VU VICKY Virtual University Assignment Solution, Past Papers, Handouts and other material

Lesson 36

VERIFICATION OF BANK BALANCES

Following points should be considered during verification of Bank Balances:  

i) Agree the balances with the bankbook, and/or general ledger and bank statement.

ii) In case of difference between bank book and bank statement obtain reconciliation for the bank 

accounts.

iii) Check that outstanding cheques have been cleared with the bank statement subsequent to the 

year-end. If cheques have not been cleared subsequently ask for any special reason why they have

not been cleared. 

iv) Check that uncollected cheques have been realized, with the statement for subsequent period.

v) Scrutinize the subsequent bank statement for dishonored cheques in order to detect worthless 

cheques deposited to conceal shortages. 

vi) Investigate any significant reconciling items of an unusual nature.

vii) Investigate about outstanding stale cheques.

viii) Obtain direct bank confirmation. 

Letter of confirmation from bank.

The purpose of this letter is to confirm the bank balances and other matters by the bank to the auditor

directly.

The letter is written by the Auditors to bank requesting them to confirm the bank balances and allied matters

directly to them.

It contains the following information:-

Requesting bank to send following information directly to them:-

(a) Full title of account and balances thereon.

(b) Accounts closed during the period.

(c) Interest charged during the period.

(d) Details of security and charges.

(e) Details of investments or document held.

Standard Letter of Request for Bank Report

The Manager

(Bank Branch)

 Date:

Dear Sir,

(CLIENT’S NAME)

STANDARD REQUEST FOR BANK REPORT  

FOR AUDIT PURPOSES

In accordance with your above named customer’s instructions given hereon, please send DIRECT to us at the

above address, as auditors of your customer, the following information relating to their affairs at your branch

as at the close of business on ………….. (Balance sheet date) and, in the case of items 2, 4 and 9, during the

period since………….. (Opening date of the period)

Please state against each items any factors which may limit the completeness of your reply; if there is nothing

to report, state ‘NONE’.

It is understood that any replies given are in strict confidence, for the purposes of audit.

BANK ACCOUNTS 

1. Full titles of all accounts together with the account numbers and balances thereon, including NIL

balances:

 a) Where your customer’s name is the sole name in the title;

 b) Where your customer’s name is joined with that of other parties;

 c) Where the account is in a trade name. 

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NOTES

Where the amount is subject to any restriction (e.g. a garnishee order or arrestment) or exchange control

considerations (e.g. ‘blocked account’) this information should be stated.

2. Full titles and dates of closure of all accounts closed during the period.

3. The separate amounts accrued but not charged or credited as at the above date, of 

 a) Interest and

 b) Provisional charges (including commitment fees)

4. The amount of interest charged during the period if not specified separately in the customer’s 

statement of account.

5. Particulars (i.e. date, type of document and accounts covered) of any written acknowledgment of set-

off, either by specific letter of set-off, or  incorporated in some other document or security. 

6. Details of loans, overdrafts, cash credits and facilities, specifying agreed limits and in the case of term 

loans, date for repayment or review.

7. a) SECURITY: Please given: 

(i) Details of any security formally charged to the bank, including the date and type of charge, (e.g.

pledge, hypothecation etc.) 

(ii) Particulars of any undertaking to assign to the bank any assets. If a security is limited to any

borrowing, or if there is a prior, equal or subordinate charge, please indicate. 

 b) Investments, bills of exchange, documents of title or other assets held but not charged.

Please give details.

CONTINGENT LIABILITIES

8. All contingent liabilities, viz.: 

i) Total of bills discounted for your customer, with recourse;

ii) Details of any guarantees, bonds or indemnities given to you by the customer in favor of 

third parties;

iii) Details of any guarantees, bonds or indemnities given by you, on your customer’s behalf, 

stating where there is recourse to your customer and/or to its holding, parent or any

other company within the group. 

iv) Total of acceptances;

v) Total of forward exchange contracts;

vi) Total of outstanding liabilities under documentary credits;

vii) Other - please give details. 

9. A list of other banks, or branches of your bank, where you are aware that a relationship has been

established during the period. 

Yours faithfully,

DISCLOSURE AUTHORISED

For and on behalf of

(CUSTOMER’S NAME)

Signed in accordance with the terms

and conditions for the conduct of the

customer’s bank account. 

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Verification of Debtors Balances

Following points should be considered during verification of Debtors Balance: 

i) Obtain confirmation from debtors.

ii) Verify debts with reference to cash received since year-end.

iii) Check accuracy and completeness of debtors' listing.

iv) Check book-keeping in small sample of ledger accounts.

v) Check postings and enquire into unusual entries in the control account.

vi) Verify nature, amount and classification of credit balance.

vii) Check transaction of foreign currency balances.

viii) Review post year-end credit notes.

ix) Enquire into debtor balances cleared by journal entries after the year-end

x) Consider un-provided claims, enquire and review correspondence.

xi) Check credit note cut-off, if material.

xii) Consider adequacy and check bases and calculations of provisions for rebates

xiii) Verify existence and title to bills receivable, trace proceeds.

xiv) Consider whether results of work on cutoff affect debtors.

xv) Review audit work on income. 

Confirmation from Debtors:

Through verification of debtor’s balances by direct communication the auditor obtains information regarding: 

(i) Adequacy of the system of internal control over sales, debtors, and collections;

(ii) Accuracy of accounting records in general and of cut-off procedures for balance sheet purposes 

in particular; and

(iii) Irregularities such as teeming and lading, overdue balances & incorrect balances. 

The above information helps an auditor to form an opinion regarding:

(a) Reliability of debtors balances; and

(b) Quantum and nature of disputes existing between the company and its customer.

Methods of obtaining Debtors Confirmation

(i) Positive Method. Under positive method the company requests the debtor to confirm his 

indebtedness to the company direct to the auditor and in case of disagreement he is also required to

state the balance as per his records and provide the auditor with full particulars of the difference. 

(ii) Negative Method. Under negative method the company requests the debtor to communicate with

the auditor only if he disagrees with the balance. If no communication is received within specified

time the auditor may assume that the balance is agreed. 

Distinguish between Positive and Negative Confirmation 

 Positive Confirmation Negative Confirmation

a) In positive confirmation company request, the debtor 

to confirm the balance direct to the auditor whether he

agrees while or not.

b) In positive confirmation if no reply is received the

auditors have to adopt other procedures to verify those

balances. 

c) Positive confirmation is preferred when the internal

control system is not satisfactory. 

d) Confirming significant balances due from debtors under

positive confirmation. 

In negative confirmation company request, the 

debtor to confirm the balance to auditor only

if he disagree with balance.

In negative confirmation if no reply is received

the auditor may assume that the balance is

agreed. 

Negative confirmation is preferred when the

internal control system is satisfactory or when

confirming a large number of small balances. 

Confirming a large number of small balances

under negative confirmation. 

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Other procedures if reply is not received to Positive Confirmation

When no reply is received to a positive confirmation the auditor should carry out the following procedures: 

i) Check the outstanding balances as of balance sheet date have been subsequently received.

ii) If subsequently not received then examine sale order, dispatch note, invoices and relevant 

documents and correspondence with concerned debtors.

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Lesson 37

VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES

Stock-In-Trade

Following are the substantive procedures to be carried out in the verification of Stock in trade: 

1.  Examine stock taking instructions issued by the client and assess their adequacy for a proper

stock count. 

2.  Observe counting of inventory at the selected location.

3.  Check that slow moving, damaged and obsolete inventories are segregated.

4.  Check final summary of stocks prepared from the stock count sheets.

5.  Check cut-off.

6.  Check calculation of rates to be applied for inventory valuation.

7.  Check valuation.

8.  Ensure that inventories are presented in accordance with the requirements of the law and IAS-2. 

Stores and Spares

Following are the substantive procedures to be carried out in the verification of Stores and Spares:

1) Verification of Opening Balance from previous year's balance sheet and audit working papers file.

2) Review and checking of Stores Record Keeping.

3) Reconciliation of closing balance i.e. Opening balance + Purchases -Purchases Return - Cost of Sales 

(Consumption).

4) Observation of physical counting done by the client.

5) Checking the source documents for purchases, purchase return and consumption.

Verification of certain expenses items:

a. Director’s Fee 

1. Examine the Articles of Association of the company to ascertain mode of determining rates of fee.

2. Examine the minutes of meeting to ensure that only the fee rates agreed are paid to the directors.

3. Where fee is payable according to attendance at meetings, examine attendance to ensure that only 

attendance is paid.

4. Ensure that proper receipt is obtained from the payees.

5. Check that proper disclosure is made in the accounts as required by the Companies Ordinance 1984. 

b. Interest on Long Term Loan (Foreign Currency)

i) Obtain loan agreement and read its terms and conditions.

ii) Check interest rate mentioned in the agreement.

iii) Check calculation of interest according to specified rate.

iv) Check accrual of interest in case of non-payment.

v) Check payment voucher with bank advice. 

vi) Ensure that any gain or loss resulting from the translation has been properly accounted for.

vii) Ensure the following are properly disclosed:

 1) Amount of interest;

 2) Interest rate;

 3) Penal interest, if any; and

 4) Interest capitalized.

viii) See that whether any interest has been capitalized. If so examine that requirements of IAS-23 

have been fully met and disclosure has been made accordingly.

c. Depreciation on Fixed Assets 

i) Check opening balances of the cost of assets and accumulated depreciation with the last

year's audited accounts. 

ii) Ensure that depreciation policy is appropriate and applied consistently i.e. there is no change

in policy as compared to last year. 

iii) Verify that the depreciation calculations for additions and disposals during the year are in

accordance with the accounting policy. 

iv) Analytical Review 

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 Check that depreciation for the year is reasonable in relation to book value, stated policies

 and previous years. 

d. Staff Loans

i) Examine the services rules and regulation of the company, note major particulars regarding 

staff loan.

ii) Examine and evaluate internal control. Authority in particular important.

iii) See application form for loan.

iv) Ensure loan is properly authorized, see Board resolution.

v) Examine agreement with the staff and ensure terms are being adhered to.

vi) Obtain certificate direct from staff.

vii) If loan is secured, examine the security.

viii) See that adequate provision for amount of doubtful recovery is made in the accounts.

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Lesson 38

AUDIT SAMPLING

Meaning and objective:

Audit sampling means application of audit procedures to less than 100 % of items appearing in an

account balance or class of transactions to enable the auditor to form conclusion concerning that

population.

Why Sampling?

Audit sampling enables an auditor to gather audit evidence through the use of tests of control or

substantive procedures, on selected number of items and forming conclusion about the whole

population. The reasons for this are:

a. Economic: Audit becomes cost effective.

b. Time: Complete check would take so long time.

c. Practical: Users do not expect 100% accuracy. Materially is important in accounting as well as in 

auditing.

d. Psychological: A complete check would be boring for the audit staff.

e. Fruitfulness: A complete check would not add much to the worth of figures if few errors were 

discovered. The emphasis in auditing should be on the completeness of record and the true and

fair view. 

Exceptions to Sampling

In some cases a 100% check is still necessary. Some of these are:

a. Categories which are few in number but of great importance e.g., land and buildings.

b. Categories with special importance where materiality does not apply e.g., directors' emoluments 

and loans.

c. Unusual, one-off, or exceptional items e.g., accidental loss.

d. Any area where the auditor is put upon enquiry e.g., legal matters, law suits.

e. High risk areas. 

Approaches to Audit Sampling:

There are two approaches to sampling in auditing:

a. Judgmental sampling

b. Statistical sampling

We will deal with each in turn.

Note that the objective in all sampling is to draw conclusions about a large group of data, e.g., all the

credit sales made in a period, or all the withholding tax calculations or all the debtors, from an

examination of a sample taken from the group.

Objectives of Audit Sampling:

Auditor is supposed to carry out procedures designed to obtain sufficient appropriate audit evidence

in order to determine with reasonable assurance whether the financial statements are free of material 

misstatements.

Here the words “reasonable and material” make it clear that it is not necessary that auditors should state

that the financial statements are absolutely 100% accurate. Sampling does not provide absolute proof

of 100% accuracy but it can provide reasonable assurance that some elements of the financial

statement are free from material misstatement.

Audit sampling

 means; drawing conclusions about an entire set of data by testing a representative

sample of items. 

Population

 means; the set of data, which may be a set of account balances (e.g. debtors, creditors,

fixed assets) or transactions (e.g. all wage payments, all advice notes).

Sampling units

 means; the individual items making up the population.

Audit Materiality and Risk 

Audit materiality (Tolerable error)

An auditor is not required to have evidence that all items in a set of Accounts are 100% correct. His

duty is to give an opinion on the truth and fairness of the Financial Statements. Errors can exist in the

Accounts and yet the Accounts can still give a true and fair view.  

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The maximum error that any particular magnitude can contain without marring (damaging) the true

and fair view is the tolerable error. Tolerable error is auditing materiality

In his audit planning, the auditor needs to determine the amount of tolerable error in any given

population and to carry out tests to provide evidence that the actual errors in the population are less

than the tolerable error. For example, stock can be a large amount in a set of accounts. Stock is

computed by counting and weighing, by multiplying quantity by price and by summing individual

values. Errors can occur at any of these stages. Applied prices may be incorrect. The effect of

incorrect prices may be to compute a stock figure that is above or below the correct stock figure by

an amount that is above the tolerable error.

Audit Risk

This term applies to the risk that the auditor will draw an invalid conclusion from his audit

procedures. Audit risk has several components:

i)

Inherent risk: This is the risk attached to any particular population because of factors like: 

• The type of industry - a new manufacturing hi-tech industry is more prone to errors of all

sorts than a stable business like beverage. 

• Previous experience indicates that significant errors have occurred.

• Some populations are always prone to error, e.g. stock calculations, work in 

progress.

ii)

Control risk:  This is the risk that internal controls will not detect and prevent material 

errors. If this risk is large the auditor may avoid compliance tests altogether and apply only

substantive tests. 

iii)

Detection risk: This is the risk that the auditor's substantive procedures and analytical

review will not detect material errors. 

The assurance that an auditor seeks from sampling procedures is related to the audit risk that he

perceives. 

The sample sizes required will be related to materiality and to audit risk.

To sample or not?

The auditor, in considering a particular population, has to consider how to obtain assurance about it.

Sampling may be the solution. Factors which may be taken into account in considering whether or

not to sample include:

a. Materiality: Petty cash expenditure may be so small that no conceivable error may affect the true 

and fair view of the accounts as a whole?

b. The number of items in the population: If these are few (e.g. land and buildings), a 100% 

check may be economic.

c. Reliability of other forms of evidence: Analytical review (e.g. wages relate closely to number of 

employees, budgets, previous years, etc.) Proof in total (GST calculations). If other evidence is

very strong, then a detailed check of a population (100% or a sample) may be unnecessary. 

d. Cost and time considerations can be relevant in choosing between evidence seeking methods.

e. A combination of evidence seeking methods is often the optimal solution.

Stages of Audit Sampling 

a. Planning the sample. 

Audit objectives. Why is this test being carried out? What contribution does it make to the

overall assessment of true and fair view? 

The population. The population has to be defined precisely. This may be all sales rather

than all sales invoices. (Can you see the difference?) 

The sampling unit. Note that in compliance testing it is the operation of the control on a

transaction not the transaction which is the sampling unit. 

The definition of error in substantive tests. In stock calculations, an error of greater than

Rs.100 only may constitute an error for this purpose. 

The definition of deviation in compliance tests. The deviation may be any failure to carry

out a control procedure or it may be a partial failure. 

The assurance required. This is a function of the other sources of evidence available, 

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 The tolerable error or deviation rate. This is related to materiality.

The expected error/deviation rate. This is a factor which is not intuitively expected by 

students. In fact, errors increase the impreciseness of conclusions drawn from sampling and

larger sample sizes are required if there are many errors. 

Stratification. It may be desirable to stratify the population into sub-populations and sample

them separately or in some cases, such as high value items, do a 100% check. 

b. Selection of the items to be tested.

c. Testing the items.

d. Evaluating the results. This should also be done in stages: 

 Analyze the errors/deviations detected in relation to the planning definitions.

 Use the errors/deviations detected to estimate the total error in the population. This is called 

projection of the errors from the sample to the population.

 Assess the risk of an incorrect solution. This will be related to the amount of projection of 

error compared with the tolerable error and the availability of alternative evidence

Judgmental Sampling

This means selecting a sample of appropriate size on the basis of the auditor's judgment of what is

desirable. 

This approach has some advantages:

a. The approach has been used for many years. It is well understood and refined by experience,

b. The auditor can bring his judgment and expertise into play. Some auditors seem to have a sixth 

sense.

c. No special knowledge of statistics is required.

d. No time is spent on playing with mathematics. All the audit time is spent on auditing. 

There are some disadvantages: 

a. It is unscientific.

b. It is wasteful - usually sample sizes are too large.

c. No quantitative results are obtained.

d. Personal bias in the selection of samples is unavoidable.

e. There is no real logic to the selection of the sample or its size.

f. The sample selection can be imbalanced to the auditors needs e.g. selection of items near the year 

end to help with cut-off evaluation.

g. The conclusion reached on the evidence from samples is usually vague - a feeling of it seems OK 

or of vague worry.

Overall, judgmental sampling is still the preferred method by a majority of auditors. Partly this can be

defended on the grounds that the auditor is weighing several strands of evidence (internal control,

business background, conversations with employees, subjective feelings, past experience, etc.) and is

usually investigating several things at once (e.g. more than one control evidenced on an invoice,

proper books, internal control compliance and substantive testing of totals) so that the whole process 

is too complex to reduce to the simple formulations of the statistician. On the other hand, the

statistician can reply that judgment sampling in the past worked well because very large samples were

always taken. Today, the small samples required by economic logic require careful measuring of the

risks attached and this can only be done by the use of statistical techniques. 

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Lesson 39

STATISTICAL SAMPLING

Drawing inferences about a large volume of data by an examination of a sample is a highly developed

part of the discipline of statistics. It seems only common sense for the auditor to draw upon this body

of knowledge in his own work. In practice, a high level of mathematical competence is required if

valid conclusions are to be drawn from sample evidence. However most firms that use statistical

sampling have drawn complex plans which can be operated by staff without statistical training. These

involve the use of tables, graphs or computer methods.

The advantages of using statistical sampling are:

a. It is scientific.

b. It is defensible / justifiable.

c. It provides precise mathematical statements about probabilities of being correct.

d. It is efficient - overlarge sample sizes are not taken.

e. It tends to cause uniform standards among different audit firms.

f. It can be used by lower grade staff; that would be unable to apply the judgment needed by 

judgmental sampling.

There are some disadvantages:

a. As a technique it is not always fully understood so that false conclusions may be drawn from the 

results.

b. Time is spent playing with mathematics which might better be spent on auditing

c. Audit judgment takes second place to precise mathematics.

d. It is inflexible.

e. Often several attributes of transactions or documents are tested at the same tir Statistics does not 

easily incorporate this.

Characteristics of audit sample:

In auditing, a sample should be:

a. Random - a random sample is one where each item of the population has an equal (or specified) 

chance of being selected. Statistical inferences may not be valid unless the sample is random.

b. Representative - the sample should be representative of the differing items in the whole 

population. For example, it should contain a similar proportion of high and low value items to

the population (e.g. all the debtors). 

c. Protective - protective, that is, of the auditor. More intensive auditing should occur on high value

items known to be high risk. 

d. Unpredictable - client should not be able to know or guess which items will be examined.

Sample Selection Methods: 

There are several methods available to an auditor for selecting items. These include:

a. Haphazard -Simply choosing items subjectively but avoiding bias. Bias might come in by 

tendency to favor items in a particular location or in an accessible file or conversely in picking

items because they appear unusual. This method is acceptable for non-statistical sampling but is

insufficiently accurate for statistical sampling. 

b. Simple random - All items in the population have (or are given) a number. Numbers are

selected by a means which gives every number an equal chance of being selected. This is done

using random number tables or computer or calculator generated random numbers. 

c. Stratified - This means dividing the population into sub populations (strata = layers) and is

useful when parts of the population have higher than normal risk (e.g. high value items, overseas

debtors). Frequently high value items form a small part of the population and are 100% checked 

and the remainders are sampled.

d. Cluster sampling - This is useful when data is maintained in clusters (= groups or bunches) as 

wage records are kept in weeks or sales invoices in months. The idea is to select a cluster

randomly and then to examine all the items in the cluster chosen. The problem with this method

is that this sample may not be representative. 

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e. Random systematic - This method involves making a random start and then taking every nth

item thereafter. This is a commonly use method which saves the work of computing random

numbers. However the sample may not be representative as the population may have some serial

properties. 

f. Multi stage sampling - This method is appropriate when data is stored in two or more levels.

For example stock in a retail chain of shops. The first stage is to randomly select a sample of

shops and the second stage is to randomly select stock items from the chosen shops. 

g. Block sampling - simply choosing at random one block of items e.g. all June invoices. This

common sampling method has none of the desired characteristics and is not recommended. 

h. Value weighted selection - This method uses the currency unit value rather than the items as

the sampling population. It is now very popular and it is also known as “Monetary Unit

Sampling”. This in relatively new variant of discovery sampling which is thought to have wide

application in auditing. This is because: 

a. Its application is appropriate with large variance populations. Large variance populations

are those like debtors or stocks where the members of the populations are of widely

different sizes. 

b. The method is suited to populations where errors are not expected.

c. It implicitly takes into account the auditor’s concept of materiality. 

Procedures are:

a. Determine sample size. This will cover: 

i. The size of the population

ii. The minimum unacceptable error rate (materiality)

iii. The Beta risk desired 

b. List the items in the population (e.g. 1,250 debtors)

Debtors Name  Balance Rs.  Cumulative Rs.

Jameel   600   600

Ibrahim   100   700

Razi    1,200   1,900

Faiz   500   2,400

Saif   4,000   6,400

Etc.   ***   ***

Etc.   ***   ***

1,250.   ***   ***

   _______  _______

   300,000   300,000

   ======  ====== 

c. If the sample size were 100 items then take a random start say 1,000 and every 3,000th (Rs.

300,000/100 sample size) item thereafter, i.e. using systematic sampling with a random start.

The idea is that: 

i. The population of debtors is not the 1,250 number of debtors but Rs. 300,000.

ii. If the particular Rupee is chosen then the whole balance of which that Re. 1 is a 

part will be investigated and any error quantified.

In our example, Razi would be selected since 1,000 lies in his balance and then Saif would also be

chosen as 1,000 + 3000 = 4,000 lies in his balance.

Note that the larger balances have a greater chance of being selected. This is protective for the auditor

but it has been pointed out that balances that contain errors of understatement will have reduced

chance of detection. 

d. At the end of the process, evaluate the result which might be a conclusion that the auditor is

95% confident that the debtors are not overstated by more than Rs. ***. Where Rs. *** is the

materiality factor (tolerable error) chosen. If the conclusion is that the auditor finds that the 

debtors appear to be overstated by more than Rs. *** then he may take a larger sample

and/or investigate the debtors more fully. 

Monetary unit sampling is especially useful in testing for overstatement where significant

understatements are not expected. Examples of applications include debtors, fixed assets 

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and stocks. It is clearly not suitable for testing creditors where understatement is the primary

characteristic to be tested. 

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Lesson 40

CONSIDERING THE WORK OF INTERNAL AUDITING

Introduction (Meaning of Internal Audit)

Internal audit is part of internal control, set by the management, delegating its supervisory functions

to specially assigned staff, with the objective to see that the internal controls are in operation and to

assist them in fulfilling their responsibilities such as 

1. safeguarding of the assets

2. reliability of financial records and 

3. efficiency in operation

Definition

“Internal auditing” means an appraisal activity established within an entity as a service to the entity. 

Its functions include, amongst other things, examining, evaluating and monitoring the adequacy and

effectiveness of the accounting and internal control system.

DIFFERENCE BETWEEN INTERNAL AND EXTERNAL AUDITORS 

INTERNAL AUDITOR EXTERNAL AUDITOR

Objective:  Accounting system and internal 

control are operating efficiently.

Report on Financial statements. 

Responsibility Responsibility to the management.  Responsibility to the share holders. 

Scope of work Determined by management.

Determined by the statute; otherwise

determined through mutual agreement

between auditor and the client. 

Scope and Objectives of the Internal Audit Function

Although the exact nature of internal audit function is determined by the management, however,

generally the aims and objectives of the internal audit function are: 

i) Review and assessment of the internal control procedures and accounting system. 

ii) Examination of financial and operating information for management, including detailed 

testing of transactions and balances. 

iii) Review of efficiency, economy and effectiveness of operation. 

iv) Review of compliance with laws, regulations, management policy and other internal 

requirements. 

Relationship between Internal Auditing and the External Auditor

Management’s Requirements Vs Independent Report on Financial Statements

Unlike the internal auditor who is an employee of the enterprise, the external auditor is required to be

independent of the enterprise, usually having a statutory responsibility to report on the financial

statements giving an account of management’s stewardship.

Common Means

Some of the means adopted by both the auditors to achieve their respective objectives are common,

e.g. evaluation of internal control. Therefore, certain aspect of internal auditing may be useful in

determining the nature, timing and extent of external audit procedures.

Dependence Vs Independence 

Whatever be the degree of autonomy given by the management to internal auditing it cannot enjoy

the same degree of independence as external auditors. Moreover, the responsibility for the report is

that of the external auditor alone, and therefore is indivisible and is not reduced by the reliance on

internal auditing. 

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As a result, all final judgments relating to matters which are material to the financial statements or

other aspects on, which he is reporting, must be made by the external auditor himself.

Understanding of Internal Auditing

The external auditors should obtain a sufficient understanding of internal audit activities to assist in

planning the audit and developing an effective audit approach.

Effective internal auditing will often allow a reduction in the procedures performed by the external

auditors but cannot eliminate them entirely. However, external auditor may decide not to use the

internal auditor’s work.

Preliminary Assessment of Internal Auditing

After obtaining understanding of internal auditing, if it appears that its work is relevant for external

auditors, the external auditor should, during the course of planning perform preliminary assessment

of internal auditing function. An effective internal audit may allow a modification in the nature, timing

and extent of procedures performed by external auditors.

Criteria while Obtaining Understanding and Preliminary Assessment of Internal Auditing

Before relying on the work performed by the internal auditor, it is necessary for the external auditor

to make an assessment of the effectiveness and relevance of the internal audit function by considering

the following:

i)

Organizational status: The internal auditor is an employee of the entity and therefore 

cannot be independent, however the external auditor should evaluate to what extent he is

free in performing his duties and communicate with external auditor and consider any

constraints placed upon his work.

Ideally, internal auditor should be reporting to the highest level of management and should

be free from other operating responsibility. 

ii)

Scope and Objectives of Internal Audit Function: The external auditor should examine

the range and aim of the assignments assigned to internal auditors by the management and

whether management acts on internal audit recommendations. 

iii)

Technical Competence: The external auditor should ascertain whether staff of the internal

audit function has adequate technical training and proficiency as auditors. 

iv)

Due Professional Care:  The external auditor should consider whether the internal auditor

has performed his work with reasonable care and skill i.e. work is properly planned,

supervised and reviewed. He should also consider existence of working papers, work

programs, audit manuals etc. 

Liaison and Coordination

The extent of liaison would normally encompass the following: 

i) Initial planning to formulate a joint approach to minimize the tests performed by the two

auditors i.e. tests level, sample selection, documentation of work performed, review and

reporting procedures.  

ii) Regular meetings between the internal and external auditors during the year. 

iii) Exchange of knowledge between the two auditors i.e. the external auditors should be

informed of any significant matter that comes to the knowledge of internal auditor which

he believes may affect to work of external auditor. Similarly the external auditor should

inform the internal auditor of any significant matters which may affect his work. 

Evaluating Internal Audit Work/Review/Controlling

Where the external auditor has decided to place reliance on the work of internal auditor, he should

review the working papers to satisfy himself as to:- 

i) Audit programs are adequate. 

ii) The work is performed by trained staff and the work of assistants is properly 

supervised, reviewed and documented. 

iii) Sufficient appropriate audit evidence was obtained. 

iv) Conclusions made are appropriate. 

v) Reports prepared are based on the work done.  

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vi) Exceptions or unusual items have been properly resolved. The external auditor

should record all the working he has received. The external auditor should also

test the work of internal auditor. 

Testing the Work of Internal Auditing

 It can be done in the following ways: 

i) Re-performing the work done by internal auditor, on test basis, to ensure that the same

results are achieved; 

ii) Selecting a few similar items and perform independent test; and

iii) Observation of internal auditing procedures.