Identifying and Assessing the Risk of Material Misstatement through Understanding the Entity and its Environment

Purpose

The purpose of this Standard is to establish standard and provide guidance on obtaining an understanding of the entity and its environment including its internal control and to identify and assess the risks of material misstatement in financial statement audit. The ultimate objective is to reduce the audit risk to an acceptably low level.

– What is Audit Risk
– Types of Audit Risk
– Concept of Misstatements
– Risk Assessment Procedure and related activities
— Inquiries of management and others within the entity
— Analytical procedures
— Observation and inspection
— Discussion among the engagement team

– The Entity and its environment
– Entity’s Internal control
– Effect of use of  Information technology (IT)
– Components of Internal Control
— Control Environments
— Risk Assessment process
— Information system and communicator
— Control Activities
— Monitoring
– Identifying and assessing the risk of material misstatements
— Financial Statement Level
— Assertion Level
– Documentation

Case Study :-

A limited company having turnover of approximately ` 50 crore uses a tailor made accounting software package. In the said package, all transactions are recorded, processed and the final accounts generated from the system. The management tells you that in view of the voluminous nature of day books. There is no need to print them and that audit can be conducted on the computer itself. The management further assures you that any ‘query based reports’ as required can be generated and printed.

As a statutory auditor of the company, enumerate the procedures you would adopt to conduct the audit.

 

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Agreeing the Terms of the Audit Engagements

Objective of the SA

Confirming that there is common understanding between the auditor and the management or those charged with governance.

The auditor’s responsibilities in agreeing to the terms of the audit engagement with management or those charged with governance.

Applicability

  • Contents of audit engagement letters
    — Limitation on scope prior to audit engagement acceptance
  • Recurring audit
  • Changes in terms of engagement
    If auditor is unable to agree to change
  • Financial reporting framework prescribed by law or regulation-other matters affecting acceptance
Case Study 1:

X, a Chartered Accountant was engaged by PQR & Co. Ltd. for auditing their accounts. He sent his letter of engagement to the Board of Directors, which was accepted by the Company. In the course of audit of the company, the auditor was unable to obtain appropriate sufficient audit evidence regarding receivables. The client requested for a change in the terms of engagement. Offer your comments in this regard.

Indian, Foreign Receipt & Accrual

Sec 9 : Income Deemed To Accrue Or Arise In India

In some cases even if the income arises outside India it is deemed to accrue in India, because it can be said to have arisen outside India because of some connection with India.

The definition given u/s 9 is exhaustive, i.e. only the income mentioned below shall be deemed to accrue or arise in India. thus receipts defined u/s 9(1)(i), (ii), (iii), (iv), (v), (vi) & (vii) shall only be deemed to accrue or arise in India

Income which is ‘deemed to accrue or arise’ in India is Indian Income and shall be taxable in the hands of all assessee irrespective of the residential status, i.e. shall be taxable in the hands of a R+OR , a R+NOR and a NR

Judicial Decisions:

  1. Though Sec 9(1) deems even all income accruing or arising abroad directly or indirectly from any source, business connection in India, the liability to tax will be subject to the provisions of any double taxation avoidance agreement falling u/s 90. Similarly the definition of royalty is different as per the Act Sec 9(1)(vii) and as per different DTAA’s, in the case of DTAA being applicable then the definition under the DTAA will prevail [CIT v Davy Ashmore India Ltd [1991] (HC)]
  2. DTAA: for determination of the taxability of the foreign collaborators the provisions of Section 90 of the Act are very relevant. This empowers the Central Government to enter into Double taxation avoidance agreements with the foreign countries.. where there exist a DTAA the tax liability of the assessee is to be determined in accordance with such an agreement as the provisions of the DTAA override the provisions of the Income Tax Act on points covered in the agreement.

CBDT Circular 333 dated 02/04/1982: states that where the DTAA provides for a particular mode of computation of income the same should be followed irrespective of the provision of the Income Tax Act. Where there is no specific provision in the agreement then the Income Tax Act will govern the taxation of income.

Where however even for points mentioned in the agreement if the provisions of the income tax act are more beneficial to the assessee then he has the option to compute income tax as per the provisions of the Act

Thus the tax-ability will depend upon whether there is an applicable DTAA

If there is – then the relevant provisions of the DTAA will override the provisions of the Income Tax Act

If there is no DTAA – the the provisions given below will be applicable

  1. Income from business connection:

Sec 9(1)(i): all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India,or through the transfer of a capital asset situate in India.

PART 1 of the above definition: where by virtue of business connection[1] in India income accrues or arises outside India to any person it is deemed to accrue or arise in India.

Thus business connection involves business carried on by a Non Resident, which yields profits…outside India….. and some activity in India… which contributes to those profits.

Judicial decisions:

  • Business connection may be in many forms for example a branch office in India or an agent appointed in India. The matter in which one has a right of interference comes within the ambit of business connection. It must be a continuous activity between the business of a non resident and the activity in India. Whether there exists a business connection or not has to be determined upon facts & circumstances of each case CIT v R.D. Aggarwal & Co [1965]

    Note: Section 9(1)(i) only tells us whether income is taxable in India or not. It does not tell us how much i.e. it does not help determine the amount of income taxable in India.

    Explanation 1 to Sec 9(1)(i): Exceptions to the rule of business connection

    1. Where all operations are not carried on in India – Explanation 1(a) to Sec 9(1)(i) : Where all the operations are not carried out in India, in such a case the income deemed to accrue or arise in India will only be such income as can be said to have been earned from operations in India.

    For example: Mr John has a shop in Germany. He sends cloth to India to his agent who stitches them into shirts and sends them to Germany. Mr. John earns a profit of Rs 10 lacs in Germany. Now it can be said that some part of the profits earned by Mr John in Germany, were because of the process of stitching carried out in India. Thus proportionate profits must be brought to tax in India, in the hands of John, as per the provisions of Section 9(1)(i) explanation 1(a).

    It is only that portion of the profits which can be reasonably attributed to the operations of the business carried out in India, which is liable to Income Tax. The apportionment is to be made only in case in which the profits and gains are deemed to accrue or arise in India and not to a case in which the actually so accrue or arise or are received in India CIT v Best & Co Ltd [1966](SC)

    1. Purchase of goods for export – Explanation 1(b) to Sec 9(1)(i) : Where a NR, or an agent on his behalf, buys goods from India for the purpose of exporting them no income will have deemed to have accrued to him from conversion of materials purchased for the purpose of export. Thus the activity of purchase is not covered under the provisions of section 9(1)

    For example: Mr John has a shop in Germany. He purchases shirts from India through his agent in India. Mr. John earns a profit of Rs 10 lacs in Germany. Now it can be said that some part of the profits earned by Mr John in Germany, were because of the process of purchase carried out in India. Thus proportionate profits must be brought to tax in India, in the hands of John, as per the provisions of Section 9(1)(i) explanation1(a)., however as per explanation b to the said section the activity of ‘purchase’ is not covered, therefore no part of Mr. John’s income earned in Germany can be said to be ‘deemed to accrue or arise in India’

    Nov 2003:

    XY (P) Ltd., a company having a registered office in Singapore, for the first time has carried out operations during the PY 2015-16 of purchase of goods in India on four occasions. Immediately after purchase, the company exports the same to China. The total value of such exports is Rs 100 lacs, on which it earns profits of Rs 20 lacs before the expenses of Rs 12 lacs, which is directly paid by the head office. The company seeks your advice to its liability to tax in India . How much income for the PY 2015-16 shall be subject to tax in India?

    Form the facts of the case it is clear that XY(P) Ltd is registered in Singapore and we will deem it to be a foreign company which is a non resident of India for the purposes of the income tax Act.

    During the PY 2015-16 the company has purchased goods from India and exported them to China, thus no profit accrues or is received in India. By the plain reading of Sec 9(1) there is some activity between the profits earned by the non resident outside India and the territory of India, however since the transaction only relates to the activity of purchase there is no deemed accrual of income in India, thus no part of the profits will be assess-able in India.

    1. Collection of news and views – Explanation 1(c) to Sec 9(1)(i): where the activity of the NR is restricted to the collection of news and views from India for use for his business of running a news agency or publishing newspapers , magazines or journals abroad. Thus the activity of collecting news and views is also exempt from the provisions of Section 9(1)(i)
    2. Shooting of Cinematography film in India Explanation 1(d) to Sec 9(1)(i) : In case of
    • NR Individual not being a citizen of India
    • NR firms where none of the partners is a citizen of India or resident in India.
    • NR companies where none of the shareholders are citizens of India or resident in India.

    In case of the above no income shall be deemed to accrue or arise in India from activities limited to shooting of cinematographic film in India.

    Example: Mrs. Nair comes to India for the shooting of her film in Hyderabad. She earns Rs 2 crore from showing this film in USA and Rs 1 crore from showing this film in India.

    • Now Rs 1 crore is Indian Income as it is actually accruing in India,
    • Rs 2 crore, Now it can be said that some part of the profits earned by Mr. Nair in USA, were because of the process of ‘Shooting Cinematography film’ was carried out in India. Thus proportionate profits must be brought to tax in India, in the hands of Mr. Nair , as per the provisions of Section 9(1)(i) explanation a., however as per explanation d to the said section the activity of ‘Shooting Cinematography film’’ is not covered, therefore no part of Mr. Nair’s income earned in USA can be said to be ‘deemed to accrue or arise in India’, provided Mr. Nair is not an Indian Citizen.

    When is Business Connection established

    Practically it is for the assessee, the CA/Lawyer or the Department to determine whether there exists a business connection between two enterprises to be able to invoke the provisions of Sec 9(1)(i). This application has been subject to a lot of interpretation & debate. Finance Act 2003 inserted the following definition to help guide the determination of a business connection, but the explanation itself is open to interpretation

    Explanation 2: has been inserted in clause (i) of section 9(1) with effect from 1.4.2004.

    1. ‘Business connection’ shall include any business activity carried out through a person acting on behalf of the non-resident.

    For example – a Non resident appoints an agent in India through whom the activities are carried out by the Non resident in India, then it can be said that the Non resident has a business connection with India and any income earned outside India because of the connection in India will be deemed to accrue or arise in India. Such agent may be a separately incorporated company, firm, individual etc.

    1. He must have an authority, which is habitually exercised to conclude contracts on behalf of the non-resident. However, if his activities are limited to the purchase of goods or merchandise for the non-resident, this provision will not apply.

    For example – a Non resident has given an authority to another person to sign contracts for an on behalf of the non resident, then it can be said that the Non resident has a businesss connection with India and any income earned outside India because of the connection in India will be deemed to accrue or arise in India. However where the activity of the agent are restricted to the purchase of goods on behalf of the non resident then no part of the profits of the non resident shall be deemed to accrue or arise in India.

    • Where he has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident, a business connection is established.

    For example – a Non resident neither appointed a person as an agent nor has given any authority to sign contracts for an on behalf of the non resident , but a person maintains stocks on behalf of the non resident as supplies the goods on directions of the Non resident, then it can be said that the Non resident has a businesss connection with India and any income earned outside India because of the connection in India will be deemed to accrue or arise in India.

    1. Business connection is also established where he habitually secures orders in India, mainly or wholly for the non-resident.

    The words wholly have not been defined in the act in terms of normal percentages it may be more than 90% [Speciality Magazines (P) Ltd in Re [2005]]

    Exception

    1. “Business connection”, however, shall not be held to be established in cases where the non-resident carries on business through a broker, general commission agent or any other agent of an independent status, if such a person is acting in the ordinary course of his business.
    2. A broker, general commission agent or any other agent shall be deemed to have an independent status where he does not work mainly or wholly for the non-resident.
    3. The new definition of the term ‘business connection’ shall also be applicable to an agent in relation to a non-resident under section 163 of the Act. Consequently, this new definition has been referred to in section 163 also.(Effective from A. Y. 2004-05)

    The new Explanation 3 provides that where a business is carried on in India through a person referred to in (ii), (iii) or (iv) mentioned above, only so much of income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India.