CA Inter FM + SM

Communication with Those Charged with Governance — SA 260 and SA 265

Standard on Auditing (SA) 260, "Communication with Those Charged with Governance" (Revised), issued by the ICAI, governs the auditor's responsibility to communicate matters arising from the audit of financial statements to those charged with governance (TCWG). SA 265, "Communicating Deficiencies in Internal Control to Those Charged with Governance and Management," is also relevant.

Who are Those Charged with Governance?

As per SA 260, TCWG are persons or organisations with responsibility for overseeing the strategic direction of the entity and obligations related to the accountability of the entity — for example, the Board of Directors, Audit Committee, or Trustees.

Significant Findings to be Communicated (SA 260)

The auditor shall communicate the following significant findings with TCWG:

1. Auditor's Responsibilities and Overview of Planned Scope and Timing: The auditor shall communicate the overall audit strategy and timing of the audit so that TCWG can raise concerns about potential threats to auditor independence or other matters.

2. Significant Qualitative Aspects of Accounting Practices: The auditor shall communicate significant qualitative aspects including accounting policies, accounting estimates, and financial statement disclosures. This includes communicating whether the accounting policies selected are appropriate and consistent with the applicable financial reporting framework.

3. Significant Difficulties Encountered During the Audit: If the auditor encounters significant difficulties such as non-availability of information, unreasonable delay by management in providing information, or significant unexpected effort required, these must be communicated.

4. Significant Matters Arising During the Audit: All significant matters arising during the audit that were discussed with management must be communicated to TCWG. This includes disagreements with management about matters that, individually or in aggregate, could be significant.

5. Written Representations Requested: The auditor shall communicate representations that are being requested from management.

6. Matters Specifically Required by Other SAs: Various other SAs require specific matters to be communicated — for instance, SA 240 requires communication of fraud identified or suspected, SA 570 requires communication of events or conditions related to going concern.

7. Modified Auditor's Opinion / Emphasis of Matter: If the auditor expects to modify the audit opinion or include an Emphasis of Matter paragraph, this shall be communicated to TCWG in advance.

Communication of Deficiencies in Internal Controls (SA 265)

Under SA 265, the auditor shall communicate in writing to TCWG significant deficiencies in internal control identified during the audit. A significant deficiency is a deficiency or combination of deficiencies in internal control that, in the auditor's professional judgment, is of sufficient importance to merit the attention of TCWG. Material weaknesses, if identified, must also be communicated promptly.

Form and Timing of Communication

As per SA 260, communication may be oral or written. However, written communication is required for significant findings. The communication should be timely — it should be made on a timely basis to enable TCWG to take appropriate action. If the auditor expects to express a modified opinion, communication should be made before the auditor's report is issued.

Adequacy of the Communication Process

The auditor shall evaluate whether the two-way communication between the auditor and TCWG has been adequate for audit purposes. If it has not, the auditor shall evaluate the effect on the audit risk assessment and audit procedures.

Documentation

Where matters are communicated orally, the auditor shall include them in the audit documentation along with the date of communication and to whom the communication was made.

In conclusion, SA 260 ensures that TCWG are kept informed of all significant audit findings to enable them to fulfill their oversight responsibilities. This enhances audit quality and strengthens corporate governance.

SA 230 – Audit Documentation governs the form, timing, and extent of audit documentation. The objective of SA 230 is to ensure the auditor prepares documentation that provides a sufficient and appropriate record of the basis for the auditor's report and evidence that the audit was planned and performed in accordance with SAs and applicable legal requirements.

Form of Audit Documentation

Audit documentation may be prepared in paper form, electronic form, or other media. It includes audit programmes, analyses, issues memoranda, summaries of significant matters, letters of confirmation, checklists, and correspondence (including e-mail). The auditor may include abstracts or copies of entity's records as part of documentation. The form should be such that an experienced auditor, having no prior connection with the audit, is able to understand: (i) the nature, timing and extent of audit procedures performed; (ii) the results of procedures and audit evidence obtained; and (iii) significant matters arising and conclusions reached thereon.

Timing of Audit Documentation

SA 230 requires that documentation be prepared on a timely basis. Timely preparation enhances the quality of the audit and facilitates effective review and supervision of work performed. Documentation prepared after the event is considered less reliable than documentation prepared contemporaneously.

Regarding the final assembly of the audit file: SA 230 para 14 requires the auditor to complete the assembly of the final audit file on a timely basis after the date of the auditor's report — ordinarily not more than 60 days after the audit report date. After final assembly, the auditor shall not delete or discard documentation before the end of the retention period, which is a minimum of 7 years from the date of the auditor's report.

If the auditor finds it necessary to modify or add documentation after assembly, the auditor must document the specific reasons for the changes, when and by whom the changes were made and reviewed.

Extent of Audit Documentation

SA 230 para 8 provides that the extent of audit documentation is a matter of the auditor's professional judgment. Factors that affect the extent include:

(i) Size and complexity of the entity being audited.
(ii) Nature of audit procedures — more complex procedures require greater documentation.
(iii) Identified risks of material misstatement — higher risk areas require more extensive documentation.
(iv) Significance of audit evidence obtained — more significant evidence warrants fuller documentation.
(v) Nature and extent of exceptions identified during the audit.
(vi) The need to document conclusions that are not readily determinable from the documentation of work performed or audit evidence obtained.
(vii) Audit methodology and tools used.

Importantly, the auditor need not document every matter considered — rather, documentation should be sufficient to enable an experienced auditor with no previous connection to the engagement to understand all significant matters. Oral explanations alone do not constitute adequate support for audit work performed.

Surprise Checks in Audit

Desirability of Surprise Checks:

Yes, surprise checks are highly desirable in audit. A surprise check is an audit procedure carried out without prior intimation to the client or the employees concerned. The primary objective is to detect errors, frauds, and irregularities that may be concealed if the auditee has advance notice of the audit.

As per SA 240 (The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements), the auditor should incorporate an element of unpredictability in audit procedures to address the risk of fraud. Surprise checks serve this purpose effectively by:

- Catching employees off-guard, thereby reducing the possibility of manipulation of records before inspection.
- Creating a deterrent effect — the mere possibility of a surprise visit discourages fraudulent or irregular conduct.
- Revealing the true state of affairs that would otherwise be concealed or rectified before a regular, pre-announced audit.
- Testing the reliability of internal controls in their natural, undisturbed state.

Important Recommendations for Surprise Checks:

(1) Cash Verification: The auditor should conduct surprise verification of cash in hand. The physical cash balance should be counted and reconciled with the cash book balance on the date of surprise visit. Any unexplained discrepancy may indicate misappropriation.

(2) Verification of Petty Cash: Petty cash funds and imprest amounts should be checked without prior notice, as these are most susceptible to defalcation by employees handling day-to-day cash transactions.

(3) Stock/Inventory Count: A surprise physical verification of stock or inventory should be carried out and compared with the stock records or bin cards. This helps detect pilferage, theft, or fictitious stock entries.

(4) Checking of Postings and Cut-offs: The auditor should surprise-check whether postings to ledger accounts are made correctly and on time, and verify that cut-off procedures are being followed properly at the period end.

(5) Scrutiny of Investments and Securities: Physical verification of investment certificates, fixed deposit receipts, and other securities without prior notice ensures they are not hypothecated or misused without management's knowledge.

(6) Verification of Books of Accounts: The auditor should suddenly call for books of accounts and supporting vouchers to check whether they are properly maintained and whether entries are supported by authentic documentation.

(7) Checking of Bank Reconciliation: A surprise scrutiny of the bank reconciliation statement with the passbook/bank statement can reveal manipulation of figures to conceal defalcation.

(8) Attendance and Payroll Verification: Surprise visits during payroll processing or attendance recording can detect ghost employees or inflated wage bills.

(9) Timing of Checks: Surprise checks should be conducted at irregular intervals and at times least expected by the staff — such as the beginning or end of a month, immediately after holidays, or mid-week — to maximise their effectiveness.

(10) Rotation of Areas: Different areas of the business should be covered in rotation across surprise visits so that no area feels immune from scrutiny.

Conclusion: Surprise checks are an indispensable tool in the auditor's arsenal for fraud detection and deterrence. They complement regular audit procedures and strengthen the overall assurance provided by the audit process. The auditor should plan and document surprise check procedures as part of the overall audit plan in line with SA 300 (Planning an Audit of Financial Statements).