Beruflich Dokumente
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Forward
It is always the endeavor of institute to provide contemporary education and training to the
students. As the distinctive characteristic of the course i.e., distance education, has emphasized the
need for bridging the gap between the current market requirement to provide quality professional
education in consonance with international norm and practice, the institute has been providing a
variety of educational inputs for the students for their updates..
In this respect, the institute of Chartered Accountants of Nepal has modified the syllabus of
various subject of the CAP III course wherein various topic has been added in the syllabus. In this
regards, The Institute of Chartered Accountants of Nepal has come up with this Supplementary
Study Material which has been prepared for the students of Chartered Accountancy Professional
[CAP] III Level by incorporating the additional chapters which has been introduced in new
syllabus of 2015. This topic will be applicable to the student appearing in the CAP III examination
from December , 2016 onwards
This Supplementary Study Material contains a discussion of the amendments made in the syllabus of
the CAP III course. They are very important to the students for updating their knowledge regarding
the latest developments in the respective areas mentioned above. We believe this Supplementary
Study material will be of immense help to students appearing exams and to gain working level
knowledge. However, students are advised not to rely solely on the material. They should update
themselves with latest developments and pronouncements in auditing and assurance profession along
with other reference books recommended by Institute of Chartered Accountants of Nepal (ICAN).
TABLE OF CONTENT
S. No
Content
Page No
26
Advanced Auditing
92
Corporate Laws
264
303
Advanced Taxation
304
370
406
CAP III
CAP III
CAP III
CAP III
2
Public Expenditure and Financial Accountability (PEFA)
PEFA is an integrated financial management reform agenda of government. It is a strategy to
strengthen public expenditure system of the country. It is considered as a tool to improve
financial transparency and accountability of all public expenditure and to reduce fiduciary
risk and to improve fiscal discipline in Nepal. The PEFA initiative has developed a robust
tool for measuring Public Financial Management performance and providing sound
assessment of the quality of Public Financial Management for countries of all income level.
The goals of PEFA are to strengthen recipient and donor ability to assess the condition of
country public expenditure, procurement and financial accountability systems and develop
practical sequence of actions for financial reform and capacity building. Nepal has assessed
PEFA indicators in 2008 and adopted action plan that serve as the national policy for overall
improvement in Public Financial Management.
3
Public Financial Management (PFM) Reform Strategy
The PFM reform strategy focuses to deliver actions that yield effective results in
strengthening the PFM system and to build the capacity of PEFA Secretariat to lead the
PEFA agenda and institutionalize the PFM reform process. This strategy is expected to be
implemented through 147 immediate and intermediate tactical action plans and help make
decisions on mobilizing and allocating resources and address the prioritized underlying
issues. It focuses on achieving, measuring and verifying the results. Over the period, it is
expected to help install performance culture. Identifying priority areas of public expenditure
and financial accountability, sustaining technical support on budgeting and treasury
functions; supporting outreach and consensus building on the need for PFM reforms among
government and civil society stakeholders, leveraging information technologies such as
Integrated Financial Management Information Systems (IFMIS), strengthening the audit
function of the Auditor general, strengthening the parliamentary oversight function carried
out by the Public Accounts Committee (PAC), moving from a rule based to principles based
approach in line with international standards, supporting the institutional development of the
primary institutions for accountability, enhancement, strengthening PFM monitoring by both
government and society stakeholders including independent verification inventions and
supporting the design of a sound financial management system in the context of state
restricting and transition to a possible federal system are the prime concerns in the context of
PFM reforms.
ROLE OF THE OFFICE OF THE AUDITOR GENERAL (OAG)
Good governance is the responsibility of state, state machineries should be mobilized to meet
public aspirations and to establish the foundations of good governance right from the level of
service delivery. Government has established legal, structural, administrative procedures to
transform society by making administration citizen friendly and responsive to public
expectation. There is a close inter relationship between public financial management and the
outcome of development. With the objective of improving public financial management
system, the government has implemented important programs that included Medium term
Budget Framework (MTBF), Nepal Public Sector Accounting Standards (NPSASs), Public
Procurement Act and Regulations, Treasury Single Accounts (TSA) system, management
reform of public administration and revenue administration. These programs have contributed
in maintaining discipline in public administration in broad term and in financial
administration and disseminating financial information. An attempt has also been made to
evaluate the roles played by the responsible officials from the perspective of transparency and
public accountability in the public financial management.
CAP III
CAP III
CAP III
2.
Corporate Governance Reporting
Corporate governance involves balancing the interests of the stakeholders in a company
these include its shareholders, management, customers, suppliers, financiers, government and
the community. Corporate governance provides the framework for attaining a companys
objectives and encompasses practically every sphere of management, from action plans and
internal controls to performance measurement and corporate disclosure. Most companies
strive to have a high level of corporate governance. These days, it is not enough for a
company to merely be profitable; it also needs to demonstrate good corporate citizenship
through environmental awareness, ethical behavior and sound corporate governance
practices. Good corporate governance requires a joint effort of the promoters who need to be
more transparent, responsible and socially accountable; the shareholders who must actively
participate in their corporate affairs to help prevent any fraudulent and insider practices and;
the regulatory authority that should effectively enforce rules and regulations in order to
protect the rights of all stakeholders and create favorable environment to enhance good
corporate governance culture.
UNIT 2: VALUATION OF GOODWILL, SHARES AND BUSINESS
Valuation of Business
The business is a composite asset. So valuation technique applied for any single asset can not
be applied for valuation of business. A business is comprised of fixed assets, investments and
current assets, loans and advances. A popular misconception is that the gross value of
business is the aggregate of the value of various assets. In fact, value of business is different
from that of aggregate value of assets. Moreover, it is dependent on the circumstances for
which such valuation is necessary.
Need for valuation of business
The following represent the need for business valuation:
Merger and take over: Companies in merger need valuation as a going concern to
settle the purchase consideration. In case of take-over ,the acquirer needs the
information about total value of business such that it can determine the value of the
proportion which it intends to buy.
Sale of Business: For selling the whole business or any division of it, both the seller
and the buyer want to know the value of business to fix up the bargaining limit.
Liquidation: In case of liquidation, the shareholders want to know the value of
business from the liquidator to understand how much they would get by liquidation.
Valuation Approaches
Two alternative approaches are available for business valuation: (i) Going concern and (ii)
Liquidation. Under the first approach, it is important to understand what benefit the business
is able to generate in future out of its existing stock of assets although value of existing assets
is not ignored. But in liquidation approach, the emphasis is what can be fetched by selling the
assets either on piecemeal basis or taking as a whole.
Valuation Methods
The following methods are used for business valuation taking as a going concern:
(i)
Historical Cost Valuation
(ii)
Current Cost Valuation
(iii) Economic Valuation
CAP III
(iv)
Assets Valuation
(i)
Historical Cost Valuation
It is also called book value method. All assets are taken at their respective historical cost.
Value of goodwill is ascertained and added to such historical cost of assets.
Value of Business = Historical Cost of all assets + Value of Goodwill
(ii)
Current Cost Valuation
Current cost of assets are taken for this purpose instead of historical cost. Current cost of
various assets can be ascertained as follows:
Tangible Fixed Assets: Price to be paid to replace such assets at their present
condition. If replacement price of the same type of intangible assets is not available,
then replacement price of the next best substitute should be taken.
Investments: Quoted investments are valued at current market price. Unquoted
investments are taken at cost unless the available information is sufficient to
determine their current value.
Stock: Current market value of the stock in hand is taken up.
Debtors: At their net collection amount.
Intangibles: Trade Marks, Patents, Copyright, etc. are valued at current acquisition
price less the proportionate value already expired.
(iii) Economic Valuation
Under this method value of the business is given by the sum of discounted value of future
earnings of cash flows.
Capitalization of future maintainable profit: Value of business as a going concern is
dependent on its future earnings. By earning we may mean earnings before interest
after tax.
Value of Business = Future Maintainable Profit
Capitalization Rate
In case of listed company inverse of the price-earnings ratio may be used for
determining capitalization rate.
Book Value/ Net Assets Value
Book Value (NAV) breakup value of business is computed as below:
a. Calculation from the liability side
Paid up value of equity and preference shares
Add: Reserves (excluding reserves not created out of
Revenue profit or not realized in cash)
Less: Miscellaneous expenses not written off
Accumulated loss
Arrears of depreciation
Contingent Liability
Net assets value of the business
b. Alternatively, calculation can be from assets side
Tangible fixed assets
Intangible assets
Trade investments
The Institute of Chartered Accountants of Nepal
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
8
CAP III
Non-trade investments
Net current assets
Less: Secured and unsecured loans
Unrealized reserves
Contingent liabilities
Arrears of depreciation
Net assets value of business
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
Particular
Tangible fixed assets
Intangible assets
Trade investments
Non trade investments
Otherwise
Finished goods
Work In- Progress
Raw materials
Debtors
Other assets
Fictitious assets
Less: Secured & unsecured Liabilities
Loans payable
Other Liabilities (including current
liabilities)
Contingent Liabilities
Basis
-Current Cost
- Cost
-Cost
-Market Value If
Quoted,
-Book Value
-Market Value
-Cost
'-Cost
- NRV
-Cost/Book Value
-Nil
-Actual Amount
Payable
-Actual Amount
Payable
-Actual Amount
Payable
Going
Concern
Basis
Liquidation
Basis
NRV
NRV
NRV
XXX
XXX
XXX
NRV
XXX
NRV
NRV
NRV
NRV
NRV
NIL
XXX
XXX
XXX
XXX
XXX
NIL
Actual Amount
XXX
Actual Amount
XXX
Actual Amount
XXX
XXX
Net assets value of the business
-Book Value
Book Value
XXX
Less: Preference capital
XXX
Net assets value of equity
Explanation Note: Here cost means historical cost based value and book value means balance
sheet value. NRV means net realizable value which is market value less further costs to be
incurred including cost of disposal.
CAP III
Discounted
Cash
Flows (Rs. In lakhs)
16,66.60
14,79.07
13,12.75
11,65.19
10,63.19
9,70.11
8,85.28
8,07.88
93,50.07
10
CAP III
Value of business Rs.93,50.07 lakhs based on discounted value of eight years cash flows.
(iv)
Assets valuation method
It may be argued that if a business is acquiring or retaining an asset, the value of that asset to
that business must, in the case of acquisition of the asset, be greater than the cost of that asset
and, in the case of retention of the asset, be greater than the net realizable value of the asset.
If, therefore, all the assets of the business are valued at their net realizable value, the
aggregate will be clearly less than value of business as a whole. It gives the lower bound to
the range of values based on the assets valuation approach. The upper bound of the range of
business will be the sum of the current costs of the companys assets so long as it is
recognized that the assets include intangibles such as goodwill.
Thus under assets valuation approach, one can get lower bound of the business value using
net realizable value of the assets and the upper bound by the current costs of the assets
including goodwill.
VALUATION OF BUSINESS FOR AMALGAMATION WITH ANOTHER
The valuation of business which is to be amalgamated with another business is more complex
process because it cannot be made in isolation. From the point of view of the potential
purchaser, the maximum price that he will be prepared to pay is the difference between the
value of the combined business and the value of existing business.
If the amalgamation gives rise to positive synergy, the value of amalgamated business will be
greater than the sum of the values of the individual business taken in isolation. The purchaser
will usually not only have to consider the tangible assets, which can be valued with relative
ease, but also the intangible assets which may be particularly influenced by the synergic
effect of the amalgamation.
In many amalgamations, all the assets of the acquired business are not retained in the new
business. So, the first step in valuing business for acquisition will be to determine the asset
structure of the business and to identify the assets which will not be acquired in the future.
Such assets must be valued at their net realizable value at the time at which they are expected
to be sold and these figures discounted to the present time to ascertain the present value of the
superfluous assets. In many cases, the sale of superfluous assets will take place immediately
and therefore, no discounting becomes necessary and the value if these may be considered to
be a deduction from the purchase price of the business.
In practice, the valuation figure is the net realizable value of the surplus assets which are to
be sold plus the present value of the additional earning which will accrue to the acquirer of
the business as a result of the acquisition. It is, apparent that a major problem arises in
determining the rate of interest at which the earning of the business should be discounted as
well as the period for which such earning of estimation should be considered. Also it is
possible to take cash flows instead of earnings as discounted earlier.
Illustration 3.2
Shyam Garments Ltd is
fashion clothings. They
next 10 years.
Year 1
2
Cash 15,00 17,00
4
25,00
5
30,00
6
34,00
7
38,00
8
45,00
9
50,00
10
60,00
11
CAP III
Flow
(Rs.
in
lakhs)
Kiddies Wear Ltd is a company which owns a series of boutiques in a certain locality. The
boutiques buy clothes from various suppliers and retail them. Each boutique has a manager
and an assistant but all purchasing and policy decision are taken centrally. Independent cash
flow estimates of Kiddies Wear Ltd was as follows:
Year
1
2
3
4
5
6
7
8
9
10
Cash Flow (Rs. in 1,20 1,60
2,00 2,80 3,40 4,60 5,20 6,00 6,60 8,00
lakhs)
Shyam Garments Ltd is interested in acquiring Kiddies Wear Ltd in order to get some
additional retail outlets. They make the following cost-benefit calculations:
(i)
Net value of assets of Kiddies Wear Ltd
Rs. in Lakhs
Sundry Fixed Assets
800
Investments
200
Stock
400
1400
Less: Sundry Creditors
(400)
Net Assets
1000
(ii)
Sundry fixed assets amounting to Rs.50 Lakhs cannot be used and their net realizable
value is Rs.45 Lakhs.
(iii) Stock can be realized immediately at Rs.470 Lakhs.
(iv)
Investments can be disposed of for Rs.212 Lakhs.
(v)
Some workers of Kiddies Wear Ltd are to be retrenched for which estimated
compensation is Rs.130 Lakhs.
(vi)
Sundry creditors are to be discharged immediately.
(vii) Liabilities on account of retirement benefits not accounted for in the Balance Sheet by
Kiddies Wear Ltd is Rs.48 Lakhs.
(viii) Expected cash flows of the combined business will be as follows:
Year 1
Cash 1800
Flow
(Rs.
in
lakhs)
2
1900
3
2300
4
2950
5
3500
6
4000
7
4500
8
5300
9
5800
10
6900
Find out the maximum value of Kiddies Wear Ltd. Which Shyam Garments Ltd can quote.
Also show the difference in valuation had there been no longer. Use 20% as discount factor.
Solution
(1)
Calculation of operational synergy expected to arise out of merger
Year (Rs. in Lakhs)
Projected cash flows
1
18,00
2
19,00
3
23,00
4
29,50
5
35,00
6
40,00
7
45,00
8
53,00
9
58,00
10
69,00
12
CAP III
of Shyam Garments
after merger with
Kiddies Wear
Less: Projected cash
flows
of
Shyam
Garments
without
merger
(2)
15,00
17,00
20,00
25,00
30,00
34,00
38,00
45,00
50,00
60,00
3,00
2,00
3,00
4,50
5,00
6,00
7,00
8,00
8,00
9,00
Year
Discount Factor
1
2
3
4
5
6
7
8
9
10
120
160
200
280
340
460
520
600
660
800
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
(3)
Year
Discount Factor
1
2
3
4
5
6
7
8
9
10
300
200
300
450
500
600
700
800
800
900
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
(4)
Lakhs
Value as per discounted cash flows
Add: Cash to be collected immediately by disposal of assets:
Sundry fixed assets
Investments
Stock
Less: Sundry Creditors
in
1863.245
45.000
212.000
470.000
400.000
727.000
13
CAP III
48.000
130.000
578.000
20,12.245
So, Shyam Garments Ltd can quote as high as Rs.20,12.245 Lakhs for taking over the
business of Kiddies Wear Ltd.
31.3.2013
Rs.
4,000,000
2,800,000
1,240,000
31.3.2014
Rs.
4,400,000
3,200,000
1,640,000
14
CAP III
Capital employed in the business at market values at the beginning of 2011 2012 was
Rs.7,320,000, which included the cost of goodwill. The normal annual return on average
capital employed in the line of business engaged by R Ltd. Is 12.5%.
The balance in the General Reserve Account on 1st April 2012 was Rs.2,000,000. The
goodwill shown on 31.3.2012 was purchased on 1.4.2011 on which date the balance in the
profit and loss account was Rs.240,000.
Find out the average capital employed each year. Goodwill is to be valued at 5 years purchase
of super profit (simple average method). Also find out the total value of business as on
31.3.2014.
Solution
Calculation of average capital employed
31.3.2012
Rs.
2000,000
3,600,000
2,400,000
40,000
240,000
(1,200,000)
7,080,000
7,320,000
7,200,000
Goodwill
Building and Machinery
Stock
Debtors
Bank Balance
Less: Creditors
Closing capital
Opening capital
Average capital
31.3.2013
Rs.
1600,000
4,000,000
2,800,000
320,000
400,000
(1,600,000)
7,520,000
7,080,000
7,300,000
31.3.2014
Rs.
1200,000
4,400,000
3,200,000
880,000
800,000
(2,000,000)
8,480,000
7,520,000
8,000,000
Note:
(i)
Since goodwill has been paid for, it is taken as part of capital employed.
(ii)
Assumed that the building and machinery figure as revalued is after considering
depreciation.
Calculation of future maintainable profit and super profit
31.3.2012
31.3.2013
Rs.
Rs.
Net profit as given
840,000
1,240,000
Less: Opening Balance
(240,000)
(280,000)
Add: Under valuation of closing stock
400,000
400,000
Less: Adjustment for opening stock
Nil
(400,000)
Add: Goodwill written off
Nil
400,000
Add: Transfer to general reserve
400,000
400,000
Future Maintainable profit
1,400,000
1,760,000
Less: Normal Return (12.5% of average (900,000)
(912,500)
capital employed)
Super Profit
500,000
847,500
Average Super Profit =
(500,000 + 847,500 + 1,120,000)/3
=
822,500
Goodwill (5 years purchase) =
=
31.3.2014
Rs.
1,640,000
(320,000)
400,000
(400,000)
400,000
400,000
2,120,000
(1,000,000)
1,120,000
822,500 5
Rs.4,112,500
15
CAP III
Valuation of Business
Total Net assets as on 31.3.2014
Less: Goodwill
Add: Goodwill
Value of Business
CHAPTER 5: ANALYSIS
FINANCIAL STATEMENTS
Rs.
8,480,000
(1,200,000)
4,112,500
11,392,500
AND
INTERPRETATION
OF
16
CAP III
acquiring and disposal of debt and equity instruments, property and fixed assets etc.
Examples of cash flows arising from investing activities are:
Cash payment to acquire fixed assets (including intangibles)
Cash receipts from disposal of fixed assets (including intangibles)
Cash payments to acquire shares, warrants or debt instruments of other enterprises
and interests in joint venture (other than payments for those instruments considered to
be cash equivalents and those held for dealing or trading purposes)
Cash receipts from disposal of shares, warrants or debt instruments of other
enterprises and interests in joint venture (other than receipts from those instruments
considered to be cash equivalents and those held for dealing or trading purposes)
Financing activities:
These activities result in change in size and composition of owners capital and borrowing of
the organization. It includes receipts from issuing shares, debentures, bonds, borrowing and
payment of borrowed amount loan etc. Examples of cash flows arising from financing
activities are:
Sale of shares
Buy back of shares
Redemption of preference shares
Issue/redemption of debentures
Long term loan/ payment thereof
Dividend/interest paid
PREPARATION OF CASH FLOW STATEMENT
Cash flow statement can be presented in two ways. First is referred as Direct Method and
second is referred as Indirect Method. Under both methods, cash flows are shown under the
three headings prescribed above. Presentation of cash flows from financing activities and
from investing activities is same in both methods. Cash flows from operating activities are
differently presented.
(i)
The Direct Method
Under the direct method, information about gross receipts and gross cash payments is
presented to ascertain cash flow from operating activities. Individual sources of cash receipts
and cash payments are shown in cash flow statement. For example, cash received from
debtors, cash paid to creditors, cash expenses are there in cash flow statement.
(ii)
The Indirect Method
Under the indirect method, the net cash flow from operating activities is determined by
adjusting net profit or loss instead of individual items appearing in profit and loss account.
Net profit or loss is adjusted with:
Items affecting profit/loss but not affecting current items such as depreciation, writing
off on non-current assets, transfer to general reserve, transfer to capital reserve,
revaluation profit/loss on non-current items, issue of bonus shares.
Unrealized foreign exchange gain/loss
Profit/loss on sale of non-current assets.
Items to be shown separately like tax
Adjusted profit/loss above should be:
Increased by decrease in trade current assets and increase in trade current liabilities.
17
CAP III
Decreased by increase in trade current assets and decrease in trade current liabilities.
RECONCILIATION STATEMENT
An entity shall present with cash flow statement, a reconciliation statement of its opening
cash and cash equivalent with closing cash and cash equivalents.
Illustration 4.1
The Balance Sheet of Tee Ltd as on 31st December 2013 was as follows:
Liabilities
Rs.
Assets
6% Redeemable Preference
Land & Building
200,000
share capital (fully paid
Plant & Machinery
680,000
shares of Rs.100 each)
200,000 Patents
100,000
Equity Share Capital (fully
Trade Investments
250,000
paid shares of Rs.100 each)
500,000 Investment in Govt. Securities
Capital Redemption Reserve
100,000
as current assets (highly liquid)
Revenue Reserve
250,000 Stock in Trade
120,000
7% Debentures
250,000 Book debts
170,000
Liabilities for goods
170,000 Less: Provision 10,000
160,000
Provision for:
Cash
110,000
Income Tax
180,000 Preliminary Expenses
Equity Dividend
50,000
1,700,000
1,700,000
Rs.
70,000
10,000
The company has prepared the following (summarized) projected profit and loss account for
2014:
Rs.
Rs.
To Opening Stock
120,000
By Sales
2,400,000
To Purchases
1,500,000 By Closing Stock
180,000
To Wages
260,000
By Income form trade Invest.
9,000
To Salaries & Other Exp.
262,500
By Profit on sale of Machine
6,000
To Interest on debentures
17,500
By Saving in provision for
To Provision for Depreciation 97,000
income tax for 2013
15,000
To Provision for Income Tax
190,000
To Preference dividend
12,000
To Proposed Equity dividend
60,000
To Preliminary Expenses
5,000
To Balance of profit
86,000
18
CAP III
2,610,000
2,610,000
You are given the under mentioned further information:
(a)
Provision for depreciation as on 31.12.2013 was Rs.230,000 against plant and
machinery and Rs.20,000 against land and building. Of the amount provided against
depreciation Rs.5,000 is for building.
(b)
At the end of 2014, the redeemable preference shares are to be redeemed.
(c)
New machinery costing Rs.150,000 will be installed towards the end of 2014. The
machine which will be disposed of cost Rs.40,000 against which Rs.30,000 has been
provided as depreciation till 31.12.2013. The sale will take place early in 2014.
(d)
The 7% debentures were to be redeemed at the end of 2014. Half of them agree to
take new 10% debentures; others agree to take equity shares.
(e)
The Company allows one months credit to its customers and receives 1 months
credit from its suppliers. Wages Rs.45,000 will be paid in January 2015.
(f)
Unclaimed Dividends for 2013 Rs.5,000.
Prepare a statement showing the cash flows in 2014. Assume that to the necessary extent
Government securities will be sold at book value and no bank overdraft will be raised.
Solution
Projected Cash flow Statement for the Year ending 31st December 2014
(i)
Operating Activities
Profit as per P & L Account
86,000
Adjustment for:
Interest on debentures
17,500
Depreciation
97,000
Tax Provision
190,000
Preference Dividend
12,000
Proposed Dividend
60,000
Preliminary Expenses w/off
5,000
Income from trade investment
(9,000)
Profit on sale of Machine
(6,000)
Saving in Tax provision (2013)
(15,000)
Adjusted profit
437,500
Increase in trade current assets
(90,000)
Increase in trade current liabilities
62,500
Cash flow from operating activities before tax
410,000
Payment of Tax
(165,000)
Cash flow from operating activities (A)
245,000
(ii)
Investing Activities
Purchase of Machinery
Sale proceeds of machine
Income from investment
Cash flow from investing activities (B)
(150,000)
16,000
9,000
(125,000)
(17,500)
19
CAP III
Preference dividend
Equity dividend
Preference Redeemed
Cash flow from financing activities (C)
(12,000)
(50,000)
(200,000)
(279,500)
(159,500)
180,000
20,500
31.12.13
120,000
160,000
280,000
31.12.14
180,000
190,000
370,000
170,000
-170,000
187,500
45,000
232,500
Illustration 4.2
The following are the balance sheets of Strong Limited as on 31st March 2013 and 31st March
2014. You are required to prepare cash flow statement for the year ended 31st March 2014
under indirect method.
Liabilities
Equity Share Capital
(Shares of Rs.10 each)
Less: Calls in arrears
Add: Forfeited Shares
6% Preference Share
(Shares of Rs.10 each)
Less: Calls in Arrears
General Reserve
Profit & Loss A/c
Capital Reserve
Capital Redemption
reserve
Bank Loan
Sundry Creditors
Provision for Tax
31.3.13 31.3.14
Rs.
Rs.
200,000 240,000
2,400
800
197,600 240,100
--1,600
241,700
100,000 2,000
1,200
98,800
60,000
10,000
---
400
1,600
20,000
32,900
4,200
---10,000
85,000
26,000
487,400
55,100
6,000
72,000
28,000
461,500
Assets
Goodwill
Machineries
Furniture
Building
Vehicles
Investments
Stock
Sundry Debtors
Income Tax Receivable
Cash at Bank
Advance Tax
31.3.13
Rs.
15,000
90,000
10,000
70,000
30,000
20,000
65,000
70,000
--92,400
25,000
31.3.14
Rs.
10,000
90,800
9,500
68,000
24,000
12,000
60,000
60,000
400
1,02,800
24,000
487,400
461,500
Additional Information
The Institute of Chartered Accountants of Nepal
20
CAP III
a.
b.
c.
d.
During the year, preference shares were redeemed at a premium of 5% and before
redemption the preference shareholders, whose calls in arrears, were given notice to
pay the arrears money. Holders of 400 shares duly paid the call money and the rest
could not, and so the directors proceeded on redemption. The directors made the
minimum necessary fresh issue of shares, after utilizing fully the balance of Rs.60,000
in general reserve.
Calls in arrears, for both classes of shares, were in respect of final call at the rate of
Rs.2 per share.
800 equity shares were forfeited out of which 600 were reissued.
Machinery purchased during the year Rs.10,000.
Investment costing Rs.8,000 were sold for Rs.9,000. Machinery costing Rs.6,000 was
sold for Rs.4,200 (No depreciation has been provided on the item sold).
Solution
Cash flow Statement for the Year ending 31st March 2014
(i)
Operating Activities
Profit as per transferred to balance sheet
Adjustment for:
Depreciation on Furniture
Depreciation on Machinery
Depreciation on Building
Depreciation on Vehicle
Transfer to General Reserve
Tax provision
Goodwill written off
Loss on sale of machine
Profit on sale of investment
Adjusted profit
Decrease in trade current assets
Decrease in trade current liabilities
Cash flow from operating activities before tax
Income tax paid
Cash flow from operating activities (A)
22,900
500
3,200
2,000
6,000
20,000
26,600
5,000
1,800
(1,000)
87,000
15,000
(13,000)
89,000
(24,000)
65,000
(ii)
Investing Activities
Purchase of machine
Sale of Investment
Sale of Machine
Cash flow from investing activities (B)
(10,000)
9,000
4,200
3,200
800
(102,900)
42,900
5,400
(4,000)
(57,800)
10,400
21
CAP III
92,400
102,800
Working Note:
31.3.2013
31.3.2014
(i)
Trade Current Assets
Stock
Debtors
Total
Decreased by Rs.15,000
65,000
70,000
135,000
60,000
60,000
120,000
(ii)
Trade Current Liabilities
Creditors
Decreased by Rs.13,000
85,000
72,000
Tutorial Note:
Journal Entries
Bank A/c
To Calls in arrears (Preference)
(Receipt of calls in arrears on preference shares)
800
800
98,000
4,900
General Reserve
To Premium on redemption
(Premium on redemption written off)
4,900
General Reserve
To Capital Redemption Reserve
(General reserve transferred CRR for preference redemption)
55,100
Bank
42,900
102,900
4,900
55,100
42,900
Preference shareholders
To Bank
(Preference shares redeemed)
102,900
8,000
Bank (B.F.)
Shares Forfeited
To Equity Share Capital
5,400
4,800
102,900
6,400
1,600
6,000
22
CAP III
To Capital Reserve
(600 shares reissued)
4,200
Illustration 4.3
From the following information as contained in the income statement and the balance sheet of
Strong Limited, you are required to prepare a cash flow statement for the year ended 31st
March 2014 using (i) direct method and (ii) indirect method:
Income statement for the year ended 31st March 2014
Rs.
4,032,000
Particulars
Net Sales
Less:
Cost of Sales
Depreciation
Salaries and wages
Operating expenses
Provision for taxation
Net operating profit
Non recurring income:
Profit on sale of equipment
Profit for the year
Profit of the previous year
3,168,000
96,000
384,000
128,000
140,800
115,200
19,200
134,400
242,880
377,280
115,200
262,080
As on
31.3.2013
As on
31.3.2014
76,800
576,000
153,600
921,600
96,000
268,800
422,400
12,480
1,452,480
576,000
142,880
384,000
38,400
19,200
192,000
1,452,480
115,200
297,600
153,600
14,400
1,656,000
710,400
262,080
374,400
76,800
21,120
211,200
1,656,000
23
CAP III
Solution
Direct Method
Cash Flow Statement for the year ending 31st March 2014
(i)
Operating Activities
Collection from sales
Payment for purchase
(2,908,800)
Payment of salaries and wages
Payment of operating expenses
Cash flow from operating activities before tax
Income tax paid
Cash flow from operating activities (A)
4,003,200
(385,920)
(89,600)
618,880
(138,880)
480,000
(ii)
Investing Activities
Purchase of land
Purchase of building and equipment
Sale of Equipment
Cash flow from investing activities (B)
(76,800)
(460,800)
57,600
(480,000)
134,400
(115,200)
19,200
19,200
96,000
115,200
Indirect Method
Cash Flow Statement for the year ending 31st March 2014
(i)
Operating Activities
Operating Profit
Adjustment for:
Depreciation
Provision for tax
115,200
96,000
140,800
352,000
238,080
28,800
618,880
(138,880)
480,000
(ii)
Investing Activities
Purchase of land
Purchase of building and equipment
Sale of Equipment
Cash flow from investing activities (B)
(76,800)
(460,800)
57,600
(480,000)
24
CAP III
134,400
(115,200)
19,200
19,200
96,000
115,200
Working Note:
(i)
Collection from sales
Opening debtors + Sales Closing debtors
268,800 + 4,032,000 297,600
4,003,200
(ii)
(iii)
(iv)
(v)
Payment of Tax
Tax provision + tax payable at beginning tax payable at end
140,800 + 19,200 21,120
138,880
(vi)
115,200
76,800
38,400
25
CAP III
57,600
19,200
31.3.2013
268,800
422,400
12,480
703,680
14,400
384,000
38,400
422,400
Illustration 4.4
The following is the balance sheet of A and B as on 31st December 2014:
Liabilities
Rs.
Assets
Capital
Building
A
100,000
Machinery
B
50,000
Stock
Creditors for Goods
20,000
Debtors
Creditors for Expenses
30,000
Bank
200,000
76,800
Rs.
65,000
50,000
30,000
40,000
15,000
200,000
Creditors velocity
1 Month
Debtors Velocity
1 Month
Stock level uniform in value (FIFO)
Trade Expenses
Rs.75,000
Depreciation:
Machinery
10%
Building
5%
In the current year cost price will go up by 10 percent.
Sales in current year will increase 20 percent in volume.
Rate of gross profit no change.
Drawings of B
Rs.5,000
From the above information prepare projected cash flow statement.
Solution
Projected cash flow statement for the year ending 31st December 2015
(i)
Operating Activities
Net profit before depreciation
29,600
26
CAP III
(12,300)
(23,850)
(6,550)
(ii)
Investing Activities
Cash flow from investing activities (B)
Nil
(5,000)
(5,000)
(11,550)
15,000
3,450
Working Note:
(i)
Trading Account
For the year ending 31st December 2014
Particulars
Rs.
To Opening Stock
30,000
To Purchases
240,000
(20,000 x 12)
To Gross Profit
80,000
350,000
GP Rate
=
=
=
Particulars
By Sales
By Closing Stock
Rs.
320,000
30,000
350,000
80,000 x 100%
320,000
25% on sales
1/3rd of cost of goods sold
Cost of goods sold in 2015
(If no change in price of materials)
240,0000 + 20% increase due to volume
288,000
Opening Stock Current Purchase
30,000
258,000
+ 10% price
= 283,800
Particulars
To Opening
To Purchase
To Gross Profit
Rs.
418,400
30,000
27
CAP III
COGS)
To Trade Expenses
To
Net
profit
depreciation
448,400
75,000
before 29,600
448,400
104,600
By Gross Profit
104,600
(ii)
104,600
31.12.2014
40,000
30,000
70,000
52,300
30,000
82,300
30,000
20,000
50,000
Nil
26,150
26,150
MEANING OF ASSOCIATES
An associate is an enterprise in which an investor has significant influence and which is
neither a subsidiary nor a joint venture of the investor. Significant influence means the power
to participate in the financial and operating policy decisions of the investee but the investor
does not have control over those policies.
Indicators of Significant influence
Significant influence may be gained by the investor by virtue of share ownership, statue or
agreement. The existence of significant influence by an investor is usually evidenced in one
or more of the following ways:
Representation on the board of directors or equivalent governing body of the investee;
Participation in policy-making processes, including participation in decisions about
dividends or other distribution;
Material transactions between the investor and the investee;
Interchange of managerial personnel; or
Provision of essential technical information.
As a general rule, significant influence is presumed to exist when an investor holds directly or
indirectly through subsidiaries, 20% or more of the voting power of the investee. As with the
classification of any investment, the substance of the arrangement in each case will be need to
be considered. If it can be clearly demonstrated that an investor holding 20% or more of the
voting power of the investee does not have significant influence, the investment will not be
The Institute of Chartered Accountants of Nepal
28
CAP III
29
CAP III
(8)
Other
Carrying Amount
238
248
30
CAP III
Liabilities
Share Capital
Capital Reserve
Profit & Loss A/c
Minority Interest
Non-current Liabilities
Current Liabilities
Rs.
1,200
30
875
450
900
600
4,055
Assets
Fixed Assets
Investment in Need Ltd
Investment in Desire Ltd
Current Assets
Rs.
3,000
180
375
500
4,055
Helpful Ltd acquired 25% stake in Need Ltd for Rs.1.80 Lakh and Desire Ltd for Rs.3.75
Lakh as on 01.01.2014. Profit and Loss Account balances of Need Ltd and Desire Ltd on that
date was Rs.2 Lakh and Rs.3 Lakh respectively.
Summarized balance sheets of Need Ltd and Desire Ltd as on 31.12.2014 are given below:
(Rs.in 000)
Liabilities
Need
Desire Assets
Need
Desire
Share Capital
500
600
Fixed Assets
600
800
Profit & Loss A/c
300
400
Current Assets
400
700
Non-current liabilities
100
150
Current Liabilities
100
350
1,000
1,500
1,000 1,500
Earnings of Need Ltd for the first quarter 2015 was Rs.32,000. There were no changes in the
long term assets and liabilities. Current assets and liabilities increased during the period by
Rs.27,000 and Rs.18,000 respectively.
In the first quarter of 2015, Desire Ltd redeemed debentures of Rs.1 Lakh at par (standing in
the books as non-current liability) and earned Rs.40,000. Current assets and liabilities
increased during the period by Rs.38,000 and Rs.25,000 respectively.
Adjust the draft consolidated balance sheet if necessary.
Solution
Consolidated Balance Sheet as on 31.3.2015
Equity and Liabilities
1. Shareholders Funds
Share Capital
Reserve and Surplus
2. Minority Interest
3. Non-current Liabilities (900 + 20)
4. Current Liabilities (600 + 150)
Total
Assets
1. Non-current Assets
Tangible Assets
Intangible Assets
2. Non-current investment in Need Ltd
3. Current Assets (500 + 266)
Note No.
Rs. in 000
1,200
994
450
920
750
4,314
3,320
20
208
766
31
CAP III
Total
Notes to Accounts
1 Reserve and Surplus
Capital reserve
Profit & Loss A/c
Helpful Ltd and its subsidiary
Need Ltd (25% of (332-200))
Desire Ltd (40% of (440-300))
2.
Intangible Assets
Goodwill (Need Ltd)
Goodwill (Desire Ltd)
4,314
30
875
33
56
5
15
Working Note
1.
Draft Balance Sheets of Need Ltd and Desire Ltd. as at 31.3.2015
(Rs.in 000)
Liabilities
Need
Desire Assets
Share Capital
500
600
Fixed Assets
Profit & Loss A/c
332
440
Current Assets
Non-current liabilities
100
50
(bal. fig)
Current Liabilities
118
375
1,050
1,465
2.
20
Desire
800
665
1,050
1,465
964
994
Cr. Rs.
33
32
CAP III
Cr. Rs.
160,000
1,760,000
1,120,000
Illustration 6.2
On April 1, 2014, a company offered 100 shares to each of its 500 employees at Rs.40 per
share. The employees are given a month to decide whether or not to accept the offer. The
shares issued under the plan shall be subject to lock-in on transfers for three years from grant
date. The market price of shares of shares of the company on the grant date is Rs.50 per
share. Due to post-vesting restrictions on transfer, the fair value of shares issued under the
plan is estimated at Rs.48 per share.
On April 30, 2014 400 employees accepted the offer and paid Rs.40 per share purchased.
Nominal value of each share Rs.10.
Record the issue of shares in book of the company under the aforesaid plan.
Solution
33
CAP III
Particulars
Bank A/c (40,000 40)
Employees Compensation (40,000 8)
To Share Capital
To Securities
Dr. Rs.
1,600,000
320,000
Cr. Rs.
400,000
1,520,000
Illustration 6.3
Hari Limited has granted 120 stock options to each of its 1000 employees subject to the
condition that they should work for three years from the grant date. Grant date is 1.1.2012.
The company closes its account every December. Fair value of each option is Rs.24. Based
past experience, the company expects that 70% of the employees will complete the vesting
condition. No variation is found in the employee turnover during the vesting period. Show
journal entries. Face value of each equity share of the company is Rs.10. Exercise price
Rs.120. Market price: on the grant date Rs.140, on vest date Rs.170, average market price
when exercised Rs.250
Also give accounting entry on issue of shares on exercise of stock options by employees.
Solution
Journal Entries
Date
2012
2013
2014
Particulars
Employee compensation A/c
To Share Suspense A/c
(No. of shares = 84,000)
Amount = (84,000 24) /3
Employee compensation A/c
To Share Suspense A/c
Employee compensation A/c
To Share Suspense A/c
Dr. Rs.
672,000
Cr. Rs.
672,000
672,000
672,000
672,000
672,000
10,080,000
2,016,000
840,000
11,256,000
Illustration 6.4
Vayu Limited has granted 120 stock options to each of its 1000 employees subject to the
condition that they should work for three years from the grant date. Grant date is 1.1.2012.
The company closes its account every December. Fair value of each option is Rs.24. Based
past experience, the company expects that 70% of the employees will complete the vesting
condition. In 2013, they revise this estimate to 80%. Finallyn78% of the employees was
found eligible. Show journal entries. Face value of each equity is Rs.10.
The Institute of Chartered Accountants of Nepal
34
CAP III
Solution
Date
2012
2013
2014
Journal Entries
Particulars
Dr. Rs.
Employee compensation A/c
672,000
To Share Suspense A/c
(Expected no. of shares to be vested 84,000, so
total charge is Rs.2,016,000 in 3 years)
Amount = 120 1,000 70% Rs.24
Employee compensation A/c
816,000
To Share Suspense A/c
(Revised expected no of shares to be vested
96,000, so revised charge is (Rs.2,304,000672,000)/2 i.e. 1,632,000/2
Amount = 120 1000 80% Rs.24
Employee Compensation A/c
758,400
To Share Suspense
(Revised expected no of shares to be vested
93,600, so revised charge is Rs.2,246,000Rs.572,000- Rs.816,000)
Amount = 120 1000 78% Rs.24
Cr. Rs.
672,000
816,000
758,400
Illustration 6.5
Rama Ltd granted 1000 share option to its 20 executives with a condition that these will vest
if share price of the company hits Rs.1,500 which is presently Rs.1,000 and stays above that
for 30 working days. Maximum length of the vesting period is 5 years.
Bionomical option pricing model was applied to find the value of the share option which is
Rs.980 and that model shows 3 years period to achieve that. Rama Ltd estimated that within 3
years period 5 executives will leave.
Actually the price target was achieved at the end of the fourth year. It was recorded that 2
executives left during the year 1, 2 left during year 2 and another 3 left in year 3. During the
year 4 another 2 executives left.
Find the value of service and recognition thereof.
Solution
Valuation at year 1
Charge in year 1
Charge in year 2
=
=
=
15 Rs.980 1000
14,700,000/3
14,700,000/3
=
=
=
Rs.14,700,000
Rs.4,900,000
Rs.4,900,000
35
CAP III
36
CAP III
PORTFOLIO MANAGEMENT
In view of peculiar nature of stock exchange operations most of the investors feel insecure in
managing their investment on the stock market because it is difficult for an individual to
identify companies which have growth prospects conducive for investment. This is further
complicated by the volatile nature of the markets, which demands constant reshuffling of
portfolios to capitalise on the growth opportunities.
Even if the investor is able to identify growth oriented companies and their securities, the
trading practices are complicated, making it a difficult task for investors to trade in all the
exchanges and follow up on post trading formalities. That is why professional investment
advice through portfolio management services (P.M.S.) can help the investor to make an
intelligent and informed choice between alternative investments opportunities without the
worry of post trading hassles.
37
CAP III
DEFINITION OF "SECURITIES":
The Companies issue various types of securities such as shares, debentures, (convertible/nonconvertible), warrants entitling the holder thereof to apply for equity shares of the Company
and Bonds. Similarly, the Government also floats securities for the purpose of raising funds.
Thus the equity/preference shares, convertible/non-convertible debentures, zero bonds,
debenture stock and all types of warrants issued by a company are deemed to be securities.
Government securities include all kinds of bonds issued by the Governments for raising
loans.
38
CAP III
39
CAP III
REMITTANCE OF FUNDS:
Funds for investment should be remitted from abroad through normal banking channel as
allowed by Nepal Rastra Bank or Nepal Government
He shall transact in securities within the limitation placed by the client himself with
regard to dealing in securities as per the provision mentioned under Management
Directive 2067 ;
He shall not derive any direct or indirect benefit out of the client's funds or securities.
He shall not pledge or give on loan securities held on behalf of his clients to a third
person without obtaining a written permission from such clients.
He shall invest his client's funds in money market instruments including commercial
paper, trade bill, treasury bills, certificate of deposit and usance bills or as specified in
the contract.
Provided the portfolio manager shall not deploy the client's funds in bill discounting,
other mode of financing or for the purpose of lending or placement with corporate or
non-corporate bodies.
He shall, ordinarily, purchase or sell securities separately for each client. However, in
the event of aggregation of purchases or sales for economy of scale, inter se allocation
shall be done on a pro rata basis and at weighted average price of the day's
transactions. He shall not keep any open position in respect of allocation of sales or
purchases effected in a day.
Any transaction of purchase or sale including that between his own accounts and his
client's accounts or between two clients' accounts shall be at the prevailing market
price.
40
CAP III
While dealing with his clients funds, he shall not indulge in speculative transactions
that is, any transaction for purchase or sale of any security in which transaction is
periodically or ultimately settled otherwise than by actual delivery or transfer of
security.
He may enter into transactions on behalf of his clients for the specific purpose
of meeting margin requirements only if the contract provides for the same and
the client is made aware of the attendant risks of such transactions.
He may hold the securities belonging to the portfolio account in his own name on
behalf of his clients only if the contract so provides. In such a case, his records and his
report to his client should clearly indicate that such securities are held by him on
behalf of his client.
He shall deploy the money received from his client for an investment purpose as soon
as possible for that purpose.
Where there is a conflict of interest with such customers, he shall ensure fair
treatment to all his customers. He shall disclose to the customers possible sources of
conflict of duties and investors, while providing unbiased services.
He shall not make any exaggerate statement, oral or written, to the client about the
qualification or the capability to render certain services or his achievements in regard
to services rendered to other clients.
He shall not disclose to any clients, or press any confidential information about his
client, which has come to his knowledge.
He shall, where necessary and in the interest of the client, take adequate steps for
registration of the transfer of his client's securities and for claiming and receiving
dividends, inert payments and other rights accruing to his clients. He shall also take
necessary action for conversion of securities and subscription/renunciation of/or rights
in accordance with the client's instructions.
He shall Endeavour to(i) Ensure that the investors are provided with true and adequate information without
making any misguiding or exaggerated claims.
41
CAP III
(ii) Ensure that the investors are made aware of attendant risks before any investment
decisions made by them.
(iii)Render the best possible advice to his clients relating to their needs and the
environment and his own professional skills.
(iv) Ensure that all professional dealings are affected in a prompt, efficient and cost
effective manner.
42
CAP III
43
CAP III
services as the investor gains confidence in the ability of the portfolio manager.
Students may refer the guidelines issued by SEBON which may prescribed a lock in period
for investments made through portfolio managers as this service may be abused for shortterm speculation purposes. Moreover, reasonable returns can be achieved only in such a time
frame. Importantly, the fee charged by the portfolio manager is to be on a only-profit sharing
basis.
Portfolio management services also vary in terms of minimum investment, lock-in-period,
risk return factors and management fee. Based on the investment policy statement from the
investor containing the specifications and quantification of his objectives, the portfolio
allocates assets, determines the appropriate portfolio strategy for each asset class and selects
the securities. The performance of the portfolio is evaluated constantly to ensure attainment
of the investor objectives.
The portfolio is re-balanced when necessary by repeating the asset allocation portfolio
strategy and security selection. Portfolio Management Services (PMS) needs to be supported
by good research base to determine and quantify capital market expectations for the
economy, industries and individual securities.
Portfolio management services (PMS) is an ideal investment vehicle for high net worth
investors and much more flexible investment instrument than a mutual fund. Under portfolio
management service the investor knows the exact nature of his investment as the shares are
held in his name. He has a regular interaction with the fund manager which allows him more
control over his investments. This is, however, meant for high net worth investors as a
reasonable corpus is needed to allow a balanced mix of securities. Construction of an optimal
portfolio requites a mix of 8-10 securities which is beyond the reach of a small investor and
therefore professional services of portfolio managers are desirable.
A portfolio manager acts as a personal financial consultant on investment decisions. He also
offers other value added services such as tax planning, benefit collection, safe custody of
securities, registration and transfers etc. Professional portfolio management services are
expected to flourish gigantically in the years ahead. However, they will have to equip
themselves to fulfill the expectations of investors.
44
CAP III
45
CAP III
TABLE 1
Class
Type of Security
(a) Bonds/debentures
- Govt. Bonds
- Local Authority Bonds
- Public Sector Bonds
(b) Corporate debentures
Preference stock
- Redeemable
- Non-redeemable
2. Non-specific income
- Equity
3. Cash equivalent
- Treasury bills
- Govt Bond
Note: Risk column covers all the following types of risks:
- Interest rate risk
- Purchasing power risk
- Business risk.
- Financial risk
(Source: Merchant Banking - Dr. J. C. Verma)
Period of
Return Maturity
Certainty
Shape
Tax of
Return
Risk
Structure
Long
Long
Long
Long
Interest coupon
-Do-Do-Do-
Definite
-Do-DoHigh
Tax relief
-Do-DoTaxable
No
No
No
Medium
Long
Perpetual
Dividend
-Do-
High
Moderately
High
Taxable
Medium
Perpetual
Dividend and
capital gains
Discount
Least
Tax relief
High
High
Taxable
Low
Short
46
CAP III
5. Liquidity i.e. nearness to money. It is desirable for the investor so as to take advantage
of attractive opportunities upcoming in the market.
6. Diversification: The basic objective of building a portfolio is to reduce the risk of loss
of capital and/or income by investing in various types of securities and over a wide
range of industries.
7. Favorable tax status: The effective yield an investor gets from his investment depends
on tax to which it is subject. By minimizing the tax burden, yield can be effectively
improved.
Types
Risk extent
Cash equivalent
47
CAP III
2. Purchasing power risk: It is also known as inflation risk also emanates from the very fact
that inflation affects the purchasing power adversely. Nominal return contains both the real
return component and an inflation premium in a transaction involving risk of the above type
to compensate for inflation over an investment holding period. Inflation rates vary over time
and investors are caught unaware when rate of inflation changes unexpectedly causing
erosion in the value of realized rate of return and expected return.
Purchasing power risk is more in inflationary conditions especially m respect of bonds and
fixed securities. It is not desirable to invest in such securities during inflationary periods.
Purchasing power risk is however, less in flexible income securities like equity shares or
common rise dividend income off-sets increase in the rate of inflation and provides advantage
of capital gains.
3. Business risk: Business risk emanates from sale and purchase of securities affected by
business cycles, technological changes etc. Business cycles affect all types of securities viz.
there is cheerful movement in boom due to bullish trend in stock prices whereas bearish trend
in depression brings down fall in the prices of all types of securities. Flexible income
securities are more affected than fixed rate securities during depression due to decline in their
market price.
4. Financial risk: It arises due to changes in the capital structure of the company. It is also
known as leveraged risk and expressed in terms of debt-equity ratio. Excess of debt vis--vis
equity in the capital structure indicates that the company is highly geared. Although a
leveraged company's earnings per share are more but dependence on borrowings exposes it to
the risk of winding-up for its inability to honor its commitments towards lenders/creditors.
This risk is known as leveraged or financial risk of which investors should be aware and
portfolio managers should be very careful.
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FACTORS
AFFECTING
INVESTMENT
DECISIONS
IN
PORTFOLIO
MANAGEMENT
Given a certain amount of funds, the investment decision basically depends upon the
following factors:
8.7.1 Objectives of investment portfolio: This is the crucial point which a finance manager
must consider. There can be many objectives of making an investment. The manager of a
provident fund portfolio has to look for security (low risk) and may be satisfied with none too
high a return. As aggressive investment company may, however, be willing to take high risk
in to order to have high capital appreciation. How the objectives can affect in investment
decision can be seen from the available PMS services provided by various portfolio mangers
like NIBL Capital, Siddhartha Capital, Nabil Investment Banking.
It is obvious, therefore, that the objectives must be clearly defined before an investment
decision is taken. It is on the basis of the objectives that a finance manager decides upon the
type of investment to be purchased.
The objectives of an investment portfolio are normally expressed in terms of risk and return.
As already motioned, risk and return have direct relationships. Higher the return that one
wishes to have from the investment portfolio, higher could be the risk that one has to take.
Thus, if one wishes to double his investment in one year, he can attempt the same by
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purchasing high risk shares, in which case there is a great amount of risk that he may even
lose his initial investment itself.
8.7.2 Selection of investment: Having defined the objectives of the investment portfolio, the
next decision is to decide upon the kind of investment which should be purchased. The
decision 'what to buy' is crucial decision and has to be seen in the context of the following:
(a) What types of securities to buy or invest in? There is a wide variety of investments
available, i.e. debentures, convertible bonds, preference shares, equity shares,
Government securities and bonds, Mutual Fund units, Hydro power company share,
etc.
(b) What should be the proportion of investment in fixed interest dividend securities and
variable dividend bearing securities? Obviously, the fixed interest bearing securities
ensure a definite return and thus a lower risk but the return is usually not as higher as
that from the variable dividend bearing shares.
(c) In case investments are to be made in the shares or debentures of companies, which
particular industries show a potential of growth? Industry-wise-analysis is important
since various industries are not at the same level from the investment point of view. It
is important to recognize that at a particular point of time, a particular industry may
have a better growth potential than other industries. For example, there was a time
when jute industry was in great favor with the investors because of its growth
potential and high profitability. However, with the fall in profitability and the advent
of substitute product, the jute industry is no longer, at this point of time, considered as
a growth-oriented industry and the likelihood of appreciation in the value of these
shares is not considered to be high.
(d) Once industries with high growth potential have been identified, the next step is to
select the particular companies, in whose shares or securities investments are to be
made.
8.7.3 Timing of purchases: The timing of buying and selling the securities, specially shares,
is of crucial importance. Even if one can identify correctly the companies in whose shares the
investments are to be made, one may lose money if the timing is bad due to wide fluctuation
in the price of shares. At what price the share is acquired for the portfolio, therefore, depends
entirely on the timing decision.
The decision regarding timing of purchases is particularly difficult because of certain
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psychological factors. It is obvious that if a person wishes to make any gains, he should "buy
cheap and sell dear", i.e., buy when the shares are selling at a low price and sell when they
are at a high price. Although this seems very clear, in practice it is exceedingly difficult to
follow this. An ordinary investor, on the contrary, normally buys when the prices are rising
and sells when they are falling. Why and how this happens is a matter of psychology. When
the prices are rising in the share market, i.e., there is bull phase, the general environment is of
great confidence. Everybody joins in buying. Those who delay buying regret that they have
not done so; since every day prices touch a new high. An ordinary investor joins the buying
rush when it is in full stream and, therefore, usually buys the shares at high prices. Later,
when the bear phase starts, prices tumble down every day. An atmosphere of despondency
pervades and everybody starts counting the losses as share prices fall. The ordinary investor
gets panicky and as every day the prices fall he regrets why he did not sell his shares the
previous day. Ultimately, he sells the shares at a loss thinking his stars that he has gone out of
the market. This kind of investment decision is entirely devoid of any sense of timing.
Fundamental analysis for identifying industries with growth potential
We have already seen that after the objects of investment portfolio in terms of risk and return
have been specified, one of the first decisions that an investment manager faces is to identify
the industries which have a high growth potential. Two approaches are suggested in this
regard:
(a) Statistical analysis of past performance: A statistical analysis of the immediate past
performance of the share price indices of the various industries and changes therein
related to the general price index of shares of all industries should be made. The NEPSE
index numbers of security prices published every month in its website may be taken to
represent the behavior of share prices of the various industries in the last few years. The
related changes in the price index of each industry as compared with the changes in the
average price index of the shares of all industries would show those industries which are
having a higher growth potential in the past few years. It may be noted that an industry
may not remain a growth industry for all the time. The analysis of share price indices over
a number of years will enable the investment manager to identify the industries which are
rated high by the investors at the time of analysis. He can thus perceive industries having
a higher growth in their share prices indices and examine whether the growth potential is
still there or not. In other words, he shall now have to make an assessment of the various
characteristics of the industries to finalize a list of industries in which he will try to spread
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his investments.
(b) Assessing the intrinsic value of an industry/company: After an investment manager
has identified statistically the industries in the share of which the investors show interest,
he would assess the various factors which influence the value of a particular share. These
factors generally relate to the strengths and weaknesses of the company under
consideration, characteristics of the industry within which the company falls and the
national and international economic scene. It is the job of the investment manager to
examine and weight the various factors and judge the quality of the share or the security
under consideration. This approach is known as the intrinsic value approach.
The major objective of this analysis is to determine the relative quality of the security and to
decide whether or not the security is good at current market prices. In this, both qualitative
and quantitative factors are to be considered.
Industry Analysis: First of all, an assessment will have to be made regarding all the
conditions and factors relating to demand of the particular product, cost structure of the
industry and other economic and Government constraints on the same. As we have discussed
earlier, an appraisal of the particular industry's prospects is essential, since the basic
profitability of any company depends upon the economic prospects of the industry to which it
belongs. The following factors may particularly be kept in mind while assessing the factors
relating to an industry.
1. Demand/supply patient for the industry's products and its growth potential: The most
important aspect is to see the likely demand of the products of the industry and the gap
between demand and supply. This would reflect the future growth prospects of the industry.
In order to know the estimated future volume and the value of output in the next 10 years or
so, the investment manager will have to rely on the various demand forecasts made by
various agencies like the Planning Commission, Chambers of Commerce and NEPSE and
SEBON itself as well as private share expert.
Management experts identify five stages in the life of an industry. These are introduction,
development, rapid growth, maturity or saturation and decline. If an industry has already
reached the saturation or decline stage, its future demand potential is not likely to be high.
2. Profitability: The cost structure of the industry as related to its sale price is an important
consideration. In Nepal, there are many industries which have a growth potential on account
of good demand position. It is obvious that profitability in an industry is a vital consideration
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for the investor, since profit is both a measure of performance as well as a source of earning
for him. The investment manager, therefore, may analyse the profitability ratios, specially
return on investment, gross profit ratio and net profit ratio of existing companies in the
industry. This would give him an idea about the profitability of the industry as a whole.
3. Particular characteristics of the industry: Each industry has its own characteristics, which
must be studied in depth in order to understand their impact on the working of the industry.
For example, certain industries have a fast changing technology. It is obvious that in such
industries technological obsolescence will take place at a fast rate. Similarly, many other
industries are characterized by high rates of profits and losses in alternate years. Such cycles
or fluctuations in earnings must be carefully studied.
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2. Growth record: The growth in sales, net income, net capital employed and earnings per
share of the company in the past few years should be examined. The following three growth
indicators may be particularly looked into: (i)Price earnings ratio, (ii) Percentage growth rate
of earnings per annum, and (iii) Percentage growth rate of net Worth.
The price earnings ratio is an important indicator for the investment manager since it shows
the number of times the earnings per share are covered by the market price of a share.
Theoretically, this ratio should be the same for two companies with similar features.
However, this is not so in practice due to many factors. Hence, by a comparison of this ratio
pertaining to different companies the investment manager can have an idea about the image
of the company and can determine whether the share is under-priced or over-priced. Consider
the following example:
Company A
Company B
150
250
25
25
10
It is obvious that the purchaser of company A's shares pays 6 times its annual earnings while
the purchaser of company B's shares pays 10 times. If other factors (intrinsic value of share,
growth potential, etc.) are quite similar, it is obvious that the shares of company A are
preferable. In practice, however, the other factors are never similar in the case of two
companies. The investment manager must try to ascertain why the EPS in company B is
comparatively low - may be some factors are not apparent. EPS calculation cannot be the sole
basis of deciding about an investment. Yet it is one of the most important factors on the basis
of which the investment manager takes a decision to purchase the shares. This is because it
relates the market price of the shares and the earnings per share.
The percentage growth rate of net worth shows how the company has been developing its
capacity levels. Obviously, a dynamic company will keep on expanding its capacities and
diversify its business. This will enable it to enter new and profitable lines and avoid
stagnation in its growth.
In this context, an evaluation of future growth prospects of the company should be carefully
made. This requires an analysis of existing capacities and their utilization, proposed
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CAP III
expansion and diversification plans and the nature of the company's technology. The existing
capacity utilization levels can be known from the quantitative information given in the
published profit and loss accounts of the company. The plans of the company, in terms of
expansion or diversification, can be known from the Directors' Reports, the Chairman's
statements and from the future capital commitments as shown by way of notes in the balance
sheets. The nature of technology of a company should be seen with reference to technological
developments in the concerned fields, the possibility of its product being superseded or the
possibility of emergence of a more effective method of manufacturing.
Growth is the single most important factor in company analysis for the purpose of investment
management. A company may have a good record of profits and performance in the past: but
if it does not have growth potential, its shares cannot be rated high from the investment point
of view.
3. Financial Analysis: An analysis of its financial statements for the past few years would
help the investment manager in understanding the financial solvency and liquidity, the
efficiency with which the funds arc used, the profitability, the operating efficiency and the
financial and operating leverages of the company. For this purpose, certain fundamental
ratios have to be calculated.
From the investment point of view, the most important figures are earnings per share, price
earning ratios, yield, book value and the intrinsic value of the share. These five elements may
be calculated for the past 10 years or so and compared with similar ratios computed from the
financial accounts of other companies in the industry and with the average ratios for the
industry as a whole. The yield and the asset backing of a share are important considerations
in a decision regarding whether the particular market price or the share is proper or not.
Various other ratios to measure profitability, operating efficiency and turnover efficiency of
the company may also be calculated. The return on owners' investment, capital turnover ratio
and the cost structure ratios may also be worked out.
To examine the financial solvency or liquidity of the company, the investment manager may
mark out current ratio, liquidity ratio, debt-equity ratio, etc. These ratios will provide an
overall view of the company to the investment analyst. He can analyze its strengths and
weaknesses and see whether it is worth the risk or not.
4. Quality of management: This is an intangible factor. Yet it has a very important bearing
on the value of the shares. Every investment manager knows that the shares of certain
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business houses command a higher premium than those of similar companies managed by
other business houses. This is because of the quality of management, the confidence that
investors have in a particular business house, its policy vis-a-vis its relationship with the
investor, dividend and financial performance record of other companies in the same group,
etc. This is perhaps the reason that an investment manager always gives a close look to the
management of a company in whose shares he is to invest. Quality of management has to be
seen with reference to the experience, skills and integrity of the persons at the helm of affairs
of the company. The policy of the management regarding relationship with the shareholders
is an important factor since certain business houses believe in very generous dividend and
bonus distributions while others are rather conservative.
6. Pattern of existing stock holding: An analysis of the pattern of existing stock holdings of
the company would also be relevant. This would show the stake of various parties in the
company. An interesting case in this regard is that holding of Nepal Investment bank share by
RBB and which was offloaded as per the provision of NRB.
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CAP III
performance of the firm. After having analyzed all the relevant information about the
company and its relative strength vis-a-vis other firms in the industry, the investor is expected
to decide whether he should buy or sell the securities.
Timing of Investment Decisions
As we have seen earlier, the timing of investment decisions is crucial. An investment
manager has to view the problem of investment as one of buying and selling over a long
period during which sometimes the markets are in a bull phase. i.e. the prices are rising
consistently and sometimes in a bear phase, i.e. the prices are falling consistently, and at
other times stagnant, i.e., there is no significant trend of rise or fall in prices. Thus, if an
investment manager wishes to make the most profitable use of the investment opportunities,
he will have to make sales and purchases of investments at proper times.
Investments are to be purchased at a time when prices are low and sold at a time when prices
are high. As we have seen earlier, this requires swimming against the general current in the
market. Hence there must be an inbuilt system of timing the purchase or sale of investments
so that psychological factors are ignored and purchases are made when prices are high and
are just entering the bull phase whereas sales are made when prices are high and are just
entering the bear phase. This requires identification of bullish and bearish trends in the prices
of stocks in the share market.
If students prepare a graph of the share market prices and the fluctuations therein, they would
see that share market prices rise for a certain time (say a year or two) and then fall and remain
low for another year or two. The best way to study the share market prices is to watch the
share prices index. Various financial news like Karobar, Aabhyan,
newspapers, compute their own indices of share prices which show daily, monthly and yearly
changes in the prices of shares of certain selected companies. (Students should study the table
given in these financial newspapers containing stock exchange quotations). These papers
trace the changes in the share price index of various industries. It also gives an all sector
industry index every day.
INVESTMENT STRATEGY
Portfolio management can be practiced by following either an active or passive strategy.
Active strategy is based on the assumption that it is possible to beat the market. This is done
by selecting assets that are viewed as underpriced or by changing the asset mix of proportion
of fixed income securities and shares. Active strategy is carried out as follows:
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PORTFOLIO THEORIES
A portfolio theory guides investors about the method of selecting securities that will provide
the highest expected rate of return for any given degree of risk or that will expose the investor
to a degree of risk for a given expected rate of return. Portfolio theory can be discussed under
two heads :
1. Traditional Approach
2. Modern Approach.
1) Traditional approach:
The traditional approach to portfolio management concerns itself with the investor, definition
of portfolio objectives, investment strategy, diversification and selection of individual
investment as detailed below:
1. Investor's study includes an insight into his - (a) age, health, responsibilities, other assets,
portfolio needs; (b) need for income, capital maintenance, liquidity: (c) attitude towards
risk, and (d) Taxation status:
2. Portfolio objectives are defined with reference to maximizing the investors' wealth which
is subject to risk. The higher the level of risk bore the more the expected returns.
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3. Daily fluctuations.
1. Primary movements: They reflect the trend of the stock market and last from one year '
three years, or sometimes even more.
If the long range behaviour of market prices is seen, it will be observed that the share markets
go through definite phases where the prices are consistently rising or falling. These phases
are brown as hull and bear phases.
Graph 1
During a bull phase, the basic trend is that of rise in prices. Graph 1 above shows the
behavior of stock market prices in bull phase.
Students would notice from the graph that although the prices fall after each rise, the basic
trend is that of rising prices, as can be seen from the graph that each trough prices reach, is at
a higher level than the earlier one. Similarly, each peak that the prices reach is on a higher
level than the earlier one. Thus P2 is higher than P1 and T2 is higher than T1. This means that
prices do not rise consistently even in a bull phase. They rise for some time and after each
rise, they fall. However, the falls are of a lower magnitude than earlier. As a result, prices
reach higher levels with each rise.
Once the prices have risen very high, the bear phase in bound to start. i.e., price will start
falling. Graph 2 shows the typical behaviour of prices on the stock exchange in the case of a
Graph 2
bear phase. It would be seen that prices are not falling consistently and, alter each fall, there
is a rise in prices. However, the rise is not much as to take the prices higher than the previous
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peak. It means that each peak and trough is now lower than the previous peak and trough.
The theory argues that primary movements indicate basic trends in the market. It state that if
cyclical swings of stock market price indices arc successively higher, the market trend is up
and there is a bull market. On the contrary, if successive highs and lows arc successively
lower, the market is on a downward trend and we are in a bear market. This theory thus relies
upon the behaviour of the indices of share market prices in perceiving the trend in the market.
According to this theory, when the lines joining the first two troughs and the lines joining the
corresponding two peaks are convergent, there is a rising trend and when both the lines are
divergent, it is a declining trend.
2. Secondary movements: We have seen that even when the primary trend is upward, there
are also downward movements of prices. Similarly, even where the primary trend is
downward there is upward movements of prices also. These movements are known as
secondary movements and are shorter in duration and are opposite in direction to the primary
movements. Then movements normally last from three weeks to three months and retrace 1/3
to 2/3 of the previous advance in a bull market or previous fall in the bear market.
3. Daily movements: There are irregular fluctuations which occur every day in the market.
These fluctuations are without any definite trend. Thus if the daily share market price index
for a few months is plotted on the graph it will show both upward and downward
fluctuations. These fluctuations are the result of speculative factors. An investment manager
really is not interested in the short run fluctuations in share prices since he is not a speculator.
It may be reiterated that any one who tries to gain from short run fluctuations in the stock
market, can make money only by sheer chance. The investment manager should scrupulously
keep away from the daily fluctuations of the market. He is not a speculator and should always
resist the temptation of speculating. Such a temptation is always very attractive but must
always be resisted. Speculation is beyond the scope of the job of an investment manager.
Timing of investment decisions on the basis of Dow Jones Theory: Ideally speaking, the
investment manager would like to purchase shares at a time when they have reached the
lowest trough and sell them at a time when they reach the highest peak. However, in practice,
this seldom happens. Even the most astute investment manager can never know when the
highest peak or the lowest trough have been reached. Therefore, he has to time his decision in
such a manner that he buys the shares when they are on the rise and sells them when they
areon the fall. It means that he should be able to identify exactly when the falling or the rising
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Dow Jones theory identifies the turn in the market prices by seeing whether the successive
peaks and troughs are higher or lower than earlier. Consider the following graph:
SELL
PURCHASE
Graph 3
According to the theory, the investment manager should purchase investments when the
prices are at T1. At this point, he can ascertain that the bull trend has started, since T2 is
higher than TI and P2 is higher than P1.
Similarly, when prices reach P7 he should make sales. At this point he can ascertain that the
bearish trend has started, since P9 is lower than P8 and T8 is lower than T7.
Random Walk Theory: In discussing the Dow Jones theory, we have seen that the theory
is based on the assumption that the behavior of stock market itself contains trends which give
clues to the future behavior of stock market prices. Thus supporters of the theory argue that
market prices can be predicted if their patterns can be properly understood. Such analysis of
stock market patterns is called technical analysis. Apart from this theory there are many
approaches to technical analysis. Most of them, however, involve a good deal of subjective
judgment.
Many investment managers and stock market analysts believe that stock market prices can
never be predicted because they are not a result of any underlying factors but are mere
statistical ups and downs. This hypothesis is known as Random Walk hypothesis which states
that the behavior of stock market prices is unpredictable and that there is no relationship
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between the present prices of the shares and their future prices. Proponents of this hypothesis
argue that stock market prices are independent. A British Statistician, M. G. Kendell, found
that changes in security prices behave nearly as if they are generated by a suitably designed
roulette wheel for which each outcome is statistically independent of the past history. In other
words, the fact that there are peaks and troughs in stock exchange prices is a mere statistical
happening - successive peaks and troughs are unconnected. In the layman's language it may
be said that prices on the stock exchange behave exactly the way a drunk would behave while
walking in a blind lane, i.e., up and down, with an unsteady way going in any direction he
likes, bending on the side once and on the other side the second time.
Formula Plans
We have seen that the basic objective in timing the investment decisions is to buy and sell
high. However, this process is full of pit falls and errors in judgment. Formula plans have,
therefore, been devised to force the investment manager to follow a path that would enable
him to buy securities when they are cheap and sell them when the prices are high. These
plans follow an automatic procedure and are suitable for small investors as well as for
investment managers of large funds. They provide an automatic timing device for guiding the
buy and sell transaction.
Under the formula plans, the total investible funds arc divided into two major categories.
1. A specified percentages, say 50%, is to be invested in fixed income securities. This
includes bank deposits, debentures and Government securities, etc.
2. The second part is invested in securities yielding variable dividends like ordinary shares.
In our example, since 50% of the monies are invested in fixed income securities, the
balance 50% would be invested in variable securities.
Thus if a person has Rs. 1,00,000 to invest, he will first of all invest Rs. 50,000 in bank
deposits etc., and the other Rs. 50,000 in shares of companies as selected by him.
The second main feature of formula plan is that at predetermined intervals, say, three months
or six months or so, the market value of the total investment portfolio (fixed income
securities and variable dividend share) is worked out. In our example, suppose after three
months of the Initial investment, the total market value of all the investments is as indicated
below:
1. Rs. 50,000 in the case of fixed income securities. It is obvious that the market value and
the cost value of such securities or deposits would remain the same.
2. Rs. 70.000 in the case of ordinary shares. It is obvious that during these three months, the
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FUNDAMENTAL ANALYSIS
Value Based Investing: Fundamental analysis is based on the premise that the price of a
share is based on the benefits the holders of the share expect to receive in the future in the
form of dividends. The present value of future dividends, computed at an appropriate
discount rate to reflect the riskiness of the share, is called the intrinsic or fundamental value
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of the share. A share that is quoting below the fundamental value should be bought, while a
share that is priced above the fundamental value should be sold.
We have seen that the price we are prepared to pay for a share is nothing but the present
value of the dividends we expect to receive on the share and the price at which we expect to
sell it in the future.
As first step, to arrive at a compact expression, let us make a simple (and unrealistic!)
assumption, that the company is expected to pay a uniform dividend of Rs.D per share every
year. i.e..
D(I) = D(2) = D(3) = ... = D.
The Eq., would then become:
P(0) =
+ ....+......
But it is unrealistic to assume that dividends remain constant over time. In case of most
shares, the dividends per share (DPS) grow because of the growth in the earnings of the firm.
Most companies, as they identify new investment opportunities for growth, tend to increase
their DPS over a period of time.
Let us assume that on an average the DPS of the company grows at the compounded rate of g
per annum, so that dividend D(1) at the end of the first period grows to D(1)(I+g). D(1)
,etc, at the end of second period, third period. etc. respectively. So we must have:
P(0) =
+ ....+......
(6)
P(0) =
(7)
or
Since D(1) may be approximated as D(0)(1+g), D(0) being the DPS in the current period (0).
When growth rule in dividends, g, is equal to or greater than the desired rate of return on
share, k, the above model is not valid, since the geometric series leads to an infinite price.
The condition that g be less than k to not very restrictive, since the long-term growth in
dividends is unlikely to exceed the rate of return expected by the market on the share.
The above result [Eq.(6)] is also know as Gordon's dividend growth model for stock
valuation, named after the model's originator, Myron J. Gordon. This is one of the most well
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The fundamental analysts use the above models or some of their variations, for estimating the
fundamental or intrinsic price or the fundamental price-earnings multiple of a security.
Toward this end, they devote considerable effort in assessing the impact of various kinds of
information on a company's future profitability and the expected return of the shareholders. If
the prevailing price or the P/E multiple of a security is higher than the estimated fundamental
value (i.e. if the security appears to be overpriced), they recommend a selling stance with
respect to that security, since once the information becomes common knowledge, the price of
the security may be expected to fall. On the other hand, if the security is under-priced in the
market, the prevailing price (or the P/E multiple) of the security being lower than the
estimated fundamental value, they recommend buying the security, counting upon a price
rise.
Because of these inherent complex interrelationships in the production processes, the fortunes
of each industry are closely tied to those of other industries and to the performance of the
economy as a whole. Within an industry, the prospects of a specific firm depend not only on
the prospects of the industry to which it belongs, but also on its operating and competitive
position within the industry. The key variable that an investor must monitor in order to
carrying out his fundamental analysis is:
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For most purposes, what is important is the difference between the nominal growth rate
quoted by GDP and the 'real' growth after taking inflation into account. The estimated growth
rate of the economy would be a pointer to the prospects for the industrial sector, and therefore
to the returns investors can expect from investment in share.
Growth Rates of Industrial Sector
This can be further broken down into growth rates of various industries or groups of
industries if required. The growth rates in various industries are estimated based on the
estimated demand for its products.
Inflation
Inflation is measured in terms of either wholesale prices (the Wholesale Price Index or WPI)
or retail prices (Consumer Price Index or CPI). The demand in some industries, particularly
the consumer products industries, is significantly influenced by the inflation rate. Therefore,
firms in these industries make continuous assessment about inflation rates likely to prevail in
the near future so as to fine-tune their pricing, distribution and promotion policies to the
anticipated impact of inflation on demand for their products.
Monsoon
Because of the strong forward and backward linkages, monsoon is of great concern to
investors in the stock market too.
ii)
When an economy grows, it is very unlikely that all industries in the economy would grow at
the same rate. So it is necessary to examine industry specific factors, in addition to economywide factors.
Product Life-Cycle
An industry usually exhibits high profitability in the initial and growth stages, medium but
steady profitability in the maturity stage and a sharp decline in profitability in the last stage of
growth.
Demand Supply Gap
Excess supply reduces the profitability of the industry because of the decline in the unit price
realization, while insufficient supply tends to improve the profitability because of higher unit
price realization.
Barriers to Entry
The Institute of Chartered Accountants of Nepal
67
CAP III
Any industry with high profitability would attract fresh investments. The potential entrants to
the industry, however, face different types of barriers to entry. Some of these barriers are
innate to the product and the technology of production, while other barriers are created by
firms in the industry.
Government Attitude
The attitude of the government towards an industry is a crucial determinant of its prospects.
iii)
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CAP III
69
CAP III
Period
1
2
3
4
5
6
7
8
9
10
Price
22
24
25
24
26
25
24
23
24
21
28
27
26
25
24
23
22
21
20
Chart Patterns
The Dow theory
This is one of the oldest and perhaps the most famous technical theory. It is based on the
principles enunciated in late nineteenth century by Charles Dow, the founder of the Dow
Jones & Co., Dow observed that most stocks move in consonance with the market, going up
when the market goes up and coming down when the market comes down. It is imperative,
therefore, to first understand the behavior of the market as a whole. To do that, he constructed
two indices calling them the Industrial Average and the Rail Average (these have evolved
over time and are now known as the Dow Jones Industrial Average (DJIA) and the Dow
Jones Transportation Average (DJTA)]. These averages reflect he aggregate impact of all
kinds of information on the market. He then postulated that the averages would show three
kinds of trends, the primary trend, the secondary reactions and the minor trends, likening
them to the tides, the waves and the ripples in the ocean. The theory concerns itself only with
the primary trend and the secondary reactions and completely minuscule-term outlook!).
He proposed that the primary uptrend would have three moves up, the first one being caused
by accumulation of shares by the far-sighted, knowledgeable investors, the second move
would be caused by the arrival of the first reports of good earnings by corporations, and the
last move up would be caused by widespread report of financial well-being of corporations.
The third stage would also see rampant speculation in the market. Towards the end of the
third stage, the far-sighted investors, realizing that the high earnings levels may not be
sustained, would start selling, starting the first move down of a downtrend, and as the nonsustainability of high earnings is confirmed, the second move down would be initiated and
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CAP III
then the third move down would result from distress selling in the market.
Market Indicators:
A major indicator of the breadth of the market is the volume of transactions. When
interpreted in conjunction with the index or price, it can provide useful clues on how the
market would behave in the near future. A rising index/price with increasing volume would
signal a buy because the situation reflects an unsatisfied demand in the market. Similarly, a
falling market with increasing volume signals a bear market and the prices would be
expectedly fall further. A rising market with decreasing volume indicates a bull market that is
running out of steam, while a falling market with dwindling volume indicates a bear market
that is becoming breathless. Thus, by combining the index/price and the volume data, a
suitable strategy can be formed for trading.
Another breadth indicator often used by the analysts is the difference between the number of
securities advancing and declining in price.
Siddhartha Bank
Laxmi Bank
177
177
171
171.5
172
175.5
12
174
177
13
177.5
181
14
181
184
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CAP III
15
180
186.5
18
163
176
19
142
162.5
20
127
156
22
123
147
25
124
147
Bhadra 3, 91
107.5
137.5
97.5
140
105
145
10
102.5
143.75
12
108.75
150
15
100
142.5
25
95
135
26
91.25
133.75
Ashwin. 1
97.5
138.75
106.25
147.5
113.75
152.5
120
155
120
152.5
113.75
150
111.375
147.5
The line charts for SBL and LBL shares are shown in Fig. 6.2. From the charts, it appears that
the support level and resistance level for SBL at that time were about Rs. 90 and Rs. 125,
while these levels for LBL were Rs. 134 and 155.
400
350
300
250
200
Laxmi Bank
150
Siddhartha Bank
100
50
1 2 3 4 5 6 7 8 9 101112131415161718192021222324252627
Line Chart
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CAP III
Channel
Wedge
Time
Time
Price
Price
Time
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CAP III
wiling to pay a much higher price to acquire the scrip. Similarly, a gap in a falling market is
an indicator of extreme selling pressure.
Decision Using Data Analysis
Technical analysts have developed rules based on simple statistical analysis of price data.
Weshall discuss some of the more popular methods of data analysis for decision making.
Moving Averages
Moving averages are frequently plotted with prices to make buy and sell decisions. The two
types moving averages used by chartists am the Arithmetic Moving Average (AMA) and the
Exponential Moving Average (EMA). An n-period AMA, at period t, is nothing but the
simple average of last n period prices.
= 1/n[ +
+ ........ +
Unlikely, the AMA, which assigns equal weight of 1/n to each of the n prices used for
computing the average, the Exponential Moving Average (EMA) assigns decreasing weights,
with the highest weight being assigned to the latest price. The weights decrease
exponentially, according to a scheme specified by the exponential smoothing constant, also
known as the exponent, a.
=a +
=a +a
)
+a
+ ........
We will study in detail about Modem Portfolio Theory and the Alpha and Beta of Capital
Asset Pricing Model in the module "Introduction to Capital Market."
Capital Assets Pricing Model (CAPM)
Portfolio theories have undergone revolutionary changes in the last 30 years. The new
approach to portfolio management comprises discussion of Capital Assets Pricing Model
covering the security market line and the Markowitz approach to diversification.
The CAPM distinguishes between risk of holding a single asset and holding a portfolio of
assets. There is a tradeoff between risk and return. Modem portfolio theory concentrates on
risk and stresses on risk management rather than on return management. Risk may be security
risk involving danger of loss of return from an investment in a single financial or capital
asset. Security risk differs from portfolio risk, which is the probability of loss from
investment in a portfolio of assets. Portfolio risk is comprised of unsystematic risk and
systematic risk. Unsystematic risks can be averted through diversification and is related to
random variables. Systematic risk is market related component of portfolio risk. It is
commonly measured by regression coefficient Beta or the Beta coefficient. Low Beta reflects
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CAP III
(i) Efficient market: It is the first assumption of CAPM. Efficient market refers to the
existence of competitive market where financial securities and capital assets are bought
and sold with full information of risk and return available to all participants. In an
efficient market, the price of individual assets will reflect a realm intrinsic value of a
share as the market prices will adjust quickly to any new situation. John .I. Hampton has
remarked in "Financial decision making" that although efficient capital market is not
much relevant to capital budgeting decisions, but CAPM would be useful to evaluate
capital budgeting proposal because the company can compare risk and return to be
obtained by investment in machinery with risk and return from investment in securities.
(ii) Rational investment goals: Investors desire higher return for any acceptable level of risk
or the lowest risk for any desired level of return. Such a rational choice is made on logical
and consistent ranking of proposals in order of preference for higher good to lower good
and this is the scale of the marginal efficiency of capital. Beside, transitive preferences
and certainty equivalents are other parameters of rational choice.
(iii) Risk aversion in efficient market is adhered to although at times risk seeking behavior is
adopted for gains.
(iv) CAPM assumes that all assets are divisible and liquid assets.
(v) Investors are able to borrow freely at a riskless rate of interest i.e. borrowings can fetch
equal return by investing in safe Government securities.
(vi) Securities can be exchanged without payment of brokerage, commissions or taxes and
without any transaction cost.
(vii) Securities or capital assets face no bankruptcy or insolvency.
Based on above assumptions the CAPM is developed with the main goal to formulate the
return required by investors from a single investment or a portfolio of assets. The required
rate of return is defined as the minimum expected return needed so that investors will
purchase and hold an asset.
Risk and return relationship in this model stipulates higher return for higher level of risk and
vice versa. However, there may be exception to this general rule where markets are not
The Institute of Chartered Accountants of Nepal
75
CAP III
efficient.
8.9.2 Modern Approach: During the 1950's Harry Markowitz first developed certain
theories that are supposed to form the basis of modem portfolio management. Other thinkers
and experts have made their contributions over the period of time. The approach heavily
relies on statistical measures to develop a portfolio plan. The modem approach takes into
consideration expected returns, standard deviation of returns of the individual security and
that of the portfolio of securities. Both traditional and modern approaches are based on the
hypothesis that a portfolio reduces risk by diversification. In traditional approach
diversification is a matter of judgernent while in the modern approach diversification is
achieved by combining securities in portfolio in such a way that individual security returns
have negative or low positive correlation between them. Thus statistical tools are used for
diversification.
Guiding principles
(a) Securities must be included in the portfolio which possesses the characteristics of highest
expected returns and lowest expected risks.
(b) To reduce risk of portfolio securities to be included should not merely have highest
expected returns but should also have either low positive or negative correlation.
(c) After the securities are selected by shifting weights of securities, it is possible to obtain
highest returns with minimum risk. The combination or weights of securities in the
portfolio depends on standard deviation of returns and coefficient of correlation.
The total risk is measured by variability of returns in term of standard deviation. Total risk
consists of two types of risks viz. diversifiable risk and non-diversifiable risk (i.e.) Total risk
= Diversifiable risk + non-diversifiable risk.
Diversifiable risk can be traced to the sources like company risk or industry risk which is also
coed unsystematic risk. The sources of such risks can be diversified away by combining
assets in a portfolio. The reduction in total risk resulting from combining the securities into a
portfolio is called the portfolio effect. Non-diversifiable risk is also known as systematic risk.
It arises due to factors that effect all marketable securities systematically and so can not be
diversified away. A change in expected rates of interest for example, influences all
marketable securities and cannot be diversified away.
Portfolio Beta: As the unsystematic risk can be diversified by building a portfolio, the
relevant risk is the non-diversifiable component of the total risk. This can be measured by
using Beta (B) a statistical parameter which measures the market sensitivity of returns. The
beta for the market is equal to 1.0. The B explains the systematic relationship between the
The Institute of Chartered Accountants of Nepal
76
CAP III
return on a security and the return on the market by using a simple linear regression equation.
The return on a security is taken as a dependent variable and the return on market is taken as
independent variable then Ri = Li + Bi Rm + ei. The Beta parameter Bi in this William
Sharpe model represents the slope of the above regression relationship and measures the
sensitivity or responsiveness of the security returns to the general market returns. The
portfolio beta is merely the weighted average of the betas of individual securities included in
the portfolio. Portfolio beta Bi =
Expected
Return
Risk
In the above figure A, B. C,D, and F define the boundary of possible investments. There are
six proposals of investment via. A, B, C, D,E and F out of which three viz., B, C and D are
efficient proposals and as such the line BCD defines the efficient frontier. Out of the efficient
proposals B, C and D the attractiveness of any given proposal to the investor would depend
upon his attitude towards risk. At B, the level of risk is minimum and return is high. At D, the
risk level is greater with highest return. At C, there exists an efficient relationship of risk and
return.
Investors' attitude towards risk as referred to above can be formulized by use of indifference
curves which show the trade-off between risk and return. Indifference curves show the risk
return indifference for hypothetical investor. All the points lying on a given indifference
curve offer the same level of satisfaction.
With the help of efficient frontier and indifference curves, an optimal investment point can he
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CAP III
be located. Optimal investment is achieved at the point at which the indifference curve is at a
tangent to the efficient frontier. The point of tangency reflects the risk level acceptable to the
investor in order to achieve a desired return and provide efficient return for a level of risk as
shown in the following figure:
Indifference Curve
Efficient Frontier
Expecte
d Return
Set of Investors
Optimal Point
Required
Return
Market
Rate of
Return
Market
Portfolio
Risk Free
Rate of
Return
following graph:
Empirical studies indicate that CM is linear. The required rate of return fora portfolio with
higher level of risk will he found to the right of market portfolio on CML and the required
rate of return for a less risky portfolio will be to the left of the market portfolio.
In the Markowitz's efficient model if risk free security is introduced then the point of
tangency of CML to the indifference curve will determine the optimum portfolio.
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CAP III
Expecte
d Return
CML
Market
Rate of
Return B
G
Riskless
Rate of
Return
Risk
0
BoB1
Market
It would be observed from the above figure that under Markowitz position with efficient
frontier, the optimum portfolio was at point B where we have considered only risk bearing
assets. But with the introduction of CML we have introduced the concept of risk-free
securities in the analysis. CML is tangent at point Con the efficient frontier which gives the
maximum market rate of return. The investor can hold portfolio at G where the CML is
tangent to higher indifference curve 3 which gives a mixture of risk free and risk-bearing
assets. As the market portfolio has no diversifiable risk, all portfolio along the CML are
theoretically efficient in which case they have no diversifiable risk and the expected return of
any portfolio along CML is a function of the total risk of the portfolio.
Capital assets pricing model can now be used to estimate the expected return of any portfolio
with the following formula:
E(Rp) = KRf +
p[E(RM)
- Rf]
Where,
E(Rp)
KRf
E(RM)
[E(RM) - Rf]
Illustration
If the risk free rate of interest (Rf) is 10%, portfolio betas are (i) 0.2 and (ii) 0.5 and the
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CAP III
expected return of market portfolio E(RM) is 15%, then the expected return of the portfolio
E(Rp) is clearly a liner function of Beta.
Solution
Using the above formula if portfolio Betas are (i) 0.2 and (ii) 0.5, then will the above rate of
Rf andE(RM), the E(Rp) will be as follows:
(i) E(Rp) =
(ii) E(Rp) =
) of .7 and
2.6% and
2.1%
= .87
Illustration
As an investment manager you are given the following information:
Investment in equity
Initial price
Dividends
shares of
Market price
Beta risk
at the end of
factor
the year
Rs.
Rs.
Rs.
25
50
0.8
Steel Ltd.
35
60
0.7
Liquor Ltd.
45
135
0.5
1,000
140
1,005
0.99
A. Cement Ltd.
B.
Government of Nepal
Bonds
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CAP III
Solution
(i) Let us first calculate the Expected return on Market portfolio.
Total Investment
Dividends
Capital gains
Rs.
Rs.
Rs.
25
25
Steel Ltd.
35
25
Liquor Ltd.
45
90
1,000
140
1,1,05
146
145
A. Cement Ltd.
= 26.33%
Rf
Bp
E(RM)
[E(RM) - Rf]
By substituting the figures in the above equation we can calculate expected rate of returns of
portfolio in each using Capital Assets Pricing Model (CAPM) as under:
Cement Ltd
= 23.86%
Steel Ltd
= 22.63%
Liquor Ltd.
= 20.17%
= 26.21%
= 23.22%
OR
Average of Betas
= (0.8 + 0.7 + 0.5 + 0.99)/4
= 0.7475
= 23.22%
Illustration
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CAP III
Return(%)
12
Risk %
12
(Standard Deviation)
(i) Which of the securities is wall be selected?
(ii) Assuming perfect correlation, analyze whether it is preferable to invest 75% in
security A and 25% in security C.
Solution
(i) Security A has a return of 8% for a risk of 4%, whereas securities B and F have a
higher risk for the same rate of return. Hence security A dominates securities B and F.
For the same degree of risk of 4% security D has only a return of 4%. Hence this
security is also dominated by A. Securities C and E have a higher return as well as a
higher degree of risk.
Hence the securities which will be selected are A, C and E.
(ii) When perfect positive correlation exist between two securities, their risk and return
can be averaged with the proportion. Hence the average value of A and C together for
a proportion of 3:1 for risk and return will be as follows:
Risk ( 3 x 4+ 1 x 12) / 4) = 6%
Return ( 3 x 8+ I x 12)/4 = 9%
Comparing the above average risk and return with security E, it is better to invest in E as it
has lesser risk (5%) for the same return of 9%.
Illustration
The Beta Coefficient of Target Ltd. is 1.4. The company has been maintaining 8% rate of
growth in dividends and earnings. The last dividend paid was Rs. 4 per share. Return on
Government securities is 10%. Return on market portfolio is 15%. The current market price
of one share of Target Ltd. is Rs. 36.
(i) What will be the equilibrium price per share of Target Ltd.?
(ii) Would you advise purchasing the share ?
Solution
(i) CAPM formula = E(Rs) = Rf + b[E(Rm) - Rf]
Where:
E(Rs) = Expected rate of return of the security (OR) the cost of equity
Rf= risk free returns
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82
CAP III
.09
Po
+0.08
= Rs. 48
(ii) The share of Target Ltd. is under valued. (Rs. 36 current market price as against Rs.
48 equilibrium price). Hence it can be purchased.
Illustration
An investor is seeking the price to pay for a security, whose standard deviation is 3.00 per
cent. The correlation coefficient for the security with the market is 0.8 and the market
standard deviation is 2.2 per cent. The return from government securities is 5.2 per cent and
from the market portfolio is 9.8 per cent. The investor knows that, by calculating the required
return, he can then determine the price to pay for the security. What is the required return o
the security?
Solution
Beta coefficient =
= 1.091
Now, required return on the security : Rate of return on risk free security + beta coefficient
(required return on market portfolio - rate of return on risk free security)
= 5.2 + 1.091 (9.8 5.2)
= 5.2 5.02
= 10.22%
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CAP III
Limitations: Like most other quantitative economic models, the limitations of portfolio
theory and the CAPM are the underlying assumptions which hardly hold in practical life
situations: The investors would always wish to go for a maximum return at the lowest
possible risk. The investors are also assumed to be price takers with homogeneous
expectations about assets' return which have a joint normal distribution. It is assumed that the
assets' market is perfect and efficient with costless information; no taxes; no restrictions on
short-selling; and the market has a risk tree return of rate which is hardly the fact of life.
Additionally the assets quantities are fixed and perfectly divisible.
In practical life, however, there are difficulties of estimating the risk free interest rate. This is
usually related to return on Government securities, but there are several such securities with
varying rates of return. Likewise, it is difficult to determine the risk premium. The project
Beta will probably, at best, be an estimate. The firm's equity Beta may not be available if is
not quoted on the stock market. The market beta itself does not include all the securities. Ross
(Wallace, 1980) has argued that because it is impossible to include all investable assets when
estimating market Beta it is impossible to verify the validity of CAPM. He contends that Beta
is meaningless. Sharpe (Wallace, 1980) also agrees that we cannot without a shadow of doubt
establish the validity of CAPM. It is doubtful if the theory developed primarily for securities
portfolio can apply equally to the firms' projects port folio. Additionally, CAPM is a single
period model while most projects are often available only as large indivisible projects
(adoption of half project is not possible). Disinvestment is not easily achieved as in the case
of investment in securities. It is, therefore, more difficult to adjust the portfolio of projects.
Expected returns and associated probabilities are less easy to estimate than for stock market
securities.
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CAP III
precautionary motive and the speculative motive. Funds required for these three purposes
should be so invested (say in marketable securities) as they can be readily available in liquid
form. From the long-term view, the available funds may be cash inflow from operations less
payments require for meeting loan commitments and for dividends to shareholders. It is not
likely that such funds will be invested immediately in long-term projects; they will be
collected for some time and, along with loans and other funds raised through further issue of
capital, invested in a suitable project at the opportune time. In the meantime, they will be
invested as to be available at the required point of time.
The various considerations in this regard are liquidity, safety, yield and image of the
investment. The various considerations may be summarized and an overall view obtained
through a matrix approach by allotting 100 marks for each consideration and then totaling the
marks allotted for each investment being considered. A point to be noted is that the marks to
be allotted in respect of liquidity will depend on the period for which funds can be spared for
example, if funds can be spared for six months, the marks as regards liquidity will be zero in
the case of a deposit required for a minimum period of one year. This means that the matrix
should be prepared separately for the various portions of the funds to be invested.
The marks in respect of yield will be with reference to the maximum available, for example,
if the loan to a trading concern can bring 16%, the marks to be given in respect of fixed
deposit in bank yielding 8% will be only 50. Below is an illustration of the use of the matrix
approach, assuming funds to be invested can be spared for two years.
Investment Matrix
Investment
Liquidity
Safety
Yield
Image
Total
(100
(100
(100
(100
(100
marks)
marks)
marks)
marks)
marks)
100
100
60
100
360
100
90
65
90
345
70
50
80
70
270
Debentures in PQ Ltd.
80
70
70
90
310
50
50
100
50
250
The above would clearly indicate that the investment should be in the form of a fixed deposit
in a commercial bank.
We have thus seen that management of investment portfolio is a complex task and involves a
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CAP III
large number of variables. Not only does it involves a detailed analysis of the economic
conditions, the relative position of various industries, the financial and other strengths of
particular company, but it also involves an understanding of share market prices and their
behavior.
PRACTICE QUESTIONS
Q.N. 1 M/s V Steels Ltd. is planning for a diversification project in Automobile Sector. Its
current equity beta is 1.2, whereas the automobile sector has 1.6. Gearing of automobile
sector is 30% debts, 70% equity. If expected market return is 25%, risk free debt is 10%
and taxation rate is taken as 30% and also that corporate debt is assumed to be risk free,
compute suitable discount rate under the following situations.
(i) Project financed by equity only.
(ii) By 30% debt and 70% equity.
(iii) By 40% debt and 60% equity
Q.N. 2 Two companies are identical in all respects except capital structure. One company AB
Ltd. has a debt equity ratio of 1:4 and its equity has a
company XY Ltd. has a debt equity ratio of 3 : 4. Income Tax is 30%. Estimate
(beta)
Coupon Rate
Purchase rate
Durations
(Years)
G.O.N. 2006
11.68
106.50
3.50
G.O.N. 2010
7.55
105.00
6.50
G.O.N. 2015
7.38
105.00
7.50
G.O.N. 2022
8.35
110.00
8.75
G.O.N. 2032
7.95
101.00
13.00
Face value of total investment if Rs. 5 crores in each Government Bond. Calculate actual
Investment in portfolio. What is suitable action to churn out investment portfolio in the
following scenario?
1. Interest rates are expected to lower by 25 basis points
2. Interest rates are expected to raise by 75 basis points
Also calculate the revised duration of investment portfolio in each scenario.
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86
CAP III
MUTUAL FUND
A mutual fund is a form of collective investment that pools money from investors and invests
the money in stocks, bonds, short-term money-market instruments, and/or other securities.
The fund manager trades the fund's underlying securities, realizing a gain or loss, and collects
the dividend or interest income. The investment proceeds are then passed on to the individual
investors.
The rationale behind a mutual fund is that there are large numbers of investors who lack the
time and/ or the skills to manage their money. Hence professional fund managers, acting on
behalf of the Mutual Fund, manage the investments (investor's money) for their benefit in
return for a management fee. Thus a Mutual Fund is the most suitable investment for the
common man as it offers an opportunity to invest in a diversified, professionally managed
basket of securities at a relatively low cost.
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CAP III
diversify its portfolio because of the large corpus. However, a small investor cannot have a
well-diversified portfolio because it calls for large investment.
Convenience: Mutual funds offer tailor-made solutions like systematic investment plans and
systematic withdrawal plans, which are very convenient to investors. Also, investors do not
have to worry about the investment decisions or deal with their brokerage or depository, etc.
for buying or selling of securities. Mutual funds also offer specialized schemes like
retirement plan, children's plan, industry specific schemes, etc. to suit personal preferences of
investors. These schemes also help small investors with asset allocation of their corpus. It
also saves a lot of paper work. When the open ended schemes are offered, they are available
for purchase/sale at any time through Distributing agents in their own city.
Cost effectiveness: A small investor will find that a mutual fund route is a cost effective
method. As per the provision made in the Mutual Fund Regulation, 2067, the total fee that
can be charged on a mutual fund for fund management, supervisory and depository is
maximum of 3 percent of NAV per annum and they also save a lot of transaction costs as the
fund may get considerable discount on brokerages. Another advantage is that they get the
service of a financial professional for a very small fee. If they were to seek a financial
advisor's help directly, they may end up paying more. Also, to get the service of investment
experts who offer portfolio management, the size of the corpus should be large enough.
Liquidity: Investors can liquidate their investments anytime they want. Most mutual funds
dispatch checks for redemption proceeds within a short span of time, in case of open end
fund. In case of close ended found, since the units are generally listed on the stock exchange,
investors can sell their units there.
Tax exemption: Usually, in most countries, investors do not have to pay any taxes on
dividends issued by mutual funds. Also, the schemes are exempted from income tax, which
ultimately is a benefit to the unit holders. In case of Nepal, there are initiatives taken by
SEBON and MoF for giving tax incentives to the mutual fund schemes in a manner similar to
international practices. If this incentive is announced, mutual fund investors also may have
taxation advantage.
Transparency: Mutual funds publish weekly NAVs of schemes, which help the investor,
monitor their investments on a regular basis. In addition, they also get periodic information
that gives details of the portfolio, performance of schemes against various benchmarks, etc.
They are also well regulated, where Fund Supervisors and SEBON monitor their actions
STRUCTURE OF MUTUAL FUND IN NEPAL
There may be different organizational structures of Mutual Funds in different jurisdictions. In
case of Nepal, Mutual Fund Regulation, 2067 has conceptualized the structure of mutual fund
with Fund Sponsor, Fund Supervisor, Fund Manager and Depository. This regulation has also
stated the roles of each of these parts of the mutual fund. The following picture can bring
clarity about the Mutual Fund structure in Nepal. The example is based on mutual fund
operated by Siddhartha Capital Ltd.
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CAP III
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CAP III
comparatively high risk. These schemes provide different options to the investors like
dividend option, capital appreciation option, etc. and the investors may choose an option
depending on their preferences. These funds also allow the investors to change the options at
a later date. Growth schemes are good for investors having a long-term outlook seeking
appreciation over a period of time.
Income/Debt Oriented Schemes
The aim of income funds is to provide regular and steady income to investors. Such schemes
generally invest in fixed income securities such as bonds, corporate debentures, government
securities and money market instruments. They are less risky as compared to equity schemes.
These funds are not affected by the fluctuations in equity markets. However, opportunities of
capital appreciation are also limited in such funds. The NAVs of such funds are affected
because of change in interest rates in the country. If the interest rates fall, NAVs of are likely
to increase in the short run and vice versa. However, long term investors need not bother
about these fluctuations.
Balanced Funds
The aim of balanced funds is to provide both growth and regular income. These schemes
invest in both equities and fixed income securities in the proportion indicated in their offer
documents. These are appropriate for investors looking for moderate growth. They generally
invest 40-60% in equity and rest in debt instruments. These funds are also affected because of
fluctuations in share prices in the stock markets and interest rates. However, NAVs of such
funds are likely to be less volatile compared to pure equity funds.
Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of
capital and moderate income. These schemes invest exclusively in safer short-term
instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank
call money, government securities, etc. Returns on these schemes fluctuate much less
compared to other funds. These funds are appropriate for corporate and individual investors
as a means to park their surplus funds for short periods.
Index Funds
Index Funds replicate the portfolio of a particular index of the stocks listed in a particular
stock exchange. NAVs of such schemes rise or fall in accordance with the rise or fall in the
index, though not exactly by the same percentage due to some factors known as "tracking
error" in technical terms. Necessary disclosures in this regard are made in the offer document
of the mutual fund schemes..
Sector specific funds/schemes
These are the funds/schemes which invest in the securities of only those sectors or industries
as specified in the offer document such as Pharmaceuticals, Software, Fast Moving Consumer
Goods (FMCG), Petroleum stocks, Real estate, Infrastructure etc. The returns in these funds
are dependent on the performance of the respective sectors/industries. While these funds may
give higher returns, they are more risky compared to diversified funds. Investors need to keep
a watch on the performance of those sectors/industries while making investment decisions.
They may also require seeking advice of an expert or getting proper counseling/information
from a fund manager.
PRACTICAL ASPECTS
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The unit price of Mutual Fund ABC is Rs. 10. The public officer price (POP) of the unit is
Rs. 10.204 and the redemption price is Rs. 9.80.
You are required to calculate:
i) Front-end load, and
ii) Back-end load.
Calculation of Front-end Load (F):
Public offer price = Net asset value
1 Front-end load
Substituting the value of POP and net asset value, we get:
Rs. 10.204 = Rs. 10/(1 F)
Or, 10.204 10.204 F = 10,
Or, F = 0.204/10.204 = 0.01999.
Front-end load = 2%.
iii) Calculation of Back-end Load (B):
Redemption price = Net asset value
1 + Back-end load
Rs. 9.80 = Rs. 10/(1 + B)
Or, 9.80 + 9.80 B = 10,
Or, B = 0.20/9.80 = 0.0204.
Back-end load = 2.04%.
PRACTICE QUESTION
Q.N 1 A mutual fund had a net asset value (NAV) of Rs. 50 at the beginning of the year.
During the year a sum of Rs. 4 was distributed as income (dividend) besides Rs. 3 as capital
gains distribution. At the end of the year, NAV was Rs. 55. Calculate total return for the year.
b) Suppose further the aforesaid Mutual fund in the next year gives a dividend of Rs.
5 as income distribution and no capital gains distribution and NAV at the end of second year
is Rs. 50. What is the return for the second year?
Q. N. 2
Date of investment
Amount invested
NAV at the date of investment
Amount of dividend received
NAV at the end of the year
Calculate annualized
MFA
1.1.2014
Rs. 5,25,000
Rs. 105
Rs. 10,000
Rs. 105,625
MFB
1.2.2014
Rs. 1,70,000
Rs. 85
Rs. 5,000
Rs. 85.05
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The quality control policies and procedures of every firm should be documented and
communicated to the firms personnel. Such communication describes the quality control
policies and procedures and the objectives they are designed to achieve, and includes the
message that each individual has a personal responsibility for quality and is expected to
comply with these policies and procedures.
Leadership Responsibilities for Quality within the Firm
The firm should establish policies and procedures designed to promote an internal culture
based on the recognition that quality is essential in performing engagements. Such policies
and procedures should require the firms chief executive officer (or equivalent) or, if
appropriate, the firms managing board of partners (or equivalent), to assume ultimate
responsibility for the firms system of quality control. The firms leadership and the examples
it sets significantly influence the internal culture of the firm. The promotion of a qualityoriented internal culture depends on clear, consistent and frequent actions and messages from
all levels of the firms management emphasizing the firms quality control policies and
procedures, and the requirement to:
(a) Perform work that complies with professional standards and regulatory and legal
requirements; and
(b) Issue reports that are appropriate in the circumstances.
Such actions and messages encourage a culture that recognizes and rewards high quality
work. They may be communicated through training seminars, meetings, formal or informal
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dialogue, mission statements, newsletters, or briefing memoranda. They are also incorporated
in the firms internal documentation and training materials and in partner and staff appraisal
procedures such that they will support and reinforce the firms view on the importance of
quality and how, practically, it is to be achieved.
Firms leadership should consider the fact that firms business strategy may override firm
objective to achieve quality in all the engagements. In such case firm should considered the
following:
a. Firm assigns its management responsibilities so that commercial considerations do not
override the quality of work performed;
b. The firms policies and procedures addressing performance evaluation, compensation,
and promotion (including incentive systems) with regard to its personnel, are designed to
demonstrate the firms overriding commitment to quality; and
c. The firm devotes sufficient resources for the development, documentation and support of
its quality control policies and procedures.
Any person or persons assigned operational responsibility for the firms quality control
system by the firms chief executive officer or managing board of partners should have
sufficient and appropriate experience and ability, and the necessary authority, to assume that
responsibility. Sufficient and appropriate experience and ability enables the responsible
person or persons to identify and understand quality control issues and to develop appropriate
policies and procedures. Necessary authority enables the person or persons to implement
those policies and procedures.
Ethical Requirements
The firm should establish policies and procedures designed to provide it with reasonable
assurance that the firm and its personnel comply with relevant ethical requirements. Ethical
requirements relating to audits and reviews of historical financial information, and other
assurance and related services engagements ordinarily comprise following fundamental
principles:
a. Integrity;
b. Objectivity;
c. Professional competence and due care;
d. Confidentiality; and
e. Professional behavior
f. Independence
The firms policies and procedures should emphasize above stated fundamental principles,
which should be reinforced by:
a.
b.
c.
d.
firms leadership,
education and training,
monitoring, and
process for dealing with non-compliance.
Independence
Every firm should set up policies and procedures designed to provide it with reasonable
assurance that the firm, its employee and experts contracted by the firm and network firm
employee maintain independence where required by the ICAN Code of Ethics and other
national ethical requirements. Such policies and procedures should enable the firm to:
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Therefore, the firm establishes criteria for determining the need for safeguards to address this
threat. In determining appropriate criteria, the firm considers such matters as (a) the nature of
the engagement, including the extent to which it involves a matter of public interest, and (b)
the length of service of the senior personnel on the engagement. Examples of safeguards
include rotating the senior personnel or requiring an engagement quality control review.
Acceptance and Continuance of Client Relationships and Specific Engagements
The firm should establish policies and procedures for the acceptance and continuance of
client relationships and specific engagements, designed to provide it with reasonable
assurance that it will only undertake or continue relationships and engagements where it:
a. Has considered the integrity of the client and does not have information that would lead it
to conclude that the client lacks integrity;
b. Is competent to perform the engagement and has the capabilities, time and resources to do
so; and
c. Can comply with ethical requirements.
The firm should obtain such information as it considers necessary in the circumstances before
accepting an engagement with a new client, when deciding whether to continue an existing
engagement, and when considering acceptance of a new engagement with an existing client.
Where issues have been identified, and the firm decides to accept or continue the client
relationship or a specific engagement, it should document how the issues were resolved.
Examples to consider integrity of the clients
- The identity and business reputation of the clients principal owners, key management,
related parties and those charged with its governance.
- The nature of the clients operations, including its business practices.
- Information concerning the attitude of the clients principal owners, key management and
those charged with its governance towards such matters as aggressive interpretation of
accounting standards and the internal control environment.
- Whether the client is aggressively concerned with maintaining the firms fees as low as
possible.
- Indications of an inappropriate limitation in the scope of work.
- Indications that the client might be involved in money laundering or other criminal
activities.
- The reasons for the proposed appointment of the firm and non reappointment of the
previous firm.
Further firm will gain extent of knowledge regarding integrity of client through ongoing
relationship with that client.
Sources from which the firm may obtain information regarding client integrity:
- Communications with existing or previous providers of professional accountancy services
to the client in accordance with the ICAN Code of Ethics
- Discussions with other third parties.
- Enquiry of other firm personnel or third parties such as bankers, legal counsel and
industry peers.
- Background searches of relevant databases.
Factors to be considered on assessing firm capabilities, competence, time and resources to
undertake a new engagement from a new or an existing client:
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Where the firm obtains information that would have caused it to decline an engagement if
that information had been available earlier, policies and procedures on the continuance of the
engagement and the client relationship should include consideration of:
a. The professional and legal responsibilities that apply to the circumstances, including
whether there is a requirement for the firm to report to the person or persons who made
the appointment or, in some cases, to regulatory authorities; and
b. The possibility of withdrawing from the engagement or from both the engagement and
the client relationship.
Policies and procedures on withdrawal from an engagement and or client:
- Discussing with the appropriate level of the clients management and those charged with
its governance regarding the appropriate action that the firm might take based on the
relevant facts and circumstances.
- If the firm determines that it is appropriate to withdraw, discussing with the appropriate
level of the clients management and those charged with its governance withdrawal from
the engagement or from both the engagement and the client relationship, and the reasons
for the withdrawal.
- Considering whether there is a professional, regulatory or legal requirement for the firm
to remain in place, or for the firm to report the withdrawal from the engagement, or from
both the engagement and the client relationship, together with the reasons for the
withdrawal, to regulatory authorities.
- Documenting significant issues, consultations, conclusions and the basis for the
conclusions.
Human Resources
Firm should establish policies and procedures designed to provide it with reasonable
assurance that it has sufficient personnel with the capabilities, competence, and commitment
to ethical principles necessary to perform its engagements in accordance with professional
standards and regulatory and legal requirements and to enable the firm or engagement
partners to issue reports that are appropriate in the circumstances. Such policies and
procedures address the following personnel issues:
a. Recruitment;
b. Performance evaluation;
c. Capabilities;
d. Competence;
e. Career development;
f. Promotion;
g. Compensation; and
h. The estimation of personnel needs.
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The continuing competence of the firms personnel depends on continuing training for all
levels of firm personnel, and provides the necessary training resources and assistance to
enable personnel to develop and maintain the required capabilities and competence. When
internal technical and training resources are unavailable, the firm may use suitably qualified
external person for that particular assignment.
Assignment of Engagement Teams
The firm should assign responsibility for each engagement to an engagement partner. The
firm should establish policies and procedures requiring that:
a. The identity and role of the engagement partner are communicated to key members of
client management and those charged with governance;
b. The engagement partner has the appropriate capabilities, competence, authority and time
to perform the role; and
c. The responsibilities of the engagement partner are clearly defined and communicated to
that partner.
The firm should also assign appropriate staff with the necessary capabilities, competence and
time to perform engagements in accordance with professional standards and regulatory and
legal requirements, and to enable the firm or engagement partners to issue reports that are
appropriate in the circumstances.
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ENGAGEMENT PERFORMANCE
The firm should establish policies and procedures designed to provide it with reasonable
assurance that engagements are performed in accordance with professional standards and
regulatory and legal requirements, and that the firm or the engagement partner issue reports
that are appropriate in the circumstances. This includes:
- Briefing the objective of the engagement
- Processes for complying with applicable engagement standards
- Processes of engagement supervision, staff training and coaching.
- Methods of reviewing the work performed, the significant judgements made and the form
of report being issued.
- Appropriate documentation of the work performed and of the timing and extent of the
review.
- Processes to keep all policies and procedures current.
Supervision includes:
- Tracking the progress of the engagement.
- Considering the capabilities and competence of individual members of the engagement
team, whether they have sufficient time to carry out their work, whether they understand
their instructions and whether the work is being carried out in accordance with the
planned approach to the engagement.
- Addressing significant issues arising during the engagement, considering their
significance and modifying the planned approach appropriately.
- Identifying matters for consultation or consideration by more experienced engagement
team members during the engagement.
Review includes:
- The work has been performed in accordance with professional standards and
regulatory and legal requirements;
- Significant matters have been raised for further consideration;
- Appropriate consultations have taken place and the resulting conclusions have been
documented and implemented;
- There is a need to revise the nature, timing and extent of work performed;
- The work performed supports the conclusions reached and is appropriately
documented;
- The evidence obtained is sufficient and appropriate to support the report; and
- The objectives of the engagement procedures have been achieved.
Consultation
The firm should establish policies and procedures designed to provide it with reasonable
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assurance that:
a. Appropriate consultation takes place on difficult or contentious matters;
b. Sufficient resources are available to enable appropriate consultation to take place;
c. The nature and scope of such consultations are documented; and
d. Conclusions resulting from consultations are documented and implemented.
Consultation includes discussion, at the appropriate professional level, with individuals
within or outside the firm who have specialized expertise, to resolve a difficult or contentious
matter.
Consultation uses appropriate research resources as well as the collective experience and
technical expertise of the firm. It helps to promote quality and improves the application of
professional judgment which requires discussion with those having appropriate knowledge,
seniority and experience within the firm (or, where applicable, outside the firm) on
significant technical, ethical and other matters, and appropriate documentation and
implementation of conclusions resulting from consultations.
Differences of Opinion
The firm should establish policies and procedures for dealing with and resolving differences
of opinion within the engagement team, with those consulted and, where applicable, between
the engagement partner and the engagement quality control reviewer. Any conclusions
reached should be documented and implemented.
Such procedures encourage identification of differences of opinion at an early stage, provide
clear guidelines as to the successive steps to be taken thereafter, and require documentation
regarding the resolution of the differences and the implementation of the conclusions
reached. The report should not be issued until the matter is resolved.
A firm using a suitably qualified external person to conduct an engagement quality control
review recognizes that differences of opinion can occur and establishes procedures to resolve
such differences, for example, by consulting with another practitioner or firm, or a
professional or regulatory body.
Engagement Quality Control Review
The firm should establish policies and procedures requiring, for appropriate engagements, an
engagement quality control review that provides an objective evaluation of the significant
judgments made by the engagement team and the conclusions reached in formulating the
report. Such policies and procedures should:
a. Require an engagement quality control review for all audits of financial statements of
listed entities;
b. Set out criteria against which all other audits and reviews of historical financial
information, and other assurance and related services engagements should be evaluated to
determine whether an engagement quality control review should be performed; and
c. Require an engagement quality control review for all engagements meeting the criteria
established above.
The firms policies and procedures should require the completion of the engagement quality
control review before the report is issued. The firm should establish policies and procedures
setting out:
a. The nature, timing and extent of an engagement quality control review;
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New developments in professional standards and regulatory and legal requirements, and
how they are reflected in the firms policies and procedures where appropriate;
Written confirmation of compliance with policies and procedures on independence;
Continuing professional development, including training; and
Decisions related to acceptance and continuance of client relationships and specific
engagements.
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Engagement Performance
The engagement partner should take responsibility for the direction, supervision and
performance of the audit engagement in compliance with professional standards and
regulatory and legal requirements, and for the auditors report that is issued to be appropriate
in the circumstances.
The engagement partner directs the audit engagement by informing the members of the
engagement team of:
(a) Their responsibilities;
(b) The nature of the entitys business;
(c) Risk-related issues;
(d) Problems that may arise; and
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Differences of Opinion
Where differences of opinion arise within the engagement team, with those consulted and,
where applicable, between the engagement partner and the engagement quality control
reviewer, the engagement team should follow the firms policies and procedures for dealing
with and resolving differences of opinion.
Engagement Quality Control Review
For audits of financial statements of listed entities, the engagement partner should:
a. Determine that an engagement quality control reviewer has been appointed;
b. Discuss significant matters arising during the audit engagement, including those
identified during the engagement quality control review, with the engagement quality
control reviewer; and
c. Not issue the auditors report until the completion of the engagement quality control
review.
An engagement quality control review should include an objective evaluation of:
a. The significant judgments made by the engagement team; and
b. The conclusions reached in formulating the auditors report.
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An engagement quality control review for audits of financial statements of listed entities
includes considering the following:
a. The engagement teams evaluation of the firms independence in relation to the specific
audit engagement.
b. Significant risks identified during the engagement
c. Judgments made, particularly with respect to materiality and significant risks.
d. Whether appropriate consultation has taken place on matters involving differences of
opinion or other difficult or contentious matters, and the conclusions arising from those
consultations.
e. The significance and disposition of corrected and uncorrected misstatements identified
during the audit.
f. The matters to be communicated to management and those charged with governance and,
where applicable, other parties such as regulatory bodies.
g. Whether audit documentation selected for review reflects the work performed in relation
to the significant judgments and supports the conclusions reached.
h. The appropriateness of the auditors report to be issued.
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Comfort reviews
Number of firms, for their largest clients (not necessarily high risk clients), feel a little
exposed and want someone else to review the work before the job is complete.
Training reviews
Where key audit staff have left, a manager-style review on files may be undertaken in
order to train a new manager or partner.
Independence reviews
Some sole practitioners require an outside review to ensure that it is reasonable for them
to maintain an audit assignment when independence might be called into question. This is
particularly the case where individuals have been an audit partner for more than seven
years.
NSQC reviews
The ISQC1: Quality control for firms that perform audits and reviews of historical
financial information, and other assurance and related services engagements, requires an
independent hot review for all listed work and certain other high profile or high risk work.
To summarize, hot review is conducted during the audit work is conducted but before the
auditors report is issued with a prime objective to ensure compliance with relevant auditing
standards and achieving engagements objectives
Cold file review:
Cold file review or cold review is an objective evaluation on the date of auditors report and
is performed by the auditor i.e. partner himself when all the audit work has been concluded
and the required sufficient appropriate audit evidence has been obtained and conclusions
drawn and reported. This review usually takes place when the auditors report is signed off.
The purpose of this review is to ensure compliance with relevant auditing standards and to
analyze weaknesses in the way whole audit work is conducted and how it can be improved
for next similar assignments by updating firms quality control standards, training the staff
etc.
Normally the cold file review would aim to:
Identify whether the disclosure requirements had been properly met - incorrect
disclosures are the largest subject of complaints to the Institute.
Identify whether the Auditing Standards and Regulations have been properly complied
with - each audit would be "scored" using a comprehensive file review checklist.
Assess the effectiveness of any independent manager review and the partner review,
looking for any points that should have been picked up by a manager but had not been,
and likewise with the partner.
To summarize, cold review is conducted with a view to check for the weaknesses in the
firms quality control procedures and system, proficiency of audit team members and how
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they can be improved to make later audit assignment more effective and efficient.
NEPAL AUDITING PRACTICE STATEMENTS
NAPS 101 AUDITS OF THE FINANCIAL STATEMENTS OF BANKS
Introduction
The purpose of this Statement is to provide practical assistance to auditors and to promote
good practice in applying Nepal Standards on Auditing (NSAs) to the audit of banks
financial statements. Banking supervisors require that the auditor report certain events to the
regulators or make regular reports to them in addition to the audit report on the banks
financial statements. This Statement does not deal with such reports.
For this Statement, a bank is a type of financial institution whose principal activity is the
taking of deposits and borrowing for the purpose of lending and investing and that is
recognized as a bank by the regulatory authorities in the country. There are a number of other
types of entity that carry out similar functions, for example, cooperative societies, savings
and loan associations, NGOs and INGOs. The guidance in this Statement is applicable to
audits of financial statements that cover the banking activities carried out by those entities. It
also applies to the audits of consolidated financial statements that include the results of
banking activities carried out by any group member. This Statement addresses the assertions
made in respect of banking activities in the entitys financial statements and so indicates
which assertions in a banks financial statements cause particular difficulties and why they do
so. This necessitates an approach based on the elements of the financial statements. However,
when obtaining audit evidence to support the financial statement assertions, the auditor often
carries out procedures based on the types of activities the entity carries out and the way in
which those activities affect the financial statement assertions.
Banks commonly undertake a wide range of activities. However, most banks continue to have
in common the basic activities of deposit taking, borrowing, lending, settlement, trading and
treasury operations. This Statements primary purpose is the provision of guidance on the
audit implications of such activities. In addition, this Statement provides limited guidance in
respect of securities underwriting and brokerage, and asset management, which are activities
that auditors of banks financial statements frequently encounter.
This Statement is intended to highlight those risks that are unique to banking activities. There
are many audit-related matters that banks share with other commercial entities. The auditor is
expected to have a sufficient understanding of such matters and so, although those matters
may affect the audit approach or may have a material affect on the banks financial
statements, this Statement does not discuss them. This Statement describes in general terms
aspects of banking operations with which an auditor becomes familiar before undertaking the
audit of a banks financial statements: it is not intended to describe banking operations.
Consequently, this Statement on its own does not provide an auditor with sufficient
background knowledge to undertake the audit of a banks financial statements. However, it
does point out areas where that background knowledge is required. Auditors will supplement
the guidance in this Statement with appropriate reference material and by reference to the
work of experts as required.
Banks have the following characteristics that generally distinguish them from most other
commercial enterprises:
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They have custody of large amounts of monetary items, including cash and negotiable
instruments, whose physical security has to be safeguarded during transfer and while
being stored. They also have custody and control of negotiable instruments and other
assets that are readily transferable in electronic form. The liquidity characteristics of these
items make banks vulnerable to misappropriation and fraud. Banks therefore need to
establish formal operating procedures, well-defined limits for individual discretion and
rigorous systems of internal control.
They often engage in transactions that are initiated in one jurisdiction, recorded in a
different jurisdiction and managed in yet another jurisdiction. (for example counter
guarantee)
They operate with very high leverage (that is, the ratio of capital to total assets is low),
which increases banks vulnerability to adverse economic events and increases the risk of
failure.
They have assets that can rapidly change in value and whose value is often difficult to
determine. Consequentially a relatively small decrease in asset values may have a
significant effect on their capital and potentially on their regulatory solvency.
They generally derive a significant amount of their funding from short-term deposits
(either insured or uninsured). A loss of confidence by depositors in a banks solvency
may quickly result in a liquidity crisis.
They have fiduciary duties in respect of the assets they hold that belong to other persons.
This may give rise to liabilities for breach of trust. They therefore need to establish
operating procedures and internal controls designed to ensure that they deal with such
assets only in accordance with the terms on which the assets were transferred to the bank.
They engage in a large volume and variety of transactions whose value may be
significant. This ordinarily requires complex accounting and internal control systems and
widespread use of information technology (IT).
They ordinarily operate through networks of branches and departments that are
geographically dispersed. This necessarily involves a greater decentralisation of authority
and dispersal of accounting and control functions, with consequential difficulties in
maintaining uniform operating practices and accounting systems, particularly when the
branch network transcends national boundaries.
Transactions can often be directly initiated and completed by the customer without any
intervention by the banks employees, for example over the Internet or through automatic
teller machines (ATMs).
They often assume significant commitments without any initial transfer of funds other
than, in some cases, the payment of fees. These commitments may involve only
memorandum accounting entries. Consequently their existence may be difficult to detect.
They are regulated by governmental authorities, whose regulatory requirements often
influence the accounting principles that banks follow.
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The objective of the audit of a banks financial statements conducted in accordance with
NSAs is, therefore, to enable the auditor to express an opinion on the banks financial
statements, which are prepared in accordance with an identified financial reporting
framework. The auditors report indicates the financial reporting framework that has been
used to prepare the banks financial statements (including identifying the country of origin of
the financial reporting framework when the framework used is not International Accounting
Standards). When reporting on financial statements of a bank prepared specifically for use in
a country other than that under whose rules it is established, the auditor considers whether the
financial statements contain appropriate disclosures about the financial reporting framework
used on that particular country.
Agreeing the Terms of the Engagement
The engagement letter documents and confirms the auditors acceptance of the appointment,
the objective and scope of the audit, the extent of the auditors responsibilities to the client
and the form of any reports.
Following are the list of characteristics that are unique to banks and indicate the areas where
the auditor and audit assistants may require specialist skills:
The need for sufficient expertise in the aspects of banking relevant to the audit of the
banks business activities.
The need for expertise in the context of the IT systems and communication networks the
bank uses.
The adequacy of resources or inter-firm arrangements to carry out the work necessary at
the number of domestic and international locations of the bank at which audit procedures
may be required.
In addition to the general factors set out in NSA 02, the auditor considers including
comments on the following when issuing an engagement letter:
The use and source of specialized accounting principles, with particular reference to:
- Any requirements contained in the law or regulations applicable to banks;
- Pronouncements of the banking supervisory and other regulatory authorities;
- Pronouncements of relevant professional accounting bodies, for example, the Nepal
Accounting Standards Board;
- Pronouncements of the Basel Committee on Banking Supervision if made applicable
by the regulatory authorities; and
- Industry practice.
The contents and form of the auditors report on the financial statements and any specialpurpose reports required from the auditor in addition to the report on the financial
statements. This includes whether such reports refer to the application of regulatory or
other special purpose accounting principles or describe procedures undertaken especially
to meet regulatory requirements.
The nature of any special communication requirements or protocols that may exist
between the auditor and the banking supervisory and other regulatory authorities.
The access that bank supervisors will be granted to the auditors working papers when
such access is required by law, and the banks advance consent to this access.
Planning the Audit
Introduction
The audit plan includes, among other things:
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Obtaining a sufficient knowledge of the entitys business and governance structure, and a
sufficient understanding of the accounting and internal control systems, including risk
management and internal audit functions;
Considering the expected assessments of inherent and control risks, being the risk that
material misstatements occur (inherent risk) and the risk that the banks system of internal
control does not prevent or detect and correct such misstatements on a timely basis
(control risk);
Determining the nature, timing and extent of the audit procedures to be performed; and
Considering the going concern assumption regarding the entitys ability to continue in
operation for the foreseeable future, which will be the period used by management in
making its assessment under the financial reporting framework. This period will
ordinarily be for a period of at least one year after the balance sheet date.
Obtaining a Knowledge of the Business
Obtaining knowledge of the banks business requires the auditor to understand:
The banks corporate governance structure;
The economic and regulatory environment prevailing for the principal countries in which
the bank operates; and
The market conditions existing in each of the significant sectors in which the bank
operates
Corporate governance plays a particularly important role in banks; many regulators set out
requirements for banks to have effective corporate governance structures. Accordingly the
auditor obtains an understanding of the banks corporate governance structure and how those
charged with governance discharge their responsibilities for the supervision, control and
direction of the bank.
There are a number of risks associated with banking activities that, while not unique to
banking, are important in that they serve to shape banking operations. The auditor obtains an
understanding of the nature of these risks and how the bank manages them.
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Liquidity risk
Operational
risk
Regulatory
risk
Reputational
risk
assets will turn out to be worth less or liabilities will turn out to be greater
than expected because of inadequate or incorrect legal advice or
documentation. In addition, existing laws may fail to resolve legal issues
involving a bank; a court case involving a particular bank may have wider
implications for the banking business and involve costs to it and many or all
other banks; and laws affecting banks or other commercial enterprises may
change. Banks are particularly susceptible to legal risks when entering into
new types of transactions and when the legal right of counterparty to enter
into a transaction is not established.
The risk of loss arising from the changes in the banks ability to sell or
dispose of an asset.
The risk of direct or indirect loss resulting from inadequate or failed internal
processes, people and systems or from external events
The risk of loss arising from failure to comply with regulatory or legal
requirements in the relevant jurisdiction in which the bank operates. It also
includes any loss that could arise from changes in regulatory requirements.
The risk of losing business because of negative public opinion and
consequential damage to the banks reputation arising from failure to
properly manage some of the above risks, or from involvement in improper
or illegal activities by the bank or its senior management, such as money
laundering or attempts to cover up losses.
Banks may be subject to risks arising from the nature of their ownership. For example, a
banks owner or a group of owners might try to influence the allocation of credit. In a closely
held bank, the owners may have significant influence on the banks management affecting
their independence and judgment. The auditor considers such risks.
Factors that contribute significantly to operational risk include the following:
The need to process high volumes of transactions accurately within a short time. This
need is almost always met through the large-scale use of IT, with the resultant risks of:
- Failure to carry out executed transactions within the required time, causing an
inability to receive or make payments for those transactions;
- Failure to carry out complex transactions properly;
- Wide-scale misstatements arising from a breakdown in internal control;
- Loss of data arising from systems failure;
- Corruption of data arising from unauthorized interference with the systems; and
- Exposure to market risks arising from lack of reliable up-to date information.
The need to use electronic funds transfer (EFT) or other telecommunications systems to
transfer ownership of large sums of money, with the resultant risk of exposure to loss
arising from payments to incorrect parties through fraud or error.
The conduct of operations in many locations with a resultant geographic dispersion of
transaction processing and internal controls. As a result:
- There is a risk that the banks worldwide exposure by customer and by product may
not be adequately aggregated and monitored; and
- Control breakdowns may occur and remain undetected or uncorrected because of the
physical separation between management and those who handle the transactions.
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The need to monitor and manage significant exposures that can arise over short timeframes. The process of clearing transactions may cause a significant build-up of
receivables and payables during a day, most of which are settled by the end of the day.
This is ordinarily referred to as intra-day payment risk. These exposures arise from
transactions with customers and counterparties and may include interest rate, currency
and market risks.
The handling of large volumes of monetary items, including cash, negotiable instruments
and transferable customer balances, with the resultant risk of loss arising from theft and
fraud by employees or other parties.
The inherent complexity and volatility of the environment in which banks operate,
resulting in the risk of inappropriate risk management strategies or accounting treatments
in relation to such matters as the development of new products and services.
Operating restrictions may be imposed as a result of the failure to adhere to laws and
regulations. Overseas operations are subject to the laws and regulations of the countries in
which they are based as well as those of the country in which the parent entity has its
headquarters. This may result in the need to adhere to differing requirements and a risk
that operating procedures that comply with regulations in some jurisdictions do not meet
the requirements of others.
Understanding the Risk Management Process
Management develops controls and uses performance indicators to aid in managing key
business and financial risks. An effective risk management system in a bank generally
requires the following:
Oversight and involvement in the control process by those charged with Governance
Those charged with governance should approve written risk management policies. The
policies should be consistent with the banks business strategies, capital strength,
management expertise, regulatory requirements and the types and amounts of risk it
regards as acceptable. Those charged with governance are also responsible for
establishing a culture within the bank that emphasises their commitment to internal
controls and high ethical standards, and often establish special committees to help
discharge their functions. Management is responsible for implementing the strategies and
policies set by those charged with governance and for ensuring that an adequate and
effective system of internal control is established and maintained.
Identification, measurement and monitoring of risks
Risks that could significantly impact the achievement of the banks goals should be
identified, measured and monitored against pre-approved limits and criteria. This function
may be conducted by an independent risk management unit, which is also responsible for
validating and stress testing the pricing and valuation models used by the front and back
offices. Banks ordinarily have a risk management unit that monitors risk management
activities and evaluates the effectiveness of risk management models, methodologies and
assumptions used. In such situations, the auditor considers whether and how to use the
work of that unit.
Control activities
A bank should have appropriate controls to manage its risks, including effective
segregation of duties (particularly between front and back offices), accurate measurement
and reporting of positions, verification and approval of transactions, reconciliations of
positions and results, setting of limits, reporting and approval of exceptions to limits,
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c. Detection risk (the risk that the auditor will not detect any remaining material
misstatements).
Inherent and control risks exist independently of the audit of financial information and the
auditor cannot influence them. The nature of risks associated with banking activities are
assessed level of inherent risk in many areas will be high. It is therefore necessary for a
bank to have an adequate system of internal control if the levels of inherent and control
risks are to be less than high. The auditor assesses these risks and designs substantive
procedures so as to reduce audit risk to an acceptably low level.
o The assessment of materiality;
On making assessment of materiality the auditor need too consider the following factors:
- Because of high leverage, relatively small misstatements may have a significant effect
on the results for the period and on capital, even though they may have an
insignificant effect on total assets.
- A banks earnings are low when compared to its total assets and liabilities and its offbalance sheet commitments. Therefore, misstatements that relate only to assets,
liabilities and commitments may be less significant than those that may also relate to
the statement of earnings.
- Banks are often subject to regulatory requirements, such as the requirement to
maintain minimum levels of capital. A breach of these requirements could call into
question the appropriateness of managements use of the going concern assumption.
The auditor therefore establishes a materiality level so as to identify misstatements
that, if uncorrected, would result in a significant contravention of such regulatory
requirements.
- The appropriateness of the going concern assumption often depends upon matters
related to the banks reputation as a sound financial institution and actions by
regulators. Because of this, related party transactions and other matters that would not
be material to entities other than banks may become material to a banks financial
statements if they might affect the banks reputation or actions by regulators.
o Managements representations
Managements representations are relevant in the context of a bank audit to assist the
auditor in determining whether the information and evidence obtained is complete for the
purposes of the audit. This is particularly true of the banks transactions that may not
ordinarily be reflected in the financial statements (off24 balance sheet items), but which
may be evidenced by other records of which the auditor may not be aware. It is often also
necessary for the auditor to obtain from management representations regarding significant
changes in the banks business and its risk profile. It may also be necessary for the auditor
to identify areas of a banks operations where audit evidence likely to be obtained may
need to be supplemented by managements representations, for example, loan loss
provisions and the completeness of correspondence with regulators.
o The involvement of other auditors;
As a result of the wide geographic dispersion of offices in most banks, it is often
necessary for the auditor to use the work of other auditors in many of the locations in
which the bank operates. This may be achieved by using other offices of the auditors
firm or by using other auditing firms in those locations.
o The geographic spread of the banks operations and the co-ordination of work
between different audit teams;
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accounting and internal control systems sufficient to plan the audit and develop an effective
audit approach. After obtaining the understanding, the auditor considers the assessment of
inherent and control risks so as to determine the appropriate detection risk to accept for the
financial statement assertions and to determine the nature, timing and extent of substantive
procedures for such assertions. Where the auditor assesses control risk at less than high,
substantive procedures are ordinarily less extensive than are otherwise required and may also
differ in their nature and timing.
On assessing internal controls relating to the accounting system, following objectives should
be duly considered:
1. Transactions are executed in accordance with managements general or specific
authorization
2. All transactions and other events are promptly recorded at the correct amount, in the
appropriate accounts and in the proper accounting period so as to permit preparation of
financial statements in accordance with an identified financial reporting framework
3. Access to assets is permitted only in accordance with managements authorization
4. Recorded assets are compared with the existing assets at reasonable intervals and
appropriate action is taken regarding any differences
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e. Analytical procedures.
a. Inspection
Inspection consists of examining records, documents, or tangible assets. The auditor inspects
in order to:
Be satisfied as to the physical existence of material negotiable assets that the bank holds;
and
Obtain the necessary understanding of the terms and conditions of agreements (including
master agreements) that are significant individually or in the aggregate in order to:
- Consider their enforceability; and
- Assess the appropriateness of the accounting treatment they have been given.
Examples of areas where inspection is used as an audit procedure are:
- Securities;
- Loan agreements;
- Collateral; and
- Commitment agreements, such as asset sales and repurchases, guarantees etc.
In carrying out inspection procedures, the auditor remains alert to the possibility that some of
the assets the bank holds may be held on behalf of third parties rather than for the banks own
benefit. The auditor considers whether adequate internal controls exist for the proper
segregation of such assets from those that are the property of the bank and, where such assets
are held, considers the implications for the financial statements.
b. Observation
Observation consists of looking at a process or procedure being performed by others e.g.
counting of inventories, cash balances etc.
c. Enquiry and Confirmation
Enquiry consists of seeking information of knowledgeable persons inside or outside the
entity. Confirmation consists of the response to an enquiry to corroborate information
contained in the accounting records. The auditor enquires and confirms in order to:
Obtain evidence of the operation of internal controls;
Obtain evidence of the recognition by the banks customers and counterparties of
amounts, terms and conditions of certain transactions; and
Obtain information not directly available from the banks accounting records.
A bank has significant amounts of monetary assets and liabilities, and of off balance- sheet
commitments. External confirmation may an effective method of determining the existence
and completeness of the amounts of assets and liabilities disclosed in the financial statements.
In deciding the nature and extent of external confirmation procedures that the auditor will
perform, the auditor considers any external confirmation procedures undertaken by internal
auditing. NSA on, External Confirmations provides guidance on the external confirmation
process.
Examples of areas for which the auditor may use confirmation including the:
Collateral.
Verifying or obtaining independent confirmation of, the value of assets and liabilities
those are not traded or are traded only on over-the-counter markets.
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Asset, liability and forward purchase and sale positions with customers and counterparties
such as:
- . Outstanding derivative transactions;
- . Nostro and vostro account holders;
- . Securities held by third parties;
- . Loan accounts;
- . Deposit accounts;
- . Guarantees; and
- . Letters of credit
Legal opinions on the validity of a banks claims
d. Computation
Computation consists of checking the arithmetical accuracy of source documents and
accounting records or of performing independent calculations. In the context of the audit of a
banks financial statements, computation is a useful procedure for checking the consistent
application of valuation models.
e. Analytical Procedures
Analytical procedures consist of the analysis of significant ratios and trends including the
resulting investigation of fluctuations and relationships that are inconsistent with other
relevant information or deviate from predicted amounts.
A bank invariably has individual assets (for example, loans and, possibly, investments) that
are of such a size that the auditor considers them individually. However, for most items,
analytical procedures may be effective for the following reasons:
Ordinarily two of the most important elements in the determination of a banks earnings
are interest income and interest expense. These have direct relationships to interest
bearing assets and interest bearing liabilities, respectively. To establish the reasonableness
of these relationships, the auditor can examine the degree to which the reported income
and expense vary from the amounts calculated on the basis of average balances
outstanding and the banks stated rates during the year.
The accurate processing of the high volume of transactions entered into by a bank, and
the auditors assessment of the banks internal controls, may benefit from the review of
ratios and trends and of the extent to which they vary from previous periods, budgets and
the results of other similar entities.
By using analytical procedures, the auditor may detect circumstances that call into
question the appropriateness of the going concern assumption, such as undue
concentration of risk in particular industries or geographic areas and potential exposure to
interest rate, currency and maturity mismatches.
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other banks are the result of large volumes of transactions, the receipt of confirmations from
those other banks is likely to provide more cogent evidence as to the existence of the
transactions and of the resultant inter-bank balances than is the testing of the related internal
controls.
Valuation
The auditor considers whether to assess the collectability of the deposit in light of the
creditworthiness of the depository bank.
Presentation and Disclosure
The auditor considers whether the balances with other banks as at the date of the financial
statements represent bona fide commercial transactions or whether any significant variation
from normal or expected levels reflects transactions entered into primarily to give a
misleading impression of the financial position of the bank or to improve liquidity and asset
ratios (often known as window-dressing). Where window-dressing occurs in a magnitude
which may distort the true and fair view of the financial statements, the auditor requests
management to adjust the balances shown in the financial statements, or make additional
disclosure in the notes. If management fails to do so, the auditor considers whether to modify
the audit report.
MONEY MARKET INSTRUMENTS
Existence
The auditor considers the need for physical inspection or confirmation with external
custodians and the reconciliation of the related amounts with the accounting records.
Rights and Obligations
The auditor considers the feasibility of checking for receipt of the related income as a means
of establishing ownership. The auditor pays particular attention to establishing the ownership
of instruments held in bearer form. The auditor also considers whether there are any
encumbrances on the title to the instruments. The auditor tests for the existence of sale and
forward repurchase agreements for evidence of unrecorded liabilities and losses.
Valuation
The auditor considers the appropriateness of the valuation techniques employed in light of the
creditworthiness of the issuer.
Measurement
The auditor considers whether there is a need to test for the proper accrual of income earned
on money market instruments, which in some cases is through the amortisation of a purchase
discount.
SECURITIES HELD FOR TRADING PURPOSES
Existence
The auditor considers physical inspection of securities or confirmation with external
custodians and the reconciliation of the amounts with the accounting records.
Rights and Obligations
The auditor considers the feasibility of checking for receipt of the related income as a means
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of establishing ownership. The auditor pays particular attention to establishing the ownership
of securities held in bearer form. The auditor also considers whether there are any
encumbrances on the title to the securities. The auditor tests for the existence of sale and
forward repurchase agreements for evidence of unrecorded liabilities and losses.
Valuation
Financial reporting frameworks often prescribe different valuation bases for securities
depending on whether they are held for trading purposes, held as portfolio investments, or
held for hedging purposes. For example, a financial reporting framework might require
trading securities to be carried at market value, portfolio investments at historic cost subject
to impairment reviews, and hedging securities on the same basis as the underlying assets they
hedge. Managements intentions determine whether any particular security is held for a given
purpose, and hence the valuation basis to be used. If managements intentions change, the
valuation basis changes too.
OTHER FINANCIAL ASSETS
Rights and Obligations
The auditor examines the underlying documentation supporting the purchase of such assets in
order to determine whether all rights and obligations, such as warranties and options, have
been properly accounted for.
Valuation
The auditor considers the appropriateness of the valuation techniques employed. Since there
may not be established markets for such assets, it may be difficult to obtain independent
evidence of value. Additionally, even where such evidence exists, there may be a question as
to whether there is sufficient depth to existing markets to rely on quoted values for the asset
in question and for any related offsetting hedge transactions that the bank has entered into in
those markets. The auditor also considers the nature and extent of any impairment reviews
that management has carried out and whether their results are reflected in the assets
valuations.
INVESTMENTS IN SUBSIDIARIES AND ASSOCIATED ENTITIES
In many cases the audit of a banks investments in subsidiaries and associated entities does
not differ from the audit of such investments held by any other entity. However, there are
some special aspects that pose particular problems in respect of banking operations.
Valuation
The auditor considers the implications of any legal or practical requirement for the bank to
provide future financial support to ensure the maintenance of operations (and hence the value
of the investment) of subsidiaries and associated companies. The auditor considers whether
the related financial obligations are recorded as liabilities of the bank.
The auditor determines whether appropriate adjustments are made when the accounting
policies of companies accounted for on an equity basis or consolidated do not conform to
those of the bank.
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(Comprising advances, bills of exchange, letters of credit, acceptances, guarantees, and all
other lines of credit extended to customers, including those in connection with foreign
exchange and money market activities)
Existence
The auditor considers the need for external confirmation of the existence of loans.
Valuation
The auditor considers the appropriateness of the provision for loan losses. The auditor
understands the laws and regulations that may influence the amounts determined by
management. The Basel Committee has published a set of Sound Practices for Loan
Accounting and Disclosure, which provides guidance to banks and banking supervisors on
recognition and measurement of loans, establishment of loan loss provisions, credit risk
disclosure and related matters. It sets out banking supervisors views on sound loan
accounting and disclosure practices for banks and so may influence the financial reporting
framework within which a bank prepares its financial statements. However, the banks
financial statements are prepared in accordance with a specified financial reporting
framework, and the loan loss provision must be made in accordance with that framework.
The major audit concern is the adequacy of the recorded provision for loan losses. In addition
to those non-performing loans identified by management and, where applicable, by bank
regulators, the auditor considers additional sources of information to determine those loans
that may not have been so identified. These include:
Various internally generated listings, such as watch list loans, past due loans, loans on
nonaccrual status, loans by risk classification, loans to insiders (including directors and
officers), and loans in excess of approved limits;
Historical loss experience by type of loan; and
Those loan files lacking current information on borrowers, guarantors or collateral.
Presentation and Disclosure
Banks are often subject to particular disclosure requirements concerning their loans and
provisions for loan losses. The auditor considers whether the information disclosed is in
accordance with the applicable financial or regulatory reporting framework.
ACCOUNTS WITH DEPOSITORS
Completeness
The auditor assesses the system of internal control over accounts with depositors. The auditor
also considers performing confirmation and analytical procedures on average balances and on
interest expense to assess the reasonableness of the recorded deposit balances.
Presentation and Disclosure
The auditor determines whether deposit liabilities are classified in accordance with
regulations and relevant accounting principles. Where deposit liabilities have been secured by
specific assets, the auditor considers the need for appropriate disclosure. The auditor also
considers the need for disclosure where the bank has a risk due to economic dependence on a
few large depositors or where there is an excessive concentration of deposits due within a
specific time.
CASH IN TRANSIT
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Existence
The auditor determines whether items in transit between branches, between the bank and its
consolidated subsidiaries, and between the bank and counterparties, are eliminated and that
reconciling items have been appropriately addressed and accounted for.
Additionally, the auditor examines individual items comprising the balance that have not
been cleared within a reasonable time period and also considers whether the related internal
control procedures are adequate to ensure that such items have not been temporarily
transferred to other accounts in order to avoid their detection.
CAPITAL AND RESERVES
Banking regulators pay close attention to a banks capital and reserves in monitoring the level
of a banks activities and in determining the extent of a banks operations. Small changes in
capital or reserves may have a large effect on a banks ability to continue operating,
particularly if it is near to its permitted minimum capital ratios. In such circumstances there
are greater pressures for management to engage in fraudulent financial reporting by miscategorizing assets and liabilities or by describing them as being less risky than they actually
are.
Presentation and Disclosure
The auditor considers whether capital and reserves are adequate for regulatory purposes (for
example, to meet capital adequacy requirements), the disclosures have been appropriately
calculated and that the disclosures are both appropriate and in accordance with the applicable
financial reporting framework. In many jurisdictions auditors are required to report on a wide
range of disclosures about the banks capital and its capital ratios, either because that
information is included in the financial statements or because there is requirement to make a
separate report to banking supervisors.
In addition, where applicable regulations provide for restrictions on the distribution of
retained earnings, the auditor considers whether the restrictions are adequately disclosed.
PROVISIONS, CONTINGENT ASSETS AND CONTINGENT LIABILITIES
(OTHER THAN DERIVATIVES AND OFF-BALANCE SHEET FINANCIAL
INSTRUMENTS)
Completeness
Many contingent assets and liabilities are recorded without there being a corresponding
liability or asset (memorandum items). The auditor therefore:
Identifies those activities that have the potential to generate contingent assets or liabilities
Considers whether the banks system of internal control is adequate to ensure that
contingent assets or liabilities arising out of such activities are properly identified and
recorded and that evidence is retained of the customers agreement to the related terms
and conditions;
Performs substantive procedures to test the completeness of the recorded assets and
liabilities. Such procedures may include confirmation procedures as well as examination
of related fee income in respect of such activities and are determined having regard to the
degree of risk attached to the particular type of contingency being considered
Reviews the reasonableness of the period-end contingent asset and liability figures in the
light of the auditors experience and knowledge of the current years activities; and
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Obtains representation from management that all contingent assets and liabilities have
been recorded and disclosed as required by the financial reporting framework.
Valuation
Many of these transactions are either credit substitutes or depend for their completion on the
credit-worthiness of the counterparty. The risks associated with such transactions are in
principle no different from those associated with Loans and advances as stated above.
Presentation and Disclosure
Where assets or liabilities have been securitised or otherwise qualify for an accounting
treatment that removes them from the banks balance sheet, the auditor considers the
appropriateness of the accounting treatment and whether appropriate provisions have been
made. Similarly, where the bank is counterparty to a transaction that allows a client entity to
remove an asset or liability from the clients balance sheet, the auditor considers whether
there is any asset or liability that the financial reporting framework requires to be shown in
the balance sheet or in the notes to the financial statements.
INTEREST INCOME AND INTEREST EXPENSE
Measurement
Interest income and expense ordinarily comprise two of the main items in a banks income
statement.. The auditor considers:
Interest income arising from loan and advances is recorded in cash basis as per NRB
regulation
Whether satisfactory procedures exist for the proper accounting of accrued income (other
than that arising from loan and advances) and expenditure at the year-end;
Assessing the adequacy of the related system of internal control; and
Using analytical procedures in assessing the reasonableness of the reported amounts.
Such techniques include comparison of reported interest yields in percentage terms:
- To market rates
- To central bank rates
The auditor considers the reasonableness of the policy applied to income recognition on nonperforming loans, especially where such income is not being received on a current basis. The
auditor also considers whether income recognition on non-performing loans complies with
the policy of the bank, as well as the requirements of the applicable financial reporting
framework and directives issued by the Central Bank / Nepal Rastra Bank (NRB).
PROVISIONS FOR LOAN LOSSES
Measurement
The major audit concerns in this area are discussed above under Loans and advances.
Usually, provisions take two forms, namely specific provisions in respect of identified losses
on individual loans and general provisions to cover losses that are thought to exist but have
not been specifically identified. The auditor assesses the adequacy of such provisions based
on such factors as past experience and other relevant information and considers whether the
specific and general provisions are adequate to absorb estimated credit losses associated with
the loan portfolio. The auditor determines whether the reported provision expense is
calculated in accordance NRB regulations. The auditor also considers the adequacy of the
disclosures in the financial statements and, when the provisions are not adequate, the
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Adheres to any specific formats and terminology specified by the law, the regulatory
authorities, professional bodies and industry practice; and
Determines whether adjustments have been made to the accounts of foreign branches and
subsidiaries that are included in the consolidated financial statements of the bank to bring
them into conformity with the financial reporting framework under which the bank is
reporting. This is particularly relevant in the case of banks because of the large number of
countries in which such branches and subsidiaries may be located and the fact that in
most countries local regulations prescribe specialized accounting principles applicable
primarily to banks. This may lead to a greater divergence in the accounting principles
followed by branches and subsidiaries, than is the case in respect of other commercial
entities.
The financial statements of banks are prepared in the context of the legal and regulatory
requirements prevailing in the country, and accounting policies are influenced by such
regulations. The financial reporting framework for banks (the banking framework) differs
materially from the financial reporting framework for other entities (the general
framework). When the bank is required to prepare a single set of financial statements that
comply with both frameworks, the auditor may express a totally unqualified opinion only
if the financial statements have been prepared in accordance with both frameworks. If the
financial statements are in accordance with only one of the frameworks, the auditor
expresses an unqualified opinion in respect of compliance with that framework and a
qualified or adverse opinion in respect of compliance with the other framework. When the
bank is required to comply with the banking framework instead of the general framework,
the auditor considers the need to refer to this fact in an emphasis of matter paragraph.
Banks often present additional information in annual reports that also contain audited
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financial statements. This information frequently contains details of the banks risk adjusted
capital, and other information relating to the banks stability, in addition to any disclosures in
the financial statements. NSA 720 Other Information in Documents Containing Audited
Financial Statements provides guidance on the procedures to be undertaken in respect of
such additional information.
Description
Chairman
Member
Member
Member
Member
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Auditing Standards Board, if deems necessary, may invite concerned experts to participate in
the meeting as observer. The tenure of FCA, CA and RA members shall be of three years and
shall be eligible for re-appointment on expiry of their tenure.
Rights and Duties of Standards on Auditing Board
The rights and duties of Standards on Auditing Board shall be as follows:
a. To develop Standards on Auditing, on the basis of relevant International Standards on
Auditing, in order to govern and regulate accounting and auditing profession,
b. To evolve appropriate process of development of Standards on Auditing and publish
material related to Standards on Auditing,
c. To redraft, improvise and revise Standards on Auditing,
d. To interpret the Standards on Auditing,
e. To undertake other related tasks related to Standards on Auditing.
GUIDANCE NOTE: 1
GUIDANCE NOTE ON INDEPENDENCE OF PROFESSIONAL ACCOUNTANTS
(GN201)
This Guidance Note aims to clarify the meaning of independence while members perform
their duties as Professional Accountants. Professional integrity and independence is an
essential characteristic of all the professions but is more so in the case of accountancy
profession.
The Code of Ethics for Professional Accountants, issued by International Federation of
Accountants (IFAC) defines the term 'independence' as follows:
"Independence is:
a. Independence of mind the state of mind that permits the provision of an opinion
without being affected by influences that compromise professional judgement, allowing
an individual to act with integrity, and exercise objectivity and professional skepticism;
and
b. Independence in appearance the avoidance of facts and circumstances that are so
significant that a reasonable and informed third party, having knowledge of all relevant
information, including any safeguards applied, would reasonably conclude a firm's, or a
member of the assurance team's integrity, objectivity or professional skepticism had been
compromised of."
Independence of the Professional Accountant has not only to exist in fact, but also appear to
so exist to all reasonable persons. The relationship between the Professional Accountant and
his client should be such that firstly, he is himself satisfied about his independence and
secondly, no unbiased person would be forced to the conclusion that, on an objective
assessment of the circumstances, there is likely to be an abridgement of the Professional
Accountants' independence.
The idea of independence is enshrined in the minds of Professional Accountants in the
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performance of their duties. It has to be applied in their day to day work and their success
is dependent entirely upon their integrity, competence and independence of approach.
Dependent as it is on the state of mind and character of a person, independence, is a very
subjective matter. One person might be independent in a particular set of circumstances,
while another person might feel he is not independent in similar circumstances. It is therefore
the duty of every Professional Accountant to determine for him whether or not he can act
independently in the given circumstances of a case and quite apart from legal rules, in no case
to place himself in a position which would compromise his independence.
The Professional Accountant should be straightforward, honest and sincere in his approach to
his professional work. He must be fair and must not allow prejudice or bias to override his
objectivity. He should maintain an impartial attitude and both be and appear to be free of any
interest which might be regarded, whatever its actual effect, as being incompatible with
integrity and objectivity.
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network firm and the party responsible for the subject matter.
OBJECTIVE & STRUCTURE OF THE GUIDELINES
The objective of this section is to assist firms and members of assurance teams in:
a. Identifying threats to independence;
b. Evaluating whether these threats are clearly insignificant; and
c. In cases when the threats are not clearly insignificant, identifying and applying
appropriate safeguards to eliminate or reduce the threats to an acceptable level.
Consideration should always be given to what a reasonable and informed third party having
knowledge of all relevant informations, including safeguards applied, and would reasonably
conclude to be unacceptable. In situations when no safeguards are available to reduce the
threat to an acceptable level, the only possible actions are to eliminate the activities or interest
creating the threat, or to refuse to accept or continue the assurance engagement.
This section concludes with some examples of how this conceptual approach to independence
is to be applied to specific circumstances and relationships. Professional judgment is used to
determine the appropriate safeguards to eliminate threats to independence or to reduce them
to an acceptable level. In certain examples, the threats to independence are so significant the
only possible actions are to eliminate the activities or interest creating the threat, or to refuse
to accept or continue the assurance engagement. In other examples, the threat can be
eliminated or reduced to an acceptable level by the application of safeguards.
When threats to independence that are not clearly insignificant are identified, and the firm
decides to accept or continue the assurance engagement, the decision should be documented.
The documentation should include a description of the threats identified and the safeguards
applied to eliminate or reduce the threats to an acceptable level.
The evaluation of the significance of any threats to independence and the safeguards
necessary to reduce any threats to an acceptable level, takes into account the public interest.
Certain entities may be of significant public interest because, as a result of their business,
their size or their corporate status they have a wide range of stakeholders. Examples of such
entities may include listed companies, credit institutions, insurance companies, and pension
funds.
A professional accountant in public practice should not engage in any business, occupation or
activity that impairs or might impair integrity, objectivity or the good reputation of the
profession and as a result would be incompatible with the rendering of professional services.
THREATS TO INDEPENDENCE
Compliance with the fundamental principles and independence may potentially be threatened
by a broad range of circumstances. Many threats fall into the following categories:
a.
b.
c.
d.
e.
Self-interest;
Self-review;
Advocacy;
Familiarity; and
Intimidation.
The nature and significance of the threats may differ depending on whether they arise in
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GUIDANCE NOTE: 2
Preparation of Financial Statements on Letter Heads and Stationery of Auditors
(GN202)
Auditing Standards Board's has drawn its attention to the fact that financial statements of
some enterprises are prepared on letter-heads and stationery of their auditor carrying the
latter's names and addresses. For such activities Auditing Standard Board clarifies that such
practice is liable to be misinterpreted and, as such should be avoided.
The management of an enterprise has the primary responsibility for the preparation and
presentation of the financial statements of the enterprise that is the board of directors and/or
other governing body of an enterprise is responsible for the preparation and presentation of its
financial statements. Therefore, the management shall prepare the financial statements on
letter - heads and stationery of the enterprise.
In no case the financial statements of the enterprise shall be prepared on letter - heads and
stationery of the auditor.
Ethics
Basic cases of verdict on disciplinary Cases
Provision of Code of Ethics on ICAN Act 1997,
As mentioned on section 34 of ICAN Act 1997, Members of ICAN should Observe the
following code of Conduct:
-
Members and members holding Certificate of Practice shall fully abide this Act and the
Regulations framed under this Act.
Auditing, either in partnership or in collusion in any manner with a person who has not
obtained the Certificate of Practice of one's class, is prohibited.
One shall not share or distribute as profit the auditing fees or remuneration with any
person other than a member of the Institute; and shall not pay any commission, brokerage
etc. out of the professional fees earned to any person or member.
One shall not, directly or indirectly, influence any person by way of fear, threat, terror or
enticement in order to secure any professional business.
One shall not disclose or divulge any information and explanations acquired in the course
of professional service to any person other than the employer employing him and the
person whom he is compiled by the law to do so.
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Members holding Certificate of Practice shall not certify any financial statement or give
report of any type until they or their partner or employee checks and verifies it.
Member holding Certificate of Practice shall, while certifying financial statements or
making report thereon of any corporate body in which he or his partner has interest,
clearly mention the extent of his or his partner's interest therein.
Provided that being merely a shareholder in a company shall not be deemed to have interest
therein.
-
Member holding Certificate of Practice shall, in order to truly present the financial
statement certified by him, clearly indicate all the material facts or any false statements or
explanations known to him or to the best of his knowledge.
Members holding Certificate of Practice shall discharge their duties with due care in the
course of their profession and shall draw attention of all concerned to all material facts
which are or have taken place contrary to the prevailing law and do not comply with
generally accepted principles of auditing.
Members holding Certificate of Practice shall not base their remuneration as a percentage
on the profit or on any other uncertain results.
One shall not knowingly or recklessly mention any false matter in a notice, explanation or
statement required under the prevailing law to be provided to any office, department of
His Majesty's Government or any organization.
One shall not perform audit of accounts of any organization where he has served until the
elapse of at least three years of his leaving the service.
A member holding Certificate of Practice shall not accept his appointment as an auditor
of an organization without ascertaining that all required procedures for appointment as the
auditor under the prevailing law has been duly fulfilled.
One should have obtained sufficient information prior to give audit opinion.
Other matters concerning the conduct to be observed by the members and members
holding Certificate of Practice shall be as prescribed
Process of filing complaints against member and members holding certificated of practice:
The concerned person may lodge complaint to the Institute of Chartered Accountants of
Nepal against any member or member holding Certificate of Practice for not upholding the
conduct mentioned in this Act or the Regulations framed under this Act or for violation of
this Act or Regulations framed under this Act. The person can give application showing all
the available evidence and paying a fee of Rs. 100. However, no fee is required if the
complainant is any Government agencies or other entity where council has waived such fee.
The Executive Director shall, if he finds convincing information that proves any member or
member holding Certificate of Practice is not observing the conduct, submit the proposal
along with the related facts to the Council for further action against such member or member
holding Certificate of Practice.
The council if finds the complaints convincing, the complaint is placed in the disciplinary
committee for further discoveries and recommendation.
Disciplinary Committee
Pursuant to section 14 of ICAN Act, a Disciplinary Committee, comprising of following
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members, shall be constituted to recommend the Council to take necessary actions after
investigation upon complaints lodged against any action, contrary to the Chartered
Accountants Act or Regulations or code of conduct framed under this Act, rendered by any
member, or the Institute receives any information of such kind.
A FCA member designated by council from amongst elected CA council members Chairman
Three persons nominated by the Council from amongst the Council members - Member
Two persons nominated by the Council amongst the members - Member
One person nominated by the Auditor General - Member
The chairman or members shall not be allowed to attend any meeting that hears complaint
against the Chairman or member of the Disciplinary Committee for their actions contrary to
this Act or the Regulations, Byelaws or code of conduct framed under this Act. The
Procedures of the meeting of the Disciplinary Committee and the term of office of the
chairman and members of the committee shall be as prescribed.
The Disciplinary committee shall have the authority, similar to a judicial court, in respect of
summoning concerned person and investigating evidences and witnesses.
The Disciplinary committee shall recommend to the Council, along with its opinion and
finding, for necessary action against a member, if found guilty, and the council may,
considering such a recommendation, impose any of the following punishment according to
the degree of offence:
a. Reprimanding,
b. Removing from the membership for a period up to five years,
c. Prohibiting from carrying on the accounting profession for any particular period,
d. Cancellation of the Certificate of Practice (COP) or membership.
Any Council member against whom the Disciplinary Committee, after investing upon the
complaint of his action contrary to the Act or Regulations, Bye laws or code of conduct
framed under the Act, has decided to recommend the Council to take necessary action, shall
not be allowed to attend and to vote at the Council meeting where the Council is hearing at
such recommendation.
Before imposing any punishment, the Council shall provide reasonable opportunity to the
concerned members to submit their clarification. The concerned member may, if he is not
satisfied with the decision file an appeal in the Appellate Court.
Code of Ethics for the members of the Institute of Chartered Accountants of Nepal,
2060
The Council of the Institute of Chartered Accountants of Nepal (ICAN) has determined that
this Code should be adopted mandatorily by all members of Institute of Chartered
Accountants of Nepal to observe in respect of the performance of professional services in
Nepal after January 15, 2004 [Magh 1, 2060]
PART A APPLICABLE TO ALL PROFESSIONAL ACCOUNTANTS
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Review the conflict problem with the immediate superior. If the problem is not resolved with
the immediate superior and the professional accountant determines to go to the next higher
managerial level, the immediate superior should be notified of the decision. If it appears that
the superior is involved in the conflict problem, the professional accountant should raise the
issue with the next higher level of management. When the immediate superior is the Chief
Executive Officer (or equivalent) the next higher reviewing level may be the Executive
Committee, Board of Directors, Non-Executive Directors, Trustees, Partners Management
Committee or Shareholders.
Seek counseling and advice on a confidential basis with ICAN to obtain an understanding of
possible courses of action.
If the ethical conflict still exists after fully exhausting all levels of internal review, the
professional accountant as a last resort may have no other recourse on significant matters
(e.g., fraud) than to resign and to submit an information memorandum to an appropriate
representative of that organization or of an external body as required under prevalent laws
and regulations in Nepal.
Any professional accountant in a senior position should endeavor to ensure that policies are
established within his or her employing organization to seek resolution of conflicts.
Professional Competence
Professional accountants should not portray themselves as having expertise or experience
they do not possess.
Professional competence may be divided into two separate phases:
Attainment of professional competence
The attainment of professional competence requires initially a standard of general education
followed by specific education, training and examination in professionally relevant subjects,
and a period of work experience, as are set out to be requisite minimum qualification to
obtain membership of ICAN.
Maintenance of professional competence
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A professional accountant may prepare tax returns involving the use of estimates if such
use is generally acceptable or if it is impractical under the circumstances to obtain exact
data. When estimates are used, they should be presented as such in a manner so as to
avoid the implication of greater accuracy than exists. The professional accountant should
be satisfied that estimated amounts are reasonable under the circumstances.
In preparing a tax return, a professional accountant ordinarily may rely on information
furnished by the client or employer provided that the information appears reasonable.
Although the examination or review of documents or other evidence in support of the
information is not required, the professional accountant should encourage, when
appropriate, such supporting data to be provided.
In addition, the professional accountant
- should make use of the clients returns for prior years whenever feasible
- is required to make reasonable inquiries when the information presented appears to be
incorrect or incomplete; and
- Is encouraged to make reference to the books and records of the business operations, as
applicable.
When a professional accountant learns of a material error or omission in a tax return of a
prior year (with which the professional accountant may or may not have been associated),
or of the failure to file a required tax return, the professional accountant has a
responsibility to:
- Promptly advise the client or employer of the error or omission and recommend that
disclosure be made to the revenue authorities. The professional accountant is not
obligated to inform the revenue authorities.
- If the client or the employer does not correct the error the professional accountant:
Should inform the client or the employer that it is not possible to act for them in
connection with that return or other related information submitted to the
authorities; and,
Should consider whether continued association with the client or employer in any
capacity is consistent with professional responsibilities.
- If the professional accountant concludes that a professional relationship with the client or
employer can be continued, all reasonable steps should be taken to ensure that the error is
not repeated in subsequent tax returns.
Cross Border Activities
When considering the application of ethical requirements in cross border activities a
number of situations may arise. Whether a professional accountant is a member of the
profession in Nepal only or is also a member of the profession in the country where the
services are performed should not materially affect the manner of dealing with each
situation.
A professional accountant qualifying in Nepal may reside in another country or may be
temporarily visiting that country to perform professional services. In all circumstances,
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the professional accountant should carry out professional services in accordance with the
relevant technical standards and ethical requirements.
When a professional accountant performs services in a country other than Nepal and
differences on specific matters exist between ethical requirements of the two countries the
following provisions should be applied:
- When the ethical requirements of the country in which the services are being performed
are less strict than the ICAN Code of Ethics, then the ICAN Code of Ethics should be
applied.
- When the ethical requirements of the country in which services are being performed are
stricter than the ICAN Code of Ethics, then the ethical requirements in the country where
services are being performed should be applied.
- When the ethical requirements of Nepal are mandatory for services performed outside
that country and are stricter than set as outabove, then the ethical requirements of Nepal
should be applied.
Publicity
In the marketing and promotion of themselves and their work, professional accountants
should:
- not use means which brings the profession into disrepute
- not make exaggerated claims for the services they are able to offer, the qualifications they
possess, or experience they have gained; and
- not denigrate the work of other accountants.
PART B APPLICABLE TO PROFESSIONAL ACCOUNTANTS IN PUBLIC
PRACTICE
Independence
Professional accountants in public practice should be and appear:
- to be free of any interest which might be regarded,
- as being incompatible with integrity, objectivity and independence.
The following situations indicate grounds for reasonable observer for doubting the
independence of a professional accountant in public practice:
- By direct financial interest in a client.
- By indirect material financial interest in a client, e.g., by being a trustee of any trust or
executor or administrator of any estate if such trust or estate has a financial interest in a
client company
- By loans to or from the client or any officer, director or principal shareholder of a client
company.
- By holding a financial interest in a joint venture with a client or employee(s) of a client.
- By having a financial interest in a non-client that has an investoror investeerelationship
with the client.
Appointments in Companies
When professional accountants in public practice are or were, within the period under
current review or immediately preceding an assignment:
a member of the board, an officer or employee of a company; or
a partner of, or in the employment of, a member of the board or an officer or employee of
a company;
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They would be regarded as having an interest which could detract from independence
when reporting on that company
Commentary
It is suggested that the period immediately preceding the assignment should be no less
than two years or as required by appropriate legislation.
Provision of Other Services to Audit Clients
When a professional accountant in public practice, in addition to carrying out an audit or
other reporting function, provides other services to a client, care should be taken not to
perform management functions or make management decisions, responsibility for which
remains with the board of directors and management.
Commentary
The preparation of accounting records is a service which is frequently requested of a
professional accountant in public practice, particularly by smaller clients, whose
businesses are not sufficiently large to employ an adequate internal accounting staff. It is
unlikely that larger clients need this service other than in exceptional circumstances. In all
cases in which independence is required and in which a professional accountant in public
practice is concerned in the preparation of accounting records for a client, the following
requirements should be observed:
The professional accountant in public practice should not have any relationship or
combination of relationships with the client or any conflict of interest which would impair
integrity or independence.
The client should accept responsibility for the statements.
The professional accountant in public practice should not assume the role of employee or
of management conducting the operations of an enterprise.
Staff assigned to the preparation of accounting records ideally should not participate in
the examination of such records.
The fact that the professional accountant in public practice has processed or maintained
certain records does not eliminate the need to make sufficient audit tests.
Personal and Family Relationships
Personal and family relationships can affect independence. There is a particular need to
ensure that an independent approach to any assignment is not endangered as a
consequence of any personal or family relationship.
Commentary
Family relationships which always pose an unacceptable threat to independence are those
in which a sole practitioner or a partner in a practice, or an employee engaged on the
assignment relating to the client, is the spouse, dependent child, the parent or grandparent,
or relative living in a common household, of the client
Fees
When the receipt of recurring fees from a client or group of connected clients, represents
a large proportion of the total gross fees of a professional accountant in public practice or
of the practice as a whole, the dependence on that client or group of clients should
inevitably come under scrutiny and could raise doubts as to independence.
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Commentary
If fees are the only or the substantial part of the gross income, the professional accountant
in public practice should carefully consider whether independence has been impaired.
Contingency Fees
Fee will be charged unless a specified finding or result is obtained or when the fee is
otherwise contingent upon the findings or results of such services.
Commentary
Fees should not be regarded as being contingent if fixed by a court or other public
authority.
Fees charged on a percentage or similar basis should be regarded as contingent fees.
Goods and Services
Acceptance of goods and services from a client may be a threat to independence.
Acceptance of undue hospitality poses a similar threat.
Commentary
Goods and services should not be accepted by professional accountants in public practice,
their spouses or dependent children except on business terms no more favorable than
those generally available to others. Hospitality and gifts on a scale which is not
commensurate with the normal courtesies of social life should not be accepted.
Actual or Threatened Litigation
Litigation involving the professional accountant in public practice and a client may cause
concern that the normal relationship with the client is affected to the extent that the
professional accountants independence and objectivity may be impaired
Commentary
The professional accountant in public practice should have regard to circumstances when
litigation might be perceived by the public as likely to affect the accountants
independence
Long Association of Senior Personnel with Audit Clients
The use of the same senior personnel on an audit engagement over a prolonged period of
time may pose a threat to independence. The professional accountant in public practice
should take steps to ensure that objectivity and independence are maintained on the
engagement.
Commentary
There is a concern that a long involvement by a single individual with an audit client
could lead to the formation of a close relationship which could be perceived to be a threat
to objectivity and independence. The professional accountant in public practice should
take steps to provide for an orderly rotation of senior personnel serving on the
engagement.
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professional accountant does not have the competence to perform a specific part of the
professional service, technical advice may be sought from experts such as other
professional accountants, lawyers, actuaries, engineers, geologists, valuers.
In such situations, although the professional accountant is relying on the technical
competence of the expert, the professional accountant must take steps to see that such
experts are aware of ethical requirements. Primary attention should be paid to the
fundamental principles provided in code of ethics.
The degree of supervision and the amount of guidance that will be needed will depend
upon the individuals involved and the nature of the engagement:
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which independence is not required and the professional accountant in public practice should
nonetheless disclose the facts to the client.
Activities Incompatible with the Practice of Public Accountancy
A professional accountant in public practice should not concurrently engage in any
business, occupation or activity which impairs or might impair integrity, objectivity or
independence, or the good reputation of the profession and therefore would be
incompatible with the rendering of professional services.
The rendering of two or more types of professional services concurrently does not by
itself impair integrity, objectivity or independence.
Clients Monies
The professional accountant in public practice should not hold clients monies if there is
reason to believe that they were obtained from, or are to be used for, illegal activities.
A professional accountant in public practice entrusted with monies belonging to others
should:
- keep such monies separately from personal or firm monies
- use such monies only for the purpose for which they are intended; and
- at all times, be ready to account for those monies to any persons entitled to such
accounting.
A professional accountant in public practice should maintain one or more bank accounts
for clients monies
Clients monies received by a professional accountant in public practice should be
deposited without delay to the credit of a client account,
Monies may only be drawn from the client account on the instructions of the client.
Fees due from a client may be drawn from clients monies provided the client, after being
notified of the amount of such fees, has agreed to such withdrawal.
Payments from a client account shall not exceed the balance standing to the credit of the
client.
When it seems likely that the clients monies remain on client account for a significant
period of time, the professional accountant in public practice should, with the concurrence
of the client, place such monies in an interest bearing account within a reasonable time.
All interest earned on clients monies should be credited to the client account.
A statement of account should be provided to the client at least once a year
Relations with Other Professional Accountants in Public Practice
Accepting New Assignments
The extension of the operations of a business undertaking frequently results in the
formation of branches or subsidiary companies at locations where an existing accountant
does not practice. In these circumstances, the client or the existing accountant in
consultation with the client may request a receiving accountant practicing at those
locations to perform such professional services as necessary to complete the assignment.
Referral of business may also arise in the area of special services or special tasks as it is
impracticable for any one professional accountant in public practice to acquire special
expertise or experience in all fields of accountancy.
Professional accountants in public practice should only undertake such services which
they can expect to complete with professional competence. Professional accountants in
public practice are encouraged to obtain advice when appropriate from those who are
competent to provide it.
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The wishes of the client should be paramount in the choice of professional advisers,
whether or not special skills are involved. Accordingly, a professional accountant in
public practice should not attempt to restrict in any way the clients freedom of choice in
obtaining special advice, and when appropriate should encourage a client to do so.
The services or advice of a professional accountant in public practice having special skills
may be sought in one or other of the following ways:
- by the client
after prior discussion and consultation with the existing accountant;
on the specific request or recommendation of the existing accountant; and
without reference to the existing accountant; or
- by the existing accountant with due observance of the duty of confidentiality.
Superseding another Professional Accountant in Public Practice
The proprietors of a business have an indisputable right to choose their professional
advisers and to change to others should they so desire. While it is essential that the
legitimate interests of the proprietors are protected, it is also important that a professional
accountant in public practice who is asked to replace another professional accountant in
public practice has the opportunity to ascertain if there are any professional reasons why
the appointment should not be accepted. This cannot effectively be done without direct
communication with the existing accountant. In the absence of a specific request, the
existing accountant should not volunteer information about the clients affairs
Communication helps to preserve the harmonious relationships which should exist
between all professional accountants in public practice on whom clients rely for
professional advice and assistance.
The extent to which an existing accountant can discuss the affairs of the client with the
proposed professional accountant in public practice depend on:
- whether the clients permission to do so has been obtained; and/or
- the legal or ethical requirements relating to such disclosure, if any.
The proposed professional accountant in public practice should treat in the strictest
confidence and give due weight to any information provided by the existing accountant
Before accepting an appointment involving recurring professional services hitherto
carried out by another professional accountant in public practice, the proposed
professional accountant in public practice should:
- Ascertain if the prospective client has advised the existing accountant of the proposed
change and has given permission, preferably in writing, to discuss the clients affairs fully
and freely with the proposed professional accountant in public practice,
- request permission to communicate with the existing accountant. If such permission is
refused or the permission referred to in above is not given, the proposed professional
accountant in public practice should, in the absence of exceptional circumstances of
which there is full knowledge, and unless there is satisfaction as to necessary facts by
other means, decline the appointment.
- On receipt of permission, ask the existing accountant, preferably in writing:
to provide information on any professional reasons which should be known before
deciding whether or not to accept the appointment and, if there are such matters;
and
to provide all the necessary details to be able to come to a decision
The existing accountant, on receipt of the communication referred above should
forthwith:
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Reply, preferably in writing, advising whether there are any professional reasons why the
proposed professional accountant in public practice should not accept the appointment.
If there are any such reasons or other matters which should be disclosed, ensure that the
client has given permission to give details of this information to the proposed professional
accountant in public practice. If permission is not granted, the existing accountant should
report that fact to the proposed professional accountant in public practice.
On receipt of permission from the client, disclose all information needed by the proposed
professional accountant in public practice to be able to decide whether or not to accept the
appointment, and discuss freely with the proposed professional accountant in public
practice all matters relevant to the appointment of which the latter should be aware
If the proposed professional accountant in public practice does not receive, within a
reasonable time, a reply from the existing accountant and there is no reason to believe that
there are any exceptional circumstances surrounding the proposed change, the proposed
professional accountant in public practice should endeavor to communicate with the
existing accountant by some other means. If unable to obtain a satisfactory outcome in
this way, the proposed professional accountant in public practice should send a further
letter, stating that there is an assumption that there is no professional reason why the
appointment should not be accepted and that there is an intention to do so.
The fact that there may be fees owing to the existing accountant is not a professional
reason why another professional accountant in public practice should not accept the
appointment.
The existing accountant should promptly transfer to the new professional accountant in
public practice all books and papers of the client which are or may be held after the
change in appointment has been effected and should advise the client accordingly, unless
the professional accountant in public practice has a legal right to withhold them
In reply to a public advertisement or an unsolicited request to make a submission or
submit a tender, a professional accountant in public practice should, if the appointment
may result in the replacement of another professional accountant in public practice, state
in the submission or tender that before acceptance the opportunity to contact the other
professional accountant in public practice is required so that inquiries may be made as to
whether there are any professional reasons why the appointment should not be accepted.
If the submission or tender is successful, the existing accountant should then be
contacted.
Advertising and Solicitation
Publicity by individual professional accountants in public practice is acceptable provided:
- The objective is to notify the public or such sectors of the public as are concerned, of
matters of fact in a manner that is not false, misleading or deceptive;
- it is in good taste;
- it is professionally dignified; and
- it avoids frequent repetition of, and any undue prominence being given to the name of the
professional accountant in public practice.
The examples which follow are illustrative of circumstances in which publicity is
acceptable and the matters to be considered in connection therewith:
Appointments and Awards
It is in the interests of the public and the accountancy profession that any appointment or
other activity of a professional accountant in a matter of national or local importance, or the
award of any distinction to a professional accountant, should receive publicity and that
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professional accountant in public practice is acceptable but it should not contain any
promotional element. There should not be any suggestion that the services offered are
superior to those offered by other professional accountants in public practice as a
consequence of size, associations, or for any other reason.
Publicity on Behalf of Clients
The professional accountant in public practice should ensure that the emphasis in the
publicity is directed towards the objectives to be achieved for the client.
Brochures and Firm Directories
A professional accountant in public practice may issue to clients or, in response to an
unsolicited request, to a non-client:
- a factual and objectively worded account of the services provided;
- a directory setting out names of partners, office addresses and names and addresses of
associated firms and correspondents.
Stationery and Nameplates
Stationery of professional accountants in public practice should be of an acceptable
professional standard and comply with the requirements of the law and of ICAN as to names
of partners, principals and others who participate in the practice, use of professional
descriptions and designatory letters, cities or countries where the practice is represented,
logotypes, etc. The designation of any services provided by the practice as being of specialist
nature should not be permitted. Similar provisions, where applicable, should apply to
nameplates.
Newspaper Announcements
Appropriate newspapers or magazines may be used to inform the public of the establishment
of a new practice, of changes in the composition of a partnership of professional accountants
in public practice, or of any alteration in the address of a practice. Such announcements
should be limited to a bare statement of facts and consideration given to the appropriateness
of the area of distribution of the newspaper or magazine and number of insertions.
Inclusion of the Name of a Professional Accountant in Public Practice in a Document Issued
by a Client
When a client proposes to publish a report by a professional accountant in public practice
dealing with the clients existing business affairs or in connection with the establishment of a
new business venture, the professional accountant in public practice should take steps to
ensure that the context in which the report is published is not such as might result in the
public being misled as to the nature and meaning of the report. In these circumstances, the
professional accountant in public practice should advise the client that permission should first
be obtained before publication of the document.
Similar consideration should be given to other documents proposed to be issued by a client
containing the name of a professional accountant in public practice acting in an independent
professional capacity. This does not preclude the inclusion of the name of a professional
accountant in public practice in the annual report of a client. When professional accountants
in their private capacity are associated with, or hold office in, an organization, the
organization may use their name and professional status on stationery and other documents.
The professional accountant in public practice should ensure that this information is not used
in such a way as might lead the public to believe that there is a connection with the
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However, where any person has entered into an agreement with an entity for an agreed period
to pursue his Chartered Accountancy Course, then this provision is not applicable to him for
the agreed period.
Branch Audit (Recommendatory from financial year 2067/68)
Branch audit of Banks shall be conducted for the year beginning from financial year 2067/68.
Branch having 2% or more Deposit and/ or Credit of the bank should be audited every year
and other branch should be audited at least once in every three years. The audit committee of
the concerned bank may be entrusted to appoint independent branch auditors and fix their
remuneration.
About Designation of members (Effective from 2067.01.29)
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All the members of the Institute shall use the word CA or RA as the case may be before their
name in their professional documents. They may also use such designation before their name
in other documents.
Accounting profession by foreign citizen
Any foreign national who wants to do accounting professional and who has had all the
required qualification as mentioned in ICAN Act/rules may do so by entering in a partnership
with a Nepali citizen. The nature and extent and limit of the accounting profession for such
accounting firm shall be as decided by the Council.
Special Provision regarding Partnership
Every partner of the firm must hold COP
One firm can have a maximum 20 partners
A member having his own proprietorship firm can be a partner in not more than two
accounting firms at a time. But he has to get approval of every partner to run his
proprietorship firm.
Partnership of foreign accounting firm is not counted for this purpose
Remaining partner must inform ICAN if there is any change in the composition of the
partner, within 35 days of such change.
The member can use the word partner if he is one of the partners of the firm
Name Plate and Sign Board
The professional accountant shall not use sign board/ hoarding board of a size greater than (2
feet X 3.5 feet). They shall not mention any words or symbols other than their name,
certificate number. Address, contact number and designation.
The professional accountant may keep a name plate disclosing his name and the professional
qualification in his residence. But sign board can be kept only at the office.
Professional accountant shall not use logo with special symbols on their own. They can use
name of the firm only, no additional symbol may be used. They may use logo/symbol
approved by the council.
Special provision regarding Anti Money Laundering (AML) issued by Nepal Rastra
Bank Financial Information Unit (NRB-FIU)
Professional Accountant should conduct a Customer Due Diligence (CDD) as required by
Financial Action Task Force (FATF) in following situations:
Professional accountants when they prepare for or carry out transactions for their client
concerning the following activities:
- buying and selling of real estate;
- managing of client money, securities or other assets;
- management of bank, savings or securities account;
- organization of contributions for the creation, operation or management of companies;
- Creation, operation or management of legal persons or arrangements, and buying and
sellingof business entities.
Customer Due Diligence (CDD) includes following:
- Keeping and verifying identification document of the key persons (Directors/ owners/
senior management personnel)
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The address of the registered office, and, if different, a principal place of business
Appointing a contact person in firm and communicating the details of the contact person
to Financial Information Unit (FIU) of NRB
Make a suspicious transaction report (STR) to the financial intelligence unit (FIU)
However, accountants acting as independent legal professionals, are not required to report
suspicious transactions if the relevant information was obtained in circumstances where they
are subject to professional secrecy or legal professional privilege.
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The auditor was found compromising the provisions of Sec.34(9) of the Nepal
Chartered Accountants Act 2053 which requires that members holding Certificate of
Practice shall discharge their duties with due care in the course of their profession
and shall draw attention of all concerned to all material facts which are or have taken
place contrary to the prevailing law and do not comply with generally accepted
principles of auditing. The auditor was also found compromising the provisions of
clause 12 of the Code of Ethics 2060. Further, the auditor was found not complying
the Accounting Policy on Non-banking assets given in the Clause 2.5 of Part B
Principle Accounting Policies of the NRB directives on the Accounting Policies
and Format of Financial Statements.
Thus, the Chartered Accountant was held guilty of professional misconduct by the
Council.
4. The respondent, a Chartered Accountant issued audit report of a bank without any
qualification where, the bank has not set aside 20% of its net profit to the General
Reserve as required by the then Banking and Financial Institution Ordinance. The
respondent pleaded that the profit was very negligible and immaterial amount, so
the transfer was not made.
The auditor was found compromising the provisions of Sec. 34(9) of the Nepal
Chartered Accountants Act 2053 which require that members holding Certificate of
Practice shall discharge their duties with due care in the course of their profession
and shall draw attention of all concerned to all material facts which are or have taken
place contrary to the prevailing law and do not comply with generally accepted
principles of auditing.
He was found violating the mandatory provisions of Sec 44 of the then Banking
Financial Institutions Ordinance which required the transfer of 20% of the net profit
to the General Reserve every year unless the balance in the General Reserve becomes
double than thepaid up capital.
On these grounds, the Chartered Accountant was held guilty of professional
misconduct.
5. The respondent, a Registered Auditor after completing the statutory audit of two
consecutive years, issued audit report for further two years though he was not
appointed as auditor for those last two years. He signed the audit report of those
last two years mentioning himself as the representative of the statutory auditor.
The auditor was found violating the provisions of Sec. 34(13) of the Nepal Chartered
Accountants Act 2053 which requires that a member holding Certificate of Practice
shall not accept his appointment as an auditor of an organization without
ascertaining that all required procedures for appointment as the auditor under the
prevailing law has been duly fulfilled.
Thus the Registered Auditor was held guilty of professional misconduct by the
Council.
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6. The respondent, a Chartered Accountant issued audit reports for those financial
years for which audit was already completed by other auditors and Tax Returns
were already filed based on those reports. The figures in the two sets of reports were
different. The respondent was also given responsibility of preparing the Financial
Statements for those financial years. The respondent pleaded that the previous
auditors gave false reports and board has not approved those financial statements,
his appointment as auditor was declared lawful by Company Law Board,
communication to previous auditors tried but not successful, he has not prepared
the financial statements, there was mistake in the appointment letter which includes
preparation of financial statements also and he informed to client about this.
The auditor was found compromising the provisions of Sec. 34 (13) of the Nepal
Chartered Accountants Act, 2053 which requires that a member holding Certificate of
Practice shall not accept his appointment as an auditor of an organization without
ascertaining that all required procedures for appointment as the auditor under the
prevailing law has been duly fulfilled. The auditor was also found compromising the
provisions of section 34 (9) of the Act which requires that members holding
Certificate of Practice shall discharge their duties with due care in the course of their
profession and shall draw attention of all concerned to all material facts which are or
have taken place contrary to the prevailing law and do not comply with generally
accepted principles of auditing. Further, he was found not complying the clause
13(23) of the Code of Ethics 2060. On these grounds, the Chartered Accountant was
held guilty of professional misconduct by the Council.
7. The respondent, a Registered Auditor conducted the audit of a school for F/Y
2061/62, and issued report, but in the Receipt and Payment account of the School
for financial 2061/62, the receivable amount of2060/61 was shown as receipt and
the receivable amount of 2061/62 was shown as payment, and thus the cash balance
was understated. The auditor when informed about this rejected to make any
correction.
The auditor was found compromising the provisions of section 34 (9) of the Nepal
Chartered Accountants Act which requires that members holding Certificate of
Practice shall discharge their duties with due care in the course of their profession
and shall draw attention of all concerned to all material facts which are or have taken
place contrary to the prevailing law and do not comply with generally accepted
principles of auditing.
Thus the Registered auditor was held guilty of professional misconduct.
8. The respondent, a registered auditor issued report on the financial statements of a
school where the financial statements were not approved by the management. He
has not informed to the Board about the audit. Also, he has not maintained proper
documentation of his audit work as required by the auditing standards.
The auditor was held guilty of professional misconduct.
9. The respondent, a registered auditor issued two different audit reports for same
financial year of a client for continuous three years.
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with the requirements of integrity, objectivity, and independence and that they should
confirm with the technical and professional standards promulgated by the Nepal
Accounting Standards Board, Nepal Standards on Auditing Board, ICAN or other
regulatory body, and relevant legislation.
On these grounds the auditor was held guilty of professional misconduct.
13. The Respondent, a Registered Auditor issued three audit reports of a Higher
Secondary School for same financial year on three different dates and the figures
in the financial statements were also different and, none of the previous audit
reports were cancelled before issuing new reports.
The auditor was found compromising the code of ethics and the generally accepted
auditing principles and thus held guilty of professional misconduct.
Legal case
Fact
A Ltd. was merged with B Ltd. to form AB Ltd (on which shareholders of A Ltd. has
majority of holding say 55%). Before merger, Mr. X was the auditor of A Ltd. for three
consecutive years. After merger, Mr. X wishes to continue as an auditor in AB Ltd citing that
AB Ltd. is a new company.
Decision
Since A, B, and AB Ltd. all are public companies, honorable court decided that, even though
at law AB Ltd. is a new company, Mr. X cannot continue as an auditor of AB Ltd. citing that
majority of shareholders of AB Ltd are of A Ltd. of which Mr. X has already served as
auditor for three consecutive years.
GOVERNANCE
Corporate governance broadly refers to the mechanisms, processes and relations by which
corporations are controlled and directed. A governance structure identify the distribution of
rights and responsibilities among different participants in the corporation (such as the board
of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders)
and includes the rules and procedures for making decisions in corporate affairs. Corporate
governance includes the processes through which corporations' objectives are set and pursued
in the context of the social, regulatory and market environment. Governance mechanisms
include monitoring the actions, policies and decisions of corporations and their agents.
Corporate governance became a pressing issue following the 2002 introduction of the
Sarbanes-Oxley Act in the U.S., which was ushered in to restore public confidence in
companies and markets after accounting fraud bankrupted high-profile companies such as
Enron and WorldCom. Both companies strive to have a high level of corporate governance.
However, these days, it is not enough for a company to merely be profitable; it also needs to
demonstrate good corporate citizenship through environmental awareness, ethical behavior
and sound corporate governance practices
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in 1999 and has since become an international benchmark for policy makers, investors,
corporations and other stakeholders worldwide. They have advanced the corporate
governance agenda and provided specific guidance for legislative and regulatory initiatives in
both OECD and non OECD countries.
The Principles of OECD are intended to assist OECD and non-OECD governments in their
efforts to evaluate and improve the legal, institutional and regulatory framework for corporate
governance in their countries and to provide guidance and suggestions for stock exchanges,
investors, corporations, and other parties that have a role in the process of developing good
corporate governance. The Principles focus on publicly traded companies, both financial and
non-financial. However, to the extent they are deemed applicable, they might also be a useful
tool to improve corporate governance in non-traded companies, for example, privately held
and state owned enterprises. The Principles represent a common basis that OECD member
countries consider essential for the development of good governance practices. They are
intended to be concise, understandable and accessible to the international community. They
are not intended to substitute for government, semi-government or private sector initiatives to
develop more detailed best practice in corporate governance.
Corporate governance involves a set of relationships between a companys management, its
board, its shareholders and other stakeholders. Corporate governance also provides the
structure through which the objectives of the company are set, and the means of attaining
those objectives and monitoring performance are determined. Good corporate governance
should provide proper incentives for the board and management to pursue objectives that are
in the interests of the company and its shareholders and should facilitate effective monitoring.
The presence of an effective corporate governance system, within an individual company and
across an economy as a whole, helps to provide a degree of confidence that is necessary for
the proper functioning of a market economy. As a result, the cost of capital is lower and firms
are encouraged to use resources more efficiently, thereby underpinning growth.
Corporate governance is affected by the relationships among participants in the governance
system. Controlling shareholders, which may be individuals, family holdings, bloc alliances,
or other corporations acting through a holding company or cross shareholdings, can
significantly influence corporate behaviour. As owners of equity, institutional investors are
increasingly demanding a voice in corporate governance in some markets. Individual
shareholders usually do not seek to exercise governance rights but may be highly concerned
about obtaining fair treatment from controlling shareholders and management. Creditors play
an important role in a number of governance systems and can serve as external monitors over
corporate performance. Employees and other stakeholders play an important role in
contributing to the long-term success and performance of the corporation, while governments
establish the overall institutional and legal framework for corporate governance.
There is no single model of good corporate governance. However, work carried out in both
OECD and non-OECD countries and within the organization has identified some common
elements that underlie good corporate governance. The Principles build on these common
elements and are formulated to embrace the different models that exist.
The OCED principle is divided into two parts. The Principles presented in the first part of the
document cover the following areas:
1. Ensuring the basis for an effective corporate governance framework;
2. The rights of shareholders and key ownership functions;
3. The equitable treatment of shareholders;
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C. Shareholders should have the opportunity to participate effectively and vote in general
shareholder meetings and should be informed of the rules, including voting
procedures, that govern general shareholder meetings:
1. Shareholders should be furnished with sufficient and timely information
concerning the date, location and agenda of general meetings, as well as full and
timely information regarding the issues to be decided at the meeting.
2. Shareholders should have the opportunity to ask questions to the board, including
questions relating to the annual external audit, to place items on the agenda of
general meetings, and to propose resolutions, subject to reasonable limitations.
3. Effective shareholder participation in key corporate governance decisions, such as
the nomination and election of board members, should be facilitated. Shareholders
should be able to make their views known on the remuneration policy for board
members and key executives. The equity component of compensation schemes for
board members and employees should be subject to shareholder approval.
4. Shareholders should be able to vote in person or in absentia, and equal effect
should be given to votes whether cast in person or in absentia.
D. Capital structures and arrangements that enable certain shareholders to obtain a
degree of control disproportionate to their equity ownership should be disclosed.
E. Markets for corporate control should be allowed to function in an efficient and
transparent manner.
1. The rules and procedures governing the acquisition of corporate control in the
capital markets, and extraordinary transactions such as mergers, and sales of
substantial portions of corporate assets, should be clearly articulated and disclosed
so that investors understand their rights and recourse. Transactions should occur at
transparent prices and under fair conditions that protect the rights of all
shareholders according to their class.
2. Anti-take-over devices should not be used to shield management and the board
from accountability.
F. The exercise of ownership rights by all shareholders, including institutional investors,
should be facilitated.
1. Institutional investors acting in a fiduciary capacity should disclose their overall
corporate governance and voting policies with respect to their investments,
including the procedures that they have in place for deciding on the use of their
voting rights.
2. Institutional investors acting in a fiduciary capacity should disclose how they
manage material conflicts of interest that may affect the exercise of key ownership
rights regarding their investments.
G. Shareholders, including institutional shareholders, should be allowed to consult with
each other on issues concerning their basic shareholder rights as defined in the
Principles, subject to exceptions to prevent abuse.
3. The Equitable Treatment of Shareholders
The corporate governance framework should ensure the equitable treatment of all
shareholders, including minority and foreign shareholders. All shareholders should have
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5.
6.
7.
8.
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B. Where board decisions may affect different shareholder groups differently, the board
should treat all shareholders fairly.
C. The board should apply high ethical standards. It should take into account the interests
of stakeholders.
D. The board should fulfill certain key functions, including:
1. Reviewing and guiding corporate strategy, major plans of action, risk policy, annual
budgets and business plans; setting performance objectives; monitoring
implementation and corporate performance; and overseeing major capital
expenditures, acquisitions and divestitures.
2. Monitoring the effectiveness of the companys governance practices and making
changes as needed.
3. Selecting, compensating, monitoring and, when necessary, replacing key executives
and overseeing succession planning.
4. Aligning key executive and board remuneration with the longer term interests of the
company and its shareholders.
5. Ensuring a formal and transparent board nomination and election process.
6. Monitoring and managing potential conflicts of interest of management, board
members and shareholders, including misuse of corporate assets and abuse in related
party transactions.
7. Ensuring the integrity of the corporations accounting and financial reporting systems,
including the independent audit, and that appropriate systems of control are in place,
in particular, systems for risk management, financial and operational control, and
compliance with the law and relevant standards.
8. Overseeing the process of disclosure and communications.
E. E. The board should be able to exercise objective independent judgement on corporate
affairs.
1. Boards should consider assigning a sufficient number of non-executive board
members capable of exercising independent judgement to tasks where there is a
potential for conflict of interest. Examples of such key responsibilities are ensuring
the integrity of financial and non-financial reporting, the review of related party
transactions, nomination of board members and key executives, and board
remuneration.
2. When committees of the board are established, their mandate, composition and
working procedures should be well defined and disclosed by the board.
3. Board members should be able to commit themselves effectively to their
responsibilities.
F. In order to fulfill their responsibilities, board members should have access to accurate,
relevant and timely information.
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d. Role in monitoring the effectiveness of the internal control process and of the internal
audit
Internal control includes the policies and practices used to control the operations,
accounting, and regulatory compliance of the entity. Management and both the internal
auditing function and external auditors provide reporting to the audit committee regarding
the effectiveness and efficiency of internal control.
e. Role in oversight of risk management
Organizations have a variety of functions that perform activities to understand and
address risks that threaten the achievement of the organization's objectives. The policies
and practices used by the entity to identify, prioritize, and respond to the risks (or
opportunities) are typically discussed with the audit committee.
AUDIT COMMITTEE AS PER NEPAL RASTRA BANK ACT 2002
The Nepal Rastra Bank Board shall constitute an Audit Committee comprising of the
following members who will be accountable to the Board:
a. One Director
:
b. Chief of Internal Audit Department of the Bank
:
c. One senior officer of the Bank designated by the Board :
Convener
Member
Member
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The intent of the SOX Act was to protect investors, and really all stakeholders in a business
firm, by improving the accuracy and reliability of corporate disclosures, such as earnings
reports, pursuant to securities laws and regulations.
The SOX Act holds company CEO's and CFO's responsible for the information presented by
their company in financial statements. It created new standards of accountability for
corporations as well as penalties of those standards of accountability are not met. SOX
established new financial reporting standards.
All companies, according to SOX, must provide a yearend report about the internal controls
they have in place and the effectiveness of those internal controls.
History and context: events contributing to the adoption of SarbanesOxley Act
A variety of complex factors created the conditions and culture in which a series of large
corporate frauds occurred between 2000 to 2002. The spectacular, highly publicized frauds at
Enron, WorldCom, and Tyco exposed significant problems with conflicts of interest and
incentive compensation practices for senior management and accounting firm. It ultimately
reveals problems like: inadequate oversight of accountants, lack of auditor independence,
weak corporate governance procedures, and stock analysts, conflict of interests, inadequate
disclosure provisions, and grossly inadequate funding of the Securities and Exchange
Commission.
Auditor conflicts of interest: Prior to SOX, auditing firms, the primary financial
"watchdogs" for investors, were self-regulated. They also performed significant non-audit
or consulting work for the companies they audited. Many of these consulting agreements
were far more lucrative than the auditing engagement. This presented at least the
appearance of a conflict of interest. For example, challenging the company's accounting
approach might damage a client relationship, conceivably placing a significant consulting
arrangement at risk, damaging the auditing firm's bottom line.
Securities analysts' conflicts of interest: The roles of securities analysts, who make buy
and sell recommendations on company stocks and bonds, and investment bankers, who
help provide companies loans or handle mergers and acquisitions, provide opportunities
for conflicts. Similar to the auditor conflict, issuing a buy or sell recommendation on a
stock while providing lucrative investment banking services creates at least the
appearance of a conflict of interest.
Banking practices: Lending to a firm sends signals to investors regarding the firm's risk.
In the case of Enron, several major banks provided large loans to the company without
understanding, or while ignoring, the risks of the company. Investors of these banks and
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their clients were hurt by such bad loans, resulting in large settlement payments by the
banks. Others interpreted the willingness of banks to lend money to the company as an
indication of its health and integrity, and were led to invest in Enron as a result. These
investors were hurt as well.
MAJOR ELEMENTS OF SOX ACT
The act contains eleven titles, or sections, ranging from additional corporate board
responsibilities to criminal penalties, and requires the Securities and Exchange Commission
(SEC) to implement rulings on requirements to comply with the law
1. Public Company Accounting Oversight Board (PCAOB)
Title I consists of nine sections and establishes the Public Company Accounting
Oversight Board, to provide independent oversight of public accounting firms providing
audit services ("auditors"). It also creates a central oversight board tasked with registering
auditors, defining the specific processes and procedures for compliance audits, inspecting
and policing conduct and quality control, and enforcing compliance with the specific
mandates of SOX.
2. Auditor Independence
Title II consists of nine sections and establishes standards for external auditor
independence, to limit conflicts of interest. It also addresses new auditor approval
requirements, audit partner rotation, and auditor reporting requirements. It restricts
auditing companies from providing non-audit services (e.g., consulting) for the same
clients.
3. Corporate Responsibility
Title III consists of eight sections and mandates that senior executives take individual
responsibility for the accuracy and completeness of corporate financial reports. It defines
the interaction of external auditors and corporate audit committees, and specifies the
responsibility of corporate officers for the accuracy and validity of corporate financial
reports. It enumerates specific limits on the behaviors of corporate officers and describes
specific forfeitures of benefits and civil penalties for non-compliance. For example,
Section 302 requires that the company's "principal officers" (typically the Chief
Executive Officer and Chief Financial Officer) certify and approve the integrity of their
company financial reports quarterly.
4. Enhanced Financial Disclosures
Title IV consists of nine sections. It describes enhanced reporting requirements for
financial transactions, including off-balance-sheet transactions, pro-forma figures and
stock transactions of corporate officers. It requires internal controls for assuring the
accuracy of financial reports and disclosures, and mandates both audits and reports on
those controls. It also requires timely reporting of material changes in financial condition
and specific enhanced reviews by the stock exchange.
5. Analyst Conflicts of Interest
Title V consists of only one section, which includes measures designed to help restore
investor confidence in the reporting of securities analysts. It defines the codes of conduct
for securities analysts and requires disclosure of knowable conflicts of interest.
6. Commission Resources and Authority
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Title VI consists of four sections and defines practices to restore investor confidence in
securities analysts. It also defines the exchange authority to censure or bar securities
professionals from practice and defines conditions under which a person can be barred
from practicing as a broker, advisor, or dealer.
7. Studies and Reports
Title VII consists of five sections and requires the Comptroller General and the exchange
authority to perform various studies and report their findings. Studies and reports include
the effects of consolidation of public accounting firms, the role of credit rating agencies
in the operation of securities markets, securities violations, and enforcement actions, and
whether investment banks assisted Enron, Global Crossing, and others to manipulate
earnings and obfuscate true financial conditions.
8. Corporate and Criminal Fraud Accountability
Title VIII consists of seven sections and is also referred to as the "Corporate and
Criminal Fraud Accountability Act of 2002". It describes specific criminal penalties for
manipulation, destruction or alteration of financial records or other interference with
investigations, while providing certain protections for whistle-blowers.
9. White Collar Crime Penalty Enhancement
Title IX consists of six sections. This section is also called the "White Collar Crime
Penalty Enhancement Act of 2002." This section increases the criminal penalties
associated with white-collar crimes and conspiracies. It recommends stronger sentencing
guidelines and specifically adds failure to certify corporate financial reports as a criminal
offense.
10. Corporate Tax Returns
Title X consists of one section. Section 1001 states that the Chief Executive Officer
should sign the company tax return.
11. Corporate Fraud Accountability
Title XI consists of seven sections. Section 1101 recommends a name for this title as
"Corporate Fraud Accountability Act of 2002". It identifies corporate fraud and records
tampering as criminal offenses and joins those offenses to specific penalties. It also
revises sentencing guidelines and strengthens their penalties. This enables the SEC to
resort to temporarily freezing transactions or payments that have been deemed "large" or
"unusual".
Audit Documentation
The Sarbanes-Oxley Act requires auditors of public companies to prepare and maintain audit
working papers for a period of no less than seven years.
Benefits of SOX
If a publicly-traded company is not in compliance with the SOX law, the penalties are rigid.
Multi-million dollar fines can result and imprisonment of the CEO or CFO. Penalties are
based on the section of SOX that the company is not in compliance with. Thus, after SOX,
this makes CEO and CFO more responsible for financial statement and tax return, through
strict regulation and penalties clause.
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In summary, the Sarbanes-Oxley Act of 2002 is probably the best piece of legislation to
protect investors in modern times.
ENGAGEMENT PROCEDURE
Legal procedure to comply before acceptance of new assignments
General provision
The audit engagement decision is the result of two sets of decisions: the prospective clients
and the proposed audit firms. However we will focus our part of this section on the decision
of the auditing firm. Client acceptance/retention decisions are critical due to three forces
reshaping the audit environment:
1. Societys expectations about the independent auditors role in maintaining the integrity of
the securities markets are increasing;
2. Legal liability expansion underscores the importance of the auditors assessments of the
risk components of an audit; and
3. Advances in information technology are changing the nature of the attestation process.
The use of an engagement risk approach on assessing the client integrity is very useful on
client acceptance/retention decisions. Engagement risk consists of three components:
1. Client business risk-the risk associated with the clients survival and profitability;
2. Audit risk-the risk that the auditor may unknowingly fail to appropriately modify his
opinion on financial statements that are materially misstated; and
3. Auditor business risk-the risk of potential litigation costs from an alleged audit failure and
the risk of other costs such as fee realization and reputational effects.
Basically clients engagement acceptance can be summoned on six-step processes which are
as follows:
1.
2.
3.
4.
5.
6.
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b. Is competent to perform the engagement and has the capabilities, time and resources to do
so; and
c. Can comply with ethical requirements.
The firm should obtain such information as it considers necessary in the circumstances before
accepting an engagement with a new client, when deciding whether to continue an existing
engagement, and when considering acceptance of a new engagement with an existing client.
Where issues have been identified, and the firm decides to accept or continue the client
relationship or a specific engagement, it should document how the issues were resolved.
Examples to consider integrity of the clients
-
The identity and business reputation of the clients principal owners, key management,
related parties and those charged with its governance.
The nature of the clients operations, including its business practices.
Information concerning the attitude of the clients principal owners, key management and
those charged with its governance towards such matters as aggressive interpretation of
accounting standards and the internal control environment.
Whether the client is aggressively concerned with maintaining the firms fees as low as
possible.
Indications of an inappropriate limitation in the scope of work.
Indications that the client might be involved in money laundering or other criminal
activities.
The reasons for the proposed appointment of the firm and non reappointment of the
previous firm.
Further firm will gain extent of knowledge regarding integrity of client through ongoing
relationship with that client.
Sources from which the firm may obtain information regarding client integrity:
-
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Where the firm obtains information that would have caused it to decline an engagement if
that information had been available earlier, policies and procedures on the continuance of the
engagement and the client relationship should include consideration of:
a. The professional and legal responsibilities that apply to the circumstances, including
whether there is a requirement for the firm to report to the person or persons who made
the appointment or, in some cases, to regulatory authorities; and
b. The possibility of withdrawing from the engagement or from both the engagement and
the client relationship.
Policies and procedures on withdrawal from an engagement and or client:
-
Discussing with the appropriate level of the clients management and those charged with
its governance regarding the appropriate action that the firm might take based on the
relevant facts and circumstances.
If the firm determines that it is appropriate to withdraw, discussing with the appropriate
level of the clients management and those charged with its governance withdrawal from
the engagement or from both the engagement and the client relationship, and the reasons
for the withdrawal.
Considering whether there is a professional, regulatory or legal requirement for the firm
to remain in place, or for the firm to report the withdrawal from the engagement, or from
both the engagement and the client relationship, together with the reasons for the
withdrawal, to regulatory authorities.
Documenting significant issues, consultations, conclusions and the basis for the
conclusions.
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The proposed professional accountant in public practice should treat in the strictest
confidence and give due weight to any information provided by the existing accountant
Before accepting an appointment involving recurring professional services hitherto
carried out by another professional accountant in public practice, the proposed
professional accountant in public practice should:
- Ascertain if the prospective client has advised the existing accountant of the proposed
change and has given permission, preferably in writing, to discuss the clients affairs fully
and freely with the proposed professional accountant in public practice,
- request permission to communicate with the existing accountant. If such permission is
refused or the permission referred to in above is not given, the proposed professional
accountant in public practice should, in the absence of exceptional circumstances of
which there is full knowledge, and unless there is satisfaction as to necessary facts by
other means, decline the appointment.
The existing accountant, on receipt of the communication referred above should forthwith:
Reply, preferably in writing, advising whether there are any professional reasons why
the proposed professional accountant in public practice should not accept the
appointment.
If there are any such reasons or other matters which should be disclosed, ensure that
the client has given permission to give details of this information to the proposed
professional accountant in public practice. If permission is not granted, the existing
accountant should report that fact to the proposed professional accountant in public
practice.
On receipt of permission from the client, disclose all information needed by the
proposed professional accountant in public practice to be able to decide whether or
not to accept the appointment, and discuss freely with the proposed professional
accountant in public practice all matters relevant to the appointment of which the
latter should be aware
If the proposed professional accountant in public practice does not receive, within a
reasonable time, a reply from the existing accountant and there is no reason to believe that
there are any exceptional circumstances surrounding the proposed change, the proposed
professional accountant in public practice should endeavor to communicate with the existing
accountant by some other means. If unable to obtain a satisfactory outcome in this way, the
proposed professional accountant in public practice should send a further letter, stating that
there is an assumption that there is no professional reason why the appointment should not be
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the audit. Audit procedures to obtain an understanding are referred to as risk assessment
procedures because some of the information obtained by performing such procedures may
be used by the auditor as audit evidence to support assessments of the risks of material
misstatement. In addition, in performing risk assessment procedures, the auditor may obtain
audit evidence about classes of transactions, account balances, or disclosures and related
assertions and about the operating effectiveness of controls, even though such audit
procedures were not specifically planned as substantive procedures or as tests of controls.
The auditor also may choose to perform substantive procedures or tests of controls
concurrently with risk assessment procedures because it is efficient to do so.
Risk Assessment Procedures
The auditor should perform the following risk assessment procedures to obtain an
understanding of the entity and its environment, including its internal control:
a) Inquiries of management and others within the entity;
b) Analytical procedures; and
c) Observation and inspection
Auditor should perform other audit procedures where the information obtained may be
helpful in identifying risks of material misstatement. For example, the auditor may consider
making inquiries of the entitys external legal counsel or of valuation experts that the entity
has used. Reviewing information obtained from external sources such as reports by analysts,
banks, or rating agencies; trade and economic journals; or regulatory or financial publications
may also be useful in obtaining information about the entity.
Although much of the information the auditor obtains by inquiries can be obtained from
management and those responsible for financial reporting, inquiries of others within the
entity, such as production and internal audit personnel, and other employees with different
levels of authority, may be useful in providing the auditor with a different perspective in
identifying risks of material misstatement. In determining others within the entity to which
inquiries may be directed, and the extent of those inquiries, the auditor considers what
information may be obtained that helps the auditor in identifying risks of material
misstatement. For example:
- Inquiries directed towards those charged with governance may help the auditor
understand the environment in which the financial statements are prepared.
- Inquiries directed toward internal audit personnel may relate to their activities concerning
the design and effectiveness of the entitys internal control and whether management has
satisfactorily responded to any findings from these activities.
- Inquiries of employees involved in initiating, processing or recording complex or unusual
transactions may help the auditor in evaluating the appropriateness of the selection and
application of certain accounting policies.
- Inquiries directed toward in-house legal counsel may relate to such matters as litigation,
compliance with laws and regulations, knowledge of fraud or suspected fraud affecting
the entity, warranties, post-sales obligations, arrangements (such as joint ventures) with
business partners and the meaning of contract terms.
- Inquiries directed towards marketing or sales personnel may relate to changes in the
entitys marketing strategies, sales trends, or contractual arrangements with its customers.
Analytical procedures may be helpful in identifying the existence of unusual transactions or
events, and amounts, ratios, and trends that might indicate matters that have financial
statement and audit implications. In performing analytical procedures as risk assessment
procedures, the auditor develops expectations about plausible relationships that are
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reasonably expected to exist. When comparison of those expectations with recorded amounts
or ratios developed from recorded amounts yields unusual or unexpected relationships, the
auditor considers those results in identifying risks of material misstatement.
Observation and inspection may support inquiries of management and others, and also
provide information about the entity and its environment that includes:
- Observation of entity activities and operations.
- Inspection of documents (such as business plans and strategies), records, and internal
control manuals.
- Reading reports prepared by management (such as quarterly management reports and
interim financial statements) and those charged with governance (such as minutes of
board of directors meetings).
- Visits to the entitys premises and plant facilities.
- Tracing transactions through the information system relevant to financial reporting (walkthrough).
When the auditor intends to use information about the entity and its environment obtained in
prior periods, the auditor should determine whether changes have occurred that may affect
the relevance of such information in the current audit.
Discussion among the Engagement Team
The members of the engagement team should discuss the susceptibility of the entitys
financial statements to material misstatements. It provides an opportunity for more
experienced engagement team members, including the engagement partner, to share their
insights based on their knowledge of the entity, and for the team members to exchange
information about the business risks1 to which the entity is subject and about how and where
the financial statements might be susceptible to material misstatement.
Understanding the Entity and Its Environment, Including Its Internal Control
The auditor understanding of the entity and its environment consists of an understanding of
the following aspects (INOMI):
a) Industry, regulatory, and other external factors, including the applicable financial
reporting framework.
b) Nature of the entity, including the entitys selection and application of accounting
policies.
c) Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements.
d) Measurement and review of the entitys financial performance.
e) Internal control.
a) Industry, regulatory, and other external factors, including the applicable financial
reporting framework.
The auditor should obtain an understanding of relevant industry, regulatory, and other
external factors including the applicable financial reporting framework. These factors
include industry conditions such as the competitive environment, supplier and customer
relationships, and technological developments; the regulatory environment encompassing,
among other matters, the applicable financial reporting framework, the legal and political
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environment, and environmental requirements affecting the industry and the entity; and
other external factors such as general economic conditions.
The industry in which the entity operates may give rise to specific risks of material
misstatement arising from the nature of the business or the degree of regulation.
b) Nature of the entity, including the entitys selection and application of accounting
policies.
The auditor should obtain an understanding of the entitys selection and application of
accounting policies and consider whether they are appropriate for its business and
consistent with the applicable financial reporting framework and accounting polices used
in the relevant industry. The understanding encompasses the methods the entity uses to
account for significant and unusual transactions; the effect of significant accounting
policies in controversial or emerging areas for which there is a lack of authoritative
guidance or consensus; and changes in the entitys accounting policies.
c) Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements.
The auditor should obtain an understanding of the entitys objectives and strategies, and
the related business risks that may result in material misstatement of the financial
statements. Business risk particularly may arise from change or complexity, though a
failure to recognize the need for change may also give rise to risk.
d) Measurement and review of the entitys financial performance.
The auditor should obtain an understanding of the measurement and review of the entitys
financial performance. Performance measures and their review indicate to the auditor
aspects of the entitys performance that management and others consider to be of
important.
Performance measures, whether external or internal, create pressures on the entity that, in
turn, may motivate management to take action to improve the business performance or to
misstate the financial statements.
e) Internal control.
Internal control is the process designed and affected by those charged with governance,
management, and other personnel to provide reasonable assurance about the achievement
of the entitys objectives with regard to reliability of financial reporting, effectiveness and
efficiency of operations and compliance with applicable laws and regulations.
The auditor should obtain an understanding of internal control relevant to the audit. The
auditor uses the understanding of internal control to identify types of potential
misstatements, consider factors that affect the risks of material misstatement, and design
the nature, timing, and extent of further audit procedures.
Limitations of Internal Control
Internal control can provide an entity with only reasonable assurance about achieving the
entitys financial reporting objectives. However, it may has following limitations:
- Internal control achievement is affected by limitations inherent to internal control
- Involvement of human judgment in decision-making that can be faulty causes
breakdowns in internal control
- Errors
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Collusion
Smaller entities with fewer employees may limit the extent to which segregation of
duties is practicable.
Control Environment
The primary responsibility for the prevention and detection of fraud and error rests with both
those charged with governance and the management of an entity.
In evaluating the design of the entitys control environment, the auditor considers the
following elements and how they have been incorporated into the entitys processes:
- Communication and enforcement of integrity and ethical values essential elements
which influence the effectiveness of the design, administration and monitoring of
controls.
- Commitment to competence managements consideration of the competence levels for
particular jobs and how those levels translate into requisite skills and knowledge.
- Participation by those charged with governance independence from management, their
experience and stature, the extent of their involvement and scrutiny of activities, the
information they receive, the degree to which difficult questions are raised and pursued
with management and their interaction with internal and external auditors.
- Participation by those charged with governance independence from management, their
experience and stature, the extent of their involvement and scrutiny of activities, the
information they receive, the degree to which difficult questions are raised and pursued
with management and their interaction with internal and external auditors.
- Organizational structure the framework, within which an entitys activities for
achieving its objectives are planned, executed, controlled and reviewed.
- Assignment of authority and responsibility how authority and responsibility for
operating activities are assigned and how reporting relationships and authorization
hierarchies are established.
- Human resource policies and practices recruitment, orientation, training, evaluating,
counseling, promoting, compensating and remedial actions.
The Entitys Risk Assessment Process
The auditor should obtain an understanding of the entitys process for identifying business
risks relevant to financial reporting objectives and deciding about actions to address those
risks, and the results thereof. In evaluating the design and implementation of the entities risk
assessment process, the auditor determines how management identifies business risks
relevant to financial reporting, estimates the significance of the risks, assesses the likelihood
of their occurrence, and decides upon actions to manage them.
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How the information system captures events and conditions, other than classes of
transactions that are significant to the financial statements.
The financial reporting process used to prepare the entitys financial statements, including
significant accounting estimates and disclosures.
Control Activities
The auditor should obtain a sufficient understanding of control activities to assess the risks of
material misstatement at the assertion level and to design further audit procedures responsive
to assessed risks. Which involves following:
- Authorization.
- Performance reviews.
- Information processing.
- Physical controls.
- Segregation of duties.
Assessing the Risks of Material Misstatement
The auditor should identify and assess the risks of material misstatement at the financial
statement level, and at the assertion level for classes of transactions, account balances, and
disclosures. For this purpose, the auditor:
- Identifies risks throughout the process of obtaining an understanding of the entity and
its environment, including relevant controls that relate to the risks, and by considering
the classes of transactions, account balances, and disclosures in the financial
statements;
- Relates the identified risks to what can go wrong at the assertion level;
- Considers whether the risks are of a magnitude that could result in a material
misstatement of the financial statements; and
- Considers the likelihood that the risks could result in a material misstatement of the
financial statements.
Significant Risks that Require Special Audit Consideration
The determination of significant risks, which arise on most audits, is a matter for the auditors
professional judgment. Significant risks are often derived from business risks that may result
in a material misstatement. In considering the nature of the risks, the auditor considers a
number of matters, including the following:
- Whether the risk is a risk of fraud.
- Whether the risk is related to recent significant economic, accounting or other
developments and, therefore, requires specific attention.
- The complexity of transactions.
- Whether the risk involves significant transactions with related parties.
- The degree of subjectivity in the measurement of financial information related to the
risk especially those involving a wide range of measurement uncertainty.
- Whether the risk involves significant transactions that are outside the normal course
of business for the entity, or that otherwise appear to be unusual.
Risks of material misstatement may be greater for risks relating to significant non- routine
transactions arising from matters such as the following:
- Greater management intervention to specify the accounting treatment.
- Greater manual intervention for data collection and processing.
- Complex calculations or accounting principles.
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The nature of non-routine transactions, which may make it difficult for the entity to
implement effective controls over the risks.
AUDIT RISK
Audit risk is the first fundamental concept that underlies the audit process. Because of the
nature of audit evidence and the characteristics of management fraud, an auditor can only
provide reasonable assurance, as opposed to absolute assurance, that the financial statements
are free from material misstatement. The term reasonable assurance is used in the paragraph
of the audit report describing the auditors responsibility to inform the reader that there is
some level of risk that the audit did not detect all material misstatements. Audit risk is
defined as follows:
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated.
While the auditor is ultimately concerned with audit risk at the financial statement level, as a
practical matter audit risk must be considered at more detailed levels through the course of
the audit, including the class of transactions, account balance or disclosure level. For ease of
presentation, we will use the term assertion to refer to consideration of audit risk at these
lower levels. In other words, consideration of audit risk at the assertion level means that the
auditor must consider the risk that he or she will conclude that an assertion for a particular
class of transactions (e.g. classification of capital lease transactions), a particular account
balance (e.g. existence of accounts receivable) or a particular disclosure (e.g. valuation of
amounts disclosed in a note dealing with stock compensation) is fairly stated, when in fact it
is materially misstated.
Thus, at the assertion level, audit risk consists of:
1. The risk that the relevant assertions related to classes of transactions, balances or
disclosures contain misstatements that could be material to the financial statements when
aggregated with misstatements in other classes, balances or disclosures (inherent risk and
control risk).
2. The risk that the auditor will not detect such misstatements (detection risk). In other
words, audit risk is the combination of these two elementsthat the clients financial
statements will contain material misstatements and that the auditor will fail to detect any
such misstatements.
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auditor to plan the appropriate audit procedures for those transactions, accounts or
disclosures. The risk that the relevant assertions are misstated consists of two components:
1. Inherent risk (IR) is the susceptibility of an assertion about a class of transactions,
account balance or disclosure to a misstatement that could be material, either
individually or when aggregated with other misstatements, before consideration of any
related controls. In other words, IR is the likelihood that a material misstatement exists
in the financial statements without the consideration of internal control.
2. Control risk (CR) is the risk that a misstatement that could occur in an assertion about a
class of transactions, account balance or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or
detected and corrected, on a timely basis by the entitys internal control. CR is a function
of the effectiveness of the design and operation of internal control in achieving the
entitys objectives relevant to preparation of the entitys financial statements. Some CR
will always exist because of the inherent limitations of internal control.
Inherent risk and control risk exist independently of the audit. In other words, the levels
of inherent risk and control risk are functions of the entity and its environment. The
auditor has little or no control over these risks. Auditing standards refer to the
combination of IR and CR as the risk of material misstatement (RMM). Some auditors
refer to this combination as client risk because it stems from decisions made by the
client (e.g. what kinds of business transactions to engage in, how much to invest in
internal controls). To properly assess CR, the auditor must understand the clients
controls and perform audit procedures to determine if the controls are operating
effectively.
3. Detection risk (DR) is the risk that the auditor will not detect a misstatement that exists
in a relevant assertion that could be material either individually or when aggregated with
other misstatements. Detection risk is determined by the effectiveness of the audit
procedure and how well the audit procedure is applied by the auditor. Thus, detection
risk cannot be reduced to zero because the auditor seldom examines 100 per cent of the
account balance or class of transactions (sampling risk). In addition, the auditors work
is subject to non-sampling risk. Non-sampling risk is the risk that the auditor might
select an inappropriate audit procedure, misapply the appropriate audit procedure or
misinterpret the audit results. Non-sampling risk can be reduced through adequate
planning, proper assignment of audit staff to the engagement team, the application of
professional skepticism, supervision and review of the audit work performed, and
supervision and conduct of a firms audit practice in accordance with appropriate quality
control standards
Detection risk has an inverse relationship to inherent risk and control risk. For example, if an
auditor judges a clients inherent risk and control risk to be high, the auditor should set a low
level of detection risk in order to achieve the planned level of audit risk. Conversely, if
inherent risk and control risk are low, the auditor can accept higher detection risk.
The audit risk model can be specified as:
AR = RMM DR
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This model expresses the general relationship of audit risk and the risks associated with the
auditors assessments of risk of material misstatement (inherent risk and control risk) and the
risks that substantive tests will fail to detect a material misstatement in a relevant assertion
(detection risk).
The determination of audit risk and the use of the audit risk model involve considerable
judgement on the part of the auditor. The audit risk model assists the auditor in determining
the scope of auditing procedures for a relevant assertion in a class of transactions, account
balance or disclosure. Auditing standards do not provide specific guidance on what is an
acceptable low level of audit risk. The auditors assessment of audit risk and its component
risks (RMM and DR) is a matter of professional judgment. At the completion of the audit,
the actual or achieved level of audit risk is not known with certainty by the auditor. If the
auditor assesses the achieved audit risk as being less than or equal to the planned level of
audit risk, an unmodified opinion can be issued. If the assessment of the achieved level of
audit risk is greater than the planned level, the auditor should either conduct additional audit
work or modify the audit opinion. In either case, the judgments involved are often highly
subjective.
Use of the Audit Risk Model
The audit risk model is not intended to be a precise formula that includes all factors
influencing the assessment of audit risk. However, auditors find the logic that underlies the
model useful when planning risk levels (and thus making scoping decisions) for audit
procedures. The discussion that follows concerning the audit risk model is limited to its use
as an audit planning tool. Three steps are involved in the auditors use of the audit risk model
at the assertion level:
1. Setting a planned level of audit risk.
2. Assessing the risk of material misstatement.
3. Solving the audit risk equation for the appropriate level of detection risk.
In applying the audit risk model, the auditor determines or assesses each component of the
model using either quantitative or qualitative terms. In step 1, the auditor sets audit risk for
each class of transactions, account balance or disclosure in such a way that, at the completion
of the engagement, an opinion can be issued on the financial statements with an acceptable
low level of audit risk. Step 2 requires that the auditor assess the risk of material
misstatement.
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Suppose that the auditor has determined that the planned audit risk for the accounts
receivable balance should be set at .05 based on the significance of the account to the
financial statements. By establishing a relatively low level of audit risk, the auditor is
minimizing the possibility that the account may contain a material misstatement. Assume
further that the auditor assesses the risk of material misstatement for accounts receivable to
be 0.60. Substituting the values for AR and RMM into the equation indicates that the auditor
should set DR at approximately 0.08 (DR = 0.05/0.60) for testing the accounts receivable
balance. Thus, the auditor establishes the scope of the audit for accounts receivable so that
there is only an 8 per cent chance that a material misstatement, if present, is not detected.
AUDITORS RISK ASSESSMENT PROCEDURES
The auditor obtains an understanding of the entity and its environment by performing the
following risk assessment procedures: inquiries of management and others; analytical
procedures; and observation and inspection.
Inquiries of Management and Others
The auditor obtains information about the entity and its environment through inquiry of
management, individuals responsible for financial reporting and other personnel within the
entity. For example, the auditor makes inquiries of management about changes in
circumstances that may give rise to new, or the need to revise existing, accounting estimates.
As another example, the auditor inquires of management about the entitys related parties and
related party transactions. Making inquiries of others within the entity may be useful in
providing the auditor with a perspective different from that of management and those
responsible for financial reporting. The auditor might make inquiries of:
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CAP III
For example, inquiries directed to internal audit personnel might relate to their activities
concerning the design and operating effectiveness of the entitys internal controls. The
auditor might also inquire of the in-house legal counsel about issues such as litigation,
compliance with laws and regulations, and the meaning of contract terms.
The auditor might also inquire of others outside the entity. For example, the auditor may
consider it is appropriate to make inquiries of customers, suppliers or valuation experts. Such
discussions may provide information that will assist the auditor in uncovering the fraud. For
example, customers may report that they received large quantities of unordered products from
the audit client just before year end. This would be an indicator of overstated revenues.
Analytical Procedures
Analytical procedures are evaluations of financial information through analysis of plausible
relationships among both financial and non-financial data. Auditing standards require that the
auditor conducts analytical procedures in planning the audit. Such preliminary analytical
procedures assist the auditor in understanding the entity and its environment, and in
identifying areas that may represent specific risks relevant to the audit. Analytical procedures
can be helpful in identifying the existence of unusual transactions or events and amounts,
ratios and trends that might have implications for audit planning. In performing such
analytical procedures, the auditor should develop expectations about plausible relationships
that are expected to exist, based on the understanding of the entity and its environment.
However, the results of such high-level analytical procedures provide only a broad initial
indication about whether a material misstatement may exist.
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When the risks relate to a single assertion or set of assertions for the same business process or
account, the auditor should consider the entitys internal controls. As discussed in Chapter 6,
the auditor needs to consider the design and operation of controls within a business process to
determine if they prevent, or detect and correct misstatements. If the controls are properly
designed, and the auditor intends to rely on those controls, the auditor will test the operating
effectiveness of the controls. Depending on the operating effectiveness of the entitys
controls, the auditor will design and perform substantive tests directed at the potential
misstatements that may result from the identified risks.
Examples of the types of items that may result in significant risks include:
Assertions identified with fraud risk factors.
Non-routine or unsystematically processed transactions.
Significant accounting estimates and judgements.
Highly complex transactions.
The Institute of Chartered Accountants of Nepal
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When the auditor has determined that a significant risk exists, the auditor should, to the
extent not already done, obtain an understanding of the entitys controls, including control
activities, relevant to that risk. The auditor should always perform substantive procedures
that directly respond to the significant risk at assertion. For example, for accounting estimates
that give rise to significant risks the auditor should perform specific substantive procedures
including evaluation of the reasonableness of managements assumptions and how estimation
uncertainty has been addressed. When the auditor plans to rely on controls over a significant
risk, the auditor tests those controls in the current period.
Evaluation of Audit Test Results
As the audit progresses and at the completion of the audit the auditor evaluates the effect of
the identified misstatements on the audit. The auditor requests, on a timely basis,
management to correct misstatements. At the completion of the audit the auditor determines
if the remaining uncorrected misstatements would cause the financial statements to be
materially misstated. If the individual or aggregate uncorrected misstatements are greater than
materiality, the auditor would have to issue a qualified or adverse opinion. When the
uncorrected misstatements are evaluated immaterial and the relevant qualitative aspects of the
entitys accounting practices and financial statements presentation do not imply otherwise,
the auditor can conclude that the financial statements as a whole are free from material
misstatement.
If the auditor has determined that the misstatement is or may be the result of fraud, and either
has determined that the effect could be material to the financial statements or has been unable
to evaluate whether the effect is material, the auditor should:
Attempt to obtain audit evidence to determine whether, in fact, material fraud has
occurred and, if so, its effect.
Consider the implications for other aspects of the audit.
Discuss the matter and the approach to further investigation with an appropriate level
of management that is at least one level above those involved in committing the fraud
and with senior management.
If appropriate, suggest that the client consult with legal counsel.
If the results of the audit tests indicate a significant risk of fraud, the auditor should consider
withdrawing from the engagement and communicating the reasons for withdrawal to those
charged with governance (i.e. the board of directors, the audit committee or others with
equivalent authority and responsibility).
Documentation of the Auditors Risk Assessment and Response
The auditor has extensive documentation requirements for risk assessment (including fraud
risk assessment) and audit responses to identified risks. For example, the auditor should
document the risk of material misstatement for all material accounts and classes of
The Institute of Chartered Accountants of Nepal
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transactions in terms of the related assertions. The level of risk may be described as
quantitative or qualitative (high, medium or low). Areas of documentation include the
following:
The nature and results of the communication among engagement personnel that occurred
in planning the audit regarding the risks of material misstatement.
The steps performed in obtaining knowledge about the entitys business and its
environment. The documentation should include:
- The risks identified.
- An evaluation of managements response to such risks.
- The auditors assessment of the risk of error or fraud after considering the entitys
response.
The nature, timing and extent of the procedures performed in response to the risks of
material misstatement due to fraud and the results of that work.
Fraud risks or other conditions that caused the auditor to believe that additional audit
procedure or other responses were required to address such risks or other conditions.
The nature of the communications about fraud made to management, those charged with
governance, and others.
The basis for the auditors conclusions about the reasonableness of accounting estimates
that give rise to significant risks.
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AUDIT TEST
Quantum of Audit evidence
Auditor should obtain sufficient audit evidence through the performance of compliance and
substantive procedures to enable him to draw reasonable conclusions there from on which to
base his opinion on the financial information.
Compliance Procedures are tests that help in obtaining reasonable assurance regarding
internal controls on which reliance is to be placed. Substantive Procedures help in obtaining
evidence for the accuracy, validity and completeness of the financial data (transactions,
balances or financial ratios and trends). There are two types (a) tests of details of
transactions and balances & (b) Analysis of significant ratios and trends including the
resulting inquiry of unusual fluctuations and items.
Sufficient, Appropriate Audit Evidence has to be obtained through compliance and
substantive procedures. While sufficiency is the quantum of audit evidence, appropriateness
refers to its relevance and reliability. The auditor's judgement as to what is sufficient
appropriate evidence is influenced by factors such as: the degree of risk of misstatement;
materiality of the item; his experience during previous audits; etc. While obtaining the audit
evidence through compliance procedures the auditor is concerned with assertions such as: the
existence of control, its effectiveness and its consistent application throughout the period.
The purpose of obtaining audit evidence through substantive procedures is to assure the
auditor of assertions such as: existence of an asset/liability; the rights/obligations regarding
the same; occurrence of transactions; their completeness; valuation; measurement;
presentation and disclosures, etc. The reliability of audit evidence is influenced by two
factors: its source - i.e., internal/external and its nature - i.e., visual/documentary/oral.
Generally a third party, documented evidence obtained by auditor himself is good. When
evidences from different sources are consistent the auditor can place a higher degree of
reliability. But in the case of the contrary, he must extend his procedures to resolve the
inconsistency.
When the auditor is unable to obtain sufficient appropriate evidence he must give a qualified
opinion.
Obtaining audit evidence could be by one or more of the following methods:
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Inquiry & Confirmation: Inquiry consists of seeking information from the persons
inside or outside the entity. When such an inquiry is responded to, it becomes
confirmation and forms a good audit evidence for the auditor.
Terms
Examine
Read
Compute
Recomputed
Foot
Recalculation
Trace
Documentation/ Reperformance
Documentation
Physical examination
Observation
Inquiries of client
Documentation
Compare
Count
Observe
Inquire
Vouch
Information about
Cash in bank
Accounts receivable
Notes receivable
Owned inventory out on
consignment
Inventory held in public
warehouses
Cash surrender value of life
insurance
Accounts payable
Notes payable
Advances from customers
Mortgages payable
Bonds payable
Source
Bank
Customer
Maker
Consignee
Public warehouse
Insurance company
Creditor
Lender
Customer
Mortgagor
Bondholder
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documentation may not be readily available and engagement teams may be provided only
with scanned or digitized copies, for example, when entities use a shared service centre. In
such circumstances, engagement teams need to assess the adequacy and reliability of such
documents as appropriate audit evidence.
While recognizing that exceptions may exist, the reliability of audit evidence often increases
when it is obtained from independent sources outside the entity. Corroborating information
obtained from a source independent of the entity may increase the assurance the auditor
obtains from audit evidence generated internally, such as evidence existing within the entity's
records, minutes of meetings, or a management representation.
Regarding communications from third parties, the more important the evidential nature of the
communication, the more important it is to have a signed original. For example, a
confirmation from a lender with respect to a significant loan transaction should be obtained in
original form. Other audit evidence is not acceptable in other than original form, such as
certain management representations and other important evidence of a similar nature.
Compliance and substantive audit procedures
Compliance procedures are the tests of internal control. This is for the purpose to check
whether there is internal control operating within the organization, whether it is operating
effectively or not, whether the operation throughout the period was effective or not. Tests of
Controls consist of procedures directed toward the evaluation of the effectiveness of the
design and implementation of internal controls. When tests of controls look at design issues,
the auditors evaluates whether the control has been properly designed to prevent or detect
material
misstatement.
Examples of tests of controls:
Inquiries of appropriate management, supervisor, and staff personnel.
Inspection of documents, reports, and electronic files.
Observation of the application of specific controls.
Re-performance of the application of the control by the auditors.
Substantive evidence is about whether the evidence obtained is complete, accurate, and valid
as to the information produced by the accounting system. In substantive testing, you gather
evidence to evaluate the integrity of data, a transaction or other information, e.g., you trace a
transaction to the accounting records to verify that it was properly recorded.
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Assertions
Occurrence
Explanation
Transactions
recognized in the
financial
statements have
occurred and
relate to the entity.
Completenes All transactions
s
that were
supposed to be
recorded have
been recognized in
the financial
statements.
Accuracy
Transactions have
been recorded
accurately at their
appropriate
amounts.
Cut-off
Transactions have
been recognized in
the correct
accounting
periods.
Classification Transactions have
been classified
and presented
fairly in the
financial
statements.
Assertions relating Account balance (assets, liabilities and equity) at the period end
Assertions
Explanation
Examples: Inventory balance
Existence
Assets, liabilities and equity
Inventory recognized in the balance
balances exist at the period end.
sheet exists at the period end.
Completeness
All assets, liabilities and equity
All inventory units that should have
balances that were supposed to be
been recorded have been recognized
recorded have been recognized in
in the financial statements. Any
the financial statements.
inventory held by a third party on
behalf of the audit entity has been
included in the inventory balance.
Rights &
Entity has the right to ownership or Audit entity owns or controls the
Obligations
use of the recognized assets, and
inventory recognized in the financial
the liabilities recognized in the
statements. Any inventory held by the
financial statements represent the
audit entity on account of another
obligations of the entity.
entity has not been recognized as part
of inventory of the audit entity.
Valuation
Assets, liabilities and equity
Inventory has been recognized at the
balances have been valued
lower of cost and net realizable value
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appropriately.
Assertions
Occurrence
Completeness
Classification &
Understandability
Accuracy &
Valuation
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Testing
Completion
provides the basis for determining the nature, timing and extent of audit
procedures that are necessary to obtain sufficient and appropriate audit
evidence in response to those assessed risks.
Substantive tests are performed to identify material misstatements at the
assertion level. In case of assertions whose ROMM has been assessed as
significant and no tests of control are planned to be performed, the substantive
procedures should include tests of detail (i.e. substantive analytical procedures
alone cannot be considered as sufficient and appropriate audit evidence for
assertions with a significant risk of material misstatement.
Tests of control (TOCs) are performed to assess the operating effectiveness of
controls at the financial statement and assertion level. TOCs are necessary to
validate the auditor's expectation of the operating effectiveness of controls (as
acquired from the risk assessment procedures performed at the planning stage)
and also in case where the performance of substantive procedures alone cannot
provide sufficient and appropriate audit evidence in respect of a specific
assertion.
Auditor shall conclude whether sufficient and appropriate audit evidence has
been obtained for all material financial statement assertions taking into account
any revisions in the assessment of ROMM at the assertion level.
Where an auditor is unable to obtain sufficient and appropriate audit evidence
in respect of a material financial statement assertion, he is required to modify
the audit report accordingly.
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levels. The assessment involves considering a number of factors such as the nature of the
risks, relevant internal controls and the required level of audit evidence.
The result of the assessment effectively categorizes the audit into
a) Areas of significant risk of material misstatement that require specific responses and
b) Areas of normal risk that can be addressed by standard audit work programs.
Having assessed risks, the auditor then designs appropriate audit responses to those risks in
order to obtain sufficient appropriate audit evidence on which to conclude. Risk assessment
continues throughout the audit and the audit plan and procedures are amended where a
reassessment is necessary.
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(individually or in combination) that are considered likely to be relevant to the audit (for
example controls related to financial reporting) not all the controls the entity employs in
managing its business.
The control framework assists auditors to focus on obtaining an understanding of relevant
controls by dividing the entitys internal controls into five components:
Control environment: the control culture of the entity and its impact
Entitys own risk assessment process: how the entity identifies, assesses and responds
to its own business risks
Information systems relevant to the financial reporting: those systems related to the
capture of significant transactions, events, conditions or accounting estimates, the
procedures related to nonstandard journal entries, reconciliations of sub-ledgers to the
general ledger, the data entry of transactions, and reporting in the financial report
Control activities relevant to audit: those policies and procedures that help ensure that
management directives are carried out (i. e. control activities designed to
prevent/detect misstatements). Examples of control activities include those relating to
authorization, performance reviews, information processing, physical controls and
segregation of duties
Monitoring of control activities: those activities the entity uses to monitor control
activities over financial reporting, as well as how it takes action to address any
identified deficiencies.
Understanding internal control in this way enables the auditor to identify what relevant
controls (if any) are in place to test, whether the absence of controls creates risk, how or
when to combine controls testing with substantive testing, how to test the operating
effectiveness of controls and the extent of reliance that can be placed on internal controls
(thereby reducing the extent of substantive testing).
2. Identifying and assessing risk
The auditors understanding of the entitys financial reporting environment enables the
auditor to identify those risks that potentially affect the overall financial report or individual
transactions, account balances and disclosures within it (at the assertion level). Considerable
professional judgement and skill are required to not only identify such risks but also to relate
how they potentially impact the recognition, measurement, presentation and disclosure in the
financial report or the valuation, allocation, occurrence, completeness, accuracy, cut-off,
classification, existence, or rights and obligations at the assertion level. The nature of the risk
will also determine how the auditor designs the audit work program (for example, through a
combination of controls testing and substantive testing or substantive testing only).
The initial risk assessment is performed at the audit planning stage, with it being reassessed
and revised if new risks are identified during the audit. The auditor exercises professional
judgement in evaluating and classifying each risk according to its potential to create a
material misstatement in the financial report as a whole or at the account and assertion levels
(for example, the accuracy, cut-off and valuation of inventory).
Risk classification is either normal or greater than normal (significant risk). Normal risk is a
risk that has a possibility of occurring, whereas significant risk is risk that is likely to occur.
Where no significant risk(s) has been identified, a normal level of risk exists. The auditor
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may identify circumstances that lead the auditor to believe the risk has a probability
(likelihood) of occurring. Any such circumstances are particular to each entity and may be
identified through the auditors prior experience with the entity, the knowledge that
inexperienced entity staff are working in a complex area or the auditors knowledge of known
difficulties in obtaining or verifying particular information required for the audit. Significant
risks, by their very nature, require the auditor to design specific/tailored audit procedures to
address them those included in a standard audit work program are usually not appropriate.
The risk assessment determines the nature, timing and extent of audit procedures to respond
to identified risk appropriately the general rule of thumb being the greater the level of risk,
the more persuasive the audit evidence required to reduce its potential to an acceptable level.
It is therefore critical to properly assess risks so that audit time and effort is spent efficiently
and effectively in testing significant risks.
3. Responding to identified risk
Responding to risk requires the auditor to obtain sufficient appropriate audit evidence
regarding the assessed risks of material misstatement, through designing and implementing
appropriate responses to those risks (NSA 330, paragraph 3). The auditor needs to relate
(and document) each identified risk directly to the assertion level and the overall financial
report impact, with the response planned to gain sufficient appropriate audit evidence on
which to base the auditors opinion.
The experienced auditor designs responses to assessed risks based on the following:
The overall effect the identified risk may have on the financial report (for example,
overstatement or understatement of certain material account balances)
The effect that the identified risk has at the assertion level for each class of
transactions, account balance or disclosure
The expected test results in terms of whether they will meet the test objectives.
The design of the audit program to address identified risks involves:
Setting the test objectives (what assertions are to be tested and why)
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In areas of significant risks, the auditor must include substantive procedures to specifically
respond to those risks. These can include both test of details and substantive analytical
procedures. Finally, a reminder that irrespective of the risk assessment, all material classes of
transactions, account balances and disclosures require a level of substantive testing to be
performed.
Once audit procedures have been performed to address assessed risks, the auditor needs to
evaluate the evidence obtained to determine whether the initial risk assessment at the
assertion level remains appropriate and whether there is reasonable assurance that a material
misstatement does not exist. Evidence must be persuasive for each material financial report
assertion, otherwise further audit procedures must be performed to obtain such evidence. If
such evidence is unable to be obtained, a qualified or disclaimer of opinion in the auditors
report is required. When sufficient appropriate evidence has been obtained, the auditor is able
to conclude on the overall risk of material misstatement to the financial report as a whole.
Getting risk right = Better efficiency and effectiveness of risk based Audit
A properly timed and performed risk assessment and response process by the experienced
auditor provides the foundation for the entire audit it focuses the auditors attention on
identifying, assessing and responding to those risks that have the potential to materially affect
the financial report. The risk-based audit approach provides the auditor with an approach to
conduct the audit as efficiently and effectively as possible, benefiting both the audit team and
the entity.
Summary
The essence of risk-based audit is therefore customer-focused, starting with the objectives of
the activity being audited, then moving on to the threats (or risks) to achievement of those
goals and then to the procedures and processes to mitigate the risks.
Risk-based audit is therefore an evolution rather than a revolution, although the results
obtained can be revolutionary in their magnitude.
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4. Risk management processes, including the effectiveness of responses and the completion
of actions, are being monitored by management to ensure they continue to operate
effectively
5. Risks, responses and actions are being properly classified and reported.
This enables internal audit to provide the board with assurance that it needs on three areas:
1. Risk management processes, both their design and how well they are working
2. Management of those risks classified as 'key', including the effectiveness of the controls
monitoring legal requirements and ensuring that operating procedures are designed to
meet these requirements,
ensuring employees are properly trained and understand the Code of Conduct,
Maintaining a register of significant laws with which the entity has to comply within
its particular industry and a record of complaints.
In case of larger entities, these policies and procedures may be supplemented by assigning
appropriate responsibilities to:
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discuss the legal and regulatory framework with auditors of subsidiaries in other
countries
After obtaining the general understanding, the auditor should perform procedures to help
identify instances of noncompliance with those laws and regulations where noncompliance
should be considered when preparing financial statements, specifically:
a) Inquiring of management as to whether the entity is in compliance with such laws and
regulations,
b) Inspecting correspondence with the relevant licensing or regulatory authorities.
Further, the auditor should obtain sufficient appropriate audit evidence about compliance
with those laws and regulations generally recognised by the auditor to have an effect on the
determination of material amounts and disclosures in financial statements. The auditor should
have a sufficient understanding of these laws and regulations in order to consider them when
auditing the assertions related to the determination of the amounts to be recorded and the
disclosures to be made.
The auditor should be alert to the fact that procedures applied for the purpose of forming an
opinion on the financial statements may bring instances of possible noncompliance with laws
and regulations to the auditors attention.
The auditor should obtain written representations that management has disclosed to the
auditor all known actual or possible noncompliance with laws and regulations whose effects
should be considered when preparing financial statements.
Procedures When Noncompliance is discovered
When the auditor becomes aware of information concerning a possible instance of
noncompliance, the auditor should obtain an understanding of the nature of the act and the
circumstances in which it has occurred, and sufficient other information to evaluate the
possible effect on the financial statements.
When evaluating the possible effect on the financial statements, the auditor considers:
When the auditor believes there may be noncompliance, the auditor should document the
findings and discuss them with management.
When adequate information about the suspected noncompliance cannot be obtained, the
auditor should consider the effect of the lack of audit evidence on the auditors report. The
auditor should consider the implications of noncompliance in relation to other aspects of the
audit, particularly the reliability of management representations.
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Reporting of Noncompliance
The auditor should, as soon as practicable, either communicate with the audit committee, the
board of directors and senior management, or obtain evidence that they are appropriately
informed, regarding noncompliance that comes to the auditors attention.
If in the auditors judgment the noncompliance is believed to be intentional and material, the
auditor should communicate the finding without delay.
If the auditor suspects that members of senior management, including members of the board
of directors, are involved in noncompliance, the auditor should report the matter to the next
higher level of authority at the entity, if it exists, such as an audit committee or a supervisory
board.
Where no higher authority exists, or if the auditor believes that the report may not be acted
upon or is unsure as to the person to whom to report, the auditor would consider seeking legal
advice.
If the auditor concludes that the noncompliance has a material effect on the financial
statements, and has not been properly reflected in the financial statements, the auditor should
express a qualified or an adverse opinion.
If the auditor is precluded by the entity from obtaining sufficient appropriate audit evidence
to evaluate whether noncompliance that may be material to the financial statements, has, or is
likely to have, occurred, the auditor should express a qualified opinion or a disclaimer of
opinion on the financial statements on the basis of a limitation on the scope of the audit.
Reporting of non compliance to Regulatory and Enforcement Authorities
The auditors duty of confidentiality would ordinarily preclude reporting noncompliance to a
third party. However, in certain circumstances, that duty of confidentiality is overridden by
statute, law or by courts of law (for example, in some countries the auditor is required to
report noncompliance by financial institutions to the supervisory authorities). The auditor
may need to seek legal advice in such circumstances, giving due consideration to the
auditors responsibility to the public interest.
Withdrawal from the Engagement
The auditor may conclude that withdrawal from the engagement is necessary when the entity
does not take the remedial action that the auditor considers necessary in the circumstances,
even when the noncompliance is not material to the financial statements.
As stated in the Code of Ethics for Professional Accountants issued by The Institute of
Chartered Accountants of Nepal, on receipt of an inquiry from the proposed auditor, the
existing auditor should advise whether there are any professional reasons why the proposed
auditor should not accept the appointment. If permission from the client to discuss its affairs
with the proposed auditor is denied by the client, that fact should be disclosed to the proposed
auditor.
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determining the extent to which he can place reliance upon the work of the internal auditor.
The external auditor should document his evaluation and conclusions in this respect. The
important aspects to be considered in this context are:
a) Organizational Status: Whether internal audit is undertaken by an outside agency or by
an internal audit department within the entity itself, the internal auditor reports to the
management. In an ideal situation, he reports to the highest level of management and is
free of any other operating responsibility. Any constraints or restrictions placed upon his
work by management should be carefully evaluated. In particular, the internal auditor
should be free to communicate fully with the external auditor.
b) Scope of Function: The external auditor should ascertain the nature and depth of
coverage of the assignment which the internal auditor discharges for management. He
should also ascertain to what extent the management considers, and where appropriate,
acts upon internal audit recommendations.
c) Technical Competence: The external auditor should ascertain that internal audit work is
performed by persons having adequate technical training and proficiency. This may be
accomplished by reviewing the experience and professional qualifications of the persons
undertaking the internal audit work.
d) Due Professional Care: The external auditor should ascertain whether internal audit
work appears to be properly planned, supervised, reviewed and documented. An example
of the exercise of due professional care by the internal auditor is the existence of adequate
audit manuals, audit program, and working papers.
Coordination
Having decided in principle that he intends to rely upon the work of the internal auditor, it is
desirable that the external auditor ascertains the internal auditors tentative plan for the year
and discusses it with him at as early a stage as possible to determine areas where he considers
that he could rely upon the internal auditors work. Where internal audit work is to be a factor
in determining the nature, timing and extent of the external auditors procedures, it is
desirable to plan in advance the timing of such work, the extent of audit coverage, test levels
and proposed methods of sample selection, documentation of the work performed, and review
and reporting procedures.
Coordination with the internal auditor is usually more effective when meetings are held at
appropriate intervals during the year. It is desirable that the external auditor is advised of, and
has access to, relevant internal audit reports and in addition is kept informed, along with
management, of any significant matter that comes to the internal auditors attention and
which he believes may affect the work of the external auditor. Similarly, the external auditor
should ordinarily inform the internal auditor of any significant matters which may affect his
work.
Evaluating Specific Internal Audit Work
Where, following the general evaluation described in paragraph 10, the external auditor
intends to rely upon specific internal audit work as a basis for modifying the nature, timing
and extent of his procedures, he should review the internal auditors work, taking into
account the following factors:
a) The scope of work and related audit program are adequate for the external auditors
purpose.
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b) The work was properly planned and the work of assistants was properly supervised,
reviewed, and documented.
c) Sufficient appropriate evidence was obtained to afford a reasonable basis for the
conclusions reached.
d) Conclusions reached are appropriate in the circumstances and any reports prepared are
consistent with the results of the work performed.
e) Any exceptions or unusual matters disclosed by the internal auditors procedures have
been properly resolved.
Conclusion
The external auditor should document his conclusions in respect of the specific work which
he has reviewed. The external auditor should also test the work of the internal auditor on
which he intends to rely. The nature, timing and extent of the external auditors tests will
depend upon his judgment as to the materiality of the area concerned to the financial
statements taken as a whole and the results of his evaluation of the internal audit function and
of the specific internal audit work. His tests may include examination of items already
examined by the internal auditor, examination of other similar items, and observation of the
internal auditors procedures.
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When determining whether to use the work of an expert or not, the auditor should consider:
- the materiality of the item being examined in relation to the financial information as a
whole,
- the nature and complexity of the item including the risk of error therein, and
- the other audit evidence available with respect to the item.
Skills and Competence of the Expert
When the auditor plans to use the experts work as audit evidence, he should satisfy himself
as to the experts skills and competence by considering the experts:
- professional qualifications, license or membership in an appropriate professional body,
and
- experience and reputation in the field in which the evidence is sought.
However, when the auditor uses the work of an expert employed by him, he will not need to
inquire into his skills and competence.
Objectivity of the Expert
The auditor should also consider the objectivity of the expert. The risk that an experts
objectivity will be impaired increases when the expert is:
- employed by the client, or
- related in some other manner to the client.
In these circumstances, the auditor should consider performing more extensive procedures
than would otherwise have been planned, or he might consider engaging another expert.
Evaluating the Work of an Expert
When the auditor intends to use the work of an expert, he should examine evidence to gain
knowledge regarding the terms of the experts engagement and such other matters as:
- the objectives and scope of the experts work,
- a general outline as to the specific items in the experts report,
- confidentiality of the experts work, including the possibility of its communication to
third parties,
- the experts relationship with the client, if any;
- confidentiality of the clients information used by the expert.
The auditor should seek reasonable assurance that the experts work constitutes appropriate
audit evidence in support of the financial information, by considering:
- the source data used,
- the assumptions and methods used and, if appropriate, their consistency with the prior
period, and
- the results of the experts work in the light of the auditors overall knowledge of the
business and of the results of his audit procedures.
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The auditor should also satisfy himself that the substance of the experts findings is properly
reflected in the financial information.
The auditor should consider whether the expert has used source data which are appropriate in
the circumstances. The procedures to be applied by the auditor should include:
- making inquiries of the expert to determine how he has satisfied himself that the source
data are sufficient, relevant and reliable, and
- conducting audit procedures on the data provided by the client to the expert to obtain
reasonable assurance that the data are appropriate
Usually, after completion of above procedures auditor gains reasonable assurance that he has
obtained appropriate audit evidence in support of the financial information. In exceptional
cases where the work of an expert does not support the related representations in the financial
information, the auditor should attempt to resolve the inconsistency by discussions with the
client and the expert. Applying additional procedures, including possibly engaging another
expert, may also assist the auditor in resolving the inconsistency.
If, after performing these procedures, the auditor concludes that:
- the work of the expert is inconsistent with the information in the financial statements, or
that
- the work of the expert does not constitute sufficient appropriate audit evidence (e.g.,
where the work of the expert involves highly technical matters or where, on grounds of
confidentiality, the expert refuses to make available to the auditor the source data used
by him),
he should express a qualified opinion, a disclaimer of opinion or an adverse opinion, as may
be appropriate.
Reference to an Expert in the Auditors Report
When expressing an unqualified opinion, the auditor should not refer to the work of an expert
in his report. If, as a result of the work of an expert, the auditor decides to express other than
an unqualified opinion, it may in some circumstances benefit the reader of his report if the
auditor, in explaining the nature of his reservation, refers to or describes the work of the
expert. Where, in doing so, the auditor considers it appropriate to disclose the identity of the
expert, he should obtain prior consent of the expert for such disclosure if such consent has not
already been obtained.
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Opening balances
Initial Audit engagement consideration from the incoming auditor regarding the
correctness of opening balances
For any auditor, opening balance of any financial statement is crucial for current year audit.
And it is of great importance when the financial statements are audited for the first time or
when the financial statements for the prior period were audited by another auditor. NSA 510
provides standards and provides guidance regarding opening balances.
Sufficient appropriate audit evidence
For initial audit engagements, the auditor should obtain sufficient appropriate audit evidence
that:
a. The opening balances do not contain misstatements that materially affect the current
periods financial statements;
b. The prior periods closing balances have been correctly brought forward to the current
period or, when appropriate, have been restated; and
c. Appropriate accounting policies are consistently applied or changes in accounting policies
have been properly accounted for and adequately disclosed.
Opening balances
It means those account balances which exist at the beginning of the period. Opening balances
are based upon the closing balances of the prior period and reflect the effects of:
a. Transactions of prior periods; and
b. Accounting policies applied in the prior period.
In an initial audit engagement, the auditor will not have previously obtained audit evidence
supporting such opening balances.
Audit Procedures
The sufficiency and appropriateness of the audit evidence the auditor will need to obtain
regarding opening balances depends on such matters as:
When the prior periods financial statements were audited by another auditor, the current
auditor may be able to obtain sufficient appropriate audit evidence regarding opening
balances by reviewing the predecessor auditors working papers. In these circumstances, the
current auditor would also consider the professional competence and independence of the
The Institute of Chartered Accountants of Nepal
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predecessor auditor. If the prior periods auditors report was modified, the auditor would pay
particular attention in the current period to the matter which resulted in the modification
Prior to communicating with the predecessor auditor, the current auditor will need to consider
the Code of Ethics for Professional Accountants issued by The Institute of Chartered
Accountants of Nepal.
For current assets and liabilities some audit evidence can ordinarily be obtained as part of the
current periods audit procedures.
Audit Conclusions and Reporting
If, after performing procedures including those set out above, the auditor is unable to obtain
sufficient appropriate audit evidence concerning opening balances, the auditors report should
include:
(a) a qualified opinion,
We did not observe the counting of the physical inventory stated at Rs... as at Ashad 3X,
20XX, since that date was prior to our appointment as auditors. We were unable to satisfy
ourselves as to the inventory quantities at that date by other audit procedures.
In our opinion, except for the effects of such adjustments, if any, as might have been
determined to be necessary had we been able to observe the counting of physical
inventory and satisfy ourselves as to the opening balance of inventory, the financial
statements give a true and fair view of (are presented fairly, in all material respects,) the
financial position of ABC Company as at Ashad 3X, 20XX and the results of its
operations and its cash flows for the year then ended in accordance with Nepal
Accounting Standards or relevant practices and comply with (Quote the relevant statute or
law)... (For example: Company Act, 2063 / Commercial Bank Act, 2031 etc.)
(b) a disclaimer of opinion; or
(c) in those jurisdictions where it is permitted, an opinion which is qualified or disclaimed
regarding the results of operations and unqualified regarding financial position,
However, if a modification regarding the prior periods financial statements remains relevant
and material to the current periods financial statements, the auditor should modify the
current auditors report accordingly.
If the current periods accounting policies have not been consistently applied in relation to
opening balances and if the change has not been properly accounted for and adequately
disclosed, the auditor should express a qualified opinion or an adverse opinion as appropriate.
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A contingent asset is a possible asset that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events
not wholly within the control of the entity. Contingent assets are not recognised in the
statement of financial position. However, in specified circumstances, they are disclosed in the
notes.
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Review and test the process used by management to develop the estimate;
Comparison, when possible, of estimates made for prior periods with actual results of
those periods; and
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The auditor should consider the effect of subsequent events on the financial statements and
on the auditors report. IAS 10 on Contingencies and Events Occurring after the Balance
Sheet Date deals with the treatment in financial statements of events, favorable and
unfavorable, occurring after period end and identifies two types of events:
(a) Those that provide further evidence of conditions that existed at period end; and
(b) Those that is indicative of conditions that arose subsequent to period end.
Events Occurring up to the Date of the Auditors Report
The auditor should perform procedures designed to obtain sufficient appropriate audit
evidence that all events up to the date of the auditors report that may require adjustment of,
or disclosure in, the financial statements have been identified.
The procedures to identify events that may require adjustment of, or disclosure in, the
financial statements would be performed as near as practicable to the date of the auditors
report and ordinarily include the following:
reviewing procedures management has established to ensure that subsequent events are
identified,
reading minutes of the meetings of shareholders, the board of directors and audit and
executive committees held after period end and inquiring about matters discussed at
meetings for which minutes are not yet available,
reading the entitys latest available interim financial statements and, as considered
necessary and appropriate, budgets, cash flow forecasts and other related management
reports,
inquiring, or extending previous oral or written inquiries, of the entitys lawyers
concerning litigation and claims
inquiring of management as to whether any subsequent events have occurred which might
affect the financial statements.
When the auditor becomes aware of events which materially affect the financial statements,
the auditor should consider whether such events are properly accounted for and adequately
disclosed in the financial statements.
Facts discovered after the Date of the Auditors Report but Before the Financial Statements
are issued
The auditor does not have any responsibility to perform procedures or make any inquiry
regarding the financial statements after the date of the auditors report. During the period
from the date of the auditors report to the date the financial statements are issued, the
responsibility to inform the auditor of facts which may affect the financial statements rests
with management.
When, after the date of the auditors report but before the financial statements are issued, the
auditor becomes aware of a fact which may materially affect the financial statements, the
auditor should consider whether the financial statements need amendment, should discuss the
matter with management, and should take the action appropriate in the circumstances.
When management amends the financial statements, the auditor would carry out the
procedures necessary in the circumstances and would provide management with a new report
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on the amended financial statements. The new auditors report would be dated not earlier
than the date the amended financial statements are signed or approved.
When management does not amend the financial statements in circumstances where the
auditor believes they need to be amended and the auditors report has not been released to the
entity, the auditor should express a qualified opinion or an adverse opinion.
When the auditors report has been released to the entity, the auditor would notify those
persons ultimately responsible for the overall direction of the entity not to issue financial
statements and the auditors report thereon to third parties. If the financial statements are
subsequently released, the auditor needs to take action to prevent reliance on the auditors
report. The action taken will depend on the auditors legal rights and obligations and the
recommendations of the auditors lawyer.
Facts Discovered After the Financial Statements Have Been Issued
After the financial statements have been issued, the auditor has no obligation to make any
inquiry regarding such financial statements.
When, after the financial statements have been issued, the auditor becomes aware of a fact
which existed at the date of the auditors report and which, if known at that date, may have
caused the auditor to modify the auditors report, the auditor should consider whether the
financial statements need revision, should discuss the matter with management, and should
take the action appropriate in the circumstances.
When management revises the financial statements, the auditor would carry out the audit
procedures necessary in the circumstances, would review the steps taken by management to
ensure that anyone in receipt of the previously issued financial statements together with the
auditors report thereon is informed of the situation, and would issue a new report on the
revised financial statements.
The new auditors report should include an emphasis of a matter paragraph referring to a note
to the financial statements that more extensively discusses the reason for the revision of the
previously issued financial statements and to the earlier report issued by the auditor.
The new auditors report would be dated not earlier than the date the revised financial
statements are approved.
Offering of Securities to the Public
In cases involving the offering of securities to the public, the auditor should consider any
legal and related requirements applicable to the auditor in all jurisdictions in which the
securities are being offered.
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ii. has an interest in the entity that gives it significant influence over the entity;
iii. or has joint control over the entity;
d. the party is an associate (An associate is an entity, including an unincorporated entity
such as a partnership, over which the investor has significant influence and that is neither
a subsidiary nor an interest in a joint venture.) of the entity;
e. the party is a joint venture in which the entity is a venturer (A joint venture is a
contractual agreement whereby two or more parties undertake an economic activity that is
subject to control.)
f. the party is a member of the key management personnel of the entity or its parent;
g. the party is a close member of the family of any individual referred to in (a) or (d);
h. the party is an entity that is controlled, jointly controlled or significantly influenced by, or
for which significant voting power in such entity resides with, directly or indirectly, any
individual referred to in (d) or (e); or
i. the party is a post-employment benefit plan for the benefit of employees of the entity, or
of any entity that is a related party of the entity.
Similarly, related party transaction as defined in NAS15 is a transfer of resources, services or
obligations between related parties, regardless of whether a price is charged.
Audit Procedures
The auditor should perform audit procedures designed to obtain sufficient appropriate audit
evidence regarding the identification and disclosure by management of related parties and the
effect of related party transactions that are material to the financial statements. However, an
audit cannot be expected to detect all related party transactions.
Related party
Parties are considered to be related if one party has the ability to control the other party or
exercise significant influence over party in making financial and operating decisions.
Managements Responsibility
Management is responsible for the identification and disclosure of related parties and
transactions with such parties. This responsibility requires management to implement
adequate accounting and internal control systems to ensure that transactions with related
parties are appropriately identified in the accounting records and disclosed in the financial
statements.
The auditor needs to have a level of knowledge of the entitys business and industry that will
enable identification of the events, transactions and practices that may have a material effect
on the financial statements. While the existence of related parties and transactions between
such parties are considered ordinary features of business, the auditor needs to be aware of
them because:
a) the financial reporting framework may require disclosure in the financial statements
of certain related party relationships and transactions;
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b) the existence of related parties or related party transactions may affect the financial
statements. For example, the entitys tax liability and expense may be affected by the
tax laws in various jurisdictions which require special consideration when related
parties exist;
c) the source of audit evidence affects the auditors assessment of its reliability. A
greater degree of reliance may be placed on audit evidence that is obtained from or
created by unrelated third parties; and (d) a related party transaction may be motivated
by other than ordinary business considerations, for example, profit sharing or even
fraud.
review prior year working papers for names of known related parties;
review the entitys procedures for identification of related parties;
inquire as to the affiliation of directors and officers with other entities;
review shareholder records to determine the names of principal shareholders or, if
appropriate, obtain a listing of principal shareholders from the share register;
e) review minutes of the meetings of shareholders and the board of directors and other
relevant statutory records such as the register of directors interests;
f) inquire of other auditors currently involved in the audit, or predecessor auditors, as to
their knowledge of additional related parties; and
g) review the entitys income tax returns and other information supplied to regulatory
agencies.
Where the financial reporting framework requires disclosure of related party relationships,
the auditor should be satisfied that the disclosure is adequate.
Transactions with Related Parties
When obtaining an understanding of the accounting and internal control systems and making
a preliminary assessment of control risk, the auditor should consider the adequacy of control
procedures over the authorization and recording of related party transactions.
During the course of the audit, the auditor needs to be alert for transactions which appear
unusual in the circumstances and may indicate the existence of previously unidentified
related parties. Examples include the following:
Transactions which have abnormal terms of trade, such as unusual prices, interest
rates, guarantees, and repayment terms.
Transactions which lack an apparent logical business reason for their occurrence.
Transactions processed in an unusual manner.
High volume or significant transactions with certain customers or suppliers as
compared with others.
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During the course of the audit, the auditor carries out procedures which may identify the
existence of transactions with related parties. Examples include the following:
Confirming the terms and amount of the transaction with the related party.
Inspecting evidence in possession of the related party.
Confirming or discussing information with persons associated with the transaction,
such as banks, lawyers, guarantors and agents.
Management Representations
The auditor should obtain a written representation from management concerning: (a) the
completeness of information provided regarding the identification of related parties; and (b)
the adequacy of related party disclosures in the financial statements.
Audit Conclusions and Reporting
If the auditor is unable to obtain sufficient appropriate audit evidence concerning related
parties and transactions with such parties or concludes that their disclosure in the financial
statements is not adequate, the auditor should modify the auditors report appropriately.
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Going concern
As defined on framework of Nepal Accounting standard, the financial statements are
normally prepared on the assumption that an entity is a going concern and will continue in
operation for the foreseeable future. Hence, it is assumed that the entity has neither the
intention nor the need to liquidate or curtail materially the scale of its operations; if such an
intention or need exists, the financial statements may have to be prepared on a different basis
and, if so, the basis used is disclosed.
Managements Responsibility
The going concern assumption is a fundamental principle in the preparation of financial
statements. Under the going concern assumption, an entity is ordinarily viewed as continuing
in business for the foreseeable future with neither the intention nor the necessity of
liquidation. Accordingly, assets and liabilities are recorded on the basis that the entity will be
able to realise its assets and discharge its liabilities in the normal course of business.
Nepal Accounting Standard (NAS) 01, Presentation of Financial Statements also requires
management to make an assessment of an enterprises ability to continue as a going concern.
Since the going concern assumption is a fundamental principle in the preparation of the
financial statements, management has a responsibility to assess the entitys ability to continue
as a going concern even if the financial reporting framework does not include an explicit
responsibility to do so.
When there is a history of profitable operations and a ready access to financial resources,
management may make its assessment without detailed analysis.
Managements assessment of the going concern assumption involves making a judgement, at
a particular point in time, about the future outcome of events or conditions which are
inherently uncertain. The following factors are relevant:
1. In general terms, the degree of uncertainty associated with the outcome of an event or
condition increases significantly the further into the future a judgement is being made
about the outcome of an event or condition. For that reason, most financial reporting
frameworks that require an explicit management assessment specify the period for
which management is required to take into account all available information;
2. Any judgement about the future is based on information available at the time at which
the judgement is made. Subsequent events can contradict a judgement which was
reasonable at the time it was made; and
3. The size and complexity of the entity, the nature and condition of its business and the
degree to which it is affected by external factors all affect the judgement regarding the
outcome of events or conditions.
Indicators of Going Concern
These are the events or conditions which may cast significant doubt about the going concern
assumption. These may be of the following types:f) Financial
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Inability to obtain financing for essential new product development or other essential
investments.
g) Operating
h) Other
Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that are unlikely to be satisfied.
Auditors Responsibility
The auditors responsibility is to consider the appropriateness of managements use of the
going concern assumption in the preparation of the financial statements, and consider
whether there are material uncertainties about the entitys ability to continue as a going
concern that need to be disclosed in the financial statements.
The auditor cannot predict future events or conditions that may cause an entity to cease to
continue as a going concern. Accordingly, the absence of any reference to going concern
uncertainty in an auditors report cannot be viewed as a guarantee as to the entitys ability to
continue as a going concern.
Planning Considerations
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Auditor should consider whether there are events or conditions which may cast
significant doubt on the entitys ability to continue as a going concern.
Auditor should remain alert for evidence of events or conditions which may cast
significant doubt on the entitys ability to continue as a going concern throughout the
audit. If such events or conditions are identified, the auditor should perform the
additional procedures and consider whether they affect the auditors assessments of
the components of audit risk.
The auditor should consider the same period as that used by management in making
its assessment under the financial reporting framework. If managements assessment
of the entitys ability to continue as a going concern covers less than twelve months
from the balance sheet date, the auditor should ask management to extend its
assessment period to twelve months from the balance sheet date.
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practices and comply with (Quote the relevant statue or law)... (For example: Company Act,
2053/ Commercial Bank Act, 2031 etc.)
The following is an example of the relevant paragraphs when an adverse opinion is to be
expressed:
The Companys financing arrangements expired and the amount outstanding was payable on
... (specify date). The Company has been unable to re-negotiate or obtain replacement
financing and is considering filing for liquidation. These events indicate a material
uncertainty which may cast significant doubt on the Companys ability to continue as a going
concern and therefore it may be unable to realise its assets and discharge its liabilities in the
normal course of business. The financial statements (and notes thereto) do not disclose this
fact. In our opinion, because of the omission of the information mentioned in the preceding
paragraph, the financial statements do not give a true and fair view of (or do not present
fairly) the financial position of the Company as at Ashad 3X, 20XX, and of its results of
operations and its cash flows for the year then ended in accordance with Nepal Accounting
Standards or relevant practices ..... (and do not comply with .....)......
Going Concern Assumption Inappropriate
If, in the auditors judgement, the entity will not be able to continue as a going concern, the
auditor should express an adverse opinion if the financial statements have been prepared on a
going concern basis.
If, on the basis of the additional procedures carried out and the information obtained,
including the effect of managements plans, the auditors judgement is that the entity will not
be able to continue as a going concern, the auditor concludes, regardless of whether or not
disclosure has been made, that the going concern assumption used in the preparation of the
financial statements is inappropriate and expresses an adverse opinion. 39. When the entitys
management has concluded that the going concern assumption used in the preparation of the
financial statements is not appropriate, the financial statements need to be prepared on an
alternative authoritative basis. If on the basis of the additional procedures carried out and the
information obtained the auditor determines the alternative basis is appropriate, the auditor
can issue an unqualified opinion if there is adequate disclosure but may require an emphasis
of matter in the auditors report to draw the users attention to that basis.
Management Unwilling to Make or Extend its Assessment
If management is unwilling to make or extend its assessment when requested to do so by the
auditor, the auditor should consider the need to modify the auditors report as a result of the
limitation on the scope of the auditors work.
When the auditor believes that it is necessary to ask management to make or extend its
assessment. If management is unwilling to do so, it is not the auditors responsibility to
rectify the lack of analysis by management, and a modified report may be appropriate
because it may not be possible for the auditor to obtain sufficient appropriate evidence
regarding the use of the going concern assumption in the preparation of the financial
statements.
Significant Delay in the Signature or Approval of Financial Statements
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When there is significant delay in the signature or approval of the financial statements by
management after the balance sheet date, the auditor considers the reasons for the delay.
When the delay could be related to events or conditions relating to the going concern
assessment, the auditor considers the need to perform additional audit procedures as well as
the effect on the auditors conclusion regarding the existence of a material uncertainty.
Existence or occurrence
Completeness
Rights and obligations
Valuation or allocation
Presentation and disclosure
The Need for Special Skill or Knowledge to Plan and Perform Auditing Procedures
The auditor may need special skill or knowledge to plan and perform auditing procedures for
certain assertions about derivatives and securities. Examples of such auditing procedures and
the special skill or knowledge required include:
Understanding the determination of the fair values of derivatives and securities, including
the appropriateness of various types of valuation models and the reasonableness of key
factors and assumptions, this may require knowledge of valuation concepts.
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Assessing inherent risk and control risk for assertions about derivatives used in hedging
activities, which may require an understanding of general risk management concepts and
typical asset/liability management strategies.
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sufficiency of the evidential matter evaluated by the auditor in support of the assertions.
Financial Statement Assertions
Existence or Occurrence
Existence assertions address whether the derivatives and securities reported in the financial
statements through recognition or disclosure exist at the date of the statement of financial
position. Occurrence assertions address whether derivatives and securities transactions
reported in the financial statements, as a part of earnings, other comprehensive income, or
cash flows or through disclosure
Examples of substantive procedures for existence or occurrence assertions about derivatives
and securities include:
Confirmation with the issuer of the security.
Confirmation with the holder of the security, including securities in electronic form, or
with the counterparty to the derivative.
Confirmation of settled transactions with the broker-dealer or counterparty.
Confirmation of unsettled transactions with the broker-dealer or counterparty.
Physical inspection of the security or derivative contract.
Reading executed partnership or similar agreements.
Completeness
Completeness assertions address whether all of the entitys derivatives and securities are
reported in the financial statements through recognition or disclosure. They also address
whether all derivatives and securities transactions are reported in the financial statements as a
part of earnings, other comprehensive income, or cash flows or through disclosure.
Examples of substantive procedures for completeness assertions about derivatives and
securities are:
Requesting the counterparty to a derivative or the holder of a security to provide
information about it, such as whether there are any side agreements or agreements to
repurchase securities sold.
Requesting counterparties or holders who are frequently used, but with whom the
accounting records indicate there are presently no derivatives or securities, to state
whether they are counterparties to derivatives with the entity or holders of its securities.
Inspecting financial instruments and other agreements to identify embedded derivatives.
Inspecting documentation in paper or electronic form for activity subsequent to the end of
the reporting period.
Performing analytical procedures. For example, a difference from an expectation that
interest expense is a fixed percentage of a note based on the interest provisions of the
underlying agreement may indicate the existence of an interest rate swap agreement.
Comparing previous and current account detail to identify assets that have been removed
from the accounts and testing those items further to determine that the criteria for sales
treatment have been met.
Rights and Obligations
Assertions about rights and obligations address whether the entity has the rights and
obligations associated with derivatives and securities, including pledging arrangements,
reported in the financial statements.
Examples of substantive procedures for assertions about rights and obligations associated
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Valuation
Assertions about the valuation of derivatives and securities address whether the amounts
reported in the financial statements through measurement or disclosure were determined in
conformity with generally accepted accounting principles. Tests of valuation assertions
should be designed according to the valuation method used for the measurement or
disclosure. Generally accepted accounting principles may require that a derivative or security
be valued based on cost, the investees financial results, or fair value.
Valuation Based on Cost.
Procedures to obtain evidence about the cost of securities may include inspection of
documentation of the purchase price, confirmation with the issuer or holder, and testing
discount or premium amortization, either by recomputation or analytical procedures. The
auditor should evaluate managements conclusion about the need to recognize an impairment
loss for a decline in the securitys fair value below its cost.
Valuation Based on an Investees Financial Results.
For valuations based on an investees financial results, including but not limited to the equity
method of accounting, the auditor should obtain sufficient evidence in support of the
investees financial results. The auditor should read available financial statements of the
investee and the accompanying audit report, if any. Financial statements of the investee that
have been audited by an auditor whose report is satisfactory, for this purpose, to the
investors auditor may constitute sufficient evidential matter.
Valuation Based on Fair Value.
The auditor should obtain evidence supporting managements assertions about the fair value
of derivatives and securities measured or disclosed at fair value. The method for determining
fair value may be specified by generally accepted accounting principles and may vary
depending on the industry in which the entity operates or the nature of the entity. Such
differences may relate to the consideration of price quotations from inactive markets and
significant liquidity discounts, control premiums, and commissions and other costs that
would be incurred to dispose of the derivative or security. The auditor should determine
whether generally accepted accounting principles specify the method to be used to determine
the fair value of the entitys derivatives and securities and evaluate whether the determination
of fair value is consistent with the specified valuation method.
Presentation and Disclosure
Assertions about presentation and disclosure address whether the classification, description,
and disclosure of derivatives and securities in the entitys financial statements are in
conformity with generally accepted accounting principles. The auditor should evaluate
whether the presentation and disclosure of derivatives and securities are in conformity with
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delivered using those resources. Public-sector auditing helps to create suitable conditions and
reinforce the expectation that public-sector entities and public servants will perform their
functions effectively, efficiently, ethically and in accordance with the applicable laws and
regulations.
Public sector auditing can be described as a systematic process of objectively obtaining and
evaluating evidence to determine whether information or actual conditions conform to the
established criteria. It is essential in that it provides legislative and oversight bodies, those
charged with governance and the general public with information and independent and
objective assessments concerning the stewardship and performance of government policies,
programmes or operations.
All public-sector audits start from objectives, which may differ depending on the type of
audit being conducted. However, all public-sector auditing contributes to good governance
by:
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detail or sporadically or a random basis and present the facts obtained therefrom, make
critical comments thereon and submit its reports.
b) The Auditor General may. if it deems necessary in course of audit exercise the following
powers:
i. To check at any time the status of the program and project being operated under the
grants obtained by Government of Nepal and examine documents relating to
accounts;
ii. To require contractors of government contracts to produce relevant documents or
other evidence relating to the contract, which are supposed to be in his/her possession;
iii. To hire services of any expert on the task of audit and, if necessary, engage someone
under contract with reasonable remuneration.
Section 4, Matters to be audited:
The Auditor General, with due regard to the regularity, economy, efficiency, effectiveness
and propriety, shall audit following matters to ascertain whether:
a) the amount appropriated in the concerned heads and subheads by the Appropriation Act
for respective services and activities have been expended for the specified purposes of
designated services or activities within the approved limit;
b) the financial transactions comply with the existing laws and the evidence relating to items
of income and expenditure are sufficient;
c) the accounts have been maintained in the prescribed forms and such accounts fairly
represent the position of the transactions;
d) the inventory of government assets is accurate and up to date and the arrangement for
protection and management of governmental property is adequate;
e) the arrangements for internal audit and internal control of cash, kind and other
governmental property against any loss, damage and abuse are adequate and if so, are
they pursued;
f) the accounts of revenue, all other incomes and deposits are correct and the rules relating
to evaluation, realization and methods of book keeping are adequate and if so, are they
followed;
g) the accounts relating to public debts, security, deposit, debt relief fund and the amounts
set aside for debt services and repayment of debts are accurate;
h) The accounts of income and expenditure of industrial and business services, and their
balance of cash and kind, and the arrangements and rules relating to their financial
transactions are adequate and if so, are they observed;
i) The organization, management and job allocation of the office are sufficient and proper
and are that operating accordingly;
j) Any function is being unnecessarily performed in duplication by any employee or agency
or any essential function is being omitted;
k) The available resources, means and assets are properly utilized and the maintenance and
perspiration thereof against any loss or damage has been properly arranged;
l) The progress has been achieved within scheduled time and the quality and quantity of the
work is satisfactory;
m) The objective and policy of the Office is explicit and the program is delineated
conforming to the specified objective and policy;
n) The program is being implemented within the limits of approved cost estimate and the
proceeds received in comparison to the cost is reasonable;
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o) The arrangements for maintaining data relating to target, progress and cost are adequate
and reliable;
Section 5, Matters to be audited in view of propriety:
I.
II.
The Auditor General shall audit following matters considering the propriety thereofa. On the propriety of any expenditure and its authorization, if in the opinion of the
Auditor General such expenditure is a reckless one or is an abuse of national property,
whether movable or immovable, despite that the expenditure confirms to the
authorization, and
b. On the propriety of all authorizations issued in respect of any grant of national
property whether movable or immovable, fixed or current, or underwriting of any
revenue, or any contract, license or permits relating to mining, forest, water resources,
etc. and any other act of abandoning movable or immovable, assets of the nation.
The Auditor General may not include in the report minor items of discrepancy and other
items deemed as insignificant in view of their property which were observed during the
audit of income and expenditure.
Audit Procedure for manufacturing and trading unit
Knowledge of clients nature of business
To carry an audit to any manufacturing company, auditor should have brief knowledge about
the clients nature of business, what are the activities they are carrying, what is the procedure
they are following while making purchases & sales, at what range they are following internal
control procedures.
Identify the Production process
Take a list of what are the major raw materials inputs they are using in production. The steps
they are following for the conversion of raw material into finished goods. Also auditor should
assess the internal control at the time of inputting raw material.
Opening balances Verification
First collect the opening balances report from the management and verify whether the
opening balances have been carried forward correctly from the previous year audited
financial statements.
Vouching of purchases
Ask about the purchase procedure and draw a flow chart which is very relevant for your
understanding while carrying audit. Compare the Purchase Voucher with the Taxable Invoice
received from the seller and Material Received Note (MRN) to confirm that whether quantity
& amount is tallied or not. Also check whether the rate of material on Invoice tallies with
Purchase Order (PO) rose by the company and check whether the date on MRN is relating to
the current period.
Vouching of Journal vouchers (JV), and Cash & Bank
Verify whether the supporting bills tallied with the JVs and that expenditure relating to the
current period. While verifying the JVs ensure whether the TDS was deducted wherever
applicable. Also verify whether bills are as per the limits set for the designation in policy.
Similarly also review whether the Bank Reconciliation Statement (BRS) is tallied.
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Reconciliations
During the course of audit VAT returns with purchase and sales should be reconciled
Physical Stock Verification
Auditor should ensure whether the physical quantity is tallied with the stock register
maintained at factory.
Assertion Financial statement
The following items are classified as assertions related to the ending balances in accounts,
and so relate primarily to the balance sheet:
Completeness. The assertion is that all reported asset, liability, and equity balances have
been fully reported.
Existence. The assertion is that all account balances exist for assets, liabilities, and equity.
Rights and obligations. The assertion is that the entity has the rights to the assets it owns
and is obligated under its reported liabilities.
Valuation. The assertion is that all asset, liability, and equity balances have been recorded
at their proper valuations.
Further appropriate presentation and disclosure should be made on financial statement.
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13. Report any old heavy arrears on account of fees, dormitory rents, etc, to the managing
committee.
14. Confirm that caution money and other deposits paid by students on admission have
been shown as liability in the balance sheet and not transferred to revenue.
15. See that the investments representing endowment funds for prized are kept separate and
any income in excess of the prizes has been accumulated and investment along with the
corpus.
16. Verify that the provident fund money of the staff has been invested in appropriate
securities.
17. Vouch donations, if any, with the list published with the annual report. If some
donations were meant for any specific purpose, see that the money was utilized for the
purpose.
18. Vouch all capital expenditure in the usual way and verify the same with the sanction for
the committee as contained in the minute book.
19. Vouch in the usual manner all establishment expenses and enquire into any unduly
heavy expenditure under any head.
20. See that increase in the salaries of the staff have been sanctioned and minuted by the
committee.
21. Ascertain that the system ordering inspection on receipt and issue of provisions,
foodstuffs, clothing and other equipment is efficient and all bills are duly authorized
and passed before payment.
22. Verify the inventories of furniture, stationery, clothing, provision and all equipment,
etc. These should be checked by reference to stock Register and values applied to
various items should be test checked.
23. Confirm that the refund of taxes deducted from the income from investment (interest on
securities, etc) has been claimed and recovered since the institutions are generally
exempted from the payment of income-tax.
24. Verify the annual statements of accounts and while doing so see that separate
statements of account have been prepared as regards poor boys fund, Games fund,
hostel and provided fund of staffs.
Audit of Agricultural farm
Agricultural activities are distinguished by the fact that management facilitates and manages
biological transformation and is capable of measuring the change in the quality and quantity
of biological assets. Management of biological transformation normally takes the form of
activity to enhance, or at least stabilize, the conditions necessary for the process of growth,
degeneration, production and procreation that cause qualitative or quantitative changes in a
biological asset to take place.
Examples of agricultural activity include:
Raising livestock, fish or poultry
Stud farms (for example, breeding horses or cattle)
Forestry
Cultivating vineyards, orchards or plantations
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Floriculture
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Initial losses on biological assets typically arise when a biological asset is purchased. The
cost of the biological asset is often higher than the fair value less costs to sell, as the latter
represents an exit price, and transaction expenses therefore create a loss. Initial gains on
biological assets arise when new biological assets are generated for example, when a calf or
a piglet is born.
Changes in fair value less costs to sell of biological assets represent the difference in value
from period to period, normally on an aggregated basis. It is therefore sometimes difficult to
distinguish from the initial gain due to procreation. The value typically increases due to
growth, procreation and higher prices, but may decrease due to degeneration, sickness and
lower prices.
Initial gains or losses on agricultural produce represents the difference between the change in
carrying value of the biological assets due to harvest and the fair value less costs to sell of the
harvested agricultural produce. It reflects the last stage of the value creation of the biological
process, and the harvested produce is transferred to inventory. There may be further costs
involved in preparing the inventory for market.
Audit of Hotel and hospitality sector
There are many problems involved in any hotel audit, some of which are peculiar to the hotel
industry such as control of cash assume greater proportions. Almost all sales points in a hotel
make both cash and credit sales. The auditor should reconcile the total sales reported with the
total of the bills issued by the sales point; this total may take the form of a bill roll or a series
of numerically controlled bills. This numerical control must be checked to ensure that all bills
are included in the total. The cash element of the sales must then be checked to the cash
records and the credit sales in total and detail to the guest's bills. The special problems in a
hotel audit can be summarised as follows :
(1)
Internal Controls - Pilfering is one of the greatest problems in any hotel and the
importance of internal control cannot be over stressed. It is the responsibility of
management to introduce controls which will minimise the leakage as far as possible.
Evidence of their success is provided by the preparation of regular perhaps weekly,
trading accounts for each sales point and a detailed scrutiny of the resulting profit
percentages, with any deviation from the anticipated form being investigated. The
auditor should obtain these regular trading accounts for the period under review,
examine them and obtain explanations for any apparent deviations. If the internal
control in a hotel is weak or perhaps breaks down, then a very serious problem exists
for the auditor. As a result of the transient nature of many of his clients' records, the
auditor must rely to a very large extent on the gross margin shown by the accounts. As a
result, the scope of his audit tests will necessarily be increased and, in the event of a
material margin discrepancy being unexplained he will have to consider qualifying his
audit report.
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(2)
Room Sales - The charge for room sales is normally posted to guest bills by the
receptionist or in the case of large hotels by the night auditor. The source of these
entries is invariably the guest register and audit tests should be carried out to ensure that
the correct numbers of guests are charged for the correct period. Any difference
between the charge rates used on the guests' bills and the standard room rate should be
investigated to ensure that they have been properly authorised. In many hotels, the
housekeeper prepares a daily report of the rooms which were occupied the previous
night and the number of beds kept in each room. This report tends not to be
permanently retained and the auditor should ensure that a sufficient number of reports
are available for him to test both with the guest register and with the individual guest's
bill.
(3)
Stocks - The stocks in any hotel are both readily portable and saleable particularly the
food and beverage stocks. It is therefore extremely important that all movements and
transfers of such stocks should be properly documented to enable control to be
exercised over each individual stores areas and sales point. The auditor should carry out
tests to ensure that all such documentation is accurately processed. Areas where large
quantities of stock are held should be kept locked, the key being retained by the
departmental manager. The key should be released only to trusted personnel and
unauthorised persons should not be permitted in the stores areas except under constant
supervision. In particular, any movement of goods in or out of the stores should be
checked, it is not unknown for a full crate to be removed in error as an empty crate.
(4)
Many hotels use specialised professional valuers to take and value the stocks on a
continuous basis throughout the year. Such a valuation is then almost invariably used as
the basis of the balance sheet stock figure at the year end. Although such valuers are
independent of the audit client, it is important that the auditor satisfies himself that the
amounts included for such stocks are reasonable. In order to satisfy himself of this the
auditor should consider attending at the physical stock taking and carrying out certain
pricing and calculation tests. The extent of such tests could well be limited since the
figures will have been prepared independently of the hotel.
(5)
Fixed Assets - The accounting policies for fixed assets of individual hotels are likely to
differ. However, many hotels account for certain quasi-fixed assets such as silver and
cutlery on stock basis. This can lead to confusion between each stock items and similar
assets which are accounted for on a more normal fixed assets basis. In such cases it is
important that very detailed definitions of stock items exist and the auditor should carry
out tests to ensure that the definitions have been closely followed.
(6)
Casual Labour - The hotel trade operates to very large extent of casual labour. The
records maintained of such wage payments are frequently inadequate. The auditor
should ensure that defalcation on this account does not take place by suggesting proper
controls to the management.
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(7)
Other points :
a. For ledgers coming through travel agents or other booking agencies the bills
are usually made on the travel agents or booking agencies. The auditor should
that money are recovered from the travel agents or booking agencies as per the
terms of credit allowed.
b. Commission, if any, paid to travel agents or booking agents should be checked
by reference to the agreement on that behalf.
c. The auditor should ensure that proper records re-maintained for booking of
halls and other premises for special parties and recovered on the basis of the
tariff.
d. The auditor should verify a few restaurant bills by reference to K.O.T.s
(Kitchen Order Tickets) or basic record. This would enable the auditor to
ensure that controls regarding revenue cycle are in order.
e. The auditor should see that costs of renovation and redecoration are treated as
deferred revenue expenditure, where as costs of major alterations and
additions to the hotel building and facilities capitalised.
f. The auditor should ensure that proper valuation of occupancy-in-progress at
the balance sheet date is made and included in the accounts.
g. The auditor should satisfy himself that all taxes collected from occupants on
food and occupation have been paid over to the proper authorities.
h. In large hotels it is usual to operate a booth to facilitate conversion of foreign
currencies to Nepali rupees.
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g. Trace debits for a selected period from subsidiary registers maintained in respect of
supplies and services, to members to confirm that the account of every member has
been debited with amounts recoverable from him.
h. Vouch purchase of sports items, furniture, crockery, etc. and trace their entries into
the respective stock registers.
i. Vouch purchases of foodstuffs, cigars, wines, etc., and test their sale price so as to
confirm that the normal rates of gross profit have been earned on their sales. The
stock of unsold provisions and stores, at the end of year, should be verified physically
and its valuation checked.
j. Check the stock of furniture, sports material and other assets physically with the
respective stock registers or inventories prepared at the end of the year.
k. Inspect the share scrips and bonds in respect of investments, check their current
values for disclosure in final accounts; also ascertain that the arrangements for their
safe custody are satisfactory.
Examine the financial powers of the secretary and, if these have been exceeded, report
specific care for confirmation by the Managing Committee.
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contribution (for the revolving fund) or by the rules and regulations laid down by the
concerned NGO in this regard.
Donations and grants received for acquisition of specific fixed assets are those grants whose
primary condition is that an NGO accepting them should purchase, construct or otherwise
acquire the assets for which the grant is given. Many a times NGOs receive contributions in
kind. These contributions include assets such as land, buildings, vehicles, office equipment,
etc. and articles related to programmes / projects such as food, books, building materials,
clothes, beds, and raw material for training purposes, e.g., Wool, reeds, cloth, etc.
The areas of application of funds for an NGO include Establishment Costs, Office and
Administrative Expenses, Maintenance Expenses, Programme / Project Expenses, Charity,
Donations and Contributions given, etc.
Audit of NGO
While planning the audit, the auditor may concentrate on the following:
(i)
Knowledge of the NGO's work, its mission and vision, areas of operations
and environment in which it operate.
(ii)
Updating knowledge of relevant statutes especially with regard to recent
amendments, circulars, judicial decisions viz. Income Tax Act 2058 etc.
and the Rules related to the statutes.
(iii) Reviewing the legal form of the Organisation and its Memorandum of
Association, Articles of Association, Rules and Regulations.
(iv)
Reviewing the NGO's Organisation chart, then Financial and
Administrative Manuals, Project and Programme Guidelines, Funding
Agencies Requirements and formats, budgetary policies if any.
(v)
Examination of minutes of the Board/Managing Committee/Governing
Body/Management and Committees thereof to ascertain the impact of any
decisions on the financial records.
(vi)
Study the accounting system, procedures, internal controls and internal
checks existing for the NGO and verify their applicability.
(vii) Setting of materiality levels for audit purposes.
(viii) The nature and timing of reports or other communications
(ix)
The involvement of experts and their reports.
(x)
Review the previous year's Audit Report.
Agreed upon Procedure
Engagement to review financial statement
Objective of a Review Engagement
The objective of a review of financial statements is to enable an auditor to state whether, on
the basis of procedures which do not provide all the evidence that would be required in an
audit, anything has come to the auditors attention that causes the auditor to believe that the
The Institute of Chartered Accountants of Nepal
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financial statements are not prepared, in all material respects, in accordance with an identified
financial reporting framework (negative assurance).
The auditor should plan and perform the review with an attitude of professional skepticism
recognising that circumstances may exist which cause the financial statements to be
materially misstated. For the purpose of expressing negative assurance in the review report,
the auditor should obtain sufficient appropriate evidence primarily through inquiry and
analytical procedures to be able to draw conclusions.
Terms of Engagement
The auditor and the client should agree on the terms of the engagement. The agreed terms
would be recorded in an engagement letter or other suitable form such as a contract.
An engagement letter will be of assistance in planning the review work. It is in the interests
of both the auditor and the client that the auditor sends an engagement letter documenting the
key terms of the appointment. An engagement letter confirms the auditors acceptance of the
appointment and helps avoid misunderstanding regarding such matters as the objectives and
scope of the engagement, the extent of the auditors responsibilities and the form of reports to
be issued.
Matters that would be included in the engagement letter include the following:
the objective of the service being performed,
managements responsibility for the financial statements,
the scope of the review, including reference to this NSRE or relevant practices,
unrestricted access to whatever records, documentation and other information requested
in connection with the review,
a sample of the report expected to be rendered,
the fact that the engagement cannot be relied upon to disclose errors, illegal acts or other
irregularities, for example, fraud or defalcations that may exist, and
a statement that an audit is not being performed and that an audit opinion will not be
expressed. To emphasise this point and to avoid confusion, the auditor may also consider
pointing out that a review engagement will not satisfy any statutory or third party
requirements for an audit.
Planning
The auditor should plan the work so that an effective engagement will be performed. In
planning a review of financial statements, the auditor should obtain or update the knowledge
of the business including consideration of the entitys organisation, accounting systems,
operating characteristics and the nature of its assets, liabilities, revenues and expenses.
Work Performed by Others
When using work performed by another auditor or an expert, the auditor should be satisfied
that such work is adequate for the purposes of the review.
Documentation
The auditor should document matters which are important in providing evidence to support
the review report, and evidence that the review was carried out in accordance with this
NSRE.
Procedures and Evidence
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The auditor should apply judgement in determining the specific nature, timing and extent of
review procedures. The auditor will be guided by such matters as the following:
any knowledge acquired by carrying out audits or reviews of the financial statements for
prior periods,
the auditors knowledge of the business including knowledge of the accounting principles
and practices of the industry in which the entity operates,
the entitys accounting systems,
the extent to which a particular item is affected by management judgement, and
the materiality of transactions and account balances.
The auditor should apply the same materiality considerations as would be applied if an audit
opinion on the financial statements were being given. Although there is a greater risk that
misstatements will not be detected in a review than in an audit, the judgement as to what is
material is made by reference to the information on which the auditor is reporting and the
needs of those relying on that information, not to the level of assurance provided.
Procedures for the review of financial statements will ordinarily include the following:
obtaining an understanding of the entitys business and the industry in which it operates,
inquiries concerning the entitys accounting principles and practices inquiries concerning
the entitys procedures for recording, classifying and summarising transactions,
accumulating information for disclosure in the financial statements and preparing
financial statements,
inquiries concerning all material assertions in the financial statements,
analytical procedures designed to identify relationships and individual items that appear
unusual. Such procedures would include:
- comparison of the financial statements with statements for prior periods,
- comparison of the financial statements with anticipated results and financial position,
and
- study of the relationships of the elements of the financial statements that would be
expected to conform to a predictable pattern based on the entitys experience or
industry norm
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The auditor should inquire about events subsequent to the date of the financial statements that
may require adjustment of or disclosure in the financial statements. The auditor does not have
any responsibility to perform procedures to identify events occurring after the date of the
review report.
If the auditor has reason to believe that the information subject to review may be materially
misstated, the auditor should carry out additional or more extensive procedures as are
necessary to be able to express negative assurance or to confirm that a modified report is
required.
Conclusions and Reporting
The review report should contain a clear written expression of negative assurance. The
auditor should review and assess the conclusions drawn from the evidence obtained as the
basis for the expression of negative assurance.
Based on the work performed, the auditor should assess whether any information obtained
during the review indicates that the financial statements do not give a true and fair view (or
are not presented fairly, in all material respects) in accordance with the identified financial
reporting framework.
Tax Audit
Tax audit is the process of review the entitys income tax returns and other information
supplied to regulatory agencies i.e. Inland Revenue Department (IRD).Tax Audit is the areas
of the modern day auditing in which Auditor is appointed for ascertaining the sales, purchase,
profit and other figure submitted by the enterprises to Tax Office.
Usually, management has an interest in pursuing inappropriate means to minimize reported
earnings for tax-motivated reasons. Thus, tax audit involves selective verification of financial
figures presented on entitys tax return reports. Basically tax audit involves compliance of the
Income Tax Act 2058 which emphasize on providing the error free Tax return to tax
authorities by assessing the correct income of the assesses.
In Nepal, though there is no any legal provision for appointing tax auditor for the Tax audit.
However, in practice, statutory auditor has been assigned with that responsibility. Generally
Tax Audit review of following transaction:
- Gross Sales and Purchase
- Vat Reconciliation
- Allowable and disallowable expenses
- Donations expenses
- Treatment of Repair and maintenance, Research and Development, Pollution control
cost, depreciation as per Income Tax act 2058
- Applicable fines and penalties to entity as a result of no submission, delayed submission
and short submission of tax amount and other tax return (including installment Tax)
- Review the entitys income tax returns and other information supplied to regulatory
agencies
- Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for
which there appears to be no clear business justification.
- Unusual transactions with companies registered in tax havens.
Even though there is no such provision for appointing tax auditor in Income Tax act 2058, tax
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return submitted by the entity contains the signature of the Auditor which evidence that the
return has been audited.
Punishment to aiding and abetting false Tax Return
If an auditor intentionally helps, advises or instigates any other person to commit any offense
under Income Tax Act shall punished with half of the punishment due to the offender.
[Section 127 of the Income Tax Act 2058]
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Basis of accounting on which the financial information is to be compiled and the fact that
it, and any known departures there from, will be disclosed.
Intended use and distribution of the information, once compiled.
Form of report to be rendered regarding the financial information compiled, when the
accountants name is to be associated therewith.
Planning
The accountant should plan the work so that an effective engagement will be performed.
Documentation
The accountant should document matters which are important in providing evidence that the
engagement was carried out in accordance with this NSA and the terms of the engagement.
Procedures
The accountant should obtain a general knowledge of the business and operations of the
entity and should be familiar with the accounting principles and practices of the industry in
which the entity operates and with the form and content of the financial information that is
appropriate in the circumstances.
If the accountant becomes aware that information supplied by management is incorrect,
incomplete, or otherwise unsatisfactory, the accountant should consider performing the above
procedures and request management to provide additional information. If management
refuses to provide additional information, the accountant should withdraw from the
engagement, informing the entity of the reasons for the withdrawal.
The accountant should read the compiled information and consider whether it appears to be
appropriate in form and free from obvious material misstatements. In this sense,
misstatements include the following:
Mistakes in the application of the identified financial reporting framework.
Non-disclosure of the financial reporting framework and any known departures there
from.
Non-disclosure of any other significant matters of which the accountant has become
aware.
Responsibility of Management
The accountant should obtain an acknowledgement from management of its responsibility for
the appropriate presentation of the financial information and of its approval of the financial
information. Such acknowledgement may be provided by representations from management
which cover the accuracy and completeness of the underlying accounting data and the
complete disclosure of all material and relevant information to the accountant.
Reporting on a Compilation Engagement
Reports on compilation engagements should contain the following:
Title
Addressee
A statement that the engagement was performed in accordance with the Nepal Standard
on Auditing or relevant practices applicable to compilation engagements
When relevant, a statement that the accountant is not independent of the entity
Identification of the financial information noting that it is based on information provided
by management
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A statement that management is responsible for the financial information compiled by the
accountant
A statement that neither an audit nor a review has been carried out and that accordingly
no assurance is expressed on the financial information;
A paragraph, when considered necessary, drawing attention to the disclosure of material
departures from the identified financial reporting framework
Date of the report;
Accountants address;
Accountants signature.
The financial information compiled by the accountant should contain a reference such as
Unaudited, Compiled without Audit or Review or Refer to Compilation Report on
each page of the financial information or on the front of the complete set of financial
statements.
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prospective financial information is based, such evidence is itself generally future oriented
and, therefore, speculative in nature, as distinct from the evidence ordinarily available in the
audit of historical financial information. The auditor is, therefore, not in a position to express
an opinion as to whether the results shown in the prospective financial information will be
achieved.
Acceptance of Engagement
Before accepting an engagement to examine prospective financial information, the auditor
would consider, amongst other things:
The intended use of the information;
Whether the information will be for general or limited distribution;
The nature of the assumptions, that is, whether they are best-estimate or hypothetical
assumptions;
The elements to be included in the information; and
The period covered by the information.
The auditor should not accept, or should withdraw from, an engagement when the
assumptions are clearly unrealistic or when the auditor believes that the prospective financial
information will be inappropriate for its intended use.
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Other services
Forensic audit and investigations
Forensic auditing covers a broad spectrum of activities, with terminology not strictly
defined in regulatory guidance. Generally, the term forensic accounting is used to describe
the wide range of investigative work which accountants in practice could be asked to
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perform. The work would normally involve an investigation into the financial affairs of an
entity and is often associated with investigations into alleged fraudulent activity. Forensic
accounting refers to the whole process of investigating a financial matter, including
potentially acting as an expert witness if the fraud comes to trial. Although this article focuses
on investigations into alleged frauds, it is important to be aware that forensic accountants
could be asked to look into non-fraud situations, such as the settling of monetary disputes in
relation to a business closure or matrimonial disputes under insurance claims.
The process of forensic accounting as described above includes the forensic investigation
itself, which refers to the practical steps that the forensic accountant takes in order to gather
evidence relevant to the alleged fraudulent activity. The investigation is likely to be similar in
many ways to an audit of financial information, in that it will include a planning stage, a
period when evidence is gathered, a review process, and a report to the client. The purpose of
the investigation, in the case of an alleged fraud, would be to discover if a fraud had actually
taken place, to identify those involved, to quantify the monetary amount of the fraud (ie the
financial loss suffered by the client), and to ultimately present findings to the client and
potentially to court.
Finally, forensic auditing refers to the specific procedures carried out in order to produce
evidence. Audit techniques are used to identify and to gather evidence to prove, for example,
how long the fraud has been carried out, and how it was conducted and concealed by the
perpetrators. Evidence may also be gathered to support other issues which would be relevant
in the event of a court case. Such issues could include:
the suspects motive and opportunity to commit fraud
whether the fraud involved collusion between several suspects
any physical evidence at the scene of the crime or contained in documents
comments made by the suspect during interviews and/or at the time of arrest
attempts to destroy evidence.
Types of Investigation
The forensic accountant could be asked to investigate many different types of fraud. It is
useful to categorise these types into three groups to provide an overview of the wide range of
investigations that could be carried out. The three categories of frauds are corruption, asset
misappropriation and financial statement fraud.
Corruption
There are three types of corruption fraud: conflicts of interest, bribery, and extortion.
Research shows that corruption is involved in around one third of all frauds.
In a conflict of interest fraud, the fraudster exerts their influence to achieve a personal
gain which detrimentally affects the company. The fraudster may not benefit financially,
but rather receives an undisclosed personal benefit as a result of the situation. For
example, a manager may approve the expenses of an employee who is also a personal
friend in order to maintain that friendship, even if the expenses are inaccurate.
Bribery is when money (or something else of value) is offered in order to influence a
situation.
Extortion is the opposite of bribery, and happens when money is demanded (rather than
offered) in order to secure a particular outcome.
Asset misappropriation
By far the most common frauds are those involving asset misappropriation, and there are
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many different types of fraud which fall into this category. The common feature is the theft of
cash or other assets from the company, for example:
Cash theft the stealing of physical cash, for example petty cash, from the premises of a
company.
Fraudulent disbursements company funds being used to make fraudulent payments.
Common examples include billing schemes, where payments are made to a fictitious
supplier, and payroll schemes, where payments are made to fictitious employees (often
known as ghost employees).
Inventory frauds the theft of inventory from the company.
Misuse of assets employees using company assets for their own personal interest.
Financial statement fraud
This is also known as fraudulent financial reporting, and is a type of fraud that causes a
material misstatement in the financial statements. It can include deliberate falsification of
accounting records; omission of transactions, balances or disclosures from the financial
statements; or the misapplication of financial reporting standards. This is often carried out
with the intention of presenting the financial statements with a particular bias, for example
concealing liabilities in order to improve any analysis of liquidity and gearing.
Conducting an Investigation
The process of conducting a forensic investigation is, in many ways, similar to the process of
conducting an audit, but with some additional considerations. The various stages are briefly
described below.
Accepting the investigation
The forensic accountant must initially consider whether their firm has the necessary skills and
experience to accept the work. Forensic investigations are specialist in nature, and the work
requires detailed knowledge of fraud investigation techniques and the legal framework.
Investigators must also have received training in interview and interrogation techniques, and
in how to maintain the safe custody of evidence gathered.
Additional considerations include whether or not the investigation is being requested by an
audit client. If it is, this poses extra ethical questions, as the investigating firm would be
potentially exposed to self-review, advocacy and management threats to objectivity. Unless
robust safeguards are put in place, the firm should not provide audit and forensic
investigation services to the same client. Commercial considerations are also important, and a
high fee level should be negotiated to compensate for the specialist nature of the work, and
the likely involvement of senior and experienced members of the firm in the investigation.
Planning the investigation
The investigating team must carefully consider what they have been asked to achieve and
plan their work accordingly. The objectives of the investigation will include:
identifying the type of fraud that has been operating, how long it has been operating for,
and how the fraud has been concealed
identifying the fraudster(s) involved
quantifying the financial loss suffered by the client
gathering evidence to be used in court proceedings
providing advice to prevent the reoccurrence of the fraud.
The investigators should also consider the best way to gather evidence the use of computer
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Insolvency practitioners
An Insolvency Practitioner (IP) often called as liquidator is someone who is licensed and
authorized to act in relation to an insolvent individual, partnership or company. Most IPs are
accountants, insolvency specialists working in firms of accountants and lawyers.
Function of an Insolvency Practitioner
IPs are appointed to sort out difficult situations; where either an individual or a business is
insolvent or is likely to become insolvent. Initially, their main task is to attempt to rescue
the situation.
If it is not possible, the IP aims to:
realise the assets of the person or company who is insolvent;
collect monies due to the person or company;
agree the claims of creditors; and
make distributions these monies after paying for the costs involved in realisation.
Nepalese provision for IP
Individual Person willing to carry out liquidator having fulfilling following criteria shall
apply for license of IP:
- S/he should attain age of thirty five years
- Should be either Chartered Accountants or lawyers
Application to be filled on
Person willing to carry IP shall apply to Office of Company Register (OCR) in prescribed
format. OCR upon scrutiny of the documents, may grant license of IP
Fund controller
Fund controller is an individual who has responsibility for all accounting-related activities
within a firm. In most organizations, the controller is the top managerial and financial
accountant. The controller supervises the accounting department and assists management in
interpreting and utilizing managerial accounting information vis a vis disbursement of the
fund.
Functions
of
the
controller
include:
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Financial meditation
Financial meditation is extrajudicial methods of resolving a dispute between clients in which
they agree to make their cases before an impartial person or panel. The two sides employ a
third party who attempts to find common ground that will resolve the dispute. Mediation is a
less lengthy and less expensive alternative to arbitration. Each side must agree to mediation
and either side may walk away from the process at any time.
Mediation is an informal, voluntary method of resolving disputes, in which the parties in
conflict meet with a trained, independent third party to come up with a solution that's
satisfactory to everyone involved. Unlike arbitration, mediation is nonbinding, which means
that if you're not happy with the outcome, you can stop the process, and either drop the issue
or move to more formal proceedings.
An entity that acts as the middleman between two parties in a financial transaction. While a
commercial bank is a typical financial intermediary, this category also includes other
financial institutions such as investment banks, insurance companies, broker-dealers, mutual
funds and pension funds. Financial intermediaries offer a number of benefits to the average
consumer including safety, liquidity and economies of scale.
Financial Intermediary
Financial intermediaries encompass a wide range of entities in terms of size and scale of
operation, ranging from a small insurance brokerage, to giant global institutions that provide
a complete range of financial services including commercial banking, investment banking
and asset management.
Audit issues
Security issues in computerized systems as stated in IFAC guidelines
The use of computers and computer based information systems have pervaded deep and wide
in every modern day organization. An organization must exercise control over these
computer based information systems because the cost of errors and irregularities that may
arise in these systems can be high and can even challenge the very existence of the
organization. An organizations ability to survive can be severely undermined through
corruption or destruction of its database; decision making errors caused by poor-quality
information systems; losses incurred through computer abuses; loss of computer assets and
their control on how the computers are used within the organization. Therefore managements
across the world have deployed specialized auditors to audit their information systems to find
out gaps between declared policies and actual use and shortcomings in the information
system design and usage.
Information Systems Audit is the process of collecting and evaluating evidence to determine
whether a computer system has been designed to maintain data integrity, safeguard assets,
allows organizational goals to be achieved effectively and uses the resources efficiently.
The Institute of Chartered Accountants of Nepal
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The IS Auditor should see that not only adequate internal controls exist in the system but they
also wok effectively to ensure results and achieve objectives. Internal controls should be
commensurate with the risk assessed so as to reduce the impact of identified risks to
acceptable levels. IT Auditors need to evaluate the adequacy of internal controls in computer
systems to mitigate the risk of loss due to errors, fraud and other acts and disasters or
incidents that cause the system to be unavailable
Auditing Standards for auditing Information Systems
The specialized nature of Information Systems auditing and the professional skills and
credibility necessary to perform such audits, require standards that would apply specifically
to IS auditing. Standards, procedures and guidelines have been issued by various institutions,
which discuss the way the auditor should go about auditing Information Systems.
In line with such developments Supreme Audit Institution of India has declared a
mission to adopt and evolve standards, guidelines and best practices for auditing in a
computerized environment. This will lend credibility and clarity in conducting audit in
computerized environment.
The framework for the IS Auditing Standards provides multiple levels of guidance.
Standards provide a framework for all audits and auditors and define the mandatory
requirements of the audit. They are broad statement of auditors responsibilities and ensure
that auditors have the competence, integrity, objectivity and independence in planning,
conducting and reporting on their work. Guidelines provide guidance in applying IS Auditing
Standards. The IS auditor should consider them in determining how to achieve
implementation of the standards, use professional judgment in their application and be
prepared to justify any departure. Procedures provide examples of procedures an IS auditor
might follow in an audit engagement. It provides information on how to meet the standards
when performing IS auditing work, but do not set requirements. The objective of the IS
Auditing Guidelines and Procedures is to provide further information on how to comply with
the IS Auditing Standards.
While conducting Information System Audit the auditor should consider the issues of
confidentiality, integrity and availability (CIA) and his work should be guided by
international or respective national standards. These may include INTOSAI Auditing
Standards, International Federation of Accountants (IFAC) Auditing Standards, International
standards of professional audit institutions such as Information Systems Audit and Control
Association (ISACA) and Institute of Internal auditors (IIA) and national auditing standards
of SAI member countries.
Information Systems Audit and Control Association (ISACA) has laid down the following
generic requirements for IS audit which are applicable to all categories of IS audits
1. The responsibility, authority and accountability of the information systems audit
function are to be appropriately documented in an audit.
2. The information systems auditor is to be independent of the auditee in attitude and
appearance.
3. The information systems auditor is to adhere to the Code of Professional Ethics. Due
professional care and observance of applicable professional auditing standards are to be
exercised.
4. The information systems auditor is to be technically competent, having the skills and
knowledge necessary to perform the auditor's work and has to maintain technical
competence through continuing professional education.
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5. The information systems auditor is to plan his work to address the audit objectives.
6. Information systems audit staff is to be appropriately supervised so as to ensure that audit
objectives and applicable professional auditing standards are met. The audit findings and
conclusions are to be supported by appropriate analysis and interpretation of sufficient,
reliable, relevant and useful evidence.
7. The information systems auditor is to provide a report, in an appropriate form, to
intended recipients upon the completion of audit work.
8. The information systems auditor follow-up action timely taken on previous relevant
findings.
Information Systems Security and Audit
Organizations in all sectors of the economy depend upon information systems and
communications networks, and share common requirements to protect sensitive information.
Organizations and professional bodies work towards establishing secure information
technology systems for protecting the integrity, confidentiality, reliability, and availability of
information.
Defining Security Audit
Information Systems Security Audit is an independent review and examination of system
records, activities and related documents to determine the adequacy of system controls,
ensure compliance with established security policy and approved operational procedures,
detect breaches in security so as to verify whether data integrity is maintained, assets are
safeguarded, organizational goals are achieved effectively and resources are used efficiently.
Security audit is a systematic, measurable technical assessment of how security policies are
built into the information systems.
Professionalism and credibility play a very important role in the auditors performance of
Information Systems Security Audit. He should have full knowledge of the organization and
its various functions, at times with considerable inside information.
The three fundamental features of an Information System that gets tested in course of security
audit are assessment of confidentiality, availability and integrity of the information systems
assets. The principle screening variables are various conceivable physical and logical security
threats.
The purpose of any audit will be essentially to examine three basic compliances in terms of
Confidentiality, Integrity and Availability (CIA)
Confidentiality concerns the protection of sensitive information from unauthorized
disclosure. Keeping in view the level of sensitivity of the data the stringency of controls
over its access should be determined.
Integrity refers to the accuracy and completeness of the information as well as to its
validity in accordance with business values and expectations. It is an important audit
objective as it provides assurance to the management as well as the users that the
information can be relied and trusted upon. It also includes reliability, which refers to
degree of consistency of the system to function.
Availability relates to information and information systems being available and
operational when they are needed. It also concerns safeguarding of necessary resources
and associated capabilities. This implies that the organization has measures in place to
ensure business continuity and timely recovery can be made in case of disasters.
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Westminster road
construction and
engineering co. Ltd.
(1932)
Decision
Held, that it was an auditors duty to ascertain that the accounts he
certifies are correct and that if he fails in this duty he is liable in
damages for dividends wrongly paid out of capital.
It was held that a company, if allowed by its articles of
association, may provide for the distribution of profits arrived at
before making good the depreciation of fixed assets.
It is the duty of an Auditor to bring to bear on the work he has to
perform that skill, care and caution which a reasonably competent,
careful and cautious Auditor would use. What is reasonable skill,
care and caution must depend on the particular circumstances of
each case. An Auditor is not bound to be a detective, or, as was
said, to approach his work with suspicion or with a foregone
conclusion that there is something wrong. He is a watch-dog, but
not a bloodhound. He is justified in believing tried servants of the
company in whom confidence is placed by the company. He is
entitled to assume that they are honest, and to rely upon their
representations, provided he takes reasonable care. If there is
anything calculated to excite suspicion he should probe it to the
bottom, but in the absence of anything of that kind, he is only
bound to be reasonably cautious and careful. The duties of
Auditors must not be rendered too onerous. Their work is
responsible and laborious, and the remuneration moderate.
Auditors must not be made liable for not tracking out ingenious
and carefully-laid schemes of fraud, when there is nothing to
arouse their suspicion and when those frauds are perpetrated by
tried servants of the company and are undetected for years by the
directors. So to hold would make the position of an Auditor
intolerable.
Auditor it was put forward inter alia that his duty was to be
performed by an examination of the books, and he was not
responsible for liabilities or other matters not in the books and not
reasonably brought to his notice; that he was entitled to rely on
information and explanations from a responsible official if there
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were no reason to doubt their accuracy and that he was not bound
to take any further step to verify this matter even though known
means of doing so existed; and that it was not his duty to go
through the minutes, letter books, or files (which would have
disclosed information as to the inflation and omissions), to see
whether there might be evidence of liabilities or other material
matters not disclosed in the books.
It was decided that the Auditor had failed in his statutory duty; his
duty with regard to unrecorded liabilities must depend on the facts
of each particular case, the nature of the business, and the practice
of the suppliers of the company as regards sending out invoices. It
was the Auditors duty to make specific inquiries as to the
existence of liabilities for which invoices might not have been
received, and to go through the invoice files to see that none were
omitted.
Special provision regarding Anti Money Laundering (AML) issued by Nepal Rastra
Bank Financial Information Unit (NRB-FIU)
Professional Accountant should conduct a Customer Due Diligence (CDD) as required by
Financial Action Task Force (FATF) in following situations:
Professional accountants when they prepare for or carry out transactions for their client
concerning the following activities:
- buying and selling of real estate;
- managing of client money, securities or other assets;
- management of bank, savings or securities account;
- organization of contributions for the creation, operation or management of companies;
- Creation, operation or management of legal persons or arrangements, and buying and
sellingof business entities.
Customer Due Diligence (CDD) includes following:
- Keeping and verifying identification document of the key persons (Directors/ owners/
senior management personnel)
- The address of the registered office, and, if different, a principal place of business
- Appointing a contact person in firm and communicating the details of the contact person
to Financial Information Unit (FIU) of NRB
- Make a suspicious transaction report (STR) to the financial intelligence unit (FIU)
However, accountants acting as independent legal professionals, are not required to report
suspicious transactions if the relevant information was obtained in circumstances where they
are subject to professional secrecy or legal professional privilege.
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years to mitigate the risk of over-familiarity. Work performed by each auditor is reviewed by
the other, in most cases by exchanging audit summary reports. The critical issues at group
level, including group consolidation, are reviewed jointly and there is joint reporting to the
legal entity's management, its audit committee, a government entity, or the general public.
A joint audit is different from a dual audit, where a dual audit is performed by two
independent auditors issuing their own separate reports, which are then used by another
auditor that ultimately reports on the entity as a whole.
Auditor competence and independence
Joint audit addresses two underlying principles of audit quality: auditors competence and
independence. It enables a benchmarking of audit approaches and affords audit committees
the opportunity to pick and choose the best local firms from within two global audit
networks. Audit committees and investors have additional assurance that the audit opinion
with which they are presented is complete. A joint audit allows rotation of audit firms, and
retains knowledge and understanding of group operations in a way that minimizes the
disruption caused when a single audit firm is changed. The rotation of audit firms is equally
likely to mitigate the risk of over familiarity. Two firms can also stand stronger together
against aggressive accounting treatments. In this way, joint audit effectively becomes a
guardian for audit quality. The benchmarking that takes place between the two firms raises
the level of service quality.
Joint audit delivers increased reporting on audit time and rates applied across the group. A
recent comparative analysis of audit fees between Germany and France shows that companies
with joint audit pay significantly less for their audit than companies without joint audit. Joint
audit increases time spent by the senior staff on the audit team, and the senior management of
the group or organization.
Joint audit is audit carried out by two separate auditors who have the assignment of the same
client. It may cover different areas or otherwise. The auditors may conduct the audit together
or only one may do the same and the liability of both of them is divided. It normally happens
in huge companies where one single auditor cannot do the audit of the whole company.
E.g. ABC and Co. and DEF and Co. are appointed as statutory auditors of XYZ Ltd.
Responsibility of joint auditors is defined on ISA 299, Responsibility of Auditor
Division of work
Joint auditor should divide the work among themselves on following basis;
- Period
- Functional Areas
- Components of financial statement
- Geographical location
Responsibility of joint Auditors
Individual responsibility
- For work allocated to him
- For drafting his own program
- Documentation
- Overall responsibility of assigned work
of component
Joint responsibility
- Audit of work not divided
- Collective decision wrt audit procedure
- Matters brought in each other knowledge
- Disclosure requirements and compliance
with statutory requirements
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Difference of opinion
Generally all joint auditors arrive at unanimous conclusion about audit opinion. However,
joint auditors are not bound by the majority opinion. Disagreement, if any, with other joint
auditor, may be provided with their own opinion through a separate report.
Branch audit
Branch audit means conducting an audit of one or more particular branch(es). In branch audit,
verifications are restricted to that particular branch only. Branch audit involves principle
auditor and branch auditor often referred as another auditor or others auditor in NSA 600,
Using the work of Another Auditor
Consideration of work of another auditor
When the principal auditor uses the work of another auditor, the principal auditor should
determine how the work of the other auditor will affect the audit.
Acceptance as Principal Auditor
The auditor should consider whether the auditors own participation is sufficient to be able to
act as the principal auditor.
For this purpose the auditor would consider:
- the materiality of the portion of the financial information which the principal auditor
audits;
- the principal auditors degree of knowledge regarding the business of the components;
- the risk of material misstatements in the financial information of the components audited
by the other auditor; and
- the performance of additional procedures as set out in this SA regarding the components
audited by other auditor resulting in the principal auditor having significant participation
in such audit.
Audit Procedure to be adopted by Principal Auditor
When planning to use the work of another auditor, the principal auditor should consider the
professional competence of the other auditor in the context of specific assignment if the other
auditor is not a member of the Institute of Chartered Accountants of Nepal.
The principal auditor should perform procedures to obtain sufficient appropriate audit
evidence, that the work of the other auditor is adequate for the principal auditors purposes, in
the context of the specific assignment. When using the work of another auditor, the principal
auditor should ordinarily perform the following procedures:
- advise the other auditor of the use that is to be made of the other auditors work and
report and make sufficient arrangements for co-ordination of their efforts at the planning
stage of the audit. The principal auditor would inform the other auditor of matters such as
areas requiring special consideration, procedures for the identification of inter-component
transactions that may require disclosure and the time-table for completion of audit; and
- advise the other auditor of the significant accounting, auditing and reporting requirements
and obtain representation as to compliance with them.
The principal auditor might discuss with the other auditor the audit procedures applied or
review a written summary of the other auditors procedures and findings which may be in the
form of a completed questionnaire or check-list. The principal auditor may also wish to visit
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the other auditor. The nature, timing and extent of procedures will depend on the
circumstances of the engagement and the principal auditors knowledge of the professional
competence of the other auditor.
After considering above audit procedure, the principal auditor should consider the significant
findings of the other auditor. The principal auditor may consider it appropriate to discuss with
the other auditor and the management of the component, the audit findings or other matters
affecting the financial information of the components. He may also decide that supplemental
tests of the records or the financial statements of the component are necessary. Such tests
may, depending upon the circumstances, be performed by the principal auditor or the other
auditor.
Documentation
The principal auditor should document in his working papers the components whose financial
information was audited by other auditors; their significance to the financial information of
the entity as a whole; the names of the other auditors; and any conclusions reached that
individual components are not material. The principal auditor should also document the
procedures performed and the conclusions reached.
Co-ordination between Auditors
There should be sufficient liaison between the principal auditor and the other auditor. For this
purpose, the principal auditor may find it necessary to issue written communication(s) to the
other auditor. The other auditor, knowing the context in which his work is to be used by the
principal auditor, should co-ordinate with the principal auditor. The principal auditor may
require the other auditor to answer a detailed questionnaire regarding matters on which the
principal auditor requires information for discharging his duties. The other auditor should
respond to such questionnaire on a timely basis.
Reporting Considerations
When the principal auditor concludes, based on his procedures, that the work of the other
auditor cannot be used and the principal auditor has not been able to perform sufficient
additional procedures regarding the financial information of the component audited by the
other auditor, the principal auditor should express a qualified opinion or disclaimer of opinion
because there is a limitation on the scope of audit. If the other auditor issues, or intends to
issue, a modified auditors report, the principal auditor should consider whether the subject of
the modification is of such nature and significance, in relation to the financial information of
the entity on which the principal auditor is reporting that it requires a modification of the
principal auditors report.
Division of Responsibility
The principal auditor would not be responsible in respect of the work entrusted to the other
auditors, except in circumstances which should have aroused his suspicion about the
reliability of the work performed by the other auditor. When the principal auditor has to base
his opinion on the financial information of the entity as a whole relying upon the statements
and reports of the other auditors, his report should state clearly the division of responsibility
for the financial information of the entity by indicating the extent to which the financial
information of components audited by the other auditors have been included in the financial
information of the entity, e.g., the number of divisions/branches/subsidiaries or other
components audited by other auditors.
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on the transaction date the transaction to buy an asset takes place in the market in which the
asset would be sold). When determining whether fair value at initial recognition equals the
transaction price, an entity shall take into account factors specific to the transaction and to the
asset or liability.
Valuation techniques
An entity shall use valuation techniques that are appropriate in the circumstances and for
which sufficient data are available to measure fair value, maximising the use of relevant
observable inputs and minimising the use of unobservable inputs. The objective of using a
valuation technique is to estimate the price at which an orderly transaction to sell the asset or
to transfer the liability would take place between market participants at the measurement date
under current market conditions. Three widely used valuation techniques are the market
approach, the cost approach and the income approach.
Market approach
A valuation technique that uses prices and other relevant information generated by market
transactions involving identical or comparable (ie similar) assets, liabilities or a group of
assets and liabilities, such as a business.
The market approach uses prices and other relevant information generated by market
transactions involving identical or comparable (ie similar) assets, liabilities or a group of
assets and liabilities, such as a business. For example, valuation techniques consistent with
the market approach often use market multiples derived from a set of comparables. Multiples
might be in ranges with a different multiple for each comparable. The selection of the
appropriate multiple within the range requires judgement, considering qualitative and
quantitative factors specific to the measurement.
Valuation techniques consistent with the market approach include matrix pricing. Matrix
pricing is a mathematical technique used principally to value some types of financial
instruments, such as debt securities, without relying exclusively on quoted prices for the
specific securities, but rather relying on the securities relationship to other benchmark
quoted securities.
Cost approach
A valuation technique that reflects the amount that would be required currently to replace the
service capacity of an asset (often referred to as current replacement cost).
The cost approach reflects the amount that would be required currently to replace the service
capacity of an asset (often referred to as current replacement cost). From the perspective of a
market participant seller, the price that would be received for the asset is based on the cost to
a market participant buyer to acquire or construct a substitute asset of comparable utility,
adjusted for obsolescence. That is because a market participant buyer would not pay more for
an asset than the amount for which it could replace the service capacity of that asset.
Obsolescence encompasses physical deterioration, functional (technological) obsolescence
and economic (external) obsolescence and is broader than depreciation for financial reporting
purposes (an allocation of historical cost) or tax purposes (using specified service lives). In
many cases the current replacement cost method is used to measure the fair value of tangible
assets that are used in combination with other assets or with other assets and liabilities.
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Income approach
Valuation techniques that convert future amounts (eg cash flows or income and expenses) to
a single current (ie discounted) amount. The fair value measurement is determined on the
basis of the value indicated by current market expectations about those future amounts.
The income approach converts future amounts (eg cash flows or income and expenses) to a
single current (ie discounted) amount. When the income approach is used, the fair value
measurement reflects current market expectations about those future amounts.
Those valuation techniques include, for example, the following:
a) present value techniques;
b) option pricing models, such as the Black-Scholes-Merton formula or a binomial model (ie
a lattice model), that incorporate present value techniques and reflect both the time value
and the intrinsic value of an option; and
c) the multi-period excess earnings method, which is used to measure the fair value of some
intangible assets.
Consistency
Valuation techniques used to measure fair value shall be applied consistently. However, a
change in a valuation technique or its application (eg a change in its weighting when multiple
valuation techniques are used or a change in an adjustment applied to a valuation technique)
is appropriate if the change results in a measurement that is equally or more representative of
fair value in the circumstances. That might be the case if, for example, any of the following
events take place:
a) new markets develop;
b) new information becomes available;
c) information previously used is no longer available;
d) valuation techniques improve; or
e) market conditions change.
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AUDIT COMMITTEE
Sec.164 of the Companies Act 2063 prescribes the provision regarding the Audit Committee
of a company. According to the legal provision of audit committee as prescribed by the Act,
it can be discussed as follows:
1. A listed company with psid up capital of thirty million rupees or more or a company
when is fully or partly owned by the Government of Nepal has to form an audit
committee under the Chairpersonship of a director who is not involve in the day to
day operations of the company and consisting of a least three members.
2. A person who is a close relative of the chief executive of a company will not be
eligible to be a member of the audit committee formed as said above.
3. At least one member of the audit committee should be an experienced person having
obtained professional certificate on accounting or a person having gained experience
in accounting and financial field after having obtained at least bachelors degree in
accounts, commerce, management, finance or economics.
4. The report of board of directors required to be prepared by a company should set out a
short description of the activities of the audit committee, working policies adopted by
the board of directors to implement the suggestions, if any, given by the audit
committee, the allowances or facilities, if any received by the members or the audit
committee and the names of the members of audit committee.
5. The audit committee may, for inquiring into any matter, notify the managing director
of the company chief executive or the company or other director, auditor, internal
auditor and accounts chief involved in the day to day operations of the company to
attend its meeting; and it will be their duty to be present in the meeting of that
committee if they are so notified.
6. The board of directors should implement the suggestions given by the audit
committee in respect of the accounts and financial management of the company; and
where any suggestion cannot be implemented, the board of directors should also
mention the reasons for the same in its report.
7. A company should arrange for such means and resources as may be adequate for the
fulfillment of responsibilities of the audit committee; and the audit committee may fix
its internal rules of procedures on its own.
8. The chairperson of the audit committee should be present in the annual general
meeting of the company.
9. The audit committee should be there to present as per necessity.
Section 165 of the Companies Act 2063 prescribes the functions, duties and powers of audit
committed as follows:
a. To review the accounts and financial statements of the company and ascertain
the truth of the facts mentioned in such statements;
b. To review the internal financial control system and the risk management
system of the company;
c. To supervise and review the internal auditing activity of the company;
d. To recommend the names of potential auditors for the appointment of the
auditor of the company, fix the remuneration and terms and conditions of
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e.
f.
g.
h.
i.
appoint of the auditor and present the same in the general meeting for the
ratification thereof;
To review and supervise as to whether the auditor of the company has
observed such conduct, standards and directives determined by the competent
body pursuant to the prevailing law as required to be observe in the course of
doing auditing work;
Based on the conduct, standard and directives determined by the competent
body pursuant to the prevailing law, to formulate the policies required to be
observed by the company in respect of appointment and selection of the
auditor;
To prepare the accounts related policy of the ompany and enforce, or cause to
be enforced the same;
Where any regulatory body has provided for the long term audit report to be
set out in the audit report of the company, to comply with the terms required to
prepare such report;
To perform such other terms as prescribed by the board of directors in respect
of the accounts, financial management and audit of the company.
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7. A person, firm, company or institution having subscribed one percent or more or the
shares in the licensed institution;
8. A person who has been punished by the court for a criminal offense involving moral
turpitude, and period of five years has not lapsed after he or she has served the
punishment;
9. A person who has been punished by a court for an offense relating to corruption or
cheating;
10. A person who is not included in the list of auditors approved by the Rastra Bank.
DEREGISTRATION OF COMPANY
Deregistration of company means the striking off the name of the company from the
company register book of the Office. Where the name of the company is cancelled from its
register book, the Office should issue a notice that the registration of the company has been
cancelled and publish the notice in a national daily newspaper that such company has been
cancelled and dissolve.
Deregistration of a company may be caused by various ways as follows:
a. By liquidation of a company: Where a company has been processed for the
liquidation of a company either voluntarily or compulsorily the company Registrar
will strike the name of the company from the register book of the office on receipt of
the report on the liquidation of a company from the liquidator, appointed for the
liquidation process.
b. By order of the Office to cancel registration: (Sec. 136)
1.
The Office may cancel the registration of a company in the following
circumstance:
a. If the promoter of the company makes an application, showing a reason for
the failure to commence the business of the company, and accompanied by
the prescribed fees, for the cancellation of the registration of the company;
b. If the company is in default in submitting to the Office the returns as
required to be submitted under the Act, or fails to pay the fine as per the
provision of the Act for three consecutive financial years; or
c. If based on the proofs received in the course of administration of the
company, the Office has a reasonable ground to believe that the company is
not carrying on its business or the company is not in operation.
2. If it is required to cancel the registration of any company as said above, the Office
should, prior to the cancellation of registration, give notice, accompanied by the
reason for such registration, to the concerned company at its registered office or to
any officer of such company, if the office of the company is not located at the
address registered. A notice given in respect of the reasons for the cancellation of
the company should also be published in a daily newspaper, as per necessity.
3. If the company fails to make an application, specifying the reasons that the
registration of the company should not be cancelled, within two months from the
date of receipt by the company of a notice of cancellation or , despite the making of
such application, the reasons specified are not found reasonable, the registration
such company may be cancelled.
4. If the registration of a company is cancelled as said above, information thereof
should be give to the concerned directors and should also be published in a national
daily newspaper.
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However, if there exists any kind of liability of the company so cancelled, the
liability of the officer or shareholder of the company will continue to exist.
5. If any debt to be repaid by or any liability to be performed/discharged by the
company of which registration has been cancelled cannot be settled from the assets,
rights of such devolved on the shareholders, directors or officers who were
involved in the management of such company and responsible for giving rise in the
situation as referred above will be personally bear such remaining loan or liability.
A company of which registration is cancelled will not be allowed to carry on any
business by the name of the same company.
6. Following the cancellation of registration of any company, the Office should return
to the shareholders only such property, if any remaining after deducting there from
the expenses incurred in the cancellation of the registration of that company.
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j.
If the banks and financial institution licensed is amalgamated with another bank
or financial institution.
If a banks and financial institutions duly makes an application for the cancellation
of its license voluntarily to Nepal Rastra Bank, NRB have to give its decision
within 45 days after the receipt of such notice. NRB will give its decision in
writing with the reason for its order. If a decision is made to cancel a license
pursuant to this provision, the Rastra Bank should publish a public notice thereof.
Restoration of registration of company of which registration was cancelled (
Sec. 137):
A contrast between the death of an individual and that of a company is that without
divine intervention but merely by an order of the court, a dissolved company can
be resurrected.
1. In the case of cancellation of the registration of a company under Sec. 136 of
the Act, where the company or its shareholder of creditor makes a petition,
setting out the reasons, to the Court to have the company restored, no latter
than five years after the date of publication of the notice of cancellation of
registration of the company, the Court may order to restore the company and
restore its name in the company register on the following circumstances:
a. If it appears that the registration of the company was cancelled while such
company was carrying on its business;
b. If the Court considers it to be just to restore the name of the company for
the proper management of the assets and liabilities of such company.
2. In the event of restoration of a company by virtue of an order of the Court as
said above the company will be considered to have been in existence from the
date of its registration.
3. While issuing an order for restoring the registration of a company, the court
may issue such order and make an order to make such arrangements as it may
consider appropriate and necessary for restoring the company and all other
persons into the status quo ante as if the registration of the company were not
cancelled.
4. While a company is restored and s fine as per the Act is to be paid, the
company should be restored and its name reentered in the company only after
such fine is paid to the Office.
5. Where a company is restored, any property received by its shareholders by
virtue of cancellation of registration of the company or the property so received
has already been sold and disposed of, the property so received or proceeds of
such sale and disposal will have the reverted to it.
However, that no property or amount already employed in the payment of debt
or liability of creditor will be returned.
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entrusted them to use its right and duty of the company. As it is established for the economic
motive, the investors do expect safe return along with profits for their investment.
To rescue company from worse condition law makers have provided various statutory
provisions for the assurance of the effective enforcement of the corporate governance
concept. For this various legislative provision has been prescribed to improve its affairs
through inspection and investigation. i.e by carrying out investigation process in respect of
the companys wrong done by concern person for the prevention of oppression and
mismanagement. This investigation process is not possible by shareholders only. It is
appropriate to be carried out government agencies. Companies Act 2063 has prescribe the
provisions of administrative remedy on companys wrong affairs under Chapter 9.
Power of Office to call for explanation (Sec. 120):
Under the companies Act every company is required to submit various documents as
prescribed with explanation in respect of the matter, where the Office has called to furnish. In
such case it is the duty of the management of the company to submit the proper replies with
respect to which explanation has been called. In pursuing explanation if the Office could find
any irregularity in the business of the company, it may give necessary directive to the
company to regularize, or cause to be regularized it.
Power of Office to depute inspector (Sec. 121):
If the shareholders representing not less than ten percent of the paid up capital or not less than
one fourth of the total number of shareholder of the company or the concerning creditors
make an application, accompanied by the supporting evidence and reasonable grounds,
stating that the company has acted in contravention of the companies Act, MOA/AOA,
prospectus, consensus agreement or prevailing law, the Office may, as per necessity depute
one or more inspectors. The applicant should deposit with the Office such amount of
estimated cost required for such investigation as specified by the Office.
However, if the Office is of opinion that the business or transaction of the company is being
carried on to defraud the shareholders or creditors of the company or for a fraudulent or
illegal purpose or it carrying our acts against the public interest, it may as per necessary
appoint a qualified inspector to investigate the transaction or business of the company even if
no application is made by the shareholders or the creditors.
Powers of inspectors (Sec. 122):
In the course of investigation, he can make to appear all the concern persons before him and
to record their statements. He also can seize or take into control any other document which
are relevant for the purpose of investigation. While making an investigation, he can examine
whether the books of account of the company have been kept properly.
If any person makes false statement, or fails to produce proper document or other thing as
required to be submitted or fails to answer any question asked by him for the purpose of
investigation, he may file a complaint report under sec. 124 in writing in the Court.
Consequences of inspections:
Report to be submitted (Sec. 124): The inspector appointed on conclusion of the
investigation, shold submit a report accompanied by his opinion to the Office. It may contain
the suggestion as to the payment of expenses to be borne by. The Office may provide a copy
to the applicant or shareholders if any makes an application to get a copy of such report by
collecting prescribed fees. The report so submitted will be administered as evidence
according to the law.
If from any report made by the inspector, it appears to the Office that any directors, managing
directors, managers, employees or any other offices of the company have knowingly caused
any loss or damage to the company or have defrauded, cheated the shareholders or creditors
or committed any other illegal acts, the Office may order the company to file a lawsuit on
behalf of the company against them.
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Accordingly where the Office is of opinion that the company may suffer further loss or
damage if its business is left further in the hand of directors, managing directors, managers,
employees or any other officers who have committed any act as said above, the Office may
give necessary direction to the company to suspend such directors or officers and carry on its
business through any other means
According to Sec. 125 the expenses incurred in an investigation carried out by the Office
should be borne by the concerned company. However any director, managing director,
manager or officer of the company appears to committed a malice, fraud or cheating, such
offenders should pay the expenses of investigation within seven days of the completion of
investigation. If the concerned director, managing director, of officer does not pay the
expenses of investigation, the expenses can be recovered as governmental dues.
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(2) A special resolution adopted by the board of directors of the company to institute the
insolvency proceedings pursuant to this Act;
(3) Certified copies of the balance sheet and audit report of the company available at the time
of making application for the institution of insolvency proceedings.
(b) Where the creditor of a company which has become insolvent makes such application:
(1) A statement of the principal and interest of the debt which the creditor claims to be due
and payable by the company;
(2) The date on which the company borrowed the debt claimed by the creditor and the reason
why the debt was borrowed;
(3) Description that the amount referred to in Clause (1) is due and such amount is payable
immediately;
(4) That the debtor believes or the reason and ground the debtor has to believe that the
company in respect of which demand is made for insolvency proceedings has
become insolvent.
(c) Where the liquidator makes such application:
(1) Evidence that the company in respect of which application is made for insolvency
proceedings has appointed the liquidator for the purposes of liquidation
of the company; and
(2) The opinion expressed by the liquidator on the matter that the company in respect of
which application is made for insolvency proceedings has become insolvent, and
the ground for such opinion.
Any shareholder or debenture-holder of a company should obtain permission of
the Court to make an application for insolvency proceedings pursuant to
Clause (c) or (d) of Sub-section (1), and the shareholder or debenture-holder
may, if so permitted, make an application on such terms and conditions as
may be specified by the Court. The Court will not give permission referred above (4) unless
and until sufficient evidence proving that the company has become insolvent is produced.
2. Notice to be given for payment of debt( Sec 5): Prior to making an
application to the Court pursuant to Section 4 for insolvency proceedings, a
notice shall be sent to the registered office of the company in the prescribed
form for the payment of debt.
3. Application to void notice issued for payment of debt: Where the
notice received is not reasonable or where there are any other reason for not repaying the debt
immediately, the concerned company may make an application to the Court in order to void
the notice, not later than thirty five days after the date of receipt of that notice.
Where the application referred to in Sub-section (1) is made, the Court shall issue a notice
summoning the creditor giving the notice referred to appear before the Court within seven
days; the notice to be so issued shall also be accompanied by a copy of such application.
The Court may make a decision to void or not to void the notice issued pursuant to Section 5
no later than seven days after the date of appearance of the creditor or after the date of
expiration of the time prescribed for the appearance before the Court where
the creditor has failed to make such appearance. The Court may issue an order to void the
notice issued pursuant Section 5 on the following condition:
(a) There is a clear dispute as to whether the creditor has extended debt to the company or
not; or
(b) The debt due to be paid by the company to the credit does not appear to be payable
immediately.
Where the Court issues an order no notice that is issued to pay the debt can be given to the
company again on the same matter nor can an application be made for the institution of
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insolvency proceedings until the condition set forth in that Sub-section continues to
exist. Where the Court does not issue an order the company shall pay the debt of creditor no
later than thirty five days from that date.
4. Company deemed to have become insolvent: (Sec 7) : According to Sec. 7 of the
insolvency Act 2063, exceot as otherwise proved or agreed, a company shall be deemed to
have become insolvent on the following condition:
(a) The general meeting of shareholders adopts a resolution that the company has become
insolvent or a meeting of the board of directors of the company makes such decision; or
(b) The Court issues an order requiring the company to pay the debt and the debt is not paid
up within thirty five days from the date of receipt by the company of such order; or
(c) The company fails to pay the debt within thirty five days after the service by the creditor
on the company a notice for the payment of the debt or fails to make an application to the
Court within the said period to void such notice.
(2) Nothing contained in this Section shall prevent the establishing
of the fact that a company has become insolvent where it is proved from any
other matter that the liability of the company exceed the value of the assets
of the company or the company itself admits that it has become insolvent.
5. Application for insolvency proceedings(Sec 8): Notwithstanding anything contained in
Section 4, no application may be made to the Court for insolvency proceedings in relation to
the following company without obtaining prior approval of the following authority:
(a) In the case of a bank or financial institution carrying on banking and financial business,
the Nepal Rastra Bank, or
(b) In the case of an insurance company carrying on insurance business, the Insurance Board
formed pursuant to the Insurance Act, 2049(---), or
(c) In the case of a company which cannot undergo voluntary liquidation without approval of
the competent body or authority, except that mentioned in Clause (a) or (b), such authority.
(2) Every application to be made for insolvency proceedings in relation to a company as
mentioned above should be accompanied by a copy of the approval given by the authority set
forth in that Sub-section for that purpose.
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a) To capitalize the debt of the company and alter the capital structure ;
(b) To pay the claims of creditors by selling any portion of the assets of the company;
(c) To change the nature of claims of creditors of the company and issue securities for the
same;
(d) To get the creditors of the company to participate in capital investment by issuing shares
in consideration for their claims;
(e) To amalgamate the company with any other company;
(f) To change the management of the company; or
(g) To do any such other act which the Court considers appropriate to restructure the
company.
3. Procedures of reorganization of the company:
After the appointment of reorganization manager he prepares the program for this
purpose. Then the manager starts to execute the procedures of reorganization.
a. The reorganization manage has to call a meeting of the creditors as accordance to the
provision of Sec 21 and to fulfill all the legal formalities within 15 days from the date
of commencement of business and such notice shall be published in a daily newspaper
of national circulation for at least two times; and such notice may also be put on the
website. . (Sec. 24).
b. The meetings of the creditors called pursuant to Sec. 21(3), discuss the details of the
Reorganization program proposal presented by the manager and adopts a resolution:
i.
With or without amendment on the program proposal, acceptance or
ii.
Recommendation for the immediate liquidation of the company.
If the court issues order approving the resolution of reorganization program, that will
be implemented.
c. The reorganization officer within the period of reorganization has to submit a report
to the court accompanied by the transactions, assets, financial situation of the
company and the reorganization program, if any amendment made.(Sec.25):
Where reorganization program is proposed in the report submitted by the manager,
the following matters must be stated:
i.
Summary and analysis of the proposed program
ii.
Details of the effect likely to be caused by the implementation of the program
to the creditors.
iii.
Details of the consideration and effect available to the creditors from the
implementation of reorganization program in comparison to the immediate
liquidation of the company.
iv.
Opinion and description accompanied by the finding in the report of the
manager that the company would not be insolvent if the reorganization
program was implemented.
Thus, reorganization program proposal must contain following matters in the
written form:
i.
All details and relevant in written form about the future program,
ii.
All details of the benefit to creditors by implementation of the
program,
iii.
Details about the matter that proposal is not illegal and prohibited by
law
iv.
Details to the consequences of implementation that company will be
rescued from insolvency, and details about the costs between
investigation and reorganization period as well as remuneration of
manager and officer
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4. Information to be given to the court if failures to submit detail report (Sec. 26):
Where it is not possible to submit the details of the restructuring program the manager
has to make an application, accompanied by the reasons, to the Court. If the Court
considers it to be reasonable, invalidate the order to make restructuring and issue an
order to liquidate the company.
5. Claim and objection to approved restructuring program (Sec. 27) :
The creditor who has not agreed the proposal of restructuring program approved pursuant to
Sub-section (7) of Section 24 may claim and object within seven days, setting out the
following grounds and reasons:
(a) The restructuring program is not beneficial to the creditors other than the secured
creditors;
(b) There is a serious irregularity in calling or conducting the meeting of creditors,
(c) False or misleading information has been given or material and substantive information
are concealed in relation to the company or its restructuring program.
Where such application is made, the Court may order to the manager and the company to
submit written statements in relation thereto within a period of seven days.
On receipt of written statements if found to be based on reasonable grounds, the Court can
invalidates to make ineffective the resolution on the restructuring program and issue order for
the liquidation of the company immediately. (Sec, 27 (2,3,4 & 5).
6. Consequence of approval of restructuring program by Court (Sec. 28):
Where the Court issues an order to approve the restructuring program adopted by the
meeting of creditors the program will be binding on all creditors of the company, directors
and shareholders other than the secured creditors of the company; and the restructuring
period will end on that date.
1. Not to affect secured creditors: (Sec 29) No restructuring program adopted by
a meeting of creditors and approved by the Court except on the following condition,
prevent the secured creditors from executing or otherwise dealing the security:
a) Where the secured creditor votes in favor of the restructuring program gives his or
her consent; or
(b) Where the Court orders that that program will be binding to the secured creditor.
On the ground that :
i) If it (execution of security by secured creditor) may substantially prejudice the
achievements of the restructuring program;
ii) If it adequately protects the right of the secured creditor to the security, and the
security.
2. Not to affect the right of owner of any property or of any lessor Sec 30):
The restructuring program adopted by a meeting of creditors and
approved by the Court pursuant to this Chapter shall, except on the following
condition, prevent the owner of any property used or possessed or owned by
the company or the lesser of such property from executing it or returning the same:
(a) Where the owner or lessor of such property votes in favor of such program or
gives his or her consent in writing; or
(b) Where the Court orders that the program will be binding to the owner or lesser of
such property on the grounds that: .
i), If it may substantially prejudice the achievement to program;
ii) If the restructuring program adequately protects the property and right of such
owner or lesser
7. Restructuring manager is to operate company (Sec. 31):
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The restructuring manager has to operate the company may exercise the following
powers:
a) Management and control of the business, properties and transactions of the
company;
b) Termination, sale and disposal of any business or property of the company;
c) Doing or exercising any such act or power that the company or its officer may do
or exercise. The restructuring manager in exercising the powers as referred will act in
the capacity of an agent of the company in the following matters:
i) He has power to inspect all books of account, ledgers, records, accounts and
documents of the company.
ii) If sought by the manager, the directors and officials of the company must provide
assistance for the management and control of company as per the need.
iii) No director and officer of the company can exercises power or do any act in that
capacity except with written direction of the restructuring manager or officer.
iv) If sought by the restructuring manager, the director of the company has to provide
information about the company, its business, property and the transaction of the
company.
8. Power of restructuring manager to borrow loan (Sec 32):
In the course of acting as the manager of the company the restructuring manager may
raise loan for the purpose of keeping on management of company, operate business
and the transaction of company with or without providing security of assets. In this
context the conditions contained in Section 17 must be fulfilled.
9. Ceiling of remittance of loan of company (Sec. 33):
On the consent of the creditors, any loan or remittances or alteration in any terms of
any loan not secured such act can be made as accordance with program.
10. Implementation of restructuring program (Sec 34): The company will be
responsible for implementing the restructuring program adopted by the
meeting of creditors and approved by the Court. The Court may designate the
restructuring manager for the supervision and management of the implementation of
the program.
11. Alteration in and amendment to restructuring program(Sec 35:
Where it appears that the restructuring program cannot be implemented wholly or
partly at the time of implementation of that program, the restructuring manager can
call a meeting of creditors for the alteration or amendment of the program for the
purpose of implementation. When there is made an alterations and amendment of the
program, it should be submitted to the court for approval. If it is finding reasonable to
approve the program for the interest of creditors, the court may order to that effect.
The altered and amended program will be implementing.
12. Termination of restructuring program( Sec 36):The program may be ended up
when the court issues an order to ended up. The court issues an order to end up the
reconstruction program in two circumstances:
i.
Where the manager makes application that company has already implemented
the restructuring program, or
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ii.
Where the company failures to implement the restructuring program, the court
may issue an order to liquidate the company.
LIQUIDATION OF COMPANY
Introduction:
The term liquidation means the act of determining the exact amount of something as a debt
that before was uncertain. It is the process of realizing upon assets and of dischanrging
liabilities in concluding the affairs of a business/company. Liquidation of company means
situation where the registration of company is cancelled by fulfilling the procedure referred to
the Insolvency Act 2063. The company of which financial condition cannot be reformed by
the reorganization process, that can be preceded in the issue of the order of the court on the
basis of recommendation or reorganization manager, under the Insolvency Act 2063.
Procedures of Liquidation of the Company:
1. The Court order to liquidate the company: The procedure of liquidation of a company
starts when the court issues an order to terminate the company, on the ground of
application of reorganization manager that the reorganization program failures.
2. Liquidation of the company on the issuance of order of Court to appointment of
Liquidator (Sec. 37) : Where the court makes an order to liquidate a copany pursuant
to their Insolvency Act, 2063, the court makes an order to appoint one person as a
liquidator, from among the persons who are capable as per law to carry on the
insolvency business at the time of making of such order. Following the court order to
appoint a liquidator for the liquidation, the liquidation proceedings of the company is
deemed to have commenced.
3. Consequences on the commencement of liquidation proceedings(Sec 38):
On the commencement of the liquidation proceedings of any company, the
following provisions shall govern the following matters in relation to such
company:
(a) Where the director and officer of the company are relieved of office, the liquidator
will exercise all such powers as may be exercisable by the director and officer of the
company in relation to the management of that company;
b) The liquidator will take in his or her custody and control all assets, accounts and
books of account of the company, except the properties in possession of secured
creditors;
(c) Except as ordered otherwise by the liquidator, the service of all employees
appointed by the company will terminate.
d) except for the following matter, the provision relating to ipso facto suspension set
forth in Sec. 19 of this Act, applies apply during the period of company of liquidation
proceedings:
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In addition to the functions, duties and powers set forth in Sec. 40 (1) and (2),
the liquidator may also perform other functions such as to get back any property of
the company if such property is used by any person or to institute legal action to get
back such property or amount involved in a void transaction. (Sec 40 (3).
However the liquidator can not make such expenses that is be payable from the assets
of the company.
Even though the company does not have adequate amount to pay necessary expenses
or remuneration to the liquidator for the exercise of the powers or performance of the
duties the liquidator has to exercise such powers and perform such duties. (Sec.40(4).
Where the liquidator faces any difficulty with the exercise of any power or the
performance of any duty pursuant to this Chapter, the liquidator may make an
application to the Court for the removal of such difficulty; and where an application is
so made, the Court may, if it holds the application to be reasonable, remove
difficulty.(Sec.40(5).
6. Money to be lent by creditor (Sec 41: Where any act to be done by any company
which has become insolvent may render or yield benefit or advantage to the creditors,
any creditor of such company may advance money to the liquidator to do such act.
Any creditor may make an application to the Court for any order for making payment
of a debt claim accepted by the company from the amount received above.
7. Report to be submitted by liquidator (Sec. 42: The liquidator has to prepare a
progress report on the proceedings carried out in relation to the company and
submit it to the Court and the Office no later than three months after the date of his or
her appointment.
The report must state the following matters, in addition to other matters (Sec 42(2):
a) The amount of issued capital of the company, capital that the shareholders have
undertaken to subscribe and paid-up capital;
b) Estimated value of the assets and liabilities of the company;
c) Opinion of the liquidator in relation to the reason for financial failure of the
company;
d) Opinion of the liquidator on the need to further examine or inquire into the
promotion, incorporation of the company or the affairs of the company and its
directors and shareholders;
(e) Such other necessary matters as the liquidator considers appropriate.
8. To call meeting of creditors(Sec. 43): The liquidator shall, prior to preparing his
or her report pursuant to Section 42 and thereafter from time to time as per necessity,
call a meeting of creditors of the company.
9. Power to form committee of creditors (Sec. 44):
The meeting of creditors held pursuant to Section 43 may form a committee
consisting of a maximum of five creditors in order to assist the liquidator in relation to
the liquidation of the company.
The scope of the committee or other necessary matters shall be as specified by the
meeting of creditors at the time of its formation.
10. To give time limit for submission of debt claim(Sec. 45: The liquidator
shall give a notice with the time limit of fifteen days to all creditors of the
company which has become insolvent to submit their respective debt claims
in the prescribed format.
The Institute of Chartered Accountants of Nepal
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The notice given pursuant to Sub-section (1) shall be published at least twice in a
newspaper of national circulation except reasonable cause, the liquidator may reflect
the claims of creditors after expiry of time limit..
11. Power of the Court to make order in relation to liquidation of company (Sec 46:
Notwithstanding anything contained elsewhere in this Chapter, the Court may at any
time issue the following order in respect of any company which is undergoing
liquidation proceedings:
(a) To suspend or terminate the liquidation of the company;
(b) To require to hand over the assets of the company to the
liquidator;
(c) To pay any call made for payment of installment;
(d) Where there is a doubt that any person is possessing or using
any property of the company, to stop such possession or use; or
(e) To arrest any person who causes any hindrance in or
obstruction to the performance of functions or duties or the
exercise of powers by the liquidators.
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more precisely referred to as a "merger of equals". The firms are often of about the same size.
Both companies' stocks are surrendered and new company stock is issued in its place. For
example in 2012 Dish TV and Home TV was merged a new company Dish Home TV was
created. Similarly when National Finance Company and Nayaryany Finance Company was
merged in 2009, a new company, Narayani National Finance Company was created.
Accordingly, in the 1999 merger of Glaxo Wellcome and SmithKline Beecham, both firms
ceased to exist when they merged, and a new company, GlaxoSmithKline was created. A
purchase deal will also be called a merger when both CEOs agree that joining together is in
the best interest of both of their companies.
Mergers and acquisitions (abbreviated M&A) also refers to the aspect of corporate strategy,
corporate finance and management dealing with the buying, selling, dividing and combining
of different companies similar entities that can help an enterprise grow rapidly in its sector or
location of origin, or a new field or new location, without creating a subsidiary, other child
entity or using a joint venture. The distinction between a "merger" and an "acquisition" has
become increasingly blurred in various respects (particularly in terms of the ultimate
economic outcome), although it has not completely disappeared in all situations. When one
company takes over another and clearly establishes itself as the new owner, the purchase is
called an acquisition. From a legal point of view, the target company ceases to exist, the
buyer "swallows" the business and the buyer's stock continues to be traded. For example in
2014 Globle IME Bank and Commerze and Trust Commercial Bank was merged and the
Globle IME Bank continued its business and C&T Bank ceased to exist.
But when the deal is unfriendly (that is, when the target company does not want to be
purchased) it is always regarded as an acquisition.
In other words an acquisition is the purchase of one business or company by another
company or other business entity. Consolidation occurs when two companies combine
together to form a new enterprise altogether, and neither of the previous companies survives
independently. For example in 2015 Vibor Finance Company and Kist Bank was merged
and Kist bank was emerged. Subsequently Prabhu development bank and Kist Bank was
merged and new name Prabhu Bank was emerged. Acquisitions are divided into "private" and
"public" acquisitions, depending on whether the acquireree or merging company (also termed
a target) is or is not listed on public stock markets. An additional dimension or categorization
consists of whether an acquisition is friendly or hostile.
Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly
on how the proposed acquisition is communicated to and perceived by the target company's
board of directors, employees and shareholders. It is normal for M&A deal communications
to take place in a so-called 'confidentiality bubble' wherein the flow of information is
restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the
companies cooperate in negotiations; in the case of a hostile deal, the board and/or
management of the target is unwilling to be bought or the target's board has no prior
knowledge of the offer. Hostile acquisitions can, and often do, ultimately become "friendly",
as the acquirer secures endorsement of the transaction from the board of the acquireree
company. This usually requires an improvement in the terms of the offer and/or through
negotiation.
"Acquisition" also usually refers to a purchase of a smaller firm by a larger one. It is also
known as takeovers which refers to acquisitions of one company by another. Sometimes,
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however, a smaller firm will acquire management control of a larger and/or longerestablished company and retain the name of the latter for the post-acquisition combined
entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger,
a form of transaction that enables a private company to be publicly listed in a relatively short
time frame. A reverse merger occurs when a privately held company (often one that has
strong prospects and is eager to raise financing) buys a publicly listed shell company, usually
one with no business and limited assets.
Effects on management
Merger & Acquisitions (M&A) term explains the corporate strategy which determines the
financial and long term effects of combination of two companies to create synergies or divide
the existing company to gain competitive ground for independent units. A study published in
the July/August 2008 issue of the Journal of Business Strategy suggests that mergers and
acquisitions destroy leadership continuity in target companies top management teams for at
least a decade following a deal. The study found that target companies lose 21 percent of
their executives each year for at least 10 years following an acquisition, in other words, there
can only be one CEO, at a time.
Brand considerations
Mergers and acquisitions often create brand problems, beginning with what to call the
company after the transaction and going down into detail about what to do about overlapping
and competing product brands. Decisions about what brand equity to write off are not
inconsequential. And, given the ability for the right brand choices to drive preference and
earn a price premium, the future success of a merger or acquisition depends on making wise
brand choices. Brand decision-makers essentially can choose from four different approaches
to dealing with naming issues, each with specific pros and cons:
1. Keep one name and discontinue the other.
2. Keep one name and demote the other. The strongest name becomes the company
name and the weaker one is demoted to a divisional brand or product brand.
3. Keep both names and use them together. Some companies try to please everyone and
keep the value of both brands by using them together.
4. Discard both legacy names and adopt a totally new one.
The factors influencing brand decisions in a merger or acquisition transaction can range from
political to tactical. Ego can drive choice just as well as rational factors such as brand value
and costs involved with changing brands.
Merger and Acquisition in India Companies Act 2013 Chapter xv S.231
COMPROMISES, ARRANGEMENTS AND AMALGAMATIONS as well as merger of the
companies in India has been prescribed as follows:
230. (1) Where a compromise or arrangement is proposed
Explanation.For the purposes of this sub-section, arrangement includes a
reorganisation of the companys share capital by the consolidation of shares of different
classes or by the division of shares into shares of different classes, or by both of those
methods.
(11) Any compromise or arrangement may include takeover offer made in such manner as
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may be prescribed
232. (1) Where an application is made to the Tribunal under section 230 for the
sanctioning of a compromise or an arrangement proposed between a company and any such
persons as are mentioned in that section, and it is shown to the Tribunal
(a) that the compromise or arrangement has been proposed for the purposes
of, or in connection with, a scheme for the reconstruction of the company or companies
involving merger or the amalgamation of any two or more companies; and
233. (1) Notwithstanding the provisions of section 230 and section 232, a scheme of merger
or amalgamation may be entered into between two or more small companies or between a
holding company and its wholly-owned subsidiary company or such other class or classes of
companies as may be prescribed.
NEPALESE LEGAL PROVISION REGARDING MERGER
Section 177 of the Companies Act prescribes the provision regarding merger of a company.
According to Sec 177 A public company may, by adopting a special resolution its general
meeting to that effect be merged with another company In case of private company, it will be
as provided in its memorandum of association, articles of association or consensus
agreement. A public company, upon merging into a private company, or a private company,
upon merging into a public company, will stand as a public company.
Where a resolution for merger is adopted, be merged with another company such company
should within thirty days, make an application, setting out the following matters:
Decision of the general meeting, and in case of private company, copies of the related
provisions contained in the memorandum of association, articles of association or
consensus agreement authorizing the merger
Last balance sheet and auditors report of the merging company
The letter of consent, in writing, of the creditors of the merging company and of the
merged company
Valuation of the movable and immovable properties of, and actual details of the assets
and liabilities of, the merging company
If the merging company and the merged company have made a decision as to the
creditors and employees and workers of the merging company, a copy of such
decision;
The scheme of arrangement concluded between the companies for merger with each
other.
Where the information is given to the Office, it will study the matter and give information of
its decision within three months. On receipt of an approval from the Office for merger, all the
assets and liabilities of the merging company will be deemed to have been transferred to the
merged company. The office should maintain separate records of the merging company in the
company registration book.
Except as otherwise provided in the memorandum of association, articles of association or
consensus agreement of the company, a shareholder who does not express his consent in
writing to the unification or merger or alteration in, or transfer of shares of the company or
the sale of entire assets of the company will be entitled to get the companys assets valuated
prior to such unification, merger of alteration in or transfer of shares or sale of assets and get
return of the amount in production to the shares held by him from the merging company.
However approval will not be given for the merger of a company if such merger appears to
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Under Sec. 7 it is the obligation of the concern Entity, Bank or financial institution to
maintain records of transaction made with a person, who is suspicious and to provide inform
in this regard to Financial Information Unit within seven days of it. The records of transaction
so made should be maintained
secured at least for a period of five years from the date of such transaction.
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nonfinancial institution under prevailing laws may receive information from the Financial
Information Unit and may provide information available with it to the Unit. The Financial
Information Unit may give necessary directives to the concerned institutions about the
method, form, time and other procedures regarding the submission of details, statistics,
notices and information and it will be the duty of such institution to be abide by such
directives.
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matter or to freeze assets or to provide required information by arresting him/her and may
fine him/her up to one thousand rupees.
Complaint(Sec.13): Any person, who has information regarding an offence under this
Act, may submit a complaint, application, to the Department in written or oral form. The
Department on obtaining the information will register the complaint, application so
received. As per Sec. 14 the Department will conduct necessary investigation and inquiry
After receiving the application or information regarding the offence. In the course of
investigation and inquiry, where there is risk of
absconding or destroying the evidence or document, taking control of any document or
asset by the person committing an offence, the Department may arrest the person involve
in it, and may take control of such relevant evidences and assets at place where offence
was committed or being committed. The Department may obtain opinion of government
attorney in this respect.
2. To Appoint or Designate Investigation Officer( Sec. 15): The Department may appoint
or designate any officer of the Department or other officer as an investigation officer, in
order to conduct investigation and inquiry of the offences under this Act and designate
other staff as required.
3. Functions, Duties and Powers of the Investigation Officer (Sec. 16): The functions,
powers and duties of the investigation officer, appointed or designated will be as follows:a) To take necessary action by arresting the offender (suspect) immediately,
b) To conduct search or cause to conduct search operation of any office, residence,
building, storage, vehicles or of any place in the course of investigation and inquiry,
c) To exercise other powers vested to the Department.
The investigation officer, while proceeding necessary action may keep the offender
(suspect) on date, release him by obtaining bail or guarantee or keep under custody with
the permission of the court if he/she fails to provide bail or guarantee.
As per Sec. 17, the investigation officer may detain the person against whom
proceedings have been initiated as per this Act, if there is risk of extinct or destroy any
evidence or create obstacles or perverse effects in the proceedings of investigation and
inquiry according to the prevailing law of the nation. While detaining the person
committing an offence It must be obtained prior approval by fulfilling required legal
formalities before the adjudicating officer. However, the detainee will not be exempted
from making a petition for his release with reasons thereof.
4.
To Order for Freezing Assets (Sec. 18): The investigation officer may give order to
the concerned entity to prevent any transfer, pledge, sale/disposal of the assets collected
by offence for a time period fixed, if it is deemed transfer or conceal such assets. The
Department may impose fine to the chief of the concerned entity, who fails to freeze the
assets.
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5.
PUNISHMENT
Chapter 7 (Sec.30-33) of the Money Laundering Prevention Act, 2063 prescribes Provision
Relating to punishment under the Act.
In pursuance to Sec 30 of the Act, anyone committing offence under the Act
will be punished as follows, in accordance with the degree of offence committed:-
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a.
Fine equal to the amount involved in the offence or imprisonment from one year
to four years or both punishments to any person or staff of a bank, financial
institution or nonfinancial institution who has committed offence or in case such
staff is not identified for the person working as a chief at the time of committal,
(b) In case an office bearer, chief or staff of a bank, financial institution or nonfinancial
institution or public servant has committed offence, ten percent more
than the punishment mentioned in Clause (a).
The person assisting or provoking to commit or causing to commit an offence under this Act
shall be punished half of the punishment to be done to the offender.
Sec 31. Of the Act also prescribes provision of imposing fines:
a. There will be a fine of five hundred thousands rupees to a bank or financial
institution and from twenty five thousands to one hundred thousands Rupees to a
non-financial institution as per the degree of offence for the act of not submitting
documents to the Financial Information Unit pursuant to Section 7 and Clause (a)
of Section 10.
b. The Financial Information Unit shall punish as said above and person not satisfied
with the punishment may appeal to the Appellate Court within thirty five days of
such punishment.
Sec 32. Prescribes Punishment for Concealing or Destroying Evidences: According to it,
any person who commits the offence of concealing or destroying evidence related to acts
deemed to be an offence under this Act shall be liable for the imprisonment from one month
to three months or fine from fifty thousand rupees to one hundred thousands rupees fine or
both in accordace with the degree of offence committed and person assisting for committing
such act shall be punished half of such punishment.
Sec 33. Of the Act prescribed Punishment for Creating Obstacles. According to it if any
person creates obstacles in the proceedings of investigation and inquiry undertaken under
this Act, the adjudicating officer may punish him/her with an imprisonment up to six
months or a fine up to five thousand rupees or both based on the report of investigation
Officer.
Any assets obtained from an offence under this Act and assets accumulated thereof and
assets utilized for committing such offence shall be confiscated under Sec 34 of the Act.
Where the entitlement to assets has been transferred to someone else and an amount has
been quoted in such act of transfer, the amount shall be dealt as per the deed with security
(Kapali).
Under Sec. 35, the Department may issue an order to the concerned office for not issuing
new passport or to seize already issued passport if so required as per the circumstance, and
degree of the offence.
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A private company is not allowed to sell its shares and debentures publicly. A private
company is restricted the right to transfer of its shares except in case of one man
company.
A private company cannot pledge, or otherwise transfer title to its securities to any
person other without taking permission of the Board of Director and
without
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A private company is not need to issue prospectus, because it does not issue shares to
public. It does not invite subscription of share and debenture from public.
There is not fixed number of directors. A private company may have any number of
directors as per the provision contained in MOA/AOA
As compare to the public company a private company can convene its business
immediately on its incorporation except in some cases.
A first annual general meeting of a private company can be held as per MOA/AOA
where as in public company it is to be held within specified time.
Section 145 of the Companies Act 2063 prescribes some special provision regarding private
company. They are as follows:
1. Consensus Agreement: Except as otherwise provided in the Companies Act 2063, the
following matters may be provided for in a consensus agreement of a private
company:
a. Management, business and transaction of the company;
b. Restriction, if any , on the transfer of share;
c. Power of one or more shareholders to liquidate the company owing to any specific
or incidental event or voluntarily;
d. Division or use of voting right;
e. Terms of appointment of officers, employees, workers of the company,
f. Matter as to who will b the directors, officers, or the persons bearing the ultimate
responsibility or the chief executive, of the company;
g. Mode of payment or distribution of dividends;
h. Matter that there shall b e no board of directors;
i. Matter that, if there shall be no board of directors, who shall perform such
functions as required to be performed by the board of directors under the Act.
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holding such inquiry, where the company fails to prove that the complainant shareholder has
taken part in such meeting, the decision made by that meeting will not be valid.
After the completion of the meeting the chairperson should prepare minutes of the
proceedings and decisions concluded and taken in the meeting annually and authenticate the
same.
The Government of Nepal may, under Sec. 151 of the companies Act 2063, by a notification
in Nepal Gazette, exempt the private company having turnover within the prescribed limit
from the provision of requirement of appointment of auditor and Auditing the accounts of the
company.
Thinkers like Comte and Owen advocated the participation of workers in management
for achieving distributive social justice.
Karl Marx proposed complete control of the enterprise by workers and socialization
of the means of the production.
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WPM is the participation resulting from the practices which increase the scope for
employees share of influence in decision-making at different tiers of organizational
hierarchy with concomitant (related) assumption of responsibility
Definition:
According to Walpole, Participation in Management gives the worker a sense of
importance, pride and accomplishment; it gives him the freedom of opportunity for
self-expression; a feeling of belongingness with the place of work and a sense of
workmanship and creativity.
ILO:
Workers participation, may broadly be taken to cover all terms of association of workers
and their representatives with the decision-making process, ranging from exchange of
information, consultations, decisions and negotiations, to more institutionalized forms such as
the presence of workers member on management or supervisory boards or even
management by workers themselves .
The main implications of workers participation in management as summarized by ILO:
Workers have ideas which can be useful; Workers may work more intelligently if they are
informed about the reasons for and the intention of decisions that are taken in a participative
atmosphere.
The concept of workers participation in management encompasses the following:
It provides scope for employees in decision-making of the organization.
The participation may be at the shop level, departmental level or at the top level.
The participation includes the willingness to share the responsibility of the organization by
the workers.
Features of WPM:
Participation means mental and emotional involvement rather than mere physical
presence.
Objective of WPM:
According to Gosep, workers participation may be viewed as:
An instrument for increasing the efficiency of enterprises and establishing harmonious
relations;
A device for developing social education for promoting solidarity among workers and
for tapping human talents;
A means for achieving industrial peace and harmony which leads to higher
productivity and increased production;
A humanitarian act, elevating the status of a worker in the society;
An ideological way of developing self-management and promoting industrial
democracy
To establish Industrial Democracy.
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Levels of WPM:
Information participation: It ensures that employees are able to receive information
and express their views pertaining to the matter of general economic importance.
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Growth-oriented ideas .
For CB to work, the workers and the employers representatives need to bargain in
the right spirit. But in practice, while bargaining, each party tries to take advantage of
the other. This process of CB cannot be called WPM in its strongest sense as in
reality;
CB is based on the crude concept of exercising power for the benefit of one party.
WPM, on the other hand, brings both the parties together and develops appropriate
mutual understanding and brings about a mature responsible relationship
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There may be one council for the entire organization or a hierarchy of councils. The
employees of the
respective sections elect the members of the councils. Such councils play a varied
role.
Their role ranges from seeking information on the managements intentions to a full
share in
decision-making.
Such councils have not enjoyed too much of success because trade union leaders fear
the erosion of
their power and prestige if such workers bodies were to prevail
Administrative Participation
Involves a greater degree of sharing of authority and responsibility of the management
functions. Members are given little for autonomy in the exercise of administrative and
supervisory powers with regard to
The preparation of schedules of working hours, breaks and holidays
Payment of reward for valuable suggestions
The changed view that employees are no longer servants but are equal partners in
their effort to attain organisational goal.
The growth of trade unions which would safeguard the interest of workers and protect
them against possible exploitation by their employers.
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The growing interest of the Government in the development of industries and the
welfare of the workers.
Consultative Participation
Involves a high degree of sharing of views of the members and giving them an
opportunity to express their feelings. Members are consulted on matters such as
Welfare amenities
Adoption of New Technology and the problems emanating from it
Safety measures
Decision Participation
Is the highest form of participation. The delegation of authority and responsibility of
managerial function is maximum in matters like
Economic, Financial and Administrative policies the decisions are mutually taken
Provision in Nepal:
There are four ways where Worker are seen Participating in Management of the
Company in Nepal specially in Nepalese industries under Labour Act 1992 are as
follows:
Collective Bargaining Section 74, 75 and 79
Labor Relation Committee Section 63
Minimum Wages Fixation Committee Section 21
Central Labor Advisory Committee Section 62
Collective Bargain Section 74
With the enactment of Labour Act 1992 and Trade Union Act, 2993 the basic legal
requirements for entering into collective bargaining 2063 guarantee freedom of
association. Trade Union Act, 1993 provides for the registration and recognition of
Trade Union at plant level. Same Act provides that an authorized trade union is
eligible to undertake collective bargaining with the employer. Sec. 74, 75 and 79 of
the Labour Act 192 are particularly relevant for collective bargaining process. Sec. 74
lays down the process of settling collective disputes. Sec 75 limijts items to be
collectively demanded and finally Sect 79 set down the rules for implementing the
collective agreements. Under this process the authorized union i.e. fifty one percent of
the workers can submit their collective demands to the management, such demands
have to be settled either by the management through bipartite negotiation or if not
through the intervention by the Labour Office. If it cannot be settled the, the dispute
will be settled through an arbitrator, unanimously appointed by worker and
management. If fails to appointing arbitrator unanimously the disputes will be referred
to tripartite committee and dispute is to be settled within 15 days. An agreement
arrived through collective bargaining is binding and enforceable as law and is valid
for next two years for both parties. To make it more attractive, Nepal has adopted the
principles concerning collective bargaining laid down by the ILO by ratifying the ILO
convention No. 98 of 1949 concerning The Right to Organise and Collective
Bargaining. However such settlement is permissible only in the plant level . So the
The Institute of Chartered Accountants of Nepal
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legal provision regarding the collective is inadequate for the national level collective
bargaining.
So upon receiving claim, dialogue by management need to be initiated. If not
resolved, the dispute shall be resolved by Labor office. If not resolved, then it may be
referred to mediator.
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Generally Trade Unions leaders who represent workers are also active members of
various political parties. While participating in management they tend to give priority
to political interests rather than the workers cause.
The focus has always been on participation at the higher levels, lower levels have
never been allowed to participate much in the decision-making in the organizations.
The unwillingness of the employer to share powers with the workers representatives .
Workers should be provided and enlightened about the benefits of their participation
in the management.
Employers and workers should agree on the objectives of the industry. They should
recognize and respect the rights of each other.
Workers and their representatives should be provided education and training in the
philosophy and process of participative management.
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With the enactment of Labour Act 1992 and Trade Union Act, 2993 the basic legal
requirements for entering into collective bargaining 2063 guarantee freedom of association.
Trade Union Act, 1993 provides for the registration and recognition of Trade Union at plant
level. Same Act provides that an authorized trade union is eligible to undertake collective
bargaining with the employer. Sec. 74, 75 and 79 of the Labour Act 192 are particularly
relevant for collective bargaining process. Sec. 74 lays down the process of settling collective
disputes. Sec 75 limijts items to be collectively demanded and finally Sect 79 set down the
rules for implementing the collective agreements. Under this process the authorized union
i.e. fifty one percent of the workers can submit their collective demands to the management,
such demands have to be settled either by the management through bipartite negotiation or if
not through the intervention by the Labour Office. If it cannot be settled the, the dispute will
be settled through an arbitrator, unanimously appointed by worker and management. If fails
to appointing arbitrator unanimously the disputes will be referred to tripartite committee and
dispute is to be settled within 15 days. An agreement arrived through collective bargaining is
binding and enforceable as law and is valid for next two years for both parties. To make it
more attractive, Nepal has adopted the principles concerning collective bargaining laid down
by the ILO by ratifying the ILO convention No. 98 of 1949 concerning The Right to
Organise and Collective Bargaining. However such settlement is permissible only in the
plant level . So the legal provision regarding the collective is inadequate for the national level
collective bargaining.
Although law has prescribed collective bargaining system as a tools of dispute settlement
mechanism at the plant level of industrial establishment, it is not so effective. Firstly there is
not an authentic Trade Union to lead the team of bargaining. Secondly workers are not so
competent to sit together with the employer during the bargaining process. They cannot put
their voice openly as possibilities of threat to job from the employer side. Thirdly workers are
not familiar with the legal knowledge and legal provision regarding industrial laws as well as
their legal rights in respect of participating in the bargaining process with management.
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For example, providing tax planning and other tax advisory services where the advice
is clearly supported by tax authority or other precedent, by established practice or has
a basis in tax law that is likely to prevail does not generally create a threat to
independence.
The significance of any threat shall be evaluated and safeguards applied when
necessary to eliminate the threat or reduce it to an acceptable level. Examples of such
safeguards include:
Using professionals who are not members of the audit team to perform the
service;
Having a tax professional, who was not involved in providing the tax service,
advise the audit team on the service and review the financial statement
treatment;
Obtaining advice on the service from an external tax professional; or
Obtaining pre-clearance or advice from the tax authorities.
Where the effectiveness of the tax advice depends on a particular accounting
treatment or presentation in the financial statements and:
(a) The audit team has reasonable doubt as to the appropriateness of the related
accounting treatment or presentation under the relevant financial reporting
framework; and
(b) The outcome or consequences of the tax advice will have a material effect on
the financial statements on which the firm will express an opinion;
The self-review threat would be so significant that no safeguards could reduce the
threat to an acceptable level. Accordingly, a firm shall not provide such tax advice to
an audit client.
In providing tax services to an audit client, a firm may be requested to perform a
valuation to assist the client with its tax reporting obligations or for tax planning
purposes. Where the result of the valuation will have a direct effect on the financial
statements, the provisions included in paragraphs 290.175 to 290.180 relating to
valuation services are applicable. Where the valuation is performed for tax purposes
only and the result of the valuation will not have a direct effect on the financial
statements (that is, the financial statements are only affected through accounting
entries related to tax), this would not generally create threats to independence if such
effect on the financial statements is immaterial or if the valuation is subject to external
review by a tax authority or similar regulatory authority. If the valuation is not subject
to such an external review and the effect is material to the financial statements, the
existence and significance of any threat created will depend upon factors such as:
The extent to which the valuation methodology is supported by tax law or
regulation, other precedent or established practice and the degree of
subjectivity inherent in the valuation.
The reliability and extent of the underlying data.
The significance of any threat created shall be evaluated and safeguards applied
when necessary to eliminate the threat or reduce it to an acceptable level.
Examples of such safeguards include:
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Using professionals who are not members of the audit team to perform the
service;
Having a professional review the audit work or the result of the tax service; or
Obtaining pre-clearance or advice from the tax authorities.
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g) Any person, firm, company or organizations which are more risky on the
basis of scope of work of an auditor.
h) Any person, firm, company or organization known/heard to be involved
directly or indirectly in evasion of duties, taxes or other government charges
or any person, firm, company or organization associated with them.
i) Any person, firm, company or organization that requests, forces or
influences to hide or reduce the actual transactions or present false
transactions.
j) Any person, firm, company or organization suspected by the auditor.
7. Execution Officer: Auditor himself or any person working with him is to be
designated as execution officer to work as focal point to perform the duties as per
Assets (Money) Laundering Prevention Act, FIU Directive and other prevailing laws
related to it. Name, Address, Contact Number, Email, etc. of such person is to be sent
FIU.
8. Process for Sending Details:
8.1 An auditor must submit the information and details of suspicious
transactions to the FIU in the format prescribed in Annexure 2 through the
execution officer.
8.2 An auditor may send the suspicious transactions to the FIU by post, fax,
email or other electronic mediums. If it is informed through fax, email or other
such medium then it should be immediately confirmed through other
mediums.
8.3 An auditor must immediately notify the FIU if anything is omitted in the
details sent to the FIU or in case new/different information or details are
received after reporting such transactions.
9. Monitoring and Controlling:
9.1 Under prevailing laws, FIU can itself, assign other to monitor the work to
be performed by an auditor as per Assets (Money) Laundering Prevention Act
and rules, by-rules, directives and orders as per the act or request the related
entities to do so.
9.2 It is the duty of the auditor to provide all the necessary help for the act of
monitoring as per Para 9.1.
10. Maintain the Secrecy: An auditor or any of his employee, officer or agent must
maintain secrecy of the information and details provided to the FIU or the facts or
paperwork which comes to the acknowledgement during the investigation or the
course of work, and must not disclose it to any customer/client or any other person
unless and otherwise required by law.
Annexure 1
Process for Identification of Customer/Client
An auditor must keep the following documents and details while doing transactions
with any customer/client:
1) Clear name and address of the association, organization, firm or company
2) Certificate of incorporation
3) Telephone number and Email (if available)
4) Permanent Account Number or VAT Number
5) Telephone number, Email, etc. of Board of Director and person working as chief
6) Other necessary documents (can be determined by the auditor himself)
Annexure 2
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Reason for
Being
Suspicious
Remarks
Signature of Submitter:
(Execution Officer/ Person Working as
Chief)
Name:
Phone:
Email:
Fax:
Date:
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U. N. Model: Since the OECD Model was regarded as furthering the interests of the
developed countries, therefore, the developing countries prepared their own model in 1979,
which is known as the 1979 UN model. This was developed / modified further in 1980 and
2001 incorporating the changes gained out of the experience. As the OECD model was the
source, both the drafts are largely similar.
U.S. Model: U.S. Model serves as a model to negotiate Treaty with USA. It is also based on
OECD Model. It adapts to the conditions peculiar to the US. The U.S. Model was first
published in 1976 and revised in 1977, 1981 and 1996. USA has also published Technical
Explanation to explain / clarify the provisions in the Articles of the U.S. Model.
Andean Model: This Model is adopted by the Member states of Andean Group namely,
Chile, Equadot, Columbia, Peru and Venezuela. The Model primarily follows the source rule
of taxation and accordingly, royalty, interest, dividend and income from mineral natural
resources are taxed in the source country. These DTAA Models have led to the development
of international tax law besides harmonization of DTAAs at the time of negotiation of the
DTAA and also at the time of interpretation of DTAAs in the event of a dispute.
10.1.3 INTERPRETATION OF TAX TREATIES
DTAAs are not different from other international agreements. They will be interpreted using
the same principles accepted in International law.
Therefore, the principles set out in the Vienna Convention on 23rd May, 1969 will be
applicable in interpreting DTAAs in the case of conflict. The International law on the subject
would also throw light on the interpretation when recourse to domestic case law does not
throw much light. In fact, now in a world of shrinking borders it is very important to
understand the evolving law on problems of interpretation of DTAAs.
The US Court in Scotland West Life Insurance Co. Canada v. CIR [1996] 107 TC US 363
has cited in the following principles of precedence for the guidelines in interpretation of the
treaty provisions:
(i) The meaning should be consistent with genuine shared expectation of the contracting
parties;
(ii) It should give effect to the purpose of the treaty. Where interpretations both restricted
and liberal are possible, the liberal interpretation should be preferred.
(iii) Words should be understood in its ordinary meaning unless it is specifically given a
special or restricted meaning. As far as possible, the language in the law and the treaty shod
be both effective.
(iv) Ambiguities could be resolved with reference to the materials during the process of
negotiations, which can be given great weight, though not conclusive.
Where a particular Model convention is accepted they would certainly be of aid on the
interpretation of the DTAA as these are views agreed upon by experts. However, different
countries have taken different approach to the weightage to be given to the working papers on
the negotiation between the countries.
The provisions of the DTAA override the provisions of the Act, Treaty override as it is
popularly known.
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The thumb rule to be followed in the interpretation of a DTAA is that the provisions of the
DTAA override the Act and the words and provisions of the DTAA must be given the
meaning assigned to them in the DTAA.
10.1.4 STATUS OF NEPAL IN RELATION TO DTAA
As per section 73 of Income Tax Act, 2058 and as per provisions of previous tax laws, the
Government of Nepal has entered into DTAA between followings:
The Government Of The Republic Of India
The Government Of The People's Republic Of China
The Government Of The Kingdom Of Thailand
The Republic Of Austria
The Democratic Socialist Republic Of Sri Lanka
The Government Of The Islamic Republic Of Pakistan
The Government Of The State Of Qatar
The Kingdom Of Norway
The Republic Of Korea
The Government Of The Republic Of Mauritius
Nepal has followed mix of Un Model & OECD Model for DTAA.
10.1.5 Methods of Elimination of Double taxation
Means of avoidance of double taxation are:
Exemption Method
The Treaty may provide for exemption from the liability in one jurisdiction i.e. the country in
question will refrain from taxing the particular income and allow the other jurisdiction to
impose tax.
Tax Credit Method
Treaty may not provide for exemption from tax liability which implies that both countries
shall be entitled to levy tax. However, income tax paid by the person in the foreign income is
allowed as tax credit to the extent of effective tax payable in the country of residence and
only the balance, if any, shall be collected.
Deduction Method
Income Tax paid by the person in the foreign income is allowed as deductible expenses.
10.1.6 SCOPE OF TAX TREATIES
A scope of DTAA under both Un Model & OECD Model mainly includes the following:
Particulars
Scope
Article 1
Persons Covered
Article 2
Taxes Covered
Article 3
General Definitions
Article 4
Resident
Article 5
Permanent
Article 6
Income from Immovable Property
Article 7
Business Profit
Article 8
Air Transport
Article 9
Shipping Income
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Article 10
Article 11
Article 12
Article 13
Article 14
Article 15
Article 16
Article 17
Article 18
Article 19
Article 20
Article 21
Article 22
Article 23
Article 24
Article 25
Article 26
Article 27
Article 28
Article 29
Article 30
Associated Enterprises
Dividend Income
Interest
Royalties
Capital Gains
Independent Personal Services
Dependent Personal Services
Directors Fee
Artistes and Athletes
Pension and Annuities
Government Services
Professors, Teachers & Research Scholars
Students & Apprentices
Other Income
Capital
Elimination of Double Taxation
Non Discrimination
Exchange of Information
Entry Into Force
Termination
Protocol
The above can vary from DTAA to DTAA, in DTAA entered by Nepal, some other articles
like follows are included;
- Mutual Agreement Procedure
- Assistance in the collection of Taxes
- Limitation of Benefits
- Members of Diplomatic Mission and Counselor Posts
10.1.7 DEFINITIONS
Article 3 normally contains the definitions which explains the terms used in the DTAA.
Terms like `resident and PE which require detailed explanation are defined in separate
Articles. While the number of terms defined may vary from DTAA to DTAA, the terms
defined would normally be person; company; enterprise of a Contracting State;
enterprise of the other Contracting State; international traffic; competent authority; tax;
national Contracting State; Fiscal year etc.
A definition limits the meaning to be given to a term while interpreting the Article. Definition
is a statement that sets forth and delimits the meaning of a word. Definition performs two
functions, namely, (i) the avoidance of ambiguities; and (ii) the avoidance, by means of
abbreviation of tedious repetitions.
The definitions Article deals with general terms which are used throughout the DTAA.
Specific terms such as royalty, interest, and dividend are defined in the Article dealing
with the treatment of the specific income. A definition of a particular term helps in the
interpretation of the Article and makes it clear as to who is identified for relief or what is
included. Terms not defined in the DTAA have the meaning which they have under the
domestic law of that State concerning the taxes to which the DTAA applies. The reason for
adopting a reference to internal law is that since the DTAAs relieve from tax, it is necessary
for the relieving provisions to follow the definitions used in the taxing provision. The terms
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avoid any controversy at the choice of comparable year to provide relief or credit of tax as the
case may be. Where the relief depends upon the duration of the stay as in the case of salary
income the financial year as per the country from which the salary income is received should
be considered.
(ix) State This terms means the State which is a party to the DTAA, generally referred to
as the Contracting State individually and Contracting States collectively. Further, each
State is individually geographically defined. Usually there is also a provision to include the
expansion to the State in the future. This is especially important in the context of countries
which are a group of countries of which one of them is a tax haven. Both the Contracting
States in the DTAA are referred to as the State this creates some confusion at the first reading
of an Article. Generally the words that State referred to the first State and the word other
State referred to the second State.
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more beneficial. The manner in which the taxes are imposed by the State is not important, i.e.
where done directly or withheld at source or on a presumptive basis.
Paragraph 2 further elaborates on the taxes covered. Therefore, while Para 1 defines the
authorities which have a right to levy the taxes and the taxes, in a broad way, Paragraph 2
elaborates the taxes which are inclusive of taxes on alienation of property and any other tax
which is peculiar to the Contracting States.
Paragraph 3 specifies the existing taxes which are currently imposed by the States. These
are the taxes which the convention intends to give relief from against double taxation.
Paragraph 4 normally provides for extending the benefit of the DTAA to taxes which may
be imposed at a later date. It also puts an obligation on the States to keep each other informed
on the change in law at the end of each year. Certain tax treaties use term tax whereas some
use the term taxation. It is important to note the context in which the two are applied as they
connote a different meaning. These terms are not interchangeable. Taxation covers the
whole gamut from liability to the imposition and quantification of the tax. Tax connotes
only the liability aspect. Even the title uses the word taxation as distinct from tax. Taxation
relates to the manner of imposing tax and the tax refers to the charge on the income.
Therefore, first the income liable to tax is identified and the tax thereon is restricted to the
rate of tax prescribed in the DTAA. The issue which arises in some cases is whether the rate
specified is inclusive of surcharge or is to be further increased by the surcharge specified as
per the Finance Act. It would seem that once the DTAA - Article 2 taxes covered surcharge
is already specified the rates cannot be further increased by surcharge.
What is essential to keep in mind while interpreting a DTAA is that the DTAA does not
require that the tax has actually been paid to claim the benefit. If a person is liable to be
subjected to tax he would be entitled to claim the benefit of the DTAA. Therefore, the
Contracting State must have a right to make him liable to tax either in the present or at any
future date.
5.5 Residence under tax treaties
Article 4 of OECD Model reads as under:
ARTICLE 4 Resident
1. For the purpose of this Convention, the term resident of a Contracting State means any
person who, under the laws of that state, is liable to tax therein by reason of his domicile,
residence, place of management or any other criterion of a similar nature, and also includes
that State and political subdivision or local authority thereof. This term, however, does not
include who is liable to tax in that State in respect only of income from source in that State or
capital situated therein.
2. Where by reason of the provisions of paragraph 1, an individual is a resident of both
Contracting States, then his status shall be determined as follows:
(a) he shall be deemed to be a resident of the State in which he has a permanent home
available to him; if he has a permanent home available in both States, he shall be deemed to
be a resident of the State with which his personal and economic relations are closer (centre of
vital interests);
(b) if the State in which he has centre of vital interests cannot be determined, or if he has not
a permanent home available to him in either State, he shall be deemed to be a resident only of
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to the benefits of the treaty. As we saw earlier a contrary view was taken by the
Residence - The term residence is to be given its normal meaning and would imply a place
where a person normally resides. It does not connote the place of origin. Residence implies
some degree of permanence.
Domicile - Domicile refers to the civil rights or the system of law a person is governed by.
Domicile describes a connection a person has with a State which may or may not be his State
of origin or nationality or citizenship. Domicile is distinct from citizenship. Domicile is a
connection with a territory and does not imply nationality of a particular State. The domicile
of origin is by birth and automatically entitles an individual to citizenship whereas domicile
of a choice is where the individual chooses to live and where he would be taxable. The fiscal
domicile is thus different from political domicile.
Any other criterion of a similar nature - Though normally words take color from the other
words which a accompany them, however here these words are used to broaden the scope of
the Article. If there is a nexus between the income, the person and the resident and if tax has
been actually paid the benefit of the DTAA must be given.
Paragraph 2 provides for tiebreaker tests in case a person is a resident of both the
Contracting States. This may happen in case of an individual who has a domicile in both the
States. Paras 2 and 3 are important to establish who has the jurisdiction to impose and collect
the tax. All the paragraphs have to be read as a whole.
Paragraph 3 deals with a situation where a person other than an individual can be considered
as resident of both the Contracting States and provides that the place where the effective
management rests will be considered as the resident State.
Tie Breaker Rules - Para 2 contains the tiebreaker rule, where a person can be considered to
be a resident of both the States the test has to be applied in the order in which the selection is
given. The ratio behind this test is to give the benefit of the DTAA in the State which has the
closest nexus with the income. It must be noted here that these tests are applicable only in the
case of individuals. The tests are:
1. Determination of where the permanent home of the resident is located. The State in
which the person permanently resides would be considered as the resident State. If there is a
permanent home in both states then, the next test is;
2. Determination of the centre of vital interest? The State with which the personal and
economic relations are closer would be considered to be the State of residence. If that also
cannot be determined then, the next test is;
3. Determination of the State in which he has an habitual abode. If has an habitual abode in
both states then, the next test is;
4. Determination of the state of which he is a national. In case he is a national in both states
then, the last option available is;
5. The Competent Authorities will decide which the State of residence is. As stated earlier
these tests have to be applied in the order stated and if a person satisfies one test there is no
need to go to the other. This requisite may, however a backfire in certain cases for e.g. take a
case where a person resides in a tax haven, however his economic and vital interests are
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connected with another State, should the State from where the income is generated lose out
on the right to tax the individual? As a counter argument, the State where he is permanently
residing may provide social benefits and therefore, claim a right to tax the individual. Such
situations are best left to the courts or the Competent Authority to interpret keeping in mind
the ultimate objective of the DTAA i.e. to avoid double taxation.
We shall now examine the above tests in a little more detail:
Permanent home - Though the concept of permanent home and domicile appear to be the
same, in the context of treaty law they are given different meanings. Though a domicile
would be a place where a person has his permanent home it could have different meaning at
different points of time. A domicile, unlike citizenship, is a matter of choice. A person may
get citizenship on birth but a domicile is where he chooses to stay. Under the DTAA a
permanent home need not be a domicile, as under Treaty law a domicile is of a special type
where a person stays more than occasionally or for more than a short time though, may be not
permanently. A permanent home, in a way, can be interpreted with reference to the opposite
i.e., what is to be considered as a temporary home. This is also required to be weighed with
the intention of the person and the facts of each case for e.g. if a person has been seconded to
another country for a period of two-three years does not mean his permanent home has
changed though, the other country may get a right to tax him on the income earned. The
permanent home is in the country of residence though on account of the secondment the
person may not be staying there for the moment. There no rules can be laid down to
determine what can be considered as permanent home and the answer would depend on the
facts of each case. The existence of a business interest, ownership of a property, family and
financial indicators like bank account investment should be taken into consideration to
determine the permanent home.
Centre of vital interests - The phrase home is where the heart is seems to apply to
interpretation in Treaty law as well. It is generally interpreted that in the case of a married
man his home would generally be the place where his family resides whereas for a single
person it would be the place with which he has an economic interest. Therefore, just because
a person retains a permanent home in say Nepal where he was born and brought up before
shifting to another country from which he derives his income and where his family is residing
with him it cannot be said that Nepal is the permanent home as his centre of vital interest is in
the other Country. The word habitual implies some sort of continuity and is derived from
the word habit which implies a tendency to repeat the same action. An abode is a place of
residence therefore if a person has been staying in one place for a long and continuous period
of time it could be called his habitual abode.
Nationality - Nationality means place of birth. This test is applied last when all the other tests
fail. A person has a relationship of rights and duties with his State of origin. This test is put
last as in Treaty law it is the nexus with the income that is important and not the nexus with
the State.
Mutual Agreement Procedure (MAP) - The last resort when all else fails is to approach the
MAP for their expert opinion to determine the residential status. What can be gauged from
above is that most of the criteria are overlapping on elaboration and there can be no definite
rules or tests laid down to determine residence and must be evaluated based on the facts of
each case. The tests seen earlier dealt with the case of an individual. Para 3 of Article 4 deals
with the determination of residence of a company. The emphasis here is on the place of
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effective management. There is a difference between the registered place of business and the
actual place of business. This distinction is essential to understand as many companies set up
their registered offices in tax havens while the actual business is managed from another
country. Therefore the DTAAs have a clause to state that the country from where the
effective management is carried on will be the country of residence. Effective
Management means the actual conduct of business, where the brain of the business is located
and from where the decisions are taken. Therefore to break the tie between a country where
the ownership rests and the management takes place it is essential to ask the questions;
(i) Who is in charge;
(ii) Where is/are the person/s in charge operating from;
(iii) Where are the finances being routed through?
Like an individual a company may also have dual residency. Though the test applied to an
individual cannot be entirely applied an analogy can be drawn. A company would be
considered to have a home where its board of directors are situated and from where the
company is controlled and managed i.e. the place from where the policy decisions are taken.
Mere activity in a place would not constitute residence of a company at that place.
To avail of the benefits of a particular DTAA, it is thus necessary that the taxpayer be a
resident of either of the States that have entered into the DTAA. This was viewed critically
by the tax authorities, especially in case of "residents" under Mauritius tax laws.
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enterprise or any of its other offices, by way of royalties, fees or other similar payments in
return for the use of patents or other rights, or by way of commission, for specific services
performed or for management, or, except in the case of a banking enterprise, by way of
interest on moneys lent to the permanent establishment. Likewise, no account shall be taken,
in the determination of the profits of a permanent establishment, for amounts charged
(otherwise than towards reimbursement of actual expenses), by the permanent establishment
to the head office of the enterprise or any of its other offices, by way of royalties, fees or
other similar payments in return for the use of patents or other rights, or by way of
commission for specific services performed or for management, or except in the case of a
banking enterprise, by way of interest on moneys lent to the head office of the enterprise or
any of its other offices.
4. Insofar as it has been customary in a Contracting State to determine the profits to be
attributed to a permanent establishment on the basis of an apportionment of the total profits
of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting
State from determining the profits to be taxed by such an apportionment as may be
customary; the method of apportionment adopted shall, however, be such that the result shall
be a accordance with the principles contained in this Article.
5. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent
establishment shall be determined by the same method year by year unless there is good and
sufficient reason to the contrary.
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body of the DTAA then Article 5, PE is the vibrating heart. We shall briefly examine the
structure of the Article to understand who and what
can constitute a PE.
Para 1 - This is a broad definition to bring within its ambit any fixed place of business
through which the business of the non-resident is carried on.
Para 2 - Further elaborates in para 1 to list as to what can be included under PE, generally a
place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a
quarry or any other place of extraction
of natural resources is normally included.
Para 3 - Is a further extension to include a temporary fixed place PE like a construction site or
supervisory activities rendered at a construction site where the activity extends for a period of
more than six months Para (b) further stipulates that if consultancy services are rendered on a
project for 12 months even that service rendered would constitute a PE.
Para 4 - Contains the exception to specify what would not be considered as a PE. Generally
warehousing facilities where goods are stocked for the purpose of display or where only the
warehousing facility are made use of, or goods are maintained to be used in processing by
another enterprise are excluded. In keeping with the principle that tax is levied only when
there is trade with a country, normally always purchase transactions or preparatory activities
are excluded. Activity of assimilation of information would also not constitute a PE.
Para 5 - This is a very important part of this Article and in todays time with Business Process
Outsourcing (BPO) emerging in a big way in India there is a controversy as to when an agent
can be considered as a PE of the nonresident.
Para 6 Normally deals with insurance companies. An insurance company carrying on
business in India would be considered to have a PE, except when it is engaged only in reinsurance, i.e. if it carries on business through an exclusive agent.
Para 7 States that an exclusive agent would constitute a PE.
Para 8 Excludes a subsidiary company from being considered as a PE. However, if there is
no business connection, there can, most certainly, not be a PE. To constitute a PE there must
be a business, the business must be carried on from that fixed place and the business must
yield income. Therefore, only a place from where goods are purchased would not be a PE.
Fixed base - As we discussed in the earlier chapters the business income can be only taxed if
the business is carried on through a PE and the income can be attributed to the PE. This is so
as to strike a balance between the rights of a source state and a residence state to tax the
income. In order to attract taxation in a country there must be a business, it must be carried on
through a fixed place and that place should have some degree of permanence. A reading of
the OECD commentary suggests that even a pitch in the market place or a permanently used
area in the customs depot would constitute a PE. What is essential is that the premises should
be at the disposal of the non-resident and identifiable with him. Klaus Vogel in his
commentary on the OECD Model Tax Convention has opined that the word fixed has to be
understood as fixed not with reference to the space or premises but with reference to the
geographical location or area.
The expression Permanent establishment used in the Double Taxation Avoidance
Agreements postulates the existence of a substantial element of an enduring or permanent
nature of a foreign enterprise in another country which can be attributed to a fixed place of
business in that country. It should be of such a nature that it would amount to a virtual
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projection of the foreign enterprise of one country into the soil of another country.
Place of management - This is where the head and the brain of the business are located. This
is the most essential test of what can constitute a PE and even in the case of agency is the
question to be asked. The head and brain in case of a company would be its Board of
Directors. If the management has complete control and authority to make decisions and steer
the business a PE would most definitely exist. However, if the place of management only
executed orders and did administrative functions especially in case of an agency it could be
argued that it does not constitute a PE.
A branch - A branch is also an extension of an enterprise and would therefore constitute PE.
A branch office is not regarded as a separate legal entity, its profits are the profits of the
corporation owning the branch.
An office - Similarly an office is also an extension of an enterprise but the functions
performed by it would be essential in determining whether or not it can be a PE. The word
office has different meanings when used in connection with an enterprise and with an
individual. It means a place for transacting business when used in connection with an
enterprise. If a representative office does not carry on any trading activity and does not
receive any income but just acts as a palace for distribution and dissemination of information
it would not be a PE however if it renders service and generates income on its own that
income would be taxable.
Therefore, a liaison office would not constitute a PE if the services are only of a preparatory
or auxiliary nature.
A mine etc. - A source of income is always a PE e.g. a mine or oil well. These are included in
the definition of the PE out of abundant caution to avoid any confusion.
Para 3 - Prescribes a limitation of when a construction site can be considered to be a PE.
Even in the absence of Para 3 a construction site may be a PE within para 1 and 2 however
para 3 puts a time frame to it to give relief to temporary projects. This variation in time limit
is a matter of negotiation. Countries which lend technology would like the period to be longer
to avoid their residents from being taxed in the other country whereas countries which borrow
technology would like the period to be shorter so as to bring the nonresident to tax. This may
go against the interest of some countries which would prefer not to give any relief to such
projects as they are real money churners. However, again the collection of taxes would have
to be weighed in the broader light of other economic advantages like generation of
employment, increased in flow of foreign capital etc. The balance is achieved by negotiating
a mutually acceptable period of say 180 days, one year or may be even less. In case of a
construction PE the period referred to is with reference to a
project and not to the financial year, though some DTAAs like the US Model provide for a
period of 120 days in any 12 months period would constitute a PE.
Para 4: Exclusions - Just as the concept of PE is introduced to allow the source state to collect
tax from business carried on in its territories as per set law certain situations and transactions
are excluded from the definition of a PE. These exceptions are listed in Para 4 of Article 5.
What can be observed from these exception listed is that they do not involve any trade but
only involve preparatory functions like warehousing, storing etc. Generally by mutual
consent or perhaps because of lack of consensus on law to treat a purchase PE it is not to be
considered as a PE unless specifically stated. Activities of preparatory or auxiliary nature are
generally not considered as PE however if these activities are essential to the formation of the
PE they would also constitute a PE.
Paras 5 - 7 - Agency PE, Exclusion of reinsurance business and independent agent
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(3) The provisions of paragraph 2 shall not apply where judicial, administrative or other legal
proceedings have resulted in a final ruling that by actions giving rise to an adjustment of
profits under paragraph 1, one of the enterprises concerned is liable to penalty with respect to
fraud, gross negligence or willful default.
The concept and definition of Associated Enterprises (AE) was introduced in the DTAAs to
prevent misuse of treaty provisions by conducting business in the State not directly but
through a chain of enterprises. This Article provides that where an enterprise has control
directly or indirectly on another enterprise either through the management or the capital of
that enterprise and if the transactions between the two enterprises are not at market rates then
the profit which would have accrued at arms length to the enterprise supplying
goods/services will be deemed to be the income of that enterprise. Here again the concept of
effective management discussed earlier has relevance because that is what is to be seen, it is
not necessary that the control should have a legal blessing but that it should be evidenced by
conduct. The ratio behind this Article is to ensure that profits are computed on an arms
length basis and are not artificially enhanced or suppressed to enhance relief or reduce
liability.
This Article allows the Tax Authorities to compute the fair profit on a transaction between
two AE. However, this should not be presumed to be a mandatory right. Only where there is
reason to believe that the profit has been maneuvered with, should the tax authorities
interfere. However, care should be taken that the income finally computed does not exceed
the real income and that the manner of computation is within the spirit of the convention and
the Transfer Pricing Rules in each country. Therefore, what is now really required is some
kind of standardization on Transfer Pricing Rules universally to ensure that too much
divergence of practice is avoided. Imagine, a case where each countrys Assessing Officer
computed the income on his belief of what should be the fair profit of the enterprise this
would be unfair and would also cause a lot of confusion in the minds of the taxpayers. No
country should assume that this is a blanket permission to rewrite the accounts in respect of
which of transactions which take place in its jurisdiction.
Para 1 - This para specifies when two undertakings can be deemed to be AE and allows
adjustment to profits to arrive at the arms length profit if the conduct of the AEs shows that
the profits have been understated. Therefore even if assets are transferred but if the parties
continue to enjoy the income therefrom on account of their control over the asset or any other
reason the income could be taxed in their hands.
Para 2 - This may sometimes result in double taxation of the same profits once in the country
where they are artificially shifted and once again in the country where they actually arise.
Para 2 aims at preventing double taxation by allowing the former State to provide relief. The
important words to note in this article are profits whichhave not so accrued what is
essential is that profit must have accrued where no profit accrues whether or not the
enterprises are associated will have no relevance. The adjustment made in one country must
be must be given corresponding effect in the other country but no automatic authorization is
give as one country cannot dictate terms to another country.
5.9 Dividend
Article 10 of UN Model reads as under:
ARTICLE 10 Dividends
1. Dividends paid by a company which is a resident of a Contracting State to a resident of the
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dividend income.
The definition of dividend in the model as seen earlier can be classified as regular dividend,
other rights not being debt claims, income from other corporate rights which is taxed in the
same way as dividends. Deemed dividend may fall into the last category. However,
depending on how the Article is worded it may be possible to contend that income from debt
claims is covered and not he claim itself and therefore loans given are not covered. Though of
course this is highly debatable as scope is left wide open by the last clause seen above. This
concept of deemed dividend is also recognized
globally to bring disguised distribution of profits into the tax net. In fact, even the OECD
commentary on the UN Model recognizes the same principles based in section 2(22).
Therefore, any distribution of profits whether from current or accumulated profits would be
considered as dividends. However, the extent to which it can be deemed to be dividend would
depend on the local laws. At the core of all these issues is the fundamental debate on the
justification of taxing dividend income. Dividend is distributed out of profits of a company
which have already suffered tax, when they are taxed in the hands of the shareholder, in a
way, the same income is being taxed twice. However, the liability has been shifted to the
company which pays tax on the dividend declared at the prescribed rates. Therefore whether
the ultimate objective, if it were so, to impose a single levy tax on dividend, is achieved or
not is doubtful.
In fact, this argument is also stretched to capital gains on shares as the increase in value
represents the intrinsic value which is represented by the net worth of the company which is
formed from taxed retained earnings. In fact, the constitutional validity of capital gains tax
raised a huge hue and cry when introduced; however the need for increasing revenue
gathering prevails over economic justification.
5.10 Interest
Article 11 of UN Model reads as under:
ARTICLE 11 - Interest
1. Interest arising in a Contracting State and paid to a resident of the other Contracting State
may be taxed in that other State.
2. However, such interest may also be taxed in the Contracting State in which it arises and
according to the laws of that State, but if the beneficial owner of the interest is a resident of
the other Contracting States, the tax so charged shall not exceedper cent (the percentage is
to be established through bilateral negotiations) of the gross amount of the interest. The
competent authorities of the Contracting States shall by mutual agreement settle the mode of
application of this limitation.
3. The term interest as used in this Article means income from debt claims of every kind,
whether or not secured by mortgage and whether or not carrying a right to participate in the
debtors profits, and in particular, income from Government securities and income from
bonds or debentures, including premiums and prizes attaching to such securities, bonds or
debentures. Penalty charges for late payment shall not be regarded as interest for the purpose
of this Article.
4. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the interest,
being a resident of a Contracting State, carries on business in the other Contracting State in
which the interest arises, through a permanent establishment situated therein, or performs in
that other State independent personal services from a fixed base situated therein, and the
debt-claim in respect of which the interest is paid is effectively connected with (a) such
permanent establishment or fixed base or with (b) business activities referred to in (c) of
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paragraph 1 of Article 7. In such cases the provisions of Article 7 or Article 14, as the case
may be, shall apply.
5. Interest shall be deemed to arise in a Contracting State when the payer is resident of that
State. Where, however, the person paying the interest, whether he is a resident of a
Contracting State or not, has in Contracting State a permanent establishment or a fixed base
in connection with which the indebtedness on which the interest is paid was incurred, and
such interest is borne by such permanent establishment or fixed base, then such interest shall
be deemed to arise in the State in which the permanent establishment or fixed base is situated.
6. Where, by reason of a special relationship between the payer and the beneficial owner or
between both of them and some other person, the amount of the interest, having regard to the
debt-claim for which it is paid, exceeds the amount which would have been agreed upon by
the payer and the beneficial owner in the absence of such relationship, the provisions of this
Article shall apply only to the last mentioned amount. In such case, the excess part of the
payments shall remain taxable according to the laws of each Contracting State, due regard
being had to the other provisions of this Convention.
Para 1 - This para gives the State of which the person receiving the dividend is a resident the
right to tax it. Here again there is a tussle between the source State and the resident State for
the right to tax the income. The resident State is given the right in para 1 but the words used
are may this has to be read in connection with para 2 which gives the source State the right
to tax the income.
Para 2 permits the source country to also tax the income to a certain extent. The bargaining
power of the country would again establish the rate of tax. Though the OECD Model
prescribes 10 per cent as the maximum rate of tax the US Model leaves the rate open for
negotiation. The country of residence will give credit for the tax deducted in the source
country to avoid double taxation and it is the gross interest which is taxed in the source
country.
Para 3 - The definition of interest is contained in para 3. The definition is same in all three
Models and it essentially means income from debt claims. The treatment/classification of
interest as interest simpliciter or as relatable to the business i.e. as business income will be
dictated by the domestic law and therefore the problems and complications would also
follow. Unlike dividend definition, which recognizes the influence of domestic law, the
definition of interest seems to have intentionally kept domestic law out of the picture.
However, in certain cases the provisions of domestic law can be resorted to e.g., for
determining whether penal interest paid is in the nature of penalty and therefore has to be
ignored from the definition of interest, as per the DTAA; or whether the penal interest can be
included within the extended meaning of interest as per the provisions of the domestic tax
law and thus enjoy the benefits available under this Article? There is, however, a view that
the strict definition of the DTAA should only be considered. In order to define the terms
debt etc used in the DTAA the local law evolved on the subject is useful. A debt, simply
put, is a sum of money which is payable or will become payable. Debt denotes an obligation
to pay for the debtor and a right to receive for the credit. This debtor-creditor relationship test
is important to classify the payment as towards interest. Though the definition of interest
seems simple and lucid the interpretation has created a lot of litigation by the tax authorities
trying to give a broader meaning to the term debt-claim by including interest on un-paid
purchase price as interest. The effective source of interest has to be the principal debt. The
interest from the debt has to accrue or be received by the person who is the principal holder
of the debt. If the debt is assigned or sold, the income received will not retain the character of
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interest.
The words at the end whether or not secured by mortgage. are introduced out of abundant
caution to ensure that irrespective of the treatment under domestic law, the interest arising on
the debt is not linked to the property which is offered as security and assessed as income from
immovable property. The debt retains its character and is distinct and separate from the
property. Similarly the words whether or not carrying a right to participate in the profit are
also used to keep the identity of the debt and the interest arising therefrom distinct. However,
if the loan is used as a means of financing capital and disguised as a loan the income could be
considered as dividend and not interest. Therefore, the intention of the contracting parties and
the treatment under domestic law or Treaty advantage which they may be trying to exploit
should all be taken into consideration. The definition of interest in the Model includes any
income from debt-claims and income arising from investments. However, penal interest and
penalties are excluded.
The recent OECD Model commentary also suggests that interest connected with funds from a
special activity will be linked with that activity therefore interest on shipping finance will be
assessed under the shipping article.
Para 4 - Provides for taxing the interest as business profits if it is related or attributable to the
PE. Debt claims which form part of the assets of the PE or if it effectively connected with it is
taken as business income. Here, another concept that must be clear is for income to be taxed
as income of the PE it must be clearly attributed to the PE and the doctrine of force of
attraction cannot be imposed. The doctrine of force of attraction creates a fiction that all
income is attributable to the PE. This fiction cannot be deemed, the connection between the
debt and the income arising there from must be real.
However, if the effective connection can be traced to the PE it would be income of the PE.
Similarly, if the loan is taken for the purpose of the PE it will be considered in arriving at the
income of the PE.
Para 5 This para provides that if the interest is borne by a PE the interest will be deemed to
arise in the State where the PE is located. This Para deems the place of the payer to be the
source of interest. The second part gives the exception where the residence will not be a
determinative factor if the loan is taken specifically for and borne by the PE however, the
loan taken must have some connection with the requirement of the PE. The absence of such a
relationship will render this clause inoperable.
Para 6 - The arms length principle is also incorporated in para 6 of this Article which
provides that if the interest is artificially suppressed or augmented owing to a special
relationship between the payer and the payee the tax authorities can look into the substance of
the transaction over the form and bring the correct amount of interest to tax. The conditions
in para 6 and the implementation thereof have to be read in connection with Article 9
Associated Enterprises (AE) and here again, the adjustment in profits cannot exceed the arms
length profit. Whether the loan is distinguished as capital or whether the rate of interest
should be adjusted would all have to be evaluated on the facts of each case.
In todays scenario money is sought from a source where the cost of funds is cheap and the
terms are favourable. Raising funds internationally, debt and equity, is now a common trend
even in India. International financing agreements are the most common feature of
international trade. This article assumes great importance as the lender would obviously
consider the tax implications for him, though most of the negotiation would try to pass on the
burden of tax to the borrower, tax payable will ultimately add to the cost of funds.
In order to arrive at the taxable income as discussed earlier it will first have to be examined
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whether the income is taxable under the Act, if it is so the quantum taxable after considering
exemption if any available under the Act will have to be seen and ultimately, recourse can be
had to the provisions of the DTAA if they are more favorable.
Interest - Amount paid by a thinly capitalized corporation
In certain countries owing to thin capital regulations, the loan of money made by a
shareholder may be treated as a part of the capital of the corporation and accordingly, the
corresponding interest expenses on such excess debts re-characterized as equity, is not
accorded similar treatment as interest.
5.11 Royalties and Fees for Technical Services (FTS)
The Article 12 of the UN Model is reproduced below:
ARTICLE 12 Royalties
1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State
may be taxed in that other State.
2. However, such royalties may also be taxed in the Contracting State in which they arise and
according to the laws of that State, but if the beneficial owner of the royalties is a resident of
the other Contracting State, the tax so charged shall not exceed..per cent (the percentage is
to be established through bilateral negotiations) of the gross amount of the royalties. The
competent authorities of the Contracting State shall by mutual agreement settle the mode of
application of this limitation.
3. The term royalties as used in this Article means payments of any kind received as a
consideration for the use of, or the right to use, any copyright of literary, artistic or scientific
work including cinematographic films, or films or tapes used for radio or television
broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for
the use of, or the right to use, industrial, commercial or scientific equipment or for
information concerning industrial, commercial or scientific experience.
4. The provisions of paragraph 1 and 2 shall not apply if the beneficial owner of the royalties,
being a resident of a Contracting State, carries on business in the other Contracting State in
which the royalties arise, through a permanent establishment situated therein or performs in
that other State independent personal services from a fixed base situated therein, and the right
or property in respect of which the royalties are paid is effectively connected with
(a) such permanent establishment or fixed base or with
(b) business activities referred to in
(c) of paragraph 1 of Article 7. In such cases, the provisions of
Article 7 or Article 14, as
the case may be, shall apply.
5. Royalties shall be deemed to arise in a Contracting State when the payer is a resident of
that State. Where, however, the person paying the royalties, whether he is a resident of a
Contracting State or not, has in a Contracting State a permanent establishment or a fixed base
in connection with which the liability to pay the royalties was incurred, and such royalties are
borne by such permanent establishment or fixed base, then such royalties shall be deemed to
arise in the State in which the permanent establishment or fixed base is situated.
6. Where, by reason of a special relationship between the payer and the beneficial owner or
between both of them and some other person, the amount of the royalties, having regard to
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the use, right or information for which they are paid, exceeds the amount which would have
been agreed upon by the payer and the beneficial owner in the absence of such relationship,
the provisions of this Article shall apply only to the last-mentioned amount. In such case, the
excess part of the payments shall remain taxable according to the laws of each Contracting
State, due regard being had to the other provisions of this Convention.
FTS is not separately defined in the UN or the OECD Model we will therefore consider the
definition in Article 13(4) of the U.K. DTAA:4. For the purposes of paragraph 2 of this
Article, and subject to paragraph 5, of this Article, the term fees for technical services
means payments of any kind of any person in consideration for the rendering of any technical
or consultancy services (including the provision of services of technical or other personnel
which :
(a) are ancillary and subsidiary to the application or enjoyment of the right, property or
information for which a payment described in paragraph 3(a) of this Article is received; or
(b) are ancillary and subsidiary to the enjoyment of the property for which a payment
described in paragraph 3(b) of this Article is received; or
(c) make available technical knowledge, experience, skill, knowhow or processes, or consist
of the development and transfer of a technical plan or technical design.
5. The definition of fees for technical services in paragraph 4 of this Article shall not include
amounts paid:
(a) for services that are ancillary and subsidiary, as well as inextricably and essentially linked,
to the sale of property, other than property described in paragraph 3 (a) of this Article;
(b) for services that are ancillary and subsidiary to the rental of ships, aircraft, containers or
other equipment used in connection with the operation of ships, or aircraft in international
traffic;
(c) for teaching in or by educational institutions;
(d) for services for the private use of the individual or individuals making the payment; or
(e) to an employee of the person making the payments or to an individual or partnership for
professional services as defined in Article 15 (Independent personal services) of this
Convention .
The economic progress of a nation is measured inter alia by its technological advancement.
Though transfer of technology is normally between developed nations to developing nations,
in certain fields recently there has been a reverse flow of technology and knowledge.
Technology transfer can be by way of transfer of the formula and allowing the right to use it
for mass production, or of know-how or of plans, technical designs or drawings patents and
copyrights are the most common form of transfer of technology.
With the advancement of knowledge, the manner of doing business has drastically changed,
with e-commerce posing problems hitherto not contemplated. Intellectual Property Rights in
fields like software, knowledge and research development in various fields of science,
technology etc. also pose new questions of ownership. The provisions for royalty and FTS
under the Indian tax laws have been discussed in the earlier Chapter III dealing with Income
of foreign taxpayers. We shall now see how they are treated under DTAA and whether the
DTAAs are capable of handling the emerging problems.
The rate specified in this Article is also a matter of bargain between the countries. Until a
consensus is reached on a uniform rate and a method of identification and allocation of
expenses to the royalty income or FTS, this Article, along with Article on business profits,
will lead to maximum litigation. Whether the State in which royalty arises should be given a
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right to tax the royalty is a matter of debate between developed and developing countries.
Developed countries feel that royalty is a result of their encouragement for the development
of technology which, they have given by way of say supply of raw material at a concessional
rate or, tax breaks which, when used by developing countries, result in their industrial
development, therefore, the right to tax should be reserved with resident State. However, the
counter to that argument by developing countries is that while capital and services may be
provided by the developed countries, it is the developing countries which provide the
management, labour and implementation therefore both countries have a right to tax the
income royalty. The compromise between the source State and the resident State is again
achieved by a reduced rate. Therefore, while para 1 gives the resident State a right to tax, para
2 recognises the
right of the source State and a rate is negotiated by the two countries to give the source State
a partial right. A Contracting State accords a concession in favour of the other Contracting
State by giving up its right to tax. This concession must benefit a real holder and not just
some pass through entity as we shall see in the discussion on para 6. This rate has to be
applied on the gross income, as determination of the net income for a source State is virtually
impossible considering that the expenditure may have been incurred over a period of years
and furthermore may have already been allowed by the resident State. To get over all these
difficulties a lower rate is prescribed which should be applied to the gross income.
To determine whether the royalty arises in a contracting State the location of the source has to
be identified. If the source from which royalty is derived is located in the State the royalty is
said to or deemed to arise in that State. The taxability of royalty arises in the State where the
licence is used and the place where it is paid has no relevance. When the Articles talk about
royalty paid it does not talk about actual payment but would even consider constructive
payment i.e. when the right to receive is made unconditionally available. Here again royalty
is taxable if it arise or is deemed to arise in the Source State. The concept of arising is
different from receipt as has been seen earlier. The word arising signifies that the origin is in
the country as distinct from being brought into the country. The word arising also and
indicates a right to receive and represents a stage anterior to the point of receipt. Para 3 Royalty as commonly understood is a fee or a consideration paid to another for the right to
use his product, patent or knowledge etc. Technical
service fee may be paid in connection with the patent, product etc. for which royalty is paid
or may be an isolated fee only for the use of service. The performance of a technical service
does not involve the transfer of knowledge however when know-how is transferred the
operational or technical skill/knowledge is also transferred. The definition of royalty has been
kept wide to include not only patents and know-how which are normally used in
manufacture/ industrial royalty but also to cover other intangible rights like copyrights of
literary artistic or scientific work. Rights to use films and television broadcasting are also
covered. With the increasing advent and popularity of satellite T.V., the latter becomes very
important.
The dictionary meaning of royalty is a sum paid to a patentee for the use of patent or to an
author etc. for each copy of a book sold or for each public performance of a work.
Therefore, an amount paid to obtain a right to use another property is royalty. The dictionary
meaning is also a royal right (now esp. over minerals) granted by the sovereign to an
individual or a corporation. This goes back to the origin of the term when royalty was paid
to Kings who were the sole owners of gold and silver mines for the right to mine. Hence from
the royal metal comes the term royalty. A person may have the knowledge to invent a
formula or a design model, but he may not have the wherewithal to manufacture or produce
or to commercially exploit the patent/design. In such a case, he may allow a manufacturer to
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commercially
develop and exploit it. This may either be by an outright sale or by giving a right to use while
retaining the ownership. The payment for the later would constitute royalty. The most
common form of royalty is industrial royalty and the payment may be made based on
production of output. In the case of books and films, the royalty may consist of a lump sum
and an additional amount linked to the sales. In a contract for royalty the terms of the
payment, the extent of the right given to use the product, patent etc., as the case may be, all
should be mentioned in the contract. In certain DTAAs, mining royalties are taxed under
income from immovable property. However, this leads to a question that if, a mine quarry etc
are held to be a PE, as discussed earlier, how can income there from be taxed as royalty? The
reply
to this is in the generally understood principle that; if an income can be clearly attributed to
the PE it should be taxed under the Article dealing with business profits.
Another popular form of royalty payments is for right to use the brand name or franchising
for e.g. McDonalds will grant a franchise to a restaurateur to use his name and run a
McDonalds outlet. The expertise, training of staff will all be provided by McDonalds and the
quality standards will be prescribed. In return the restaurateur will pay McDonalds a royalty
which may be a lump sum an X percentage of sales. Technology is the scientific or organized
knowledge of a way of doing something. Therefore, transfer of technology involves transfer
of some knowledge and the payment for the use of such technology, will be royalty or
payment for technical fees. Know-how is also accumulated knowledge from
years of research and the knowledge or information is not publicly available and is
confidential and secret.
The technical fee is, generally, not considered in a separate Article. Normally, when the fee is
not in connection with the right to use the product, patent etc., for which royalty is paid, it can
be taxed as business income which, in the absence of a PE, may not be taxable.
Paras 4 and 5 - Paras 4 and 5 are the exceptions to paras 1 and 2. Para 4 provides that if the
royalty is effectively connected with the PE the royalty will be deemed to arise in the State in
which the PE is situated. Para 5 provides
that royally will arise in the State where the payer is a resident. However, if the payer has a
PE in the State and the royalty is obtained in connection with the PE and is borne by the PE
the royalty will be deemed to arise in the State in
which the PE is situated. In that case the royalty will be assessed as business profits under
Article 7 or Article 14 if it can be attributed a fixed base.
Para 6 - The benefit of the lower rate of tax is given to the person who is the ultimate
recipient of the royalty provided he is the resident of the other contracting State. The
intention is to give the benefit to the correct person
and to avoid treaty shopping by putting a resident of a country where royalty is exempt or not
taxable as the front or where a person tries to obtain DTAA benefits indirectly which would
not be directly available to him. There has to
be a close and real nexus between the resident and the resident State which is to be
ascertained from the facts of each case. A State accords a concession by giving up its right to
tax. This concession must benefit a real holder and not just some pass through entity. This
rate has to apply on the gross income as determination of the net income for a resident State
is virtually impossible considering that the expenditure may have been incurred over a period
of years and furthermore may have already been allowed by the resident State. To get over all
these difficulties a lower rate is prescribed which should be applied to the gross income. To
determine whether it arises
in a contracting state the location of the source has to be identified. If the source from which
royalty is derived is located in the state it is said to or deemed to arise in that State. In order to
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control artificial suppression of or augmentation of profit Para 6 also gives the tax authorities
the right to apply the arms length principle and to decide whether the royalty paid is
excessive owing to a close relationship between the payer and the recipient. This excess can
be dealt with as per
the local laws.
Analysis:
The fees would not be for included services. The American company is providing a
consultancy service which involves the use of substantial technical skill and expertise. It is
not, however, making available to the Indian company any technical experience, knowledge
or skill, etc., nor is it transferring a technical plan or design. What is transferred to the Indian
company through the service contract is commercial information. The fact that technical
skills were required by the performer of the service in order to perform the commercial
information service does not make the service a technical service within the meaning of the
DTAA.
Royalty/FTS or business profits - The eternal debate Payment for royalty for technology
usage is the most common form of royalty. The eternal debate is the classification of the
amount as either royalty or business profits. Normally, the person supplying the equipment or
the knowhow will also supply the services of his employees to train in the use of the
equipment and allow the trade mark to be used; the payment for the equipment along with the
trade mark and technical services will amount to payment for royalty/FTS. On the other hand
if the person rents the equipment in the normal course of his business it is business income. A
similar view was taken in CEPT v. Shri Lakshmi Silk Mills Ltd. [1951] 20 ITR 451 (SC).
While deciding whether the income is royalty or business income the courts will give
importance to the special provision which overrides the general provision as held in the case
of CIT v. Copes Vulcan Inc. [1987] 167 ITR 884 (Mad) where the court held that if the
nature of income is such that it is FTS it must be taxed under the special provision and a
deeming concept would apply irrespective of whether there was a business connection to not
and the
FTS would be covered by the special provision.
In AAR P. No. 30 of 1999, In re [1999] 238 ITR 296 (AAR) as discussed above the payment
for the rights in software was held as royalty for included services and not business income.
Transfer of technology can take various forms, e.g. Transfer of computer software, or transfer
of human skills. However, if the right to use an equipment is given it is not royalty but
business income. Royalty also involves transfer of intellectual property rights. These are
rights over a
creation which requires skill and knowledge of an individual or an organization. These can
include copyrights which relate to literary, scientific or artistic work. These rights would be
protected by a licence or a patent. It is the licence or patent which would be allowed to be
exploited. In CIT v. Davy Ashnmore India Ltd. [1991] 190 ITR 626 (Cal.) it was held that
consideration received by the owner of the patents etc. was royalty. Another important
development in royalty is transfer of technical service. In certain cases the patent or the
design is transferred and the person who pays for its use is capable of using it independently
without the help of the owner/producer/inventor. However, in some or most cases this may
not be possible. In that case the owner/producer/inventor would also provide his people to
demonstrate the usage, or help in the installation or modification of the know-how. This
would be characterised as a technical service. Theplace where it is used would have the right
to tax it.
5.12 Independent personnel services (IPS)
The UN Model of the Article reads as under:
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the fee/salary paid and furthermore the employment is exercised therein. The place where the
directors meetings are held can be said to the head and brain of the Company. That place
would also be considered the resident State. If the Director works in a dual capacity i.e. as a
Director as well as top level executive the compensation if it does not fall under para 1 and 2
of this Article may have to be split up and considered as salary and directors fees. In the case
of top level management the salary income is taxed in the country of residence of the
company under Article 16; Article15 has no
operation; as already seen it is subject to the provision of Article 16.
(ii) Article 17 Articles and sportspersons
Article 17 of UN Model reads as under:
ARTICLE 17 Artistes and Sportspersons
1. Notwithstanding the provisions of Articles 14 and 15, income derived by a resident of a
Contracting State as an entertainer, such as a theatre, motion picture, radio or television
artiste, or a musician, or as a sportsperson, from his personal activities as such exercised in
the other Contracting State, may be taxed in that other State.
2. Where income in respect of personal activities exercised by an entertainer or a
sportsperson in his capacity as such accrues not to the entertainer or sportsperson himself, but
to another person, that income may, notwithstanding the provisions of Articles 7, 14 and 15,
be taxed in the Contracting State in which the activities of the entertainer or sportsperson are
exercised.
Para 1 Provides the State in which the activities are performed the right to tax the income
therefrom. This is in recognition of the attribution rule and the principle that the source State
is giving the means and opportunity to exploit the talent and generate income. Here
entertainment covers all the possible medias of radio, TV, films, theatre, music, sports
persons are also covered.
Para 2 provides that when a resident of a State other than the contracting States benefits from
the association with the activity performed by the entertainer/sportsmen the jurisdiction of the
State will extend to tax such person also. Here the question that may come to ones mind is
would this not restrict performers from coming and there by limit cultural exchanges?
Cultural exchanges programmes which are inter-government organized would normally have
a waiver
on all taxes which may include entertainment and service tax.To avoid issuing a notification
each time the OECD suggests that a clause to the effect of exemption for government
sponsored programmes be inserted. However a general exemption it is felt is not practical as
if may lead to treaty abuse. Implementation of this Article also has practical problems when
one considers that most organised programes are in Orchestras/Groups further complicated
by all members not being residents of the same country as it is possible that person may be
resident of one State and exercise employment in the other State. Should revenue and tax
sharing certificates given by the organizer be sufficient to claim credit? Should the liability
be of the group or should the liability be if the individual would depend on the facts of each
case. Normally the group payment would be considered unless the arrangement is to pay
individually. However, again here the credit in the resident country becomes difficult unless a
certificate of proportionate income and tax if any deducted thereon is issued.
Para 2 assumes relevance as todays Artists/ sportspersons are managed by companies who
take care of their endorsements, arrange performances and events. In fact, this is big money
today. Para 2 provides that the income of earned by such company will be taxed in the source
State overriding the possibility that Article7 or Article 14 i.e. the PE or fixed base will be
used to tax the income by the source State.
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payments made by the business are not governed by this Article but by the earlier Articles
seen i.e. 15,16,17 and 18. Para 1 applies to remuneration and para 2 to pensions. The State
which pays the remuneration and pension is given the exclusive right
to tax it. Exception is given to a national of the other state who renders service in the other
State i.e. where the local employee becomes a resident solely for the purpose of rendering
service to the foreign government.
(v) Article 20 - Students and Apprentices
Article 20 of UN Model reads as under:
ARTICLE 20 - Students
Payments which a student or business trainee or apprentice who is or was immediately
before visiting a Contracting State a resident of the other Contracting State and who is
present in the first-mentioned State for the purpose of his education or training receives for
the purpose of his maintenance, education or training shall not be taxed in that State,
provided that such payments arise from sources outside that State. This Article normally
exempts the income of a student as the resident State where the student is studying has no
nexus to the income and has not contributed to it earning the income. This exception is for
income which is received from outside that State. Some DTAAs may put a ceiling to the
income which can be treated as exempt. Further the amount is supposed to be for the living
expenses therefore scholarships are also exempt. Scholarship is different from remuneration
and if the receipt is in the nature of remuneration which is generally received from the
rendering of service it would be taxable. Again here remuneration would cover a wider scope
and any reward for service would be taxable as it is different from scholarship. Certain
DTAAs also give a definition to student to make it clear who is to be the beneficiary of the
exemption. As far as the stay is temporary and the monies are received for maintenance the
remuneration within reasonable limits for a specified period would be exempt. The
reasonability of period is normally stated to be 5 years. The education referred to is very wide
and would technical education or general education.
(vi) Article 21 - Other Income
Article 21 of the UN Model reads as under:
ARTICLE 21 - Other Income
1. Items of income of a resident of a Contracting State, wherever arising, not dealt with in the
foregoing articles of this Convention shall be taxable only in that State.
2. The provisions of paragraph 1 shall not apply to income, other than income from
immovable property as defined in paragraph 2 of Article 6, if the recipient of such income,
being a resident of a Contracting State, carries on business in the other Contracting State
through a permanent establishment situated therein, or performs in that other State
independent personal services from a fixed base situated therein, and the right or property in
respect of which the income is paid is effectively connected with such permanent
establishment or fixed base. In such case, the provisions of Article 7 or Article 14, as the case
may be, shall apply.
3. Notwithstanding the provisions of paragraph 1 and 2, items of income of a resident of a
Contracting State not dealt with in the foregoing articles of this convention and arising in the
other Contracting State may also be taxed in that other State. This residuary clause is there
in a few DTAAs to cover incomes which have not been included already or which may not
have been otherwise covered to bring every conceivable income within the scope of the
DTAA and uphold the principle that no income should be doubly taxed.
Para 1 - This para upholds the right of resident State to tax any income. This is based on the
primary concept of residence. Para 1 also uses the positive shall be taxable which is distinct
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from may be taxable and gives the resident State the right to tax the income. What is also
important to note is that word taxable as against taxed has been used therefore the actual
taxing is not necessary as long as it taxable then if that State chooses to exempt it, it is its
prerogative.
Para 2 - Contains two exceptions. Both of these are in line with the generally accepted
principles of interpreting and giving effect to DTAA .The first part provides that income
from immovable properly shall be taxed only in the State in which it is situated as that
country alone has the right to collect tax. The second part recognises the unique place which
a PE or a fixed base has been given in DTAAs and acknowledges that if there is a PE/Fixed
base that State and the income is attributable to the PE/fixed base the State where the PE/FD
is located alone has the right to tax it.
Para 3 - Recognizes the right of a source State and provides that the source State may also tax
the income. It is up to the negotiators to the DTAA to specify the terms and conditions under
which the source State can tax the income. It is also up to the negotiators whether to keep this
Article or not. If in spite of all precautions income is ultimately doubly taxed, tax sparing or
credit will have to be given in the State of ultimate liability. In fact, the OECD has also
suggested that the Arms Length Principle be introduced in this clause also to avoid DTAA
abuse. All unconventional and new means of income and financial transactions are covered
by this Article. This leads us to the question; is this Article good enough to cover ECommerce? The jury is still out on this one and would depend on whether it is an isolated
transaction
or can be linked to a PE.
5.15 Elimination of double taxation
Article 23A and 23B of UN Model read as under:
ARTICLE 23A - Exemption method
1. Where a resident of a Contracting State derives income or owns capital which, in
accordance with the provisions of this Convention, may be taxed in the other Contracting
State, the first-mentioned state shall, subject to the provisions of paragraphs 2 and 3, exempt
such income or capital from tax.
2. Where a resident of a Contracting State derives items of income which, in accordance with
the provisions of Article 10, 11 and 12, may be taxed in the other Contracting State, the firstmentioned state shall allow as a deduction from the tax on the income of that resident an
amount equal to the tax paid in that other State. Such deduction shall not, however, exceed
that part of the tax, as computed before the deduction is given, which is attributable to such
items of income derived from that other State.
3. Where in accordance with any provision of the Convention income derived or capital
owned by a resident of a Contracting State is exempt from tax in that State, such State may
nevertheless, in calculating the amount of tax on the remaining income or capital of such
resident, take into account the exempted income or capital.
ARTICLE 23B - Credit Method
1. Where a resident of a Contracting State derives income or owns capital which, in
accordance with the provisions of this Convention, may be taxed in the other Contracting
State, the first-mentioned State shall allow as a deduction from the tax on the income of that
resident, an amount equal to the income-tax paid in that other State; and as a deduction from
the tax on the capital of that resident, an amount equal to the capital tax paid in that other
State. Such deduction in either case shall not, however, exceed that part of the income-tax or
capital tax, as computed before the deduction is given, which is attributable, as the case may
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be, to the income or the capital which may be taxed in that other State.
2. Where, in accordance with any provisions of the Convention income derived or capital
owned by a resident of a Contracting State is exempt from tax in that State, such State may
nevertheless, in calculating the amount of tax on the remaining income or capital of such
resident, take into account the exempted income or capital. With DTAAs being a subject
matter of negotiation some amount of double taxation may be consciously agreed or
unavoidable e.g. incomes which are taxed at concessional rates would normally suffer tax in
both countries. However, in keeping with the spirit of avoidance of double taxation, Article
23 provides for relief in respect of doubly taxed income. The relief can be either
by exemption method which exempts the income from taxation in the resident State if taxed
in the source State or the credit method which allows credit for taxes paid in the source State.
Exemption method
As we saw DTAAs provide concurrent rights to the source State and the resident State to tax
the income. In certain cases, like shipping income the State of residence has the exclusive
right to tax the income, in case of certain income the State of source has the right to tax, in
certain other cases like royalty income the State of Source has a right to tax it at the agreed
rate. To avoid double taxation one of the methods are resorted to. In the exemption method
the residence State grants an exclusive right to the source State to tax the income. This
method may be applied in two ways:
(i) full exemption in this method the residence State does not take into account the income
earned in the source State at all while determining the tax to be levied on the global income
of the non-resident.
(ii) exemption with progression- the residence State does not tax the income but takes it into
account in computing the total income to be taxed.
Credit method
Under this method
the resident State retains its right to tax the income but allows
credit/deduction for tax paid in the source State. Under this method the residence State treats
the tax paid in the source country as if it were tax paid to itself. This method is also applied in
two main methods:
(i) full credit in this method full credit is given for the total tax paid in the source State.
(ii) ordinary credit- in this method the credit is restricted to the tax which the State of
residence would have levied on that income.
Para 1 provides for exemption of tax on the income which has been taxed in the source
country Para 2 deals with certain cases of certain income like dividend interest and royalty
(included in the UN model) which both the States have a right to tax, credit is given to extent
of the tax paid. The basic difference in the two Models is that Para 1 of the tax exemption
method exempts the income while also providing for credit in respect of doubly taxed income
while tax credit method only allows for credit in respect of taxes paid. However, in both
Models where income is totally exempt in the source State it will be considered for rate
purposes. Exemption method exempts income while tax credit method spares tax therefore it
is also referred to as tax sparing method. Tax credit takes into consideration the tax actually
paid whereas tax sparing is sparing the tax payable. On account of the Difference in
taxation laws of each country the tax payable on the same income may differ as rebates and
deductions offered are different. Depending on the way the Article is worded the taxable
income in the home country, on that income, may have to be worked out against which the
credit is allowed for tax paid or the exemptions given in the source country will be ignored
and the tax payable will be worked out. Alternatively, irrespective of the tax payable in the
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home country on that income, credit will be allowed of tax paid in the source country.
Therefore there may be total or partial tax sparing depending on whether it is for tax paid or
tax payable. The term tax paid will also be defined to emphasize what should or should not
be considered in arriving at the tax paid/payable and would normally be the tax
paid/payable without considering the special deductions available against that income in the
source State. This would depend on the nature of income for e.g. where certain incomes are
taxed at a flat rate no deduction is allowed. The exemptions/deductions which are peculiar to
that State and which are to be ignored/considered will also be specified. The intention here is
to make the taxes payable on par by neutralizing the differences. The extent to which it is the
done and how administratively it will be handled by each State is decided in negotiations.
The wordings used in the para are in accordance with the provisions of this Convention
this means that even if there is a difference in classification of the taxpayer or the income in
the States, the Source State taxes the income in accordance with the Convention which
though they may be different from the provisions which the resident State may have applied
the source States taxation would still be in accordance with this Convention and the
resident State would be obliged to give credit for taxes deducted irrespective of the
quantification applied by the source State. This problem is typical in the case of partnerships
where one of the States considers them to be taxable while the other considers them to be
fiscally transparent entities. However, if the problem is not of classification of the taxpayer
but of the interpretation of the provisions of the DTAA which the resident State does not
agree with it is not obliged to grant credit for taxes paid.
Para 2 - As we have seen so far certain Articles in the DTAA allow both the
States to impose tax e.g. interest, dividend whereas some Articles make it clear that the
source State or the resident State is to levy tax e.g. Income from Immovable property or
business income in the absence of a PE. In the latter category there is no double taxation but
tax sparing may have to be given in respect of tax paid on the immovable property in the
State of residence. In the former there is most definitely double taxation whose effect has to
be neutralised. To provide for this Article 23 is introduced. The main feature of the
exemption method is that the residence State (Para 1) completely gives up its fundamental
right to tax the income in favour of the source State. Under the credit method it retains the
right but allow credit for taxes paid. The credit method deals with tax to the extent paid in the
source state the exemption method deals with income. Para 2 in the exemption method is an
exception to para 1 and deals with double taxed income like interest, dividend and in some
DTAAs royalty. Double taxation is avoided by giving credit for tax paid in the resident
country. In the tax credit method the credit is restricted to the tax actually paid which
however cannot exceed the amount which would have been payable in the resident State on
that income. This is to ensure that the resident State does not lose out on its revenue
collections by giving higher tax credits.
Tax sparing - The developing countries in order to attract capital and investment give various
concession, other incentives are given. This may push the effective rate of tax down. If the
credit is restricted to the tax paid this concession given to the investor is lost by the resident
State
getting the benefit of the incentives by collecting the tax paid. To keep this benefit
in fact the resident State agrees to give credit not of tax paid but that which would have been
payable in the absence of such incentives. Therefore, the incentive is retained by the investor
and the tax incentive is not nullified in the State of residence. Tax sparing goes beyond the
pure credit method and takes into account the fictitious tax which would have been payable.
In tax sparing method credit may be restricted to ceiling rates therefore; if the tax paid in the
source country is lower automatically the incentive is retained by the investor. If the credit is
higher than the ceiling rate the resident country also sacrifices some tax collections.
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5.17 Non-discrimination
Article 24 of UN Model reads as under:
ARTICLE 24 - Non- Discrimination
1. Nationals of a Contracting State shall not be subjected in the other Contracting State to
any taxation or any requirement connected therewith, which is other or more burdensome
than the taxation and connected requirements to which nationals of that other state in the
same circumstances, in particular with respect to residence, are or may be subjected. This
provision shall, notwithstanding the provisions of Article 1, also apply to persons who are not
residents of one or both of the Contracting State.
2. Stateless persons who are residents of a Contracting State shall not be subjected in either
Contracting State to any taxation or any requirement connected therewith, which is other or
more burdensome than the taxation and connected requirements to which nationals of the
State concerned in the same circumstances, in particular with respect to residence, are or may
be subjected
3. The taxation on a permanent establishment which an enterprise of a Contracting State has
in the other Contracting State shall not be less favourably levied in that other State than the
taxation levied on enterprises of that other state carrying on the same activities. This
provisions shall not be construed as obliging a Contracting State to grant to resident of the
other Contracting State any personal allowances, relief and reductions for taxation purposes
on account of civil status or family responsibilities which it grants to its own residents.
4. Except where the provisions of paragraph 1 of article 9, paragraph 6 of article 11, or
paragraph 6 of Article 12 apply, interest, royalties and other disbursements paid by an
enterprise of a Contracting State to a resident of the other Contracting State shall, for the
purpose of determining the taxable profits of such enterprise, be deductible under the same
conditions as if they had been paid to a resident of the first mentioned State. Similarly, any
debts of an enterprise of a Contracting State to a resident of the other Contracting State shall,
for the purpose of determining the taxable capital of such enterprise, be deductible under the
same conditions as if they had been contracted to a resident of the first-mentioned state.
5. Enterprises of a Contracting State, the capital of which is wholly or partly owned or
controlled, directly or indirectly, by one or more resident of the other Contracting State, shall
not be subjected in the first-mentioned State to any taxation or any requirement connected
therewith which is other or more burdensome than the taxation and connected requirements
to which other similar enterprises of the first mentioned State are or may be subjected.
6. The provisions of this article shall, notwithstanding the provisions of Article 2, apply to
taxes of every kind and description. The basic intention of this Article is to ensure that that
resident enterprises of a Contracting State doing business in the other State i.e. source State
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are treated fairly therein and on an equal footing as its own residents.
Paras 1 and 2 deal with nationals and Stateless Persons and provide that taxation and
anything connected therewith shall be on an equal footing as with residents/nationals of the
contracting State/source State. Para 1 basically ensures that, all things being equal, the
resident and the on-resident will be treated on par under the same circumstance unless
there is a good enough reason to deviate. This is in line with the principle of equity. However,
differentiation in the rate of tax is not considered as discrimination. It is internationally
accepted that there will always be two different systems of taxation as no State can tax a
person who does business on its soil on his global income. Therefore, there will always be
one set of rules for a resident and one for a non-resident. Generally, a resident company
which pays tax on global income may enjoy some additional benefits whereas nonresident
companies which do not pay tax on total income are not necessarily entitled to extra
advantages. The discrimination is to the extent of quantum of tax (more taxation) and taxes
other than what nationals are subject to (other). However, the reverse i.e. a favorable or less
burdensome taxation is not forbidden. This Article however ensures that discrimination based
on nationality is not allowed. Also the word used in the article is taxation and not levy of
tax; levy means the charge of tax and covers the rate of tax; taxation is of wider import
than tax and includes imposition and administration of taxes. When rate of tax is meant to be
restricted the words tax charged shall not exceed are normally used (refer articles on
royalty, interest etc). The words tax and taxation are different and not interchangeable. The
expression any requirement connected therewith includes the manner of imposition and
collection and assessment of taxes.
Nationality Non Discrimination (Para 1 and 2) The word national would include natural
persons and artificial persons such as a partnership. A stateless person is one who is resident
of either State but may not be national of one. Here nationality should not be confused with
citizenship nationality determines the civil rights and duties of a person, all citizens will be
nationals but all nationals may or may not be. The term resident used in the DTAA is also
not interchangeable with national as resident is with reference to tax liability whereas a
national will have tax liability depending on the physical presence therefore a national of a
State will not have liability if he is not physical present in that State.
Para 2 is extended to stateless persons who must be resident of one of the Treaty States to
take advantage of this clause. They have to be resident of at least one to prevent them from
exploiting this clause by claiming nondiscrimination
in both the States. Only individuals can be Stateless as an artificial person gets its status
from the State where it is registered. Discrimination based on nationality and not residence is
not permitted and that too under similar circumstance.
Para 3 deals with PE and states that taxation of a PE should be on the same footing as a
resident enterprise. Here the word any requirement connected therewith are absent. The
Para also specified that the source State is not obliged to grant any special concessions to the
PE which it does not grant to its own residents.
PE Discrimination - As we saw earlier para 3 require a PE to be put on the same footing as a
resident Company. In the case of nationals, discrimination is to be concerned with reference
to same circumstances, in case of a PE if is to be considered with reference to same
activities. The activities of the resident and non-resident are to be distinguished if the nonresident is to be put on a more burdensome levy. Here, the residence and activity plays the
deciding role and not the nationality same would mean comparable and not identical. The
clause and factors is concerned with computation of income and not rate of tax, as we saw
earlier in the case of the French bank. All deduction rebates should be uniformly available.
Therefore, subject to the specific Articles and application of the arms length principle
deduction of royalty, interest etc ought to be allowed.
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Para 4 provides that, subject to the provisions of the special Articles dealing with interest and
royalties, if they are paid by an enterprise it should be allowed a deduction in respect thereof
in the same way a resident enterprise would be allowed. Similarly any interest paid should
also be allowed.
Para 5 provides that the enterprise whose capital is held by a non- resident/s shall be treated
on par in taxation and connected requirements with enterprises whose capital is held by
residents of that State.
Para 6 makes this Article applicable across the board to all taxes notwithstanding provisions
of para 2 (Taxes Covered).
Ownership Discrimination - This is more or less on the same lines as PE to ensure that an
enterprise is not biased against on account of the ownership being with non-resident. Here the
emphasis is on similar enterprise. This clause ensures that the enterprise is not discriminated
because of the ownership and is treated equally as the taxpayers of that State. The Article is
based on the fundamental principle of equality. Discrimination based on residence i.e. that the
State is not bound to give extra concessions to non-residents (see para 3) is accepted, though
internationally with some reservations, but discrimination based on nationality is not
considered at all justifiable. However a favoured nation clause is considered acceptable
though in a way it is a discrimination against countries that are not so favourably treated. In
fact the protocol to the DTAA may also state that where this is a lower rate say in the case of
interest etc. or some other terms in another DTAA are more favorable than the terms listed in
that DTAA, that DTAA will be considered as modified to that extent. The reference to which
it is to be benchmarked with is stated in the protocol itself e.g. OECD countries.
However differing modes of taxing different entities does not amount to discrimination e.g.
Partnership are taxed differently in different countries.
5.18 Mutual Agreement Procedure
UN Model reads as under:
ARTICLE 25- Mutual Agreement Procedure
1. Where a person considers that the actions of one or both of the Contracting States result or
will result for him in taxation not in accordance with the provisions of the Convention, he
may, irrespective of the remedies provided by the domestic law of those States, present his
case to the competent authority of the Contracting State of which he is a resident or, if his
case comes under paragraph 1 of Article 24, to that of the Contracting State of which he is a
national. The case must be presented within three years from the first notification of the
action resulting in taxation not in accordance with the provisions of the Convention.
2. The competent authority shall endeavor, if the objection appears to it to be justified and if
it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement
with the competent authority of the other Contracting State, with a view to the avoidance of
taxation which is not in accordance with this convention. Any agreement reached shall be
implemented notwithstanding any time limits in the domestic law of the Contracting States.
3. The competent authorities of the Contracting States shall endeavor to resolve any mutual
agreement any difficulties or doubts arising as to the interpretation or application of the
convention. They may also consult together for the elimination of double taxation in cases
not provided for in the convention.
4. The competent authorities of the Contracting States may communicate with each other
directly, including through a joint commission consisting of themselves or their
representatives, for the purpose of reaching an agreement in the sense of the preceding
paragraphs. The competent authorities, through consultations, shall develop appropriate
bilateral procedures, conditions, methods and techniques for implementation of the mutual
agreement procedure provided for in this Article. In addition, a competent authority may
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devise appropriate unilateral procedures, conditions, methods and techniques to facilitate the
above- mentioned bilateral actions and the implementation of the mutual agreement
procedure. We have seen in the preceding paras that there is scope for plethora of disputes
and issues which can arise in the implementation of the provisions of the DTAA which is not
surprising as DTAAs are also laws in themselves. Any law will tend to be interpreted
differently by the taxpayer and by the authorities as the interests are conflicting. Indeed if
they were not a whole lot of professionals would be redundant! A bit of humor apart as
conflicts is inevitable in anything short of a Utopian society hence, the need for this Article.
5.19 Protocol to DTAAs
The protocol to DTAAs appears at the end, after all the Articles. The protocol is used to
explain the terms used in the DTAA and, the intention of the provisions or to elaborate on the
treatment intended to be given. Normally, before a DTAA is finalized there are a series of
letters exchanged between the Contracting States setting out objections if any to a proposed
Article or seeking clarification on a particular Article. This ultimately culminates into the
DTAA. Sometimes few of these letters may also form part of the DTAA or there may be a
technical explanation as in the Indo-US DTAA. These also form part of the DTAA and are
useful in interpretation of the DTAA. Further additions to the Protocol or a Notification are
also used to amend or update the provisions of the DTAA. A protocol is an essential part of
DTAA and the relevant Article must be read along with the explanation there to contain in
the protocol.
PROTOCOL
[Reference: DTAA Between Nepal & India]
At the moment of signing of the Agreement this day concluded between the Government of
Nepal and the Government of the Republic of India for the Avoidance of Double Taxation
and the Prevention of Fiscal Evasion with respect to Taxes on Income, the undersigned have
agreed upon the following provisions which shall be an integral part of the Agreement:
1. It is understood that if the domestic law of a Contracting State is more beneficial to a
resident of the other Contracting State than the provisions of this Agreement, then the
provisions of the domestic law of the first-mentioned State shall apply to the extent they are
more beneficial to such a resident.
2. With reference to Article 12:
In respect to Article 12 (Royalties) if under any Agreement, Convention or Protocol between
Nepal and a third state, Nepal limits its taxation at source on royalties to a rate lower or a
scope more restricted than the rate or scope provided for in this agreement on Royalties, then
as from the date on which the relevant Nepal Agreement or Convention or Protocol enters
into force, the same rate or scope as provided for in that Agreement or Convention or
Protocol on Royalties shall also apply under this Agreement.
IN WITNESS WHEREOF the undersigned, duly authorized thereto, have signed this
Agreement.
DONE in duplicate at Kathmandu on this 27th day of November 2011, each in the Nepali,
Hindi and English languages, all texts being equally authentic. In case of divergence of
interpretation, the English text shall prevail.
For the Government of
For
the
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Government of the
Nepal:
(BARSHA MAN PUN)
MUKHERJEE)
MINISTER OF FINANCE
FINANCE
Republic of India:
(PRANAB
MINISTER
OF
EXCHANGE OF INFORMATION
Article 26
[Reference: DTAA Between Nepal & India]
1. The competent authorities of the Contracting States shall exchange such information,
including documents or certified copies thereof, as is foreseeably relevant for carrying out the
provisions of this Agreement or to the administration or enforcement of domestic laws
concerning taxes of every kind and description imposed on behalf or of their political
subdivisions or local authorities, insofar as the taxation thereunder is not contrary to the
Agreement. The exchange of information is not restricted by Articles 1 and 2.
2. Any information received under paragraph 1 by a Contracting State shall be treated as
secret in the same manner as information obtained under the domestic laws of that
Contracting State and shall be treated as secret in the same manner as information obtained
under the domestic laws of that State and shall be disclosed only to persons or authorities
(including courts and administrative bodies) concerned with the assessment or collection of,
the enforcement or prosecution in respect of, or the determination of appeals in relation to the
taxes referred to in paragraph 1, or the oversight of the above. Such persons or authorities
shall use the information only for such purposes. They may disclose the information in public
court proceedings or in judicial decisions. Notwithstanding the foregoing, Information
received by a Contracting States may be used for other purposes when such information may
be used for such other purposes under the laws of both States and the competent authority of
the supplying Contracting States authorizes such use.
3. In no case shall the provisions of paragraphs 1 and 2 be construed so as to impose on a
Contracting State the obligation:
(a) To carry out administrative measures at variance with the laws and administrative practice
of that or of the other Contracting State;
(b) To supply information including documents and certified copies thereof which is not
obtainable under the laws or in the normal course of the administration of that or of the other
Contracting State;
(c) To supply information which would disclose any trade, business, industrial, commercial
or professional secret or trade process, or information, the disclosure of which would be
contrary to public policy (ordre public).
4. If information is requested by a Contracting State in accordance with this Article, the other
Contracting State shall use its information gathering measures to obtain the requested
information, even though that other State may not need such information for its own tax
purposes. The obligation contained in the preceding sentence is subject to the limitations of
paragraph 3 but in no case shall such limitations be construed to permit a Contracting State to
decline to supply information solely because it has no domestic interest in such information.
The Institute of Chartered Accountants of Nepal
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Contracting State shall only be brought before the courts or administrative bodies of that
State. Nothing in this Article shall be construed as creating or providing any right to such
proceedings before any court or administrative body of the other Contracting State.
7. Where, at any time after a request has been made by a Contracting State under paragraph 3
or 4 and before the other Contracting State has collected and remitted the relevant revenue
claim to the first-mentioned State, the relevant revenue claim ceases to be
(a) in the case of a request under paragraph 3, a revenue claim of the first mentioned State
that is enforceable under the laws of that State and is owed by a person who, at that time,
cannot, under the laws of that State, prevent its collection, or
(b) in the case of a request under paragraph 4, a revenue claim of the first mentioned State in
respect of which that State may, under its laws, take measures of conservancy with a view to
ensure its collection, the competent authority of the first-mentioned State shall promptly
notify the competent authority of the other State of that fact and, at the option of the other
State, the first-mentioned State shall either suspend or withdraw its request.
8. In no case shall the provisions of this Article be construed so as to impose on a Contracting
State the obligation:
(a) to carry out administrative measures at variance with the laws and administrative practice
of that or of the other Contracting State;
(b) to carry out measures which would be contrary to public policy (ordre public);
(c) to provide assistance if the other Contracting State has not pursued all reasonable
measures of collection or conservancy, as the case may be, available under its laws or
administrative practice;
(d) to provide assistance in those cases where the administrative burden for that State is
clearly disproportionate to the benefit to be derived by the other Contracting State.
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(corresponding to 1st day of Shrawan month of the Nepalese B.S.) next following the
calendar year in which the Agreement enters into force; and
(b) In India, in respect of income derived in any fiscal year beginning on or after the first day
of April next following the calendar year in which the Agreement enters into force.
4. The agreement between the Government of the Republic of India and His Majesty's
Government of Nepal for the Avoidance of Double Taxation and Prevention of Fiscal
Evasion with respect to Taxes on Income signed at Kathmandu on the 8th day of January,
1987 shall cease to have effect when the provisions of this Agreement become effective in
accordance with the provisions of paragraph 3, provided that any action or proceedings
already initiated prior to the coming into force of this Agreement shall be dealt with in
accordance with the Agreement for the Avoidance of Double Taxation and Prevention of
Fiscal Evasion with Respect to Taxes on Income Signed at Kathmandu on January 8, 1987.
TERMINATION
Article 31
[Reference: DTAA Between Nepal & India]
This Agreement shall remain in force until terminated by a Contracting State. Either
Contracting State may terminate the Agreement, through diplomatic channels, by giving
notice of termination at least six months before the end of any calendar year beginning after
the expiration of five years from the date of entry into force of the Agreement. In such event,
the Agreement shall cease to have effect:
(a) In Nepal, in respect of income derived in any fiscal year on or after the mid July
(corresponding to 1st day of Shrawan month of the Nepalese B.S.) next following the
calendar year in which the notice is given.
(b) In India, in respect of income derived in any fiscal year on or after the first day of April
next following the calendar year in which the notice is given;
IN WITNESS WHEREOF the undersigned, duly authorized thereto, have signed this
Agreement.
DONE in duplicate at Kathmandu on this 27th day of November 2011, each in the Nepali,
Hindi and English languages, all texts being equally authentic. In case of divergence of
interpretation, the English text shall prevail.
For the Government of
the
Nepal:
(BARSHA MAN PUN)
MUKHERJEE)
MINISTER OF FINANCE
FINANCE
OF
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Notwithstanding the above, there are also business restructurings which involve the allocation
of more intangibles andmore risks to operational units (manufacturers and distributors).
Moreover, there are business restructurings consisting of the rationalization, specialization or
de specialization of operations, such as: research and development, manufacturing
processes, manufacturing sites, distribution activities, marketing services etc.
However, independently of the business restructuring forms and reasons, there are certain
typical transfers that might arise when such restructurings are put in place, as follows:
transfer of tangible assets, transfer of intangible assets and transfer of activities (ongoing
concern). Another feature common to all business restructurings is the fact that such a
process always involves the reallocation of profits among the entities within the group, either
immediately after the restructuring or over certain years.
Typically, the profitability of an entity depends on the functions performed and risk assumed
(meaning that the higher are functions performed and risk assumed, the higher is the
profitability), as presented by the below figure:
Functions
&
Risks
x
x
x
x
x
x
Reward
Figure1. Relation profitability risks & functions
In the bellow paragraphs there will be presented the most important characteristics, (from a
tax and transfer pricing perspective) of manufacturer and sales business models
A. Manufacturer models
Manufacturing is the process of transformation from raw materials into finished goods. As
presented in the chart below, manufacturing is generally performed in one of three
risk/function models recognized for transfer pricing purposes: toll manufacturing, contract
manufacturing and fully fledged manufacturing.
Reward belonging to the Principal
Fully Fledged
Manufacturer
Contract
Manufacturer
Toll
Manufacturer
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processing raw materials following the specification and clearly instruction of the principal.
The toll manufacturer does not become the owner of the raw-materials, work-in-progress or
goods manufactured; it has no responsibility for production scheduling, procurement of raw
material, quality control, distribution, logistic or revenues collections (Adams & Graham,
1999). Thus, such an entity assumes neither inventory risk and usually owns no valuable
intangible (just routine manufacturing/processing skills). The transfer prices used for
remunerating the operations performed by a toll manufacturer can be determined by using the
costplus method or the transactional net margin method (assuming that the comparable
uncontrolled price method CUP, cannot be used).
A contract manufacturer generally provide manufacturing functions based on a written
agreement, becomes the owner of the raw materials and the finished products and is
responsible for processing the raw materials (quality control). The contract manufacturer
bears the inventory risk, and generally bears more risks and responsibilities than a toll
manufacturer, however, the procurement decisions, production scheduling and logistics
remain with the principal. Also, the contract manufacturer does not hold valuable intangibles.
As in case of a toll manufacturer, the transfer prices used for remunerate a
contractmanufacturer might be determined by applying the cost-plus method or the
transactional net margin method (assuming that the comparable uncontrolled price method
CUP, cannot be used).
A fully fledged manufacturer typically assumes all the relevant functions related to the
production process (sourcing and purchasing raw materials, finding clients, R&D - use of
intangibles, production schedule, quality control, logistics) and also the associated risks
(inventory risk, market risk, warranty risk etc). If the fully fledge manufacturer and the
distributor with which it transacts use valuable intangible, the most appropriate method to be
used for determining the transfer prices is the profit split method.
B. Sales models
The sales or distribution represent the process by which a product/service is passed through
the business system to the end-consumer. As in the manufacturer case, there are different
types of distributors (depending on functions performed, risks assumed and assets used), as
presented in the chart below:
Fully
Stripped
Commissionaire
Commission
Buy/Sell
Buy/Sell
Agent
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activity performed by the commission agent is typically based on the cost-plus method
(assuming that the CUP method cannot be used), or a commission (percentage) on the sales.
A commissionaire is similar with the commission agent, with the difference that it sells the
goods on behalf of the principal but in its name. The commissionaire does not become the
owner of the goods and does not bear any inventory risk. The transfer prices used for
remunerate a commissionaire might be determined by applying the resale-price method or the
transactional net margin method (assuming that the comparable uncontrolled price method
CUP, cannot be used).
A stripped buy/sell distributor is similar to fully fledged distributor, with the difference that
the former is stripped of certain functions and risks. The stripped buy/sell distributor become
the owner of the goods sold (immediately prior to the sale to the client) and thus bears certain
limited inventory risks. Also, the distributor acts in its account and in its name. As in case of
a commissionaire, the transfer prices used for remunerate a stripped buy/sell distributor might
be determined by applying the resale-price method or the transactional net margin method
(assuming that the comparable uncontrolled price method CUP, cannot be used).
A fully fledge distributor is acting more autonomously than a stripped distributor; the activity
performed is decentralized, with little or no central control or consistency.
Other transfer pricing aspects relevant for business restructurings
In order for a business restructuring to be in compliance with the transfer pricing rules, then,
these rules have to be respected both by the restructuring itself and by the post restructuring
transactions as well.
The arms length principle (which is the international standard that OECD member countries
have agreed should be used for establishing transfer prices for tax purposes) treats the entities
within a group as separate units rather than inseparables parts of a single business.
Consequently, for transfer pricing purposes, it is not enough that a restructuring process
makes operational and commercial sense for the group as a whole, but the process should be
arms length at the level of each individual entity (taxpayer).
10.2.3 Provision of Income Tax Act, 2058
The provison of transfer pricing between associated person and other agreement is mentioned
in Section 33 of Income Tax Act, 2058.
In any arrangements between associated persons, operated by them according to general
market practice ( At arms length), Inland Revenue Department (IRD), by a notification in
writing, distribute, apportion, or allocate the amounts to be included or deducted in the
income between the persons as to reflect their taxable income or tax liability.
IRD or IRO may, in the process of notification:
a. Re-charaterized the source and type of any income , loss, and amount of payment: or
b. Allocate costs , including the head office expenses, incurred by one person in
conducting a business the benefits an associate or associates also in conducting their
business, based on the comparative turnover of the business.
TP is an arrangement of transferring the profit by way of cost rather by repatriation of income
after paying corporate/ individual tax. It generally happens between associated parties where
the resulting loss and profit from the arrangement go to the same person.
As per this provision, it is applicable to transactions within country and international
transactions too, but transaction should be among associated persons.
10.2.4 Transfer Pricing with Unrelated Party
It is covered by Other Arrangement mentioned in section 33 of Income Tax Act, 2058.
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Even though the transaction is between an enterprise and an unrelated enterprise, since there
is a prior agreement between the unrelated enterprise and the associated enterprise or the
terms of the transaction are determined in substance between such unrelated enterprise and
the associated enterprise, Transfer Pricing provisions are applicable to this transaction. To
illustrate, if X has entered into a transaction with a non-associated person, say A Ltd. and
there exists a prior agreement in relation to this transaction between A Ltd. and Y (an
associated enterprise of X); or the terms of this transaction are determined in substance
between A Ltd. and Y, then the transaction between A Ltd. and X would be deemed to be an
international transaction.
10.2.5 Associated Person
As per section 2 of Income Tax Act 2058, Associated Persons means two or more persons or
group of such persons where one may reasonably be expected to act in accordance with the
intentions of the other and includes(1) an individual and a relative of the individual or an individual and a partner of the
individual;
(2) a foreign permanent establishment and its owner; and
(3) an entity and a person who, either alone or together with an associate or associates
controls or may benefit from 50 percent or more of the rights to income, capital, or voting
power of the entity, as the case requires, either directly or through one or more interposed
entities; or a person who is an associate of such person.
provided that, the term does not include the following persons
(1) employee and
(2) persons prescribed by the department as not being associate persons.
Again, Relative means a spouse, children (including adopted children) parent, grandparent,
sibling, aunt, uncle, nephew, niece, grandson, granddaughter, brother in laws, sister in laws,
father in laws and mother in laws of an individual.
10.2.6 Arms-length price
The provisions require any income arising from an transaction with an associated person
must be computed having regard to the arms length price . Further, costs or expenses
allocated or apportioned between two or more associated enterprises should be determined
having regard to arms-length prices (Income Tax Act).
Though, Arms Length price means a price of transaction between the buyer and sellers of a
product or service at independently and have no relationship to each other. The concept of an
arms length transaction is to ensure that both parties in the deal are acting in their own selfinterest and are not subject to any pressure or stress from other party in any means.
10.2.7 Computation of arms-length price
The arms-length price in relation to an transaction is to be determined using the most
appropriate method out of the specified methods, having regard to the nature or class of
transaction or class of associated persons or functions performed by such persons or other
relevant factors. The methods specified may be as under:
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Rs 3,000
Rs 820
Rs 2,180
Rs 2,00,00,000
Rs 2,18,00,000
Rs 18,00,000
Rs 3,000
Rs 360
Rs 35
Rs 10
Rs 2,595
Rs 29,00,000
Rs 25,95,000
Rs 3,05,000
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Requried:
What is the Arms Length Price on above transaction of NLL to HLL?
Answer
Priced Charged to Domestic Customer
Gross Profit on Cost at Domestic Sale (A)
50%
Less:
Differences to be adjusted
Technology Support ( 20% of 50 %)
10%
Discount (10% of 50%)
Further Cost (10% of 50%)
5%
Total(B)
Add:
Cost of credit to HLL
(3% of 50%)(C)
Arms Length Gross Profit (A-B+C)
1500
5%
20%
1.5%
31.5%
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Here, The total cost of product to NLL (D)= Rs4,250,000 (5000kg* Rs 850)
Domestic Selling Price
= Rs7500000(5000*1500)
Transaction Price to HLL
= Rs5,000,000 (5000kg* Rs 1000)
Arms Length Price( D+D*31.5%) =4250000+4250000*31.5%)
=Rs5,588,750 ( Not 75 Lacs)
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$ 5,000
$ 2,000
$ 3,000
$ 9,500
$ 14,500
transactions which lay down explicitly or implicitly how the responsibilities, risks and
benefits are to be divided between the respective parties to the transactions; and
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conditions prevailing in the markets in which the respective parties to the transactions
operate, including the geographical location and size of the markets, the laws and
government orders in force, costs of labour and capital in the markets, overall
economic development and level of competition and whether the markets are
wholesale or retail.
the class or classes of associated enterprises entering into the transaction and the
functions performed by them taking into account assets employed or to be employed
and risks assumed by such enterprises;
method;
uncontrolled transaction and between the enterprises entering into such transactions;
the extent to which reliable and accurate adjustments can be made to account for
differences, if any, between the international transaction and the comparable
uncontrolled transaction or between the enterprises entering into such transactions;
and
the nature, extent and reliability of assumptions required to be made in application of
a method.
Arithmetic mean
It is also internationally practiced that where more than one price is determined by the most
appropriate method, the arms-length price shall be the arithmetical mean of such prices.
Further, In some country it provides that where the variation between the arms length price
so determined and price at which the international transaction has actually been undertaken
does not exceed certain percent of the latter, the price at which the international transaction
has actually been undertaken shall be deemed to be the arms length price.
Example
An international transaction was carried out at Rs 1175. The following arms length prices
have been determined by the most appropriate method:
Price 1: Rs1150
Price 2: Rs 1185
Price 3: Rs 1260
Price 4: Rs 1290
Allowed variation 3%
The Institute of Chartered Accountants of Nepal
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Required:
a) What is the Arms length Price on that transaction?
b) What is the Arm's length price on above transaction if transaction price is Rs 1190?
Answer a:
Arithmetic Mean= (1150+1185+1260+1290)/4
=1221.25
3% on Actual Transaction Price = 1175*3%
= 35.25
Now, The difference between Arithmetic mean & transaction price= 1221.25-1175
= 46.25
Since, the difference above is more than allowed variation 3% i.e Rs 35.25<46.25, arms
length price is Rs 1221.25.
Answer b
Arithmetic Mean
= 1221.25
Allowed Variation
= 35.7 (1,190 x 3%)
Actual Variation
= 31.25(1,221.25 - 1190)
Since the difference between arms length price calculated by arithmetic mean and
transaction price is not exceeding the allowed variation, the arms length price for the
transaction is Rs 1190.
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Some arbitrary cost apportionment may still be required for cost like rent, rates and
building depreciation.
b)
Single cost driver may not explain the cost behavior of all items in its associated pool.
c)
Every cost may not have an identifiable cost driver like what drivers the cost of annual
external audit?
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d)
e)
The cost of implementing and maintaining an ABC system can exceed the benefits of
improved accuracy.
f)
Implementing ABC may be problematic. Recent journal articles have highlighted issues
like incorrect belief that ABC can solve all an organization's problems and difficulty in
determining appropriate cost drivers.
g)
ABC is relatively new technique and as such management is not familiar with its
principles and methods and as such may be reluctant to introduce the system.
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upcoming budgetary period can the organization hope to draft a budget that is truly practical
and likely to meet the needs of the organization over the course of the upcoming period.
COST AUDIT
Cost Audit represents the verification of cost accounts and check on the adherence to cost
accounting plan. Cost Audit ascertain the accuracy of cost accounting records to ensure that
they are in conformity with Cost Accounting principles, plans, procedures and objective. Cost
Audit comprises following;
1. Verification of the cost accounting records such as the accuracy of the cost accounts,
cost reports, cost statements, cost data and costing technique and
2. Examination of these records to ensure that they adhere to the cost accounting
principles, plans, procedures and objective.
Cost Audit is a critical review undertaken to verify the correctness of Cost Accounts and to
check that cost accounting principles and planning have been efficiently followed.
Important aspects of cost audit:
(i) The objects of cost accounting with reference to which the cost accounting plan must
have been drawn up have to be kept in mind to see whether or not the plan itself and
the figures collected will lead to the achievement of the goal or objective set. For
instance, if the objective is to achieve maximum efficiency, the plan and the analysis
of data will be different from the case where the only objective is to fix prices.
(ii) It has to be examined whether the methods laid down for ascertaining costs and other
relevant decisions are being implemented. Treatment and determination of abnormal
losses or gains or treatment of certain expenses as direct or indirect are cases in point.
(iii) The correctness of the figures has to be vouched.
(iv) The chief advantage of cost audit will be that management will be sure to get reliable
data for its objectives price fixing, decision-making, control, etc. Existence of such
a system of audit will also be of great use for maintaining internal check and control
and will be of great help to even financial audit. But it must be understood that the
aims of financial and cost audit are different.
The former aims at prevention of frauds and errors and with presentation of Profit and
Loss Account and Balance Sheet which exhibit a true and fair view of the state of
affairs (of profit earned during the year and of financial position at the end of the year).
It is concerned with totality of expenditure and revenue rather than its functional
analysis.
Cost Audit will establish the accuracy of cost of each product, job, activity, etc., and is
concerned with proper analysis of information and its estimation so that management
gets the necessary information promptly. Apart from reliability of data, cost audit
should afford certain incidental advantages. Rather, it should be said that cost audit
will help consolidate and realize advantages expected from a system of costing.
v) A close check will be maintained on all wastagesmaterials in store, labour, etc.and
they will be promptly located and reported.
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vi) Inefficiencies in production (or efficiencies) will be located and converted into
monetary terms.
vii) Through fixation of individual responsibility, management by exception will be
possible.
viii) The system of budgetary control and standard costing will be greatly facilitated with
cost audit at the hands of a qualified cost accountant.
ix) Records will be up-to-date and information for various purposes will be available.
x) Cost audit may detect a number of errors and frauds which may not be revealed
otherwise. This is because a cost auditor examines expenditure minutely and compares
it with standards and ascertains exact reasons for discrepancy.
Purpose of Cost Audit
The main purposes of cost audit are as under:
i)
To establish the accuracy of costing data. This is done by verifying the arithmetical
accuracy of cost accounting entries in the books of accounts.
ii)
To ensure that cost accounting principles are governed by the management objectives
and these are strictly adhered in preparing cost accounts.
iii)
To ensure that cost accounts are correct and also to detect errors, frauds and wrong
practice in the existing system.
iv)
To check up the general working of the costing department of the organization and to
make suggestions for improvement.
v)
To help the management in taking correct decisions on certain important matters i.e to
determine the actual cost of production when the goods are ready.
vi)
To reduce the amount of detailed checking by the external auditor if effective internal
cost control system is in place.
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CAP III
(ii)
Cost audit can serve to measure performance of managers and better performance
can be rewarded.
(iii)
It helps to prepare accurate cost reports and thus business planning can be more
accurate.
(iv)
Inter-firm comparisons can be made with ease and this might be a very useful
proposition if industrial intelligence is good.
(v)
Cost audit can give an idea about the comparative operational efficiency of each
department of division; and may thus pin-point deficiencies and also encourage to
operate in a competitive spirit.
His task is facilitated since errors, deficiencies, etc., are pointed out. Costing plans
can be prepared to take care of these things.
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CAP III
(ii)
Cost audit may help in easier reconciliation of cost and financial accounts.
(iii)
If the cost auditor is an outsider and is an expert, he can certainly give some
practical and sound advice to streamline costing systems and organisation.
(iv)
Cost audit helps to focus attention of management on the problems faced by the cost
accountant. This helps him to realize his goals and objectives with ease.
Audited cost data helps him to determine the value of stocks, remuneration of
managerial personnel, etc., with ease and accuracy.
(ii)
Data and statements of cost audit help him to prepare his audit programme and plan
so that he concentrates more on those aspects which have not been adequately
covered by cost audit.
Advantages to Consumers:
(i)
The direct benefit accrues where a statutory cost audit has been done to fix a
reasonable price for the consumers.
(ii)
Since cost audit aims at ensuring efficiency in the organisation, this may also get
reflected in reduced prices to the consumers.
Advantages to Labour:
(i) If cost audit is done thoroughly labour also stands to gain through increased
profitability in the shape of bonus and other benefits.
(ii) Also it brings into focus the role of labour in improving efficiency in term of
increased productivity.
Advantages to Shareholders:
(i) There is correct valuation of all kinds of inventories. This may project a true picture
of the organisation before shareholders and other investors and help them to assess its
performance.
(ii) External cost audit highlights efficiency or inefficiency, utilisation of manpower and
other resources, adequacy of return, etc.
Advantages to Government and Economy:
(i) It helps the government to settle accounts where cost-plus contracts have been made.
(ii) The government can intervene to protect the interests of the consumers, labor,
shareholders and investors from exploit-age or inefficient managements.
(iii) At the national level, cost audit promotes cost consciousness and overall efficiency.
This means that every rupee invested produces the maximum quantity of goods and
services.
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CAP III
It verifies that the cost accounts have been correctly maintained and prepared
according to the system of cost accounting employed by the concern so as to serve
both cost ascertainment and cost control functions.
ii)
It ensures that the costing plan laid down i.e. prescribed routine of cost accounting is
being carried out.
iii)
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CAP III
Identify Problems
The first step in the process is to recognize that there is a decision to be made. Decisions are
not made arbitrarily; they result from an attempt to address a specific problem, need or
opportunity.
A supervisor in a retail shop may realize that he has too many employees on the floor
compared with the day's current sales volume, for example, requiring him to make a decision
to keep costs under control.
2.
Seek Information
Managers seek out a range of information to clarify their options once they have identified an
issue that requires a decision. Managers may seek to determine potential causes of a problem,
the people and processes involved in the issue and any constraints placed on the decisionmaking process.
3.
Possible solutions
Having a more complete understanding of the issue at hand, managers move on to make a list
of potential solutions. This step can involve anything from a few seconds of though to a few
months or more of formal collaborative planning, depending on the nature of the decision.
4.
Choose an alternate
Managers weigh the pros and cons of each potential solution, seek additional information if
needed and select the option they feel has the best chance of success at the least cost.
Consider seeking outside advice if you have gone through all the previous steps on your own;
asking for a second opinion can provide a new perspective on the problem and your potential
solutions.
5.
There is no time to second guess yourself when you put your decision into action. Once you
have committed to putting a specific solution in place, get all of your employees on board and
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CAP III
put the decision into action with conviction. That is not to say that a managerial decision
cannot change after it has been enacted; savvy managers put monitoring systems in place to
evaluate the outcomes of their decisions.
6.
Evaluate outcomes
Even the most experienced business owners can learn from their mistakes. Always monitor
the results of strategic decisions you make as a small business owner; be ready to adapt your
plan as necessary, or to switch to another potential solution if your chosen solution does not
work out the way you expected.
BEHAVIORAL STUDY OF COSTS FOR DECISION MAKING
Understanding the behavior of costs is of vital importance to managers. Understanding how
costs behave, whether costs are relevant to specific decisions, and how costs are affected by
income taxes allows managers to determine the impact of changing costs and other factors on
a variety of decisions.
We defined and determined the cost of a product or a service. We now focus our attention on
the nature of those costs and how they are used in decision making. As production volume
changes, some costs may increase or decrease and other costs may remain stable, but specific
costs behave in predictable ways as volume changes. This concept of predictable cost
behavior based on volume is very important to the effective use of accounting information for
managerial decision making.
The Behavior of Fixed and Variable Costs
Fixed costs are costs that remain the same in total but vary per unit when production volume
changes. Facility-level costs, such as rent, depreciation of a factory building, the salary of a
plant manager, insurance, and property taxes, are likely to be fixed costs. Summarizing this
cost behavior, fixed costs stay the same in total but vary when expressed on a per unit basis.
On the other hand, variable costs vary in direct proportion to changes in production volume
but are constant when expressed as per unit amounts. As production increases, variable costs
increase in direct proportion to the change in volume; as production decreases, variable costs
decrease in direct proportion to the change in volume. Examples include direct
material, direct labor (if paid per unit of output), and other unit-level costs, such as factory
supplies, energy costs to run factory machinery, and so on.
a cost that varies in direct proportion to changes in volume requires a linear (straight-line)
relationship between the cost and volume. However, in reality costs may behave in a
curvilinear fashion. Average costs or cost per unit may increase or decrease as production
increases.
Step Costs
Classification of costs is not always a simple process. Some costs vary but only with
relatively large changes in production volume. Batch-level costs related to moving materials
may vary with the number of batches of product produced but not with every unit of product.
Product-level costs associated with quality control inspections may vary when new products
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CAP III
are introduced. Costs like these are sometimes referred to as step costs. In practice, step costs
may look like and be treated as either variable costs or fixed costs. Although step costs are
technically not fixed costs, they may be treated as such if they remain constant within a
relatively wide range of production.
Mixed cost
Mixed costs present a unique challenge because they include both a fixed and a variable
component. Consequently, it is difficult to predict the behavior of a mixed cost as production
changes unless the cost is first separated into its fixed and variable components. Once we
know that a cost is mixed, we are left with the task of separating the mixed cost into its fixed
and variable components.
A variety of tools can be used to estimate the fixed and variable components of a mixed cost.
When we separate a mixed cost into its variable and fixed components, what we are really
doing is generating the equation for a straight line, with the y intercept estimating the fixed
cost and the slope estimating the variable cost per unit.
Cost Behavior and Activity-Based Costing
So far, we have examined the behavior of unit-level costs related to changes in production
volume. However, costs are affected by changes in other cost drivers as well. The concept of
activities as procedures or processes that cause work to be accomplished (purchasing,
receiving, production, plant occupancy, etc.) and cost drivers as allocation bases that cause,
or drive, the incurrence of costs. Some of these drivers are related to volume (machine hours
and labor hours), but drivers of batch- and product-level costs are more likely related to the
complexity of a product (number of parts, number of inspections) or product diversity
(number of setups, number of purchase orders). Although these costs may not vary in direct
proportion to volume, they may vary in direct proportion to other cost drivers. Regression
analysis can be used to help managers identify the best cost drivers of activities for use in
activity-based costing. For example, the activity of processing customer orders might vary
with the number of orders or the number of customers. Regression analysis can be used to
identify which of the two possible independent variables better explains the variation in the
dependent variable (costs of placing customer orders).
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CAP III
As consumers, we buy millions of products every year. And just like us, these products have
a life cycle. Older, long-established products eventually become less popular, while in
contrast, the demand for new, more modern goods usually increases quite rapidly after they
are launched.
Because most companies understand the different product life cycle phases, and that the
products they sell all have a limited lifespan, the majority of them will invest heavily in new
product development in order to make sure that their businesses continue to grow.
PRODUCT LIFE CYCLE PHASES EXPLAINED
The product life cycle has 4 very clearly defined phases, each with its own characteristics that
mean different things for business that are trying to manage the life cycle of their particular
products.
Introduction Phase This phase of the cycle could be the most expensive for a company
launching a new product. The size of the market for the product is small, which means sales
are low, although they will be increasing. On the other hand, the cost of things like research
and development, consumer testing, and the marketing needed to launch the product can be
very high, especially if its a competitive sector.
Growth Phase The growth phase is typically characterized by a strong growth in sales and
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CAP III
profits, and because the company can start to benefit from economies of scale in production,
the profit margins, as well as the overall amount of profit, will increase. This makes it
possible for businesses to invest more money in the promotional activity to maximize the
potential of this growth stage.
Maturity Phase During the maturity phase, the product is established and the aim for the
manufacturer is now to maintain the market share they have built up. This is probably the
most competitive time for most products and businesses need to invest wisely in any
marketing they undertake. They also need to consider any product modifications or
improvements to the production process which might give them a competitive advantage.
Decline Phase Eventually, the market for a product will start to shrink, and this is whats
known as the decline phase. This shrinkage could be due to the market becoming saturated
(i.e. all the customers who will buy the product have already purchased it), or because the
consumers are switching to a different type of product. While this decline may be inevitable,
it may still be possible for companies to make some profit by switching to less-expensive
production methods and cheaper markets.
PRODUCT LIFE CYCLE EXAMPLES
Its possible to provide examples of various products to illustrate the different stages of the
product life cycle more clearly. Here is the example of watching recorded television and the
various stages of each method:
1.
2.
3.
4.
Introduction 3D TVs
Growth Blueray discs/DVR
Maturity DVD
Decline Video cassette
The idea of the product life cycle has been around for some time, and it is an
important principle manufacturers need to understand in order to make a profit and stay in
business.
However, the key to successful manufacturing does not just understand this life cycle, but
also proactively managing products throughout their lifetime, applying the appropriate
resources and sales and marketing strategies, depending on what stage products are at in the
cycle.
NEW PRODUCT DEVELOPMENT STAGES
Developing a new product involves a number of stages which typically center on the
following key areas:
The Idea: Every product has to start with an idea. In some cases, this might be fairly simple,
basing the new product on something similar that already exists. In other cases, it may be
something revolutionary and unique, which may mean the idea generation part of the process
is much more involved. In fact, many of the leading manufacturers will have whole
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departments that focus solely on the task of coming up with the next big thing.
Research: An organization may have plenty of ideas for a new product, but once it has
selected the best of them, the next step is to start researching the market. This enables them to
see if theres likely to be a demand for this type of product, and also what specific features
need to be developed in order to best meet the needs of this potential market.
Development: The next stage is the development of the product. Prototypes may be modified
through various design and manufacturing stages in order to come up with a finished product
that consumers will want to buy.
Testing: Before most products are launched and the manufacturer spends a large amount of
money on production and promotion, most companies will test their new product with a small
group of actual consumers. This helps to make sure that they have a viable product that will
be profitable, and that there are no changes that need to be made before its launched.
Analysis: Looking at the feedback from consumer testing enables the manufacturer to make
any necessary changes to the product, and also decide how they are going to launch it to the
market. With information from real consumers, they will be able to make a number of
strategic decisions that will be crucial to the products success, including what price to sell at
and how the product will be marketed.
Introduction: Finally, when a product has made it all the way through the new product
development stage, the only thing left to do is introduce it to the market. Once this is done,
good product life cycle management will ensure the manufacturer makes the most of all their
effort and investment.
Thousands of new products go on sale every year, and manufacturers invest a lot of time,
effort and money in trying to make sure that any new products they launch will be a success.
Creating a profitable product isnt just about getting each of the stages of new product
development right, its also about managing the product once its been launched and then
throughout its lifetime.
This product life cycle management process involves a range of different marketing and
production strategies; all geared towards making sure the product life cycle curve is as long
and profitable as possible.
Characteristics of Product Life cycle
The major characteristics of product life cycle concept are as follows:
i)
The product has finite lives and passes through the cycle of development, introduction,
growth, maturity, decline and deletion at varying speeds.
ii)
Product cost, revenue and profit patterns tend to follow predictable courses through the
product life cycle. Profits first appear during the growth phase and after stabilizing
during the maturity phase, decline thereafter to the point of deletion.
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CAP III
iii)
Profit per unit varies as products move through their life cycles.
iv)
Each phase of the product life cycle poses different threats and opportunities that give
rise to different strategic actions.
v)
vi)
Finding new uses or new users or getting the present uses to increase their
consumption, this may extend the life of the product.
Product life cycle costing involves tracing of costs and revenues of each product over
several calendar periods throughout their entire life cycle. Costs and revenues can be
analysed by time periods, but the emphasis is on cost and revenue accumulation over
the entire life cycle for each product.
ii)
Product life cycle costing traces research and design and development cost etc.,
incurred to individual products over their entire life cycles, so that the total magnitude
of these costs of each individual product can be reported and compared with product
revenues generated in later periods.
Life cycle costing therefore ensures that costs for each individual product can be reported and
compared with product revenues generated in later periods. Hence the costs are made more
visible.
PRODUCT LIFE CYCLE MANAGEMENT
Just about all manufactured products have a limited life, and during this life they will pass
through four product life cycle stages; Introduction, Growth, Maturity and Decline. In each of
these stages manufacturers face a different set of challenges. Product life cycle management
is the application of different strategies to help meet these challenges and ensure that,
whatever stage of the cycle a product may be going through, the manufacturer can maximize
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The product life cycle costing results in earlier actions to generate revenue or to lower
costs than otherwise might be considered. There are a number of factors that need to be
managed in order to maximize return on a product.
ii)
Better decisions should follow from a more accurate and realistic assessment of
revenues and costs, at least within a particular life cycle stage.
iii)
Product life cycle thinking can promote long term rewarding in contrast to short term
profitability rewarding.
iv)
It provides an overall framework for considering total incremental costs over the entire
life span of a product, which in turn facilitates analysis of parts of the whole where cost
effectiveness might be improved.
SELF-EXAMINATION QUESTIONS
1.
2.
3.
What is product life cycle costing? What are the characteristics of Product life cycle
costing?
Explain briefly the phases in product life cycle.
Explain briefly the importance of Product life cycle costing.
PRACTICAL QUESTION
1.
Activities has been identified and the budget quantities for the three months ended 31st
March 2015 as follows:
Activities Cost
Product Design
Purchasing
Production
Packing
Distribution
Units of cost
8000
4000
12000
20000
120000
Note 1: this includes all design costs for new products released this period.
Note2: this includes a depreciation provision of Rs. 300000 of which Rs 8000 applies to 3
months depreciation on a straight line basis for a new product (NPD). The remainder applies
to other products.
New product NPD is included in the above budget. The following additional information
applies to NPD.
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CAP III
i)
Estimated total output over the product life cycle: 5000 units (4 years life cycle).
ii)
iii)
iv)
v)
Other product unit data: production time 0.75 machine hour: volume 0.4 cu meters:
weight 3 kg.
Required: Prepare a unit overhead cost for product NPD using an activity based approach
which includes an appropriate share of life cycle costs using the information provided above.
Solution
Product Life Cycle Cost (life 4 years)
Output: 5000
Description
Premanufacturing
Design Cost (2000000/8000*400)
Manufacturing
Purchase (200000/4000*100)
Production cost
Purchase (200000/4000*100)
Production cost
Other (12 lakhs/12000*0.75*5000)
Cost of machine:(Dep. 8000/3 month*48)
Post manufacturing
Packing(400000/20000*5000*0.4)
Distribution (600000/120000*3*5000)
Total Cost
No. of units
Cost per unit
Rs.
100000
50000
50000
375000
128000
40000
75000
818000
5000
163.6
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CAP III
2. Labour shortage
3. Plant capacity
4. Sales expectancy
5. Cash availability etc.
In case of key factor situation the procedures for decision making is as under;
a. Identify the key factor
b. Compute total contribution or contribution per unit of the product
c. Compute contribution per unit of the key factor i.e. contribution per hour, contribution per
kg of raw material
d. Rank the products based on contribution per unit of key factor
e. Allocate the key resources based on ranks given above.
Illustration 1. X ltd. which produces using the same raw material and production facilities,
provides you the following information
Product A
Product B
Rs
Rs
Selling price per unit
100
80
Material @ Rs 2 per kg
20
10
Labour @ Rs 3 per hour
15
30
Variable Overheads@ Rs 4 per machine hour
40
16
Total fixed Overheads: Rs 600000
Required: Comment on the profitability of each product when
a. Sales quantity is limited;
b. Sales value is limited;
c. Raw material is in short supply;
d. Labour hours are limited;
e. Production capacity (in terms of machine hours) is limited;
f. there are heavy demand conditions;
g. there are low demand conditions
Solution: Statement showing the contribution per unit of key factor
Particulars
Product A Rs
A. Selling price per unit
100
B. Less: Variable Cost
Material
20
Labour
15
Variable Overheads
40
Total Variable Cost
75
Contribution per unit (A-B)
25
P/V Ratio=Contribution/ Sales*100
25%
Contribution per kg of ram material
=Rs 25/10
=Contribution per unit of raw material/raw mat req.
=Rs 2.5
per unit
Contribution per labour hour
=Contribution per unit/Labour hours required per unit
Contribution per machine hour
=Contribution per unit/machine hours per unit
The Institute of Chartered Accountants of Nepal
=Rs 25/5
=Rs 5
=Rs 25/10
=Rs 2.5
Product B Rs
80
10
30
16
56
24
30%
=Rs 24/5
=Rs 4.8
=Rs 24/10
=Rs 2.4
=Rs 24/4
=Rs 6
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=Rs 600000/Rs
25
=Rs
600000/Rs24
a. When sales quantity is limited, product A is more profitable because its contribution per
unit is higher than that of product B.
b. When sales value is limited, Product B is more profitable because its P/V Ratio is higher
than that of Product A.
c. When raw material is in short supply product B is more profitable because its contribution
per kg of raw material is higher than that of product A.
d. When labour hours are limited product A is more profitable because its contribution per
labour hour is higher than that of product B.
e. When production capacity in terms of machine hours is limited, Product B is more
profitable because its contribution per machine hour is higher than that of product A.
f. When there are heavy demand conditions, product B is more profitable because its P/V
ratio is higher than that of product A.
g. When there is a low demand condition, Product A is more profitable because its Break
even point is lower than that of product B.
2.00
2.50
1.00
1.50
Machine hours
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CAP III
2.00
2.50
1.00
1.50
Contribution (Rs.)
1.00
1.00
0.50
1.00
From the above it is evident that the contribution of product A & B in absolute terms is the
same. However, when we link this contribution with the machine hour which is a key factor,
the product B gives more profit. As such, product B is to given preference over product
A.
Illustration:
A firm manufactures 5 products using the same raw material which is in short supply. By
examining the following information, show which product is to be chosen so that the profit
can be the maximum.
Sales (units)
Production (units)
Possible sales
Selling price per unit
Marginal cost per unit
Contribution per unit
Raw material required (kgs.)
Contribution against 1 kg.
Of raw material
A
1,500
2,000
1,500
4.00
3.00
1.00
2
Products
B
2,500
3,000
2,500
3.50
2.00
1.50
8
C
1,600
1,500
1,500
1.50
1.25
0.25
3
D
2,000
2,000
2,000
1.00
0.75
0.25
5
E
2,200
2,000
2,000
3.00
2.50
0.50
2
0.50
0.19
0.083
0.05
0.25
Solution:
When raw material is in short supply, the order in which production is to be undertaken is A,
E, B, C, D based on contribution per unit of the key factor.
Let us suppose that 5,000 kgs. of raw material is available. Our production pattern will be as
under:
Product
Sales
units
A
E
1,500
1,000
Material
Per unit
Kgs.
2
2
Total
Material
Kgs.
3,000
2,000
5,000
Contribution
Per unit
Rs.
1.00
0.50
Total
contribution
Rs.
1,500
500
2,000
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CAP III
capacity is limited. In such a situation, the firm should compute all the possible combinations
and select a price- mix which yields the maximum profitability.
Illustration
Sellaway Ltd. manufactures and markets 2 products A & B, the demand in the market of
which fluctuates with the prices quoted. As a result of the deliberations of its recent sales
conference the following data were agreed upon as a working basis:
Product
Selling price per unit Rs
Expected demand/ month Nos.
32
900
A
30
1000
28
1500
22
1600
B
20
18
2000 3000
8 labour hours are required to produce Product A and 4 labour hours to produce product B
and the maximum capacity of the factory is restricted to 20000 labour hours per month.
The cost structure per unit of production is as under:
Product
A
Rs
Direct material
B
Rs
4
Direct labour
Variable overheads
10
20
14
32
30
28
22
20
18
900
1000
1500
1600
2000
3000
7200
8000
12000
6400
8000
12000
20
20
20
14
14
14
12
10
Total Contribution
Possible combinations
Products
A
B
32
22
Contribution
Lab hrs
required
Rs
23600
13600
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32
32
30
30
30
28
28
28
20
18
22
20
18
22
20
18
22800
22800
22800
22000
22000
24800
24000
24000
15200
19200
14400
16000
20000
18400
20000
24000
Recommendations
The above computations show that the maximum contribution of Rs 24800 is possible at
18400 labour hours. Therefore, profitable price mix is A Rs 28 and B Rs 22.
PROFIT PLANNING
A firms performance is measured by the profit it makes. Profits of a firm depend upon a
large
number of factors. But, the most important factors are costs of manufacture, volume of sales
and selling price of the products.
The analytical technique employed to study the inter-relationship of cost, volume and price
and its impact on the behavior of profit is known as Cost-Volume Profit Analysis.
In the short-run, profit planning can be made with the use of CVP analysis. It helps the
management to achieve an ideal combination of costs and volume. This becomes possible
with the understanding of the implications of variable cost, fixed costs and volume. CVP
analysis helps the management in deciding the quantum of sales required to be made to avoid
losses, as well as reaching a particular level of sales to achieve the targeted amount of profit.
Utility of CVP Analysis: CVP analysis studies the relationship of cost-volume-profit at
different levels of output. This analysis is an important tool for profit planning. The three
factors of CVP analysis costs, volume and profit are interconnected and dependent on
one another.
For example, profits depend upon the selling price. Selling price, largely, depends upon cost
of production. Cost of production, in turn, depends upon volume of production. It is only the
variable costs that vary directly with production, whereas fixed costs remain constant,
regardless of the volume of production, in the short-run.
There is an opinion that business firms, rarely, operate at their break-even point. Therefore,
the break-even analysis is of very limited use to the management. This is incorrect. Reason is
many people consider CVP analysis and Break-even point are one and the same. It is not so.
The scope of CVP analysis is quite wide, while BEP is only a part of CVP analysis. Breakeven analysis provides answer how much sales are to be made to avoid losses.CVP analysis
provides not only this answer, as BEP is a part of it, but provides answers in many areas to
the management.
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CAP III
These are some of the intricate questions for which management can find answers with the
help of CVP analysis. All the above aspects have immense influence on the profitability of
the firm. CVP analysis is concerned with entire profit planning, as managements main thrust
is to build a good level of profit, at all times. This analysis provides the necessary insight to
the management to take suitable decisions for necessary and timely action. It is of great use
for profit planning, cost control and decision-making.
PARTICIPATIVE BUDGETING
Participative budgeting is a budgeting process under which those people impacted by a
budget are actively involved in the budget creation process.
This bottom-up approach to budgeting tends to create budgets that are more achievable than
are top-down budgets that are imposed on a company by senior management, with much less
participation by employees. Participatory budgeting is also better for morale, and tends to
result in greater efforts by employees to achieve what they predicted in the budget. However,
a purely participative budget does not take high-level strategic considerations into account, so
management needs to provide employees with guidelines regarding the overall direction of
the company, and how their individual departments fit into that direction.
When participative budgeting is used throughout an organization, the preliminary budgets
work their way up through the corporate hierarchy, being reviewed and possibly modified by
mid-level managers along the way. Once assembled into a single master budget, it may
become apparent that the submitted budgets will not work together, in which case they are
sent back down to the originators for another iteration, usually with guidelines noting what
senior management is looking for.
Because of the larger number of employees involved in participatory budgeting, it tends to
take longer to create a budget than is the case with a top-down budget that may be created by
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a much smaller number of people. The labor cost associated with creating such a budget is
also relatively high.
Another problem with participative budgeting is that, since the people originating the budget
are also the ones whose performance will be compared to it, there is a tendency for
participants to adopt a conservative budget with extra expense padding, so that they are
reasonably assured of achieving what they predict in the budget. This tendency is more
pronounced when employees are paid bonuses based on their performance against the budget.
This problem of budgetary slack can be mitigated by imposing a review of the budgets by
those members of management who are most likely to know when budgets are being padded,
and who are allowed to make adjustments to the budget as needed. Only by following this
approach can stretch goals be integrated into a budget.
Advantages
Participative budgeting is said to have the following advantages:
a. It promotes acceptance of budget target.
b. Through participative budgeting, an employee job is enriched and this leads to greater job
satisfaction.
c. It encourages more positive attitudes towards the organization as whole and higher levels
of morale.
d. Participation should help to decrease distortion of information.
TARGET COSTING
DEFINITION AND MEANING OF TARGET COSTING
Target Costing is defined as follows:
A product cost estimate derived by subtracting a desired profit margin from a competitive
market price. This may be less than the planned initial product cost, but will be expected to
be achieved by the time the product reaches the mature production stage.-CIMA
Terminology
Target costing is a pricing method used by firms. It is defined as "a cost management tool for
reducing the overall cost of a product over its entire life-cycle with the help of production,
engineering, research and design". A target cost is the maximum amount of cost that can be
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incurred on a product and with it the firm can still earn the required profit margin from that
product at a particular selling price.
In the traditional cost-plus pricing method, materials, labor and overhead costs are measured
and a desired profit is added to determine the selling price.
Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.
A lengthy but complete definition is "Target Costing is a disciplined process for determining
and achieving a full-stream cost at which a proposed product with specified functionality,
performance, and quality must be produced in order to generate the desired profitability at the
products anticipated selling price over a specified period of time in the future."
This definition encompasses the principal concepts: products should be based on an accurate
assessment of the wants and needs of customers in different market segments, and cost
targets should be what result after a sustainable profit margin is subtracted from what
customers are willing to pay at the time of product introduction and afterwards. These
concepts are supported by the four basic steps of Target Costing as under:
Japanese companies have developed target costing as a response to the problem of controlling
and reducing costs over the product life cycle.
The fundamental objective of target costing is to enable management to manage the business
to be profitable in a very competitive marketplace. In effect, target costing is a proactive cost
planning, cost management, and cost reduction practice whereby costs are planned and
managed out of a product and business early in the design and development cycle, rather than
during the later stages of product development and production.
Target costing is a system under which a company plans in advance for the price points,
product costs, and margins that it wants to achieve for a new product. If it cannot
manufacture a product at these planned levels, then it cancels the design project entirely.
With target costing, a management team has a powerful tool for continually monitoring
products from the moment they enter the design phase and onward throughout their product
life cycles. It is considered one of the most important tools for achieving consistent
profitability in a manufacturing environment.
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that customers are most likely to buy, and the amount they will pay for those features.
The team must learn about the perceived value of individual features, in case they
later need to determine what impact there will be on the product price if they drop one
or more features. It may be necessary to later drop a product feature if the team
decides that it cannot provide the feature while still meeting its target cost. At the end
of this process, the team has a good idea of the target price at which it can sell the
proposed product with a certain set of features, and how it must alter the price if it
drops some features from the product.
2. Calculate maximum cost. The company provides the design team with a mandated
gross margin that the proposed product must earn. By subtracting the mandated gross
margin from the projected product price, the team can easily determine the maximum
target cost that the product must achieve before it can be allowed into production.
3. Engineer the product. The engineers and procurement personnel on the team now take
the leading role in creating the product. The procurement staff is particularly
important if the product has a high proportion of purchased parts; they must determine
component pricing based on the necessary quality, delivery, and quantity levels
expected for the product. They may also be involved in outsourcing parts, if this
results in lower costs. The engineers must design the product to meet the cost target,
which will likely include a number of design iterations to see which combination of
revised features and design considerations results in the lowest cost.
4. Ongoing activities. Once a product design is finalized and approved, the team is
reconstituted to include fewer designers and more industrial engineers. The team now
enters into a new phase of reducing production costs, which continues for the life of
the product. For example, cost reductions may come from waste reductions in
production (known as kaizen costing), or from planned supplier cost reductions.
These ongoing cost reductions yield enough additional gross margin for the company
to further reduce the price of the product over time, in response to increases in the
level of competition.
Target Costing Pros and Cons
Target costing recognizes that a business doesn't have total control over pricing; price is
limited by what the market will pay. It also encourages -- requires, even -- businesses to
operate efficiently. On the other hand, target costing often requires a business to design its
entire production process for meeting the cost. That's a challenge for a small business that
doesn't have a dedicated development team. Target costing can also lead to corner-cutting -using cheap materials or skimping on workmanship in order to get the cost down to the
proper level.
TARGET COSTING PROCESS
The most common procedure of target costing is as follows:
a. Set target selling price based on customer expectations and sales forecast
b. Establish profit margin based on long term profit objectives and projected volumes
c. Determine target (or allowable) cost per unit (target selling price less required profit
margin)
d. Compare with the estimated current cost of new product
e. Establish cost reduction targets for each component and production activity , using
value engineering and value analysis.
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Methodology
Traditional costing involves first determining the total cost of the product (adding together
direct, indirect and fixed costs of the total production run, then calculating a per-unit cost and
adding an amount for expected profit (called the profit margin). In target costing, the profit
margin is subtracted from a set market price to determine a target cost. Then the production
procedures are centered around this cost. Essentially, target costing goes in the opposite
direction of traditional costing.
Benefits
Each method has benefits. Businesses like traditional costing for its simplicity. Little data is
required initially for cost-plus pricing, and later adjustments to the price can be made more
easily than with target costing. Target costing is praised for its efficiency and focus on
keeping costs low.
Drawbacks
Drawbacks of traditional costing include its tendency to underestimate costs and overestimate
profits, leading to wasteful spending and unprofitable products. It is also criticized for
inefficiency. Target costing is criticized for its complexity and rigidity. It requires much more
attention to the production life cycle. Traditional costing is better suited to process-oriented
businesses that use continuous production. Target costing is better suited to assemblyoriented businesses, such as car manufacturing.
SELF-EXAMINATION QUESTIONS:
1.
2.
3.
4.
What is target costing? What are the steps involved in target costing.
Explain the steps involved in target costing approach to pricing
Discuss the principal four steps in target costing.
Discuss target costing Vs traditional costing.
INTRODUCTION
If you are searching for a way to gain an edge on your competition, consider one of the
business world's most valuable tools: the value chain analysis.
Value chain analysis relies on the basic economic principle of advantage companies are
best served by operating in sectors where they have a relative productive advantage compared
to their competitors. Simultaneously, companies should ask themselves where they can
deliver the best value to their customers.
To conduct a value chain analysis, the company begins by identifying each part of its
production process and identifying where steps can be eliminated or improvements can be
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made. These improvements can result in either cost savings or improved productive capacity.
The end result is that customers derive the most benefit from the product for the cheapest
cost, which improves the company's bottom line in the long run.
SCOPE
The aspects of value chain analysis are addressed to managers and more specifically to
management accountants, who may lead efforts to implement value chain analysis in their
organizations.
The concepts, tools and techniques of value chain analysis apply to all those organizations
which produce and sell a product or provide a service.
VALUE CHAIN
To understand how to conduct a value chain analysis, a business must first know what its
value chain is. A value chain is the full range of activities including design, production,
marketing and distribution businesses go through to bring a product or service from
conception to delivery. For companies that produce goods, the value chain starts with the raw
materials used to make their products, and consists of everything that is added to it before it is
sold to consumers. The process of actually organizing all of these activities so they can be
properly analyzed is called value chain management. The goal of value chain management is
to ensure that those in charge of each stage of the value chain are communicating with one
another, to help make sure the product is getting in the hands of customers as seamlessly and
as quickly as possible.
MEANING AND DEFINITIONS
The idea of a value chain was first suggested by Michael Porter (1985) to depict how
customer value accumulates along a chain of activities that lead to an end product or service.
Porters definition: He described the value chain as the internal processes or activities a
company performs to design, produce, market, deliver and support its product. He further
stated that a firms value chain and the way it performs individual activities are a reflection
of its history, its strategy, its approach of implementing its strategy, and the underlying
economics of the activities themselves.
CLASSIFICATION OF BUSINESS ACTIVITIES FOR VCA
Porter classified business activities under two heads viz , primary activities line activities
and support activities. Primary activities are directly involved in transforming inputs into
outputs and delivery and after sales support to output. In other words they include:
Support activities are the activities which support primary activities. They are handled by the
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2.
3.
4.
Value chain is a useful method for locating superior skills and resources. A companys value
chain comprises of all the activities that the company undertakes to be able to serve its
customers. These activities can be categorized into primary and support activities. All
companies design, manufacture, market, distribute and service its products. When a
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company delineates its value chain, it can better locate and understand its sources of costs
and differentiation. A companys primary activities include in-bound logistics, warehousing,
manufacturing, marketing, out-bound logistics, selling, order processing, installation, and
repair.
Support activities are found within all these primary functions and include purchasing,
technology, human resource management and the companys infrastructure. They are not
defined within a given primary activity because they can be found in all of them. By
examining each value creating activity, a company can look for skills and resources that may
form the basis for low cost or differentiated strategy. The company also looks for linkage
between value creating activities.
For example, greater co-ordination between manufacturing and in-bound logistics may
reduce costs through lower inventory levels. Value chain analysis can extend to the value
chains of suppliers and customers. A company can reduce its costs or enhance its differential
positions by creating effective linkages between its value chain and those of its suppliers and
customersa company can reduce its inventory holding costs by enabling its supplier to
supply in smaller lot sizes, or its engineers can collaborate with suppliers engineers to
produce better quality products.
Value chain analysis provides an understanding of the nature and location of skills and
resources that provide the basis for competitive advantage. Operating costs and assets are
assigned to the activities of the value chain and improvements can be made and cost
advantage defended.
For example, if a companys cost advantage is based on its superior manufacturing facility,
it should always be willing to upgrade it, to maintain its position against competitors. But, if
a companys differential position is based upon skills in product design, it should always be
keen to hire the best designers and procure the latest design tools. The identification of
specific sources of advantage can lead to their exploitation in new markets where customers
place a similar high value on these resultant outcomes.
For a differential advantage to be realized, a company not only needs to provide customer
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value, but the value should also be superior to that provided by competitors. Besides creating
an effective marketing mix, a company also needs to react fast to changes in the market.
Using advanced telecommunications, companies receive sales information from around the
world 24 hours a day, every day of the year and react promptly to them.
VALUE CHAIN APPROACH FOR ASSESSING COMPETITIVE ADVANTAGES
Most of the firms define their mission as one of creating products or services. For these
firms the products or services generated are more important than any single step within their
value chain. These firms use the value chain approach to better understand and identify
which segment, distribution channel, price point, product differentiation, selling proposition
and value chain configuration will yield them the greatest competitive advantage.
The way the value chain approach helps these firms to assess competitive advantage
includes the use of following steps of analysis:
a) Internal Cost analysis- to determine the sources of profitability and the relative cost
positions of internal value creating processes.
b) Internal Differentiation Analysis- to understand the sources of differentiation (including
the cost) within internal value creating processes, and
c) Vertical linkage analysis- to understand the relationships and associated costs among
external suppliers and customers in order to maximize the value delivered to customers and
to minimize cost.
These types of analysis are not mutually exclusive. In fact, firms begin by focusing on their
internal operations and gradually widening their focus to consider their competitive position
within their industry. The value chain approach used for assessing competitive advantage is
an integral part of the strategic planning process.
STRATEGIC FRAMEWORK FOR VCA
Value chain is the linked set of value-creating activities all the way from basic raw material
sources for component suppliers through to the ultimate end-use product or service delivered
to the customer.
Porters described the value chain as the internal processes or an activity a company
performs to design, produce, market, deliver and support its product. He further stated that
a firms value chain and the way it performs individual activities are a reflection of its
history, its strategy, its approach of implementing its strategy, and the underlying economics
of the activities themselves. The business activities are classified in to primary activities
and support activities.
Primary activities are those activities which are involved in transforming the inputs in to
outputs, delivery and after sales service. Support activities are intended to support the
primary activities like for example procurement, human resources management, etc.
Value chain analysis requires a strategic framework or focus for organizing internal and
external information, for analyzing information, and for summarizing findings and
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recommendations. Because value chain analysis is still evolving, no uniform practices have
yet been established. However, borrowing recent concepts from strategists and organization
experts, three useful strategic frameworks for value chain analysis are:
Industry structure analysis;
Core competencies; and
Segmentation analysis.
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5. Resistance from employees: Value chain analysis is not easily understandable to all
employees and hence may face resistance from employees as well as managers.
6. Science vs. Art: Value chain analysis is not exact science. It is more art than preparing
precise accounting reports. Certain judgments and factors of analysis are purely subjective
and differ from person to person.
VALUE
CHAIN
ACCOUNTING
ANALYSIS
VS
CONVENTIONAL
MANAGEMENT
Information generated from the traditional management accounting systems, including cost
accounting, is generally unsuitable for value chain analysis for a variety of reasons.
Generally, traditional management accounting focuses on internal information. It often
places
excessive emphasis on manufacturing costs. It also assumes that cost reduction must be
found in the value-added process, i.e., selling price less the cost of raw material. Using a
value added approach can be misleading, since there are many other purchased inputs such
as engineering, maintenance, distribution and service. The value-added process starts too
late because it ignores linkages with suppliers, and stops too early because it ignores
linkages with customers. The value chain approach encompasses external and internal data,
uses appropriate cost drivers for all major value-creating processes, exploits linkages
throughout the value chain, and provides continuous monitoring of a firms strategic
competitive advantage.
Basis of
comparison
Focus
Traditional management
accounting
It focuses on internal information
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decisions
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Nature
Impact
1.Political-legal
2.Economic
3. social-cultural +
+
4. Technological +
+
5. Competitive
Environment
+
+
+
PEST-NG APPROACH
It is a model for external environment analysis.
PEST-NG approach is concerned with analysis if forces in the external environment it looks
at their future impact in the organization. PEST-NG comprises the following forces:
P = Political-legal forces
E = Economic forces
S = Socio-cultural forces
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T = Technology forces
N = Natural forces
G = Global forces
PEST-NG analysis help to identify future opportunity and threats to the organization.
Opportunity is a favorable condition in the environment. It enables an organization to
consolidate and strengthen its strategic position.
Threat is an unfavorable condition in the environment. It creates risks and causes
damages to the organizations strategies position.
PEST-NG analysis indicates what environmental forces are affecting the business and which
of them are the most important.
The important forces is PEST-NG are
P = Political: Political system, institutions, philosophies and pressure groups, legal
framework.
E = Economic system, policies, and conditions.
S = Socio institutions, demographics, social change, culture aspect such as altitudes,
values, beliefs,
religion, language. Level of technology
T = Technology change, technology transfer and research and development efforts.
N = Natural forces such as physical selling, resource endorsements, energy supply,
environment protection
G = Global forces such as multinational companies, international institutions, competition
and various currency.
External Environment Analysis Process
Environment is dynamic. Business is environment-specific. It must be aware about condition and
forces that influences its performance and outcome. It must keep track of emerging signals and
trends through environmental analysis.
External environmental analysis is assessment of opportunities and threats in the external
environment of business. External environment consists of political, legal, economics, social,
cultural and technological dimensions.
Environment Signals
Environmental signals can be of three types:
1. Fad: It is a temporary phenomenon. It is unpredictable. Short-lived and without political,
economic and social significance.
2. Trends: They are directions or sequence of events that have some momentum and durability.
They are predictable. They reveal the shape of future.
3. Megatrends: They are direction or sequence of event that are of longer duration. They are slow
to form. Once in place, they last for seven to ten years or longer. They are larger political,
economic, socio-cultural and technology changes.
Managers should pay attention to trends and megatrends. They should anticipate them, understand
them and identify opportunities and threats in them.
External Analysis Process
External environmental analysis consists of following steps:
Scanning
Monitoring
Forecasting
Assessment
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1. Scanning
Scanning involves acquiring information from the environment. It detects trends already
underway. It detects emerging trends that have potential impact on business.
Determine Source of
Observation
Select Scanning
Method
Scan and
Respond to Data
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d) Scan and Respond to Data: the collected data is studied, analysed, assessed, interpreted,
correlated and understood. Crucial development in the environment are pin-pointed. They can
be:
Events: important and specific occurrences
Trends: Direction or sequences of events that have some momentum and durability.
Issues: current concerns arising from events and trends
Expectations: Stakeholders demands arising from issues
Environmental scanning serves as a basis for SWOT analysis (strengths, weaknesses, opportunities
and threats).
2. Monitoring
It involves tracking environmental trends and events. It is auditing of environmental
influences. The likely effects of environmental influences on business performance are
identified. This step provides:
a) Specification description of environmental trends and events.
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CHAPTER FOUR:
SECTION- 4-6 STRATEGIC ADVANTAGE PROFILE
Weight
Ratin
g
Weighte
d Score
comments
0.10
0.20
0.05
0.05
5
4
3
3
0.50
0.80
0.15
0.15
0.10
0.20
0.30
3
4
0.45
0.40
0.10
0.05
Weaknesses
6. Poor
research
& 0.10
development
7. Limited product mix
0.15
8. Raw materials shortage
0.10
9. Poor
employee 0.05
development
10. lack
of
0.05
countrywide
orientation
Total
1.00
3.10
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CHAPTER FIVE
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Purchase sources
Product development: Develop new products or improve old products
Mass production or customization
Basics production or customization
Basic or applied research
Budget allocations for R & D; in house or outsourced R & D
Collaboration with competitors
Outsourcing
Choice of technology: Hi-tech or traditional
Plant capacity utilization
Quality control
Inventory management
STRATEGIC CHOICE
Strategic choice is the decision for selection of the best strategic option. It helps achieve the
organizations objectives. Strategic options are evaluated to assess their suitability,
acceptability and feasibility. The evaluated strategic options are ranked in the order of their
potential to achieve. The strategic choice is made from among these ranked alternatives. Only
the attractive strategic options are considered for strategic choice. Such option should allow
businesses to maintain or create sustainable strategic advantages.
The criteria used for strategic choice are:
a) Suitability
b) Acceptability
c) Feasibility
5.1 SUITABILITY
Suitability is concerned with environmental fit of the strategic option. An organization is
environment specific, the strategic option should be address the circumstances in which the
organization is operating. It should fit with the future trends and changes in the environment.
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Suitability provides the rationale to a strategy. It indicates whether the strategic option make
sense in relation to environmental circumstances. The strategic option should be suitable
from the following point of view:
Exploring opportunities and avoiding threats
Capitalizing on strengths and avoiding weaknesses
Addressing stakeholders expectations
Screening Methods for Suitability (Techniques)
Suitable of a specific strategic option is relative to other available options. The methods used
for screening suitability are:
1. Ranking
2. Decision Trees
3. Scenarios
1. Ranking
It is systematic way of assessing strategic option against a set of key factors in the
environment, resources and stakeholders expectations. It compares strategic options
against the key strategic factors identified by SWOT analysis. A rank is established by
assigning weight for each option to indicate its suitability.
Stakehold Investme
er
nt funds
Key
Strategic
Factors
Marketi Technolo
ng Skills gy
3
3
1
2
1
3
1
3
3
2
Strategic
options
1.Do nothing
2.consolidatio
n
3.Penetration
4.New
product
development
5.Diversificat
ion
6.Strategic
rankin
g
2
2
Qualit Tota
y
l
point
s
1
8
1
11
1
2
1
2
1
3
5
13
C
A
12
C
B
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alliances
3=Favourable
A=Most suitable
2=Unfavourable
B=Possible
1=Irrelevant
C=unsuitable
3. Scenarios
They match strategic option to different possible future scenarios. They are useful where a
high degree of uncertainty exists. They generate forecasts of future environmental conditions
to assess suitability of strategic options.
Scenarios prepare organizations for future surprises. Contingency plans are prepared to
respond to them. Likely future environmental changes are carefully monitored to adjust
strategic options accordingly.
Steps in scenario building:
i. Prepare the background information. Select critical indicators.
ii. Search for future trends in critical indicators.
iii. Analyze reasons for past behavior for each trend.
iv.
Forecast three scenarios for each critical indicator:
Least favourable environment
Likely environment
Most favourable environment
v. Develop various scenarios from the viewpoint of future.
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5.2 ACCEPTABILITY
It is concerned with the expected performance outcome of a strategic option. The criteria for
acceptability of a strategic option are:
1. Return: Expected returns in term of profitability, cost-benefits, shareholder value.
2. Risk: Level of risk in term of financial ratio projection and sensitivity analysis.
3. Stakeholder Reactions: Likely reaction of stakeholders.
Acceptability Screening Methods
The methods used are
1. Analyzing Returns
It involves profitability analysis. Expected return from specific strategic options are
assessed. The approaches used for analyzing returns are:
a) Profitability Returns:
It assesses financial return on investment. The tools used for profitability analysis are:
i)
Return on Capital Employment (ROCE): It examines the relationship
between net profit after tax and capital employed.
ROCE=Net profit after tax
Capital employed
ii)
iii)
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CAP III
the life of the projects is calculated. The cost of capital serves as the standard for
discounting rate. The methods can be:
Internal Rate of Return: It is uses trial and error method to find out the
rate of discounting.
Discounted Cash Flow (DCF): It considers time value of cash flow for
total life project. However, the discount rate used in terms of cost of
capital may not be realistic.
b) Cost/Benefit Analysis(CBA):
It assesses the overall economic impact of the strategic option. All the costs and benefits
of a specific option are forecasted. Cost/ Benefit ratio is calculated. Strategic option are
compared on the basis of cost/benefit ratio.
For business projects, CBA analyses profitability. It is ability of the strategic
option to earn profit to investors.
For public projects, CBA analyses social profitability. Money value is put on all
social costs and benefits of a strategic option. Shadow pricing is used for the
purpose.
c) Shareholder Value Analysis (SVA):
It assesses the impact of strategic option in generation shareholder value. The
shareholder value is total share returns (TSR). TSR is calculated as follows:
Increase in Share
price over the year
Dividends earned
in the year
TSR=
Share price at the start of the year
The strategic option should maximize the value to the owners through increased TSR.
2. Risk Analysis:
Involves profitability estimates about robustness of a strategic option. The level of risk is
important for acceptability of a strategic option. New product development carries high
level of risk.
The approaches for analyzing risk are
Projection of Financial Ratios
Sensitivity analysis
Simulation modeling
Heuristic models
Decision matrices
a) Financial ratio projection
It projects changes in key financial ratios resulting from a strategic option. Such
changes indicates level of risk. The ratios can be related to capital structure and
liquidity.
Capital structure is indicated by debt to equity ratio
Capital structure =
Total debt
Total equity
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Increase gearing increase the level of risk. Addition of long terms loans increases gearing.
Liquidity is increased by current assets to current liability ratio.
Liquidity =
Current assets
Current liability
Decrease in liquidity increase the level of risk. It may even threaten survival of the
organization.
b) Sensitivity Analysis
It is what if? analysis. It questions and challenges the underlying assumptions of a
particular strategic options. It tests sensitivity of performance outcome to each of
these assumptions. For example, key assumption may be 10% growth in market
demand. Sensitivity analysis asks what would be the effect on profit if market demand
grew by 5% or 15%.
c) Simulation Modeling
Simulation is abstraction of reality. It is used to analyze a strategic option when
several uncertain variables affect its outcomes. Computers are used to simulate
outcome over time by changing certain variables for a strategic option.
Simulation builds model to represent reality of a system. It conducts a series of trial
and error experiments to predict the behavior of the system over a period of time by
changing certain variables.
d) Heuristic Models:
Heuristic are rules of thumb. They are based in managerial memory and judgment.
Risk assessment of strategic options is based in past experience, memory, intuition,
hunch, and abstract reasoning. These models do not consider logical facts. They are
judgmental shortcuts. Risk analysis is affected by
i)
Availability: The events that are readily available in memory are assumed to
be more likely to occur in future.
ii)
Representativeness: The likelihood of future occurrence is assessed by
matching it with a preexisting category.
iii)
Anchor: Initial values serves as anchor.
e) Decision Matrices
They are rectangular array of numbers arranged in rows and columns. They are used
to assess the level of risk of different strategic option. Low risk strategic options are
identified.
An example for market promotion strategy is given in figure
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Criteria
1. Return Analysis
a) Profitability
Used to understand
b) Cost benefit
c) Shareholder
value analysis
2. Risk Analysis
a) Financial Ratio
Projections
b) Sensitivity
c) Simulations
Modeling
d) Heuristic
Models
e) Decision
Materials
3. Stakeholder
Reactions
Tools
Financial return
of investment
Tangible
and
intangible
cost/benefits
Impact if strategic
options
on
shareholder value
Robustness
of
strategic option
Test assumptions
Outcome, when
variables
uncertain
Managerial
judgment
Impact
of
decision
Political
dimensions
of
strategic options
Limitations
Return on capital
employed;
Payback period;
Ignores
time
value of money;
Problem
of
discount rate
Intangible
costs/benefits
difficulty
to
quantify
Total shareholder No
standard
Return
(TSR)
about
TSR
analysis
Technical detail
difficulty.
Capitalization
ratio;
Liquidity ratio
what-if analysis
Tests financial
soundness
Tests
factors
separately
Subjective
Modelling
Rule of thumb
Rectangular matrix
Stake
holder
mapping;
Game theory
Largely
quantitative
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2005 (Rs.)
8,00,000
6,50,000
80,000
50,000
20,000
8,00,000
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BEP=
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1. BCG Matrix
2. GEs business Screen
3. Hofers Product-Market Evolution Matrix
A Question Mark (problem child) is a business unit with high market growth tare but low
market share. It is not achieving cost reduction. It has uncertain future.
A Cash Cow is a business unit with high market share but low market growth rate. Heavy
investment is not needed. It generates high cash flow. It has low costs relative to
competitors.
A Dog has low market share and low growth rate. It drains cash to survive. Its future
prospect is bleak.
Organization use market share and growth rate to buildup portfolio. The aim is to achieve
balance.
The strategic options for building portfolio of SBU can be:
Build: Allocate more resources to Stars and Question Marks to gain and sustain market
share.
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Hold: Allocate present level of resources to cash cows to defend market share and
generate cash flows.
Harvest: Allocate less resources to weak cash cows. Eventually withdraw them from
business.
Divest: Do not allocate resources to Dogs. Liquidate them.
Competitive Position
Market share
Marketing and sales force
Research and Development
Manufacturing
Distribution
Financial resources
Competitive position regarding
- Image
- Product line
- Customer service
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Successful SBUs in GE matrix requires high market attractiveness and strong competitive
position. The matrix can be divided in three zones strategic alternativeness.
i)
Cell 1.2.4 Invest Grow: SBUs in these cells are overall successful. They should
be given priority in portfolio. More investment should be allocated.
ii)
Cell 3, 5, and 7 Grow of Let Go: SBUs in these cells have medium success and
attractiveness. They should be included in the portfolio in a selective basis for
investment.
iii)
Cell 6, 8, 9 Harvest/Divest: SBU in these cells have low success and
attractiveness. They should be divested or closed down.
GE matrix forces managers to give attention to the design of appropriate portfolio.
But the positioning of SBUs may not necessarily be unprofitable. GE matrix
provides broad strategy guidelines only.
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CAP III
Source: W.Chan Kim and R.Mauborgne: Blue ocean Strategy Hazard business review,
October 2004, pp. 1-9
STRATEGIC CHOICE
Strategic choice is the decision for selection of the best strategic option. It helps achieve the
organizations objectives. Strategic option. It helps achieve to assess their suitability,
acceptability and feasibility. The evaluated strategic option are ranked in order of their
potential to achieve objectives. The strategic choice is made from among these ranked
alternatives. Only the attractive strategic option are considered for strategic choice. Such
options should allow businesses to maintain or create sustainable strategic advantage.
Strategic choice makes subjective decisions based on objective information.
Approaches for Strategic Choice
Strategic choice involves strategic decision making. The approaches that can be used for
making strategic choice can be:
a) Planned Approach: This approach involves formal appraisal of the relevant
strategic option for suitability, acceptability and feasibility. The appraised option
are ranked in terms of their potential for objectives achievement. The choice of the
best option is made. It is suitable for complex large organization.
b) Enforced Choice Approach: An organization has various stakeholders. The
dominant stakeholder play an important role in strategic choice.
c) Experience-based Approach: Strategist managers possess an experience curve.
Past experience of managers in strategy implementation serves as a guideline for
strategic choice.
d) Command Approach: The strategic choice is based in the command of top
management. It is top-down approach.
e) Entrepreneurial Approach: The strategic choice is based on search for new
opportunities. The risk is high. The judgement is subjective. It is suitable for
business ventures.
Process of Strategic choice
The process of strategic choice of the following steps
a) Ranked attractive strategic options
b) Make strategic choice
1. Ranked feasible Strategic Options
Attractive strategic options, evaluated in terms of suitability, acceptability and feasibility are
ranked. The ranking is done on the basis of their potential for objective achievement.
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CAP III
b)
c)
d)
e)
Marketing Mix
Marketing segmentation
Market positioning
Product life cycle
Price leader or follower
Exclusive dealership or multiple channels
Media or online advertising
Market development
Diversification
Financial Strategies related to the best use of financial assets:
Acquisition of financial resources-equality of debt, short-term or long- term
Cost of capital
Lease or buy fixed assets: utilization of financial resources
Dividend payout: distribution of profit
Whether to go public, merge or acquire
Human resources Management strategies related to best use of human assets:
Traditional 10-5 work day of flexible working hours
Pay-for-performance: Bonus, profit sharing, stock options
Benefits and services
Balancing work life and home life
Operations and Research and Development Strategies related to product
manufacture and innovation:
In-house or outsource R & D
Product development: Develop new products or improve old products or
imitate
Basic or applied research
Budget for R & D
Collaboration with competitors
Choice of technology: Hi-tech or traditional
Plant capacity utilization
Quality control
Inventory management
Management Information System Strategies related to use of information system
technology:
Computerization
E-commerce
Viral office
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CAP III
Strategic information system consists of people, equipment, and procedures to gather, sort,
analyze, and distribute needed, timely, and accurate information to strategic decision
makers.
Strategic information system is a unified system of interrelated parts to provide information
support to achieve strategic objectives. It consists of input-processing-output feedback
components.
Data Analysis
OUTPUT
INPUT
Data Generation
-External Sources
-Internal Sources
Data
Evaluation
Data Sorting
Information
dissemination
Data
Storage
-regular reports
-special reports
-others
Data
Retrieval
Feedback
Figure: Strategic Information System
a) Input: It is based on database of the organization. It consists of data generated from
external and internal sources. Internal sources are within the organization. External
sources are environment, market and competitors. Need assessment is done to find
data requirements.
b) Processing: It consists of activities related to data sorting, analysis, evaluation,
storage retrieval and dissemination. The information is timely, up-to-date and
accurate. Its flow is continuous.
c) Output: It consists of regular and special reports needed for strategic decision
making. It is information dissemination.
d) Feedback: It provides information to redesign input and processing to meet changing
needs. People, equipment, and procedures and needed for the development and
management of strategic information system. Information technology, especially the
internet and computer, play an important role in its operation. Strategic information
system should be tailor-made according to the organizational needs. Information
overload should be avoided. It should be cost-effective.
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Data
Bank
decesion
Support
System
methods
Banks
7. Research System
Research is systematic gathering of information. It is systematic inquiry undertaken to help
resolve a specific problem. Its purpose is to guide strategic decisions by gathering
information. It provides alternatives for making the choice. It is a tool strategy and minimize
threats.
STRATEGIC CONTROL: PROCESS
Control ensures that the right things are done in the right manner and at the right time.
Strategic control continually assesses the changing environment to uncover events that
significantly affect the course of the strategy.
Strategic control is exercised by top management. It is long-term oriented. It focuses on
external environment. It is proactive and provides early warning about the performance of the
strategy. Timely feedback is the cornerstone of strategic control.
Strategic control involves:
a) Reexamination of Assumptions
Assumption relate to environmental and organization factors. Environment is
dynamic. There is time lag between strategy formulation and implementation.
Assumption made while formulating a strategy may no longer be valid and relevant.
Strategic control takes into account the changing assumptions.
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CAP III
b) Measuring Performance
Strategic control continually evaluates the implementation performance of a strategy.
It evaluates whether the plans, programmes , project and budget are guidline the
organization towards objectives achievement. Implementation gaps are identified.
Information is important for evaluation of implementation Management
information system should be established.
c) Appropriate Measures
Appropriate measures are taken to adjust the strategy to new requirement. This is
done to steer the strategy to the right direction. Due consideration is given to the
changing assumptions and implementation gaps. Corrective actions adjust the strategy
to keep it on track to achieve objectives.
Characteristics of Strategic control
The characteristic of strategic control are:
1. Right Direction: Strategic control ensures that the strategy is moving in the right
direction.
2. Proactive: Strategic control is an early warning system of control. It proacts by
continuously questioning the direction of strategy. It has flexibility to adapt to
environmental changes and make correction.
3. Future-oriented: Strategic control aims to steer the future direction of strategy.
4. Focus: Strategic control focuses on forces and events in the external environment.
It should have strategic focus on key performance areas.
5. Time Horizon: Strategic control has a long-term time horizon.
6. Responsibility: Strategic control is the responsibility of top management.
7. Cost Effective: Benefits should justify the costs of strategic control.
8. Techniques: Strategic control is based on premises reexamination,
implementation review, strategic surveillance, and special alert.
TYPES OF CONTROL
Control can be strategic and operational
Strategic Control Types
Strategic control can be of the following four types
Premise control
Implementation control
Strategic surveillance
Special Alert control
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CAP III
Types of Strategic
Premise
Implementation
Strategic
survellance
special Alert
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Financial
Customer
Vision and
Strategy
Business Process
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