THE AUDIT OF INTERNATIONAL COMMERCIAL BA NKS

CONTENTS
Paragraphs
1. Introduction................................................................................................ 1.1-1.7
2. Audit Objectives and the Audit Process
The objectives ............................................................................................ 2.1-2.3
The process................................................................................................. 2.4-2.5
3. Defining the Terms of the Engagement ............................................... 3.1-3.3
4. Planning the Audit
Introduction................................................................................................ 4.1-4.2
Gaining a knowledge of the client............................................................ 4.3-4.12
Development of an overall audit plan...................................................... 4.13-4.26
Co-ordinating the work to be performed................................................. 4.27-4.28
5. Establishing the Degree of Reliance on Internal Control
Introduction................................................................................................ 5.1
Identifying, documenting and testing control procedures ...................... 5.2-5.12
Examples of controls ................................................................................. 5.13
Inherent limitations of internal control.................................................... 5.14
Considering the influence of environmental factors............................... 5.15
Determining the nature, timing and extent of substantive tests ............. 5.16-5.19
6. Performing Substantive Procedures
Introduction................................................................................................ 6.1-6.2
Audit techniques ........................................................................................ 6.3-6.10
Specific substantive procedure considerations........................................ 6.11-6.29
7. Reporting on the Financial Statements................................................ 7.1-7.3
Appendices
Examples of Internal Control Checklists to Assist in Assessing Three
Typical Areas of a Bank’s Operations I
Examples of Financial Ratios Commonly Used in the Analysis of
Bank Financial Condition and Performance II
Examples of Substantive Audit Procedures for the Evaluation of
Loan Loss Provisions III

This Statement has been prepared by the International Auditing Practices Committee (IAPC) of the International
Federation of Accountants after consultation with the Basle Committee on Banking Supervision* (formerly
known as the Committee on Banking Regulations and Supervisory Practices). It was approved for publication by
the IAPC at its meeting in November 1989. It has a common release date of February 1990.
The purpose of this Statement is to provide practical assistance to auditors in the audit of international
commercial banks. It is not intended to have the authority of an International Standard on Auditing.

*The Basle Committee on Banking Supervision comprises representatives of the central banks and
supervisory authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan,
Netherlands, Sweden, Switzerland, United Kingdom and United States) and Luxembourg. The
supervisory authorities of the countries represented on the Basle Committee attach considerable
importance to thorough and reliable standards of external audit. However, there are considerable
differences in the way in which individual supervisory authorities use the work of auditors in their
supervisory arrangements. Some authorities have specific regulations relating to the scope of the audit and
the suggestions made in this Statement are not intended to limit or alter those arrangements but it is hoped
that they will be helpful guidance where auditors and supervisors are involved together in the supervisory
process.

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1. Introduction
1.1 The International Auditing Practices Committee (IAPC) of the International
Federation of Accountants (IFAC) issues standards (ISAs) on generally
accepted auditing practices and on related services and on the form and
content of the auditor’s reports. These standards are intended to improve the
degree of uniformity of auditing practices and related services throughout the
world. The purpose of this Statement is to provide additional guidance to
auditors by amplifying and interpreting these standards in the context of the
audit of international commercial banks. It is not, however, intended to be an
exhaustive listing of the procedures and practices to be used in such an audit.
1.2 For the purpose of this Statement:
• a bank is a type of financial institution that is recognized as a bank by the
regulatory authorities in the countries in which it operates and usually has
the exclusive right to use the term “bank” as part of its name;
• a commercial bank is a bank whose primary function is the acceptance of
deposits and the making of loans. A commercial bank will often also offer
other financial services such as the purchase and sale of precious metals,
foreign currencies and a wide range of financial instruments, the issuance
and acceptance of bills of exchange and the issuance of guarantees; and
• an international commercial bank is a commercial bank which has
operating offices in countries other than the country of its incorporation or
whose activities transcend national boundaries.
1.3 While this Statement is primarily directed to the audits of international
commercial banks, it has relevance also to the audits of commercial banks
which operate solely in one country. The term “bank” is henceforth used in
this Statement to mean an international commercial bank.
1.4 Banks have the following characteristics which generally distinguish them
from most other commercial enterprises:
• They have custody of large volumes of monetary items, including cash and
negotiable instruments, whose physical security has to be assured. This
applies both to the storage and the transfer of monetary items and makes
banks vulnerable to misappropriation and fraud. They therefore need to
establish formal operating procedures, well defined limits for individual
discretion and rigorous systems of internal control.
• They engage in a large volume and variety of transactions both in terms of
number and value. This necessarily requires complex internal control and
in particular, the entity’s information system and related business
processes relevant to financial reporting, and widespread use of electronic
data processing.
• They normally operate through a wide network of branches and
departments which are geographically dispersed. This necessarily involves
a greater decentralization of authority and dispersal of financial reporting
and internal control functions, with consequent difficulties in maintaining

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uniform operating practices and information systems, particularly when the

branch network transcends national boundaries.
• They often assume significant commitments without any transfer of funds.
These items, normally called “off-balance-sheet” items, may not involve
accounting entries and consequently the failure to record such items may
be difficult to detect.
• They are regulated by governmental authorities and the resultant
regulatory requirements often influence generally accepted accounting
principles and auditing practices within the industry.
1.5 Special audit considerations arise in the audits of banks because of:
• the particular nature of the business risks associated with the transactions
undertaken by banks;
• the scale of banking operations and the resultant significant exposures
which can arise within short periods of time;
• the extensive dependence on computerized systems to process transactions;
• the effect of the regulations in the various jurisdictions in which they
operate; and
• the continuing development of new products and banking practices which
may not be matched by the concurrent development of accounting
principles and auditing practices.
1.6 In many countries banks undertake activities which are not strictly banking
activities and which may not be restricted to banks. These activities include
insurance, securities brokerage and leasing services. This Statement is not
intended to provide guidance in the audit of such activities.
1.7 This Statement is organized into a discussion of the various stages of the
audit of a bank with emphasis being given to those matters which are either
peculiar to or of particular importance in such an audit. Also included for
illustrative purposes are Appendices which contain examples of:
• typical control procedures likely to exist in three of the major operating
areas of a bank, being the lending, foreign exchange trading and trust
activities;
• financial ratios commonly used in the analysis of a bank’s financial
condition and performance; and
• substantive procedures for the evaluation of loan loss provisions.
2. Audit Objectives and the Audit Process
The objectives

2.1 ISA 200 “Objective and General Principles Governing an Audit of Financial
Statements” states:
The objective of an audit of financial statements is to
enable the auditor to express an opinion whether the

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financial statements are prepared, in all material respects,

in accordance with an identified financial reporting
framework.
2.2 The basic objective of the audit of a bank is therefore to render an opinion
based on ISAs or relevant national standards or practices establis hed within
the country (“relevant auditing standards”) on the bank’s annual financial
statements which are prepared in accordance with IASs or applicable
financial reporting framework (“relevant accounting principles”), to the
extent they are applicable to banks.
2.3 The auditor of a bank is also often required to make special purpose reports to
banking supervisory and other regulatory authorities. The requirements for
such reports vary significantly between countries and this Statement is not
intended to provide guidance in the discharge of the auditor’s responsibilities
for such reports.
The process

2.4 In carrying out the work required to form an opinion on a bank’s financial
statements, the auditor’s work will be divided into several distinct phases, as
contemplated in the ISAs.
2.5 A schematic representation of these phases is as follows:

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Defining the terms

of the engagement

Planning
• gaining a knowledge of the client
• development of an overall plan
• co-ordinating the work to be performed

Establishing the degree of reliance on

internal control
• identifying, documenting and testing
control procedures
• considering the influence of
environmental factors
• determining the nature, scope and extent
of the required substantive procedures

Performing substantive procedures

Reporting on the financial statements

3. Defining the Terms of the Engagement

3.1 As stated in ISA 210 “Terms of Audit Engagements”:
The engagement letter documents and confirms the
auditor’s acceptance of the appointment, the objective and
scope of the audit, the extent of the auditor’s
responsibilities to the client and the form of any reports.
3.2 In considering the objective and scope of the audit and the extent of his
responsibilities, the auditor needs to assess his own skills and competence
and that of his staff to conduct the engagement. In making such an
assessment, the auditor should consider the following factors:
• the availability of sufficient expertise in the aspects of banking relevant to
the audit of the business activities of the bank;
• the adequacy of expertise in the context of the computer information
systems (CIS) and electronic funds transfer (EFT) systems used by the
bank; and

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• the adequacy of resources and/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 are likely to be required.
3.3 In issuing an engagement letter, the auditor should, in addition to the general
factors set out in ISA 210 “Terms of Audit Engagements,” consider including
comments on the following:
• 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 and relevant professional accounting bodies; and
– industry practice;
• the contents and format of any special purpose reports required in addition
to the annual financial statements, including the application of special
purpose accounting principles and/or special purpose auditing procedures;
and
• the nature of any special reporting relationships that may exist between the
auditor and the banking supervisory and other regulatory authorities.

4. Planning the Audit

Introduction

4.1 ISA 300 “Planning” states:

The auditor should plan the audit work so that the audit
will be performed in an effective manner.
Plans should be made to cover, among other things:
• performing risk assessment procedures to obtain an understanding of the
entity and its environment, including its internal control;
• assessing the level of audit risk which includes the risk that material
misstatements will occur and the risk that any remaining material
misstatements will not be detected by the auditor;
• determining and programming the nature, timing and extent of the audit
procedures to be performed; and

• considering the going concern assumption regarding the entity’s ability to

continue in operation for the foreseeable future, generally for a period not
exceed one year after the balance sheet date.

Plans should be further developed and revised as necessary during the course
of the audit.

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4.2 ISA 300 “Planning” and ISA XX, “Understanding the Entity and Its
Environment and Assessing the Risks of Material Misstatement,” amplify
that principle, primarily in the context of recurring audits.

Risk Assessment Procedures

4.3 Obtaining an understanding of the bank entity and its environment will
require the auditor to understand:

• the economic and regulatory environment prevailing for each of the

countries in which the bank operates; and

• the market conditions existing in each of the sectors in which the bank
operates.

4.4 Similarly the auditor will need to acquire and maintain a good working
knowledge of the products and services offered by the bank. In acquiring and
maintaining that knowledge, the auditor needs to be aware of the many
variations in the basic deposit, loan and treasury services that are offered and
continue to be developed by banks in response to market conditions. To do
so, the auditor needs to understand the nature of services rendered through
instruments such as letters of credit, acceptances, interest rate future, forward
and swap contracts, and other similar instruments in order to understand the
inherent risks and accounting implications thereof.

4.5 Often a bank’s loan portfolio has large concentrations of credits to highly
specialized industries such as real estate, shipping and natural resources.
Evaluating the nature of these may require an understanding of the business
and reporting practices of those industries.

4.6 There are a number of business risks associated with banking activities
which, while not unique to banking, are sufficiently important in that they
serve to shape banking operations. An understanding of the nature of these
risks is fundamental to the auditors’ performance of the audit as it enables the
auditor to assess the risk of material misstatement associated with different
aspects of a bank’s operations and assists in designing further audit
procedures in response to assessed risks.
4.7 The business risks associated with banking activities can be broadly grouped
into:
• product and service risks; and
• operating risks.
Some of the important risks in both categories are discussed in subsequent
paragraphs.
Product and service risks
4.8 The most significant product and service risk in a bank is usually credit risk,
which is the risk that a customer or counterparty will not settle an obligation

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for full value, either when due or at any time thereafter. Credit risk also
includes:
• country or transfer risk — the risk of foreign customers and counter-
parties failing to settle their obligations
due to economic, political and social
factors of the foreign country and external
to the customer or counterparty;
• replacement risk — the risk of failure of a customer or
counterparty to perform the terms of a
contract. This failure creates the need to
replace the failed transaction with another
at the current market price. This may result
in a loss to the bank equivalent to the
difference between the contract price and
the current market price; and
• settlement risk — the risk that one side of a transaction will
be settled without value being received
from the customer or counterparty. This
will result in the loss to the bank of the full
principal amount.
To address credit risk, banks have complex and comprehensive systems and
procedures devoted to the various aspects of the credit function, including
those activities relating to:
• origination and disbursement;
• monitoring;
• collection; and
• periodic review and evaluation.
4.9 A large portion of the audit effort will typically be devoted to assessing credit
risk and in this regard, the auditor needs to be aware that credit risk will also
exist in assets other than loans, such as investments and balances due from
other banks and also in off-balance sheet commitments.
4.10 Other product and service risks include:
• interest rate risk — the risk of loss arising from the sensitivity
of earnings to future movements in interest
rates.
It comprises two elements, being:
a. income risk, which is the risk of loss
arising when movements in borrowing
and lending rates are not perfectly
synchronized; and
b. investment risk, which is the risk of
loss arising from a change in the value
of fixed income securities as a result

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of interest rate changes.

• liquidity risk — the risk of loss arising from the possibility
of the bank not having sufficient funds to
meet its obligations;
• currency risk — the risk of loss arising from movements in
the exchange rates applicable to foreign
currency assets, liabilities, rights and
obligations;
• market risk — the risk of loss arising from movements in
market prices of investments; and
• fiduciary risk — the risk of loss arising from factors such as
failure to maintain safe custody or
negligence in the management of assets on
behalf of other parties.
4.11 Banking product and service risks increase with the degree of concentration
of a bank’s exposure to any one customer, industry, geographic area or
country.
Operating risks
4.12 Operating risks, primarily arise out of:
• the need to process high volumes of transactions accurately within short
time-frames. This need is almost always addressed through the use of
large-scale CIS, with the resultant risks of:
– failure to process executed transactions within required time-frames,
causing an inability to receive or make payments for those transactions;
– wide-scale error arising from a breakdown in internal control;
– loss of data arising from system failure;
– corruption of data arising from unauthorized interference with the
system; and
– exposure to market risks arising from lack of reliable up-to-date
financial information.
• the need to use EFT systems to transfer ownership of large volumes of
money, with the resultant risk of exposure to loss arising from
mispayments through fraud or error;
• the conduct of operations in a number of locations with a resultant
geographic dispersion of transaction processing and internal controls. As a
result:
– there is a risk that the bank’s worldwide exposure by customer and by
product may not be adequately aggregated and monitored; and
– control breakdowns may occur and remain undetected and 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 which can arise over
short time -frames. The process of clearing transactions may cause a
significant build -up of receivables and payables during a day, most of
which are completed by the end of the day. This is usually referred to as
intra-day payment risk. The nature of these exposures can arise from
transactions with customers and counterparties and can include interest
rate, currency and market risks;
• the dealing in 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 use of high gearing (i.e., high debt-to-equity ratios), which results in
the exposure to:
– the risk of significant erosion of capital resources as a result of a
relatively small percentage loss in asset value;
– the risk of being unable to obtain the funds required to maintain
operations at a reasonable cost as a result of a loss of depositor
confidence; and
• the inherent complexity and volatility of the environment in which banks
operate, resulting in the risk of inappropriate risk management strategies in
relation to such matters as the development of new products and services.
• the need to adhere to laws and regulations. The failure to do so could result
in exposure to sanctions in the nature of fines or operating restrictions.

Development of an overall audit plan

4.13 In developing an overall plan for the audit, the auditor needs to give
particular attention to:
• the determination of materiality;
• the assessment of the risk of material misstatement;
• the expected degree of reliance on internal control;
• the extent of CIS and EFT systems used by the bank;
• the work of internal audit;
• the complexity of the transactions undertaken by the bank and the
documentation in respect thereof;

• the existence of significant areas of audit concern not readily apparent

from the bank’s financial statements;

• the existence of related party transactions;

• the involvement of other auditors;
• management’s representations; and
• the work of supervisors.

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These matters are discussed in subsequent paragraphs.

Materiality
4.14 In making an assessment of materiality, in addition to the considerations set
out in ISA 320 “Audit Materiality,” the auditor must keep in mind that:
• because of high gearing, relatively small errors may have a significant
effect on the statement of earnings and on capital, though they may have
an insignificant effect on the balance sheet itself;
• as the net income of a bank is low when compared to its gross assets and
liabilities and its off balance sheet commitments, errors which relate only
to assets, liabilities and commitments may be less significant than those
which could also relate to the statement of earnings; and

• banks are often subject to regulatory requirements, such as the requirement

to maintain minimum levels of capital. It would therefore be necessary to
set materiality levels which should identify errors and audit differences
which, if uncorrected, would result in a significant contravention of such
regulatory requirements.
Audit Risk
4.15
The risks associated with banking activities as discussed in paragraphs 4.7 to
4.12 indicate that, in most cases, there is a higher risk of material
misstatement. It is therefore necessary to evaluate the design of the bank’s
internal control and determine whether it has been implemented. The
auditor’s understanding of internal control may raise doubts about the
auditability of the bank’s financial statements.
The risks of material misstatement exists independently of the audit of
financial information and cannot be controlled by the auditor. However, the
auditor can assess these risks and so design audit procedures as to produce an
acceptable level of detection risk.

The extent of CIS and EFT systems

4.16 The high volume of transactions and the short time-frames in which they
must be processed typically result in the extensive use by most banks of CIS
and EFT systems.
The characteristics and control concerns arising from the use of CIS by a
bank are similar to those arising when such systems are used by other
organizations. However, the matters which are of particular concern to the
auditor of a bank include:
• the use of CIS to calculate and record substantially all the interest income
and interest expense, which are normally the two most important elements
in the determination of a bank’s earnings;
• the use of CIS to determine the foreign exchange and security trading
positions and to calculate and record the gains and losses arising
therefrom; and

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• the extensive, almost total, dependence on the records produced by the CIS
because they represent the only readily accessible source of detailed up-to-
date information on the bank’s assets and liability positions, such as
customer loan and deposit balances.
EFT systems are used by banks both internally, for example, for transfers
between branches and between automated banking machines and the central
computerized file which records account activity, and externally between the
bank and other financial institutions, for example, through the SWIFT
network.
In order to properly evaluate internal control and to determine the nature,
timing and extent of further audit procedures, the auditor needs to be aware of
the extent and manner in which CIS and EFT systems are used by the banks.
Reliance on internal control
4.17 In performing further audit procedures, the auditor generally cannot rely
solely on substantive procedures alone because of:
• the high volume of transactions entered into by banks;
• the manner in which transactions are entered into by banks;
• the geographic dispersion of banks’ operations; and
• the extensive use of CIS and EFT systems.
In most situations the auditor will therefore need to place significant reliance
on the bank’s internal control. To do so the auditor will need to carefully
evaluate internal control to determine the degree of reliance to place upon the
same in determining the nature, timing and extent of other audit procedures.
The work of internal audit
4.18 While the scope and objectives of internal audit can vary widely depending
upon the size and structure of the bank and the requirements of those charged
with governance and its management, its role normally includes the review of
the information system relevant to financial reporting and related control
procedures and monitoring their operation and recommending improvements
thereto. It also generally includes a review of the means used to identify,
measure and report financial and operating information and specific inquiry
into individual items including detailed testing of classes of transactions,
account balances and relevant control procedures. The factors which often
require the auditor to place significant reliance on the bank’s internal control,
will also often require the auditor to use the work of the internal auditor. This
is especially relevant in the case of banks which have a large geographic
dispersion of branches. Often, as a part of the internal audit department or as
a separate component, a bank has a loan review department which reports to
management on the quality of loans and the adherence to established
procedures in respect thereof. In either case, the auditor will often wish to
make use of the work of this department. Detailed guidance on the use of the
work of an internal auditor is provided in ISA 610 “Considering the Work of
Internal Auditing.”

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The complexity of transactions undertaken

4.19 Banks undertake transactions which have complex and important underlying
features which may not be apparent from the documentation which is used to
process the transactions and to enter them into the bank’s accounting records.
This results in the risk that all aspects of a transaction may not be fully or
correctly recorded, with the resultant risks of:
• loss due to the failure to take timely corrective action;
• failure to record adequate provisions for loss on a timely basis; and
• inadequate or improper disclosure in the financial statements and other
reports.
Accordingly, the auditor needs to acquire a good understanding of the nature
of the transactions and the types of documentation that need examination.
The existence of significant areas of audit concern not readily apparent
4.20 Banks also typically engage in transactions which:
• have a low fee revenue or profit element as a percentage of the principal
exposure; and
• may not be required by local regulations to be disclosed in the balance
sheet, or even in the notes to the financial statements.
Examples of such transactions are guarantees, comfort letters and letters of
credit, interest rate and currency swaps and commitments and options to
purchase and sell foreign exchange.
4.21 The auditor should review the bank’s sources of revenue, evaluate the related
internal control and perform sufficient audit procedures to obtain reasonable
assurance regarding:
• the completeness of the accounting records relating to such transactions;
• the existence of proper controls to limit the banking risks arising from such
transactions;
• the adequacy of any provisions for loss which may be required; and
• the adequacy of any financial statement disclosures which may be
required.
Related party transactions
4.22 The auditor needs to be particularly aware of the risk that where transactions
with related parties exist, normal measures of banking prudence, such as
credit assessment and the taking of security, may not be appropriately
exercised. Management is responsible for the identification and disclosure of
related parties. The auditor needs to perform audit procedures to obtain
reasonable assurance that:
• all significant related parties and related party transactions are identified;

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• all such transactions, including their terms and conditions, are properly
authorized and appropriately recorded and disclosed in the bank’s financial
statements; and
• the resultant balances outstanding are collectible.
The auditor also needs to be aware of any regulatory guidance or restrictions
on related party transactions. ISA 550 “Related Parties,” defines related
parties and provides detailed guidance as to the issues to be considered and
the procedures to be performed in respect of related parties.
Involvement of other auditors

4.23 As a result of the wide geographic dispersion of offices in most banks, it will
often be necessary for the auditor to employ the services of other auditors in a
number of the locations in which the bank operates. This is most likely to be
achieved through the use of other offices of the auditor’s firm or through the
use of other auditing firms in those locations.
4.24 Where the auditor is relying on the work of another auditor, he will need to:
• be satisfied as to the independence of those auditors and their competence
to undertake the necessary work (including their knowledge of banking);
• ensure that the terms of the engagement, the accounting principles to be
applied and the reporting arrangements are clearly communicated; and
• perform procedures to obtain reasonable assurance that the work
performed by the other auditor is adequate for his purpose by discussion
with the other auditor, by a review of a written summary of the procedures
applied and findings, by a review of the working papers of the other
auditor, or in any other manner appropriate to the circumstances.
ISA 600 “Using the Work of Another Auditor” provides more detailed
guidance on the issues to be addressed and procedures to be performed in
such situations.
Management’s representations
4.25 Management’s representations are relevant in the context of a bank audit to
assist the auditor in determining whether the information and audit evidence
produced to him is complete for the purposes of his examination. This is
particularly true of the bank’s transactions which are not normally reflected in
the financial statements, 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 the management representations regarding significant changes
in the bank’s business and its risk profile and also to identify areas of a
bank’s operations where audit evidence likely to be obtained may need to be
supplemented by management’s representations. ISA 580 “Management
Representations” provides guidance as to the use of management
representations as audit evidence, the procedures that the auditor should apply
in evaluating and documenting them, and the circumstances in which
representations should be obtained in writing.

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The work of supervisors

4.26 There are many tasks performed by auditors and bank supervisors which are
common in nature, including:
• the performance of analytical procedures;
• the obtaining of assurance regarding the existence satisfactory internal
control structure; and
• the review of the quality of a bank’s assets and the assessment of banking
risks.
The auditor would therefore find it advantageous to interact with the
supervisors and to have access to communications which the supervisors may
have addressed to the bank management on the results of their work. The
assessment made by the supervisors in important areas such as the adequacy
of provisions for bad and doubtful loans and the prudential ratios used by the
supervisors can be of assistance to the auditor in performing analytical
reviews and in focusing attention on specific areas of supervisory concern.
The International Auditing Practice Statement 1004 “The Relationship
Between Bank Supervisors and External Auditors” issued in July 1989 by the
IAPC in association with the Basle Committee provides information and
guidance on the relationship between bank auditors and supervisors.
Co-ordinating the work to be performed

4.27 Given the size and geographic dispersion of most banks, the co-ordination of
the work to be performed will be important in achieving an efficient and
effective audit. The co-ordination required should take into account the
following factors:
• the work to be performed by:
– various members of the auditor’s staff;
– other offices of the auditor’s firm; and
– other audit firms;
• the extent to which it is proposed to use the work of the internal auditor;
• required reporting dates to shareholders and the regulatory authorities; and
• the need for any special analyses and other documentation to be provided
by bank management.
4.28 The best level of co-ordination between senior staff involved in the audit can
often be achieved by audit planning and regular audit-status meetings.
However, given the number of staff involved in the audit and the number of
locations at which they will be involved, the auditor will usually find it most
effective to communicate all or relevant portions of the audit plan in writing.
When setting out his requirements in writing, the auditor should consider
including commentary on the following matters:

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• the financial statements and other information which is to be subjected to

audit (and if considered necessary, the authority under which the audit is
being conducted);
• details of any additional information needed by the auditor [e.g.,
information on certain loans, portfolio composition, narrative commentary
on the audit work performed (especially on the areas of risk described in
paragraphs 4.7 to 4.12 which are important to the bank) and on the results
of the operation, points for inclusion in letters to management on internal
control, local regulatory concerns, income tax assessment status reports],
and if relevant, the formats of any required reports;
• the relevant auditing standards to be applied to the work conducted (and, if
considered necessary, information on those standards);
• the relevant accounting principles to be followed in the preparation of the
financial statements and other information (and, if considered necessary,
the details of those principles);
• interim audit status reporting requirements and deadlines;
• particulars of clients’ officials to be contacted;
• fee and billing arrangements; and
• any concerns of a regulatory, internal control, accounting or audit nature of
which the local auditor should be aware.

5. Establishing the Degree of Reliance on Internal Control

Introduction

5.1 Management’s responsibilities include the maintenance of adequate internal

control, the selection and application of accounting policies, and the
safeguarding of the assets of the entity.
The auditor is required to obtain a sufficient understanding of the internal
control to plan the audit and develop an effective audit approach. After
obtaining the understanding, the auditor should consider the assessment of
control risk to determine the appropriate detection risk to accept for the
financial statement assertions and to determine the nature, timing and ext ent
of substantive procedures for such assertions.
Where the auditor assesses control risk at a lower level, substantive
procedures would normally be less extensive than would otherwise be
required and may also differ as to their nature and timing.
Identifying, documenting and testing the operating effectiveness of control
procedures

5.2 ISA 400 “Risk Assessments and Internal Control” sets out four objectives of
internal controls, as follows:
• transactions are executed in accordance with management’s general or
specific authorization;

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• all transactions and other events are promptly recorded in 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;
• access to assets is permitted only in accordance with management’s
authorization; and
• recorded assets are compared with the existing assets at reasonable
intervals and appropriate action is taken regarding any differences.
In the case of banks, a further objective is to ensure that the bank adequately
fulfills its fiduciary responsibilities arising out of its trustee activities.
The audit considerations in relation to each of these objectives are discussed
in the subsequent paragraphs.
“Transactions are executed in accordance with management’s general or
specific authorization.”
5.3 The primary responsibility for the control structure in a bank rests with the
board of directors and its committees which are responsible for governing the
bank’s operations. However, since the operations of banks are generally large
and geographically dispersed, decision-making functions need to be
decentralized and the authority to commit the bank to material transactions is
usually dispersed geographically and delegated among the various levels of
management and staff. Such dispersion and delegation will almost always be
found in the lending, treasury and funds transfer functions, where, for
example, payment instructions are sent via a tested message. This feature of
banking operations creates the need for a structured system of delegation of
authority, resulting in the formal identification and documentation of:
• employees who can authorize specific transactions;
• procedures to be followed in granting that authorization; and
• limitations on the amounts that can be authorized, by individual employee
and/or by staff level, as well as any requirements that may exist for
concurring authorization.
It also creates the need to ensure that appropriate procedures exist for
monitoring the level of exposures. This will usually involve the aggregation
of exposures, not only within, but across the different activities, departments
and offices of the bank.
5.4 An examination of the authorization controls will be important to the auditor
in satisfying himself that transactions have been entered into in accordance
with the bank’s policies and, for example, in the case of the lending function,
that they have been subject to appropriate credit assessment procedures prior
to the disbursement of funds. The auditor will typically find that limits for
levels of exposures will exist in respect of various transaction types. The
auditor will wish to ensure that these limits are reasonable, are being adhered
to and that positions in excess of these limits are reported to the appropriate
level of management on a timely basis.

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5.5 From an audit perspective, the proper functioning of a bank’s authorization

controls will be particularly important in respect of transactions entered into
near the date of the financial statements, where aspects of the transaction will
have yet to be fulfilled, or where there is a lack of evidence on which to
assess the value of the asset acquired or liability incurred. Examples of such
transactions are commitments to purchase or sell specific securities after the
year-end and loans, where principal and interest payments from the borrower
have yet to fall due.
“All transactions and other events are promptly recorded in 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.”
5.6 In assessing the appropriateness of the individual internal controls used to
ensure that all transactions are properly recorded, the auditor will need to take
into account a number of factors which are especially important in a banking
environment. These are as follows:
• Banks deal in large volumes of transactions, which can individually and
cumulatively involve large amounts of money. Accordingly, the bank will
need to have balancing and reconciliation procedures which are operated
within a time-frame that provides the ability to detect errors and
discrepancies so that they can be investigated and corrected with a minimal
risk of loss to the bank. Such procedures may be operated hourly, daily,
weekly, or monthly, depending on the volume, nature of the transaction,
level of risk, and transaction settlement time-frame.
• Many of the transactions entered into by banks are subject to specialized
accounting rules. It will therefore be necessary to have control procedures
in place to ensure those rules are applied in a manner and in a time-frame
which results in the generation of accounting entries that may be required
for the preparation of appropriate financial information for management
and external reporting. Examples of such control procedures are those
which result in the market revaluation of foreign exchange and security
purchase and sale commitments so as to ensure that all unrealized profits
and losses are recorded.
• Many transactions entered into by banks are not disclosed in the balance
sheet or even in the notes to the financial statements. Accordingly, control
procedures must be in place to ensure that such transactions are recorded
and monitored in a manner which provides management with the required
degree of control over them and which allows for the prompt
determination of any change in their status which needs to result in the
recording of a profit or loss.
• New financial products and services are constantly being developed by
banks. The auditor needs to obtain reasonable assurance that necessary
revisions are made in accounting procedures and related internal controls.
• End of day balances may not be indicative of the volume of transactions
processed through the systems or of the maximum exposure to loss during
the course of a business day. This is particularly relevant in executing and

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processing foreign exchange and securities transactions. Assessment of

controls in these areas must take into account the ability to maintain
control during the period of maximum volumes or maximum financial
exposure.
• The majority of banking transactions must be recorded in a manner which
is capable of being verified both internally and by the bank’s customers
and counterparties. The level of detail to be recorded and maintained on
individual transactions must allow for bank management, transaction
counterparties, and the bank’s customers to verify the accuracy of the
amounts. An example of such a control is the continuous verification of
foreign exchange trade tickets by having an independent employee match
them to incoming confirmations from counterparties.
5.7 The extensive use of CIS and EFT systems will have a significant effect on
how the auditor evaluates a bank’s accounting system and related internal
controls. ISA 400 “Risk Assessments and Internal Control,” and International
Auditing Practice Statement 1008 “Risk Assessments and Internal Control—
CIS Characteristics and Considerations,” provide guidance on the CIS aspects
of such an evaluation. In carrying out his study and evaluation of the CIS, the
auditor will need to ensure that his procedures include an assessment of those
controls which affect system development and modifications, system access
and data entry, the security of communications networks, and contingency
planning. To the extent that the use of EFT is within the bank, similar
considerations will apply. To the extent that the EFT systems are external to
the bank, the auditor will need to give additional emphasis to the assessment
of the integrity of pre-transaction supervisory controls and post-transaction
confirmation and reconciliation procedures.
“Access to assets is permitted only in accordance with management’s
authorization.”
5.8 The assets of a bank are often readily transferable, of high value and of a
form which cannot be safeguarded solely by physical procedures. In order,
therefore, to ensure that access to assets is permitted only in accordance with
management’s authorization, a bank generally uses controls such as:
• passwords and joint access arrangements to limit CIS and EFT system
access to authorized employees;
• segregation of the record-keeping and access functions (including the use
of computer generated transaction confirmation reports available
immediately and only to the employee in charge of the record-keeping
functions); and
• frequent third-party confirmation and reconciliation of asset positions by
an independent employee.
5.9 The auditor will need to obtain reasonable assurance that each of these
controls is operating effectively. However, given the materiality and
transferability of the amounts involved, he will also usually wish to review
and/or participate in the confirmation and reconciliation procedures that occur
in connection with the preparation of the year-end financial statements.

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“Recorded assets are compared with the existing assets at reasonable

intervals and appropriate action is taken regarding any differences.”
5.10 The large amounts of assets handled by banks, the volumes of transactions
undertaken, the potential for changes in the value of those assets due to
fluctuations in market prices and the importance of confirming the continued
operation of access and authorization controls will necessitate the frequent
operation of reconciliation controls. This will have particular importance in
regard to:
• assets in negotiable form, such as cash, bearer securities and assets in the
form of deposit and security positions with other institutions where failure
to detect errors and discrepancies on a timely basis (which may be daily
where money market transactions are involved) could lead to an
irrecoverable loss. The reconciliation procedures used to achieve this
control objective will normally be based on physical counting and third
party confirmation; and
• assets whose value is determined with reference to external market prices,
such as securities and foreign exchange contracts.
5.11 In designing an audit strategy to assess the effectiveness of a bank’s
reconciliation controls, the following factors should be considered:
• Because of the number of accounts requiring reconciliation and the
frequency with which these reconciliations need to be performed:
– a large portion of the audit effort will need to be directed to the
documentation, testing and evaluation of the reconciliation controls; and
– the work of the internal auditor will also be similarly directed. The
auditor therefore can usually make use of the work of the internal
auditor.
• Since reconciliations are cumulative in their effect, most reconciliations
can be satisfactorily audited at the year-end date, assuming that they are
prepared as at that date, within a time-frame useful to the auditor and that
the auditor is satisfied that the reconciliation control procedures are
effective.
• The auditor needs to obtain reasonable assurance in examining a
reconciliation that items have not been improperly transferred to other
accounts which are not subject to reconciliation and investigation in the
same time -frame.
“Fiduciary duties are adequately fulfilled”
5.12 The main objectives of internal control with regard to the fiduciary activities
of a bank are to ensure that:
• all duties arising from fiduciary relationships are adequately fulfilled; and
• all assets in the bank’s custody, arising from fiduciary relationships are
adequately safeguarded and properly recorded.

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An essential feature of the system is the proper segregation of fiduciary assets

from the bank’s own assets and the discharge of fiduciary responsibilities by
a separate department or by a subsidiary of the bank.
Examples of controls

5.13 Appendix 1 to this Statement contains examples of controls over

authorization, recording, access and reconciliation normally found ni the
credit, foreign exchange trading and trust activities of a bank.
Inherent limitations of internal control

5.14 ISA 400 “Risk Assessments and Internal Control” describes the procedures to
be followed by the auditor in identifying, documenting and testing internal
controls. In doing so, the auditor should be aware of the inherent limitations
of internal control and of the fact that in the context of a bank’s operations
there may be transactions which are of such a size and importance to the
bank’s financial statements that reliance on the results of testing internal
control alone cannot replace the need to have actual inspection of the
underlying documentation.
Considering the influence of environmental factors

5.15 In assessing the effectiveness of specific control procedures, the auditor

should consider the environment in which internal control operates. Some of
the factors which may be considered are:
• the organizational structure of the bank and the manner in which it
provides for the delegation of authority and responsibilities;
• the quality of management supervision;
• the extent and effectiveness of the internal audit system;
• the quality of key personnel; and
• the degree of inspection by supervisory authorities.
Determining the nature, timing and extent of substantive tests

5.16 As a result of his evaluation of the system of internal control, the auditor
should be in a position to determine the nature, timing and extent of the
substantive tests to be performed on individual account balances and other
information contained in the bank’s financial statements. The risks and
factors that served to shape the bank’s systems of internal control will need to
be considered by the auditor in designing these substantive tests. In addition,
there are a number of audit considerations significant to these risk areas to
which the auditor should direct his attention. These are discussed in
subsequent paragraphs.
5.17 In addressing the audit considerations affecting product and service risks, the
auditor should consider the need to:
• physically examine, confirm and reconcile negotiable items as of the year-
end date;

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• specifically test balances which are individually significant through

procedures such as examinations of underlying documentation and third-
party confirmations; and
• examine post year-end transactions and events for evidence of impairment
of value at the year-end date.
5.18 In addressing the audit considerations affecting operating risks, the auditor
should consider the need to:
• carry out certain tests prior to the year-end in order to complete the audit
on a timely basis;
• use computer-assisted audit techniques such as the use of interrogation
software to achieve the desired extent of testing in the time-frame
available;
• use statistical sampling techniques where there are a large number of
homogeneous accounts or transactions of which the auditor wishes to
examine a representative sample;
• use analytical review techniques to detect conditions of audit concern. This
may be more cost efficient than to test a satisfactory sample of items;
• be satisfied as to the appropriate reconciliation of asset and liability
accounts with counterparties (i.e., nostro and vostro accounts with other
banks) so as to provide assurance on the propriety and accuracy of
completed transactions with those counterparties;
• establish a basis of reliance on the work of the internal auditor as a means
of obtaining satisfactory coverage both geographically and in terms of the
extent of transaction and account balance coverage;
• ensure that audit staff and representatives conducting examinations at other
locations of the bank are appropriately instructed and that the results of
their work are properly reviewed;
• ensure that all significant principal positions and related unrealized profits
and losses have been recorded;
• be satisfied as to the viability of the bank by considering evidence of
factors such as funding difficulties which could call into question the
going-concern assumption;
• assess the implications on the bank’s financial position of non-compliance
with regulatory rules and guidelines; and
• assess the implications on the bank’s position of non-compliance with its
fiduciary duties, with particular reference to those duties relating to the
safekeeping of assets held in trust.
5.19 The above considerations generally determine the specific substantive
procedures to be carried out by the auditor. These are further discussed in
Section 6.

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6. Performing Substantive Procedures

Introduction

6.1 The nature, timing and extent of the specific substantive procedures to be
performed on the financial statement balances will be based on the auditor’s
assessment of inherent and control risk.
6.2 As stated in ISA 500 “Audit Evidence”:

Substantive procedures means tests performed to obtain

audit evidence to detect material misstatements in the
financial statements and are of two types:
(a) tests of details of transactions and balances; and

(b) analytical procedures.

ISA 500 “Audit Evidence” goes on to state:
When obtaining audit evidence from substantive
procedures, the auditor should consider the sufficiency
and appropriateness of audit evidence from such
procedures together with any evidence from tests of
control to support financial statement assertions.
Financial statement assertions are assertions by
management, explicit or otherwise, that are embodied in
the financial statements. They can be categorized as
follows:

Existence — an asset or a liability

exists at a given date

Rights and Obligations — an asset or a liability

pertains to the entity at a
given date
Occurrence — a transaction or event
took place which
pertains to the entity
during the period

Completeness — there are no unrecorded

assets, liabilities,
transactions or events, or
undisclosed items
Valuation — an asset or liability is
recorded at an
appropriate carrying
value

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Measurement — a transaction or event is

recorded at the proper
amount and revenue or
expense is allocated to
the proper period
Presentation and Disclosure — an item is disclosed,
classified, and described
in accordance with the
applicable, financial
reporting framework
Audit techniques

6.3 To address the assertions discussed above, the auditor will find that the
procedures particularly important to the examination of a bank’s accounts
are:
• analytical procedures;
• inspection; and
• inquiry and confirmation.
A discussion of their application in a bank audit context is contained in the
following paragraphs:
Analytical Procedures
6.4 As defined by ISA 500 “Audit Evidence,” 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.
6.5 A bank will invariably have individual assets (e.g., loans and, possibly,
investments) which are of such a size that the auditor will wish to examine
their documentation individually. However, in respect of most items, the use
of analytical procedures techniques will prove to be a particularly important
and useful procedure for the following reasons:
• Normally the two most important elements in the determination of a
bank’s 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 bank’s stated rates during the year. This examination
would usually be made in respect of the categories of assets and liabilities
used by the bank in the management of its business. Such a study could,
for example, highlight the existence of significant amounts of non-
performing loans. In addition, the auditor may also wish to assess the
reasonableness of the stated rates to those prevailing in the market during
the year for similar classes of loans and deposits. Evidence of rates
charged or allowed above market rates may, in the case of loan assets ,
indicate the existence of excessive risk, or, in the case of deposit liabilities,
may indicate liquidity or funding difficulties. Similarly, fee income which

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is also a large component of a bank’s earnings, will often bear a direct

relationship to the volume of obligations on which the fees have been
earned.
• The accurate processing of the high volume of transactions entered into by
a bank and the need for the auditor to rely on the continued and appropriate
operation of the bank’s internal controls can 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.
• The analytical review of account composition is an important method by
which the auditor can detect certain conditions of audit concern, such as
undue concentration of risk of particular industries or geographic areas and
potential exposure to interest rate, currency and maturity mismatches.
• In most countries there is widespread availability of statistical and
financial information available from regulatory and other sources which
the auditor can use to conduct an in-depth analytical review of trends and
peer group analyses.
Appendix 2 to this Statement contains examples of the most frequently used
ratios in the banking industry.
Inspection
6.6 As defined by ISA 500 “Audit Evidence,” inspection consists of examining
records, documents, or tangible assets. The auditor inspects in order to:
• satisfy himself as to the physical existence of negotiable assets available
with the bank; and
• ensure he has the necessary understanding of the terms and conditions of
agreements which are significant individually or in the aggregate in order
to:
– assess their enforceability; and
– be satisfied as to the appropriateness of the accounting treatment they
have been given.
6.7 Examples of areas where inspection is used as an audit technique are:
• bullion;
• securities;
• loan agreements;
• commitment agreements, such as:
– asset sales and repurchases
– guarantees.
6.8 In carrying out inspection procedures, the auditor should be particularly
vigilant regarding the existence of assets held in a fiduciary capacity. He
needs to obtain reasonable assurance that adequate internal controls exist for
the proper segregation of such assets from those which are the property of the
bank.

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Inquiry and Confirmation

6.9 As defined by ISA 500 “Audit Evidence,” inquiry consists of seeking
information of knowledgeable persons inside or outside the entity.
Confirmation consists of the response to an inquiry to corroborate
information contained in the accounting records. The auditor inquires and
confirms in order to:
• obtain evidence of the operation of internal controls;
• obtain evidence of the recognition by the bank’s customers and
counterparties of amounts, terms and conditions of certain transactions;
and
• obtain information not immediately available from the bank’s accounting
records.
Due to the existence in a bank of significant amounts of monetary assets and
liabilities and of off-balance-sheet commitments, confirmation of balances
often proves to be relatively the safest and most practical method of
determining the existence and completeness of the amounts of assets and
liabilities disclosed in the financial statements.
6.10 Examples of areas for which the auditor may use confirmation, either as a
compliance or a substantive audit procedure, are:
• collateral security positions on specific loans;
• asset, liability and forward purchase and sale positions with customers and
counterparties such as:
– outstanding foreign exchange transactions;
– nostro and vostro accounts;
– securities held by third parties;
– loan accounts;
– deposit accounts;
– guarantees; and
– letters of credit.
Specific substantive procedure considerations

6.11 Paragraphs 6.13 to 6.29 identify the audit objectives which are usually of
particular importance in relation to the typical items in a bank’s financial
statements. They also describe some of the audit considerations which would
be helpful to the auditor in planning his substantive procedures and suggest
some of the techniques which could be used in relation to the items selected
by the auditor for his examination.
6.12 In addition to the specific financial statement items addressed in paragraph
6.13 to 6.29, the auditor will need to consider the audit procedures required in
connection with the bank’s fiduciary activities in the context of their effect on
the bank’s financial statements. In conducting such procedures, the auditor
will need to obtain reasonable assurance that:

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• all the bank’s income from such activities has been recorded and is fairly
stated in the bank’s financial statements;
• the bank has not incurred any material liability from a breach of its
fiduciary duties, including the safekeeping of assets; and
• in the event that the bank discloses the nature and extent of its fiduciary
activities in the notes to its financial statements, that such information is
fairly stated.

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Financial Audit Objectives and Considerations

Statement Item of Particular Importance

6.13 Existence
Bullion Because bullion is generally similar in appearance
and hence easily interchangeable, the auditor should
consider the need for confirmation or physical
inspection and tests of reconciliations of the results
of physical counts to the accounting records of the
amounts held by the bank on its own account and on
behalf of customers. As an understanding of the
circumstances under which bullion may be held by a
bank is necessary to an understanding of how it is
accounted for, the audit considerations that relate to
the verification of its existence are commented on in
conjunction with the discussion below of Rights and
Obligations.
Rights and Obligations
Where a bank holds bullion on behalf of customers,
the auditor will encounter two possible sets of
circumstances, being;
1. The bullion held on behalf of customers is
“allocated” (i.e., the bullion received on deposit is
specifically identified and the depositor is entitled to
have the identified bullion returned—this is
equivalent to a fiduciary arrangement); or
2. the bullion held on behalf of customers is
“unallocated” (i.e., the bullion received on deposit is
not specifically identified but the bank
acknowledges receipt of the bullion by general
description, specification and weight and the
depositor is not entitled to have the specific bullion
returned—this is equivalent to a deposit of money,
which the bank will in turn attempt to lend to
customers requiring loans denominated in bullion).
Where the bank holds bullion on its own account
(i.e., as a result of its own dealing position) and also
on behalf of customers, the auditor will be
concerned to ensure that the bullion of each party
has been appropriately segregated and accounted
for.
When the bullion held on behalf of customers is
held in common custody with the bank’s own
bullion, the bank will need to ensure there has been
a physical count of the bullion on hand and a
reconciliation of the results of that count to the

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accounting records of the amounts held by the bank

on its own account and on behalf of customers.
When the bullion held on behalf of customers is
held in separate custody, the auditor will need to
obtain reasonable assurance as to the adequacy of
the system of internal control, failing which, he will
need to ensure there has been a physical count and
reconciliation as described above.
Where the bank has a dealing position in bullion, the
audit considerations will be generally similar to
those discussed with respect to foreign exchange
(see 6.17).
However, in establishing the physical existence of
the bank’s bullion position, the auditor needs to be
aware that some portion of the bank’s “long”
positions may be in the custody of other banks or
bullion dealers and that the bank may have itself
“borrowed” and sold bullion from the unallocated
bullion deposits of customers, thereby creating
“short” positions.
6.14 Existence
Balances with The auditor should consider the need for third-
other banks party confirmation of the balance. Because the
balances held with other banks will usually be the
result of large volumes of transactions, the receipt of
confirmations from those other banks is likely to
provide more conclusive evidence as to the
existence of the transactions and of the resultant
inter-bank balances than is the testing of the related
internal controls. Guidance on inter-bank
confirmation procedures, including terminology and
the content of confirmation requests, can be found in
the International Auditing Practice Statement 1000
“Inter-Bank Confirmation Procedures.”
Valuation
The auditor should consider whether there is a need
to assess the collectability of the deposit in light of
the credit-worthiness of the depository bank. The
procedures required in such an assessment will be
similar to those used in the audit of loan valuation,
discussed later.

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Presentation and Disclosure

The auditor should consider whether the balances
with other banks as at the date of the financial
statements are representative of bona-fide
commercial transactions or whether any significant
variation from normal or expected levels is
indicative of transactions entered into primarily to
give a misleading impression of the financial
position of the bank and/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 may consider the
need for the adjustment of the balances shown on
the financial statements, additional disclosure in the
notes, or qualification in the audit report.
6.15 Existence
Money market The auditor should consider the need for
paper physical inspection and confirmation with external
custodians and the reconciliation of these related
amounts with the accounting records.
Rights and Obligations
The auditor should consider the feasibility of
checking for receipt of the related income as a
means of establishing ownership.
The auditor should examine for the existence of sale
and forward repurchase agreements for evidence of
unrecorded liabilities and losses.
Valuation
The auditor should consider the appropriateness of
the valuation techniques employed, in light of the
creditworthiness of the issuer.
Measurement
The auditor should consider whether there is a need
to ensure that income earned on money market
instruments, which in some cases will be through
the amortization of a purchase discount, has been
accrued.
6.16 Existence
Trading The auditor should consider the need for
securities physical inspection of securities and confirmation
with external custodians and the reconciliation of
these amounts with the accounting records.

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Rights and Obligations

The auditor should consider the feasibility of
checking for receipt of the related income as a
means of establishing ownership. The auditor should
examine for the existence of sale and forward
repurchase agreements for evidence of unrecorded
liabilities and losses.
Valuation
Since trading securities are normally carried at
market value or at the lower of cost and market
value, the auditor should ensure that securities
whose market value has increased are not arbitrarily
transferred from the Investment Account (see 6.18)
primarily so that an unrealized gain can be taken
into income.

6.17
Other
financial
assets
(a) those involving Rights and Obligations
a current
The auditor should examine the underlying
investment of
documentation supporting the purchase of such
funds (e.g., blocks
of loans purchased assets in order to ensure that all rights and
obligations, such as warranties and options, have
for resale,
been properly accounted for.
purchases of
securitized assets Completeness
such as mortgage
backed securities) Due to the continuing development of new financial
instruments, there is often a lack of established
procedures between participants and within the
bank. Many of these transactions are entered into
orally, with written documentation being completed
subsequently, and therefore, the auditor should
assess the adequacy of the system of internal
control, particularly with respect to:
• the adequacy of the procedures and the division
of duties regarding the matching of documen-
tation received from counterparties and
reconciliation of accounts with counterparties;
and
• the adequacy of internal audit review.

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The auditor will also find it useful to examine post

year-end transactions for evidence of items that
should have been recorded in the year-end financial
statements.

Valuation
The auditor should consider 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 which the bank has
entered into in those markets.
Presentation and Disclosure
Since many of the items included in this category of
assets could, in accordance with relevant accounting
principles, also be included in other asset categories,
the auditor should consider whether such assets have
been included in the appropriate financial statement
item.
(b) those not Rights and Obligations
involving the
The auditor should examine the underlying
current
documentation supporting such transactions in order
investment of
funds, being: to ensure that all rights and obligations, such as
warranties and options, have been properly
– those accounted for.
involving the
option or Completeness
commitment to Similar considerations as applicable to item a) above
purchase an will arise.
asset (e.g.,
securities and Valuation
foreign In addition to the audit considerations mentioned in
currencies) a) above, which are also applicable to this item,

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– those the following additional considerations would arise:

involving the
option or • Where market values need to be considered, but
are not available, the auditor should ensure that
commitment to
appropriate alternative valuation techniques have
deposit funds
been employed, based, where appropriate, on
– those current interest or foreign exchange rates.
involving the
option or
• As many of these instruments have been
commitment to developed only recently, the auditor should
examine their valuation with a special degree of
exchange
caution, and in doing so should bear in mind the
future
payments or following factors:
receipts (e.g., – in most cases the enforceability of the terms in
interest rate the underlying agreements cannot be evaluated
swaps) against legal precedents, as such precedents
may not have been established;
– as there are normally relatively few employees
involved in managing the portfolio of such
instruments, there will be a relatively small
number of management personnel who are
familiar with the inherent risks of these
instruments; and
– most of these instruments will not have existed
through a full economic cycle (bull and bear
markets, high and low interest rates, high and
low trading and price volatility) and it may
therefore be more difficult to assess their value
with the same degree of certainty as for more
established instruments. Additionally, for the
same reason, it may be difficult to predict with
any degree of certainty the price correlation
with other offsetting instruments used by the
bank to hedge its positions.
Measurement
The auditor should satisfy himself as to the purpose
for which the transaction resulting in the instrument
was entered into, namely whether the bank was
dealing as principal to create a dealing position or as
principal, intermediary or broker for hedge
purposes. The purpose will determine the
appropriate accounting treatment.
Since settlement of such transactions is at a future
date, the auditor should consider whether a profit or
loss has arisen to date.
The auditor should be particularly vigilant for
reclassification of hedging and trading trans-

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actions/positions which may have been made

primarily with a view to taking advantage of
differences in the timing of profit and loss
recognition.
Presentation and Disclosure
In some countries the relevant accounting principles
will require the recording of accrued gains and
losses on open positions, whether or not these
positions are recorded on the balance sheet. In other
countries there is only an obligation to disclose the
commitment. Where the latter is the case, the auditor
should consider whether the unrecorded amounts are
of such significance as to require a disclosure in the
financial statements and/or qualification in the audit
report.
6.18 Presentation and Disclosure

Investments The auditor should consider whether the stated

(long-term) objectives at the time such securities are purchased
and subsequent trading activity in those securities
provides support for their classification as long-term
investments or whether they should more properly be
classified as “trading securities.”

(a) Marketable Valuation

Where securities have been transferred from the
Trading Account, the auditor should ensure that any
unrealized losses in market value are recorded if so
required by relevant accounting principles.
(b) Non-marketable Valuation
The auditor should examine the value of the assets
supporting the security value.
The auditor also should consider 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. In certain cases there will be a need to
ensure that the related financial obligations are
recorded as liabilities of the bank.
The auditor should ensure that appropriate
adjustments are made when the accounting policies
of companies which are accounted for on an equity
basis or are consolidated do not conform to those of
the bank.

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6.19 Valuation
Loans The major audit concern is the adequacy of the
recorded provision for loan losses.
(comprising advances,
bills of exchange, In establishing the nature, extent and timing of the
letters of credit, work to be performed, the auditor should consider
acceptances, the following factors:
guarantees, and all
other lines of credit
• The degree of reliance it is reasonable to place on
extended to customers, the bank’s system of loan quality classification,
on its procedure for ensuring that all
including those in
documentation is properly completed, on its
connection with
foreign exchange and internal loan review procedures and on the work
of the internal auditor.
money market
activities) • Given the relative importance of foreign lending,
• personal there is also usually a need for the auditor to
• commercial examine:
• government
– the information on the basis of which the bank
– domestic assesses and monitors the country risk and the
– foreign criteria (e.g., specific classifications and
valuation ratios) it uses for this purpose;
– whether and, if so, by whom credit limits are
set for the individual countries, what they are
and the extent to which they are being utilized;
and
– how the foreign loans are distributed by
country.
• The composition of the loan portfolio, with
particular attention to:
– the concentration of loans to specific:
• borrowers and parties connected to them
(including the procedures in place to
identify such “connections”);
• commercial and industrial sectors;
• geographic regions; and
• countries;
– the size of individual credit exposures (few
large loans versus numerous small loans);
– the trends in loan volume by major categories,
especially categories having exhibited rapid
growth, and in delinquencies, non-accrual and
restructured loans; and
– related party lending.

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• Identified potential problem loans, with particular

attention to:
– the previous loss and recovery experience,
including the adequacy and timeliness of
provisions and charge-offs; and
– results of regulatory examinations.
• Local, national and international economic and
environmental conditions, including restrictions
on the transfer of foreign currency which may
affect the repayment of loans by borrowers.
In addition to those problem loans identified by
management and, where applicable, by bank
regulators, the auditor should consider additional
sources of information to determine those loans
which may not have been so identified. These
include:
• various internally generated listings, such as
“watchlist” loans, past due loans, loans on non-
accrual status, loans by risk classification, loans
to insiders (including directors and officers), and
loans in excess of approved limits;
• historical loss experience by types of loan; and
• those loan files lacking current information on
borrowers, guarantors or collateral.
6.20

Accounts with
depositors, including:
(a) General deposits Completeness
Given the volume and value of deposit transactions,
the auditor should assess the adequacy of the related
system of internal control and perform confirmation
and analytical review procedures on average
balances and on interest expense to assess the
reasonableness of the recorded deposit balances.
Presentation and Disclosure
The auditor should ensure that deposit liabilities are
classified in accordance with regulations and
relevant accounting principles.
Where deposit liabilities have been secured by
specific assets, the auditor should consider the need
for appropriate disclosure.

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The auditor should also consider the need for

disclosure where the bank has a funding risk due to
economic dependence on a few large depositors or
where there is an excessive concentration of
deposits due within a specific time-frame.
(b) Items in transit Existence
The auditor should ensure that 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 should examine individual
items comprising the balance which have not been
cleared within a reasonable time period and should
also consider 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.
6.21 Presentation and Disclosure
Capital and The auditor should ensure that capital and reserves
reserves are adequate for regulatory purposes (e.g., to meet
capital adequacy requirements) and that disclosure is
both appropriate and in accordance with legal
requirements.
In addition, where applicable regulations provide for
restrictions on the distribution of retained earnings,
the auditor should assess whether they are
adequately disclosed.
The auditor should also determine whether the
requirements of the International Accounting
Standards or local regulations with respect to the
disclosure of hidden reserves have been complied
with (see also paragraph 7.3).

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6.22 Completeness
Contingencies and Because most commitments and contingencies are
Commitments often not recorded in the bank’s accounting records,
the auditor should:
(e.g., commitments to
lend funds and to • identify those activities which have the potential
guarantee repayment to generate contingent liabilities;
of funds by customers
to third parties)
• ascertain, with regard to these activities whether
the bank’s system of internal control is adequate,
particularly with regard to the records maintained
for such obligations to ensure that contingent
liabilities arising out of such activities are
properly identified and recorded and that
evidence is retained of the customer’s agreement
to the related terms and conditions;
• perform substantive audit tests to establish the
completeness of the recorded obligations. Such
tests could include confirmation procedures as
well as examination of related fee income in
respect of such activities and would be
determined having regard to the degree of risk
attached to the particular type of contingency
being considered;
• review the reasonableness of the year-end
contingency figures in the light of his experience
and his knowledge of the current year’s activities;
and
• obtain representation from management that all
contingent liabilities have been recorded.
Valuation
As 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.” The
audit objectives and considerations of particular
importance discussed in paragraph 6.19 would be
equally relevant in respect of such transactions.
Presentation and Disclosure
Although relevant accounting principles will usually
require disclosure of such obligations in the notes to
the financial statements rather than in the balance
sheet, the auditor should nevertheless consider the
potential financial impact on the bank’s capital,
funding and profitability of the need to honor such

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obligations and whether this needs to be specifically

disclosed in the financial statements.
6.23 Measurement
Interest income and Given the large volume of loans and deposits on
interest expense which interest income and expense are calculated as
well as the variations in interest rates between
various categories of loans and deposits and over
time, there is a need to:
• obtain reasonable assurance that satisfactory
procedures exist for the proper accounting of
accrued income and expenditure at the year-end;
• assess the adequacy of the related system of
internal control; and
• utilize analytical review techniques in assessing
the reasonableness of the reported amounts.
Such techniques include comparison of reported
interest yields in percentage terms:
• to market rates;
• to prime rates;
• to advertised rates (by type of loan or deposit);
and
• between portfolios.
In making such comparisons, it is important to
ensure that average rates in effect (e.g., by month)
are used in order to avoid distortions caused by
interest rate volatility.
The auditor also needs to assess the reasonableness
of the policy applied to income recognition on
troubled loans, especially where such income is not
being received on a current basis.
6.24 Measurement
Income from The audit procedures in this area should be carried
securities, including: out in conjunction with Money Market Instruments,
gains and losses Trading Securities, Other Financial Instruments and
interest Investments to ensure that:
dividends
• the correlation between securities owned and the
related income is reasonable; and
• all significant gains and losses from sales and
revaluations have been reported in accordance
with relevant accounting principles (e.g., where
gains and losses on trading securities are treated
differently from those on investment securities).

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6.25 Measurement
Provisions for
loan losses The major audit concerns in this area are discussed
above under “Loans.” Usually, provisions will take
two forms, namely specific provisions in respect of
identified losses on individual accounts and general
provisions to cover losses which are thought to exist
but which have not been specifically identified. In
those countries where levels of general provisions
are prescribed by local regulations, the auditor
should ensure that the reported provision expense is
calculated in accordance with such regulations. In
other countries the auditor should assess the
adequacy of such general provisions based on such
factors as past experience and other relevant
information. Appendix 3 to this Statement contains
examples of substantive audit procedures for the
evaluation of loan loss provisions.
6.26 Measurement
Gains and losses on Given the volume of transactions that are typically
foreign exchange undertaken in this area, the auditor should assess:
• the adequacy of the related system of internal
control, including the period-end reconciliation
procedures, particularly in respect of the
completeness and accuracy of the recording of
outstanding positions as at the financial statement
date (which will necessitate a familiarity by the
auditor with the standard inter-bank transaction
confirmation procedures);
• the appropriateness of the exchange rates used at
the financial statement date to calculate accrued
gains and losses; and
• the appropriateness of the accounting policies
used having regard to relevant accounting
principles particularly with regard to the
distinction between realized and unrealized
profits and losses.
Additionally, the auditor should ensure that
individual foreign exchange contracts have been
revalued, rather than foreign exchange positions, as
such positions can include contracts maturing on
varying dates at varying rates.
6.27 Measurement
Fee and commission The auditor should consider whether the fee and
income commission income recorded:

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• relates to the period covered by the financial

statements and that those amounts relating to
future periods have been deferred;
• is collectible (this should be considered as part of
the loan review audit procedures where the fee
has been added to a loan balance outstanding);
• is accounted for in accordance with applicable
regulatory instructions and relevant accounting
principles; and
• is complete (i.e., all individual items have been
recorded). In this respect, there may be a need to
utilize analytical review techniques in assessing
the reasonableness of the reported amounts.
6.28 Measurement
Provision for The auditor should be familiar with special taxa -
taxes on income tion rules applicable to banks in the jurisdiction in
which the bank on which he is reporting is located
and also needs to ensure that any auditors on whose
work he is relying in respect of the bank’s foreign
operations are similarly familiar with the rules in
their jurisdiction. An awareness of the taxation
treaties between the various jurisdictions in which
the bank operates is also required.
6.29 Presentation and Disclosure
Notes to the financial The auditor should ensure that the notes to the
statements bank’s financial statements are in accordance with
(including, where both regulatory instructions and with relevant
applicable, a Statement accounting principles, including International
of Accounting Accounting Standards.
Policies)
Where such notes include information in respect of
foreign operations of the bank, the auditor should
ensure that appropriate audit procedures have been
applied to that information and that the necessary
adjustments have been made to ensure it conforms to
the accounting principles followed by the
preparation of the bank’s financial statements.

7. Reporting on the Financial Statements

7.1 ISA 700 “The Auditor’s Report on Financial Statements,” states:

The auditor should review and assess the conclusions
drawn from the audit evidence obtained as the basis for
the expression of an opinion on the financial statements.

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This review and assessment involves forming an overall

conclusion as to whether:
• the financial statements have been prepared using
acceptable accounting policies, which have been
consistently applied;
• the financial statements comply with regulations and
statutory requirements relating to the preparation of
financial statements;
• the view presented by the financial statements as a
whole is consistent with the auditor’s knowledge of the
business of the entity; and
• there is adequate disclosure of all material matters
relevant to the proper presentation of the financial
statements.
7.2 In rendering his opinion on the bank’s financial statements, the auditor should
consider the need to:
• adhere to specific formats, terminology and accounting principles as
specified by the law, the regulatory authorities, professional bodies and
industry practice; and
• ensure that adjustments have been made to the accounts of foreign
branches and subsidiaries which are included in the consolidated financial
statements of the bank to bring them into conformity with the accounting
principles 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 could lead to a greater divergence in
the accounting principles followed by branches and subsidiaries, than
would be the case in respect of other business entities.
7.3 In some countries, local regulations permit banks to maintain hidden reserves.
Where the existence of hidden reserves is not disclosed in the financial
statements, the auditor should disclose this fact in his audit report. It is
suggested that this may be accomplished by reference to the relevant statutes
or law which permit the existence of hidden reserves.

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Appendix 1

Examples of Internal Control Checklists to Assist in Assessing Three Typical

Areas of a Bank’s Operations:

• Foreign Exchange Trading

• Credit
• Trust Activities

A. Foreign Exchange Trading

Operational controls

Does the bank have written policies which are in the hands of all dealers in
respect of the following:
• prohibiting dealers from trading on their own account;
• identification of approved counterparties; and
• procedures for the review of dealers’ activities by management?
Limits & Trading Activity

Does the bank have written policies established for intra -day and end-of-day
limits:
• by currency;
• by counterparty;
• by maturity date; and
• by trader?
Recording

Does the bank have written policies in use to:

• spotlight unusually heavy dealing by a customer who may be experiencing
financial difficulties;
• adequately disclose sudden increases in trading volume by any one trader,
customer or counterparty; and
• adequately disclose transactions at unusual contract rates?
Does the bank have written procedures which require:
• prenumbered trade tickets to be allocated to each dealer;
• the accounting for all used and unused trade tickets;
• the prompt recording into the accounting records by an independent party
of all transactions, including procedures to identify and correct rejected
transactions;

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• the daily reconciliation of dealer’s positions and profits with the

accounting records and the prompt investigation of all differences; and
• regular reports to management in appropriate detail to allow the
monitoring of the limits referred to above?
Confirmations

Does the bank have written procedures in use:

• for the independent dispatch of prenumbered outward confirmations to
counterparties for all trades entered into by the dealers;
• for the independent receipt of all incoming confirmations and their
matching to pre-numbered copies of internal trade tickets;
• for independent comparison of signatures on incoming confirmations to
specimen signatures;
• for the independent confirmation of all deals for which no inward
confirmation has been received; and
• for the independent follow-up of discrepancies on confirmations received?
Position account maintenance

Does the bank have accounting records which allow it to prepare reports
which show its spot, forward and net open and overall positions:
• by purchase and sale, by currency;
• by maturity dates, by currency; and
• by counterparty, by currency?
Are foreign exchange positions revalued periodically (e.g., daily) to current
values bas ed on quoted foreign exchange rates?
Settlement of transactions

Are settlement instructions exchanged in writing with counterparties by the

use of inward and outward confirmations?
Are settlement instructions compared to the contracts?
Are settlements made only by appropriate authorized employees independent
of the initiation and recording of transactions and only on the basis of
authorized, written instructions?
Are all scheduled settlements (receipts and payments) notified daily in
writing to the settlements department so that duplicate requests and failures to
receive payments can be promptly detected and followed-up?

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Are accounting entries either prepared from or checked to supporting

documentation by operational employees, other than those who maintain
records of uncompleted contracts or perform cash functions?
Account reconciliations

Are all nostro and vostro account reconciliations performed frequently and by
employees independent of the settlement function?

B. Credit
The credit function may conveniently be divided into the following
categories:
(a) origination and disbursement;
(b) monitoring;
(c) collection; and
(d) periodic review and evaluation.
Within these categories, the key internal controls are as follows:
(a) origination and disbursement:
• does the bank obtain complete and informative loan applications,
including financial statements of the borrower and the intended use of
proceeds;
• does the bank have written guidelines as to the criteria to be used in
assessing loan applications (e.g., interest coverage, margin
requirements, debt-to-equity ratios);
• does the bank obtain credit reports or have independent investigations
conducted on prospective borrowers;
• does the bank have procedures in use to ensure that connected party
lending has been identified;
• is there an appropriate analysis of customer credit information,
including projected sources of loan servicing and repayments;
• are loan approval limits based on the lending officer’s expertise;
• is appropriate lending committee or board of director approval
required for loans exceeding prescribed limits;
• is there appropriate segregation of duties between the loan approval
function and the loan disbursement monitoring, collection and review
functions;
• is the ownership of loan collateral and priority of the security interest
verified;
• is the documentation supporting the loan application reviewed and
approved by an employee independent of the lending officer;

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• is there a control to ensure the appropriate registration of security

(e.g., recording of liens with governmental authorities);
• is there adequate physical protection of notes, collateral and
supporting documents;
• is there a control to ensure that loan disbursements are recorded
immediately; and
• is there a control to ensure that to the extent possible, loan proceeds
are used by the borrower for the intended purpose?
(b) monitoring:
• are ledger trial balances prepared and reconciled with control
accounts by employees who do not process or record loan
transactions;
• are reports prepared on a timely basis of loans on which principal or
interest payments are in arrears;
• are these reports reviewed by employees independent of the lending
function;
• are there procedures in use to monitor the borrower’s compliance
with any loan restrictions (e.g., covenants) and requirements to
supply information to the bank;
• are there procedures in place that require the periodic reassessment of
collateral values;
• are there procedures in place to ensure that the borrower’s financial
position and results of operations are reviewed on a regular basis; and
• are there procedures in place to ensure that key administrative dates,
such as the renewal of security registrations, are accurately recorded
and acted upon as they arise?
(c) collection:
• are the records of principal and interest collections and the updating
of loan account balances maintained by employees independent of
the credit granting function;
• is there a control to ensure that loans in arrears are followed up for
payment on a timely basis;
• are there written procedures in place to define the bank’s policy for
recovering outstanding principal and interest through legal
proceedings, such as foreclosure or repossession; and
• are there procedures in place to provide for the regular confirmation
of loan balances by direct written communication with the borrower
by employees independent of the credit granting and loan recording
functions, as well as the independent investigation of reported
differences?
(d) periodic review and evaluation:

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• are there procedures in place for the independent review of all loans
on a regular basis, including:
– the review of the results of the monitoring procedures referred to
above; and
– the review of current issues affecting borrowers in relevant
geographic and industrial sectors?
• are there appropriate written policies in effect to establish the criteria
for:
– the establishment of loan loss provisions;
– the cessation of interest accruals (or the establishment of offsetting
provisions);
– the valuation of collateral security for loss provisioning purposes;
– the reversals of previously established provisions; and
– the resumption of interest accruals?
• are the procedures in place to ensure that all required provisions are
entered into the accounting records on a timely basis?

C. Trust Activities
Account Initiation and Authorization

Does the bank:

• have a committee in place to determine criteria for acceptance of new
accounts and to set the fees thereon;
• utilize standard trust agreements to the extent possible and obtain legal
advice, where necessary; and
• review the initial deposit of assets to ensure compliance with the trust
agreement?
Does the bank have written policies available to all employees responsible for
administration of trust assets in respect of the following:
• guidelines for investment decisions;
• listing of brokers and dealers with whom the trust is prepared to deal;
• conflict of interest and self-dealing;
• organizational charts and job descriptions of all employees within the trust
function; and
• compliance with regulatory rules?
Monitoring

Does the bank have written procedures in use:

• to ensure on a periodic basis that the customer and the bank have complied
with their obligations under the trust agreement;

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• to ensure that assets acquired on behalf of a trust adhere to the trust

agreement and relevant laws;
• to ensure appropriate approval of all investment decisions;
• to ensure the timely investment or distribution of trust funds;
• to ensure that any principal or income receivable by the trust has been
collected, is in the process of collection or requires follow-up;
• to ensure that fees are calculated and charged at regular intervals in
accordance with the trust agreement; and
• to ensure adequate review and supervision of the above procedures?
Safeguarding of Trust Assets
Does the bank have written procedures in use in respect of the following:
• joint custody and control over trust assets;
• adequate physical security over trust assets, including storage in locked,
fireproof vaults;
• safeguarding of unissued stock or bond certificates;
• existence of an accurate and up-to-date listing of all assets under
administration;
• periodic reconciliation of physical holdings of assets in the vault with
accounting records, by employees independent of the recording or custody
of trust assets; and
• adequate insurance coverage in relation to level of assets under
administration?
Accounting
Does the bank:
• ensure that staff engaged on trust operations are distinct from staff engaged
in other operations of the bank;
• ensure that trust records are adequately segregated from the records for
transactions which the bank enters into on its own account;
• ensure the segregation of duties within the trust operations relating to
initiation of transactions, authorization of transactions, custody of assets
and maintenance of accounting records;
• maintain control accounts for cash balances relating to principal and
income for each trust;
• ensure periodic reconciliations of all control and suspense accounts are
performed by an employee independent of the receipts and disbursements
functions;
• ensure daily posting of journals including detailed descriptions of principal
and income transactions;

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• have procedures to ensure appropriate classification of trust assets and

income by trust account and nature of assets;
• have procedures in use to ensure appropriate classification of cash receipts
between capital and income;
• regularly report the value of assets and income earned to the customer;
• monitor the receipt of income with that expected and follow-up on any
differences; and
• have procedures in place to record accurately rights and bonus issues,
stock dividends and stock splits?

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Appendix 2

Examples of Financial Ratios Commonly Used in the Analysis of Bank

Financial Condition and Performance
There are a large number of financial ratios which are used to analyze a bank’s
financial condition and performance. While these ratios vary somewhat between
countries and between banks, their basic purpose tends to remain the same, that is, to
provide measures of performance in relation to prior years, to budget and to other
banks.
These ratios generally fall into the following categories:
• Asset quality;
• Liquidity;
• Earnings; and
• Capital adequacy.
Set out below are those overall ratios which the auditor is likely to encounter. Many
other, more detailed ratios will usually be prepared by management to assist in the
analysis of the condition and performance of the bank and its various categories of
assets and liabilities, departments and market segments.
(a) Asset quality ratios:
• loan losses to total loans
• non-performing loans to total loans
• loan loss reserves to non-performing loans
• earnings coverage to loan losses
• increase in loan loss reserves to gross income
(b) Liquidity ratios:
• cash and liquid securities (e.g., those due within 30 days) to total assets
• inter-bank and money market deposit liabilities to total assets
(c) Earnings ratios:
• return on average total assets
• return on average total equity
• net interest margin as a percentage of average total assets and average
earning assets
• interest income as a percentage of average interest bearing assets
• interest expense as a percentage of average interest bearing liabilities
• non-interest income as a percentage of average commitments
• non-interest income as a percentage of average total assets
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• non-interest expense as a percentage of average total assets

(d) Capital adequacy ratios:
• equity as a percentage of total assets
• equity as a percentage of risk assets

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Appendix 3

Examples of Substantive Audit Procedures for the

Evaluation of Loan Loss Provisions

1. The Examination of Loans, Individually and by Category

A. Introductory Comments
The review of individual loans is generally the most difficult task in the
completion of a bank audit. It is also the most critical due to the level of
risk and the effect of the provision for loan losses upon the financial
position of the bank. In addition, the task of assessing loan collectability
is one which demands the greatest amount of judgment and diligence
from the auditor. It is therefore essential that the auditor be well
prepared prior to commencing such a review.
The auditor must:
• Obtain an understanding of the bank’s method of controlling risk.
Such risks will arise from factors such as:
– currency of the loan;
– creditworthiness of the borrower;
– purpose of the loan;
– security for the loan;
– nature of borrower’s business activities; and
– country of operation of the borrower.
• Obtain a knowledge and understanding of:
– the bank’s loan monitoring process, and its system for ensuring
that all connected party lending has been identified and
aggregated;
– the bank’s method for appraising the value of loan collateral and
for identifying potential and definite losses;
– the loan portfolio and the various features and characteristics of
the loans;
– the loan documentation used by the bank;
– what constitutes appropriate loan documentation for different types
of loans;
– the bank’s lending practices and customer base; and
– the bank’s procedures and authority levels for granting a loan.
The governing statutes and regulations under which the bank operates
may specify the extent of the loan review process and any special
reporting requirements to the regulatory authority. Consequently, these
should be reviewed to identify any special reporting requirements which
may affect the audit.

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B. Audit Objectives
Within the context of the overall audit objective, the principal objective
of the loan review is to ensure that loans receivable are appropriately
valued and that loans requiring a provision for loss have been
completely identified and provided for as necessary.
C. Audit Approach
The approach will generally be based upon year-end substantiation
although the loan review is often performed before the year-end, with a
review of the intervening period being performed at the year-end.
The procedures to be applied should apply not only to loans, but also
extend to all other items for which the bank is at risk, whether recorded
on or off balance sheet.
In addition to the provisions required against individual loans, a bank
will normally need to consider the requirement for provisions in respect
to certain categories of loans. Such provisions may be required, either in
addition to specific provisions that may have been made against
individual loans in the category, or in lieu of such specific provisions.
Examples of categories in which an additional provision for loss may be
required would be those relating to geographic or industry sectors,
where overall concerns as to collectability exist but are not felt to be
fully quantified by the provisions against the individual loans. Examples
of categories in which a provision for loss may be required in lieu of
specific provisions against the individual loans would be those relating
to:
(a) categories of homogeneous loans, such as credit card loans and,
perhaps, residential mortgages, where the small size of the
individual loans may not warrant an item by item evaluation and
historical experience may be deemed a satisfactory basis on which
to provide for likely losses; and categories of loans, such as those
to countries which are experiencing foreign exchange problems,
where there is insufficient information available on which to
establish specific provisions and where there may be alternative
sources of guidance. Such guidance may be provided by:
– the bank’s previous provisioning practice and loss experience;
– available information from the supervisors; or
– where such loans are held for disposal, secondary market prices.
In each of the above situations, the auditor will need to assess
whether the provisions made in respect of each category are
adequate in the light of the information available.
D. Sample substantive procedures

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SAMPLE SUBSTANTIVE PROCEDURES

General

1. Record on the audit program the nature, extent and timing of the audit
procedures, as determined by the degree of reliance that can be placed on
internal controls, the materiality and volume of accounts, and the frequency
of transactions, and the proposed degree of coordination of loan review
procedures with those of internal audit. Consider performing the following
procedures at an early validation date, with an update review to the year-end.
2. Obtain a copy of the bank’s complete listing of loans as examined in the
loans section of the working paper file.
3. Obtain a listing of definite and potential loan losses identifying the borrower,
principal amount outstanding, accrued interest receivable and assessment of
the amount of definite and potential loss. (This should be the same listing
used in the loans section of the working paper file.) Consider requesting the
assistance of an insolvency specialist in completing the review of selected
loans.
Sample Selection Criteria

4. Before commencing the loan review, the following general factors should be
reviewed for their effect on the sample selection criteria:
• any change in the level of risk highlighted by a review of the bank’s
liquidity, interest rate and maturity mismatch and capital adequacy ratios
over a longer period of time (e.g., 4 years) and a comparison to other
similar financial institutions; and
• any change in the bank’s reliance on inter-bank deposits versus customer
deposits, which may be indicative of a decline in external confidence and
an over-dependence on more volatile money markets.
5. Consider any special requirements of the regulatory authorities (e.g.,
maximum limits on individual or connected exposures) and determine the
sample selection criteria appropriate in the circumstances. Selection criteria
should be applied to all connected party lending and should include the
following (the sample size selected below in each case will vary with the
selection criteria):
• accounts with an outstanding balance equal to or greater than (sample size
selected);
• accounts on a “Watch List” with an outstanding balance in excess of
(sample size selected);
• accounts with a provision in excess of (sample size selected);

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• accounts which are handled by the department that manages the bank’s
problem or higher risk accounts;
• accounts where principal or interest is in arrears for more than a specified
period (sample size selected);
• accounts where the amount outstanding si in excess of the authorized
credit line;
• problem accounts identified by the bank regulatory authorities and
problem accounts selected in the prior year;
• degree of exposure to other financial institutions on inter-bank lines; and
• amount of participation in syndicated loans.
In addition, where the bank’s personnel have been requested to summarize
characteristics of all loans over a specified size grouped on a connection
basis, review the summaries for loans with the following characteristics
which may indicate a need for a more detailed review:
• large operating loss in the most recent fiscal year;
• sustained operating losses (e.g., 2 or more years);
• a high debt/equity ratio (e.g., in excess of 2:1 — the ratio will vary by
industry, however);
• failure to comply with terms of agreement on covenants;
• negative comments by account manager as to:
– trends and factors affecting performance;
– company prospects; and
– significant events such as restructuring of loans or failure to comply
with debt covenants;
• qualified audit report;
• information provided not current or complete;
• advances significantly unsecured or secured substantially by a guarantee;
• accounts where reviews not performed by bank management on a timely
basis in accordance with laid -down procedures; and
• groupings of accounts that may result in increased exposure (e.g., by
currency, country, geographic location, connected group and industry).
Loan Review

6. Select the loans for detailed review from the loan listings above using the
sample selection criteria determined in steps 4 and 5.
7. Obtain the documents necessary to assess the collectability of the loans.
These may include:
(a) the loan and security documentation files;
(b) arrears listings or reports;
(c) activity summaries;

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(d) previous doubtful accounts lis tings;

(e) the non-current loan report;
(f) financial statements of the borrower; and
(g) security valuation reports.
8. Using the loan documentation file, ascertain the loan type, interest rate,
maturity date, repayment terms, security and purpose of the loan.
9. Ensure that security documents bear evidence of registration as appropriate,
and that security has been obtained in a legally enforceable form. Determine
whether the fair value of the security appears adequate (particularly for those
loans where a provision may be required) to secure the loan and that where
applicable, the security has been properly insured. Critically evaluate the
collateral appraisals, including the appraiser’s methods and assumptions.
10. Ensure that the loan application or renewal has been approved by the
appropriate authority levels within the bank.
11. Review prior arrears listings and activity summaries and ascertain that the
operating history of the loan is in accordance with the original terms of the
loans.
12. Review periodic financial statements of the borrower and note significant
amounts and operating ratios (i.e., working capital, earnings, shareholders’
equity and debt-to-equity ratios).
13. Review any notes and correspondence contained in the loan review file. Note
the frequency of review performed by the bank’s staff and ensure that it is
within bank guidelines.
14. Consider where applicable, the reports of the bank’s internal loan review
department.
15. Review correspondence and agreements for loans sold or participated by the
bank. Ensure that there is no recourse to the bank, or if there is recourse,
consider the loans for further review.
Loan Provisions

16. Based upon the information obtained in the preceding steps, evaluate the
collectability of loans receivable and determine the need for a provision
against the account.
17. Quantify the amount of the provision, identifying the specific loan where a
provision is required. Provide details of the calculation of the provision.
18. Compare the amount of the provision to the amount established by the bank
and quantify the difference. Summarize the amounts identified.
19. Obtain a listing of provisions established at the previous year-end and ensure
all significant movements have been reviewed during the course of the loan
review.
20. In addition to assessing the adequacy of the provisions against individual
loans, consider whether any additional provisions need to be established

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against particular categories or classes of loans (e.g., credit card loans and
country risk loans) and assess the adequacy of any provisions that the bank
may have established.
21. Discuss the results of the above procedures with management.
Conclusions

22. Based upon the preceding procedures, determine the appropriateness of the
bank’s provision for loan losses.
23. (a) Confirm that the accounting policies applied for determining loan loss
provisions are consistent with those applied in the previous year, are in
accordance with relevant accounting principles and are appropriately
disclosed in the bank’s financial statements.
(b) i) State whether any exceptions were noted in steps 1 to 21 above;
ii) If so, confirm that they have been recorded on the working papers
and that the nature and level of substantive procedures have been
amended as necessary; and
iii) Confirm that all exceptions have been carried forward to the
summary of unadjusted differences.
(c) i) Consider whether the above substantive procedures have provided
any evidence that the bank’s loan loss provisions are not fairly
stated in its accounts; and
ii) If there is such evidence, draw it to the attention of the audit
manager and partner, along with the appropriate working paper
references.

2. The Evaluation of the Overall Loan Loss Provision

After completing the examination of individual loans, the auditor should
evaluate the adequacy of the overall loan loss provision in light of trends
noted;
• in the examination of individual loans; and
• in the loan portfolio as a whole and in its components.
These trends can be categorized between those relating to quantitative
information and those relating to qualitative information. Using these
categorizations, the trends which the auditor may wish to consider are as
follows:
(a) trends in quantitative information
1. Information specifically relating to the bank:
i) financial and statistical information for the current and prior
years, compared to the loan portfolio as a whole and, where
appropriate, to individual categories of loans (portfolios):
• the level of provisions

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• the actual loan loss experience.

• the level of non-accrual loans
• the level of work-outs
• the level of write-offs
• the level of loans in each of the bank’s risk rating
categories
• recoveries of prior years’ provisions
• concentration of loans:
– by industry
– by geographic region
– to specific borrowers and their related parties
• the level of differences in judgement on individual loans
between management and the auditor
ii) information which may not be gathered by the bank in a
quantitative manner:
• the absence of current financial data on the loan files (e.g.,
financial statements, appraisals of collateral)
• level of loans to borrowers experiencing financial
difficulties
• level of dependence for collectability or relatively illiquid
collateral
• frequency of increases in credit lines to troubled borrowers
• level of loans to borrowers exceeding approved credit lines
• frequency of extensions granted for the repayment of
principal and interest.
2. Information which may be compared to data available for other
banks:
the level of loan loss experience
the level of loan loss provisions in the statement of earnings.
3. Information on the countries in which the bank has credit risk:
gross national product
commodity (e.g., oil and foodstuff) prices
real estate prices/housing starts/commercial construction permits
interest rates
foreign exchange rates.
(b) trends in qualitative information

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An outline of the factors the auditor might consider in an assessment of

qualitative trends noted in the examination of individual loans is set out
below:
• the expertise of credit management, including their industry
knowledge;
• the extent of reliance by credit management on external evidence and
expertise, particularly in the valuation of collateral; and
• the criteria used for classifying loans as non-accrual and for
establishing provisions (e.g., the assumed “loan work-out” success
ratio).
In practice, the specific trends which the auditor will consider and the
extent to which they are considered and documented will depend on:
• the overall financial condition of the bank;
• the auditor’s initial and ongoing assessment of risk (which will be
influenced by factors such as the auditor’s assessment of the inherent
risk in the loan portfolio, the results of the examination of internal
control and the review of the work of the internal auditor);
• the results of the examination of individual loans; and
• the degree of comfort the auditor has with management’s judgments
(usually as a result of previous audits and the above mentioned
examinations of individual loans and, in some cases, on the results of
the auditor’s examination of other financial statement balances).

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HIGHLIGHTS
1.7 This Statement is organized into a discussion of the various stages of the audit of a bank with
emphasis being given to those matters which are either peculiar to or of particular importance in
such an audit. Also included for illustrative purposes are appendices which contain examples of:
• typical internal control procedures likely to exist in three of the major operating areas of a bank,
being the lending, foreign exchange trading and trust activities;
• financial ratios commonly used in the analysis of a bank’s financial condition and performance;
and
• substantive audit procedures for the evaluation of loan loss provisions.

Audit Risk
4.15 The three components of audit risk as defined in ISA 400 “Risk Assessments and Internal Control,”
and as amplified in ISA 320 “Audit Materiality” are:
• inherent risk (the risk that material errors will occur);
• control risk (the risk that the bank’s system of internal control will not prevent or correct such
errors); and

• detection risk (the risk that any remaining material errors will not be detected by the auditor).
The risks associated with banking activities as discussed in paragraphs 4.7 to 4.12 indicate that the
inherent risk in most cases will be fairly high. It is therefore necessary to ensure through an
adequate system of internal control that the control risk is kept at a low level.
Inherent and control risks exist independently of the audit of financial information and cannot be
controlled by the auditor. However, he can assess these risks and so design his substantive
procedures as to produce an acceptable level of detection risk.

The extent of CIS and EFT systems

4.16 The high volume of transactions and the short time-frames in which they must be processed
typically result in the extensive use by most banks of CIS and EFT systems.
The characteristics and control concerns arising from the use of CIS by a bank are similar to those
arising when such systems are used by other organizations. However, the matters which are of
particular concern to the auditor of a bank include:
• the use of CIS to calculate and record substantially all the interest income and interest expense,
which are normally the two most important elements in the determination of a bank’s earnings;
• the use of CIS to determine the foreign exchange and security trading positions and to calculate
and record the gains and losses arising therefrom; and
• the extensive, almost total, dependence on the records produced by the CIS because they
represent the only readily accessible source of detailed up-to-date information on the bank’s
assets and liability positions, such as customer loan and deposit balances.
EFT systems are used by banks both internally, for example, for transfers between branches and
between automated banking machines and the central computerized file which records account
activity, and externally between the bank and other financial institutions, for example, through the
SWIFT network.
In order to properly evaluate the system of internal control and to determine the nature, timing and
extent of the substantive audit procedures, the auditor needs to be aware of the extent and manner in
which CIS and EFT systems are used by the banks.

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Reliance on internal control

4.17 In forming his audit opinion, the auditor generally cannot rely solely on the results of his substantive
tests because of:
• the high volume of transactions entered into by banks;
• the manner in which transactions are entered into by banks;
• the geographic dispersion of banks’ operations; and
• the extensive use of CIS and EFT systems.
In most situations the auditor will therefore need to place significant reliance on the bank’s system
of internal control. To do so he will need to make a careful evaluation of the system to assess the
degree of reliance he can place upon the same in determining the nature, timing and extent of his
other audit procedures.
The work of internal audit
4.18 While the scope and objectives of internal audit can vary widely depending upon the size and
structure of the bank and the requirements of the board of directors and its management, its role
normally includes the review of the accounting system and related internal controls and monitoring
their operation and recommending improvements thereto. It also generally includes a review of the
means used to identify, measure and report financial and operating information and specific inquiry
into individual items including detailed testing of transactions, balances and procedures. The factors
which often require the auditor to place significant reliance on the bank’s system of internal control,
will also often require the auditor to use the work of the internal auditor. This is especially relevant
in the case of banks which have a large geographic dispersion of branches. Often, as a part of the
internal audit department or as a separate component, a bank has a loan review department which
reports to management on the quality of loans and the adherence to established procedures in respect
thereof. In either case, the auditor will often wish to make use of the work of this department.
Detailed guidance on the use of the work of an internal auditor is provided in ISA 610 “Considering
the Work of Internal Auditing.”

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