CU-MCOM-SEM-III-Advanced Auditing (1)

hardly any debate on the same and it was approved. The CAE thought that in the current practice, they were not really benefiting from the experience and knowledge of the Audit Committee Members. He therefore thought it fit to arrange for meetings with each of the Audit Committee Members to gain individual input prior to the next Audit Committee Meeting, where his first report would be presented. These meetings helped the CAE improve the audit plan. 3. The Risk Based Audit Planning process as currently implemented ( Refer article of BCAJ IAS article in March/April, 2003) was generally found to be robust. The process included the following: (a) Identify the Audit Universe (comprehensive list of Audit Areas), (b) Established weights and ranks for criteria which will form the basis of ranking the audit areas and cut off score, (c) Applying criteria to the various audit areas, (d) Arrive at scores for each area, and (e) Applying the Cut off criteria and shortlisting the areas of audit for the year. This forms a part of the Annual Audit Plan. 4. The revised Annual Audit Plan was also reviewed along with the first report. In order to ensure continuing relevance of the audit plan, a process of a half yearly review of the audit plan with the Audit Committee was suggested and approved. For the Audit Engagement or each specific Audit Project – A brainstorming on the issues and difficulties faced by the Audit Team Members in Audit Engagements was undertaken. A few of the difficulties that came up from all members was: 1. the general appreciation of raising the right business issues in the audit reports. 2. the adequacy of time for performance of the audit – at times, key areas of audit were left out given the demands of completing the report. 3. the team members voiced their concern that the response that the CAE gets from officials was not the same as that received by them. They felt that the auditor’s employees did not give the required efforts and seriousness, which resulted in avoidable delays. 51 CU IDOL SELF LEARNING MATERIAL (SLM)

The team thought of the options that the Standard provided towards overcoming these difficulties. The following were the guidelines that they felt could overcome the difficulties: 1. Preliminary Review: A visit by the CAE along with the audit team members of the audit area was planned to be conducted 15 days prior to the actual start date. This audit visit was to understand the business process area and operational realities within which the team performs, the expectations of the auditee and the auditor are discussed and firmed up, the data and time requirements from the auditees are discussed and the JOINT objectives of the audit process are laid down. The auditee’s person-in-charge is made aware of the audit objectives, methodology and the ways that risk and control needs to be looked at within the Risk Management Framework implemented. Apprehensions of the Auditee team are laid to rest in these interactions. This meeting is also sought to be used as a means to improve auditee’s person-in charge responses. 2. Audit Engagement Planning: The Preliminary Review meeting was also to be used to study past reports . The larger participation of all team members in identification of potential risk and control focus in each area was scheduled for at least once a fortnight in such a way that no area is taken up without the inputs received from all team members. These measures would also ensure that the issues that are relevant to the organisation Notes and the auditee team are addressed. This will also ensure that there is an ongoing value addition out of the audit process. 3. The CAE decided to improve the following areas: (a) Resource allocation in line with the scope: The knowledge and skills required for each audit was sought to be formally identified and matched with the ability of the team members. In case there was a mismatch, the CAE considered the option of training a team member in the area in advance and also involving an outside professional for the specific aspect of audit as part of the on the job training for the team. The option of including a guest auditor from within the organisation also was considered. (b) Detailed Audit Programme with specific priority for audit checks: Normally the Audit Programmes were packed with all possible tests to be conducted during an audit for all identified risks and controls. The team decided to identify which controls significantly mitigate the risk (Key Control). Single control mitigating multiple risks were also sought to 52 CU IDOL SELF LEARNING MATERIAL (SLM)

be specifically identified in a list of controls. The audit priority was focused on key controls. This focus improved audit effectiveness. Conclusions These measures were implemented in the quarter and some significant improvements were observed. The gaps identified vis a vis the standard and the measures already taken and thus impact were shared with the Audit Committee. The initiatives taken were highly appreciated by the Audit Committee members. All the action of CAE were based on Internal audit standard issued by the Institute of Chartered Accountant of India. Exhibit 1: Standards of Internal Audit – 1 of The Institute of Chartered Accountants of India The internal auditor should, in consultation with those charged with governance, including the audit committee, develop and document a plan for each internal audit engagement to help him conduct the engagement in an efficient and timely manner. The internal audit plan should be comprehensive enough to ensure that it helps in achieving of the above overall objectives of an internal audit. The internal audit plan should, generally, also be consistent with the goals and objectives of the internal audit function as listed out in the internal audit charter as well as the goals and objectives of the organisation. An internal audit charter is an important document defining the position of the internal audit vis a vis the organisation. The internal audit charter also outlines the scope of internal audit as well as the duties, responsibilities and powers of the internal auditor(s). In case the entire internal audit or the particular internal audit engagement has been outsourced, the internal auditor should also ensure that the plan is consistent with the terms of engagement. A plan once prepared should be continuously reviewed by the internal auditor to identify any modifications required to bring the same in line with the changes, if any, in the audit environment. However, any major modification to the internal audit plan should be done in consultation with those charged with governance. Further, the internal auditor should also document the changes to the internal audit plan. 53 CU IDOL SELF LEARNING MATERIAL (SLM)

Internal audit plan should cover areas such as: 1. Obtaining the knowledge of the legal and regulatory framework within which the entity operates. 2. Obtaining the knowledge of the entity’s accounting and internal control systems and policies. 3. Determining the effectiveness of the internal control procedures adopted by the entity. 4. Determining the nature, timing and extent of procedures to be performed. 5. Identifying the activities warranting special focus based on the materiality and criticality of such activities, and their overall effect on operations of the entity. 6. Identifying and allocating staff to the different activities to be undertaken. 7. Setting the time budget for each of the activities. 8. Identifying the reporting responsibilities. The internal audit plan should also identify the benchmarks against which the actual results of the activities, the actual time spent, the cost incurred would be measured. The internal auditor should obtain a level of knowledge of the entity sufficient to enable him to identify events, transactions, policies and practices that may have a significant effect on the financial information. The audit universe and the related audit plan should also reflect changes in the management’s course of action, corporate objectives, etc. The internal auditor should periodically, say half yearly, review the audit universe to identify any changes therein and make necessary amendments, to make the audit plan responsive to those changes. The establishment of such objectives should be based on the auditor’s knowledge of the client’s business, especially a preliminary understanding and review of the risks and controls associated with the activities forming the subject matter of the internal audit engagement. The internal auditor should also document the results of his preliminary review so conducted. For this purpose, the internal auditor should prepare an audit work schedule, detailing aspects such as: 1. Activities/procedures to be performed; 2. Engagement team responsible for performing these activities/procedures; and 54 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Time allocated to each of these activities/procedures. While preparing the work schedule, the internal auditor should have regard to aspects such as: 1. Any significant changes to the entity’s missions and objectives, business processes, and management’s strategies to counter these changes, for example, changes in the entity’s controls structure or changes in the risk assessment and management structures 2. Any changes or proposed changes to the governance structure of the entity. The engagement work schedule should, however, be flexible enough to accommodate any unanticipated changes as well as professional judgment of the engagement Notes team in the components of the audit universe as discussed above. The work schedule should also reflect the internal auditor’s assessment of risks associated with various areas covered by the particular internal audit engagement and the priority attached thereto. The internal auditor should also prepare a formal internal audit programme listing the procedures essential for meeting the objective of the internal audit plan. Though the form and content of the audit programme and the extent of its details would vary with the circumstances of each case, yet the internal audit programme should be so designed as to achieve the objectives of the engagement and also provide assurance that the internal audit is carried out in accordance with the Standards on Internal Audit. Questions: 1. Analyze the case and find out different methods employed in planning internal audit ___________________________________________________________________________ ____________________________________________________________________ 2. What were the main areas identified for overall annual audit plan? ___________________________________________________________________________ ____________________________________________________________________ 3.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What do you understand by audit planning? 2. What is the purpose and methodology of audit planning? 55 CU IDOL SELF LEARNING MATERIAL (SLM)

3. What do you understand by obtaining an understanding with the client? 4. What factors are considered by an auditor in understanding client’s business and industry? Long Questions 1. Why transactions with related parties are important to auditors? Write its implications. 2. Why assessing audit risk and inherent risk is an essential part of audit planning? Elaborate with suitable example. 3. Identify different factors affecting audit planning. 4. What is audit programming? What is its importance in developing audit planning strategies? B. Multiple Choice Questions 1. If an auditor is not appointed at annual general meeting, he is appointed by the a) The Central Government b) Board of Directors c) Shareholders d) Company Law board 2. The audit that is made compulsory under statute is called ________ a) Statutory audit b) Partial audit c) Complete audit d) Continuous audit 3. Audit means _______. a) Recording business transactions b) Preparing final accounts c) Examination of books, accounts or vouchers Decision making 4. When a transaction has not been recorded in the books of account either wholly or partially such errors are called _______. a. Error of commission 56 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Error of omission c. Compensating error d. None of these 5. The liabilities of an auditor can be ________. Civil Criminal Civil & Criminal Financial Answers 1 – a, 2 – a, 3 – c, 4 – b, 5 – c, 3.11 REFERENCES  Arens and Lobbecke, Auditing and integrated approach  Bubbard and Johnson, Auditing  Gupta, K., Contemporary auditing, Tata McGraw Hill  Knechel, R. W., Auditing, South-Western College Publishing. 57 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 4 - AUDITS OF INTERNAL CONTROL Structure 4.0 Learning Objectives 4.1 Introduction 4.2 Relevance of internal control for the auditors 4.3 Evaluation of Internal control procedures 4.4 Summary 4.5 Key Words 4.6 Learning Activity 4.7 Unit End Questions 4.8 References 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe nature of Internal Audit  Identify scope of Internal Audit  Benefits of Internal Audit  Process of Internal Audit 4.1 INTRODUCTION The management style and the expectations of upper-level managers, particularly their control policies, determine the control environment. An effective control environment helps ensure that established policies and procedures are followed. The control environment includes independent oversight provided by a board of directors and, in publicly held companies, by an audit committee; management’s integrity, ethical values, and philosophy; a defined organizational structure with competent and trustworthy employees; and the assignment of authority and responsibility. 58 CU IDOL SELF LEARNING MATERIAL (SLM)

Control activities are the specific policies and procedures management uses to achieve its objectives. The most important control activities involve segregation of duties, proper authorization of transactions and activities, adequate documents and records, physical control over assets and records, and independent checks on performance. A short description of each of these control activities appears below. 1. Segregation of duties requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or record keeping. For example, the same person who is responsible for an asset’s record keeping should not be responsible for physical control of that asset having different individuals perform these functions creates a system of checks and balances. 2. Proper authorization of transactions and activities helps ensure that all company activities adhere to established guide lines unless responsible managers authorize another course of action. For example, a fixed price list may serve as an official authorization of price for a large sales staff. In addition, there may be a control to allow a sales manager to authorize reason able deviations from the price list. 3. Adequate documents and records provide evidence that financial statements are accurate. Controls designed to ensure adequate record keeping include the creation of invoices and other documents that are easy to use and sufficiently informative; the use of pre- numbered, consecutive documents; and the timely preparation of documents. 4. Physical control over assets and records helps protect the company’s assets. These control activities may include electronic or mechanical controls (such as a safe, employee ID cards, fences, cash registers, fireproof files, and locks) or computer-related controls dealing with access privileges or established backup and recovery procedures. 5. Independent checks on performance, which is carried out by employees who did not do the work being checked, help ensure the reliability of accounting information and the efficiency of operations. For example, a supervisor verifies the accuracy of a retail clerk’s cash drawer at the end of the day. Internal auditors may also verity that the supervisor performed the check of the cash drawer. In order to identify and establish effective controls, management must continually assess the risk, monitor control implementation, and modify controls as needed. Top managers of 59 CU IDOL SELF LEARNING MATERIAL (SLM)

publicly held companies must sign a statement of responsibility for internal controls and include this statement in their annual report to stockholders. 4.2 RELEVANCE OF INTERNAL CONTROL FOR THE AUDITORS Internal control is the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Safeguarding assets against theft and unauthorized use, acquisition, or disposal is also part of internal control. Internal Control defined as a process designed to provide reasonable assurance regarding the achievement of objectives in the following categories: 1. Effectiveness and efficiency of operations 2. Reliability of financial reporting 3. Compliance with applicable laws and regulations Several key points should be made about this definition: Internal control is, to some degree, everyone’s responsibility. For example Within the University, administrative employees at the department-level are primarily responsible for internal control in their departments. Effective internal control is a built-in part of the management process (i.e., plan, organize, direct, and control). Internal control keeps an organization on course toward its objectives and the achievement of its mission, and minimizes surprises along the way. Internal control promotes effectiveness and efficiency of operations, reduces the risk of asset loss, and helps to ensure compliance with laws and regulations. Internal control also ensures the reliability of financial reporting (i.e., all transactions are recorded and that all recorded transactions are real, properly valued, recorded on a timely basis, properly classified, and correctly summarized and posted). Effective internal control helps an organization achieve its objectives; it does not ensure success. There are several reasons why internal control cannot provide absolute assurance that objectives will be achieved: cost/benefit realities, collusion among employees, and external events beyond an organization’s control. 60 CU IDOL SELF LEARNING MATERIAL (SLM)

Internal Control Process Internal control consists of five inter-related components as follows: 1. Control (or Operating) environment 2. Risk assessment 3. Control activities 4. Information and communication 5. Monitoring All five internal control components must be present to conclude that internal control is effective. Control Environment The control environment is the control consciousness of an organization; it is the atmosphere in which people conduct their activities and carry out their control responsibilities. An effective control environment is an environment where competent people understand their responsibilities, the limits to their authority, and are knowledgeable, mindful, and committed to doing what is right and doing it the right way. They are committed to following an organization’s policies and procedures and its ethical and behavioural standards. The control environment encompasses technical competence and ethical commitment; it is an intangible factor that is essential to effective internal control. A governing board and management enhance an organization’s control environment when they establish and effectively communicate written policies and procedures, a code of ethics, and standards of conduct. Moreover, a governing board and management enhance the control environment when they behave in an ethical manner creating a positive “tone at the top”—and when they require that same standard of conduct from everyone in the organization. Who is Responsible? Management is responsible for “setting the tone” for their organization. Management should foster a control environment that encourages: 61 CU IDOL SELF LEARNING MATERIAL (SLM)

1. the highest levels of integrity and personal and professional standards. 2. a leadership philosophy and operating style which promote internal control throughout the organization assignment of authority and responsibility. Importance of Internal Control Internal controls help safeguard funds, provide efficient and effective management of assets, and permit accurate financial accounting. Internal controls cannot eliminate all errors and irregularities, but they can alert management to potential problems. Effective controls reduce the risk of asset loss and help ensure that plan information is complete and accurate, financial statements are reliable, and laws and regulations are complied with. Internal auditors play an important role in their organization’s corporate governance, internal control structure, risk management analysis, and financial reporting process. In the past decade, auditors actively have provided management with consulting and assurance services to assist in compliance with regulations such as the U.S. Sarbanes-Oxley Act of 2002. Internal audit resources also have been expanded to satisfy the high demand for services to assist in executive certifications of internal controls and financial reports. Internal Controls in a Computerised Environment It includes:  General control and application controls in a computerised environment. The purpose of application controls is to establish specific control procedures over the accounting applications in order to provide reasonable assurance that all transactions are authorised and recorded and are processed completely, accurately and on a timely basis.  Development of computer application, for example, standards over systems design, programming and documentation; testing procedures using test data; approval by computer users and management; segregation of duties from those who design and those who test; installation procedures and training of staff, etc.  Prevention or detection of unauthorised changes to program, which include full records of program changes, password protection, restricted access to central computer, virus checks, backup copies of program or control copies. 62 CU IDOL SELF LEARNING MATERIAL (SLM)

 Testing and documentation of program changes  Controls to prevent wrong programs or files being used Controls to prevent unauthorised amendments to data files  Controls to ensure continuity of operation, for example, storing extra copies of programs and data files off-site, protection of equipment against fire and other hazards, backup power sources, disaster recover procedures or maintenance agreements and insurance. An internal control can only provide, at best, a reasonable assurance that objectives are being reached because of inherent limitations, such as, human error and potential for fraud. These inherent limitations demonstrate why auditors cannot obtain all their evidence from tests of the systems of internal control. 4.3 EVALUATION OF INTERNAL CONTROL PROCEDURES Internal Control comprises the plan and all the co-ordinate methods and measures adopted within an organization with the express objectives of: 1. Safeguarding the assets of the organization, 2. Verifying the accuracy and reliability of its accounting data, 3. Promoting operational efficiency, and 4. Fostering and encouraging adherence to the prescribed managerial policies. A review of internal control can be done by a process of study, examination and evaluation of the control system installed by the management. The first step involves determination of the control and procedures laid down by the management. By reading company manuals, studying organization charts and flow charts and by making suitable enquiries from the officers and employees, the auditor may ascertain the character, scope and efficacy of the control system. To acquaint himself about how all the accounting information is collected and processed and to learn the nature of controls that makes the information reliable and protect the company’s assets, calls for considerable skill and knowledge. In many cases, very little of this information is available in writing; the auditor must ask the right people the right questions if he is to get the information he wants. It would be better if he makes written notes of the relevant information and procedures contained in the manual or ascertained on enquiry. 63 CU IDOL SELF LEARNING MATERIAL (SLM)

To facilitate the accumulative of the information necessary for proper review and evaluation of internal controls, the auditor can use one of the following to help him to know and assimilate the system and evaluate thesame: Narrative record; Check list; Questionnaire; and Flow chart; The narrative record is a complete and exhaustive description of the system as found in operation by the auditor. Actual testing and observation are necessary before such a system is in operation and would be more suited to small business. The basic disadvantages of narrative records are: To comprehend the system is operation is quite difficult. To identify weaknesses or gaps in the system To incorporate charges arising on account of reshuffling of manpower,etc. A check list is a series of instruction and/or answer. When he completes instruction, he initials the space against the instruction. Answers to the check list instruction are usually Yes, No or Not applicable. This is again an on the job requirement and instructions are framed having regard to the desirable element of control. A few examples of check list instruction are given hereunder: Are tenders called before placing orders? Are the purchases made on the basis of a written order? Is the purchase order form standardized? Are purchase order forms are pre-numbered? Are the stock control accounts maintained by persons who havenothing to do with: Custody of work; Receipt of stock; 64 CU IDOL SELF LEARNING MATERIAL (SLM)

Inspection of stock; and Purchase of stock? The complete check list is studied by the principle/manager/senior to ascertain existence of internal control and evaluate its implementation and efficiency. Internal control questionnaire is a comprehensive series of questions concerning internal control. This is the most widely used from for collecting information An important advantage of the questionnaire approach is that oversight or omission of significant internal control review procedures is less likely to occur with this method. With a proper questionnaire, all internal control evaluation can be completed at one time or in sections. The review can more easily be made on an interim basis. The questionnaire form also provides an orderly means of disclosing control defects. It is the general practice to review the internal control system annually and record the review the detail. In the questionnaire, generally questions are so framed that a ‘Yes’ answer denotes satisfactory position and a ‘No’ answer suggests weakness. Provision is made for an explanation or further details of ‘No’ answers. In respect of questions not relevant to the business, ’Not applicable’ reply is given. The questionnaire is annually issued to the client and the client is requested to get it filled by the concerned executives and employees. If on a perusal of the answers, inconsistencies or apparent incongruities are noticed, the matter is further discussed by auditor’s staff with the client employees for a clear picture. The concerned auditor then prepares a report of deficiencies and recommendation for improvement. A flow chart is a graphical presentation of each part of the company’s system of internal control. A flow chart is considered to be themost concise way of recording the auditor’s review of the system. It minimizes the amount of narrative explanation and thereby achieves and consideration or presentation not possible in any other form. It gives bird’s eye view of the system and the flow of transactions and integration and indocumentation, can be easily spotted and improvements can be suggested. It is also necessary for the auditor to study the significant features of the business carried on by the concern: the nature of its activities and variouschannels of goods and materials 65 CU IDOL SELF LEARNING MATERIAL (SLM)

as well as cash, both inward and outward, and also a comprehensive study of the entire process of manufacturing, trading and administration. This will help him to understand and evaluate the internal controls in the correct perspective. Two Dimensions of Internal Control The two dimensions of internal controls are 1. Administrative Controls, which include but are not limited to the plan of organization and records that are concerned with the decision processes leading to the management’s authorization of transactions. 2. Accounting Controls comprise the plan of organization, procedures and records that are concerned with safeguarding of assets and the reliability of financial records designed to provide reasonable assurance that the transactions are recorded and executed in accordance Notes with the general and /or specific authorization of the Management, recording of transactions to ensure the preparation of financial statements in conformity with the generally accepted accounting principles and any other criteria applicable to such statements, proper maintenance of accountable of assets, Management’s authorization of access to assets and accountability for the physical verification of assets. From the above it is clear that in an audit engagement the distinction between the two types of controls requires considerable dexterity as the two are very often inter-related. Needless to say that the distinction should not be artificially made and administrative controls generally have a nexus with the accounting controls even if the linkage is indirect. Scope of Review Naturally therefore, the scope and objectives of the Statutory Auditor would vary and depend upon both the size and structure of the entity as also the requirements of the Management. Normally, however, the Statutory Auditor operates in one or more of the following areas. 1. Review of the Accounting Systems and the related internal controls. Thus while the adequacy of the accounting systems is the responsibility of the Management, the Statutory Auditor is usually assigned the specific responsibility for reviewing the accounting systems and the related internal controls, as also monitoring their operations. 66 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Review of financial and operating information including identification, measurement, and classification and reporting such information specifically enquiring into individual items including detailed testing of transactions, procedures and balances. 3. Examination of the economy, efficiency and effectiveness of operations including non- financial controls. Thus, before an evaluation is undertaken the auditor should determine:- 1. The degree of reliance that can be placed on the various systems and procedures in existence. 2. The nature, extent and timing of substantive audit tests to be applied. In this process due to factors including the limitations of time, the volume of transactions and magnitude of operations the Auditor can conduct:- 3. Selective Verification in areas where he finds that internal control is effective. 4. Detailed or comprehensive verification of transactions in areas where the internal control is weak. 5. Internal control investigation and evaluation is most relevant in the context of (a) Independent financial audits, (b) Special systems study engagements. Advantages of Internal Control Evaluation 1. Enables an Auditor to restrict his detailed examination in areas where internal controls is satisfactory, and intensifying the scrutiny in areas where the controls are weak. 2. Resultantly, the time available to the auditor is more gainfully employed. 3. Highlights areas of weakness in the operating systems, for suitable remedial action to be taken by the Management. Inter-relationship between Audit and Internal Controls 67 CU IDOL SELF LEARNING MATERIAL (SLM)

The Statement on Standard Auditing Practices (SAP) pertaining to the “Study and Evaluation of the Accounting System and Related Internal Controls in connection with an Audit”, defines the inter-relationship between the Statutory Auditor and internal control. The System of Internal Control is the plan of organization and all the methods and procedures adopted by the Management of an entity to assist in achieving management’s objective of ensuring, as far as practicable, the orderly and efficient conduct of business, including adherence to Management policies, the safeguarding of assets, prevention and detection of fraud and error, the accuracy and completeness of the accounting records and the timely preparation of reliable financial information. The system of internal control extends beyond those matters which relate directly to the functions of the accounting system. The internal audit functions constitute a separate component of internal control established with the objective of determining whether other internal controls are well designed and properly operated. Distinction between Control Environment and Control Procedures It would be necessary at this stage, to make a distinction between the concepts of ‘control environment’ and ‘control procedures’. The control environment refers to the overall attitude, awareness and actions of the Management regarding control and its role and importance in the entity. Factors reflected in the control environment include: 1. Management’s philosophy and operating style. 2. The organizational structure and methods of assigning authority and responsibility. 3. Management’s control system (including internal audit functions). 4. The functions of the Board of Directors, personnel policies, procedures and external influences. A strong control environment (e.g. one with tight budgetary controls and an effective audit function) can significantly complement specific controls. However, this by itself does not ensure the overall effectiveness of the system of internal control. Hence arises the necessity for ‘control procedures’. 68 CU IDOL SELF LEARNING MATERIAL (SLM)

Control Procedures Control procedures encompass policies and procedures established by the Management, in order to provide for the attainment of certain objectives. These could include the existence of systems for: 1. An effective system of reconciliation of Books of Accounts. 2. Check of the arithmetical accuracy of the records. 3. Controls over computer applications and environment. 4. Maintenance of control accounts and Trial Balances. 5. Approval and control of balances. 6. Comparison of results of cash, security and inventory checks with accounting records. 7. Limiting direct physical access to assets and records. 8. Comparison of budgetary estimates with actual estimates 9. Physical verification of assets and a system of safeguarding the assets. 10. Appropriate action taken with regard to any differences and discrepancies. 11. Distribution and proper allocation of functional responsibilities. 12. System of operation of accounting procedures for ascertainment of accurate of accurate and reliable accounting data. 13. Existence of an effective system for the efficient operation of the asset and a well regulated system for safeguarding of assets. 14. System of managerial review of the work allocated to various individuals in the organization. 4.4 SUMMARY  The internal audit activity evaluates risk exposures relating to the organization’s governance, operations and information systems, in relation to: Effectiveness and efficiency of operations; Reliability and integrity of financial and operational information; Safeguarding of assets; Compliance with laws, regulations, and contracts. 69 CU IDOL SELF LEARNING MATERIAL (SLM)

 Internal check is an element of internal control. Weak internal check mechanisms mandate a greater degree of auditing procedures.  Control procedures encompass policies and procedures established by the Management, in order to provide for the attainment of certain objectives. These could include the existence of systems for: An effective system of reconciliation of Books of Accounts; Check of the arithmetical accuracy of the records; Controls over computer applications and environment; Maintenance of control accounts and Trial Balances; Approval and control of balances; Comparison of results of cash, security and inventory checks with accounting records; Limiting direct physical access to assets and records, etc.  A strong control environment (e.g. one with tight budgetary controls and an effective audit function) can significantly complement specific controls.  Control procedures encompass policies and procedures established by the Management, in order to provide for the attainment of certain objectives.  Evaluation of Internal Controls by the questionnaire methods (used in conjunction with other methods.) is a convenient and efficient medium for documented evidence of such review having actually taken place. 4.5 KEYWORDS  Internal Auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.  Statement on Standard Auditing Practices (SAP): The Statement on Standard Auditing Practices (SAP) pertaining to the “Study and Evaluation of the Accounting System and Related Internal Controls in connection with an Audit”, defines the inter- relationship between the Statutory Auditor and internal control.  Systems Control Evaluation (SCE): It is based on the questions and answers exercise illustrated above, is thus designed to identify the controls in the system which would satisfy the general audit objectives (prevent or detect the various types of material errors). 70 CU IDOL SELF LEARNING MATERIAL (SLM)

4.6 LEARNING ACTIVITY 1. Identify various factors contribute to internal control for a manufacturing company ___________________________________________________________________________ ___________________________________________________________________ 4.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Identify the scope and objectives of the Statutory Auditor and its role in internal control. 2. What are the two dimensions of internal control? 3. Write short notes on Internal Control Questionnaire 4. Write short notes on Systems Based Audit (SBA) 5. Write short notes on Systems Control Evaluation Long Questions 1. Define internal control and internal check. Explain the internal control process with respect to audit. 2. What are the factors reflected in the control environment? 3. Distinguish between control environment and control procedures. 4. Establish inter-relationship between audit and internal controls. 5. What are the advantages of internal control evaluation? B. Multi Choice Questions 1.Which of the following is responsible for establishing a private company’s internal control? a. Management 71 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Auditors c. Management and auditors d. Committee of Sponsoring Organization. 2. Internal controls can never be considered as absolutely effective because: a. their effectiveness is limited by the competency and dependability of employees. b. not all organizations have internal audit departments. c. controls are designed to prevent and detect only material misstatements. d. internal controls prevent separation of duties 3. _______ is a method of organising the accounting system of a business concern or a factory by which the duties of various clerks are arranged in such a way that the work of one person is automatically checked by another a. Internal control b. Internal check c. Internal audit d. All of these 4. Internal check is a part of a. Internal audit b. Internal accounting c. External audit d. Internal control. 5. Internal control includes ________. 72 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Internal audit b. Internal check c. Both internal audit and internal check d. Internal check and external audit Answers 1 – c, 2 – a, 3 – a, 4 – d, 5 – c, 4.8 REFERENCES  Arens and Lobbecke, Auditing and integrated approach  Bubbard and Johnson, Auditing  Gupta, K., Contemporary auditing, Tata McGraw Hill  Knechel, R. W., Auditing, South-Western College Publishing. 73 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 5 - AUDIT PROCEDURES AND TECHNIQUES FOR AN INTERNAL AUDIT Structure 5.0 Learning Objectives 5.1 Techniques 5.2 Flow chart 5.3 Internal Audit & External Audit 5.4 Co-Ordination between the two 5.5 Summary 5.6 Key Words 5.7 Learning Activity 5.8 Unit End Questions 5.9 References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe nature of Audit Procedure & internal Audit  Identify scope of Audit Procedure & internal Audit  Benefits of Audit Procedure & internal Audit  Process of Audit Procedure & internal Audit 5.1 TECHNIQUES Book Debts/ Debtors: The term ‘book debts’ suggests particularly amounts recoverable from customers, but in practice it is applied to a wide range of claims which a business may carry as an asset in its books. Advances or loans cannot, however, be included under this head. Verification of debtors may be carried out by employing the following procedures: 74 CU IDOL SELF LEARNING MATERIAL (SLM)

Examination of records; Direct confirmation procedure (also known as ‘circulationprocedure’) Analytical review procedures. The nature, timing and extent of audit procedures to be performed is, however, a matter of professional judgement of the auditor. The general procedure is as under: Examination of Records: The auditor should carry out an examination of the relevant records himself about the validity, accuracy and recoverability of the debtor balances. The extent of such examination would depend on the auditor's evaluation of the efficacy of internal controls. The auditor should check the agreement of balances as shown in the schedules of debtors with those in the ledger accounts. He should also check the agreement of the total of debtor balances with related control account. Any differences in this regard should be examined. Verification of subsequent realizations is a widely used procedure, even in cases where direct confirmation procedure is followed. In the case of significant debtors, the auditor should also examine the correspondence or other documentary evidence to satisfy himself about their validity and accuracy. While examining the schedules of debtors with reference to the debtors' ledger accounts, the auditor should pay special attention tothe following aspects : (a) Where the schedules show the age of the debts, the auditor should examine whether the age of the debts has been properlydetermined. (b) Where the amounts outstanding are made up of items which are not overdue, having regard to the credit terms of the entity. Whether transfers from one account to another are properly evidenced. Whether provisions for allowances, discounts and doubtful debts should recognize that even though a debtor may have confirmed the balance due by him, he may still not pay the same. 75 CU IDOL SELF LEARNING MATERIAL (SLM)

The following are some of the indications of doubtful and uncollectible debts, loans and advances : The terms of credit have been repeatedly ignored. There is stagnation, or lack of healthy turnover, in the account. Payments are being received but the balance is continuously increasing. Payments, though being received regularly are quite small in relation to the total outstanding balance. An old bill has been partly paid (or not paid), while later bills have been fully settled. The cheques received from the debtors have been repeatedly dishonoured, The debt is under litigation, arbitration, or dispute. The auditor becomes aware of unwillingness or inability of the debtorto pay the dues, e.g. a debtor has either become insolvent, or has closed down his business, or is not traceable. Amounts due from employees, which have not been repaid on termination of employment. Collection is barred by statute of limitation. Bad debts written off or excessive discounts or unusual allowances should be verified with the relevant correspondence. Proper authorization should be inspected. In the case of claims made against insurance companies, shipping companies, railways, etc., the auditor should examine the correspondence or other available evidence to ascertain whether theclaims have been acknowledged as debts and there is a reasonable possibility of their being realized. If it appears that they are not collectible, they should be shown as doubtful. Similar considerations apply in respect of claims for export incentives, claims for price escalation in case of construction contracts, claims for interest on delayed payments, etc. 76 CU IDOL SELF LEARNING MATERIAL (SLM)

The auditor should examine whether contingent liability, if any, in respect of bills accepted by customers and discounted with the banks is properly disclosed. He should also examine whether adequate provision on this account has been made, where required. Date Confirmation Procedure The verification of balances by direct communication with debtors is theoretically the best method of ascertaining whether the balances are genuine, accurately stated and undisputed, particularly where the internal control system is weak. The utility of this procedure depends to a large extent on receiving adequate response to confirmation requests. Therefore, in situations where the auditor has reasons to believe, based on his past experience or other factors, he may limit his reliance on direct confirmation procedure and placegreater reliance on the other auditing procedures. The auditor employs direct confirmation procedure with the consent of the entity under audit. There may be situations where the management of the entity requests the auditor not to seek confirmation from certain debtors. In such cases, the auditor should consider whether there are valid grounds for such a request. In appropriate cases, the auditor may also need to reconsider the nature, timing and extent of his audit procedures including thedegree of planned reliance on management's representations. The confirmation date, the method of requesting confirmations, andthe particular debtors from whom confirmation of balances is to be obtained are to be determined by the auditor. The debtors may be requested to confirm the balances either (a) as at the date of the balance sheet, or (b) as at any other selected datewhich is reasonably close to the date of the balance sheet. The dateshould be settled by the auditor in consultation with the entity. The form of requesting confirmation from the debtors may be either the 'positive' form of request, wherein the debtor is requested to respond whether or not he is in agreement with the balance shown, or (b) the 'negative' from of request wherein the debtor is requestedto respond only if he disagrees with the balance shown. The use of the positive form is preferable when individual account balances are relatively large, or where the internal controls are weak, or where the auditor has 77 CU IDOL SELF LEARNING MATERIAL (SLM)

reasons to believe that there may be a substantial number of accounts in dispute or inaccuracies orirregularities. ,,,.,. The negative form is useful when internal controls are considered to be effective, or when a large number of small balances are involved,or when the auditor has no reason to believe that the debtors are unlikely to respond. If the negative rather than the positive form of confirmation is used, the number of requests sent and the extent of the other auditing procedures to be performed should normally be greater so as to enable the auditor to obtain the same degree of assurance with respect to the debtor balances. In many situations, it may be appropriate to use the positive form for debtors with large balances and the negative form for debtors with small balances. Where the number of debtors is small, all of them may be circularized, but if the debtors are numerous; this may be done on a sample basis. The sample list of debtors to be circularized, in order to be meaningful, should be based on a complete list of All debtor accounts. While selecting the debtors to be circularized, special attention Should be paid to accounts with large balances, accounts with old outstanding balances, and customer accounts with credit balances. In addition, the auditor Should consider accounts in respect of which provisions have been made or balances have beenwritten off during the period under audit of earlier years and request Confirmation of the balance without considering the provision or write-off. The auditor may also consider including in his sample some of the accounts with nil Balances. The nature of the entity's business (e.g., the type of sales made or services rendered) and thetype of third parties with whom the entity deals, should also be Considered in selecting the sample, so that the auditor can reach appropriate conclusions about the debtors as a whole. In appropriate cases, the debtor may sent a copy of his complete ledger account for a specific period as shown in the entity's books. The method of selection of the debtors to be circularized should not be revealed to the entity until the trial balance of the debtors' ledger is handed over to the auditor. A list of debtors selected for confirmation should be given to the entity for preparing requests for confirmation which should be properly addressed and duly stamped, The auditor should 78 CU IDOL SELF LEARNING MATERIAL (SLM)

maintain strict control to ensure the correctness and proper despatch of request letters. In the alternative, the auditormay request the client to furnish duly authorised confirmation letters and the auditor may fill in the names, addresses and the amounts relating to debtors selected by him and mail the letters directly. should be ensured that confirmations as well as any undeliveredletters are returned to the auditor and not to the client. Any discrepancies revealed by the confirmations received or by the additional tests carried out by the auditor may have a bearing on other accounts not included in the original sample. The entity shouldbe asked to investigate and reconcile the discrepancies. In addition,the auditor should also consider what further tests he can carry out in order to satisfy himself as to the correctness of the amount of debtors taken as a whole. Analytical Review Procedures •In addition to the audit procedures discussed above, the following analytical review procedures may often be helpful as a means of obtaining audit evidence regarding the various assertions relating to debtors, loans and advances: Comparison of closing balances of debtors, loans and advances withthe corresponding figures or the previous year; Comparison of the relationship between current year debtor balances and the current year sales with the corresponding budgeted figures, if available; Comparison of actual closing balances of debtors, loans and advances with the corresponding budgeted figures, if available; Comparison of current year's aging schedule with the correspondingfigures for the previous year; Comparison of significant ratios relating to debtors, loans and advances with similar ratios for other firms in the same industry, if available; comparison of significant ratios relating to debtors, loans andadvances with the industry norms, if available. 79 CU IDOL SELF LEARNING MATERIAL (SLM)

It may be clarified that the foregoing is only an illustrative list of analytical review procedures which an auditor may employ in carrying out an audit of debtors, loans and advances. The exact nature of analytical review procedures to be applied in specific situation is a matter of professional judgement of the auditor. 5.2 FLOW CHART In a flow chart, narratives, though cannot perhaps be totally banished but are reduced to the minimum and by that process, it can successfully bring the whole control structure, especially the essential parts thereof, in a condensed but meaningful manner. It gives a bird’s eye view of the system and is drawn up as a result of the auditor’s review thereof. It should, however, not be understood that details are not reflected in a flow chart. Every detail relevant from the control point of view and the details about how an operation is performed can be included in the flow chart. Essentially a flow chart is a diagram full with lines and symbols and, if judicious use of them can be made, it is probably the most effective way of presenting the state of internal controls in the client’s organization. A properly drawn up flow chart can provide a neat visual picture of the whole activities of the section or department involving flow of documents and activities. More specifically it can show: (a) At what point a document is raised internally or received from external sources. (b) The number of copies in which a document is raised or received. (c) The intermediate stages set sequentially through which the document and the activity passes. (d) Distribution of the document to various section department or operations. (e) Checking authorization and matching at relevant stages. (f) Filing of the documents. (g) Final disposal by sending out or destruction. As a matter of fact a very sound knowledge of internal control requirements is imperative for adopting flow charting technique for evaluation of internal controls, also it demands a highly analytical mind to be able to see clearly the inter division of a job and the appropriate control at relevant points. A flow chart is normally a horizontal one in which documents and activities are shown to flow horizontally from section to section and the concerned sections are shown as the vertical 80 CU IDOL SELF LEARNING MATERIAL (SLM)

column head; in appropriate cases an individual also may be shown as the vertical column head. Care should be taken to see that the first column head is devoted to the section or the individual wherefrom a transaction originates and the placements of other column heads should be in the order of the actual flow of the transaction. It has been stated earlier that a flow chart is a symbolic representation the flow of activity and related documents through the section from origin to conclusion. These can be sales, purchases, wages, production etc. Each one of the main functions is to be linked with related functions for making a complete course. Purchase is to be linked with sundry creditors and payments; sales with sundry debtors and collection. For actual drawing of the flow chart, the auditor has to formulate his symbols to reflect the flow and the connected details. There should be a direction of movement for the activity and documents, at several stages new documents may be added, documents may be matched, annexed or destroyed; there may be points for checking the documents. This will depend upon the details that the auditor can get from the section head or by a process of verification on the basis of the rough flow chart. 5.3 INTERNAL AUDIT & EXTERNAL AUDIT Internal Audit Internal audit is described as the verification of the operations within the business by a specially assigned staff. It is an important tool ofmanagement to evaluate the correctness of records on a continuous basis in an organisation. The term internal audit has been defined as \"an independent appraisal of activity” within an organisation for review of operations as a basis of service to management. It is a managerial control which functions by measuring and evaluating the effectiveness of other controls. According to Howard F. Stettler, \"internal auditing is an independent appraisal activity within an organisation for the review of operations as a service to management.” The overall objective of internal auditing, therefore, is to assist the management in the effective discharge of their responsibilities by furnishing them with objective analysis, appraisals, recommendations andpertinent comments concerning the activities reviewed. In short internalaudit assures the management that the system of internal check andother types of controls are effective in design and operation. 81 CU IDOL SELF LEARNING MATERIAL (SLM)

Thus, internal audit is a thorough examination of the accounting transactions to ensure that- The transactions are properly recorded. The accounts are maintained systematically and There is no possibility for manipulation of accounts or misappropriation of property of the business. In modern times, an internal auditor carries a new task. Thetraditional function of checking the arithmetical correctness of the accounts with the help of vouchers and documents and verification of few items such as stock, cash and fixed assets is not sufficient. The duty of internal auditor now is to chart the procedure, examine the efficiency and work on programs of improvement of assessing the effectiveness of controls. He is expected to plan and arrange his task for effective functioning, set clear objectives of his own section, phase his objectives, gain the confidence of the management and demonstrate the value of hisfunctions in areas of performance. The internal audit is carried out generally in the same manner as is followed for a professional audit. However, it varies in form from enterprise to enterprise according to its size and specific needs. It is installed in large organisation and is carried out by the salaried staff who are qualified to conduct professional audit. Being the employee of the organisation he has to ensure that there is no waste in the organisation. Internal auditor has to follow the provisions of law, standard auditing practices and procedure prescribed for professional auditors and by the professional bodies controlling the audit system in the country. At the same time internal auditor must be aware of the policies and programs of the enterprise he should be professionally competent to carry out a detailed examination of the working of the business. Equipped with professional expertise and knowledge of the business, he will be in a better position to make the internal audit system more effective. External Audit: An external audit, defined as a company audit which is performed by a party which is not a department or employed by business to be audited, are very commonly performed. The external audit approach has 2 main purposes: The company believes an outside party 82 CU IDOL SELF LEARNING MATERIAL (SLM)

will be more efficient at the work or because a governmental entity, such as the IRS, is auditing the business. 1. External Audit Explanation An external audit, explained also as a voluntary or non-voluntary audit performed by a 3rd party, is a necessary tool. It provides both business and government with a valuable check of company accounting. The internal and external audit differences effect the value of the audit in many ways. Generally, an external audit conflict of interest is less likely to happen than when an internal audit occurs. 2 Reasons for an External Audit When contracted from the business controllers, the external audit process happens for 2 reasons. First, the company can receive more efficiency by using an external auditor. This could happen for many reasons: company employees are already occupied on other tasks, external auditors are better trained for the purpose, internal fraud may prevent an internal audit from being valuable, and more. In any event, the company will use an external auditing company to find the answer to certain questions about their accounting. The external audit plan by professional companies may be concerned with missing funds, providing a second opinion, or merely auditing the Accounting Cycle which a company follows. Second, an external audit report may occur when a governmental entity questions part of the financial statements of a company. In this instance, an external audit will not be voluntary. The IRS or a court usually mandates it. There are many reasons why an external audit will occur under these situations: the IRS questions the financial statements of a company, the IRS may detect internal fraud, the company may not be creating GAAP compliant statements, a court authorizes the audit because they suspect funds may have been spent on illegal activities, and more. External audit fees are usually paid by the business being audited. The exception to this is that if they find illegal activity; then the business may be charged with the costs of the external audit. 5.4 CO-ORDINATION BETWEEN INTERNAL & EXTERNAL AUDIT 1. The role of internal audit function within an entity is determined by management and 83 CU IDOL SELF LEARNING MATERIAL (SLM)

its prime objective differs from that of the external auditor who is appointed to report independently on financial information. Nevertheless, some of the means of achieving their respective objectives are often similar and, thus, much of the work of the internal auditor may be useful to the external auditor in determining the nature, timing and extent of his procedures. 2. The external auditor should, as part of his audit, evaluate the internal audit function to the extent considers that it will be relevant in determining in nature, timing and extent of his compliance and substantive procedures. Depending upon such evaluate, the external auditor may be adopting less extensive procedure than would otherwise be required. 3. By its very nature, the internal audit function cannot be expected to have some degree of independence as is essential when the external auditor expresses his opinion on the financial information. The report of the external auditor is his sole responsibility, and that responsibility is not by any means reduced because of the reliance he place’s on the internal work. 5.5 SUMMARY  It highlighted the purpose, objectives, and rationale for establishing and maintaining internal auditing capabilities and described some of the potential benefits organizations expect to realize from effectively managed internal audit programs.  The material in this chapter explains the typical positioning of the internal audit function within the organization structure and its relation to governance bodies such as corporate boards of directors. It also described some of the characteristics of internal auditors and the relevant skills and experience auditors need to do their jobs effectively. 5.6 KEY WORDS  Evaluation: Evaluation is a systematic determination of a subject's merit, worth and significance, using criteria governed by a set of standards.  Flow Charts: A graphic representation of a system which depicts the various operations, controls, and stages involved in a system.  GAAP: Generally Accepted Accounting Practices.  Internal Control Questionnaire: A list of various questions which an auditor may 84 CU IDOL SELF LEARNING MATERIAL (SLM)

ask in order to verify the existence and effectiveness of an internal control system.  Questionnaire: A questionnaire is a research instrument consisting of a series of questions and other prompts for the purpose of gathering information from respondents. 5.7 LEARNING ACTIVITY 1. List six important questions that can be included in the internal control questionnaire regarding purchase of machinery. ___________________________________________________________________________ ____________________________________________________________________ 2. Draft a suitable internal control system by which control may be exercised over the purchase of raw materials. ___________________________________________________________________________ ____________________________________________________________________ 5.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write short notes on Internal Control Questionnaire 2. Write short notes on Systems Control Evaluation 3. What are the advantages of internal control evaluation? 4. Explain the concept of EDP Environment the New Dimension. 5. What is External Audit? Long Questions 85 1. Describe the objectives of evaluation of internal control system. 2. Explain the steps in evaluation of internal control system. 3. Discuss flow charts and internal control questionnaire. CU IDOL SELF LEARNING MATERIAL (SLM)

4. What are the points to be consider in formulating internal control scheme? 5. Distinguish between control environment and control procedures. B. Multi Choice Questions 1. _______ is a method of organising the accounting system of a business concern or a factory by which the duties of various clerks are arranged in such a way that the work of one person is automatically checked by another a. Internal control b. Internal check c. Internal audit d. All of these 2. When an independent auditor decides that the work performed by internal auditors may have bearing on the nature, timing and extent of planned audit procedures, the independent auditor should evaluate objectivity of the internal auditor. The most important factor influencing it would be a. Organizational level to which he reports b. Qualification of internal auditor c. System of quality control of his work d. All of these 3.The term _____suggests particularly amounts recoverable from customers, but in practice it is applied to a wide range of claims which a business may carry as an asset in its books. a. Loan b. Book Debts c. Bad Debts d. None of these 86 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Internal check is a part of a. Internal audit b. Internal accounting c. External audit d. Internal control. 5. Internal control includes ________. a. Internal audit b. Internal check c. Both internal audit and internal check d. Internal check and external audit Answers 1 – c, 2 – d, 3 – a, 4 – d, 5 – c, 5.9 REFERENCES  Arens and Lobbecke, Auditing and integrated approach  Bubbard and Johnson, Auditing  Gupta, K., Contemporary auditing, Tata McGraw Hill  Knechel, R. W., Auditing, South-Western College Publishing 87 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 6 - COMPANIES ACT, 1956 Structure 6.0 Learning Objectives 6.1 Introduction 6.2 Position of auditor under Companies Act, 1956 6.3 Audit of limited companies 6.4 Statutory requirements under the Companies Act, 1956 6.5 Summary 6.6 Key Words 6.7 Learning Activity 6.8 Unit End Questions 6.9 References 6.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe nature of Companies Act, 1956  Identify scope of Companies Act, 1956  Benefits of Companies Act, 1956  Process of Companies Act, 1956 6.1 INTRODUCTION The Companies Act 1956 is administered by the Government of India through the Ministry of Corporate Affairs and the Offices of Registrar of Companies, Official Liquidators, Public Trustee, Company Law Board, Director of Inspection, etc. The Act is 658 sections long. The Act contains provisions about Companies, directors of the companies, memorandum and articles of associations, etc. This act states and discusses every single provision requires or may need to govern a company. It mentions what type on companies their differences, constitution, management, members, capital, how should the shares should be issues, 88 CU IDOL SELF LEARNING MATERIAL (SLM)

debentures, registration of charge, at the end of the act it concludes the about winding up of a company, discussing the situations a company needs to be winded up. The ways it should be done by volunteer or through courts. Provisions of the Act Article 3 of the act describes the definition of a company, the types of companies that can be formed e.g. public, private, holding, subsidiary, limited by shares, unlimited etc. Further on in Article 10 E it explains about the constitution of board of company, it explains the companies’ name, the jurisdictions, tribunals, memorandums and the changes that can be made. Article 26 and further on explains about the article of association of the company which a very important part when forming a company and various amendments that can be made. Article 53 to 123,it explains about the shares, the shareholders their rights, it explains about debentures, share capital, their procedure and powers within the company. Article 146 to 251 it explains about the management and administration of the company and the provisions registered office and name. Article 252 to 323 elaborates on the provisions of duties, powers responsibility and liability of the directors in the company which is a very integral part of the company when it is formed. Article 391 to 409 explains about the arbitration, the prevention and obsession of the company Article 425 to 560 it explains the procedure of winding up of a company, the preventions the rights of shareholders, creditors, methods of liquidations, compensation provided and ways of winding up the company. Article 591 and further on explains about setting up companies outside India and their fees and registration procedure and all. An overview of Companies Act 1956 Companies Act 1956 explains about the whole procedure of the how to form a company, its fees procedure, name, constitution, its members, and the motive behind the company, its share capital, about its general board meetings, management and administration of the company including an important part which is the directors as they are the decision makers and they take all the important decisions for the company their main responsibility and liabilities about the company matter the most. The Act explains about the winding of the business as well and what happens in detail during liquidation period. Company objective and legal procedure based on the Act The basic objectives underlying the law are: 89 CU IDOL SELF LEARNING MATERIAL (SLM)

A minimum standard of good behavior and business honesty in company promotion and management. Due recognition of the legitimate interest of shareholders and creditors and of the duty of managements not to prejudice to jeopardize those interests. Provision for greater and effective control over and voice in the management for shareholders. A fair and true disclosure of the affairs of companies in their annual published balance sheet and profit and loss accounts. Proper standard of accounting and auditing. Recognition of the rights of shareholders to receive reasonable information and facilities for exercising an intelligent judgment with reference to the management. A ceiling on the share of profits payable to managements as remuneration for services rendered. A check on their transactions where there was a possibility of conflict of duty and interest. A provision for investigation into the affairs of any company managed in a manner oppressive to minority of the shareholders or prejudicial to the interest of the company as a whole. Enforcement of the performance of their duties by those engaged in the management of public companies or of private companies which are subsidiaries of public companies by providing sanctions in the case of breach and subjecting the latter also to the more restrictive provisions of law applicable to public companies. Companies Act empowerment and mechanism In India, the Companies Act, 1956, is the most important piece of legislation that empowers the Central Government to regulate the formation, financing, functioning and winding up of companies. The Act contains the mechanism regarding organizational, financial, and managerial, all the relevant aspects of a company. It empowers the Central Government to inspect the books of accounts of a company, to direct special audit, to order investigation into the affairs of a company and to launch prosecution for violation of the Act. 90 CU IDOL SELF LEARNING MATERIAL (SLM)

These inspections are designed to find out whether the companies conduct their affairs in accordance with the provisions of the Act, whether any unfair practices prejudicial to the public interest are being resorted to by any company or a group of companies and to examine whether there is any mismanagement which may adversely affect any interest of the shareholders, creditors, employees and others. If an inspection discloses a prima facie case of fraud or cheating, action is initiated under provisions of the Companies Act or the same is referred to the Central Bureau of Investigation. The Companies Act, 1956 has been amended from time to time in response to the changing business environment. 6.2 POSITION OF AUDITOR UNDER COMPANIES ACT, 1956 Requirement under Companies Act, 1956 Every company registered in India is required to get its accounts audited by a practicing Chartered Accountant. Section 224 (1) of the Companies Act, 1956 states that every company, whether it is public or private, shall have an auditor to audit its accounts. This audit is called statutory audit and through it the Companies Act ensures that the persons carrying on business with others money are accountable to them. Appointment of Auditors The appointment of auditor is mandatory in the Annual General Meeting for the following year. The auditors appointed at the Annual General Meeting hold the office from the conclusion of the Annual General Meeting at which he is appointed until the conclusion of the next Annual General Meeting. Thus, the Act seeks to ensure that the appointment of auditors is not in the hands of the directors and is vested in the general body of shareholders. However, the first auditors of the Company are appointed by the Board of Directors within one month from the date of incorporation of a company. The auditors, so appointed, hold the office until the conclusion of the first annual general meeting of the Company. If the Board fails to appoint the first auditor, the company may do so at a general meeting. Who can be appointed as Auditors? 91 CU IDOL SELF LEARNING MATERIAL (SLM)

As per Sec 226 of Companies Act, 1956, a person who is Chartered Accountant within the meaning of Chartered Accountants Act, 1949 and holds a certificate of practice, or a partnership firm where of all the partners are Chartered Accountants holding certificates of practice, may be appointed as auditor of a company. However, in the latter case, the appointment as an auditor may be made in the firm name and any of its partners may act in the name of the firm. The following persons cannot be appointed as auditor of a Company: An officer or employee of the company A person who is partner with an employee of the company or employee of an employee of the company. Any person who is indebted to a company for a sum exceeding Rs. 1,000/- or who have guaranteed to the company on behalf of another person for a sum exceeding Rs. 1,000/-. A person who is holding any security of that company, after a period of one year from the date of commencement of Companies (Amendment) Act, 2000. If an auditor, after his appointment, becomes subject to any disqualification mentioned above, he shall be deemed to have vacated as such. Does the accounts of branch office needs to be audited? Yes. As per section 228 of the Companies Act, 1956, where a company (whether public or private limited) has a branch office, its accounts should also be audited. The audit of the accounts of branch office can be done either by: the company’s auditor or by any other person who is qualified to act as the company’s auditor However, if the branch is situated in a country outside India, a person who is duly qualified to act as auditor of the branch in accordance with the laws of that country can also be appointed as auditor of branch. If the branch is not being audited by the company’s auditor, even then he is entitled to visit the branch office if he considers it necessary to do so for the performance of his duties as the auditor. He has a right of access at all times to the books, accounts and vouchers of the company maintained at such branch office. 92 CU IDOL SELF LEARNING MATERIAL (SLM)

6.3 AUDIT OF LIMITED COMPANIES Qualification Of An Auditor The provision regarding qualification of auditor is governed bySection 226 of the Companies Act, 1956 Sec 226(1) states A person will be qualified for appointment as an auditor of a company (public or private) only if he is a Chartered Accountantwithin the meaning of the Chartered Accountants Act, 1949. The same section also provides that a firm of Chartered Accountants will be qualified for appointment as the auditor of acompany in its firm name provided all the partners practicing inIndia are qualified for appointment In case of the firm being appointed as auditor, any practicing partner may act in the name of the firm. Disqualification Of Auditors The provision regarding disqualification of auditor is governed bysection 226 of the Companies Act, 1956. Section 226(3) The following persons are not qualified for appointment as auditorsof a company: A body corporate an officer or employee of the company A partner or employee of an officer or employee of the company A partner or employee of an officer or employee of the company A person who is indebted to the company for more than Rs.1000 OR A person who has given any guarantee or provided any securityin connection with the Indebtedness of any third person to the company for more than Rs. 1000. 93 CU IDOL SELF LEARNING MATERIAL (SLM)

A person holding any security (a security would mean an instrument carrying voting rights) of that company after a periodof one year from the date of commencement of the Companies(Amendment) Act, 2000. Section 226(4) A person is not eligible for appointment as an auditor of anycompany if he is disqualified from acting as auditor of that company’s subsidiary or holding company or of any other subsidiary of the same holding company and vice- versa. Section 226(5) If an auditor after his appointment, becomes subject to any of the disqualification mentioned in section 226(3) and section 226(4), heshall be deemed to have automatically vacated his office. Appointment Of First Auditors The main points regarding appointment of the First Auditors of a company are given in Section 224(5): The first auditors of a company can be appointed by the board of directors within one month of the date of registration/ incorporation of the company by means of a resolution. The auditors so appointed shall hold office until the conclusion of the first Annual General Meeting. If the Board of Directors fails to appoint the First Auditor within one month, the company in a general meeting is empowered tomake the appointment. The auditors so appointed by the Board of Directors may be removed by the company at a general meeting which may appoint any other auditor. An auditor cannot be appointed as First Auditor simply becausehis name has been stated in the Articles of Association. The First Auditor need not sent an intimation by the company oftheir appointment and the First Auditor are themselves notrequired to inform the registrar of Companies about their acceptance/ refusal of such an appointment. 94 CU IDOL SELF LEARNING MATERIAL (SLM)

Appointment Of The Subsequent Auditor The main points regarding appointment of Subsequent Auditor of acompany are given below: - Section 224(1) empowers the shareholders to appoint auditor ateach Annual General Meeting by means of a resolution. Upon an auditor being appointed in the Annual General Meeting, the company is to give intimation thereof to the concerned auditor within seven days of the appointment. On receipt of the intimation from the company about his appointment, the auditor is required to send a writtencommunication to the concerned Registrar of Companies within 30 days in form no.23B indicating whether he has accepted or declined the appointment. The auditor so appointed shall hold the office from the conclusion of one Annual General Meeting to the conclusion ofthe next Annual General Meeting. The auditor will be guilty of professional misconduct if at any time he accepts audit more than the specified numbers of auditassignments of the company u/s 224 of the Act. Removal Of Auditor The first auditor appointed by the directors may be removed bythe shareholder in the first Annual General Meeting. SuchAuditors can even be removed from their office before the expiryof their term of office without the permission from the Central Government. In any other case, auditor can be removed only by the companyin General Meeting after obtaining previous approval from the Central Government An Auditor, on the expiry of the terms of his office may not be reappointed and thus removed from his office. Resolution requiring special notice (of fourteen days) shouldbe passed at the general meeting [Sec. 225(1)]. On receipt of notice of resolution, company shall send copy of the notice to the retiring auditor [Sec. 225(2)]. 95 CU IDOL SELF LEARNING MATERIAL (SLM)

On receipt of notice, retiring auditor can send written representation of a reasonable nature to the company whichshould be informed to the members. Normally company has to circulate such representation to the shareholders, unless itis received too late. A notice of resolution also should be circulated, stating a fact of such a representation. If the representation in not circulated for being received too late orbecause of the default of the company, auditor can insist it tobe read at the meeting. [Sec. 225(3)]. However, company or any other person like directors or shareholders have a right to file a petition with Company Law Board (CLB) to refrain the auditor from making such representation, if it is to secure needless publicity or is defamatory. In such a case, on the direction of the CLB, copies need not be sent or read at the meeting [Sec. 225(3)]. These provisions apply to removal of the auditors appointed by Central Government also. The other relevant provisions are that if a new auditor is appointed, the company should within 7 days, inform the new auditor. The new auditor should inform the Registrar within one month of such intimation received about his decision and he should also communication with the retiring auditor in this matter, is he accepts the post 6.4 STATUTORY REQUIREMENTS UNDER THE COMPANIES ACT, 1956 Requirement under Companies Act, 1956 Every company registered in India is required to get its accounts audited by a practicing Chartered Accountant. Section 224 (1) of the Companies Act, 1956 states that every company, whether it is public or private, shall have an auditor to audit its accounts. This audit is called statutory audit and through it the Companies Act ensures that the persons carrying on business with others money are accountable to them. Appointment of Auditors The appointment of auditor is mandatory in the Annual General Meeting for the following year. The auditors appointed at the Annual General Meeting hold the office from the conclusion of the Annual General Meeting at which he is appointed until the conclusion of 96 CU IDOL SELF LEARNING MATERIAL (SLM)

the next Annual General Meeting. Thus, the Act seeks to ensure that the appointment of auditors is not in the hands of the directors and is vested in the general body of shareholders. However, the first auditors of the Company are appointed by the Board of Directors within one month from the date of incorporation of a company. The auditors, so appointed, hold the office until the conclusion of the first annual general meeting of the Company. If the Board fails to appoint the first auditor, the company may do so at a general meeting. Who can be appointed as Auditors? As per Sec 226 of Companies Act, 1956, a person who is Chartered Accountant within the meaning of Chartered Accountants Act, 1949 and holds a certificate of practice, or a partnership firm where of all the partners are Chartered Accountants holding certificates of practice, may be appointed as auditor of a company. However, in the latter case, the appointment as an auditor may be made in the firm name and any of its partners may act in the name of the firm. The following persons cannot be appointed as auditor of a Company:  An officer or employee of the company  A person who is partner with an employee of the company or employee of an employee of the company  Any person who is indebted to a company for a sum exceeding Rs. 1,000/- or who have guaranteed to the company on behalf of another person for a sum exceeding Rs. 1,000/-.  A person who is holding any security of that company, after a period of one year from the date of commencement of Companies (Amendment) Act, 2000. If an auditor, after his appointment, becomes subject to any disqualification mentioned above, he shall be deemed to have vacated as such. Does the accounts of branch office needs to be audited? Yes. As per section 228 of the Companies Act, 1956, where a company (whether public or private limited) has a branch office, its accounts should also be audited. The audit of the accounts of branch office can be done either by:  the company’s auditor or  by any other person who is qualified to act as the company’s auditor. However, if the branch is situated in a country outside India, a person who is duly qualified to 97 CU IDOL SELF LEARNING MATERIAL (SLM)

act as auditor of the branch in accordance with the laws of that country can also be appointed as auditor of branch. If the branch is not being audited by the company’s auditor, even then he is entitled to visit the branch office if he considers it necessary to do so for the performance of his duties as the auditor. He has a right of access at all times to the books, accounts and vouchers of the company maintained at such branch office. 6.5 SUMMARY  A company, being an artificial person, acts through human agency.  Every company is required to have a Board of Director for managing the affairs of the company. The Act has made provision for the appointment of a managing director or a manager.  The Act has regulated the remuneration which can he paid to the managerial personnel.  A meeting of the Board of Directors of every company must be held at least once in every three months and at least four such meetings must be held in every calendar year.  It has provides for liabilities and duties of directors.  It provides that every public company, having a paid up share capital of ` 5 crore or more shall constitute a committee of the Board of Directors known as Audit Committee.  Act has made provision for the appointment of a Company Secretary. 6.6 KEY WORDS  Compensation: It is the remuneration provided to the directors for their services.  Director: A director is any person occupying the position of director, by whatever name called  Manager: He is an individual who, subject to the superintendence, control and direction of the board of director, has the management of the affairs of the company.  Managing Director: He is ‘director’ who, by virtue of an agreement with the company or of a resolution passed by the company in general meeting or by its Board of Directors. 98 CU IDOL SELF LEARNING MATERIAL (SLM)

 Secretary: A secretary is defined as a company secretary within the meaning of the Company Secretaries Act, 1980 and includes any other individual possessing the prescribed qualifications and appointed to perform the duties which may be performed by a secretary. 6.7 LEARNING ACTIVITY The Board of Directors of a public company met on three times in the previous year, the fourth meeting though called, but not held for want of quorum on two occasions successively. Discuss whether any provisions of the Companies Act have been contravened. CASE STUDY Compensation packages of key non-promoter executives at the country’s top three IT firms - TCS, Infosys and Wipro - grew faster than the companies’ net revenues for fiscal 2009 over previous year. Their pays were also more than the industry wage inflation of 12-15 per cent. The remuneration for top executives at Infosys grew faster than that of their counterparts at TCS and Wipro. The net revenues of these three firms grew an average of 17.5 per cent. Interestingly, much of the growth in the compensation packages was driven by an increase in incentives and commissions, even as stock options or restricted stock units lost their charm. For Infosys promoters such as the Co-chairman, Mr Nandan Nilekani, CEO Mr S. Gopalakrishnan, COO, Mr S. D. Shibulal and Director, Mr K. Dinesh, the compensation grew by about 11 per cent each. However, the CFO, Mr V. Balakrishnan’s package saw a dramatic increase of 274 per cent at ` 2.36 crore, followed by Director’s Mr Srinath Batni at 47 per cent and Mr T.V. Mohandas Pai’s at 44 per cent. The TCS Chief Executive and Managing Director, Mr S. Ramadorai’s total compensation grew 21 per cent to ` 4.09 crore, while the CFO, Mr S. Mahalingam’s remuneration rose 30 per cent to ` 1.70 crore. The COO and CEO-designate, Mr N. Chandrasekaran’s package increased 36 per cent to ` 1.92 crore over fiscal 2008, while 99 CU IDOL SELF LEARNING MATERIAL (SLM)

the Executive Director, Mr Phiroz Vandrevala’s remuneration saw the highest increase of 41 per cent at ` 1.41crore. Though the Wipro Chairman, Mr Azim Premji, took a cut of eight per cent in his package, the compensation of other key executives went up. The Joint CEO, Mr Girish Paranjpe’s package saw the highest rise of 38.6 per cent to $363,000, while the other Joint CEO, Mr Suresh Vaswani’s remuneration grew 35.4 per cent to $384,000. The CFO, Mr Suresh Senapaty, and the Head of HR, Mr Pratik Kumar, got jumps of 26 per cent each at $364,000 and $270,000, respectively. Key Parameters “The CEO and top management salaries are generally benchmarked against key parameters which may differ from company to company,” said Mr E. Balaji, CEO, Ma Foi Management Consultants. The target set could be anything from improving market capitalisation, earnings, profit after tax or a combination of all the above. “In the case of IT companies, one would not be surprised if key performance indicators are related to bringing down day sales outstanding, maintaining key customers, doing well in specific geographies or controlling costs,” he said. The trend of offering big incentives as part of overall compensation package is likely to continue, said Ms Priya Chetty Rajagopal, Vice-President, Stanton Chase. Satyam Effect The fall of Satyam Computer Services may also have contributed to the swelling wallets of IT company’s executives. Major IT firms lay lot of impetus on winning new clients especially at a time when firms are shrinking their IT budgets. “It is a known fact that all companies were busy making sales pitches to Satyam’s customers soon after the fraud came to light. Invariably, the ones who were able to attract most of Satyam’s customers were the top tier IT firms. As a result, key officials with those IT firms would have been appropriately rewarded by the management,” said a senior official of Mumbai-based IT solutions firm. Questions 1. Elaborate the role of Satyam in context of the case. 100 CU IDOL SELF LEARNING MATERIAL (SLM)