Due Care: Acts as evidence in defending against negligence charges,
showcasing the exercise of reasonable skill and care expected from a professional auditor.

DISADVANTAGES OF AUDIT PROGRAMME

CATESTSERIES.ORG
A) Mechanical Work: Risk of the work becoming mechanical, with some parts carried out
without understanding their overall purpose in the audit.
B) Rigidity and Inflexibility: The program may become rigid, following set patterns that may
not adapt to changes in business operations, staff, or internal controls.
C) Inefficient Defence: Inefficient assistants may use the program as a defence, citing lack
of instructions for deficiencies in their work
D) Initiative Suppression: A rigid program may stifle the initiative of capable assistants,
hindering their ability to adapt and be innovative in their approach.

CATESTSERIES.ORG
 CAtestseries.org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 3

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concepts Notes

Chapter- 3

RISK ASSESSMENT AND INTERNAL CONTROL

AUDIT RISK

Audit risk is the chance that an auditor gives the wrong opinion when financial statements
are significantly wrong, potentially damaging their reputation and inviting regulatory and
legal actions. To avoid this, auditors follow standards like SA-200, planning and performing
audits to reduce audit risk. For instance, if a company falsely inflates profits, the probability
of the auditor giving an incorrect opinion, known as audit risk, is influenced by both material
misstatement and detection risk. SA-200 mandates obtaining sufficient evidence for a reliable
opinion.

RISKS OF MATERIAL MISSTATEMENT

The risks of material misstatement, as per SA-200, signify the likelihood of significant errors
or fraud in financial statements before an audit. Misstatement, in this context, means
discrepancies in reported financial items compared to what's required by the financial
reporting framework.

These misstatements can occur due to errors or fraudulent activities. There are two levels of
risk: overall financial statement level and assertion level for transactions, balances, and
disclosures. The former pertains to pervasive risks affecting the entire financial statement,
while the latter is assessed to guide the auditor in conducting necessary procedures to obtain
sufficient evidence for a reliable opinion on the financial statements at a low audit risk.

CATESTSERIES.ORG
COMPONENTS OF RISK OF MATERIAL MISSTATEMENT

The risk of material misstatement at the assertion level has two components: inherent risk
(linked to the nature of the company's transactions) and control risk (related to the
effectiveness of internal controls). These risks are inherent to the company and are not
influenced by the auditor; they exist independently and are shaped by the client's operations.

a) Inherent risk: Inherent risk, per SA-200, is the chance of material misstatement in financial
statements before accounting for internal controls. It's higher for complex transactions,
influencing the design of tests by auditors. Even when assessing lower inherent risk, auditors
must understand the reasons. External factors, such as technological shifts, can impact
inherent risk, highlighting the need to consider both internal and external factors in risk
assessment according to auditing standards.
b) Control risk: Control risk, as outlined in SA-200, is the risk that an internal control system
within a company may not effectively prevent, detect, or correct material misstatements in
financial statements on a timely basis. In simpler terms, it's the risk that the company's
internal controls might not be efficient enough to catch and address significant errors or fraud
in a timely manner. There's an inverse relationship: when internal controls are highly
effective, control risk is low, and when controls are less effective, control risk is higher.

DETECTION RISK

Detection risk, as per SA-200, is the risk that the auditor's procedures may not identify a
material misstatement, either individually or when combined with others, despite efforts to
reduce overall audit risk. In simpler terms, it's the chance that the audit procedures chosen
may not catch a significant error in the financial statements.

CATESTSERIES.ORG
AUDIT RISK-WHAT IS NOT INCLUDED

Audit risk is a term specific to the auditing process and doesn't encompass business risks faced
by auditors, such as litigation or adverse publicity. In the context of SAs, audit risk doesn't
involve the risk of the auditor giving an incorrect opinion on the material accuracy of financial
statements, as this risk is typically considered negligible.

ASSESSMENT OF RISKS- A MATTER OF PROFESSIONAL JUDGMENT

Audit risk is influenced by the risks of material misstatement and detection risk, assessed
through audit procedures and evidence collected during the audit. Assessing these risks
involves professional judgment, not precise measurement, highlighting the importance of the
auditor's training and experience in making reasonable judgments.

Audit risk

Risks of
material Detection risk
misstatement

Non-Sampling
Inherent risk Control risk Sampling risk
risk

CATESTSERIES.ORG
a) Risks of material misstatement
The auditing standards typically address the combined assessment of "risks of material
misstatement," but auditors can choose to evaluate inherent and control risks separately
based on their preferred methods. The assessment of risks of material misstatement can be
expressed quantitatively or qualitatively. Regardless of the approach, making appropriate risk
assessments is more crucial than the specific method.

In summary, audit risk is the product of risks of material misstatement and detection risk,
with risks of material misstatement being influenced by inherent and control risks,
represented as:

Audit Risk = Risks of Material Misstatement × Detection Risk

Or
Audit Risk = Inherent Risk × Control Risk × Detection Risk.

a) Inherent Risk: The risk arises because employees might misappropriate items, posing a
threat to the accuracy of inventory records.

b) Control Risk: Despite security tags and monthly physical verifications, collusion among
employees remains a potential risk, impacting the accuracy of inventory records.

DETECTION RISK

The auditor assesses control system efficiency through observation, inspection, and
sampling. However, there's still a risk of not detecting stolen or misappropriated items
despite these procedures.

a) Sampling Risk: This is the risk that the auditor's conclusion, drawn from a sample, might
differ from the conclusion if the entire population underwent the same audit procedure. It
indicates that the sample didn't accurately represent the whole population.

CATESTSERIES.ORG
b) Non-sampling Risk: This is the risk that the auditor makes an incorrect conclusion not tied
to sampling. For instance, an error in judgment due to an inappropriate audit procedure could
lead to an erroneous conclusion.

IDENTIFYING AND ASSESSING THE RISK OF MATERIAL MISSTATEMENT

SA 315 guides auditors to identify and assess the risks of material misstatement in financial
statements. This involves understanding the entity, its environment, and internal controls.
The goal is to design effective responses to these risks, reducing them to an acceptably low
level. By comprehensively evaluating potential misstatements due to fraud or error at both
the financial statement and assertion levels, auditors enhance the overall reliability of
financial reporting.

The objective of the auditor as stated in SA 315 is to identify and assess the risks
Of material misstatement.
The primary objective, as per SA 315, is to identify and assess the risks of material
misstatement.
1. The auditor is required to identify and assess the risks at two levels:
(a) Financial Statement Level
(b) Assertion Level for classes of transactions, account balances, and disclosures
This serves as the foundation for designing and performing further audit procedures.
Steps for Identifying and Assessing Risks:
2. For the purpose of identifying and assessing the risks of material misstatement, the
auditor shall: -
(a) Identifying risks: This involves understanding the entity and its environment, considering
relevant controls, and examining classes of transactions, account balances, and disclosures in
the financial statements.
(b)Assessing identified risks: The auditor evaluates whether these risks have a broader
impact on the financial statements as a whole and potentially affect multiple assertions.

CATESTSERIES.ORG
(c) Relating risks to assertion level: This step involves connecting identified risks to potential
issues at the assertion level, considering relevant controls that will be tested.
(d)Considering likelihood and magnitude: The auditor evaluates the likelihood of
misstatement, including the possibility of multiple misstatements, and assesses whether the
potential misstatement could result in a material misstatement.

RISK ASSESSMENT PROCEDURES

Risk assessment procedures are like the first step in finding mistakes in financial statements.
They help the auditor identify where things could go wrong. However, just knowing where
the risks are isn't enough. The auditor needs more evidence to be sure that the financial
statements are accurate. It's like finding clues but needing more proof to solve the whole
mystery.
What is included in risk assessment procedures?
(a) Inquiries of Management and Others:
 Auditors ask questions to management and others responsible for financial reporting to get
information.
 They might also talk to different people within the company to get different perspectives
and find potential risks.
(b) Analytical Procedures:
 Auditors use analytical procedures (analyzing financial and non-financial data) to find risks
of mistakes.
 These procedures can reveal unexpected things or unusual patterns that may indicate errors
or fraud risks.
 However, these procedures give a broad indication, and auditors need to consider other info
to understand and evaluate the results better.
(c) Observation and Inspection:
 Auditors observe and inspect things in the company to support the info they get from
inquiries.
 This might include looking at documents, processes, or specific activities within the
company.

CATESTSERIES.ORG
 It helps auditors understand the company and its environment better.

MATERIALITY
SA 320 emphasizes the crucial role of materiality in auditing. Material misstatements,
individually or combined, should reasonably impact users' economic decisions based on the
financial statements. The auditor's objective is to ensure reasonable assurance that the
financial statements are free from material misstatements, whether due to fraud or error,
aligning with the applicable financial reporting framework. This is vital because users rely on
accurate financial information for informed economic decisions. In summary, SA 320
underscores the significance of materiality in assuring the reliability of financial statements.

MATERIALITY IN PLANNING AND PERFORMING AN AUDIT- AUDITOR’S RESPONSIBILITY

a) Materiality in Auditing:
 Materiality is a crucial concept applied by auditors in planning, conducting, and assessing
audits.
 SA 320 outlines the auditor's responsibility in using materiality during the audit of financial
statements.
b) Financial Reporting Framework and Materiality:
 Financial reporting frameworks discuss materiality concerning the preparation of financial
statements.
 Misstatements, individually or collectively, are considered material if they could reasonably
impact users' economic decisions based on the financial statements.
c) Judgments in Determining Materiality:
 Judgments about materiality consider surrounding circumstances, size, or nature of
misstatements.
 Materiality judgments are based on the common financial information needs of users as a
group, not specific individuals.
d) Planning the Audit:
 In audit planning, the auditor makes judgments about the size of misstatements considered
material.

CATESTSERIES.ORG
 These judgments guide risk assessment procedures, identification and assessment of risks,
and planning further audit procedures.
e) Uncorrected Misstatements:
 Materiality determined during planning doesn't set a fixed threshold for uncorrected
misstatements.
 Circumstances may cause the auditor to consider misstatements as material even if they are
below the initially determined materiality.
f) Nature and Size of Misstatements:
Auditors consider not only the size but also the nature of uncorrected misstatements and
specific circumstances when evaluating their impact on financial statements.
g) Professional Judgment in Materiality:
 Auditors apply professional judgment in determining materiality, choosing benchmarks, and
deciding their levels.
 Materiality is the foundation for determining the audit scope and testing levels for
transactions.
h) Significance from Different Perspectives:
 While judging materiality, auditors consider the impact on profit and loss, balance sheet, or
the total of relevant categories.
 Comparison with the corresponding figure from the previous year provides context for
assessing materiality.

DETERMINATION OF MATERIALITY- A MATTER OF PROFESSIONAL JUDGMENT

The auditor's decision on what's material involves professional judgment.
It considers the users' financial information needs, assuming them:
(a) Possess reasonable knowledge of business, economics, and accounting, and are willing to
study financial statements diligently.
(b) Understand that financial statements are prepared, presented, and audited with specified
levels of materiality.
(c) Acknowledge the inherent uncertainties in estimating amounts, involving judgment and
future events.

CATESTSERIES.ORG
(d) Make reasonable economic decisions based on the information provided in the financial
statements.

PERFORMANCE MATERIALITY
Designing tests to identify individual misstatements can be challenging for auditors. In
practice, misstatements are often significant in aggregate. This leads to the concept of
"performance materiality," which is an amount set by the auditor below the materiality for
the financial statements. The goal is to minimize the likelihood that the total of uncorrected
and undetected misstatements surpasses materiality for the entire financial statements.
Performance materiality may also be set for specific classes of transactions, account balances,
Or disclosures. It is established at a level below overall materiality, reducing the risk of
overlooking material misstatements when combined.

USE OF BENCHMARKS IN DETERMINING MATERIALITY FOR THE FINANCIAL STATEMENTS AS

A WHOLE
Determining materiality for financial statements involves professional judgment, often
applying a percentage to a chosen benchmark. Benchmarks can include elements like assets,
liabilities, equity, revenue, and expenses. Factors influencing the choice of a benchmark
include the focus of users (e.g., on profit or revenue), the entity's nature, life cycle, industry,
economic environment, ownership structure, and financing. For instance, if an entity is debt-
financed, users may prioritize assets over earnings. Benchmarks like profit before tax, total
revenue, gross profit, total expenses, total equity, or net asset value are considered, with the
choice influenced by factors such as volatility. For profit-oriented entities, profit before tax
from continuing operations is common, but in cases of volatility, alternatives like gross profit
or total revenues may be more suitable. This approach ensures materiality is contextually
relevant to the entity's characteristics and user expectations.

MATERIALITY LEVEL OR LEVELS FOR PARTICULAR CLASSES OF TRANSACTIONS, ACCOUNT

BALANCES OR DISCLOSURES

CATESTSERIES.ORG
Auditors need to identify specific classes (like transactions, account balances, or disclosures)
where misstatements, even smaller than overall materiality, could impact users' decisions
significantly.

1. Legal requirements, regulations, and financial reporting frameworks impact user

expectations on items such as related party transactions and management remuneration.
2. Industry-specific disclosures, like research and development costs for a pharmaceutical
company, are key for providing comprehensive information.
3. Specific attention is directed towards separately disclosed aspects, such as newly acquired
businesses, reflecting user interest in distinct business facets within the financial statements.

DOCUMENTING THE MATERIALITY

In documenting materiality for an audit, the following elements and the factors guiding their
determination are included:
a) Specifies the threshold for materiality in the context of the entire financial statements.
b) Identifies materiality levels for particular classes like transactions, account balances, or
disclosures if applicable.
c) Defines the level of materiality set to ensure the overall audit is effective, addressing the
risk of not detecting misstatements.
d) Documents any adjustments made to materiality (a-c) during the audit process, reflecting
changes in risk assessments or other relevant factors.

MATERIALITY AND AUDIT RISK

Materiality is a crucial concept in auditing, influencing planning, execution, and assessment.
Auditors aim to provide reasonable assurance that financial statements are free from material
misstatements, align with reporting frameworks, and adhere to auditing standards. To
achieve this, auditors collect sufficient and appropriate evidence, minimizing audit risk— the
risk of issuing an incorrect opinion due to material misstatements. Essentially, materiality
ensures the accuracy and reliability of financial statements throughout the audit process.

CATESTSERIES.ORG
UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

A) External Factors:
 Understand the industry conditions, competitive environment, and technological
developments.
 Evaluate regulatory aspects, financial reporting framework, legal, political, and
environmental factors.
 Consider general economic conditions, interest rates, financing availability, and inflation.
B) Nature of the Entity:
 Assess operations, ownership, governance structures, investments, and financing.
 Identify complex structures, potential related party transactions, and ownership
relationships.
C) Accounting Policies:
 Evaluate the entity's selection and application of accounting policies.
 Ensure policies align with business, industry, and applicable financial reporting framework.
D) Objectives, Strategies, and Business Risks:
 Understand the entity's objectives and strategies, which may evolve over time.
 Recognize business risks that may lead to risks of material misstatement in financial
statements.
 Not required to identify or assess all business risks, only those with potential financial
consequences.
E) Measuring and Reviewing Financial Performance:
Understanding how management measures and reviews financial performance is crucial, as
it can create pressures leading to potential misstatements. Auditors consider various
performance measures, both internal and external, to assess if management actions to
achieve targets might increase the risks of material misstatement, including fraud.

INTERNAL CONTROL

CATESTSERIES.ORG
Internal control, according to SA-315, is a system established by governance, management,
and personnel to reasonably ensure an entity achieves its objectives. This includes reliability
in financial reporting, operational effectiveness, asset safeguarding, and compliance with
laws. The term "controls" encompasses various elements within this internal control system.

AS DERIVED FROM ABOVE DEFINITION, THE PURPOSE OF INTERNAL CONTROL IS AS UNDER

Internal control serves to manage identified business risks that may hinder an entity's
objectives related to:
 Reliability of Financial Reporting
 Effectiveness and Efficiency of Operations
 Compliance with Laws and Regulations
 Safeguarding of Assets
The design, implementation, and maintenance of internal control measures are adapted
based on the size and complexity of the entity, recognizing that different organizations
require tailored approaches to address their unique challenges and objectives.

BENEFITS OF UNDERSTANDING OF INTERNAL CONTROL

a. Identifying Potential Misstatements: Recognizing where errors or fraud could occur in
processes aids targeted correction efforts.
b. Factors Affecting Risks: Internal control insights pinpoint influences on material
misstatement risks, guiding risk assessment.
c. Tailoring Audit Procedures: Understanding internal control helps design precise audit
procedures, determining methods, timing, and extent for effective financial statement
scrutiny.

LIMITATIONS OF INTERNAL CONTROL

1) Reasonable Assurance: Internal control offers reasonable, not absolute, assurance due to
inherent limitations.

CATESTSERIES.ORG
2) Human Judgment: Errors in control design can result from faulty human judgment.
3) Lack of Understanding: Ineffective controls may result from a lack of understanding or
misuse of control-related information.
4) Collusion and Override: Controls can be bypassed through collusion or management
override, risking improper practices.
5) Management Judgments: Management's judgments in control design and risk
assumptions influence control effectiveness.
6) Limitations in Small Entities: Small entities face challenges in segregating duties, but
owner-managers may compensate with oversight, introducing risks of potential control
override.

COMPONENTS OF INTERNAL CONTROL

A) Control environment
The control environment sets the organizational tone, influencing control consciousness. It
encompasses governance, management functions, and the attitudes of those in charge.
Elements:
(a) Communication and Integrity: Integrity and ethical values communicated and enforced
impact control effectiveness. Management actions and policies reinforce these values.
(b)Commitment to Competence: Focus on management's consideration of job competence,
translating into skills and knowledge.
(c) Governance Participation: Attributes of governance, including independence, experience,
involvement, and information scrutiny.
(d)Management's Philosophy: Encompasses attitudes toward financial reporting, approach
to risks, and attitudes toward information processing.
(e) Organizational Structure: Framework for planning, executing, controlling, and reviewing
activities, considering authority, responsibility, and reporting lines.
(f) Authority and Responsibility: How authority and responsibility for activities are assigned,
and the establishment of reporting relationships.
(g) Human Resource Policies: Policies related to recruitment, orientation, training,
evaluation, and compensation demonstrate the entity's commitment to competent and
trustworthy personnel.

CATESTSERIES.ORG
B) The entity’s risk assessment process
(a) Identifying relevant business risks for financial reporting objectives.
(b) Estimating the significance of these risks.
(c) Assessing the likelihood of their occurrence.
(d) Deciding actions to address identified risks.
This process serves as the foundation for managing risks, helping the auditor identify material
misstatement risks. Risks may evolve due to technological changes, new business elements,
or shifts in the operating environment. Judging the appropriateness of the entity's risk
assessment process involves evaluating its effectiveness in adapting to circumstances. This
judgment is crucial for effective risk management and the auditor's identification of potential
material misstatements.
C) Information system and financial reporting
The auditor must grasp the information system and associated business processes pertinent
to financial reporting.
 Identify key classes of transactions impacting financial statements.
 Understand initiation, recording, processing, correction, transfer, and reporting
procedures.
 Examine records, supporting information, and specific accounts involved in transaction
processing.
 Evaluate how the information system captures vital events and conditions for financial
statements.
 Comprehend the process used to prepare the entity's financial statements.
 Assess controls surrounding journal entries to ensure accuracy and reliability.
Information systems, comprising physical infrastructure, software, people, procedures, and
data, often leverage information technology (IT). They should ensure the provision of high-
quality financial information, influencing management's decision-making and the reliability of
financial reports. The auditor must also comprehend how the entity communicates financial
reporting roles, which may involve policy manuals, accounting documents, memoranda,
electronic means, oral communication, and management actions.
D) Control activities
In auditing, understanding control activities is essential to assess the risk of material
misstatement. The auditor focuses on significant transactions, account balances, and

CATESTSERIES.ORG
disclosures, aligning with relevant risk assessment assertions. Control activities involve
policies and procedures ensuring the implementation of management directives, spanning
both IT systems and manual processes. Key audit areas include performance reviews,
information processing controls, physical asset security, and segregation of duties. This
understanding enables the auditor to evaluate the effectiveness of controls in managing risks
and ensuring the reliability of financial statements.
E) Monitoring of controls
The auditor is required to understand the key processes an entity employs to monitor internal
control over financial reporting. Monitoring involves assessing the ongoing effectiveness of
controls, ensuring they operate as intended, and making adjustments as needed for changing
conditions. Management conducts monitoring through continuous activities integrated into
regular operations or through separate evaluations. This may include using feedback from
external sources like customer complaints or regulatory comments to identify issues and
areas for improvement. The goal is to evaluate and enhance control effectiveness over time,
promoting the reliability of financial reporting.

RISKS THAT REQUIRE SPECIAL AUDIT CONSIDERATION

As part of the risk assessment process, the auditor must determine if any identified risks are
deemed significant. This judgment considers factors such as:
(a) Evaluating if the risk involves the potential for fraudulent activities
(b) Assessing if the risk is connected to recent significant economic, accounting, or regulatory
developments, warranting specific attention.
(c) Considering the complexity of transactions associated with the risk.
(d) Examining if the risk involves significant transactions with related parties.
(e) Analyzing the degree of subjectivity in financial information measurement, especially in
areas with wide measurement uncertainty.
(f) Assessing whether the risk involves significant transactions outside the entity's normal
course of business or those that appear unusual.

CATESTSERIES.ORG
EVALUATION OF INTERNAL CONTROL SYSTEM
The auditor's examination of the internal control system is vital to gain reasonable assurance
about the adequacy of the accounting system and the accurate recording of all necessary
financial information. Internal control mechanisms play a key role in providing this assurance
by ensuring the reliability of financial data, making it an essential part of the overall audit
program.

BENEFITS OF EVALUATION OF INTERNAL CONTROL TO THE AUDITOR

a. Evaluate whether internal controls facilitate the identification of errors and fraud during
normal business operations.
b. Assess whether the internal control system is adequate and operates as planned by
management.
c. Determine the effectiveness of the internal auditing department in overseeing controls.
d. Consider the influence of administrative controls on the audit, e.g., weak controls in
worker recruitment leading to inclusion of dummy names in the wages sheet.
e. Verify if the internal controls adequately safeguard the entity's assets.
f. Evaluate how well management is fulfilling its role in ensuring accurate recording of
transactions.
g. Assess the reliability of reports, records, and certificates provided to management.
h. Determine the appropriate extent and depth of examination required in different
accounting areas.
i. Identify suitable audit techniques and procedures based on the given circumstances.
j. : Recognize areas where control is strong and weak within the organization.
k. Provide worthwhile suggestions for enhancing the overall control system.

EVALUATION OF INTERNAL CONTROL– METHODS

Conducting an internal control review entails a systematic examination of the management-
installed control system. The process begins with identifying controls and procedures through
manuals, organization charts, and flow charts. Engaging with officers and employees through

CATESTSERIES.ORG
inquiries helps assess the system's character and effectiveness. The auditor uses targeted
questions, documented through written notes, and may employ tools to streamline data
gathering for an efficient audit process.

A) Narrative Record: The narrative record is a thorough and detailed depiction of the
operational system as observed by the auditor. Its development requires actual testing and
observation. This method is often suggested when there's no formal control system, making
it suitable for small businesses.
However, the narrative record has some drawbacks:
 Understanding the operational system can be challenging due to the detailed nature of
the narrative.
 It may be difficult to pinpoint weaknesses or gaps in the system solely through the
narrative.
 Incorporating changes resulting from factors like reshuffling of manpower can be
cumbersome.
B) Check List: A checklist is a set of instructions or questions that an auditing staff member
follows and answers during the audit process. Upon completing each instruction, the auditor
often initials the space against it. Responses in the checklist are typically categorized as Yes,
No, or Not Applicable. This on-the-job tool is designed with consideration for the essential
elements of control.
Example Check List Instructions
 Are tenders solicited prior to order placement?
 Are purchases initiated with a written order?
 Is the purchase order form standardized?
 Are purchase order forms pre-numbered?
 Is inventory control handled by individuals independent of inventory custody, receipt,
inspection, and procurement?
C) Internal Control Questionnaire: The Internal Control Questionnaire (ICQ) is a widely
employed assessment tool, consisting of a series of detailed questions, to evaluate the
existence, functionality, and effectiveness of an organization's internal control system. It
minimizes oversights, allowing for a systematic review either annually or in sections. By using
'Yes' or 'No' answers, it helps identify satisfactory positions or weaknesses. The questionnaire

CATESTSERIES.ORG
is a structured means of revealing control defects, facilitating discussions, and enabling
auditors to compile reports outlining deficiencies and proposing improvement
recommendations.
D) Flow Chart: A flow chart is a concise graphic representation of each aspect of a company's
internal control system, offering a bird's-eye view of transaction flow and integration. It
minimizes narrative explanations, facilitating a comprehensive overview that aids in
identifying areas for improvement. By visually mapping the system's components and
transaction paths, it enables the auditor to understand and assess internal controls
accurately, allowing for effective evaluation and suggestions for enhancements.

TESTING OF INTERNAL CONTROL

After understanding the internal control system, the auditor examines its actual operation
through selective testing, covering important areas over a few years. Tests of controls aim to
assess the design and operation of the accounting and internal control system. These tests
include examining elements of the control environment, using strengths to reduce control
risk. Some procedures for understanding systems may unintentionally serve as tests of
control. The auditor evaluates deviations, considering factors like staff changes and seasonal
fluctuations. Results inform whether controls align with the preliminary assessment,
influencing control risk and modifying substantive procedures if needed. The final assessment
considers results from substantive procedures and other evidence, ensuring alignment with
the control risk assessment. Adjustments are made if deviations indicate a need for revised
control risk assessment.

WHAT IS AN AUTOMATED ENVIRONMENT

An automated environment signifies a business setting where processes, operations,
accounting, and decision-making are conducted through computer systems, commonly
referred to as Information Systems (IS) or Information Technology (IT) systems. This
widespread adoption of computer systems is now prevalent across various business sectors.

CATESTSERIES.ORG
KEY FEATURES OF AN AUTOMATED ENVIRONMENT
 Faster business operations
 Accurate data processing and computation
 Capacity to handle large transaction volumes
 Integration of business operations
 Enhanced security and controls
 Reduced susceptibility to human errors
 Real-time access to the latest information
 Connectivity and networking capabilities

UNDERSTANDING AND DOCUMENTING AUTOMATED ENVIRONMENT

In a financial statement audit, the auditor must comprehend the organization, its operations,
and IT. Understanding the entity's automated environment entails knowledge of IT
department structure, activities, dependencies, and key risks and controls.
Here are key considerations for the auditor to understand the company's automated
environment:
 Understand IT department organization, activities, dependencies, risks, and controls.
 Identify types and purposes of information systems.
 Determine the locations of IT systems (local or global).
 Examine the architecture (desktop, client-server, web, or cloud-based) and software
versions.
 Investigate interfaces between systems, especially in the case of multiple systems.
 Differentiate between in-house and packaged solutions.
 Consider any outsourced IT activities for maintenance and support.
 Identify key personnel like the Chief Information Officer (CIO) and Chief Information Security
Officer (CISO).
 Document the obtained understanding for audit purposes.

CATESTSERIES.ORG
RISKS ARISING FROM USE OF ITS SYSTEM
After grasping the IT systems and automated environment, the auditor needs to comprehend
the risks associated with their use.
Below are some risks that should be considered:
 Inaccurate data processing.
 Unauthorized access to data.
 Direct data changes (backend changes).
 Excessive or privileged access (super users).
 Lack of adequate segregation of duties.
 Unauthorized changes to systems or programs.
 Failure to make necessary changes to systems or programs.
 Loss of data.

IMPACT OF IT RELATED RISKS

The identified IT-related risks must be mitigated to avoid adverse impacts on the audit
process. If these risks are not addressed, the consequences can be observed in various ways:

a) Substantive Checking: Non-mitigated risks may lead to distrust in system-generated data,

requiring extensive testing for completeness and accuracy.
b) Controls: Automated controls, system calculations, and accounting procedures may not be
relied upon, necessitating additional audit efforts.
c) Reporting: Regulatory requirements on internal financial controls may lead to
modifications in the auditor's report in certain instances.

TYPES OF CONTROLS IN AN AUTOMATED ENVIRONMENT

Controls in an automated environment can be categorized as under: -
(A) General IT controls
(B) Application controls

CATESTSERIES.ORG
(C) IT-dependent controls

(A) General IT controls

General IT controls are broad policies and procedures designed to support the overall
effectiveness of various applications. These controls, often referred to as "pervasive" or
"indirect" controls, focus on maintaining information integrity and data security.

Key components of general IT controls include:

a) Controls over Data centre and network operations: Controls over Data Centre and
network operations ensure that production systems meet financial reporting objectives. They
manage computer operations, execute batch jobs, monitor backups, and oversee
performance, including Business Continuity Plan (BCP) and Disaster Recovery Plan (DRP) for
resilience. These controls are essential for maintaining operational integrity and supporting
reliable financial reporting.
b) Program Change: Program change controls aim to guarantee that modified systems align
with financial reporting objectives. They involve processes like change management,
recording and tracking change requests, as well as making and testing alterations. These
controls are crucial for maintaining the integrity of financial systems amid any program
changes.
c) Access Security: Access security controls aim to verify and authorize access to programs
and data to align with financial reporting objectives. They involve aspects such as managing
security organizations, implementing security policies and procedures, securing applications,
data, operating systems, networks, and physical spaces. These controls are essential for
safeguarding the confidentiality and integrity of financial information.
d) Application system acquisition, development, and maintenance: Controls over
application system acquisition, development, and maintenance aim to guarantee that
systems are created, configured, and implemented to align with financial reporting
objectives. This involves managing the entire development process, from project initiation
and analysis to design, construction, testing, and quality assurance. These controls ensure the
integrity and reliability of financial reporting systems throughout their lifecycle.

CATESTSERIES.ORG
(B) Application Controls
Application controls encompass both automated and manual controls that function at the
business process level. Automated application controls are integrated into IT applications like
ERPs, playing a crucial role in verifying the completeness, accuracy, and integrity of data
within those systems. Examples of these controls include edit checks, validation of input data,
sequence number checks, user limit checks, reasonableness checks, and mandatory data
fields, ensuring the reliability of data processing within the applications.
(C)IT dependent Controls
IT-dependent controls are manual controls that rely on data, information, or reports
generated from IT systems. While these controls are executed manually, their design and
effectiveness hinge on the accuracy and reliability of the underlying IT-generated data. The
efficacy of both automated application controls and IT-dependent controls is contingent on
the effectiveness of General IT controls, emphasizing the crucial role of overarching IT
governance and security measures.

TESTING METHODS IN AN AUTOMATED ENVIRONMENT

In an automated environment, audit testing involves four main methods: inquiry,
observation, inspection, and reperformance. While inquiry is efficient, it provides the least
evidence and should be combined with other testing methods. Reperformance is the most
effective but can be time-consuming. Combining inquiry with inspection often yields the most
effective and efficient evidence. The choice of testing methods depends on professional
judgment, considering factors like risk assessment, control environment, evidence
requirements, and business complexity. In an automated setting, common testing methods
include walkthroughs, observing user transactions, and inspecting application configurations.
If general IT controls are inadequate, the auditor must assess the impact on IT risks and plan
alternative procedures for reliable system-based information.

CATESTSERIES.ORG
CHARACTERISTICS OF MANUAL AND AUTOMATED COMPONENTS OF INTERNAL CONTROL
PERTINENT TO THE AUDITOR’S RISK EVALUATION
In the context of an entity's internal control system, both manual and automated elements
play a crucial role, impacting the auditor's risk assessment and subsequent audit procedures.

Here's a brief explanation of the specified content:

In a manual system, controls involve approvals, transaction reviews, reconciliations, and
follow-ups. Alternatively, an entity may adopt automated procedures, replacing paper
documents with electronic records for transaction initiation, recording, processing, and
reporting.
In IT systems, controls comprise a mix of automated controls embedded in computer
programs and manual controls. Manual controls in IT systems may be independent of IT,
utilize information produced by IT, or focus on monitoring IT and automated controls

AUDIT APPROACH IN AN AUTOMATED ENVIRONMENT

Risk assessement Understand and Test for operating Test for operating
evaluate effectiveness effectiveness

• Identify significant • Document • Evaluate control

account and understanding of • Assess nature deficiencies
disclosures business processes ,timing and extent • Significant
• Qualitative and using Flow chart / (NTE) of controls deficiencies,
quantitative Narratives testing Material weakness
considerations • Prepare risk and • Assess reliability of • Remediation of
• Relevant financial control matrices data: control
assertions (FSA) (RCM) completeness of weaknesses
• Idenfity likely • Understand design population • Interal controls
source of of controls by • Testing of key Memo (ICM) OR
misstatement performing reports and spreed Management
• Consider risk walkthroughts of sheets letter
arising from use of end-to-end process • Auditor"s report
• Sample testing
IT systems • Process wide
• Consider
considerations for
competence and
entity level
independence of
controls ,
staff/ team
segregation of
performing contro;
duties
testing
• IT General control ,
Application control

CATESTSERIES.ORG
DATA ANALYTICS FOR AUDIT
In today's digital age, companies rely heavily on IT systems and networks, leading to a massive
amount of data. Data analytics, using processes, tools, and techniques, helps extract valuable
information from this data. Companies benefit from analytics with increased profits, better
customer service, competitive advantages, and more efficient operations. Auditors also use
similar tools, known as Computer Assisted Auditing Techniques (CAATs), to achieve good
results in the audit process. CAATs, like spreadsheets and specialized tools such as IDEA and
ACL, help auditors:
 Check if all data needed for tests or audits is complete.
 Choose audit samples using methods like random or systematic sampling.
 Recalculate balances and reconstruct trial balances from transaction data.
 Double-check mathematical calculations, such as depreciation or bank interest.
 Analyse journal entries for accuracy.
 Investigate fraud.
 Evaluate the impact of control issues.

DIGITAL AUDIT
Businesses are adopting digitization to stay current, using new technologies to reshape their
operations and business models. Automation plays a crucial role in this transformation. In this
digital landscape, auditors are also leveraging digital technology throughout the audit
process, from planning to forming the final opinion. They employ artificial intelligence, data
analytics, and other cutting-edge technologies to gain a deeper understanding of business
processes. These tools enable auditors to enhance the audit process, allowing more focused
attention on critical areas. Digital audits aid auditors in identifying risks more effectively
through the use of technology, contributing to a more thorough and efficient audit.

INTERNAL FINANCIAL CONTROLS AS PER REGULATORY REQUIREMENTS

Internal Financial Controls (IFC) encompass policies and procedures established by
companies to ensure:

CATESTSERIES.ORG
 Reliability of Financial Reporting
 Effectiveness and Efficiency of Operations
 Compliance with Applicable Laws and Regulations
 Safeguarding of Assets
 Prevention and Detection of Frauds

Legal Emphasis: The Companies Act, 2013 places significant importance on effective
implementation and reporting of internal controls. It mandates the following responsibilities:
1. Section 134(5) (e): For listed companies, the Directors' responsibility statement must
affirm that they have established internal financial controls, ensuring their adequacy and
effective operation.
2. Section 143(3) of the Act: Section 143(3) (i) of the Companies Act, 2013 requires auditors
to confirm a company's robust Internal Financial Controls (IFC) and their effectiveness.
However, exemptions are granted for small private companies, including One Person
Companies, with a turnover below ₹50 crore and borrowings under ₹25 crore.
3. Section 177(4): Audit Committees, according to their terms of reference, must evaluate
internal financial controls and risk management systems.
4. Section 149(8): The company and independent directors, as per Schedule IV, must adhere
to the Code for Independent Directors, which involves ensuring the integrity of financial
information and robustness of financial controls and risk management systems.

DOCUMENTING THE RISKS

(a) Record team discussions and key decisions made during the audit.
(b) Document understanding of the entity, internal controls, and sources of information,
along with risk assessment procedures.
(c) Detail identified risks of material misstatement at financial and assertion levels.
(d)Document identified risks and associated controls understood during the audit process.
This documentation ensures transparency and accountability in the audit procedures.

CATESTSERIES.ORG
ASSESS AND REPORT AUDIT FINDINGS
After completing an audit, there may be identified issues or discrepancies in the company's
IT environment and controls. These findings need evaluation and reporting to key
stakeholders, including management, the Board of Directors, and the Audit Committee.
 Assess if there are any weaknesses in IT controls.
 Determine the impact of these weaknesses on the overall audit.
 Report identified deficiencies to management through an Internal Controls Memo or
Management Letter.
 Communicate significant deficiencies in writing to those charged with governance, such as
the Board of Directors or Audit Committee.

THE AUDITOR’S RESPONSES TO ASSESSED RISKS

After identifying and assessing risks of material misstatement, the auditor's role, according to
SA 330, is to design and implement responses to ensure sufficient and appropriate audit
evidence is obtained. Key points include:
1. Overall Responses: Design and implement responses at the financial statement level to
address assessed risks of material misstatement.
2. Assertion-Level Responses: Design further audit procedures based on and responsive to
risks at the assertion level.
3. Considerations in Designing Procedures: Consider inherent risk and control risk in
assessing risks for each transaction, account balance, or disclosure. Obtain more persuasive
evince when the risk is higher.
4. Tests of Controls: Perform tests of controls to assess the operating effectiveness of
relevant controls when relying on them or when substantive procedures alone are
insufficient.
5. Level of Assurance: Seek a higher assurance level for controls when the audit approach
relies heavily on them, especially when substantive procedures alone are insufficient.

CATESTSERIES.ORG
 CAtestseries.org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 4

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concepts Notes

Chapter -4

AUDIT EVIDENCE

INTRODUCTION

Auditing is a logical process where an auditor objectively examines financial statements to

assess their accuracy and fairness. The auditor's role is to provide an expert opinion on the
truth and fairness of these statements. To do this, they must critically scrutinize the
accounting information, ensuring it accurately reflects the actual state of affairs. This
objective examination, guided by standards like SA 500, involves thorough evaluation to form
a reliable opinion. The auditor needs sufficient and appropriate evidence to support their
judgment, aiming to draw reasonable conclusions for the final opinion. Negligent evaluation
can lead to legal consequences and harm the auditor's professional reputation. In summary,
auditing is about objectively reviewing financial information, following standards like SA 500,
and providing a well-founded opinion based on careful examination and evidence.

This evidence is drawn from various sources:

1. Information in Accounting Records:

 Original accounting entries and supporting documents like cheques and electronic fund
transfer records.
 Invoices.
 Contracts.
 General and subsidiary ledgers, journal entries, and other adjustments not reflected in
journals.
 Records such as worksheets and spreadsheets supporting cost allocations, computations,
reconciliations, and disclosures.
2. Other Supporting Information:
 Minutes of meetings.

CATESTSERIES.ORG
 Written confirmations from trade receivables and payables.
 Manuals detailing internal controls.

TYPES OF AUDIT EVIDENCE

Types of
audit
evidence

Depending
Depending
upon
upon nature
sources

Visual Oral Documentary Internal External

(a) Depending upon nature:

1. Visual Evidence: Watching the client's staff physically verify inventory.
2. Oral Evidence: Engaging in discussions with the client's management and officers.
3. Documentary Evidence: Reviewing tangible documents such as fixed deposit certificates,
loan agreements, sales bills, etc.
(b)Depending upon source:
1. Internal Evidence: Evidence generated within the audited organization.

Examples: Sales invoice, copies of sales challan, forwarding notes, goods received notes,
inspection reports, cash memos, debit and credit notes, etc.

2. External Evidence: Evidence that comes from sources outside the client's organization.
Examples: Purchase invoices, supplier's challan, forwarding notes, debit and credit notes
received from external parties, quotations, confirmations, etc.

CATESTSERIES.ORG
RELEVANCE AND RELIABILITY OF AUDIT EVIDENCE

Relevance
Relevance ensures information connects logically to the audit's purpose. Tests of controls
evaluate internal control effectiveness, while substantive procedures focus on detecting
misstatements, both involving the identification of relevant conditions. Inspecting documents
on receivable collections after the period end provides evidence on existence and valuation
but not necessarily on cut-off.
(a) Tests of Controls: Assessing how well internal controls prevent or detect and correct
material misstatements. Involves identifying conditions indicating control performance and
deviations that suggest inadequate performance.
(b)Substantive Procedures: Detecting material misstatements at the assertion level. Includes
tests of details and analytical procedures, identifying conditions relevant to the test's purpose
that constitute a misstatement in the relevant assertion.

Reliability
The reliability of audit evidence depends on its source, nature, and the circumstances of
acquisition, including relevant controls. Generalizations about reliability may have
exceptions, even when information is obtained externally. Auditors must carefully consider
these factors to ensure the trustworthiness of the evidence.

While acknowledging the potential for exceptions, the following general observations
about the reliability of audit evidence can offer guidance:

1. Independence Boosts Reliability: Audit evidence from external, independent sources

increases reliability.
2. Internal Evidence Reliability: Internal evidence is more reliable when effective controls,
including preparation and maintenance, are in place.
3. Direct Observation vs. Inference: Evidence directly observed by the auditor is more
reliable than information inferred indirectly.
4. Documentary Form Enhances Reliability: Evidence in written or electronic form is more
reliable than oral information.

CATESTSERIES.ORG
5. Original Documents vs. Copies: Original documents are more reliable than copies or
electronic transformations, as their reliability depends on control measures.
SUFFICIENT APPROPRIATE AUDIT EVIDENCE
"Sufficient appropriate audit evidence" means the auditor needs to gather enough reliable
and relevant information to form reasonable conclusions about the accuracy and fairness of
the financial statements. In essence, it's about ensuring the audit process is thorough enough
to support a well-informed and trustworthy opinion on the financial health of the audited
entity.

SUFFICIENCY AND APPROPRIATENESS ARE INTERRELATED

1. Sufficiency: It's about having enough audit evidence. The quantity needed is determined
by the auditor's assessment of risks of misstatement. Higher risks may require more evidence.
2. Appropriateness: It's about the quality of audit evidence. Quality is affected by relevance
and reliability. Higher-quality evidence (reliable and relevant) means less may be needed.
Moreover, the auditor's assessment of sufficiency may be influenced by factors such as:
a) Materiality
b) Risk of Material Misstatement
c) Size & characteristics of the population

a) Materiality: It's the importance of transactions, balances, and disclosures to financial

statement users. Less evidence is needed for less material assertions, while more evidence is
required for more material assertions.
b) Risk of Material Misstatement: The risk that financial statements have significant errors
before the audit.
Components:
 Inherent Risk: The vulnerability of an assertion to material misstatement before
considering controls.
 Control Risk: The risk that internal controls won't prevent or detect a material
misstatement in a timely manner.

CATESTSERIES.ORG
c) Size and Characteristics of Population: Refers to the number of items in a group.
Less evidence is needed for smaller, more similar groups, while more evidence is required for
larger, diverse groups.
AUDIT PROCEDURES FOR OBTAINING AUDIT EVIDENCE
To form a well-founded opinion, auditors gather audit evidence through two main phases:
1. Risk Assessment Procedures: These initial steps involve understanding the business,
assessing risks, and developing a strategic plan for the audit.
2. Further Audit Procedures: This phase consists of two key components:
a) Tests of Controls: Conducted when required by auditing standards or when the auditor
chooses to assess the effectiveness of internal controls.
b) Substantive Procedures: These encompass detailed tests and analytical procedures to
validate the accuracy and completeness of financial information.

AUDIT PROCEDURES TO OBTAIN AUDIT EVIDENCE CAN INCLUDE:

1. Inspection: Inspection in auditing involves reviewing records or physical examination of
assets, providing evidence of varying reliability based on nature and source. For example,
inspecting records for authorization serves as a control test. While some documents directly
evidence asset existence, like financial instruments, inspection may not reveal ownership or
value details. Tangible asset inspection confirms existence but may lack details on rights or
valuation. Inspecting individual inventory items often aligns with observing inventory counts.
2. Observation: Observation involves watching others perform a process or procedure. It
offers audit evidence about how a task is executed but is constrained by the specific moment
it's observed. Additionally, the awareness of being observed can influence how the process
or procedure is carried out. In essence, observation provides insights into performance but
has limitations in terms of timing and potential behavioral impact.
3. External confirmation: auditing refers to evidence directly received from a third party,
either in writing, electronically, or through other means. Typically used for assertions related
to account balances, these confirmations aren't limited to just account balances. They offer
the auditor a direct response from an independent source, enhancing the reliability of audit
evidence.

CATESTSERIES.ORG
4. Recalculation: Recalculation is verifying the mathematical accuracy of documents, done
manually or electronically.
5. RePerformance: Reperformance is the auditor independently redoing procedures or
controls initially conducted by the entity's internal control.
6. Analytical Procedures: Analytical procedures involve assessing financial information by
examining relationships among financial and non-financial data. This includes investigating
fluctuations and inconsistencies in comparison to predicted amounts.
7. Inquiry: Inquiry involves seeking information from knowledgeable individuals within or
outside the entity. It is a widely used audit method, ranging from formal written to informal
oral inquiries. Evaluating responses is crucial, as they can offer new information or
corroborate existing evidence. However, conflicting responses may prompt the auditor to
adjust or perform additional audit procedures, especially when there are indications of
potential control override by management.

ASSERTIONS
Assertions are statements, explicit or implicit, in financial statements made by management.
Auditors use them to assess potential misstatements, aiding in ensuring the accuracy
reliability of financial information.

that are embodied to consider different

Representations by
in the financial types of potential
management
statements misstatements

ASSERTIONS CONTAINED IN THE FINANCIAL STATEMENTS

Management, when stating that financial statements comply with reporting standards,
implicitly or explicitly asserts aspects like recognition, measurement, presentation, and
disclosure. Auditors categorize assertions into three types (existence, completeness,
accuracy) to assess potential misstatements in financial statements, ensuring their reliability.

CATESTSERIES.ORG
 Classes of
Account Presentation and
transactions and
balances Disclosure
events
• Occurence • Existence • Occurence and rights
• Completeness • Rights and and obligations
• Accuracy • obligations • Completeness
• Cut - Off • Completeness • Classification and
• Classification • Valuation and understandability
• allocation • Accuracy andvaluation

1. Assertions about classes of transactions and events for the period under audit
(a) Occurrence: Verify that recorded transactions and events indeed took place and are
relevant to the entity.
(b)Completeness: Confirm that all transactions and events that should be recorded have been
accurately captured.
(c) Accuracy: Ensure that amounts and data associated with recorded transactions are precise
and appropriate.
(d)Cut-off: Validate that transactions and events are recorded in the correct accounting
period.
(e) Classification: Verify that transactions and events are appropriately placed in the proper
accounts.

2. Assertions about account balances at the period end

(a) Existence: Confirm that assets, liabilities, and equity interests actually exist.
(b)Rights and Obligations: Ensure the entity has control over assets and is responsible for
liabilities.
(c) Completeness: Verify that all necessary assets, liabilities, and equity interests have been
accurately recorded.
(d)Valuation and Allocation: Confirm that items in the financial statements are appropriately
valued, and adjustments are recorded accurately.

CATESTSERIES.ORG
3. Assertions about presentation and disclosure
(a) Occurrence and Rights and Obligations: Confirm that disclosed events and transactions
truly occurred and are relevant to the entity.
(b)Completeness: Verify that all required disclosures are included in the financial statements.
(c) Classification and Understandability: Ensure that financial information is presented
appropriately, described clearly, and is easily understandable.
(d)Accuracy and Valuation: Disclose financial information fairly and at the correct amounts,
providing an accurate representation of the entity's financial position.

AUDIT TRAIL
An audit trail is a documented record of how a transaction moves from a source document to
a financial statement in an entity. It serves as audit evidence to ensure the authenticity and
integrity of transactions, maintaining a log of system and user activities. While audit trails
enhance internal controls and data security by tracking events, they also involve costs, both
in terms of system expenditure and the time needed for analysis. Despite the costs,
automated tools can be used to efficiently analyze large volumes of data, providing auditors
with confidence in verifying the effectiveness of management controls and the legitimacy of
transactions.

INFORMATION TO BE USED AS AUDIT EVIDENCE

a) When utilizing information as audit evidence that has been generated with the assistance
of a management's expert, the approach to audit procedures may be influenced in terms of
their nature, timing, and extent.
 The nature and complexity of the subject matter and associated risks of material
misstatement.
 Availability of alternative audit evidence sources.
 Nature, scope, and objectives of the management expert's work.
 Employment relationship with the entity or engagement for services.
 Control and influence management has over the expert's work.

CATESTSERIES.ORG
 Adherence to technical standards or professional requirements by the management's
expert.
 Internal controls within the entity over the expert's work.
 Auditor's knowledge and experience in the expert's field.
 Auditor's past experience with the same expert.
b) When relying on information generated by the entity, the auditor must assess its reliability
for the auditor's purposes, considering factors such as:
 The auditor must gather evidence to ensure that the information is both accurate and
complete.
 The auditor needs to evaluate whether the information is precise and detailed enough to
meet the specific needs and objectives of the audit.

INCONSISTENCY IN OR DOUBTS OVER RELIABILITY OF AUDIT EVIDENCE

a) If the evidence obtained from one source contradicts evidence from another source, the
auditor must figure out why this inconsistency exists.
b) If the auditor has concerns about the reliability of information used as audit evidence, they
need to address these doubts.
c) The auditor has to consider how resolving these inconsistencies or doubts may affect other
parts of the audit. It's about understanding the broader implications.

SA 230 specifies that if the auditor finds information inconsistent with their final conclusion
on a significant matter, they must document this. This documentation ensures transparency
and accountability.

EVALUATION OF AUDIT EVIDENCE

SA 500, "Audit Evidence," guides auditors in obtaining enough reliable evidence for a
reasonable opinion on financial statements. Professional judgment is crucial to determining

CATESTSERIES.ORG
if the evidence gathered sufficiently reduces audit risk to an acceptable level. The goal is to
draw reasonable conclusions based on the evidence obtained.

USING THE WORK OF INTERNAL AUDITORS (SA 610)

The internal audit function is a department within an organization responsible for assessing
and improving the effectiveness of governance, risk management, and internal control
processes. Its role is to provide assurance and conduct consulting activities to enhance the
overall performance and reliability of the entity.

Internal audit activities focus on improving an organization by:

1. Governance:
 Assessing how well the governance process achieves objectives in ethics, performance,
and accountability.
 Ensuring effective communication of risk and control information.
2. Risk Management:
 Identifying and evaluating significant risks, contributing to better risk management and
internal control.
 Performing procedures to detect fraud.
3. Internal Control:
 Evaluating and recommending improvements to internal controls, providing assurance.
 Reviewing financial and operating information, ensuring accuracy.
 Assessing the efficiency and effectiveness of operating activities.
 Ensuring compliance with laws, regulations, and internal policies.

SCOPE OF SA 610
Standard on Auditing (SA) 610 outlines the external auditor's responsibilities when utilizing
the work of internal auditors. This involves:

CATESTSERIES.ORG
(a) Using Internal Audit Work for Evidence: The external auditor can incorporate the work of
the internal audit function to gather audit evidence.
(b) Direct Assistance from Internal Auditors: Internal auditors can provide direct assistance
under the external auditor's direction, supervision, and review.

EXTERNAL AUDITOR’S RESPONSIBILITY FOR THE AUDIT

The external auditor holds exclusive responsibility for the audit opinion, and this responsibility
is not diminished when utilizing the work of the internal audit function or internal auditors.
Despite performing similar procedures, internal auditors lack the required independence
mandated by SA 200. SA 610 establishes conditions for the external auditor to use internal
audit work, specifying the necessary effort to ensure its adequacy for the audit. The
requirements aim to guide the external auditor's judgment, preventing excessive reliance on
internal audit work and ensuring a balanced approach.

EVALUATING THE INTERNAL AUDIT FUNCTION

In evaluating the Internal Audit Function for audit purposes, the external auditor considers
three key factors:

1. Objectivity and Policies:

 Assessing the extent to which the internal audit function's organizational status and
policies uphold the objectivity of internal auditors.
 Examining relevant policies and procedures to ensure they support unbiased and impartial
internal auditing.
2. Competence:
 Evaluating the level of competence within the internal audit function.
 Determining the systematic and disciplined approach, including the application of quality
control measures.

CATESTSERIES.ORG
OBJECTIVITY AND ITS EVALUATION
Objectivity means executing tasks without letting bias, conflicts of interest, or undue
influence compromise professional judgments, ensuring impartiality in decision-making.
Considerations for the internal audit function's independence:
 Assess organizational status supporting freedom from bias, conflicts, and undue influence.
 Evaluate governance oversight of employment decisions for the internal audit function.
 Examine constraints on communication of internal audit findings to the external auditor.
 Verify freedom from conflicting responsibilities, such as managerial or operational duties.

COMPETENCE AND ITS EVALUATION

Competence in the internal audit function means having the knowledge and skills needed to
perform tasks diligently and in line with professional standards, ensuring effective execution
of responsibilities.

Factors impacting the external auditor's assessment of competence in the internal audit
function include:

 Adequate resourcing relative to entity size and operations.

 Established policies for hiring, training, and assigning internal auditors.
 Adequate technical training and proficiency in auditing.
 Possession of required knowledge regarding the entity's financial reporting and applicable
frameworks.

APPLICATION OF A SYSTEMATIC AND DISCIPLINED APPROACH

The effectiveness of the internal audit function is characterized by its systematic and
disciplined approach in planning, executing, supervising, reviewing, and documenting
activities. This sets it apart from other control monitoring activities within the organization.
External auditors assess the internal audit function's approach by considering factors such as:

CATESTSERIES.ORG
a) Documented Procedures: The presence, sufficiency, and utilization of documented
internal audit procedures, including risk assessments, work programs, and reporting
protocols. The adequacy aligns with the entity's size and circumstances.
b) Quality Control Policies: Evaluation of whether the internal audit function has established
and follows appropriate quality control policies and procedures to ensure the reliability and
consistency of its activities.

CIRCUMSTANCES WHEN WORK OF THE INTERNAL AUDIT FUNCTION CANNOT BE USED

The external auditor refrains from utilizing the work of the internal audit function if:

(a) Lack of Objectivity: The organizational status and policies of the internal audit function do
not sufficiently ensure the objectivity of internal auditors.

(b) Insufficient Competence: The internal audit function lacks the necessary competence to
carry out its responsibilities effectively.

(c) Absence of Systematic Approach: The internal audit function does not apply a systematic
and disciplined approach, including quality control measures in its activities. This ensures that
the work of the internal audit function meets the required standards for reliability and
integrity.

CIRCUMSTANCES IN WHICH THE EXTERNAL AUDITOR SHALL PLAN TO USE LESS OF THE
WORK OF THE INTERNAL AUDIT FUNCTION AND PERFORM MORE OF THE WORK DIRECTLY

The external auditor opts to use less of the internal audit function's work and perform more
direct work when:

(a) Judgment Intensity: The audit involves significant judgment in planning, executing audit
procedures, and evaluating gathered evidence.

(b) Higher Risk of Misstatement: The assessed risk of material misstatement at the assertion
level is higher, with specific attention to risks identified as significant.

CATESTSERIES.ORG
(c) Objectivity Concerns: The organizational status and relevant policies of the internal audit
function do not sufficiently support the objectivity of its auditors.

(d) Lower Competence: The internal audit function demonstrates a lower level of
competence, prompting the external auditor to take a more direct role in the audit process.

BASICS OF INTERNAL FINANCIAL CONTROL AND REPORTING REQUIREMENTS

Internal Financial Controls (IFC) encompass policies and procedures ensuring reliable financial
reporting, operational effectiveness, legal compliance, asset safeguarding, and fraud
prevention. In contrast, Internal Controls over Financial Reporting specifically pertains to
auditors expressing an opinion on the effectiveness of an entity's internal controls over
financial reporting, distinct from their opinion on the financial statements. IFC is a broader
term, while Internal Controls over Financial Reporting is narrower and focused solely on
financial reporting controls.

AUDIT SAMPLING (SA 530)

Audit sampling, as per SA 530, involves applying audit procedures to less than 100% of items
within a relevant population, ensuring each item has an equal chance of selection. This
method allows auditors to draw conclusions about the entire population, serving as a
reasonable basis for their opinions. SA 530 applies when auditors use statistical or non-
statistical sampling in designing, selecting, and evaluating the results of audit samples during
procedures. It complements SA 500, which outlines means, including audit sampling, for
selecting items to obtain sufficient and appropriate audit evidence for forming reasonable
conclusions

CATESTSERIES.ORG
POPULATION

The population in auditing refers to the complete dataset from which a sample is chosen for
examination. It encompasses all the relevant data the auditor aims to draw conclusions about.
To ensure the sample is representative, the auditor should use a selection method where
every item in the population has an equal chance of being chosen, allowing for reliable and
unbiased inferences.

Characteristics of Population

1. Appropriateness: The population for sampling must be relevant to the specific audit
objective. The auditor ensures that the population aligns with the purpose of the audit
procedure to draw accurate conclusions.
2. Completeness: The population should be comprehensive, encompassing all relevant items
for the audit objective. A complete population ensures that conclusions drawn from the
sample are considered reasonable.
3. Reliable: The auditor verifies the reliability of the population's information before
conducting audit sampling. The accuracy and source reliability of the population are crucial
for the sample to be pertinent to the audit objective.

SAMPLING UNIT

A sampling unit is an individual item within the population subject to audit. When conducting
audit sampling, the auditor selects specific sampling units from the population, applies audit
procedures to them, and then extrapolates the conclusions drawn from the sample to
represent the entire population. In essence, the sampled units serve as representatives for
making broader conclusions about the overall population.

CATESTSERIES.ORG
APPROACHES TO SAMPLING

Audit sampling involves evaluating evidence about certain characteristics of selected items to
draw conclusions about the entire population. There are two approaches:
A) Non-Statistical Sampling
B) Statistical Sampling

(A) Statistical Sampling-More Scientific

Statistical sampling in auditing is more scientific, utilizing mathematical laws of probability to

determine sample size. It is particularly suitable for large populations with similar items, such
as compliance testing, trade receivables confirmation, and payroll checking. This approach
eliminates personal bias, providing reliable results that can be projected onto the entire
population. In larger organizations with extensive transactions, statistical sampling is
recommended for its unbiased nature. For example, when dealing with a large number of
purchase transactions, random sampling is a method commonly chosen.

(B) Non-Statistical Sampling

In non-statistical sampling, the auditor determines sample size and composition based on
personal experience. This method, though simple, lacks objectivity and scientific precision.
The auditor may choose samples using personal judgment, such as selecting specific months
or top-value items. However, this approach is criticized for its potential personal bias and lack
of scientific rigor. While it's straightforward, its reliability in representing the entire
population is questioned, and the results may not be as objective as those achieved through
statistical techniques.

SAMPLE DESIGN
When designing an audit sample (as per SA 530), the auditor considers the specific purpose
and optimal audit procedures. They account for the nature of evidence sought, potential
deviations, and other characteristics. SA 500 ensures the completeness of the population for
the sample. Understanding the purpose is critical to assess what constitutes a deviation or
misstatement. The auditor includes only relevant conditions, aligning with SA standards. In

CATESTSERIES.ORG
evaluating population characteristics, expected rates guide sample design. For tests of details,
the auditor assesses expected misstatements. This process ensures representative evidence
in line with SA standards.

STRATIFICATION AND VALUE-WEIGHTED SELECTION

When selecting a sample from a population, auditors might use either stratification or value-
weighted selection based on characteristics identified in the population. SA 530 guides
auditors on employing these techniques, helping enhance the efficiency of audit procedures
and reduce sampling risk.

a) Stratification: Stratification involves categorizing a population into subgroups based on

specific characteristics, aiming to minimize variability within each subgroup. This allows
auditors to reduce sample size without increasing risk. For detailed tests, populations are
often stratified by monetary value or other risk-indicating factors. Results from each subgroup
are projected to draw conclusions about the entire population, requiring a combination of
findings to assess potential deviations or risks of material misstatement in account balances
and transactions.
b) Value-Weighted Selection: In tests of details, selecting individual monetary units within a
population (like accounts receivable) can enhance efficiency. This approach, called value-
weighted selection, focuses on larger value items, optimizing audit effort. The systematic
method of sample selection, especially when combined with random selection, proves most
efficient in this context.

SAMPLE SELECTION METHODS

Representative sampling in auditing ensures that every item in the population has an equal
chance of being included in the sample, providing a fair reflection of the entire population.

CATESTSERIES.ORG
 Sample
Selection
Method

Random Systematic Haphazard Monetary Unit Block

Sampling Samplingc Sampling Sampling Sampling

(1) Random Sampling: Random Sampling ensures every item in the population or each
stratum has an equal chance of selection. It may use random number tables. Two common
methods are Simple Random Sampling and Stratified Sampling .
A. Simple Random Sampling: Simple Random Sampling involves giving each unit in the
population, like invoices, an equal chance of being chosen. It uses random number tables,
ensuring a fair and unbiased selection. Modern methods include computer-generated
numbers or smartphone apps. This method is suitable for a homogeneous population with
reasonably similar units and falls within a reasonable range.
B. Stratified Sampling: In Stratified Sampling, the auditor divides the population, such as
trade receivables, into groups (strata) based on characteristics like balance ranges. For
instance
 Balances in excess of 10,00,000 (Top Group)
 Balances in the range of 7,75,001 to 10,00,000
 Balances in the range of 5,50,001 to 7,75,000
 Balances in the range of 2,25,001 to 5,50,000
 Balances of 2,25,000 and below (Lowest Group)
The auditor may then select different percentages of items from each group. For example:
 From the top group, examine all items.
 From the second group, examine 25% of items.
 From the third group, examine 10% of items.
 From the lowest group, examine 2% of items.
Random sampling is employed within each stratum using random number tables, ensuring a
representative sample that reflects the diversity of the entire population.

CATESTSERIES.ORG
(2) Interval Sampling or Systematic Sampling: Interval Sampling, or Systematic Sampling,
involves selecting every nth item from a population based on a fixed sampling interval (e.g.,
every 50th item). To enhance randomness, the starting point is determined haphazardly or
using a computerized random number generator. Multiple starting points may be used to
reduce the risk of the sampling interval aligning with a pattern in the population, ensuring a
more unbiased sample.
(3) Monetary Unit Sampling: This method involves selecting a sample based on the value of
the items, with the sample size, selection, and evaluation all conducted in monetary terms.
(4) Haphazard sampling: Haphazard sampling is a non-structured approach where the
auditor selects items without following a specific technique. The key is to avoid conscious bias
or predictability in selection.
(5) Block Sampling: Block sampling involves selecting contiguous groups of items from within
a population. However, it's not commonly used in audit sampling because continuous
transactions often have similar characteristics, limiting the representativeness of the sample.

AUDIT EVIDENCE-SPECIFIC CONSIDERATIONS FOR SELECTED ITEMS (SA 501)

In the audit process, the auditor must express an opinion on an entity's financial statements
by examining its books of accounts. Audit evidence is crucial in supporting recorded
transactions. Specific Considerations for Selected Items, as outlined in SA 501, refer to the
auditor's focused attention on particular aspects like inventory, litigation and claims involving
the entity, and segment information. SA 501 guides auditors in obtaining sufficient and
appropriate audit evidence for these specific areas to ensure a thorough and reliable audit of
financial statements.

OBJECTIVE OF SPECIFIC CONSIDERATIONS FOR SELECTED ITEMS

 The existence and condition of inventory
 The completeness of litigation and claims involving the entity;

CATESTSERIES.ORG
 The accurate presentation and disclosure of segment information as per the applicable
financial reporting framework.

INVENTORY

When inventory is material to financial statements, the auditor ensures sufficient and
appropriate evidence on its existence and condition through:

Attendance at physical inventory counting

 Attend physical inventory counting (unless impracticable).

 Evaluate management's instructions and procedures.
 Observe and inspect the inventory.
 Perform test counts to validate accuracy.
Audit Procedures on Final Inventory Records:
 Conduct audit procedures on the entity's final inventory records.
 Verify if these records accurately reflect the actual results of the inventory count.

ATTENDANCE AT PHYSICAL INVENTORY COUNTING

To ensure inventory accuracy:

(a) Inspect inventory to confirm existence and assess its condition, including test counts.

(b) Observe adherence to management's instructions and performance in recording and

controlling physical inventory results.

(c) Obtain evidence on the reliability of management's count procedures.

These procedures can function as either tests of controls or substantive procedures,

depending on the auditor's risk assessment and planned approach.

CATESTSERIES.ORG
MATTERS RELEVANT IN PLANNING ATTENDANCE AT PHYSICAL INVENTORY COUNTING

Matters relevant in planning attendance at physical inventory counting include, for

Example:

(a) Nature of inventory.

(b) Work in progress completion stages.

(c) Risks of material misstatement in inventory.

(d) Internal control nature related to inventory.

(e) Anticipation of proper procedures and instructions.

(f) Timing of physical inventory counting.

(g) Existence of perpetual inventory system.

(h) Inventory locations, their materiality, and associated risks.

(i) Need for an auditor's expert to ensure sufficient audit evidence.

PHYSICAL INVENTORY COUNTING CONDUCTED OTHER THAN AT THE DATE OF THE

FINANCIAL STATEMENTS

When physical inventory counting occurs on a date different from the financial statements,
the auditor, in addition to standard procedures, must verify if changes in inventory post-count
are accurately recorded.

Key considerations:

a) Confirm proper adjustment of perpetual inventory records.

b) Assess the reliability of the entity's perpetual inventory records.
c) Investigate reasons for notable variances between physical count information and
perpetual inventory records.

CATESTSERIES.ORG
WHEN INVENTORY UNDER THE CUSTODY AND CONTROL OF A THIRD PARTY- WHAT WILL
THE AUDITOR DO

When inventory under the control of a third party is significant to financial statements, the
auditor must obtain sufficient evidence on its existence and condition.

This involves:

a) Request confirmation from the third party regarding the quantities and condition of
inventory held for the entity.
b) Perform appropriate audit procedures or inspections based on the circumstances to verify
the existence and condition of the inventory.

LITIGATION AND CLAIMS

To uncover and address potential risks of material misstatement from litigation and claims,
auditors undertake specific procedures:

1. Management Inquiry: Question management and relevant personnel, including in-house

legal counsel.
2. Governance Review: Examine minutes of meetings with those charged with governance.
3. Legal Expense Analysis: Scrutinize legal expense accounts.

Reference SA 540 for further requirements and guidance, especially concerning accounting
estimates and disclosures related to litigation and claims. These measures ensure a
comprehensive evaluation of potential risks arising from legal matters in financial statements.

IF THE AUDITOR ASSESSES A RISK OF MATERIAL MISSTATEMENT REGARDING LITIGATION

OR CLAIMS - COMMUNICATION WITH THE ENTITY’S EXTERNAL LEGAL COUNSEL

If the auditor identifies a risk of material misstatement in litigation or claims, they seek direct
communication with the entity's external legal counsel through a letter of inquiry. If legal

CATESTSERIES.ORG
restrictions prevent this, alternative audit procedures are performed. A specific inquiry letter
may be used for detailed information when a general inquiry is unlikely to yield a response,
ensuring accurate information is obtained despite potential legal constraints.

In a specific inquiry letter, include:

(a) A list of litigation and claims.

(b) Management's assessments and financial implications, if available.

(c) A request for external legal counsel to confirm and provide additional information if they
find the list incomplete or incorrect.

In certain cases, the auditor may meet with the entity's external legal counsel to discuss likely
outcomes of litigation or claims, particularly when the matter is deemed significant, complex,
or when there is disagreement between management and legal counsel.

Meetings with external legal counsel are warranted when:

a) The matter is deemed a significant risk.

b) The issue is complex.
c) There is a disagreement between management and external legal counsel.
d) If management denies permission or legal counsel doesn't respond appropriately, and
alternative procedures are insufficient, the auditor modifies the opinion in the report per SA
705.

SEGMENT INFORMATION

Segment Information entails details about an enterprise's diverse products, services, and
operations across various geographical areas. It provides a breakdown of the business's
performance and composition, aiding stakeholders in understanding the distinct components
and geographic reach of the enterprise.

CATESTSERIES.ORG
OBTAINING SUFFICIENT APPROPRIATE AUDIT EVIDENCE REGARDING THE PRESENTATION
AND DISCLOSURE OF SEGMENT INFORMATION
To ensure accurate presentation and disclosure of segment information, the auditor must:
(a) Understanding and Evaluation: Understand management's methods for determining
segment information. Evaluate if these methods align with the financial reporting framework.
Test the application of these methods where necessary.
(b) Analytical Procedures: Conduct analytical procedures or other appropriate audit
procedures in line with the circumstances.

UNDERSTANDING OF THE METHODS USED BY MANAGEMENT

When delving into management's methods for determining segment information, it's crucial
to assess the consistency and conformity of these methods with the established financial
reporting framework. Factors such as adherence to regulatory guidelines, transparency in
allocation criteria, and the reliability of measurement methods play a pivotal role in ensuring
that the disclosed segment information aligns appropriately with the applicable financial
reporting standards.
1. Intersegment Transactions: Examine sales, transfers, and charges between segments, and
the elimination of intersegment amounts.
2. Performance Comparisons: Assess comparisons with budgets and expected results, such
as operating profits as a percentage of sales.
3. Asset and Cost Allocation: Evaluate the allocation of assets and costs among segments.
4. Consistency and Disclosure Adequacy: Ensure consistency with prior periods and evaluate
the adequacy of disclosures, especially concerning any inconsistencies.

EXTERNAL CONFIRMATIONS (SA 505)

As per SA 505, the reliability of audit evidence is influenced by its source and nature, with
specific principles:

CATESTSERIES.ORG
a) Independence Emphasis: Audit evidence is more reliable when sourced from independent
entities outside the audited entity.
b) Direct vs. Indirect Evidence: Evidence directly obtained by the auditor is deemed more
reliable than evidence acquired indirectly or inferred.
c) Documentary Form Requirement: Audit evidence, in forms such as paper, electronic, or
other mediums, is considered more reliable.

SCOPE OF THIS SA (505)

SA 505 outlines the auditor's use of external confirmation procedures to obtain audit
evidence in accordance with SA 500 requirements. In certain audit circumstances, external
confirmations received directly from third parties may be deemed more reliable than
internally generated evidence. The standard's purpose is to guide auditors in designing and
executing external confirmation procedures to ensure the acquisition of pertinent and
trustworthy audit evidence. The objective is clear: when using external confirmation
procedures, the auditor aims to obtain audit evidence that is both relevant and reliable for an
effective audit process.

DEFINITION OF EXTERNAL CONFIRMATION

External confirmation is audit evidence acquired through a direct written response to the
auditor from a third party (the confirming party), conveyed in paper form, electronic format,
or other mediums.

CATESTSERIES.ORG
 in paper
form, or by
Audit as a direct from a
to the electronic
evidence written third
auditor or
obtained response party
other
medium

DEFINITIONS OF OTHER TERMS

1) Positive Confirmation: Direct response indicating agreement, disagreement, or providing
requested information.
2) Negative Confirmation: Direct response required only if the confirming party disagrees
with the provided information.
3) Non-response: Failure of the confirming party to reply or fully respond to a positive
confirmation, or an undelivered confirmation.
4) Exception: A response indicating a difference between requested and provided
information.

EXTERNAL CONFIRMATION PROCEDURES ADOPTED BY THE AUDITOR TO OBTAIN AUDIT

EVIDENCE

1. Information for Confirmation: External confirmation procedures commonly verify or

request information related to account balances, elements, terms of agreements, contracts,
transactions, or the absence of specific conditions like a side agreement.

CATESTSERIES.ORG
2. Confirming Party Selection: The relevance and reliability of confirmation responses are
enhanced when requests are directed to confirming parties deemed knowledgeable about
the information to be confirmed.
3. Designing Confirmation Requests: The design of a confirmation request directly influences
the response rate and the nature of audit evidence obtained.

Factors for Design Consideration:

 Addressed Assertions.
 Risks of Material Misstatement, including fraud risks.
 Confirmation request layout and presentation.
 Prior audit or similar engagement experiences.
 Communication method (e.g., paper, electronic).
 Management's authorization or encouragement for confirming parties to respond.
 The confirming party's ability to confirm or provide requested information (e.g., individual
invoice amounts versus total balance).
4. Positive Confirmation Request: A positive confirmation request is a method used by
auditors where the confirming party is asked to respond, indicating agreement with provided
information or supplying additional details. While this approach is generally reliable, there is
a risk of unverified responses. Auditors can mitigate this risk by not specifying amounts in the
confirmation request, prompting the confirming party to fill in the details, though this may
lead to lower response rates due to increased effort required from the confirming parties.
5. Address Validation and Follow-Up: Validating addresses on confirmation requests
ensures accurate communication. In cases of non-response within a reasonable timeframe,
auditors may send follow-up confirmation requests to prompt replies and ensure the
completeness of audit evidence.

MANAGEMENT’S REFUSAL TO ALLOW THE AUDITOR TO SEND A CONFIRMATION REQUEST-

STEPS TAKEN BY THE AUDITOR

In the event of management refusing confirmation requests, the auditor must:

CATESTSERIES.ORG
(a) Inquire about and assess the validity of management's reasons, seeking supporting
evidence;

(b) Evaluate the impact on risk assessment, including fraud risk, and adjust audit procedures
accordingly;

(c) Perform alternative procedures to obtain relevant and reliable evidence. If management's
refusal is considered unreasonable, or alternative evidence is insufficient, the auditor shall
communicate with those charged with governance in accordance with SA 260.

NEGATIVE CONFIRMATIONS

Negative confirmations, while providing evidence, are less persuasive than positive
confirmations. They should not be the sole substantive audit procedure unless certain
conditions are met:

(a) The risk is assessed as low with effective controls,

(b) The population involves numerous, small, homogeneous items

(c) A very low exception rate is anticipated, and

(d) There's no indication recipients would disregard the requests.

Non-response to negative confirmations doesn't explicitly indicate acknowledgment or

verification. Consequently, it yields less persuasive evidence compared to positive
confirmations. Respondents may be more inclined to dispute unfavorable information,
potentially skewing the results.

CATESTSERIES.ORG
EVALUATING THE EVIDENCE OBTAINED

After external confirmation procedures, the auditor must assess if obtained evidence is
relevant and reliable, determining if further procedures are needed. Results are categorized
(a) Agreement or information provision without exception,

(b) Unreliable responses,

(c) Non-responses, and

(d) Responses indicating exceptions.

This evaluation, combined with other audit procedures, aids the auditor in deciding if
sufficient and appropriate evidence has been acquired, aligning with SA 330 requirements for
determining the extent of audit procedures.

INITIAL AUDIT ENGAGEMENTS – OPENING BALANCES (SA 510)

1. Initial Audit Engagement: An audit where either the financial statements for the prior
period were not audited, or they were audited by a predecessor auditor.

2. Opening Balances: Balances at the start of a period, derived from the prior period's closing
balances, reflecting prior period transactions, events, and applied accounting policies. It
includes disclosure-worthy items like contingencies.

3. Predecessor Auditor: The auditor from a different firm who audited an entity's financial
statements in the prior period and has been replaced by the current auditor.

SCOPE OF SA 510

SA 510 focuses on the auditor's responsibilities concerning opening balances in an initial audit
engagement. Opening balances encompass financial statement amounts and disclosure-

CATESTSERIES.ORG
worthy items like contingencies. If comparative financial information is present, SA 710
requirements and guidance are also applicable.

OBJECTIVE OF AUDITOR WITH RESPECT TO OPENING BALANCES IN CONDUCTING AN INITIAL

AUDIT ENGAGEMENT

In an initial audit engagement, the auditor aims to gather sufficient, appropriate evidence to
determine:

(a) If opening balances have material misstatements affecting the current financial
statements.

(b) Whether accounting policies in opening balances are consistently applied in the current
period's financial statements, or changes are appropriately accounted for and disclosed per
the relevant financial reporting framework.

PROCEDURES ADOPTED BY THE AUDITOR TO OBTAIN AUDIT EVIDENCE REGARDING

OPENING BALANCES
The nature and extent of audit procedures to obtain adequate evidence on opening balances
depend on:
 Entity's accounting policies.
 Nature of account balances, transaction classes, and disclosures, considering risks.
 Significance of opening balances relative to current financial statements.
 Whether prior period financial statements were audited and if the predecessor auditor's
opinion was modified.

RELATED PARTIES (SA 550)

A related party is:
(i) As defined by the applicable financial reporting framework, or

CATESTSERIES.ORG
(ii) where the applicable financial reporting framework sets forth minimal or no specific
related party requirements, a related party is defined as
a. An entity/person exerting control or significant influence directly or indirectly over the
reporting entity
b. An entity under the reporting entity's control or significant influence
c. An entity under common control with the reporting entity through shared ownership,
close family members, or common key management. However, entities under common
control by a state are not considered related unless significant transactions or resource
sharing occurs.

SCOPE OF THIS SA (550)

SA 550, "Related Parties," guides auditors in addressing risks of material misstatement linked
to related party relationships and transactions during financial audits, emphasizing the need
for a comprehensive examination and disclosure of financial information involving closely
associated parties.

CONSIDERATIONS SPECIFIC TO SMALLER ENTITIES BY THE AUDITOR

In smaller entities, the control environment differs from larger ones. Governance may involve
owner-managers without outside members. Control activities are less formal, lacking
documented processes for related party transactions. An owner-manager's active role in
transactions can affect risk. The auditor gains understanding through inquiries, observing
oversight, and inspecting relevant documentation, adapting procedures to the informal
nature of controls in smaller entities.

 The auditor can review the following records or documents to gather information about
related party relationships and transactions, including:
 Entity income tax returns.
 Regulatory filings and information submitted to authorities.
 Shareholder registers for key ownership details.

CATESTSERIES.ORG
 Disclosures on conflicts of interest from management and governance.
 Records of entity investments and pension plans.
 Agreements with key management or governance.
 Unusual contracts and agreements outside the normal course of business.
 Invoices and correspondence from professional advisors.
 Life insurance policies held by the entity.
 Contracts renegotiated during the period.
 Internal auditors’ reports.
 Documents filed with securities regulators (e.g., prospectuses)

ANALYTICAL PROCEDURES (SA520)

Analytical procedures are additional audit procedures, beyond routine checks, that involve
comparisons, trend analysis, and ratio analysis to detect mistakes or manipulation in financial
accounts. These procedures, collectively known as overall tests, play a significant role in
substantive audit work. SA-520 provides guidance on the application of analytical procedures,
emphasizing their importance in enhancing the effectiveness of the audit process.

SCOPE OF SA 520

SA 520 focuses on the auditor's use of analytical procedures, both as substantive procedures
and as procedures near the end of the audit. The objectives are to obtain relevant and reliable
audit evidence through substantive analytical procedures and to design and perform
analytical procedures at the end of the audit to assist in forming an overall conclusion on the
consistency of the financial statements with the auditor's understanding of the entity. In
short, it guides the auditor in using analytical procedures effectively for a comprehensive
assessment of financial statements.

CATESTSERIES.ORG
PURPOSE AND TIMING OF ANALYTICAL PROCEDURES
A. Purpose of Analytical Procedures
B. Timing of Analytical Procedures

PURPOSE OF ANALYTICAL PROCEDURES

Analytical procedures involve comparing and assessing relationships within financial data to
identify anomalies. For example, comparing balances in the Balance Sheet and the Statement
of Profit and Loss with the previous year, reconciling physical asset balances with financial
records, confirming account balances with bankers, and assessing outstanding income and
expenses through reconciliation statements. These procedures help detect unusual situations
and errors in accounts. Analytical review includes setting up expense ratios based on the
Statement of Profit and Loss, comparing them with previous years to evaluate changes, and
investigating material differences. Independent verification of certain expenses, such as
duties paid on imported goods or GST on sales, can further validate financial information.
Analytical procedures aid auditors in identifying unusual transactions, assessing risks of
material misstatement, and detecting potential fraud.

TIMING OF ANALYTICAL PROCEDURES

Analytical procedures are utilized by experienced auditors at various stages of the audit
process. They are required during the planning phase to assess the reasonableness of financial
information. These procedures are also commonly conducted in the testing phase to gather
evidence and ensure accuracy. Additionally, analytical procedures play a role during the
completion phase to finalize the overall assessment of the financial statements.

SUBSTANTIVE ANALYTICAL PROCEDURES

In the audit process, the auditor decides on the appropriate procedures, such as tests of
details or substantive analytical procedures, based on judgment regarding their expected

CATESTSERIES.ORG
effectiveness and efficiency in reducing audit risk. The auditor may inquire about the
availability and reliability of information needed for analytical procedures, and may use
analytical data prepared by management if satisfied with its accuracy and preparation.

FACTORS TO BE CONSIDERED FOR SUBSTANTIVE AUDIT PROCEDURES

1) Availability of Data: Effective analytical procedures rely on the availability of reliable and
relevant data.
2) Disaggregation: The usefulness of data in detecting misstatements is directly affected by
the degree of disaggregation.
3) Account Type: Analytical procedures are more useful for income statement accounts,
which reflect accumulated transactions, compared to balance sheet accounts, which
represent the net effect at a point in time or involve greater management judgment.
4) Source: Routine transactions are more predictable, making them suitable for substantive
analytical procedures, while non-routine and estimated transactions may be harder to
predict.
5) Predictability: Substantive analytical procedures are more appropriate when there is
predictability in account balances or relationships between data items.
6) Nature of Assertion: The effectiveness of substantive analytical procedures varies for
different assertions, being more suitable for some (e.g., completeness or valuation) than
others (e.g., rights and obligations).
7) Inherent Risk or "What Can Go Wrong": Analytical procedures are considered based on
the nature of inherent risk, and when inherent risk is higher, tests of details may be more
suitable. For significant risks, relying solely on substantive analytical procedures may not be
sufficient.

TECHNIQUES AVAILABLE AS SUBSTANTIVE ANALYTICAL PROCEDURES

1. Trend Analysis: Compares current data with prior periods or established trends to assess
if the current balance aligns with historical patterns or expected changes.

CATESTSERIES.ORG
2. Ratio Analysis: Utilizes ratios to analyze asset, liability, revenue, and expense accounts,
providing insights into relationships between different accounts. Comparisons can be made
over time or with entities in the same industry.
3. Reasonableness Tests: Examines non-financial data for the current period (e.g., occupancy
rates, interest rates) to estimate income or expenses. Particularly applicable to income
statement accounts and certain accrual or prepayment accounts.
4. Structural Modelling: Utilizes statistical models from past financial and non-financial data
to predict current account balances, such as employing linear regression for forecasting.

ANALYTICAL PROCEDURES USED AS SUBSTANTIVE TESTS

(a) Suitability Assessment: Evaluate the appropriateness of substantive analytical procedures
for specific assertions, considering the assessed risks of material misstatement and any
related tests of details.
(b)Reliability Evaluation: Assess the reliability of data used to form expectations, considering
factors like source credibility, comparability, and the nature of available information. Also,
consider controls over data preparation.
(c) Expectation Development: Formulate an expectation of recorded amounts or ratios and
assess its precision. Ensure the expectation can effectively identify misstatements, whether
individually or in aggregate, that might materially impact the financial statements.
(d)Acceptable Differences: Determine the threshold for acceptable differences between
recorded amounts and expected values that can be tolerated without triggering further
investigation.

SUITABILITY OF PARTICULAR ANALYTICAL PROCEDURES FOR GIVEN ASSERTIONS

1. Transaction Volume Suitability: Substantive analytical procedures are more effective for
large transaction volumes that exhibit predictability over time.

CATESTSERIES.ORG
2. Basis of Application: Planned analytical procedures rely on the expectation that data
relationships persist unless conditions indicate otherwise.
3. Procedure Suitability: The effectiveness of an analytical procedure depends on the
auditor's assessment of its ability to detect misstatements, either individual or aggregated,
that could materially impact the financial statements.
4. Effectiveness of Predictive Models: Even simple predictive models, in some cases, can be
effective as analytical procedures in detecting misstatements.

EVALUATION OF WHETHER THE EXPECTATION IS SUFFICIENTLY PRECISE

A. Accuracy of Predictions: The auditor evaluates the accuracy of predicting expected results,
considering variations in predicting gross profit margins versus discretionary expenses like
research.
B. Disaggregation Potential: The degree to which information can be disaggregated
influences the effectiveness of analytical procedures. For instance, analyzing individual
sections of an operation may be more effective than analyzing the entity as a whole.
C. Availability and Reliability: The auditor considers the availability and reliability of both
financial and non-financial information. Availability of data, such as budgets or forecasts, and
its reliability, impacts the design and effectiveness of substantive analytical procedures.

INVESTIGATING RESULTS OF ANALYTICAL PROCEDURES

When analytical procedures reveal inconsistencies or significant differences from expected

values (as per SA 520), the auditor investigates by:

a) Inquiring with Management: The auditor asks management for explanations and gathers
audit evidence relevant to management's responses. This involves evaluating responses in
the context of the auditor's understanding of the entity and other evidence collected during
the audit.
b) Performing Additional Procedures: If management's explanation is insufficient or
unavailable, the auditor conducts additional audit procedures as necessary. These procedures

CATESTSERIES.ORG
help gather more evidence or insights to address the identified inconsistencies or
discrepancies.

CATESTSERIES.ORG
 CAtestseries.org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 5

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concepts Notes

Ch-5

AUDIT OF ITEMS OF FINANCIAL STATEMENTS

INTRODUCTION

Companies follow generally accepted accounting principles (Indian GAAP) to prepare financial
statements, subject to examination by independent auditors. The audit assesses the truth and
fairness of financial statements and disclosures, with management responsible for their
preparation. Financial statements include overall representations and specific assertions. The
auditor's opinion addresses these overall representations, relying on evaluations of individual
assertions within each statement. Assertions cover completeness, cut-off,
existence/occurrence, valuation/measurement, rights and obligations, and
presentation/disclosure. The audit procedures aim to verify these assertions. An assertion is
a representation by management in the financial statements, explicit or implicit, guiding
auditors in considering potential misstatements. For instance, if a balance sheet claims a
building's carrying amount is ₹50 lakh, assertions include existence, rights and obligations,
valuation, and completeness. The auditor then devises an audit program to gather relevant
evidence and verify these assertions.

INCOME STATEMENT CAPTIONS COMPRISING REVENUE AND EXPENSE BALANCES

Assertion Explanation Example

CATESTSERIES.ORG
 Occurrence Transactions recognized have a) Employee benefit expense
occurred and relate to the incurred during the period for
entity. valid personnel.
b) Recorded sales represent
valid customer orders.

Completeness All transactions supposed to a) Employee benefit expenses

be recorded have been for all personnel fully accounted
recognized; no omissions. for.
b) All genuine sales recorded.

Cut-off Ensures all income and a) Employee benefit expenses

expenses are reported in the recognized relate to the current
correct accounting period. accounting period.
Treated separately from b) Sales include goods
completeness. despatched at the year-end

Measurement Transactions accurately a) Employee benefit expense

recorded at appropriate accurately measured and
amounts; no errors in calculated.
preparing documents or b) Sales recorded correctly based
posting transactions. on invoices.

Presentation and Transactions presented fairly; a) Additional information on

Disclosure appropriately segregated or employee benefits disclosed,
disaggregated; disclosures including salaries, wages,
are complete and accurate. contributions, and staff welfare.
b) Revenue from operations
disclosed separately for various
categories.

BALANCE SHEET CAPTIONS COMPRISING ASSETS, LIABILITIES AND EQUITY BALANCES

CATESTSERIES.ORG
 Assertion Explanation Example
Existence Assets, liabilities, and equity Inventory recognized
exist at the period end. actually existed at the period
end.
Completeness All assets, liabilities, and All inventory units held have
equity are recorded as been recognized; third-party
required. inventory is included.
cut-off Assets and liabilities are Inventory at year-end
reported in the appropriate includes only relevant items;
period. regardless of location.
Valuation Assets, liabilities, and equity Inventory valued at lower of
are valued appropriately. cost and net realizable value;
uses acceptable valuation
basis.
Rights & Obligations Entity has the right to assets, Entity owns or controls
and liabilities represent inventory; no recognition of
obligations. inventory held for another
entity.
Presentation and Proper classification, Disclosures complete,
Disclosure description, and disclosure accurate, and not
in financial statements. misleading; understandable
in accordance with financial
reporting framework.

BALANCE SHEET CAPTIONS

SHARE CAPITAL

When a company begins, it needs money, and most companies, except private ones, share
their plans in a document called a prospectus. This outlines how they'll distribute shares and

CATESTSERIES.ORG
use the money. Auditors check if everything is done correctly: receiving share applications,
following the prospectus rules, and making sure everyone involved meets their commitments
on time. They also look at contracts that guarantee the sale of shares. This ensures that the
company's financial actions are clear and follow the rules.

The table below outlines the typical audit procedures to be performed when examining share
capital:

Audit Procedure Description

Existence of Share Capital a) Tally period-end share capital to
previous year's financial statements.
b) Obtain confirmation of no changes in
capital structure if no changes occurred.
c) Verify paid-up capital against
authorized capital and examine the
Memorandum of Association (MOA).
d) Obtain certified copies of resolutions
authorizing changes in authorized or paid-
up capital.
e) Verify compliance with Companies Act
for fresh share issues.
f) Check SEBI regulations, Ministry of
Corporate Affairs (MCA) filings, and
Reserve Bank of India (RBI) forms for
accuracy and compliance.
Valuation of Share Capital a) Ensure shares are not issued at a
discount, complying with Section 53 of
Companies Act.
b) Verify if shares are issued for cash or
non-cash consideration.
c) Check compliance with SEBI
regulations and guidelines.

CATESTSERIES.ORG
 d) Verify forms filed with MCA and RBI for
accuracy and compliance.
Sweat Equity Shares a) Examine compliance with Section 66 of
Companies Act for reduction of share
capital. Verify proper convening of
shareholder meetings and circulation of
proposals.
b) Check compliance with Articles of
Association and examine defaults related
to repayments or deposits.
c) Verify the Tribunal's order confirming
reduction, Registrar's certificate, and
accounting entries.
d) Confirm disclosure of revaluation of
assets and compliance with Tribunal
terms.
Buy-Back Exemption Confirm that Section 66 exemptions do
not apply to buy-back of securities under
Section 68.
Disclosure Requirements a) Ensure compliance with Schedule III
(Part I) to Companies Act for share capital
disclosure.
b) Verify details such as authorized and
issued shares, par value, rights, and
restrictions. Check disclosure of shares
held by related parties, shares reserved
for options, and details on securities
convertible into equity. Disclose the
number and class of shares allotted as
fully paid-up, bonus shares, and buy-back
details for the past five years. Provide

CATESTSERIES.ORG
 details on convertible securities, calls
unpaid, and forfeited shares.
c) Disclose promoter shareholding,
percentage changes, and utilization of
unutilized amounts from specific-purpose
securities issues.

RESERVES AND SURPLUS

Reserves are portions of profits set aside for various purposes, not meant to cover existing
liabilities or asset value reductions. They serve as internal funding sources and can be
categorized as revenue or capital reserves. Revenue reserves are available for distribution or
specific purposes like business expansion, working capital, or strengthening the financial
position. Capital reserves, derived from profits on capital asset sales, have limited uses,
including writing down fictitious assets or losses. Securities premium or capital redemption
reserve accounts have specific purposes defined by Sections 52 and 55 of the Companies Act,
2013.

The table below outlines the typical audit procedures to be performed when examining
reserves and surplus:

Audit Procedure Description

Existence of Reserves and Surplus a) Trace and reconcile opening balances
of reserves and surplus with the previous
year's financial statements.
b) For the current year, trace
movements in Profit and Loss balances,
ensuring alignment with the Statement
of Changes in Equity. Verify board
resolutions related to dividend

CATESTSERIES.ORG
 recommendations and shareholder
resolutions declaring dividends.
c) Consider AS-4 (Revised) or IND AS 10
guidelines for recognizing dividends
proposed or declared after the balance
sheet date.
d) Confirm and verify resolutions for the
issuance of shares in excess of nominal
value from the Securities Premium
account.
Valuation of Reserves and Surplus a) Confirm that securities premium
account usage aligns with limited
purposes defined by Section 52 of the
Companies Act, 2013.
Disclosures for Reserves and Surplus a) Ensure compliance with Schedule III
(Part I) of the Companies Act, 2013 for
appropriate disclosure of reserves and
surplus.
b) Classify reserves and surplus into
categories such as Capital Reserves,
Capital Redemption Reserve, Debenture
Redemption Reserve, Revaluation
Reserve, Share Options Outstanding
Account, and Other Reserves.
c) Disclose surplus balances in the
Statement of Profit and Loss, specifying
allocations, appropriations, dividends,
bonus shares, and transfers to/from
reserves.

CATESTSERIES.ORG
 d) Identify and disclose reserves
specifically represented by earmarked
investments as "funds."
e) Show negative balances of the
Statement of Profit and Loss under
"Surplus" and negative adjusted
balances under "Reserves and Surplus."

BORROWINGS

Liabilities encompass the financial commitments of a business, excluding owner's funds. This
category includes borrowings, trade payables, current liabilities, deferred payment credits,
and provisions. Accurate verification of liabilities is crucial to present a true and fair view of a
company's financial position. Borrowings specifically refer to funds obtained from external
sources, such as bank loans, debentures, or public fixed deposits, serving as a key component
in a company's financial structure.
The table below outlines the typical audit procedures to be performed when examining
borrowings:
Audit Objective Audit Procedures
Existence a) Review board minutes for approval of
new lending agreements.
b) Agree details of loans to the loan
agreement. Obtain independent balance
confirmations. Agree details of leases and
hire purchase creditors to underlying
contracts/agreements. Examine trust deed
for debentures. - Ensure a discharge is
received on assets when debt is retired.
c) Obtain Written Representation for
validity of recorded liabilities.

CATESTSERIES.ORG
 Completeness a) Obtain a schedule of short-term and
long-term borrowings.
b) Trace closing balances to the general
ledger. -Direct confirmation procedures for
borrowings.
c) Check for unrecorded liabilities at year-
end.
Valuation a) Determine appropriateness of
accounting policies for recording debt.
b) Agree loan balance and payables to the
loan agreement. Recompute interest,
discount, or premium on redemption.
c) Verify computations of restatements for
foreign currency loans.
d) Read provisions in loan agreements and
test compliance with covenants.
Presentation and Disclosure a) Ensure proper classification between
long-term and short-term loans.
b) Review debt agreements for restrictive
covenants and default provisions.
c) Examine due dates on loans for correct
classification.
d) Review disclosures for compliance with
Schedule III to Companies Act, 2013.
e) Verify compliance with Sections 180, 185,
and 186 of the Companies Act, 2013.
f) Examine the purpose of borrowings and
compliance with regulations.
g) Check for proper classification of
borrowings and compliance with AS 18 or
IND AS 24.

CATESTSERIES.ORG
 h) Verify disclosures for trade payables and
other liabilities.
i) Confirm that borrowings have been
presented, classified, and disclosed
correctly.

TRADE RECEIVABLES

Trade receivables, also known as debtors, represent amounts owed to an organization for
goods or services provided. In the balance sheet, the invoice amounts are recorded as
accounts receivable until they are paid. If these amounts become unrecoverable, they may
need to be written off as bad debts in the income statement. To ensure the accuracy and
effectiveness of internal controls over sales and debtors, the auditor conducts Test of
Controls. This involves verifying that sales leading to trade receivables are genuine, made to
approved customers, properly recorded, and can only be settled through cash receipt or
authorized procedures. The auditor also checks for segregation of duties in sales transactions,
timely collection of debtors, and proper review of balances. If necessary, reminders are sent,
legal actions are taken for overdue debts, and provisions for bad debts are made based on an
aging schedule of debtors. After testing controls, the auditor determines the appropriate
audit procedures to verify the accuracy of the debtors' balances.

The below table summarises the audit procedures generally required to be undertaken while
auditing trade receivables:

Audit Objective Audit Procedures

Existence of Trade Receivables a) Review controls preventing duplicate
invoicing and ensuring automatic recording
of receivable balances.
b) Trace period-end accounts receivable to
the general ledger.
c) Verify chronological and FIFO-based
adjustments for cash received from

CATESTSERIES.ORG
 debtors. Directly confirm significant
account balances with customers.
d) Investigate and reconcile discrepancies in
confirmation responses.
e) Perform alternate procedures for non-
responsive confirmations.
f) Review and analyze a trend line of sales
and accounts receivable.
Completeness of Trade Receivables a) Perform cut-off procedures for invoices
issued and goods dispatched near the
reporting year-end.
b) Test invoices listed in the receivable
report for accuracy and completeness.
c) Match invoices to shipping/dispatch logs
and assess bill and hold sales.
d) Review the process of giving
discounts/incentives and check compliance
with policies.
e) Examine credit memos for proper
authorization and correct period issuance.
Valuation of Trade Receivables a) Review the process for deriving an
allowance for doubtful accounts, ensuring
consistency with previous years.
b) Obtain and analyze the ageing report of
accounts receivable.
c) Scrutinize debtors under litigation and
assess provision for bad debts.
d) Verify appropriateness of provisions at
relevant rates and check write-offs'
approval.

CATESTSERIES.ORG
 Disclosure of Trade Receivables a) Ensure proper restatement of foreign
currency trade receivables in accordance
with AS 11.
b) Verify disclosure of related party
transactions regarding receivables per AS
18 or IND AS 24.
c) Report transactions with parties under
Section 189 of the Companies Act in CARO
2020.
d)Confirm compliance with Schedule III
(Part I) to Companies Act, 2013 for trade
receivables disclosures.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents, comprising elements such as physical cash, stamps, bank balances
in current and margin money accounts, cash credit accounts (debit balance), fixed deposits,
and cheques, constitute the most liquid assets for an enterprise. These holdings are easily
convertible to cash and involve minimal value risk. Given their high liquidity, they are vital for
meeting short-term obligations. However, due to their susceptibility to misappropriation,
auditors must approach the examination of these balances with the utmost professional
skepticism. Ensuring the accuracy and reliability of the audit is paramount for a
comprehensive financial assessment of the organization.

The below table summarises the audit procedures generally required to be undertaken while
auditing cash and cash equivalents:

Audit Objective Audit Procedures

Existence a) Conduct surprise checks on cash balances
to ensure their validity.

CATESTSERIES.ORG
 b) Simultaneously verify multiple cash
balances to prevent transfer discrepancies.
c) Check rough Cash Books for correctness
and match with the main Cash Book.
d) Verify temporary advances to employees
for approval and recording.
e) Perform cash sensitivity analysis to
identify trends and variations.
Completeness a) Obtain bank reconciliation statements
(BRS) and ensure they are signed by
authorized personnel.
b) Check BRS for discrepancies and
reconcile items related to cheques issued
and deposited.
c) Request subsequent bank statements to
verify the clearing of cheques.
d) Confirm bank account balances directly
with banks and perform additional testing if
needed.
Valuation Ensure all bank accounts holding foreign
currency are restated at closing exchange
rates.
Disclosures a) Verify required disclosures under
Schedule III (Part I) to Companies Act, 2013,
including classification of cash and cash
equivalents.
b) Separate disclosure of earmarked
balances, balances used as margin money,
and any repatriation restrictions.

CATESTSERIES.ORG
INVENTORIES

Inventories comprise assets held for sale, in the production process, or as materials for
consumption in production or service delivery. According to AS 2, "Valuation of Inventories,"
they are valued at the lower of cost and net realizable value, with a consistent valuation basis
year on year. Any changes in accounting policy must be disclosed adequately in the financial
statements.

The below table summarises the audit procedures generally required to be undertaken while
auditing inventories:

Audit Objective Audit Procedures

Existence of Inventories a) Review entity’s inventory count plan.
b) Ensure segregation of consigned goods.
c) Participate in inventory count, observing
adherence to the plan.
d) Test counts, observe employee
adherence, supervision, tag accuracy, and
reconciliation.
e) Perform cut-off tests.
f) Confirm or investigate third-party
inventory.
Completeness of Inventories a) Perform analytical procedures (inventory
turnover ratio, vertical analysis, budget
comparisons).
b) Examine non-financial information
related to inventory.
c) Perform purchase and sales cut-off tests.
Verify clerical accuracy of inventory listings.
Reconcile physical counts with perpetual
records.
d) Reconcile third-party-held inventories. -
Segregate consigned goods.

CATESTSERIES.ORG
 Valuation of Inventories a) Assess reasonableness of valuation
method (FIFO, weighted average).
b) For raw materials, check cost elements,
standard costs, and damaged/obsolete
items. For work in progress, understand
stages of production, cost elements, and
abnormal wastage.
c) For finished goods, ensure inclusion of
normal costs, net realizable value
consideration, and write-downs for
obsolete items.
d) Compare recorded costs with
replacement costs.
e) Verify overhead allocation rates. - Apply
lower-of-cost-or-net realizable value
principles.

Disclosures for Inventories a) Check if inventory is classified

appropriately (raw materials, work-in-
progress, finished goods, etc.).
b) Disclose goods-in-transit separately.
Specify the mode of valuation.
c) Ensure required disclosures under
Schedule III (Part I) to the Companies Act,
2013 are made.

CATESTSERIES.ORG
LAND, BUILDING, PLANT & EQUIPMENT, FURNITURE & FIXTURES, VEHICLES, OFFICE
EQUIPMENT, COMPUTERS ETC. REFERRED TO AS “PROPERTY, PLANT AND EQUIPMENT”
(“PPE”)

This passage discusses the recognition criteria and valuation of "Property, Plant, and
Equipment" (PPE) in the context of auditing. Key points include:

1. Recognition Criteria for PPE: PPE should be recognized as an asset if it is probable that
future economic benefits will flow to the enterprise, and the cost can be reliably measured.
2. Evaluation of Costs: The enterprise assesses all costs related to PPE at the time they are
incurred, including initial acquisition or construction costs and subsequent costs for additions,
replacements, or servicing.
3. Measurement at Recognition: PPE recognized as an asset is measured at its cost.

Elements of Cost:

 Purchase price, after deducting trade discounts and rebates.

 Costs directly attributable to bringing the asset to the necessary location and condition for
intended operation.
 Initial estimate of costs for dismantling, removing, and restoring the site
(decommissioning, restoration, and similar liabilities) incurred either upon acquisition or as a
consequence of usage for purposes other than inventory production.

The below table summarises the audit procedures generally required to be undertaken while
auditing tangible fixed assets:

Audit Objective Audit Procedure

Existence of PPE as at the Period-End a) Review entity's plan for physical
verification of PPE.
b) Examine evidence of appropriate
supervision.
c) Obtain physical verification report and
working sheets.
d) Assess if all PPE items are properly tagged
and identified.

CATESTSERIES.ORG
 e) Reconcile physically verified items with
the fixed asset register.
f) Verify discrepancies and their treatment
in books.
Additions to PPE during the Period a) Verify movement in the PPE schedule
(asset class-wise).
b) Check arithmetical accuracy of the
movement.
c) Tally closing balance to books of account.
d) Verify material additions against AS 10
criteria.
e) Test purchase invoice, installation
documents, and approval processes.
f) Understand and verify deletion
processes, approvals, and disposal
methods.
Valuation of PPE a) Verify depreciation charges on all PPE
items (except non-depreciable ones).
b) Assess the appropriateness of the
depreciation method.
c) Check for impairment assessment
compliance as per AS 28.
d) Ensure depreciation reflects the
expected consumption pattern of future
economic benefits.
Rights and Obligations a) Verify legal ownership through PPE
purchase invoices.
b) Check conveyance deed/sale deed for
land and building additions.
c) Insist on and verify original title deeds for
immovable properties.

CATESTSERIES.ORG
 d) Confirm with lenders if PPE is given as
security and original title deeds are held by
them.
Required Disclosures for PPE a) Ensure Schedule III (Part I) to Companies
Act, 2013 disclosures are made under
"Property, Plant and Equipment".
b) Check classification (land, buildings, etc.).
c) Specify assets under lease separately.
d) Disclose reconciliation of gross and net
carrying amounts.
e) Include details of additions, disposals,
acquisitions, revaluations, and other
adjustments.

INTANGIBLE ASSETS (COMPRISING GOODWILL, BRAND/ TRADEMARKS, COMPUTER

SOFTWARE ETC.)

Intangible assets are non-monetary, identifiable assets without physical substance, held for
use in production, rental, or administrative purposes. Examples include computer software,
patents, copyrights, and goodwill. Not all items incurred for acquisition or development meet
the definition of an intangible asset; only those meeting criteria like identifiability, control,
and expectation of future economic benefits qualify. Internally generated goodwill is not
recognized. In some cases, assets may have both tangible and intangible elements; judgment
is needed to determine the predominant element. For instance, computer software integral
to hardware is treated as a fixed asset, while standalone software is considered an intangible
asset.

The below table summarises the audit procedures generally required to be undertaken while
auditing intangible fixed assets:

Audit Objective Audit Procedures

CATESTSERIES.ORG
 Existence a) Verify active use of intangible assets in
production, services, or administrative
purposes.
b) For software, verify usage by checking
related sales of services/goods.
c) For designs/drawings, verify production
data to confirm production and sales.
d) Check for deletion records for assets not
in active use.
e) Confirm cessation of amortization for
deleted assets.
Completeness a) Verify movement in the intangible assets
schedule (opening + additions - deletions =
closing).
b) Ensure arithmetical accuracy of the
movement schedule.
c) Confirm additions with management and
assess compliance with AS 26 criteria.
d) Verify approval and internal processes for
acquisitions.
e) Investigate reasons for deletions and
verify disposal process
Valuation a) Confirm amortization on all intangible
assets.
b) Verify appropriateness of amortization
method.
c) Confirm impairment assessment and
compliance with AS 28.
Rights and Obligations Check ownership by verifying expense
invoices and purchase contracts in the
entity's name.

CATESTSERIES.ORG
 Required Disclosures a) Confirm classification of intangible assets
per Schedule III to Companies Act, 2013.
b) “Intangible Assets: Goodwill, Brands
/trademarks, Computer software,
Mastheads and publishing titles, Licences
and franchise
c) Reconcile gross and net carrying
amounts, showing additions, disposals,
acquisitions, revaluations, and adjustments.
d) Disclose depreciation, impairment losses
or reversals separately.
e) Disclose write-offs, additions on
revaluation, and relevant details for the first
five years post such events.

TRADE PAYABLES AND OTHER CURRENT LIABILITIES

Trade payables and other current liabilities, including deferred payment credits and
provisions, constitute liabilities beyond borrowings. A liability is classified as current if it is
expected to be settled within twelve months and is primarily related to the entity's normal
operating cycle. Examples include short-term debt and dividends. The verification of liabilities
is crucial to ensure accurate financial reporting. Omitted, understated, or overstated liabilities
can distort the true and fair view of an entity's financial position, emphasizing the importance
of thorough auditing procedures for liabilities to maintain financial statement integrity.

The below table summarises the audit procedures generally required to be undertaken while
auditing trade payables and other current liabilities:

Audit Objective Audit Procedures

Existence and Completeness a) Review controls to prevent duplicate
recording of purchase/expense invoices

CATESTSERIES.ORG
 and ensure accurate recording in the
general ledger.
b) Obtain and reconcile the accounts
payable aging report with the general
ledger. Investigate any differences and
examine journal entries, especially for large
amounts.
c) Employ direct confirmation procedures
by contacting vendors independently to
confirm significant accounts payable
balances.
d) Verify the completeness of trade
payables through cut-off procedures,
ensuring invoices are recorded in the
correct period.
e) Review related party payables for proper
authorization and reasonableness.
Valuation a) Review the process for identifying and
writing back old creditor balances, ensuring
consistency with prior years.
b) Obtain and analyze the aging of payable
balances, identifying disputes and claims
from vendors and comparing with the
previous year.
c) Check the restatement of foreign
currency trade payables in accordance with
accounting standards (e.g., AS 11).
Required Disclosures a) Ensure compliance with Schedule III (Part
I) to Companies Act, 2013 disclosures for
micro and small enterprises, including

CATESTSERIES.ORG
 principal amount, interest, and payment
details.
b) Confirm appropriate classification of
other current liabilities, such as finance
lease obligations, interest accruals, income
received in advance, and application money.

LOANS AND ADVANCES AND OTHER CURRENT ASSETS

Loans and advances comprise funds extended by a company, including those to related
parties and recoverable amounts. Other current assets encompass diverse short-term assets,
such as balances with statutory authorities and prepaid expenses.

The below table summarises the audit procedures generally required to be undertaken while
auditing loans and advances and other current assets:

Audit Objective Audit Procedures

Existence and Completeness a) Perform direct confirmation procedures,
including interest receivable, for loans and
advances balances.
b) Obtain a list of all advances and other
current assets, comparing them with ledger
balances.
c) Verify loan agreements and approvals,
ensuring compliance with the entity's
governing documents.
d) Inspect board meeting minutes for
approval of significant loans and advances.
e) Verify acknowledgment and collateral for
loans, ensuring regular repayments.

CATESTSERIES.ORG
 f) Review related party loans for proper
authorization and reasonableness.
g) Assess balances with statutory
authorities, applying reasonability checks.
Valuation a) Assess the allowance for doubtful
accounts and review the methodology
consistency.
b) Obtain an aging report of loans and
advances and identify those under
litigation.
c) Scrutinize doubtful loans, discuss reasons
with management, and assess bad loans
write-offs.
d) Check approval for write-offs or
reductions in recoverable balances.
e) Review the restatement of foreign
currency loans and advances according to
AS 11.
Required Disclosures a) Ensure compliance with Schedule III
(Part I) to Companies Act, 2013
disclosures for long-term and short-
term loans and advances, including
classifications and allowances.
b) Separate disclosures for loans and
advances to directors or officers and
amounts due from firms or private
companies in which directors are
involved.

CATESTSERIES.ORG
PROVISIONS AND CONTINGENT LIABILITIES

Provisions are recognized liabilities that arise from present obligations due to past events,
where it is probable that an outflow of resources will be needed, and a reliable estimate can
be made. If these conditions aren't met, no provision is recognized. Contingent liabilities, on
the other hand, are possible obligations stemming from past events, dependent on uncertain
future events. They are not recognized unless it is probable that a future outflow of resources
will be required, and the amount can be reliably measured. If these criteria aren't fulfilled,
contingent liabilities are not recognized.

The below table summarises the audit procedures generally required to be undertaken while
auditing provisions and contingent liabilities:

Audit Objective Audit Procedure

Completeness a) Obtain a list of all provisions and
compare them with ledger balances.
b) Inspect underlying agreements (e.g.,
warranty commitments, legal claims) to
assess their validity.
Valuation a) Obtain the underlying working and the
basis for each of the provisions made from
the management and verify whether the
same is complete and accurate.
b) Where required, obtain expert’s report,
calculation, and underlying working for the
provision amount.
c) In case of a legal dispute, request
assessment made by a legal expert
regarding the likelihood of a liability
devolving on the entity.
d) When using the work of a management’s
expert, obtain evidence evaluating the

CATESTSERIES.ORG
 competence, capabilities, and objectivity of
that expert.
e) Obtain an understanding of the work of
that expert, including evaluating
assumptions and methods used by the
management.
f) Evaluate the relevance, reasonableness,
and accuracy of the source data used by the
expert.
Disclosure Compliance a) Check if required disclosures under
Schedule III (Part I) to Companies Act, 2013,
have been made.
b) Check if required disclosures under AS
29, "Provisions, Contingent Liabilities and
Contingent Assets," have been made.

STATEMENT OF PROFIT AND LOSS CAPTIONS

SALE OF PRODUCTS AND SERVICES

The sales and collections cycle encompasses the processes initiated when a customer
acquires goods or services until the entity receives full payment. Sales, a critical component
in financial statements, significantly impacts profits and closing stock. Given the high risk of
material misstatement in revenue items, auditors, following SA 315, conduct year-end tests
on sales transactions and related internal controls. A thorough understanding of the
organization and its revenue centers is essential for effective audit procedures in this cycle.

The below table summarises the audit procedures generally required to be undertaken while
auditing sales:

Objective Audit Procedures

CATESTSERIES.ORG
 Occurrence a) Check for duplicate or cancelled sales
invoices. Test a sample of invoices against
entries in the sales journal.
b) Confirm sales transactions with
customers. - Verify existence of fictitious
customers and sales.
c) Ensure shipments align with customer
consent, especially at year-end.
d) Verify unearned revenue recognition.
e) Assess collectability uncertainty.
f) Confirm customer obligations contingent
on other actions.
g) Review sequence of sales invoices.
Review journal entries for unusual
transactions. Calculate sales return ratio
and analyze changes.
h) Check sales return documentation
against sales invoice, challan, credit note,
and stock register.
Completeness a) Perform cut-off procedures to ensure
accurate recognition in the current
accounting period.
b) Verify credit notes issued after the
accounting period.
c) Trace transactions from shipping
documents to the sales journal.
d) Check quantity in sales register and
reconcile with stock and financial records.
Review GST tax and returns, reconciling
with reported revenue. Analyze GST
variance and reasons.

CATESTSERIES.ORG
 Measurement a) Trace a sample of transactions from
inception to completion, ensuring accurate
recording and measurement per accounting
standards.
b) Ensure compliance with AS 11 for export
sales. Understand client's operations and
relevant GAAP issues.
c) Review related party transactions for
collectability, authorization, and
reasonableness.
Required Disclosure a) Verify disclosures under Schedule III, Part
II to Companies Act, 2013.
b) Ensure separate disclosure of revenue
from various sources.
c) Confirm proper disclosure of brokerage
and discount on sales. Review disclosure of
transactions with related parties in the
notes.

OTHER INCOME COMPRISING INTEREST INCOME, DIVIDEND INCOME, GAIN/ LOSS ON SALE
OF INVESTMENTS ETC.

Other income encompasses earnings not directly related to an entity's core business.
Examples include interest on fixed deposits, interest on loans, and gains or losses from
investment sales. Recognition of interest income on fixed deposits is based on the time
proportion, factoring in the outstanding amount and applicable interest rate. Dividends are
recognized when the entity establishes its right to receive payment, economic benefits are
probable, and the dividend amount can be reliably measured. Gain or loss on the sale of
mutual fund investments is recorded as other income at the transfer of title, calculated as the
difference between redemption price and carrying value.

CATESTSERIES.ORG
 Audit Objective Audit Procedure
Occurrence a) Verify interest income on fixed deposits
by obtaining a listing of deposits, checking
the arithmetical accuracy of interest
calculations, and reconciling with direct
confirmations from banks.
b) For dividends, ensure recognition when
the right to receive payment is established.
c) Confirm Gain/(loss) on the sale of mutual
fund investments is recorded only at the
transfer of title, and calculate the difference
between redemption price and carrying
value.
Completeness a) Confirm that all fixed deposits opened
during the audit period are included in the
interest income calculation.
b) Trace outstanding deposits to direct
confirmations and reconcile with bank
statements.
c) Obtain Form 26AS to reconcile TDS
withholding by the bank.
Measurement a) Review the mutual fund statement to
trace gain/loss recorded in the books to the
statement.
b) For dividends, verify proper recognition
in the statement of profit and loss.
Required Disclosure Ensure appropriate classification of other
income, including interest income, dividend
income, and net gain/loss on the sale of

CATESTSERIES.ORG
 investments, as per Schedule III to
Companies Act, 2013.

PURCHASES

The purchases and disbursement cycle in an entity involves processes from placing orders for
goods or services to receiving products and making complete payments. During year-end
audits, auditors examine purchase transactions and internal controls to ensure accurate
financial reporting. Auditors gain a clear understanding of the organization's procurement
practices, including sources, major vendors, credit terms, and quality checks. They identify
control points, such as segregation of duties and purchase authorization procedures, and test
their effectiveness. Internal controls commonly include competitive quotations, numbered
purchase orders, GRN generation, quality inspection, and 2-way/3-way matching. Substantive
audit procedures, including analytical analysis and purchase trend assessment, are performed
to validate purchase transactions and identify any discrepancies or irregularities. For example,
if XYZ Ltd. recorded purchases of raw material at a total cost of $1,500,000 during the year,
the auditor expects this amount based on factors like the average purchase price per unit and
the number of units received.

The below table summarises the audit procedures generally required to be undertaken while
auditing purchases:

Audit Objective Audit Procedures

Occurrence a) Review the vendor selection process to
ensure existence of vendors.
b) Verify goods receipt at the factory gate
with entry in the security gate inward
register.
c) Confirm quality inspection of goods.
d) Verify the preparation and approval of
the goods receipt note (GRN).

CATESTSERIES.ORG
 e) Ensure purchase invoice approval per
delegation of authority and perform a 2 or
3-way match.
f) Verify the update of stock records by the
stores personnel.
g) Confirm that the purchase invoice is the
"Original" copy and has been booked only
once risk and reward incidental to
ownership has been transferred.
h) For purchases from related parties, check
for requisite approval and perform
analytical procedures on the price charged.
i) Review journal entries for unusual
transactions.
j) Assess whether purchases should be
capitalized or expensed based on
professional judgment.
k) Examine tax returns to reconcile input tax
with books.
l) Ensure proper addressing of purchase
invoices in case of different branches.
m) Review accounting treatment of goods in
transit.
n) Obtain written representation from
management regarding proper recording of
purchases.
Completeness a) Perform cut-off test to ensure correct
recognition of purchases in the accounting
period.

CATESTSERIES.ORG
 Measurement b) Examine material inward records for the
last transactions at the period end to check
for completeness.
c) Verify accounting treatment of goods in
transit based on agreed terms.
d) Perform analytical procedures to assess
overall reasonableness of purchase quantity
and price.
e) Scrutinize raw material consumption and
stock composition, comparing with previous
years.
f) Compare creditors turnover ratios and
stock turnover ratios with previous years.
g) Review quantitative reconciliation of
closing stocks with opening stock,
purchases, and consumption.
Required Disclosures a) Ensure specific disclosures for purchases
of stock-in-trade and changes in inventories
are made.
b) Confirm appropriate disclosure of
transactions with related parties in notes to
accounts.

EMPLOYEE BENEFITS EXPENSES

Employee benefits expenses encompass the total remuneration an entity pays to its
employees, covering wages, benefits, and various post-employment perks. For auditors, it is
crucial to verify that these expenses are appropriately accounted for based on accounting
standards and principles. The audit process involves assessing internal controls, such as
attendance records and payroll processing, and conducting substantive testing, including the

CATESTSERIES.ORG
examination of relevant documentation like appointment letters and HR policies. Substantive
analytical procedures, comparing expenses with historical data and industry trends, are also
employed to ensure reasonability and appropriateness of the recorded expenses. Overall,
auditors aim to validate that employee benefits expenses align with organizational practices
and accounting standards.

The below table summarises the audit procedures generally required to be undertaken while
auditing employee benefits expenses:

Audit Objective Audit Procedures

Occurrence a) Understand and assess the entity's
process for capturing employee attendance
to prevent recording expenses for fictitious
employees. Meet employees in person on
a sample basis. Select a sample of
employees and request payroll department
to share bank details or identity proofs for
verification.
b) Obtain a list of employees at the period-
end with monthly movement details.
c) For new hires, verify the processing of
salaries for the first and subsequent months
as per agreed terms.
d) For resigned employees, verify full and
final computation, ensuring payment of all
dues and post-retirement benefits.
Completeness a) Obtain monthly salary registers for all 12
months.
b) Compile a monthly payroll reasonability
by calculating average salary per employee
per month.

CATESTSERIES.ORG
 c) Compare with previous year and
preceding month, analyzing variances (e.g.,
annual increments, senior-level
joinings/leavings, bonus pay-outs).
d) Verify accruals/provisions for employee
benefits and obligations (e.g., bonus,
gratuity, leave encashment).
e) Verify provident fund (PF) and employee
state insurance (ESI) applicability,
comparing recorded amounts with
calculated rates.
f) Obtain monthly deposit challans to
ensure timely deposit of liabilities.
g) Perform analytical procedures, analyzing
units produced per employee and
comparing with industry trends and
previous years.
Measurement a) Ensure that all employee benefit
expenses recorded are actually incurred
during the period.
b) Review appointment letters for new hires
and verify compliance with agreed-upon
salary terms.
c) Verify full and final computations for
resigned employees, ensuring payment of
all dues and benefits.
d) Review monthly salary registers for
accuracy.
e) Verify accruals/provisions for
completeness.

CATESTSERIES.ORG
 f) Analyze provident fund (PF) and
employee state insurance (ESI) amounts for
reasonableness.
g) Perform analytical procedures, analyzing
production per employee.
Required Disclosures a) Ensure compliance with Schedule III (Part
II) to Companies Act, 2013.
b) Check if employee benefits expenses are
appropriately disclosed, showing salaries
and wages, contribution to provident and
other funds, expenses on Employee Stock
Option Scheme (ESOP) and Employee Stock
Purchase Plan (ESPP), and staff welfare
expenses.

DEPRECIATION AND AMORTISATION

Depreciation and amortization are methods used to systematically allocate the cost of assets
over their useful lives, impacting an entity's overall expenses. Auditors ensure accurate
calculation and accounting in compliance with relevant provisions. Key considerations include
verifying consistent application of the entity's depreciation and amortization policy,
adherence to statutory regulations, adjustment for residual value, validity and accuracy of
charges, recording in the correct period, and separate depreciation for significant
components. For example, an aircraft's airframe and engines might be depreciated
separately. The auditor also evaluates the appropriateness of the chosen depreciation
method for each component.

The below table summarises the audit procedures generally required to be undertaken while
auditing depreciation and amortization expense:

Audit Objective Audit procedure

CATESTSERIES.ORG
 Understanding Entity's Process Obtain insight into the entity's process of
charging depreciation and amortization.
Fixed Asset Register Review Examine the fixed asset register to identify
any risk of capitalizing expenses or fake
assets. Physically verify material assets for
accuracy. Obtain a list of additions/deletions
with proper approvals.
Sample Asset Verification Select a sample of assets from the register
based on materiality. Verify depreciation
rates and calculations for accuracy.
Component Identification Ensure proper identification of components,
especially for intangible assets. Verify
correct amortization over the period.
Depreciation Start Date Confirm that depreciation starts when the
asset is available for use, not necessarily
when it is first used.
Revalued Amount Verify correct accounting of depreciation on
revalued amounts from revaluation
reserves.
Income Tax Act Compliance Check additions against Companies Act,
reconcile opening written down value to the
tax audit schedule.
Analytical Procedures Perform independent calculations, such as
recomputing depreciation, to ensure overall
reasonableness of expense.
Useful Lives and Residual Values Confirm that depreciation aligns with the
useful lives of PPE and intangible assets.
Verify and assess the accuracy of residual
values.

CATESTSERIES.ORG
 Prospective Computation Ensure prospective computation of
depreciation and amortization for any
changes in useful lives.
Required Disclosures Check for appropriate disclosures, including
accounting policy, useful lives, residual
values, and depreciation methods.

OTHER EXPENSES LIKE POWER AND FUEL, RENT, REPAIR TO BUILDING, PLANT AND
MACHINERY, INSURANCE, TRAVELLING, LEGAL AND PROFESSIONAL, MISCELLANEOUS
EXPENSES

The auditor, when examining other expenses such as rent, power and fuel, repairs, insurance,
etc., focuses on verifying key attributes. This includes ensuring that the expenditure is for the
current audit period, qualifies as revenue rather than capital, is supported by valid
documents, is correctly classified, complies with authorization protocols, and is business-
related rather than personal. By vouching for these expenses, auditors aim to confirm the
accuracy, legitimacy, and appropriateness of such expenditures in the entity's financial
statements.

The below table summarises the audit procedures generally required to be undertaken while
auditing other expenses:

Audit Objective Audit procedure

Rent Expense Obtain month-wise expense schedule and
agreements.
Verify recording for all 12 months and
agreement terms.
Check if the agreement is in the entity's
name.
Disclose under "Rent" in financial
statements.

CATESTSERIES.ORG
 Specify any escalation clauses in the rent
agreement.
Ensure accurate classification between
prepaid and expense.
Power and Fuel Expense Obtain month-wise schedule along with
power bills.
Verify recording for all 12 months.
Disclose under "Power and Fuel" in financial
statements.
Analyze power units consumed and
reconcile with bills.
Insurance Expense Obtain summary of insurance policies and
validity.
Verify correct classification between
prepaid and expense.
Disclose under "Insurance" in financial
statements.
Legal and Professional Expense Obtain month-wise and consultant-wise
summary.
Verify correctness of monthly retainership
agreements.
Disclose under "Legal and Professional" in
financial statements.
Travel, Repair, Maintenance, Printing, Select a sample and vouch for attributes.
Stationery, Miscellaneous Expenses Prepare a monthly summary and analyze
trends.
Disclose under respective categories in
financial statements.
Overall Other Expenses Perform analytical procedures for overall
reasonableness.

CATESTSERIES.ORG
 Analyze expense per unit produced and
compare with trends.
Disclose total other expenses in financial
statements.
Required Disclosures Ensure proper classification of expenses.
Clearly state expenses under specific
categories.

CATESTSERIES.ORG
 CAtestseries.org
CA Final | Inter | Foundation Test Series

As Per New Syllabus of

ICAI AIR
Times

NOTES
Conceptual notes
Auditing and Ethics
Chapter - 6

Only Test Series Providing

Other Than ICAI Questions
In Test Papers
Unique MCQ’s with Detailed Reasoning

INDIA’S FIRST FREE DOUBT SOLVING

PORTAL FOR ALL CA STUDENTS
GET IT ON Available on the
www.CAtestseries.org
+91 99884-83167
Google Play App Store
 Concept Notes

Chapter -6

AUDIT DOCUMENTATION

AUDIT DOCUMENTATION

SA 230 requires auditors to create thorough documentation during financial statement

audits, applicable also to other historical financial information audits. It underscores the
importance of comprehensive documentation and acknowledges that additional
requirements may exist based on local laws or regulations.

DEFINITION OF AUDIT DOCUMENTATION

Audit documentation, often called working papers or work papers, encompasses the records
of audit procedures conducted, the pertinent evidence acquired, and the conclusions reached
by the auditor. It serves as a detailed account of the audit process for reference and
verification

Relevant audit Conclusions

Record of audit
evidence the auditor
procedures performed
obtained reached

CATESTSERIES.ORG
OBJECTIVE OF THE AUDITOR

The auditor's objective in creating documentation is to furnish:

a) A comprehensive and suitable record supporting the auditor's report.

b) Evidence demonstrating adherence to SAs, as well as legal and regulatory requirements,
in the planning and execution of the audit.

NATURE OF AUDIT DOCUMENTATION

Audit documentation serves as

(a) Proof of the auditor's rationale for reaching conclusions on overall audit objectives.

(b) Confirmation that the audit adhered to SAs and relevant legal/regulatory mandates in
planning and execution.

PURPOSE OF AUDIT DOCUMENTATION

1. Aid the engagement team in planning and executing the audit.

2. Support team members in overseeing and managing audit work and review duties.
3. Establish accountability for the engagement team's work.
4. Preserve a record of enduring significance for future audits.
5. Facilitate quality control reviews and inspections as per SQC 1.
6. Facilitate external inspections in line with legal, regulatory, or other obligations.

FORM, CONTENT AND EXTENT OF AUDIT DOCUMENTATION

1. Prepare audit documentation for clear understanding by an experienced auditor unfamiliar

with the audit.
2. Document the nature, timing, and extent of audit procedures, as well as results, evidence,
and professional judgments.

CATESTSERIES.ORG
3. Record identifying characteristics of specific items tested, individuals who performed and
reviewed audit work, and corresponding dates.
4. Document discussions of significant matters with management, governance, and others,
specifying the nature and timing of discussions.
5. Address any inconsistency between identified information and the final conclusion on a
significant matter, and document how it was resolved.

THE FORM, CONTENT AND EXTENT OF AUDIT DOCUMENTATION DEPEND ON FACTORS

SUCH AS

1. Entity size and complexity.

2. Nature of audit procedures.
3. Identified risks of material misstatement.
4. Significance of audit evidence.
5. Nature and extent of exceptions.
6. Need to document conclusions not readily determinable.
7. Audit methodology and tools used.

EXAMPLES OF AUDIT DOCUMENTATION

Audit documentation formats: paper, electronic, or other media.

Examples of audit documentation:

a) Audit programs.
b) Analyses.
c) Issues memoranda.
d) Summaries of significant matters.
e) Letters of confirmation and representation.
f) Checklists.

CATESTSERIES.ORG
g) Correspondence (including e-mail) on significant matters.

TIMELY PREPARATION OF AUDIT DOCUMENTATION

Timely preparation of audit documentation is crucial for ensuring the accuracy and quality of
the audit. It allows for effective review and evaluation of audit evidence and conclusions
before finalizing the auditor's report. Documentation prepared promptly, during the audit
process, is more likely to accurately reflect the details of the work performed compared to
documentation created after the fact.

AUDIT FILE

An audit file refers to a collection of folders or storage media, either physical or electronic,
containing records that constitute the comprehensive audit documentation specific to a
particular engagement. It serves as a consolidated repository for all relevant information and
evidence compiled during the audit process.

ASSEMBLY OF THE FINAL AUDIT FILE

1) Assemble the audit documentation promptly after the auditor's report.

2) SQC 1 mandates firms to establish policies for timely completion of audit file assembly.
3) Complete the final audit file assembly within around 60 days post the auditor's report.
4) The process is administrative and doesn't involve new audit procedures or conclusions.
5) Administrative changes can be made during the final assembly.
6) Do not delete or discard any audit documentation before its retention period.
7) SQC 1 requires firms to establish policies for retaining engagement documentation.

CATESTSERIES.ORG
8) The retention period for audit engagements is typically at least seven years from the
auditor's report date.

DOCUMENTATION OF SIGNIFICANT MATTERS AND RELATED SIGNIFICANT PROFESSIONAL

JUDGEMENTS

In auditing, documenting significant matters and related professional judgments is essential

for transparency and quality assurance. The extent of professional judgment exercised in
analyzing and evaluating these matters influences the form, content, and extent of audit
documentation. Documenting these judgments helps clarify the auditor's conclusions,
reinforcing the quality of the judgment. This documentation is particularly valuable during
reviews of audit records, aiding subsequent auditors in understanding and assessing matters
of ongoing significance, such as retrospective reviews of accounting estimates.

COMPLETION MEMORANDUM OR AUDIT DOCUMENTATION SUMMARY

In the audit process, an auditor may find it beneficial to create and retain a summary, often
referred to as a completion memorandum. This summary outlines the significant matters
identified during the audit and details how they were addressed. The purpose is to enhance
the efficiency of review and inspection of the audit documentation, especially in large and
complex audits. Additionally, the preparation of such a summary aids the auditor in evaluating
significant matters and assessing whether any specific objectives of auditing standards cannot
be achieved, potentially hindering the overall audit objectives.

CATESTSERIES.ORG
OWNERSHIP OF AUDIT DOCUMENTATION

According to Standard on Quality Control (SQC) 1, audit documentation is considered the

property of the auditor unless specified otherwise by law or regulation. The auditor has the
discretion to share portions or extracts of the documentation with clients, as long as such
disclosure doesn't compromise the validity of the work performed or the independence of
the auditor and their personnel in assurance engagements.

CATESTSERIES.ORG