2008 Hanbook IAPS 1006

INTERNATIONAL AUDITING
PRACTICE STATEMENT 1006

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS
(This Statement is effective)
CONTENTS
Paragraph
Introduction ...................................................................................................
1-8
Audit Objectives ............................................................................................
9-11
Agreeing the Terms of the Engagement ........................................................
12-14
Planning the Audit .........................................................................................
15-55
Internal Control ..............................................................................................
56-70
Performing Substantive Procedures ............................................................... 71-100

Reporting on the Financial Statements .......................................................... 101-103
Appendix 1: Risks and Issues in Respect of Fraud and Illegal Acts
Appendix 2: Examples of Internal Control Considerations and Substantive
Procedures for Two Areas of a Banks Operations
Appendix 3: Examples of Financial Information, Ratios and Indicators
Commonly Used in the Analysis of a Banks Financial
Condition and Performance
AUDITING
Appendix 4: Risks and Issues in Securities Underwriting and Securities

Brokerage
Appendix 5: Risks and Issues in Private Banking and Asset Management
Glossary and References
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International Auditing Practice Statement (IAPS) 1006, Audits of the Financial

Statements of Banks should be read in the context of the Preface to the
International Standards on Quality Control, Auditing, Review, Other Assurance
and Related Services, which sets out the application and authority of IAPSs.
This Statement has been prepared by the International Auditing Practices
Committee (IAPC) of the International Federation of Accountants. The IAPC
bank audit sub-committee included observers from the Basel Committee on
Banking Supervision (the Basel Committee).* The document was approved for
publication by the IAPC at its meeting in October 2001. It is based on ISAs extant
at October 1, 2001.
The Basel Committee on Banking Supervision is a committee of banking and supervisory authorities
that was established by the central bank governors of ten countries in 1975. It consists of senior
representatives of bank supervisory authorities and central banks from Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom
and the United States. It usually meets at the Bank for International Settlements in Basel, where its
permanent secretariat is located.
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1.
The purpose of this Statement is to provide practical assistance to auditors

and to promote good practice in applying International Standards on
Auditing (ISAs) to the audit of banks financial statements. It is not,
however, intended to be an exhaustive listing of the procedures and
practices to be used in such an audit. In conducting an audit in accordance
with ISAs the auditor complies with all the requirements of all the ISAs.
2.
In many countries, banking supervisors require that the auditor report

certain events to the regulators or make regular reports to them in addition
to the audit report on the banks financial statements. This Statement does
not deal with such reports, the requirements for which often vary
significantly between countries. IAPS 1004, The Relationship Between
Banking Supervisors and Banks External Auditors discusses that subject
in more detail.
3.
For the purpose of this Statement, a bank is a type of financial institution

whose principal activity is the taking of deposits and borrowing for the
purpose of lending and investing and that is recognized as a bank by the
regulatory authorities in any countries in which it operates. There are a
number of other types of entity that carry out similar functions, for example,
building societies, credit unions, friendly societies, savings and loan
associations and thrift institutions. The guidance in this Statement is
applicable to audits of financial statements that cover the banking activities
carried out by those entities. It also applies to the audits of consolidated
financial statements that include the results of banking activities carried out
by any group member. This Statement addresses the assertions made in
respect of banking activities in the entitys financial statements and so
indicates which assertions in a banks financial statements cause particular
difficulties and why they do so. This necessitates an approach based on the
elements of the financial statements. However, when obtaining audit
evidence to support the financial statement assertions, the auditor often
carries out procedures based on the types of activities the entity carries out
and the way in which those activities affect the financial statement
assertions.
4.
Banks commonly undertake a wide range of activities. However, most

banks continue to have in common the basic activities of deposit taking,
borrowing, lending, settlement, trading and treasury operations. This
Statements primary purpose is the provision of guidance on the audit
implications of such activities. In addition, this Statement provides limited
guidance in respect of securities underwriting and brokerage, and asset
management, which are activities that auditors of banks financial
statements frequently encounter. Banks typically undertake activities
involving derivative financial instruments. This Statement gives guidance
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Introduction
on the audit implications of such activities when they are part of the banks
trading and treasury operations. IAPS 1012, Auditing Derivative Financial
Instruments gives guidance on such activities when the bank holds
derivatives as an end user.
5.
This Statement is intended to highlight those risks that are unique to

banking activities. There are many audit-related matters that banks share
with other commercial entities. The auditor is expected to have a sufficient
understanding of such matters and so, although those matters may affect the
audit approach or may have a material affect on the banks financial
statements, this Statement does not discuss them. This Statement describes
in general terms aspects of banking operations with which an auditor
becomes familiar before undertaking the audit of a banks financial
statements: it is not intended to describe banking operations. Consequently,
this Statement on its own does not provide an auditor with sufficient
background knowledge to undertake the audit of a banks financial
statements. However, it does point out areas where that background
knowledge is required. Auditors will supplement the guidance in this
Statement with appropriate reference material and by reference to the work
of experts as required.
6.
Banks have the following characteristics that generally distinguish them

from most other commercial enterprises:
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They have custody of large amounts of monetary items, including cash

and negotiable instruments, whose physical security has to be
safeguarded during transfer and while being stored. They also have
custody and control of negotiable instruments and other assets that are
readily transferable in electronic form. The liquidity characteristics of
these items make banks vulnerable to misappropriation and fraud.
Banks therefore need to establish formal operating procedures, welldefined limits for individual discretion and rigorous systems of internal
control.
They often engage in transactions that are initiated in one jurisdiction,

recorded in a different jurisdiction and managed in yet another
jurisdiction.
They operate with very high leverage (that is, the ratio of capital to
total assets is low), which increases banks vulnerability to adverse
economic events and increases the risk of failure.
They have assets that can rapidly change in value and whose value is
often difficult to determine. Consequentially a relatively small decrease
in asset values may have a significant effect on their capital and
potentially on their regulatory solvency.
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They generally derive a significant amount of their funding from shortterm deposits (either insured or uninsured). A loss of confidence by
depositors in a banks solvency may quickly result in a liquidity crisis.
They have fiduciary duties in respect of the assets they hold that belong
to other persons. This may give rise to liabilities for breach of trust.
They therefore need to establish operating procedures and internal
controls designed to ensure that they deal with such assets only in
accordance with the terms on which the assets were transferred to the
bank.
They engage in a large volume and variety of transactions whose value

may be significant. This ordinarily requires complex accounting and
internal control systems and widespread use of information technology
(IT).
They ordinarily operate through networks of branches and departments

that are geographically dispersed. This necessarily involves a greater
decentralization of authority and dispersal of accounting and control
functions, with consequential difficulties in maintaining uniform
operating practices and accounting systems, particularly when the
branch network transcends national boundaries.
Transactions can often be directly initiated and completed by the

customer without any intervention by the banks employees, for
example over the Internet or through automatic teller machines
(ATMs).
They often assume significant commitments without any initial transfer

of funds other than, in some cases, the payment of fees. These
commitments may involve only memorandum accounting entries.
Consequently their existence may be difficult to detect.
They are regulated by governmental authorities, whose regulatory

requirements often influence the accounting principles that banks
follow. Non-compliance with regulatory requirements, for example,
capital adequacy requirements, could have implications for the banks
financial statements or the disclosures therein.
Customer relationships that the auditor, assistants, or the audit firm

may have with the bank might affect the auditors independence in a
way that customer relationships with other organizations would not.
They generally have exclusive access to clearing and settlement

systems for checks, fund transfers, foreign exchange transactions, etc.
They are an integral part of, or are linked to, national and international
settlement systems and consequently could pose a systemic risk to the
countries in which they operate.
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7.
8.
They may issue and trade in complex financial instruments, some of

which may need to be recorded at fair values in the financial
statements. They therefore need to establish appropriate valuation and
risk management procedures. The effectiveness of these procedures
depends on the appropriateness of the methodologies and mathematical
models selected, access to reliable current and historical market
information, and the maintenance of data integrity.
Special audit considerations arise in the audits of banks because of matters

such as the following:
The particular nature of the risks associated with the transactions

undertaken by banks.
The scale of banking operations and the resultant significant exposures

that may arise in a short period.
The extensive dependence on IT to process transactions.
The effect of the regulations in the various jurisdictions in which they

operate.
The continuing development of new products and banking practices

that may not be matched by the concurrent development of accounting
principles or internal controls.
This Statement is organized into a discussion of the various aspects of the

audit of a bank with emphasis being given to those matters that are either
peculiar to, or of particular importance in, such an audit. Included for
illustrative purposes are appendices that contain examples of:
(a)
Typical warning signs of fraud in banking operations;
(b)
Typical internal controls, tests of control and substantive audit

procedures for two of the major operational areas of a bank: treasury
and trading operations and lending activities;
(c)
Financial ratios commonly used in the analysis of a banks financial

condition and performance; and
(d)
Risks and issues in securities operations, private banking and asset

management.
Audit Objectives
9.
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 financial statements are
prepared, in all material respects, in accordance with an
applicable financial reporting framework.
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10.
The objective of the audit of a banks financial statements conducted in

accordance with ISAs is, therefore, to enable the auditor to express an
opinion on the banks financial statements, which are prepared in
accordance with the applicable financial reporting framework.
11.
The auditors report indicates the financial reporting framework that has
been used to prepare the banks financial statements (including identifying
the country of origin of the financial reporting framework when the
framework used is not International Accounting Standards). When reporting
on financial statements of a bank prepared specifically for use in a country
other than that under whose rules it is established, the auditor considers
whether the financial statements contain appropriate disclosures about the
financial reporting framework used. Paragraphs 101-103 of this Statement
discuss the auditors report in more detail.
Agreeing the Terms of the Engagement

12.
As stated in ISA 210, Terms of Audit Engagements:

The engagement letter documents and confirms the auditors
acceptance of the appointment, the objective and scope of the
audit, the extent of the auditors responsibilities to the client and
the form of any reports.
14.
Paragraph 6 lists some of the characteristics that are unique to banks and
indicates the areas where the auditor and assistants may require specialist
skills. In considering the objective and scope of the audit and the extent of
the responsibilities, the auditor considers his own skills and competence and
those of his assistants to conduct the engagement. In doing so, the auditor
considers the following factors:
The need for sufficient expertise in the aspects of banking relevant to

the audit of the banks business activities.
The need for expertise in the context of the IT systems and

communication networks the bank uses.
The adequacy of resources or inter-firm arrangements to carry out the

work necessary at the number of domestic and international locations
of the bank at which audit procedures may be required.
In addition to the general factors set out in ISA 210, the auditor considers
including comments on the following when issuing an engagement letter:
The use and source of specialized accounting principles, with particular

reference to:
Any requirements contained in the law or regulations applicable to

banks;
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13.
Pronouncements of the banking supervisory and other regulatory

authorities;
Pronouncements of relevant professional accounting bodies, for

example, the International Accounting Standards Board;
Pronouncements of the Basel Committee on Banking Supervision;

and
Industry practice.
The contents and form of the auditors report on the financial

statements and any special-purpose reports required from the auditor in
addition to the report on the financial statements. This includes whether
such reports refer to the application of regulatory or other special
purpose accounting principles or describe procedures undertaken
especially to meet regulatory requirements.
The nature of any special communication requirements or protocols

that may exist between the auditor and the banking supervisory and
other regulatory authorities.
The access that bank supervisors will be granted to the auditors

working papers when such access is required by law, and the banks
advance consent to this access.
Planning the Audit

Introduction
15.
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The audit plan includes, among other things:
Obtaining a sufficient knowledge of the entitys business and

governance structure, and a sufficient understanding of the accounting
and internal control systems, including risk management and internal
audit functions;
Considering the expected assessments of inherent and control risks,

being the risk that material misstatements occur (inherent risk) and the
risk that the banks system of internal control does not prevent or detect
and correct such misstatements on a timely basis (control risk);
Determining the nature, timing and extent of the audit procedures to be

performed; and
Considering the going concern assumption regarding the entitys ability

to continue in operation for the foreseeable future, which will be the
period used by management in making its assessment under the
financial reporting framework. This period will ordinarily be for a
period of at least one year after the balance sheet date.
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Obtaining a Knowledge of the Business

Obtaining a knowledge of the banks business requires the auditor to
understand:
The banks corporate governance structure;
The economic and regulatory environment prevailing for the principal

countries in which the bank operates; and
The market conditions existing in each of the significant sectors in

which the bank operates.
17.
Corporate governance plays a particularly important role in banks; many

regulators set out requirements for banks to have effective corporate
governance structures. Accordingly the auditor obtains an understanding of
the banks corporate governance structure and how those charged with
governance discharge their responsibilities for the supervision, control and
direction of the bank.
18.
Similarly the auditor obtains and maintains a good working knowledge of

the products and services offered by the bank. In obtaining and maintaining
that knowledge, the auditor is 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. The auditor obtains
an understanding of the nature of services rendered through instruments
such as letters of credit, acceptances, interest rate futures, forward and swap
contracts, options and other similar instruments in order to understand the
inherent risks and the auditing, accounting and disclosure implications
thereof.
19.
If the bank uses service organizations to provide core services or activities,

such as cash and securities settlement, back office activities or internal audit
services, the responsibility for compliance with rules and regulations and
sound internal controls remains with those charged with governance and the
management of the outsourcing bank. The auditor considers legal and
regulatory restrictions, and obtains an understanding of how the
management and those charged with governance monitor that the system of
internal control (including internal audit) operates effectively. ISA 402,
Audit Considerations Relating to Entities Using Service Organizations
gives further guidance on this subject.
20.
There are a number of risks associated with banking activities that, while
not unique to banking, are important in that they serve to shape banking
operations. The auditor obtains an understanding of the nature of these risks
and how the bank manages them. This understanding allows the auditor to
assess the levels of inherent and control risks associated with different
aspects of a banks operations and to determine the nature, timing and
extent of the audit procedures.
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16.
Understanding the Nature of Banking Risks

21.
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The risks associated with banking activities may broadly be categorized as:
Country risk:
The risk of foreign customers and counterparties

failing to settle their obligations because of
economic, political and social factors of the
counterpartys home country and external to the
customer or counterparty.
Credit risk:
The risk that a customer or counterparty will not

settle an obligation for full value, either when
due or at any time thereafter. Credit risk,
particularly from commercial lending, may be
considered the most important risk in banking
operations. Credit risk arises from lending to
individuals, companies, banks and governments.
It also exists in assets other than loans, such as
investments, balances due from other banks and
in off-balance sheet commitments. Credit risk
also includes country risk, transfer risk,
replacement risk and settlement risk.
Currency risk:
The risk of loss arising from future movements

in the exchange rates applicable to foreign
currency assets, liabilities, rights and obligations.
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.
Interest rate risk:
The risk that a movement in interest rates would

have an adverse effect on the value of assets and
liabilities or would affect interest cash flows.
Legal and
documentary risk:
The risk that contracts are documented

incorrectly or are not legally enforceable in the
relevant jurisdiction in which the contracts are to
be enforced or where the counterparties operate.
This can include the risk that assets will turn out
to be worth less or liabilities will turn out to be
greater than expected because of inadequate or
incorrect legal advice or documentation. In
addition, existing laws may fail to resolve legal
issues involving a bank; a court case involving a
particular bank may have wider implications for
the banking business and involve costs to it and
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Liquidity risk:
The risk of loss arising from the changes in the

banks ability to sell or dispose of an asset.
Modeling risk:
The risk associated with the imperfections and

subjectivity of valuation models used to
determine the values of assets or liabilities.
Operational risk:
The risk of direct or indirect loss resulting from

inadequate or failed internal processes, people
and systems or from external events.
Price risk:
The risk of loss arising from adverse changes in

market prices, including interest rates, foreign
exchange rates, equity and commodity prices and
from movements in the market prices of
investments.
Regulatory risk:
The risk of loss arising from failure to comply

with regulatory or legal requirements in the
relevant jurisdiction in which the bank operates.
It also includes any loss that could arise from
changes in regulatory requirements.
Replacement risk:
(Sometimes called performance 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.
Reputational risk:
The risk of losing business because of negative

public opinion and consequential damage to the
banks reputation arising from failure to properly
manage some of the above risks, or from
involvement in improper or illegal activities by
the bank or its senior management, such as
money laundering or attempts to cover up losses.
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many or all other banks; and laws affecting

banks or other commercial enterprises may
change. Banks are particularly susceptible to
legal risks when entering into new types of
transactions and when the legal right of a
counterparty to enter into a transaction is not
established.
Settlement risk:
The risk that one side of a transaction will be

settled without value being received from the
customer or counterparty. This will generally
result in the loss to the bank of the full principal
amount.
Solvency risk:
The risk of loss arising from the possibility of

the bank not having sufficient funds to meet its
obligations, or from the banks inability to access
capital markets to raise required funds.
Transfer risk:
The risk of loss arising when a counterpartys

obligation is not denominated in the
counterpartys home currency. The counterparty
may be unable to obtain the currency of the
obligation irrespective of the counterpartys
particular financial condition.
22.
Banking risks increase with the degree of concentration of a banks

exposure to any one customer, industry, geographic area or country. For
example, a banks loan portfolio may have large concentrations of loans or
commitments to particular industries, and some, such as real estate,
shipping and natural resources, may have highly specialized practices.
Assessing the relevant risks relating to loans to entities in those industries
may require a knowledge of these industries, including their business,
operational and reporting practices.
23.
Most transactions involve more than one of the risks identified above.
Furthermore, the individual risks set out above may be correlated with one
another. For example, a banks credit exposure in a securities transaction
may increase as a result of an increase in the market price of the securities
concerned. Similarly, non-payment or settlement failure can have
consequences for a banks liquidity position. The auditor therefore
considers these and other risk correlations when analyzing the risks to
which a bank is exposed.
24.
Banks may be subject to risks arising from the nature of their ownership.
For example, a banks owner or a group of owners might try to influence
the allocation of credit. In a closely held bank, the owners may have
significant influence on the banks management affecting their
independence and judgment. The auditor considers such risks.
25.
In addition to understanding the external factors that could indicate

increased risk, the auditor considers the nature of risks arising from the
banks operations. Factors that contribute significantly to operational risk
include the following:
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The need to process high volumes of transactions accurately within

a short time. This need is almost always met through the large-scale
use of IT, with the resultant risks of:
(i)
Failure to carry out executed transactions within the required

time, causing an inability to receive or make payments for
those transactions;
(ii)
Failure to carry out complex transactions properly;
(iii)
Wide-scale misstatements arising from a breakdown in

internal control;
(iv)
Loss of data arising from systems failure;
(v)
Corruption of data arising from unauthorized interference

with the systems; and
(vi)
Exposure to market risks arising from lack of reliable up-todate information.
(b)
The need to use electronic funds transfer (EFT) or other

telecommunications systems to transfer ownership of large sums of
money, with the resultant risk of exposure to loss arising from
payments to incorrect parties through fraud or error.
(c)
The conduct of operations in many locations with a resultant

geographic dispersion of transaction processing and internal
controls. As a result:
(i)
There is a risk that the banks worldwide exposure by

customer and by product may not be adequately aggregated
and monitored; and
(ii)
Control breakdowns may occur and remain undetected or

uncorrected because of the physical separation between
management and those who handle the transactions.
(d)
The need to monitor and manage significant exposures that 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 settled by the end of the day. This is
ordinarily referred to as intra-day payment risk. These exposures
arise from transactions with customers and counterparties and may
include interest rate, currency and market risks.
(e)
The handling of large volumes of monetary items, including cash,

negotiable instruments and transferable customer balances, with the
resultant risk of loss arising from theft and fraud by employees or
other parties.
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(a)
(f)
The inherent complexity and volatility of the environment in which

banks operate, resulting in the risk of inappropriate risk management
strategies or accounting treatments in relation to such matters as the
development of new products and services.
(g)
Operating restrictions may be imposed as a result of the failure to

adhere to laws and regulations. Overseas operations are subject to
the laws and regulations of the countries in which they are based as
well as those of the country in which the parent entity has its
headquarters. This may result in the need to adhere to differing
requirements and a risk that operating procedures that comply with
regulations in some jurisdictions do not meet the requirements of
others.
26.
Fraudulent activities may take place within a bank by, or with the knowing
involvement of, management or personnel of the bank. Such frauds may
include fraudulent financial reporting without the motive of personal gain,
(for example, to conceal trading losses), or the misappropriation of the
banks assets for personal gain that may or may not involve the falsification
of records. Alternatively, fraud may be perpetrated on a bank without the
knowledge or complicity of the banks employees. ISA 240, The Auditors
Responsibility to Consider Fraud and Error in an Audit of Financial
Statements1 gives more guidance on the nature of the auditors
responsibilities with respect to fraud. Although many areas of a banks
operations are susceptible to fraudulent activities, the most common take
place in the lending, deposit-taking and dealing functions. The methods
commonly used to perpetrate fraud and a selection of the fraud risk factors
that indicate that a fraud may have occurred are set out in Appendix 1.
27.
By the nature of their business, banks are ready targets for those engaged in
money laundering activities by which the proceeds of crime are converted
into funds that appear to have a legitimate source. In recent years drug
traffickers in particular have greatly added to the scale of money laundering
that takes place within the banking industry. In many jurisdictions,
legislation requires banks to establish policies, procedures and controls to
deter and to recognize and report money laundering activities. These
policies, procedures and controls commonly extend to the following:
A requirement to obtain customer identification (know your client).
Staff screening.
A requirement to know the purpose for which an account is to be used.
ISA 240, The Auditors Responsibility to Consider Fraud and Error in an Audit of Financial
Statements was withdrawn in December 2004 when the revised ISA 240, The Auditors
Responsibility to Consider Fraud in an Audit of Financial Statements became effective.
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The maintenance of transaction records.
The reporting to the authorities of suspicious transactions or of all

transactions of a particular type, for example, cash transactions over a
certain amount.
The education of staff to assist them in identifying suspicious

transactions.
In some jurisdictions, auditors may have an express obligation to report to

the authorities certain types of transactions that come to their attention.
Even where no such obligation exists, an auditor who discovers a possible
instance of noncompliance with laws or regulations considers the
implications for the financial statements and the audit opinion thereon. ISA
250, Consideration of Laws and Regulations in an Audit of Financial
Statements gives further guidance on this matter.
Understanding the Risk Management Process
Management develops controls and uses performance indicators to aid in
managing key business and financial risks. An effective risk management
system in a bank generally requires the following:
Oversight and involvement in the control process by those charged with

governance
Those charged with governance should approve written risk
management policies. The policies should be consistent with the banks
business strategies, capital strength, management expertise, regulatory
requirements and the types and amounts of risk it regards as acceptable.
Those charged with governance are also responsible for establishing a
culture within the bank that emphasizes their commitment to internal
controls and high ethical standards, and often establish special
committees to help discharge their functions. Management is
responsible for implementing the strategies and policies set by those
charged with governance and for ensuring that an adequate and
effective system of internal control is established and maintained.
Identification, measurement and monitoring of risks

Risks that could significantly impact the achievement of the banks
goals should be identified, measured and monitored against preapproved limits and criteria. This function may be conducted by an
independent risk management unit, which is also responsible for
validating and stress testing the pricing and valuation models used by
the front and back offices. Banks ordinarily have a risk management
unit that monitors risk management activities and evaluates the
effectiveness of risk management models, methodologies and
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28.
assumptions used. In such situations, the auditor considers whether and

how to use the work of that unit.
Control activities
A bank should have appropriate controls to manage its risks, including
effective segregation of duties (particularly between front and back
offices), accurate measurement and reporting of positions, verification
and approval of transactions, reconciliations of positions and results,
setting of limits, reporting and approval of exceptions to limits,
physical security and contingency planning.
Monitoring activities
Risk management models, methodologies and assumptions used to
measure and manage risk should be regularly assessed and updated.
This function may be conducted by an independent risk management
unit. Internal auditing should test the risk management process
periodically to check whether management polices and procedures are
complied with and whether the operational controls are effective. Both
the risk management unit and internal auditing should have a reporting
line to those charged with governance and management that is
independent of those on whom they are reporting.
Reliable information systems

Banks require reliable information systems that provide adequate
financial, operational and compliance information on a timely and
consistent basis. Those charged with governance and management
require risk management information that is easily understood and that
enables them to assess the changing nature of the banks risk profile.
Development of an Overall Audit Plan

29.
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In developing an overall plan for the audit of the financial statements of a

bank, the auditor gives particular attention to:
The complexity of the transactions undertaken by the bank and the

documentation in respect thereof;
The extent to which any core activities are provided by service

organizations;
Contingent liabilities and off-balance sheet items;
Regulatory considerations;
The extent of IT and other systems used by the bank;
The expected assessments of inherent and control risks;
The work of internal auditing;
The assessment of audit risk;

694
The assessment of materiality;
Managements representations;
The involvement of other auditors;
The geographic spread of the banks operations and the co-ordination

of work between different audit teams;
The existence of related party transactions; and
Going concern considerations.
These matters are discussed in subsequent paragraphs.

The Complexity of Transactions Undertaken
Banks typically have a wide diversity of activities, which means that it is
sometimes difficult for an auditor to fully understand the implications of
particular transactions. The transactions may be so complex that
management itself fails to analyze properly the risks of new products and
services. The wide geographic spread of a banks activities can also lead to
difficulties. Banks undertake transactions that have complex and important
underlying features that may not be apparent from the documentation that is
used to process the transactions and to enter them into the banks
accounting records. This results in the risk that all aspects of a transaction
may not be fully or correctly recorded or accounted for, with the resultant
risks of:
Loss due to the failure to take timely corrective action;
Failure to make adequate provisions for loss on a timely basis; and
Inadequate or improper disclosure in the financial statements and other

reports.
The auditor obtains an understanding of the banks activities and the

transactions it undertakes sufficient to enable the auditor to identify and
understand the events, transactions and practices that, in the auditors
judgment, may have a significant effect on the financial statements or on the
examination or audit report.
31.
Many of the amounts to be recorded or disclosures made in the financial

statements involve the exercise of judgment by management, for example,
loan loss provisions, and provisions against financial instruments such as
liquidity risk provision, modeling risk provision and reserve for operational
risk. The greater the judgment required, the greater the inherent risk and the
greater the professional judgment required by the auditor. Similarly, there
may be other significant items in the financial statements that involve
accounting estimates. The auditor considers the guidance set out in ISA
540, Audit of Accounting Estimates.
695
IAPS 1006
AUDITING
30.
The Extent to which any Core Activities are Provided by Service Organizations
32.
In principle, the considerations when a bank uses service organizations are

no different from the considerations when any other entity uses them.
However, banks sometimes use service organizations to perform parts of
their core activities, such as credit and cash management. When the bank
uses service organizations for such activities, the auditor may find it
difficult to obtain sufficient appropriate audit evidence without the
cooperation of the service organization. ISA 402, Audit Considerations
Relating to Entities Using Service Organizations provides further guidance
on the auditing considerations and the types of reports that auditors of
service organizations provide to the organizations clients.
Contingent Liabilities and Off-balance Sheet Items

33.
Banks also typically engage in transactions that:
Have a low fee revenue or profit element as a percentage of the

underlying asset or liability;
Local regulations may not require to be disclosed in the balance sheet,

or even in the notes to the financial statements;
Are recorded only in memorandum accounts; or
Involve securitizing and selling assets so that they no longer appear in

the banks financial statements.
Examples of such transactions are safe custody services, guarantees,

comfort letters and letters of credit, interest rate and currency swaps and
commitments and options to purchase and sell foreign exchange.
34.
IAPS 1006
The auditor reviews the banks sources of revenue, and obtains sufficient
appropriate audit evidence regarding the following:
(a)
The accuracy and completeness of the accounting records relating to

such transactions.
(b)
The existence of proper controls to limit the banking risks arising

from such transactions.
(c)
The adequacy of any provisions for loss which may be required.
(d)
The adequacy of any financial statement disclosures which may be

required.
696
35.
The International Auditing Practices Statement 1004 provides information

and guidance on the relationship between bank auditors and banking
supervisors. The Basel Committee has issued supervisory guidance
regarding sound banking practices for managing risks, internal control
systems, loan accounting and disclosure, other disclosures and for other
areas of bank activities. In addition, the Basel Committee has issued
guidance on the assessment of capital adequacy and other important
supervision topics. This guidance is available to the auditor and to the
public on the internet website of the Bank for International Settlements
(BIS).
36.
In accordance with ISA 310, Knowledge of the Business2 the auditor

considers whether the assertions in the financial statements are consistent
with the auditors knowledge of the business. In many regulatory
frameworks, the level and types of business a bank is allowed to undertake
depend upon the level of its assets and liabilities and the types and
perceived risks attached to those assets and liabilities (a risk-weighted
capital framework). In such circumstances there are greater pressures for
management to engage in fraudulent financial reporting by miscategorizing
assets and liabilities or by describing them as being less risky than they
actually are, particularly when the bank is operating at, or close to, the
minimum required capital levels.
37.
There are many procedures that both auditors and bank supervisors perform,
including:
The performance of analytical procedures;
Obtaining evidence regarding the operation of the internal control

system; and
The review of the quality of a banks assets and the assessment of

banking risks.
The auditor therefore finds it advantageous to interact with the supervisors

and to have access to communications that 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 risk management practices and provisions for loan losses, and the
prudential ratios used by the supervisors can be of assistance to the auditor
in performing analytical procedures and in focusing attention on specific
areas of supervisory concern.
2
ISA 310, Knowledge of the Business was withdrawn in December 2004 when ISA 315,
Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement
became effective.
697
IAPS 1006
AUDITING
Regulatory Considerations
The Extent of IT and Other Systems

38.
The high volume of transactions and the short times in which they must be
processed typically result in most banks making extensive use of IT, EFT
and other telecommunications systems.
The control concerns arising from the use of IT by a bank are similar to
those arising when IT is used by other organizations. However, the matters
that are of particular concern to the auditor of a bank include the following:
The use of IT to calculate and record substantially all of the interest

income and interest expense, which are ordinarily two of the most
important elements in the determination of a banks earnings.
The use of IT and telecommunications systems to determine the foreign

exchange security and derivative trading positions, and to calculate and
record the gains and losses arising from them.
The extensive, and in some cases almost total, dependence

records produced by IT because they represent the only
accessible source of detailed up-to-date information on the
assets and liability positions, such as customer loan and
balances.
The use of complex valuation models incorporated in the IT systems.
The models used to value assets and the data used by those models are
often kept in spreadsheets prepared by individuals on personal
computers not linked to the banks main IT systems and not subject to
the same controls as applications on those systems. IAPS 1001, IT
EnvironmentsStand-Alone Personal Computers3 provides guidance
to auditors in respect of these applications.
The use of different IT systems resulting in the risk of loss of audit trail
and incompatibility of different systems.
on the
readily
banks
deposit
EFT systems are used by banks both internally (for example, for transfers
between branches and between automated banking machines and the
computerized files that record account activity) and externally between the
bank and other financial institutions (for example, through the SWIFT
network) and also between the bank and its customers through the internet
or other electronic commerce media.
39.
The auditor obtains an understanding of the core IT, EFT and

telecommunication applications and the links between those applications.
The auditor relates this understanding to the major business processes or
IAPS 1001, IT EnvironmentsStand-Alone Personal Computers was withdrawn in December

2004.
IAPS 1006
698
40.
When auditing in a distributed IT environment, the auditor obtains an

understanding of where the core IT applications are located. If the banks
wide area network (WAN) is dispersed over several countries, specific
legislative rules might apply to cross-border data processing. In such an
environment, audit work on the access control system, especially on the
access violation system, is an important part of the audit.
41.
An electronic commerce environment changes significantly the way the

bank conducts its business. Electronic commerce presents new aspects of
risk and other considerations that the auditor addresses. For example, the
auditor considers the following:
The business risks the banks e-commerce strategy presents.
The risks inherent in the technology the bank has chosen to implement
its electronic commerce strategy.
Managements responses to the risks identified, including control

considerations regarding:
42.
Compliance with legal and regulatory requirements in respect of

cross-border transactions;
The security and privacy of transmissions across the Internet; and
The completion, accuracy, timeliness and authorization of Internet

transactions as they are recorded in the banks accounting system.
The level of IT and electronic commerce skill and competence the

auditor and assistants possess.
An organization may outsource IT or EFT related activities to an external

service provider. The auditor gains an understanding of the outsourced
services and the system of internal controls within the outsourcing bank and
the vendor of the services, in order to determine the nature, extent and
timing of substantive procedures. ISA 402 gives further guidance on this
subject.
Expected Assessment of Inherent and Control Risks

43.
The nature of banking operations is such that the auditor may not be able to
reduce audit risk to an acceptably low level by the performance of
699
IAPS 1006
AUDITING
balance sheet positions in order to identify the risk factors for the
organization and therefore for the audit. In addition, it is important to
identify the extent of the use of self-developed applications or integrated
systems, which will have a direct effect on the audit approach. (Selfdeveloped systems require the auditor to focus more extensively on the
program change controls.)
substantive procedures alone. This is because of factors such as the

following:
The extensive use of IT and EFT systems, which means that much of
the audit evidence is available only in electronic form and is produced
by the entitys own IT systems.
The high volume of transactions entered into by banks, which makes

reliance on substantive procedures alone impracticable.
The geographic dispersion of banks operations, which makes obtaining

sufficient coverage extremely difficult.
The difficulty in devising effective substantive procedures to audit

complex trading transactions.
In most situations the auditor will not be able to reduce audit risk to an
acceptably low level unless management has instituted an internal control
system that allows the auditor to be able to assess the level of inherent and
control risks as less than high. The auditor obtains sufficient appropriate
audit evidence to support the assessment of inherent and control risks.
Paragraphs 56-70 discuss matters relating to internal control in more detail.
The Work of Internal Auditing
44.
The scope and objectives of internal auditing may vary widely depending
upon the size and structure of the bank and the requirements of management
and those charged with governance. However, the role of internal auditing
ordinarily includes the review of the accounting system and related internal
controls, monitoring their operation and recommending improvements to
them. 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 referred to in paragraph 44 also often lead the
auditor to use the work of internal auditing. This is especially relevant in the
case of banks that 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 that reports to management on the quality of
loans and the adherence to established procedures in respect thereof. In
either case, the auditor often considers making use of the work of the loan
review department after an appropriate review of the department and its
work. Guidance on the use of the work of internal auditing is provided in
ISA 610, Considering the Work of Internal Auditing.
Audit Risk
45.
The three components of audit risk are:

(a)
IAPS 1006
Inherent risk (the risk that material misstatements occur);

700
(b)
Control risk (the risk that the banks system of internal control does
not prevent or detect and correct such misstatements on a timely
basis); and
(c)
Detection risk (the risk that the auditor will not detect any remaining
material misstatements).
Inherent and control risks exist independently of the audit of financial

information and the auditor cannot influence them. The nature of risks
associated with banking activities, which are discussed in paragraphs 21-25
indicate that the assessed level of inherent risk in many areas will be high. It
is therefore necessary for a bank to have an adequate system of internal
control if the levels of inherent and control risks are to be less than high.
The auditor assesses these risks and designs substantive procedures so as to
reduce audit risk to an acceptably low level.
Materiality
In making an assessment of materiality, in addition to the considerations set
out in ISA 320, Audit Materiality, the auditor considers the following
factors:
Because of high leverage, relatively small misstatements may have a

significant effect on the results for the period and on capital, even
though they may have an insignificant effect on total assets.
A banks earnings are low when compared to its total assets and
liabilities and its off-balance sheet commitments. Therefore,
misstatements that relate only to assets, liabilities and commitments
may be less significant than those that may also relate to the statement
of earnings.
Banks are often subject to regulatory requirements, such as the

requirement to maintain minimum levels of capital. A breach of these
requirements could call into question the appropriateness of
managements use of the going concern assumption. The auditor
therefore establishes a materiality level so as to identify misstatements
that, if uncorrected, would result in a significant contravention of such
regulatory requirements.
The appropriateness of the going concern assumption often depends

upon matters related to the banks reputation as a sound financial
institution and actions by regulators. Because of this, related party
transactions and other matters that would not be material to entities
other than banks may become material to a banks financial statements
if they might affect the banks reputation or actions by regulators.
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IAPS 1006
AUDITING
46.
Managements Representations
47.
Managements representations are relevant in the context of a bank audit to

assist the auditor in determining whether the information and evidence
obtained is complete for the purposes of the audit. This is particularly true
of the banks transactions that may not ordinarily be reflected in the
financial statements (off-balance sheet items), but which may be evidenced
by other records of which the auditor may not be aware. It is often also
necessary for the auditor to obtain from management representations
regarding significant changes in the banks business and its risk profile. It
may also be necessary for the auditor to identify areas of a banks
operations where audit evidence likely to be obtained may need to be
supplemented by managements representations, for example, loan loss
provisions and the completeness of correspondence with regulators. ISA
580, Management Representations provides guidance as to the use of
management representations as audit evidence, the procedures that the
auditor applies in evaluating and documenting them, and the circumstances
in which representations should be obtained in writing.
Involvement of Other Auditors

48.
As a result of the wide geographic dispersion of offices in most banks, it is

often necessary for the auditor to use the work of other auditors in many of
the locations in which the bank operates. This may be achieved by using
other offices of the auditors firm or by using other auditing firms in those
locations.
49.
Before using the work of another auditor, the auditor:
Considers the independence of those auditors and their competence to

undertake the necessary work (including their knowledge of banking
and applicable regulatory requirements);
Considers whether the terms of the engagement, the accounting

principles to be applied and the reporting arrangements are clearly
communicated; and
Performs procedures to obtain sufficient appropriate audit evidence that

the work performed by the other auditor is adequate for this 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 further guidance
on the issues to be addressed and procedures to be performed in such
situations.
IAPS 1006
702
Co-Ordinating the Work to be Performed

Given the size and geographic dispersion of most banks, co-ordinating the
work to be performed is important to achieve an efficient and effective
audit. The co-ordination required takes into account factors such as the
following:
51.
The work to be performed by:

Experts;
Assistants;
Other offices of the auditors firm; and
Other audit firms.
The extent to which it is planned to use the work of internal auditing.
Required reporting dates to shareholders and the regulatory authorities.
Any special analyses and other documentation to be provided by bank

management.
The best level of co-ordination between assistants can often be achieved by

regular audit-status meetings. However, given the number of assistants and
the number of locations at which they will be involved, the auditor
ordinarily communicates all or relevant portions of the audit plan in writing.
When setting out the requirements in writing, the auditor considers
including commentary on the following matters:
The financial statements and other information that are to be audited

(and if considered necessary, the legal or other mandate for the audit).
Details of any additional information requested by the auditor, for

example, information on certain loans, portfolio composition, narrative
commentary on the audit work to be performed (especially on the areas
of risk described in paragraphs 21-25 which are important to the bank)
and on the results of the audit work, potential points for inclusion in
letters to management on internal control, local regulatory concerns,
and if relevant, the forms of any required reports.
That the audit is to be conducted in accordance with ISAs and any local
regulatory requirements (and, if considered necessary, information on
those requirements).
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 the entitys officials to be contacted.

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IAPS 1006
AUDITING
50.
Fee and billing arrangements.
Any other concerns of a regulatory, internal control, accounting or

audit nature of which those conducting the audit should be aware.
Related Party Transactions

52.
The auditor remains alert for related party transactions during the course of
the audit, particularly in the lending and investment areas. Procedures
performed during the planning phase of the audit, including obtaining an
understanding of the bank and the banking industry, may be helpful in
identifying related parties. In some jurisdictions, related party transactions
may be subject to quantitative or qualitative restrictions. The auditor
determines the extent of any such restrictions.
Going Concern Considerations

53.
54.
IAPS 1006
ISA 570, Going Concern provides guidance as to the auditors

consideration of the appropriateness of managements use of the going
concern assumption. In addition to matters identified in that ISA, events or
conditions such as the following may also cast significant doubt on the
banks ability to continue as a going concern:
Rapid increases in levels of trading in derivatives. This may indicate

that the bank is carrying out trading activities without the necessary
controls in place.
Profitability performance or forecasts that suggest a serious decline in

profitability, particularly if the bank is at or near its minimum
regulatory capital or liquidity levels.
Rates of interest being paid on money market and depositor liabilities

that are higher than normal market rates. This may indicate that the
bank is viewed as a higher risk.
Significant decreases in deposits from other banks or other forms of

short term money market funding. This may indicate that other market
participants lack confidence in the bank.
Actions taken or threatened by regulators that may have an adverse

effect on the banks ability to continue as a going concern.
Increased amounts due to central banks, which may indicate that the
bank was unable to obtain liquidity from normal market sources.
High concentrations of exposures to borrowers or to sources of funding.
ISA 570 also provides guidance to auditors when an event or condition that
may cast significant doubt on the banks ability to continue as a going
concern has been identified. The ISA indicates a number of procedures that
704
may be relevant, and in addition to those, the following procedures may

also be relevant:
55.
Reviewing correspondence with regulators.
Reviewing reports issued by regulators as a result of regulatory

inspections.
Discussing the results of any inspections currently in process.
The regulatory regime under which the bank operates may require the
auditor to disclose to the regulator any intention to issue a modified opinion
or any concerns that the auditor may have about the banks ability to
continue as a going concern. IAPS 1004 provides further discussion of the
relationship between the auditor and the banking supervisor.
Internal Control
56.
The Basel Committee on Banking Supervision has issued a policy paper,

Framework for Internal Control Systems in Banking Organisations
(September 1998), which provides banking supervisors with a framework
for evaluating banks internal control systems. This framework is used by
many banking supervisors, and may be used during supervisory discussions
with individual banking organizations. Auditors of banks financial
statements may find a knowledge of this framework useful in understanding
the various elements of a banks internal control system.
57.
Managements responsibilities include the maintenance of an adequate

accounting system and internal control system, the selection and application
of accounting policies, and the safeguarding of the assets of the entity.
The auditor obtains an understanding of the accounting and internal control
systems sufficient to plan the audit and develop an effective audit approach.
After obtaining the understanding, the auditor considers the assessment of
inherent and control risks so as to determine the appropriate detection risk
to accept for the financial statement assertions and to determine the nature,
timing and extent of substantive procedures for such assertions.
Where the auditor assesses control risk at less than high, substantive
procedures are ordinarily less extensive than are otherwise required and
may also differ in their nature and timing.
705
IAPS 1006
AUDITING
Introduction
Identifying, Documenting and Testing Control Procedures

58.
ISA 400, Risk Assessments and Internal Control4 indicates that internal
controls relating to the accounting system are concerned with achieving
objectives such as the following:
Transactions are executed in accordance with managements general or

specific authorization (paragraphs 59-61).
All transactions and other events are promptly recorded at the correct
amount, in the appropriate accounts and in the proper accounting period
so as to permit preparation of financial statements in accordance with
the applicable financial reporting framework (paragraphs 62 and 63).
Access to assets is permitted only in accordance with managements

authorization (paragraphs 64 and 65).
Recorded assets are compared with the existing assets at reasonable

intervals and appropriate action is taken regarding any differences
(paragraphs 66 and 67).
The audit considerations in relation to each of these objectives are discussed

in the subsequent paragraphs.
In the case of banks, a further objective of internal controls is to ensure that
the bank adequately fulfills its regulatory and fiduciary responsibilities
arising out of its trustee activities. The auditor is not directly concerned with
these objectives except to the extent that any failure to comply with such
responsibilities might have led to the financial statements being material
misstated.
Transactions are Executed in Accordance with Managements General or Specific
Authorization
59.
The overall responsibility for the system of internal control in a bank rests
with those charged with governance, who are responsible for governing the
banks operations. However, since banks operations are generally large and
dispersed, decision-making functions need to be decentralized and the
authority to commit the bank to material transactions is ordinarily dispersed
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 secure 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:
ISA 400, Risk Assessments and Internal Control was withdrawn in December 2004 when ISA 315,
and ISA 330, The Auditors Procedures in Response to Assessed Risks became effective.
IAPS 1006
706
(a)
Those who may authorize specific transactions;
(b)
Procedures to be followed in granting that authorization; and
(c)
Limits on the amounts that can be authorized, by individual

employee or by staff level, as well as any requirements that may
exist for concurring authorization.
60.
An examination of the authorization controls will be important to the

auditor in considering whether transactions have been entered into in
accordance with the banks 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 exist in respect of various
transaction types. When performing tests of controls, the auditor considers
whether these limits are being adhered to and whether positions in excess of
these limits are reported to the appropriate level of management on a timely
basis.
61.
From an audit perspective, the proper functioning of a banks authorization

controls is particularly important in respect of transactions entered into at or
near the date of the financial statements. This is because aspects of the
transaction have yet to be fulfilled, or there may be a lack of evidence with
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 period-end and loans, where principal and interest
payments from the borrower have yet to be made.
All Transactions and Other Events are Promptly Recorded at the Correct Amount, in
the Appropriate Accounts and in the Proper Accounting Period so as to Permit
Preparation of Financial Statements in Accordance with the Applicable Financial
Reporting Framework
62.
In considering the internal controls that management use to ensure that all
transactions and other events are properly recorded, the auditor takes into
account a number of factors that are especially important in a banking
environment. These include the following:
Banks deal in large volumes of transactions that can individually or

cumulatively involve large sums of money. Accordingly, the bank
needs to have balancing and reconciliation procedures that are carried
out within a time-frame that allows the detection of errors and
discrepancies so that they can be investigated and corrected with
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IAPS 1006
AUDITING
Those charged with governance also need to ensure that appropriate

procedures exist for monitoring the level of exposures. This will ordinarily
involve the aggregation of exposures, not only within, but also across, the
different activities, departments and branches of the bank.
minimal loss to the bank. Such procedures may be carried out hourly,
daily, weekly, or monthly, depending on the volume and nature of the
transaction, level of risk, and transactions settlement time-frame. The
purpose of these reconciliations is often to ensure the completeness of
transaction processing across highly complex integrated IT systems and
the reconciliations themselves are normally automatically generated by
these systems.
IAPS 1006
Many of the transactions entered into by banks are subject to

specialized accounting rules. Banks should have control procedures in
place to ensure those rules are applied in the preparation of appropriate
financial information for management and external reporting. Examples
of such control procedures are those that 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.
Some of the transactions entered into by banks may not be required to

be disclosed in the financial statements (for example, transactions that
the accounting framework allows to be regarded as off balance sheet
items). Accordingly, control procedures must be in place to ensure that
such transactions are recorded and monitored in a manner that provides
management with the required degree of control over them and that
allows for the prompt determination of any change in their status that
needs to result in the recording of a profit or loss.
Banks are constantly developing new financial products and services.

The auditor considers whether the necessary revisions are made in
accounting procedures and related internal controls.
End of day balances may reflect 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
processing foreign exchange and securities transactions. The
assessment of controls in these areas takes 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 that

is capable of being verified both internally and by the banks customers
and counterparties. The level of detail to be recorded and maintained on
individual transactions must allow the banks management, transaction
counterparties, and customers to verify the accuracy of the amounts and
terms. An example of such a control is the continuous verification of
foreign exchange trade tickets by having an employee not involved in
the transaction match the tickets to incoming confirmations from
counterparties.
708
63.
The extensive use of IT and EFT systems has a significant effect on how the
auditor evaluates a banks accounting system and related internal controls.
ISA 400, ISA 401, Auditing in a Computer Information Systems
Environment, and IAPS 1008, Risk Assessments and Internal Control
CIS Characteristics and Considerations,5 provide guidance on the IT
aspects of such an evaluation, as do other IAPSs dealing with information
technology. The audit procedures include an assessment of those controls
that affect system development and modifications, system access and data
entry, the security of communications networks, and contingency planning.
Similar considerations apply to EFT operations within the bank. To the
extent that EFT and other transaction systems are external to the bank, the
auditor gives additional emphasis to the assessment of the integrity of pretransaction supervisory controls and post-transaction confirmation and
reconciliation procedures. Reports from the auditors of service
organizations may be of use here, and ISA 402 gives guidance on the
auditors consideration of such reports.
Access to Assets is Permitted Only in Accordance with Managements Authorization
65.
A banks assets are often readily transferable, of high value and in a form
that cannot be safeguarded solely by physical procedures. In order to ensure
that access to assets is permitted only in accordance with managements
authorization, a bank generally uses controls such as the following:
Passwords and joint access arrangements to limit IT and EFT system

access to authorized employees.
Segregation of the record-keeping and custody functions (including the

use of computer generated transaction confirmation reports available
immediately and only to the employee in charge of the record-keeping
functions).
Frequent third-party confirmation and reconciliation of asset positions

by an independent employee.
The auditor considers whether each of these controls is operating

effectively. However, given the materiality and transferability of the
amounts involved, the auditor also ordinarily reviews the confirmation and
reconciliation procedures that occur in connection with the preparation of
the year-end financial statements and may carry out confirmation
procedures himself.
ISA 400, Risk Assessments and Internal Control, ISA 401, Auditing in a Computer Information
Systems Environment, and IAPS 1008, Risk Assessments and Internal ControlCIS
Characteristics and Considerations were withdrawn in December 2004 when ISA 315,
and ISA 330, The Auditors Procedures in Response to Assessed Risks became effective.
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IAPS 1006
AUDITING
64.
Recorded Assets are Compared with the Existing Assets at Reasonable Intervals and
Appropriate Action is Taken Regarding Any Differences
66.
67.
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 necessitates the
frequent operation of reconciliation controls. This is particularly important
for:
(a)
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 quickly (which may
mean daily where money market transactions are involved) could
lead to an irrecoverable loss: reconciliation procedures used to
achieve this control objective will ordinarily be based on physical
counting and third party confirmation;
(b)
Assets whose value is determined with reference to valuation

models or external market prices, such as securities and foreign
exchange contracts; and
(c)
Assets held on behalf of clients.
In designing an audit plan to assess the effectiveness of a banks

reconciliation controls, the auditor considers factors such as the following.
IAPS 1006
Because of the number of accounts requiring reconciliation and the

frequency with which these reconciliations need to be performed:
Much of the audit effort is 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 ordinarily use the work of internal auditing.
Since reconciliations are cumulative in their effect, most reconciliations

can be satisfactorily audited at the year-end date, assuming that they are
prepared as of that date, soon enough for the auditor to use and that the
auditor is satisfied that the reconciliation control procedures are
effective.
In examining a reconciliation, the auditor considers whether items have

not been improperly transferred to other accounts that are not subject to
reconciliation and investigation at the same time.
710
Examples of Controls
68.
Appendix 2 to this Statement contains examples of controls over

authorization, recording, access and reconciliation ordinarily found in the
treasury and trading and lending operations of a bank.
Inherent Limitations of Internal Control

69.
ISA 4006 describes the procedures to be followed by the auditor in

identifying, documenting and testing internal controls. In doing so, the
auditor is aware of the inherent limitations of internal control. The assessed
levels of inherent and control risks cannot be sufficiently low to eliminate
the need for the auditor to perform any substantive procedures. Irrespective
of the assessed levels of inherent and control risks, the auditor performs
some substantive procedures for material account balances and classes of
transactions.
Considering the Influence of Environmental Factors

In assessing the effectiveness of specific control procedures, the auditor
considers the environment in which internal control operates. Some of the
factors that may be considered include the following:
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 internal auditing.
The extent and effectiveness of the risk management and compliance

systems
The skills, competence and integrity of key personnel.
The nature and extent of inspection by supervisory authorities.
AUDITING
70.
Performing Substantive Procedures

Introduction
71.
As a result of the assessment of the level of inherent and control risks, the
auditor determines the nature, timing and extent of the substantive tests to
be performed on individual account balances and classes of transactions. In
designing these substantive tests, the auditor considers the risks and factors
that served to shape the banks systems of internal control. In addition, there
are a number of audit considerations significant to these risk areas to which
the auditor directs attention. These are discussed in subsequent paragraphs.
See footnote 4.
711
IAPS 1006
72.
ISA 500, Audit Evidence7 lists the assertions embodied in the financial
statements as: existence, rights and obligations, occurrence, completeness,
valuation, measurement, and presentation and disclosure.
Tests of the completeness assertion are particularly important in the audit of
banks financial statements particularly in respect of liabilities. Much of the
audit work on liabilities of other commercial entities can be carried out by
substantive procedures on a reciprocal population. Banking transactions do
not have the same type of regular trading cycle, and reciprocal populations
are not always immediately in evidence. Large assets and liabilities can be
created and realized very quickly and, if not captured by the systems, may
be overlooked. Third party confirmations and the reliability of controls
become important in these circumstances.
Audit Procedures
73.
To address the assertions discussed above, the auditor may perform the
following procedures:
(a)
Inspection.
(b)
Observation.
(c)
Inquiry and confirmation.
(d)
Computation.
(e)
Analytical procedures.
In the context of the audit of a banks financial statements, inspection,

inquiry and confirmation, computation and analytical procedures require
particular attention and are discussed in the following paragraphs.
Inspection
74.
Inspection consists of examining records, documents, or tangible assets.

The auditor inspects in order to:
Be satisfied as to the physical existence of material negotiable assets

that the bank holds; and
Obtain the necessary understanding of the terms and conditions of

agreements (including master agreements) that are significant
individually or in the aggregate in order to:
Consider their enforceability; and
ISA 500, Audit Evidence was withdrawn in December 2004 when the revised ISA 500, Audit
Evidence became effective.
IAPS 1006
712

75.
76.
Assess the appropriateness of the accounting treatment they have

been given.
Examples of areas where inspection is used as an audit procedure are:
Securities;
Loan agreements;
Collateral; and
Commitment agreements, such as:

Asset sales and repurchases; and
Guarantees.
In carrying out inspection procedures, the auditor remains alert to the

possibility that some of the assets the bank holds may be held on behalf of
third parties rather than for the banks own benefit. The auditor considers
whether adequate internal controls exist for the proper segregation of such
assets from those that are the property of the bank and, where such assets
are held, considers the implications for the financial statements. As noted in
paragraph 58 the auditor is concerned with the existence of third party
assets only to the extent that the banks failure to comply with its
obligations may lead to the financial statements being materially misstated.
Inquiry and Confirmation

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 banks customers and

counterparties of amounts, terms and conditions of certain transactions;
and
Obtain information not directly available from the banks accounting

records.
A bank has significant amounts of monetary assets and liabilities, and of

off-balance-sheet commitments. External confirmation may an effective
method of determining the existence and completeness of the amounts of
assets and liabilities disclosed in the financial statements. In deciding the
nature and extent of external confirmation procedures that the auditor will
perform, the auditor considers any external confirmation procedures
undertaken by internal auditing. ISA 505, External Confirmations
provides guidance on the external confirmation process.
713
IAPS 1006
AUDITING
77.
78.
Examples of areas for which the auditor may use confirmation including the
following:
Collateral.
Verifying or obtaining independent confirmation of, the value of assets

and liabilities that are not traded or are traded only on over-the-counter
markets.
Asset, liability and forward purchase and sale positions with customers
and counterparties such as:
Outstanding derivative transactions;
Nostro and vostro account holders;
Securities held by third parties;
Loan accounts;
Deposit accounts;
Guarantees; and
Letters of credit.
Legal opinions on the validity of a banks claims.
Computation
79.
Computation consists of checking the arithmetical accuracy of source

documents and accounting records or of performing independent
calculations. In the context of the audit of a banks financial statements,
computation is a useful procedure for checking the consistent application of
valuation models.
Analytical Procedures
80.
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. ISA 520, Analytical Procedures provides guidance on the
auditors use of this technique.
81.
A bank invariably has individual assets (for example, loans and, possibly,
investments) that are of such a size that the auditor considers them
individually. However, for most items, analytical procedures may be
effective for the following reasons:
IAPS 1006
Ordinarily two of the most important elements in the determination of a

banks earnings are interest income and interest expense. These have
direct relationships to interest bearing assets and interest bearing
liabilities, respectively. To establish the reasonableness of these
714
The accurate processing of the high volume of transactions entered into

by a bank, and the auditors assessment of the banks internal controls,
may benefit from the review of ratios and trends and of the extent to
which they vary from previous periods, budgets and the results of other
similar entities.
By using analytical procedures, the auditor may detect circumstances

that call into question the appropriateness of the going concern
assumption, such as undue concentration of risk in particular industries
or geographic areas and potential exposure to interest rate, currency and
maturity mismatches.
In most countries there is a wide range of statistical and financial

information available from regulatory and other sources that the auditor
can use to conduct an in-depth analytical review of trends and peer
group analyses.
A useful starting point in considering appropriate analytical procedures is to

consider what information and performance or risk indicators management
use in monitoring the banks activities. Appendix 3 to this Statement contains
examples of the most frequently used ratios in the banking industry.
Specific Procedures in Respect of Particular Items in the Financial
Statements
82.
Paragraphs 83-100 identify the assertions that are ordinarily of particular

importance in relation to the typical items in a banks financial statements.
They also describe some of the audit considerations that help the auditor to
plan substantive procedures and suggest some of the techniques that could
be used in relation to the items selected by the auditor for testing. The
715
IAPS 1006
AUDITING
relationships, the auditor can examine the degree to which the reported
income and expense vary from the amounts calculated on the basis of
average balances outstanding and the banks stated rates during the
year. This examination is ordinarily made in respect of the categories of
assets and liabilities used by the bank in the management of its
business. Such an examination could, for example, highlight the
existence of significant amounts of non-performing loans or unrecorded
deposits. In addition, the auditor may also consider the reasonableness
of the banks stated rates to those prevailing in the market during the
year for similar classes of loans and deposits. In the case of loan assets,
evidence of rates charged or allowed above market rates may indicate
the existence of excessive risk. In the case of deposit liabilities, such
evidence may indicate liquidity or funding difficulties. Similarly, fee
income, which is also a large component of a banks earnings, often
bears a direct relationship to the volume of obligations on which the
fees have been earned.
procedures do not represent an exhaustive list of procedures that it is

possible to perform, nor do they represent a minimum requirement that
should always be performed.
Financial Statement
Item
83.
Financial Statement Assertions of Particular

Importance
BALANCES WITH OTHER BANKS
Existence
The auditor considers third party confirmations of the
balance. Where the balances held with other banks are
the result of large volumes of transactions, the receipt
of confirmations from those other banks is likely to
provide more cogent evidence as to the existence of the
transactions and of the resultant inter-bank balances
than is the testing of the related internal controls.
Guidance on inter-bank confirmation procedures,
including terminology and the content of confirmation
requests, can be found in the IAPS 1000, Inter-Bank
Confirmation Procedures.
Valuation
The auditor considers whether to assess the
collectability of the deposit in light of the creditworthiness of the depository bank. The procedures
required in such an assessment are similar to those used
in the audit of loan valuation, discussed later.
Presentation and Disclosure
The auditor considers whether the balances with other
banks as at the date of the financial statements
represent bona fide commercial transactions or whether
any significant variation from normal or expected
levels reflects transactions entered into primarily to
give a misleading impression of the financial position
of the bank or to improve liquidity and asset ratios
(often known as window-dressing).
Where window-dressing occurs in a magnitude which
may distort the true and fair view of the financial
statements, the auditor requests management to adjust
the balances shown in the financial statements, or make
additional disclosure in the notes. If management fails
to do so, the auditor considers whether to modify the
audit report.
IAPS 1006
716
84.
MONEY MARKET INSTRUMENTS

Existence
The auditor considers the need for physical inspection
or confirmation with external custodians and the
reconciliation of the related amounts with the
accounting records.
Rights and Obligations
The auditor considers the feasibility of checking for
receipt of the related income as a means of establishing
ownership. The auditor pays particular attention to
establishing the ownership of instruments held in
bearer form. The auditor also considers whether there
are any encumbrances on the title to the instruments.
The auditor tests for the existence of sale and forward
repurchase agreements for evidence of unrecorded
liabilities and losses.
Measurement
The auditor considers whether there is a need to test for
the proper accrual of income earned on money market
instruments, which in some cases is through the
amortization of a purchase discount.
The auditor also considers whether:
The relationship between the types of securities

owned and the related income is reasonable; and
All significant gains and losses from sales and

revaluations have been reported in accordance
with the financial reporting framework (for
example, where gains and losses on trading
securities are treated differently from those on
investment securities).
85.
SECURITIES HELD FOR TRADING PURPOSES

Appendix 2 gives further examples of internal control
considerations and audit procedures in respect of
trading operations.
717
IAPS 1006
AUDITING
Valuation
The auditor considers the appropriateness of the
valuation techniques employed in light of the
creditworthiness of the issuer.
Existence
The auditor considers physical inspection of securities or
confirmation with external custodians and the
reconciliation of the amounts with the accounting records.
The auditor considers the feasibility of checking for
receipt of the related income as a means of establishing
ownership. The auditor pays particular attention to
establishing the ownership of securities held in bearer
form. The auditor also considers whether there are any
encumbrances on the title to the securities.
The auditor tests for the existence of sale and forward
repurchase agreements for evidence of unrecorded
liabilities and losses.
Valuation
Financial reporting frameworks often prescribe different
valuation bases for securities depending on whether they
are held for trading purposes, held as portfolio
investments, or held for hedging purposes. For example,
a financial reporting framework might require trading
securities to be carried at market value, portfolio
investments at historic cost subject to impairment
reviews, and hedging securities on the same basis as the
underlying assets they hedge. Managements intentions
determine whether any particular security is held for a
given purpose, and hence the valuation basis to be used.
If managements intentions change, the valuation basis
changes too. Accordingly, when securities have been
transferred from one category to another, the auditor
obtains sufficient appropriate audit evidence to support
managements assertions as to their revised intentions.
The possibility of changing an assets categorization
provides management with an opportunity for fraudulent
financial reporting, as it would be possible to recognize a
profit or avoid recognizing a loss by changing the
categorization of particular securities.
When securities held for trading purposes are carried at
market value, the auditor considers whether securities
whose market value has increased have been arbitrarily
transferred from Portfolio Investments (see paragraph
87) primarily so that an unrealized gain can be taken
into income.
IAPS 1006
718
The auditor also considers whether to reperform the

valuation calculations and the extent of tests of the
controls over the banks valuation procedures.
Measurement


revaluations have been reported in accordance
with the financial reporting framework (for
example, where gains and losses on trading
securities are treated differently from those on
investment securities).
87.
(Those
involving
current
investment of
funds, for
example,
blocks of loans
purchased for
resale,
purchases of
securitized
assets)
OTHER FINANCIAL ASSETS

The auditor examines the underlying documentation
supporting the purchase of such assets in order to
determine whether all rights and obligations, such as
warranties and options, have been properly accounted
for.
Valuation
valuation techniques employed. Since there may not be
established markets for such assets, it may be difficult
to obtain independent evidence of value. Additionally,
even where such evidence exists, there may be a
question as to whether there is sufficient depth to
existing markets to rely on quoted values for the asset
in question and for any related offsetting hedge
transactions that the bank has entered into in those
markets. The auditor also considers the nature and
extent of any impairment reviews that management has
carried out and whether their results are reflected in the
assets valuations.
PORTFOLIO INVESTMENTS
In many cases the audit of a banks portfolio
investments does not differ from the audit of portfolio
investments held by any other entity. However, there
are some special aspects that pose particular problems
in respect of banking operations.
719
IAPS 1006
AUDITING
86.
Valuation
The auditor considers the value of the assets supporting
the security value, particularly in respect of securities
that are not readily marketable. The auditor also
considers the nature and extent of any impairment
reviews that management has carried out and whether
their results are reflected in the assets valuations.
Measurement
As discussed in paragraph 85, financial reporting
frameworks frequently allow different valuation bases
for securities held for different purposes. Where
securities have been transferred from the Trading
Account, the auditor determines whether any
unrealized losses in market value are recorded if so
required by relevant financial reporting framework.
When the financial reporting framework does not
require the recording of unrealized losses, the auditor
considers whether the transfer was made to avoid the
need to recognize reductions in the securities market
value.


revaluations have been reported in accordance with
the financial reporting framework (for example,
where gains and losses on trading securities are
treated differently from those on investment
securities).
88.
INVESTMENTS IN SUBSIDIARIES AND

ASSOCIATED ENTITIES
In many cases the audit of a banks investments in
subsidiaries and associated entities does not differ from
the audit of such investments held by any other entity.
However, there are some special aspects that pose
particular problems in respect of banking operations.
Valuation
The auditor considers the implications of any legal or
practical requirement for the bank to provide future
financial support to ensure the maintenance of operations
(and hence the value of the investment) of subsidiaries
IAPS 1006
720
and associated companies. The auditor considers whether

the related financial obligations are recorded as liabilities
of the bank.
The auditor determines whether appropriate adjustments
are made when the accounting policies of companies
accounted for on an equity basis or consolidated do not
conform to those of the bank.
(Comprising
advances, bills of
exchange, letters
of credit,
acceptances,
guarantees, and
all other lines of
credit extended to
customers,
including those in
connection
with foreign
exchange and
money market
activities)
Personal
Commercial
Government
Domestic
Foreign
LOANS
Existence
The auditor considers the need for external confirmation
of the existence of loans.
Valuation
provision for loan losses. The auditor understands the
laws and regulations that may influence the amounts
determined by management. The Basel Committee has
published a set of Sound Practices for Loan Accounting
and Disclosure, which provides guidance to banks and
banking supervisors on recognition and measurement
of loans, establishment of loan loss provisions, credit
risk disclosure and related matters. It sets out banking
supervisors views on sound loan accounting and
disclosure practices for banks and so may influence the
financial reporting framework within which a bank
prepares its financial statements. However, the banks
financial statements are prepared in accordance with a
specified financial reporting framework, and the loan
loss provision must be made in accordance with that
framework.
Appendix 2 gives further information on the auditors
consideration of loans.
The major audit concern is the adequacy of the
recorded provision for loan losses.
In establishing the nature, extent and timing of the work
to be performed, the auditor considers the following
factors:
The degree of reliance it is reasonable to place on

the banks system of loan quality classification,
on its procedures for ensuring that all
documentation is properly completed, on its
internal loan review procedures and on the work
721
IAPS 1006
AUDITING
89.
of internal auditing.
Given the relative importance of foreign lending,

the auditor ordinarily examines:
The information on the basis of which the
bank assesses and monitors the country risk
and the criteria (for example, specific
classifications and valuation ratios) it uses for
this purpose; and
Whether and, if so, by whom credit limits are
set for the individual countries, what the
limits are and the extent to which they have
been reached.
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.
Identified potential non-performing 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 that may affect the
repayment of loans by borrowers.
In addition to those non-performing loans identified by
management and, where applicable, by bank regulators,
IAPS 1006
722
the auditor considers additional sources of information

to determine those loans that may not have been so
identified. These include:
Various internally generated listings, such as

watchlist loans, past due loans, loans on nonaccrual status, loans by risk classification, loans
to insiders (including directors and officers), and
loans in excess of approved limits;
Historical loss experience by type of loan; and
Those loan files lacking current information on

borrowers, guarantors or collateral.
Banks are often subject to particular disclosure
requirements concerning their loans and provisions for
loan losses. The auditor considers whether the
information disclosed is in accordance with the
applicable financial or regulatory reporting framework.
90.
ACCOUNTS WITH DEPOSITORS
(a) General deposits
Completeness

The auditor determines whether deposit liabilities are
classified in accordance with regulations and relevant
accounting principles.
Where deposit liabilities have been secured by specific
assets, the auditor considers the need for appropriate
disclosure.
The auditor also considers the need for disclosure
where the bank has a risk due to economic dependence
on a few large depositors or where there is an excessive
concentration of deposits due within a specific time.
(b) Items in transit
Existence
The auditor determines whether items in transit between
branches, between the bank and its consolidated
subsidiaries, and between the bank and counterparties,
723
IAPS 1006
AUDITING
The auditor assesses the system of internal control over

accounts with depositors. The auditor also considers
performing confirmation and analytical procedures on
average balances and on interest expense to assess the
reasonableness of the recorded deposit balances.
are eliminated and that reconciling items have been

appropriately addressed and accounted for.
Additionally, the auditor examines individual items
comprising the balance that have not been cleared
within a reasonable time period and also considers
whether the related internal control procedures are
adequate to ensure that such items have not been
temporarily transferred to other accounts in order to
avoid their detection.
91.
CAPITAL AND RESERVES

Banking regulators pay close attention to a banks
capital and reserves in monitoring the level of a banks
activities and in determining the extent of a banks
operations. Small changes in capital or reserves may
have a large effect on a banks ability to continue
operating, particularly if it is near to its permitted
minimum capital ratios. In such circumstances there are
greater pressures for management to engage in
fraudulent financial reporting by miscategorizing assets
and liabilities or by describing them as being less risky
than they actually are.
The auditor considers whether capital and reserves are
adequate for regulatory purposes (for example, to meet
capital adequacy requirements), the disclosures have
been appropriately calculated and that the disclosures are
both appropriate and in accordance with the applicable
financial reporting framework. In many jurisdictions
auditors are required to report on a wide range of
disclosures about the banks capital and its capital ratios,
either because that information is included in the
financial statements or because there is requirement to
make a separate report to banking supervisors.
In addition, where applicable regulations provide for
restrictions on the distribution of retained earnings, the
auditor considers whether the restrictions are
adequately disclosed.
The auditor also determines whether the requirements
of the applicable financial reporting framework with
respect to the disclosure of hidden reserves have been
complied with (see also paragraph 103).
IAPS 1006
724
(For example,
commitments to
lend funds and to
guarantee
repayment of
funds by
customers to third
parties)
PROVISIONS, CONTINGENT ASSETS AND

CONTINGENT LIABILITIES (OTHER THAN
DERIVATIVES AND OFF-BALANCE SHEET
FINANCIAL INSTRUMENTS)
Completeness
Many contingent assets and liabilities are recorded
without there being a corresponding liability or asset
(memorandum items). The auditor therefore:
Identifies those activities that have the potential to

generate contingent assets or liabilities (for
example, securitizations);
Considers whether the banks system of internal

control is adequate to ensure that contingent
assets or liabilities arising out of such activities
are properly identified and recorded and that
evidence is retained of the customers agreement
to the related terms and conditions;
Performs substantive procedures to test the

completeness of the recorded assets and liabilities.
Such procedures may include confirmation
procedures as well as examination of related fee
income in respect of such activities and are
determined having regard to the degree of risk
attached to the particular type of contingency being
considered;
Reviews the reasonableness of the period-end

contingent asset and liability figures in the light of
the auditors experience and knowledge of the
current years activities; and
Obtains representation from management that all

contingent assets and liabilities have been
recorded and disclosed as required by the
financial reporting framework.
Valuation
Many of these transactions are either credit substitutes
or depend for their completion on the credit-worthiness
of the counterparty. The risks associated with such
transactions are in principle no different from those
associated with Loans. The audit objectives and
considerations of particular importance discussed in
paragraph 89 is equally relevant in respect of these
transactions.
725
IAPS 1006
AUDITING
92.

Where assets or liabilities have been securitized or
otherwise qualify for an accounting treatment that
removes them from the banks balance sheet, the
auditor considers the appropriateness of the accounting
treatment and whether appropriate provisions have
been made. Similarly, where the bank is a counterparty
to a transaction that allows a client entity to remove an
asset or liability from the clients balance sheet, the
auditor considers whether there is any asset or liability
that the financial reporting framework requires to be
shown in the balance sheet or in the notes to the
financial statements.
Although the relevant financial reporting framework
ordinarily requires disclosure of such obligations in the
notes to the financial statements rather than in the
balance sheet, the auditor nevertheless considers the
potential financial impact on the banks capital,
funding and profitability of the need to honor such
obligations and whether this needs to be specifically
disclosed in the financial statements.
93.
(For example,
foreign exchange
contracts, interest
rate and currency
swaps, futures,
options, and
forward rate
agreements)
DERIVATIVES AND OFF-BALANCE SHEET

FINANCIAL INSTRUMENTS
Many of these instruments are dealt with as part of the
banks treasury and trading activities. Appendix 2 gives
more information on the auditors consideration of
treasury and trading activities. For transactions
involving derivatives that the bank enters into as an end
user, IAPS 1012 provides further guidance.
The auditor examines the underlying documentation
supporting such transactions in order to determine
whether all rights and obligations, such as warranties
and options, have been properly accounted for.
Existence
The auditor considers the need for third party
confirmations of outstanding balances, which are
selected from back office records of open transactions
and from lists of approved counterparties, brokers and
exchanges. It may be necessary to perform
confirmation tests separately on the various products as
the systems may not facilitate a combined selection of
IAPS 1006
726
all transactions with any given counterparty.
Valuation
Similar considerations arise here as arise for Other
Financial Assets above. However, the following further
considerations also arise.
Derivatives and off-balance sheet financial instruments
are ordinarily valued at market or fair value, except
that, in some financial reporting frameworks, hedging
instruments are valued on the same basis as the
underlying item being hedged. The applicable financial
reporting framework may not require financial
instruments to be shown on the balance sheet, or may
require them to be to be valued at cost. In such
instances, there may be an obligation to disclose the
market or fair values of derivatives or off-balance sheet
instruments in the notes to the financial statements.
727
IAPS 1006
AUDITING
Completeness
Due to the continuing development of new financial
instruments, there may be a lack of established
procedures between participants and within the bank.
The auditor therefore assesses 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 documentation
received from counterparties and reconciliation of
accounts with counterparties; and
The adequacy of internal audit review.

The auditor considers assessing the adequacy of the
related system of internal control, including regular
profit and loss account reconciliations at appropriate
intervals and period-end reconciliation procedures,
particularly in respect of the completeness and
accuracy of the recording of outstanding positions as at
the period end. (This requires the auditor to be familiar
with standard inter-bank transaction confirmation
procedures);
The auditor may also find it useful to examine post
period-end transactions for evidence of items that
should have been recorded in the year-end financial
statements. ISA 560, Subsequent Events provides
further guidance on the auditors consideration of
events occurring after the period end.
If the instrument is traded on an investment exchange,

the value may be determined through independent
sources. If the transaction is not traded, independent
experts may be required to assess the value.
Additionally, the auditor considers the need for and
adequacy of fair value adjustments to financial
instruments, such as a liquidity risk provision, a
modeling risk provision and a provision for operational
risk. The auditor considers matters such as the
following:
The appropriateness of the exchange rates,

interest rates or other underlying market rates
used at the financial statement date to calculate
unrealized gains and losses.
The appropriateness of the valuation models and

assumptions used to determine the fair value of
financial instruments outstanding as at the
financial statement date. In addition, the auditor
considers whether details of individual contracts,
valuation rates and assumptions used are
appropriately entered into the models.
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.
When market values need to be considered, but are not
available, the auditor considers whether appropriate
alternative valuation techniques have been employed,
based, where appropriate, on current interest or foreign
exchange rates.
As some of these instruments have been developed
only recently, the auditor examines their valuation with
a special degree of caution, and in doing so bears in
mind the following factors:
There may be no legal precedents concerning the

terms of the underlying agreements. This makes it
difficult to assess the enforceability of those terms.
There may be a relatively small number of

management personnel who are familiar with the
inherent risks of these instruments. This may lead
to a higher risk of misstatements occurring and a
IAPS 1006
728
Measurement
The auditor considers the purpose for which the
transaction resulting in the instrument was entered into,
in particular whether the transaction was a trading
transaction or a hedging one. The bank may have been
dealing as principal to create a dealing position or to
hedge another asset, or it may have been dealing as an
intermediary or broker. The purpose may determine the
appropriate accounting treatment.
Since settlement of such transactions is at a future date,
the auditor considers whether a profit or loss has arisen
by the period end that is required to be recorded in the
financial statements.
The auditor considers whether there has been a
reclassification
of
hedging
and
trading
transactions/positions that may have been made
primarily with a view to taking advantage of
differences in the timing of profit and loss recognition.
In some financial reporting frameworks, the relevant
accounting principles require the recording of accrued
gains and losses on open positions, whether or not
these positions are recorded on the balance sheet. In
other financial reporting frameworks there is only an
obligation to disclose the commitment. Where the latter
is the case, the auditor considers whether the
729
IAPS 1006
AUDITING
greater difficulty in establishing controls that

would prevent misstatements or detect and correct
them on a timely basis.
Some of these instruments have not 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. Similarly, it may be difficult to
predict with a sufficient degree of certainty the
price correlation with other offsetting instruments
used by the bank to hedge its positions.
The models used for valuing such instruments
may not operate properly in abnormal market
conditions.
unrecorded amounts are of such significance as to

require a disclosure in the financial statements or
qualification in the audit report.
The following additional considerations may arise:
The auditor considers the appropriate accounting

treatment and presentation of such transactions in
accordance with relevant financial reporting
requirements. Where those requirements have
different treatments for transactions that are
entered into for hedging purposes, the auditor
considers whether transactions have been
appropriately identified and treated.
Some financial reporting frameworks require the

disclosure of the potential risk arising from open
positions, as for example, the credit risk
equivalent and replacement value of outstanding
off-balance sheet instruments.
94.
INTEREST INCOME AND INTEREST EXPENSE

Measurement
Interest income and expense ordinarily comprise two of
the main items in a banks income statement. The
auditor considers:
Whether satisfactory procedures exist for the

proper accounting of accrued income and
expenditure at the year-end;
Assessing the adequacy of the related system of

internal control; and
Using analytical procedures in assessing the

reasonableness of the reported amounts.
Such techniques include comparison of reported
interest yields in percentage terms:
To market rates;
To central bank rates;
To advertised rates (by type of loan or
deposit); and
Between portfolios.
In making such comparisons, average rates in
effect (for example, by month) are used in order
to avoid distortions caused by changes in interest
rates.
IAPS 1006
730
The auditor considers the reasonableness of the policy

applied to income recognition on non-performing
loans, especially where such income is not being
received on a current basis. The auditor also considers
whether income recognition on non-performing loans
complies with the policy of the bank, as well as the
requirements of the applicable financial reporting
framework.
PROVISIONS FOR LOAN LOSSES
Measurement
The major audit concerns in this area are discussed
above under Loans. Usually, provisions take two
forms, namely specific provisions in respect of
identified losses on individual loans and general
provisions to cover losses that are thought to exist but
have not been specifically identified. The auditor
assesses the adequacy of such provisions based on such
factors as past experience and other relevant
information and considers whether the specific and
general provisions are adequate to absorb estimated
credit losses associated with the loan portfolio.
Appendix 2 to this Statement contains examples of
substantive procedures for the evaluation of loan loss
provisions. In some countries the levels of general
provisions are prescribed by local regulations. In those
countries, the auditor determines whether the reported
provision expense is calculated in accordance with
such regulations. The auditor also considers the
adequacy of the disclosures in the financial statements
and, when the provisions are not adequate, the
implications for the audit report.
96.
FEE AND COMMISSION INCOME

Completeness
The auditor considers whether the amount recorded is
complete (that is, all individual items have been
recorded). In this respect, the auditor considers using
analytical procedures in assessing the reasonableness of
the reported amounts.
Measurement
The auditor considers matters such as the following:
731
IAPS 1006
AUDITING
95.
97.
Whether the income relates to the period covered

by the financial statements and that those amounts
relating to future periods have been deferred.
Whether the income is collectible (this is
considered as part of the loan review audit
procedures where the fee has been added to a loan
balance outstanding).
Whether the income is accounted for in
accordance with the applicable financial reporting
framework.
PROVISION FOR TAXES ON INCOME

Measurement
The auditor becomes familiar with the special taxation
rules applicable to banks in the jurisdiction in which
the bank being reported on is located. The auditor also
considers whether any auditors on whose work it is
intended to rely in respect of the banks foreign
operations are similarly familiar with the rules in their
jurisdiction. The auditor is aware of the taxation
treaties between the various jurisdictions in which the
bank operates.
98.
RELATED PARTY TRANSACTIONS

Financial reporting frameworks often require the
disclosure of the existence of related parties and of
transactions with them. Related party transactions may
occur in the ordinary course of a banks business. For
example, a bank may extend credit to its officers or
directors or to entities that are owned or controlled by
officers or directors. The auditor remains aware of the
risk that where such lending transactions with related
parties exist, normal measures of banking prudence,
such as credit assessment and collateral requirements,
may not be exercised properly. The auditor becomes
familiar with the applicable regulatory requirements for
lending to related parties and performs procedures to
identify the banks controls over related party lending,
including approval of related party credit extensions
and monitoring of performance of related party loans.
Other related party transactions that may occur in the
ordinary course of a banks business include deposit and
IAPS 1006
732
Valuation
Related party transactions may also result from
managements attempts to avoid adverse circumstances.
For example, a banks management may transfer
problem assets to an unconsolidated affiliated entity at or
near the period end, or prior to a regulatory examination,
to avoid a deficiency in the provision for loan losses or
to avoid criticism about asset quality. The auditor
considers reviewing transactions involving related
parties that have been accounted for as sales transactions
to determine whether there are unrecorded recourse
obligations involved.
Representations from management or others are often
required to understand the business purpose of a
particular transaction. Such representations are
evaluated in the light of apparent motives and other
audit evidence. In order to obtain a complete
understanding of a transaction, certain circumstances
may warrant a discussion with the related party, their
auditor, or other parties such as legal counsel, who are
familiar with the transaction. ISA 580, Management
Representations gives further guidance on the use of
management representations.
733
IAPS 1006
AUDITING
other transactions with directors, officers, or affiliated

entities. A bank may also guarantee loans to, or the
financial performance of, an affiliated entity. The
guarantee may be formalized in a written agreement or
the guarantee may be informal. Informal guarantees may
be oral agreements, understood agreements based on
the affiliates historical performance, or the result of the
business culture in which the bank operates. Such
agreements, whether formal or informal, are of particular
concern when the guarantee relates to an unconsolidated
affiliate, as the guarantee is not disclosed in the banks
consolidated financial statements. The auditor makes
inquiries of management and reviews the minutes of the
board of directors to determine if such guarantees exist
and whether there is appropriate disclosure of the
guarantees in the banks financial statements.
99.
FIDUCIARY ACTIVITIES
Completeness
The auditor considers whether all the banks income
from such activities has been recorded and is fairly
stated in the banks financial statements. The auditor
also considers whether the bank has incurred any
material undisclosed liability from a breach of its
fiduciary duties, including the safekeeping of assets.
The auditor considers whether the financial reporting
framework requires disclosure of the nature and extent
of its fiduciary activities in the notes to its financial
statements, and whether the required disclosures have
been made.
100.
IAPS 1006
(Including, where
applicable, a
Statement of
Accounting
Policies)
NOTES TO THE FINANCIAL STATEMENTS

The auditor determines whether the notes to the banks
financial statements are in accordance with the
applicable financial reporting framework.
734
Reporting on the Financial Statements

In expressing an opinion on the banks financial statements, the auditor:
Adheres to any specific formats and terminology specified by the law,

the regulatory authorities, professional bodies and industry practice; and
Determines whether adjustments have been made to the accounts of

foreign branches and subsidiaries that are included in the consolidated
financial statements of the bank to bring them into conformity with the
financial reporting framework under which the bank is reporting. This is
particularly relevant in the case of banks because of the large number of
countries in which such branches and subsidiaries may be located and the
fact that in most countries local regulations prescribe specialized
accounting principles applicable primarily to banks. This may lead to a
greater divergence in the accounting principles followed by branches and
subsidiaries, than is the case in respect of other commercial entities.
102.
The financial statements of banks are prepared in the context of the legal
and regulatory requirements prevailing in different countries, and
accounting policies are influenced by such regulations. In some countries
the financial reporting framework for banks (the banking framework)
differs materially from the financial reporting framework for other entities
(the general framework). When the bank is required to prepare a single set
of financial statements that comply with both frameworks, the auditor may
express a totally unqualified opinion only if the financial statements have
been prepared in accordance with both frameworks. If the financial
statements are in accordance with only one of the frameworks, the auditor
expresses an unqualified opinion in respect of compliance with that
framework and a qualified or adverse opinion in respect of compliance with
the other framework. When the bank is required to comply with the banking
framework instead of the general framework, the auditor considers the need
to refer to this fact in an emphasis of matter paragraph.
103.
Banks often present additional information in annual reports that also

contain audited financial statements. This information frequently contains
details of the banks risk adjusted capital, and other information relating to
the banks stability, in addition to any disclosures in the financial
statements. ISA 720, Other Information in Documents Containing Audited
Financial Statements provides guidance on the procedures to be
undertaken in respect of such additional information.
735
IAPS 1006
AUDITING
101.
Appendix 1
Risks and Issues in Respect of Fraud and Illegal Acts
Paragraph 26 of this Statement indicates some of the general considerations in
respect of fraud. These are also discussed in more detail in ISA 240, The Auditors
Responsibility to Consider Fraud and Error in an Audit of Financial Statements.8
ISA 240 requires the auditor to consider whether fraud risk factors are present that
indicate the possibility of either fraudulent financial reporting or misappropriation of
assets. Appendix 1 to the ISA gives an indication of general fraud risk factors: this
appendix gives examples of fraud risk factors applicable to banks.
The risk of fraudulent activities or illegal acts arises at banks both from within the
institution and from outsiders. Among the many fraudulent activities and illegal acts
that banks may face are check-writing fraud, fraudulent lending and trading
arrangements, money laundering and misappropriation of banking assets. Fraudulent
activities may involve collusion by management of banks and their clients. Those
perpetrating fraudulent activities may prepare false and misleading records to justify
inappropriate transactions and hide illegal activities. Fraudulent financial reporting is
another serious concern.
In addition, banks face an ongoing threat of computer fraud. Computer hackers, and
others who may gain unauthorized access to banks computer systems and
information databases, can misapply funds to personal accounts and steal private
information about the institution and its customers. Also, as is the case for all
businesses, fraud and criminal activity perpetrated by authorized users inside banks
is a particular concern.
Fraud is more likely to be perpetrated at banks that have serious deficiencies in
corporate governance and internal control. Significant losses from fraud may arise
from the following categories of breakdowns in corporate governance and internal
control:
Lack of adequate management oversight and accountability, and failure to

develop a strong control culture within the bank. Major losses due to fraud often
arise as a consequence of management's lack of attention to, and laxity in, the
control culture of the bank, insufficient guidance and oversight by those charged
with governance and management, and a lack of clear management
accountability through the assignment of roles and responsibilities. These
situations also may involve a lack of appropriate incentives for management to
carry out strong line supervision and maintain a high level of control
consciousness within business areas.
See footnote 1.
IAPS 1006 APPENDIX
736
Inadequate recognition and assessment of the risk of certain banking activities,

whether on- or off-balance sheet. When the risks of new products and activities
are not adequately assessed and when control systems that function well for
simpler traditional products are not updated to address newer complex products,
a bank may be exposed to a greater risk of loss from fraud.
The absence or failure of key control structures and activities, such as

segregation of duties, approvals, verifications, reconciliations, and reviews of
operating performance. In particular, the lack of a segregation of duties has
played a major role in fraudulent activities that resulted in significant losses at
banks.
Inadequate communication of information between levels of management within

the bank, especially in the upward communication of problems. When policies
and procedures are not appropriately communicated to all personnel involved in
an activity, an environment is created that may foster fraudulent activities. In
addition, fraud may go undetected when information about inappropriate
activities that should be brought to the attention of higher level management is
not communicated to the appropriate level until the problems become severe.
Inadequate or ineffective internal audit programs and monitoring activities.

When internal auditing or other monitoring activities are not sufficiently
rigorous to identify and report control weaknesses, fraud may go undetected at
banks. When adequate mechanisms are not in place to ensure that management
corrects deficiencies reported by auditors, fraud may continue unabated.
Management &
Employee Fraud
Deposit Taking
Dealing
Lending
Depositors
camouflage
Off-market rings
Loans to fictitious
borrowers
Related party
deals
Unrecorded
deposits
Use of nominee
companies
Broker kickbacks
Theft of
customer
deposits or
investments,
particularly from
dormant accounts
False deals
Unrecorded deals
Delayed deal
allocations
Misuse of
737
Deposit
transformation
Transactions with
connected
companies
Kickbacks and
inducements
IAPS 1006 APPENDIX
AUDITING
The following table and discussion in this appendix provide examples of fraud risk
factors.
Deposit Taking
Dealing
Lending
discretionary
accounts
Use of parallel
organizations
Exploiting
weaknesses in
matching
procedures
Funds
transformation
Mismarking of
book
External Fraud
Selling recovered
collateral at below
market prices
Collusion in
providing
valuations
(Valuation rings)
Bribes to obtain
the release of
security or to
reduce the amount
claimed
Theft or misuse
of collateral held
as security
Theft or misuse of
collateral held as
security
Money
laundering
Fraudulent
custodial sales
Fraudulent
instructions
False information
or documents
regarding
counterparties
Impersonation
and false
information on
loan applications
and subsequently
provided
documents
Counterfeit
currency or
drafts
Double-pledging
of collateral
Fraudulent use of
Check float
periods (Check
kiting)
Fraudulent
valuations (Land
flips)
Forged or
valueless
collateral
Misappropriation
of loan funds by
IAPS 1006 APPENDIX
738
Deposit Taking
Dealing
Lending
agents/ customers
Unauthorized sale
of collateral
Fraud Risk Factors in Respect of the Deposit Taking Cycle
Depositors Camouflage
(Hiding the identity of a depositor, possibly in connection with funds transformation
or money laundering.)
Similar or like-sounding names across various accounts.
Offshore company depositors with no clearly defined business or about which

there are few details.
Unrecorded Deposits
Any evidence of deposit-taking by any other company of which there are details
on the premises, whether part of the bank or not.
Documentation held in management offices that it is claimed has no connection

with the business of the bank or evasive replies regarding such documents.
Customers with hold-mail arrangements who only have very occasional contact
with the bank.
No independent resolution of customer complaints or review of hold-mail

accounts.
Fraud Risk Factors in Respect of the Dealing Cycle

Off-market Rings/Related Party Deals
No spot checks on the prices at which deals are transacted.
Unusual levels of activity with particular counterparties.
Broker Kickbacks
High levels of business with a particular broker.
Unusual trends in broker commissions.
739
IAPS 1006 APPENDIX
AUDITING
Theft of Customer Deposits/Investments
False Deals
A significant number of cancelled deals.
Unusually high value of unsettled transactions.
Unrecorded Deals
High levels of profit by particular dealers in relation to stated dealing strategy.
Significant number of unmatched counterparty confirmations.
Delayed Deal Allocations
No time stamping of deal tickets or a review of the time of booking.
Alterations to or overwriting of details on deal sheets.
Misuse of Discretionary Accounts
Unusual trends on particular discretionary accounts.
Special arrangements for preparation and issue of statements.
Mismarking of the Book
No detailed valuation policies and guidelines.
Unusual trends in the value of particular books.
Fraud Risk Factors in Respect of the Lending Cycle

Loans to Fictitious Borrowers/Transactions with Connected Companies
Thin loan files with sketchy, incomplete financial information, poor

documentation or management claim the borrower is wealthy and undoubtedly
creditworthy.
Valuations which seem high, valuers used from outside the usually permitted
area or the same valuer used on numerous applications.
Generous extensions or revised terms when the borrower defaults.
Deposit Transformation or Back-to-back Lending

A bank deposit is made by another bank, which is then used to secure a loan to a
beneficiary nominated by the fraudulent staff member of the first bank, who hides
the fact that the deposit is pledged.
Pledges over deposits (disclosed by confirmations which have specifically

requested such pledges to be disclosed).
Documentation of files held in directors or senior managers offices outside the

usual filing areas; deposits continually rolled over or made even when liquidity
is tight.
IAPS 1006 APPENDIX
740
Use of Nominee Companies/Transactions with Connected Companies
Complex structures which are shrouded in secrecy.
Several customers with sole contact, that is, handled exclusively by one member
of staff.
Limited liability partnerships without full disclosure of ownership or with

complex common ownership structures.
Kickbacks and Inducements
Excessive amounts of business generated by particular loan officers.
Strong recommendation by director or lending officer but missing data or

documentation on credit file.
Indications of week documentation controls, for example providing funding

before documentation is complete.
Use of Parallel Organizations

(Companies under the common control of directors/shareholders)
Unexpected settlement of problem loans shortly before the period end or prior to
an audit visit or unexpected new lending close to the period end.
Changes in the pattern of business with related organizations.
Funds Transformation
Loans which suddenly become performing shortly before the period end or prior
to an audit visit.
Transactions with companies within a group or with its associated companies

where the business purpose is unclear.
Lack of cash flow analysis that supports the income generation and repayment
ability of the borrower.
Impersonation and False Information on Loan Applications/Double-pledging of

Collateral/Fraudulent Valuations/Forged or Valueless Collateral
No on-site appraisal of or visit by the borrower.
Difficulty in obtaining corroboration of the individuals credentials, inconsistent

or missing documentation and inconsistencies in personal details.
Valuer from outside the area in which the property is situated.
Valuation is ordered and received by the borrower rather than the lender.
Lack of verification of liens to substantiate lien positions and priorities

741
IAPS 1006 APPENDIX
AUDITING
(Methods used to conceal the use of bank funds to make apparent loan repayments)
Lack of physical control of collateral that requires physical possession to secure

a loan (for example, jewelry, bearer bonds and art work).
IAPS 1006 APPENDIX
742
Appendix 2
Examples of Internal Control Considerations and Substantive
Procedures for Two Areas of a Banks Operations
1.
The internal controls and substantive procedures listed below represent

neither an exhaustive list of controls and procedures that should be
undertaken, nor do they represent any minimum requirement that should be
satisfied. Rather, they provide guidance on the controls and procedures that
the auditor may consider in dealing with the following areas:
(a)
Treasury and trading operations; and
(b)
Loans and advances.
Treasury and Trading Operations
2.
Treasury operations, in this context, represent all activities relating to the

purchase, sale, borrowing and lending of financial instruments. Financial
instruments may be securities, money market instruments or derivative
instruments. Banks usually enter into such transactions for their own use
(for example, for the purpose of hedging risk exposures) or for meeting
customers needs. They also carry out, to a larger or smaller extent, trading
activities. Trading may be defined as the purchase and sale (or origination
and closing) of financial instruments (including derivatives) with the
intention of deriving a gain from the change in market price parameters (for
example, foreign exchange rates, interest rates, equity prices) over time.
Banks manage and control their treasury activities on the basis of the
various risks involved rather than on the basis of the particular type of
financial instrument dealt with. The auditor ordinarily adopts the same
approach when obtaining audit evidence. IAPS 1012 gives guidance on the
audit implications of derivatives acquired by the bank as an end user.
Internal Control Considerations

3.
Generally, treasury operations involve transactions that are recorded by IT

systems. The risk of processing error in such transactions is ordinarily low
provided they are processed by reliable systems. Consequently, the auditor
tests whether key processing controls and procedures are operating
effectively before assessing the level of inherent and control risks as low.
Typical controls in a treasury environment are listed below. These include
controls that address business risks of banks and do not necessarily
represent controls that address audit risks and that are tested by the auditor
in order to assess the levels of inherent and control risks.
743
IAPS 1006 APPENDIX
AUDITING
Introduction
Typical Control Questions

Strategic Controls
4.
Have those charged with governance established a formal policy for the
banks treasury business that sets out:
The authorized activities and products the bank can trade on its own or
a third partys behalf, ideally broken down by product or risk group;
The markets in which trading activities take place: these could be

regional markets, or Over-the-Counter (OTC) versus Exchange
markets;
The procedures for measuring, analyzing, supervising and controlling

risks;
The extent of risk positions permissible, after taking into account the
risk they regard as acceptable;
The appropriate limits and procedures covering excesses over defined

limits;
The procedures, including documentation, that must be complied with

before new products or activities are introduced;
The type and frequency of reports to those charged with governance;

and
The schedule and frequency with which the policy is reviewed, updated
and approved?
Operational Controls
5.
Is there appropriate segregation of duties between the front office and back
office?
6.
Are the following activities conducted independently of the front

office/business unit:
Confirmation of trades;
Recording and reconciliation of positions and results;
Valuation of trades or independent verification of market prices; and
Settlement of trades?
7.
Are trade tickets pre-numbered (if not automatically generated)?
8.
Does the bank have a code of conduct for its dealers that addresses the
following:
Prohibiting dealers from trading on their own account;
IAPS 1006 APPENDIX
744
Restricting acceptance of gifts and entertainment activities;
Confidentiality of customer information;
Identification of approved counterparties; and
Procedures for the review of dealers activities by management?
9.
Are remuneration policies structured to avoid encouraging excessive risk

taking?
10.
Are new products introduced only after appropriate approvals are obtained
and adequate procedures and risk control systems are in place?
Limits and Trading Activity

11.
Does the bank have a comprehensive set of limits in place to control the
market, credit and liquidity risks for the whole institution, business units
and individual dealers? Some commonly used limits are notional or volume
limits (by currency or counterparty), stop loss limits, gap or maturity limits,
settlement limits and value-at-risk limits (for both market and credit risks).
12.
Are limits allocated to risks in line with the overall limits of the bank?
13.
Do all dealers know their limits and the use thereof? Does every new
transaction reduce the available limit immediately?
14.
Are procedures in place that cover excesses over limits?
15.
Is there an independent risk management function (sometimes referred to as

Middle Office) for measuring, monitoring and controlling risk? Does it
report directly to those charged with governance and senior management?
16.
Which method is employed to measure the risk arising from trading

activities (for example, position limits, sensitivity limits, value at risk limits,
etc.)?
17.
Are the risk control and management systems adequately equipped to

handle the volume, complexity and risk of treasury activities?
18.
Does the risk measurement system cover all portfolios, all products and all
risks?
19.
Is appropriate documentation in place for all elements of the risk system

(methodology, calculations, parameters)?
20.
Are all trading portfolios revalued and risk exposures calculated regularly,
at least daily for active dealing operations?
745
IAPS 1006 APPENDIX
AUDITING
Risk Measurement and Management
21.
Are risk management models, methodologies and assumptions used to

measure risk and to limit exposures regularly assessed, documented and
updated continuously to take account of altered parameters, etc?
22.
Are stress situations analyzed and worst case scenarios (which take into
account adverse market events such as unusual changes in prices or
volatilities, market illiquidity or default of a major counterparty) conducted
and tested?
23.
Does management receive timely and meaningful reports?
Confirmations
24.
Does the bank have written procedures in use:
For the independent dispatch of pre-numbered 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?
Settlement of Transactions
25.
Are settlement instructions exchanged in writing with counterparties by the

use of inward and outward confirmations?
26.
Are settlement instructions compared to the contracts?
27.
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?
28.
Are all scheduled settlements (receipts and payments) notified daily in

writing to the settlement department so that duplicate requests and failures
to receive payments can be promptly detected and followed-up?
29.
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?
IAPS 1006 APPENDIX
746
30.
Are exception reports generated for excesses in limits; sudden increases in

trading volume by any one trader, customer or counterparty; transactions at
unusual contract rates, etc? Are these monitored promptly and
independently of the dealers?
31.
Does the bank have written procedures that require:
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;
The daily reconciliation of dealers 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?
32.
Are all nostro and vostro account reconciliations performed frequently and
by employees independent of the settlement function?
33.
Are suspense accounts regularly reviewed?
34.
Does the bank have an accounting system that allows it to prepare reports
that show its spot, forward, net open and overall positions for the different
types of products, for example:
35.
By purchase and sale, by currency;
By maturity dates, by currency; and
By counterparty, by currency?
Are open positions revalued periodically (for example, daily) to current

values based on quoted rates or rates obtained directly from independent
sources?
General Audit Procedures

36.
Certain audit procedures apply to the environment in which treasury

activities are carried out. To understand this environment, the auditor
initially obtains an understanding of the:
Scale, volume, complexity and risk of treasury activities;
Importance of treasury activities relative to other business of the bank;
Framework within which treasury activities take place; and
Organizational integration of the treasury activities.
747
IAPS 1006 APPENDIX
AUDITING
Recording
37.
38.
Once the auditor has obtained this understanding and has performed tests of
controls with satisfactory results, the auditor ordinarily assesses:
The accuracy of the recording of transactions entered into during the

period and related profits and losses, by reference to deal tickets and
confirmation slips;
The completeness of transactions and proper reconciliation between the

front office and accounting systems of open positions at the period end;
The existence of outstanding positions by means of third party

confirmations at an interim date or at the period end;
The appropriateness of the exchange rates, interest rates or other

underlying market rates used at the year end date to calculate
unrealized gains and losses;
The appropriateness of the valuation models and assumptions used to

determine the fair value of financial instruments outstanding as at the
period end; and
The appropriateness of the accounting policies used particularly around

income recognition and the distinction between hedged and trading
instruments.
Relevant aspects of treasury operations that generally pose increased audit

risks are addressed below:
Changes in Products or Activities

39.
Particular risks often arise where new products or activities are introduced.
To address such risks the auditor initially seeks to confirm that predefined
procedures are in place for these cases. Generally, the bank should
commence such activities only when the smooth flow of the new
transactions through the controls system is ensured, the relevant IT systems
are fully in place (or where adequate interim system support is in place) and
the relevant procedures are properly documented. Newly traded instruments
are ordinarily subject to careful review by the auditor, who initially obtains
a list of all new products introduced during the period (or a full list of all
instruments transacted). Based on this information, the auditor establishes
the associated risk profile and seeks to confirm the reliability of the internal
control and accounting systems.
Reliance on Computer Experts

40.
Due to the volume of transactions, virtually all banks support the treasury
transactions cycle using IT systems. Due to the complexity of systems in
use and the procedures involved, the auditor ordinarily seeks the assistance
of IT experts to supply appropriate skills and knowledge in the testing of
systems and relevant account balances.
IAPS 1006 APPENDIX
748
Purpose for which Transactions are Undertaken

41.
The auditor considers whether the bank holds speculative positions in

financial instruments or hedges them against other transactions. The
purpose for entering such transactions, whether hedging or trading, should
be identified at the dealing stage in order for the correct accounting
treatment to be applied. Where transactions are entered for hedging
purposes, the auditor considers the appropriate accounting treatment and
presentation of such transactions and the matched assets/liabilities, in
accordance with relevant accounting requirements.
42.
Off-balance sheet financial instruments are ordinarily valued at market or

fair value, except for instruments used for hedging purposes, which, under
many financial reporting frameworks, are valued on the same basis as the
underlying item being hedged. Where market prices are not readily
available for an instrument, financial models that are widely used by the
banking industry may be used to determine the fair value. In addition to
disclosure of the notional amounts of open positions, several countries
require the disclosure of the potential risk arising, as for example, the credit
risk equivalent and replacement value of such outstanding instruments.
43.
The auditor ordinarily tests the valuation models used, including the
controls surrounding their operation, and considers whether details of
individual contracts, valuation rates and assumptions are appropriately
entered into such models. As many of these instruments have been
developed only recently, the auditor pays particular attention to their
valuation, and in doing so bears in mind the following factors:
There may be no legal precedents concerning the terms of the

underlying agreements. This makes it difficult to assess the
enforceability of those terms.
There may be a relatively small number of management personnel who

are familiar with the inherent risks of these instruments. This may lead
to a higher risk of misstatements occurring and a greater difficulty in
establishing controls that would prevent misstatements or detect and
correct them on a timely basis.
Some of these instruments have not 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. Similarly, it may be difficult to predict with a
sufficient degree of certainty the price correlation with other offsetting
instruments used by the bank to hedge its positions.
749
IAPS 1006 APPENDIX
AUDITING
Valuation Procedures
The models used for valuing such instruments may not operate properly
in abnormal market conditions.
44.
In addition, the auditor considers the need for, and adequacy of, provisions
against financial instruments, such as liquidity risk provision, modeling risk
provision and reserve for operational risk. The complexity of certain
instruments requires specialist knowledge. If the auditor does not have the
professional competence to perform the necessary audit procedures, advice
is sought from appropriate experts.
45.
A further issue of particular interest to the auditor is transactions entered

into at rates outside the prevailing market rates; these often involve the risk
of hidden losses or fraudulent activity. As a result, the bank ordinarily
provides mechanisms that are capable of detecting transactions out of line
with market conditions. The auditor obtains sufficient appropriate audit
evidence concerning the reliability of the function performing this task. The
auditor also considers reviewing a sample of the identified transactions.
Loans and Advances

Introduction
46.
According to a consultative paper, Principles for the Management of

Credit Risk, issued by the Basel Committee on Banking Supervision,
credit risk is most simply defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with agreed
terms.
47.
Loans and advances are the primary source of credit risk for most banks,
because they usually are a banks most significant assets and generate the
largest portion of revenues. The overriding factor in making a loan is the
amount of credit risk associated with the lending process. For individual
loans, credit risk pertains to the borrowers ability and willingness to pay.
Aside from loans, other sources of credit risk include acceptances, interbank transactions, trade financing, foreign exchange transactions, financial
futures, swaps, bonds, equities, options, and in the extension of
commitments and guarantees, and the settlement of transactions.
48.
Credit risk represents a major cause of serious banking problems, and is

directly related to lax credit standards for borrowers and counterparties, lack
of qualified lending expertise, poor portfolio risk management, and a lack of
attention to changes in economic or other circumstances that may lead to a
deterioration in the credit standing of a banks counterparties. Effective
credit risk management is a critical component of a comprehensive
approach to risk management and essential to the long-term success of any
banking organization. In managing credit risk, banks should consider the
level of risk inherent in both individual credits or transactions and in the
IAPS 1006 APPENDIX
750
entire asset portfolio. Banks also need to analyze the risk between credit
risk and other risks.
Typical Control Questions
49.
Credit risks arise from characteristics of the borrower and from the nature of
the exposure. The creditworthiness, country of operation and nature of
borrowers business affect the degree of credit risk. Similarly, the credit risk
is influenced by the purpose and security for the exposure.
50.
The credit function may conveniently be divided into the following

categories:
(a)
Origination and disbursement.
(b)
Monitoring.
(c)
Collection.
(d)
Periodic review and evaluation.
51.
Does the bank obtain complete and informative loan applications, including
financial statements of the borrower, the source of the loan repayment and
the intended use of proceeds?
52.
Does the bank have written guidelines as to the criteria to be used in

assessing loan applications (for example, interest coverage, margin
requirements, debt-to-equity ratios)?
53.
Does the bank obtain credit reports or have independent investigations

conducted on prospective borrowers?
54.
Does the bank have procedures in use to ensure that related party lending
has been identified?
55.
Is there an appropriate analysis of customer credit information, including

projected sources of loan servicing and repayments?
56.
Are loan approval limits based on the lending officers expertise?
57.
Is appropriate lending committee or board of director approval required for

loans exceeding prescribed limits?
58.
Is there appropriate segregation of duties between the loan approval

function and the loan disbursement monitoring, collection and review
functions?
59.
Is the ownership of loan collateral and priority of the security interest

verified?
751
IAPS 1006 APPENDIX
AUDITING
Origination and Disbursement
60.
Does the bank ensure that the borrower signs a legally enforceable
document as evidence of an obligation to repay the loan?
61.
Are guarantees examined to ensure that they are legally enforceable?
62.
Is the documentation supporting the loan application reviewed and

approved by an employee independent of the lending officer?
63.
Is there a control to ensure the appropriate registration of security (for

example, recording of liens with governmental authorities)?
64.
Is there adequate physical protection of notes, collateral and supporting

documents?
65.
Is there a control to ensure that loan disbursements are recorded

immediately?
66.
Is there a control to ensure that to the extent possible, loan proceeds are
used by the borrower for the intended purpose?
Monitoring
67.
Are trial balances prepared and reconciled with control accounts by

employees who do not process or record loan transactions?
68.
Are reports prepared on a timely basis of loans on which principal or

interest payments are in arrears?
69.
Are these reports reviewed by employees independent of the lending

function?
70.
Are there procedures in use to monitor the borrowers compliance with any
loan restrictions (for example, covenants) and requirements to supply
information to the bank?
71.
Are there procedures in place that require the periodic reassessment of

collateral values?
72.
Are there procedures in place to ensure that the borrowers financial

position and results of operations are reviewed on a regular basis?
73.
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?
Collection
74.
Are the records of principal and interest collections and the updating of loan
account balances maintained by employees independent of the credit
granting function?
75.
Is there a control to ensure that loans in arrears are followed up for payment
on a timely basis?
IAPS 1006 APPENDIX
752
76.
Are there written procedures in place to define the banks policy for
recovering outstanding principal and interest through legal proceedings,
such as foreclosure or repossession?
77.
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?
Periodic Review and Evaluation
79.
80.
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;
The resumption of interest accruals; and
The writing off of loans?
Are there procedures in place to ensure that all required provisions are
entered into the accounting records on a timely basis?
General Audit Procedures

81.
The following audit procedures are intended to allow the auditor to discover
the operating standards and processes that the bank has established and to
consider whether controls regarding credit risk management are adequate.
Planning
82.
The auditor obtains a knowledge and understanding of the banks method of

controlling credit risk. This includes matters such as the following:
The banks exposure monitoring process, and its system for ensuring
that all connected party lending has been identified and aggregated.
753
IAPS 1006 APPENDIX
AUDITING
78.
The banks method for appraising the value of exposure collateral and
for identifying potential and definite losses.
The banks lending practices and customer base.
83.
The auditor considers whether the exposure review program ensures

independence from the lending functions including whether the frequency is
sufficient to provide timely information concerning emerging trends in the
portfolio and general economic conditions and whether the frequency is
increased for identified problem credits.
84.
The auditor considers the qualifications of the personnel involved in the

credit review function. The industry is changing rapidly and fundamentally
creating a lack of qualified lending expertise. The auditor considers whether
credit review personnel possess the knowledge and skills necessary to
manage and evaluate lending activities.
85.
The auditor considers, through information previously generated, the causes

of existing problems or weaknesses within the system. The auditor
considers whether these problems or weaknesses present the potential for
future problems.
86.
The auditor reviews management reports and considers whether they are
sufficiently detailed to evaluate risk factors.
87.
Note that defining and auditing related party lending transactions are
difficult because the transactions with related parties are not easily
identifiable. Reliance is primarily upon management to identify all related
parties and related-party transactions and such transactions may not be
easily detected by the banks internal control systems.
Tests of Control
88.
89.
The auditor obtains a knowledge and understanding of the banks method of

controlling credit risk. This includes matters such as:
The exposure portfolio and the various features and characteristics of

the exposures;
The exposure documentation used by the bank;
What constitutes appropriate exposure documentation for different

types of exposures; and
The banks procedures and authority levels for granting an exposure.
The auditor reviews the lending policies and considers:
Whether the policies are reviewed and updated periodically to ensure

they are relevant with changing market conditions and new business
lines of the bank; and
IAPS 1006 APPENDIX
754
91.
The auditor examines the exposure review reporting system, including

credit file memoranda and an annual schedule or exposure review plan, and
considers whether it is thorough, accurate and timely and whether it will
provide sufficient information to allow management to both identify and
control risk. Do the reports include:
Identification of problem credits;
Current information regarding portfolio risk; and
Information concerning emerging trends in the portfolio and lending

areas?
The auditor considers the nature and extent of the scope of the exposure
review, including the following:
Method of exposure selection.
Manner in which exposures are reviewed including:

o
92.
An analysis of the current financial condition of the borrower

which addresses repayment ability; and
Tests for documentation exceptions, policy exceptions,
noncompliance with internal procedures, and violations of laws
and regulations.
The auditor considers the effectiveness of the credit administration and

portfolio management by examining the following:
Managements general lending philosophy in such a manner as to elicit

management responses.
The effect of credits not supported by current and complete financial

information and analysis of repayment ability.
The effect of credits for which exposure and collateral documentation

are deficient.
The volume of exposures improperly structured, for example, where the

repayment schedule does not match exposure purpose.
The volume and nature of concentrations of credit, including

concentrations of classified and criticized credits.
The appropriateness of transfers of low quality credits to or from

another affiliated office.
The accuracy and completeness of reports.
755
IAPS 1006 APPENDIX
AUDITING
90.
Whether those charged with governance have approved the policies and
whether the bank is in compliance.
Competency of senior management, exposure officers and credit

administration personnel.
Substantive Procedures
93.
94.
The auditor considers the extent of managements knowledge of the banks

own credit exposure problems through selective exposure file reviews.
Selection criteria include the following:
Accounts with an outstanding balance equal to or greater than a

specified amount.
Accounts on a Watch List with an outstanding balance in excess of a

specified amount.
Accounts with a provision in excess of a specified amount.
Accounts that are handled by the department that manages the banks
problem or higher risk accounts.
Accounts where principal or interest of more than a specified amount is

in arrears for more than a specified period.
Accounts where the amount outstanding is in excess of the authorized

credit line.
Accounts with entities operating in industries or countries that the

auditors own general economic knowledge indicates could be at risk.
Problem accounts identified by the bank regulatory authorities and

problem accounts selected in the prior year.
The extent of exposure to other financial institutions on inter-bank

lines.
In addition, where the banks personnel have been requested to summarize

characteristics of all exposures over a specified size grouped on a
connection basis, the auditor reviews the summaries. Exposures with the
following characteristics may indicate a need for a more detailed review:
Large operating loss in the most recent fiscal year.
Sustained operating losses (for example, 2 or more years).
A high debt/equity ratio (for example, in excess of 2:1the ratio will

vary by industry).
Failure to comply with terms of agreement on covenants.
Modified auditors report.
Information provided not current or complete.
IAPS 1006 APPENDIX
756
96.
Advances significantly unsecured or secured substantially by a

guarantee.
Accounts where reviews not performed by bank management on a

timely basis.
The auditor selects the exposures for detailed review from the exposure
listings above using the sample selection criteria determined above and
obtains the documents necessary to consider the collectability of the
exposures. These may include the following:
The exposure and security documentation files.
Arrears listings or reports.
Activity summaries.
Previous doubtful accounts listings.
The non-current exposure report.
Financial statements of the borrower.
Security valuation reports.
Using the exposure documentation file, the auditor:
Ascertains the exposure type, interest rate, maturity date, repayment

terms, security and stated purpose of the exposure;
Considers whether security documents bear evidence of registration as

appropriate, and that the bank has receive appropriate legal advice
about the securitys legal enforceability;
Considers whether the fair value of the security appears adequate

(particularly for those exposures where a provision may be required) to
secure the exposure and that where applicable, the security has been
properly insured. Critically evaluates the collateral appraisals, including
the appraisers methods and assumptions;
Evaluates the collectability of the exposure and considers the need for a
provision against the account;
Determines whether the appropriate authority levels within the bank

have approved the exposure application or renewal;
Reviews periodic financial statements of the borrower and notes

significant amounts and operating ratios (that is, working capital,
earnings, shareholders equity and debt-to-equity ratios); and
Reviews any notes and correspondence contained in the exposure

review file. Notes the frequency of review performed by the banks
staff and considers whether it is within bank guidelines.
757
IAPS 1006 APPENDIX
AUDITING
95.
97.
98.
The auditor considers whether policies and procedures exist for problem
and workout exposures, including the following:
A periodic review of individual problem credits.
Guidelines for collecting or strengthening the exposure, including

requirements for updating collateral values and lien positions,
documentation review, officer call reports.
Volume and trend of past due and non-accrual credits.
Qualified officers handling problem exposures.
Guidelines on proper accounting for problem exposures, for example,

non-accrual policy, specific reserve policy.
In addition to assessing the adequacy of the provisions against individual

exposures, the auditor considers whether any additional provisions need to
be established against particular categories or classes of exposures (for
example, credit card exposures and country risk exposures) and assesses the
adequacy of any provisions that the bank may have established through
discussions with management.
IAPS 1006 APPENDIX
758
Appendix 3
Examples of Financial Information, Ratios and Indicators
Commonly Used in the Analysis of a Banks Financial Condition
and Performance
There are a large number of financial ratios that are used to analyze a banks
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. The auditor considers the ratios obtained by one bank in the context of similar
ratios achieved by other banks for which the auditor has, or may obtain, sufficient
information.
These ratios generally fall into the following categories:
Asset quality.
Liquidity.
Earnings.
Capital adequacy.
Market risk.
Funding risk.
(a)
(b)
AUDITING
Set out below are those overall ratios that the auditor is likely to encounter. Many
other, more detailed ratios are ordinarily 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.
Asset quality ratios:
Loan losses to total loans
Non-performing loans to total loans
Loan loss provisions to non-performing loans
Earnings coverage to loan losses
Increase in loan loss provisions to gross income
Size, credit risk concentration, provisioning
Liquidity ratios:
Cash and liquid securities (for example, those due within 30 days) to
total assets
Cash, liquid securities and highly marketable securities to total assets

759
IAPS 1006 APPENDIX
(c)
(d)
(e)
(f)
Inter-bank and money market deposit liabilities to total assets
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
Non-interest expense as a percentage of average total assets
Non-interest expense as a percentage of operating income
Capital adequacy ratios:
Equity as a percentage of total assets
Tier 1 capital as a percentage of risk-weighted assets
Total capital as a percentage of risk-weighted assets
Market risk:
Concentration of risk of particular industries or geographic areas
Value at risk
Gap and duration analysis (basically a maturity analysis and the

effect of changes in interest rates on the banks earnings or own
funds)
Relative size of engagements and liabilities
Effect of changes in interest rates on the banks earnings or own

funds
Funding risk:
Clients funding to total funding (clients plus interbank)
Maturities
Average borrowing rate
IAPS 1006 APPENDIX
760
Appendix 4
Risks and Issues in Securities Underwriting and Securities
Brokerage
Securities Underwriting
Many banks provide such financial services as underwriting publicly offered
securities or assisting in the private placement of securities. Banks engaging in these
activities may be exposed to substantial risks that have audit implications. These
activities and the risks associated with them are quite complex, and consideration is
given to consulting with experts in such matters.
The type of security being underwritten, as well as the structure of the offering,
influence the risks present in securities underwriting activities. Depending upon how
a security offering is structured, an underwriter may be required to buy a portion of
the positions offered. This creates the need to finance the unsold portions, and
exposes the entity to the market risk of ownership.
Securities Brokerage
Many banks also are involved in securities brokerage activities that include
facilitating customers securities transactions. As with securities underwriting, banks
engaging in these activities (as a broker, dealer, or both) may be exposed to
substantial risks that have audit implications. These activities and the risks associated
with them are quite complex, and consideration is given to consulting with experts in
such matters.
The types of services offered to customers and the methods used to deliver them
determine the type and extent of risks present in securities brokerage activities. The
number of securities exchanges on which the bank conducts business and executes
trades for its customers also influences the risk profile. One service often offered is
the extension of credit to customers who have bought securities on margin, resulting
in credit risk to the bank. Another common service is acting as a depository for
securities owned by customers. Entities are also exposed to liquidity risks associated
with funding securities brokerage operations. The related audit risk factors are
similar to those set out in Appendix 5, Risks and Issues in Asset Management.
761
IAPS 1006 APPENDIX
AUDITING
There is also a significant element of legal and regulatory risk that is driven by the
jurisdiction in which the security offering is taking place. Examples of legal and
regulatory risk areas include an underwriters exposure for material misstatements
included in a securities registration or offering statement and local regulations
governing the distribution and trading in public offerings. Also included are risks
arising from insider trading and market manipulation by management or the banks
staff. Private placements are ordinarily conducted on an agency basis and therefore
result in less risk than that associated with a public offering of securities. However,
the auditor considers local regulations covering private placements.
There is also a significant element of legal and regulatory risk that is driven by the
jurisdiction in which the security brokerage activities are taking place. This may be a
consideration for regulatory reporting by the bank, reports directly by the auditor to
regulators and also from the point of view of reputation and financial risk that may
occur in the event of regulatory breaches by the bank.
IAPS 1006 APPENDIX
762
Appendix 5
Risks and Issues in Private Banking and Asset Management
Private Banking
Whether management oversight over private banking activities includes the

creation of an appropriate corporate culture. Additionally, high levels of
management should set goals and objectives and senior management must
actively seek compliance with corporate policies and procedures.
Policies and procedures over private banking activities should be in writing and
should include sufficient guidance to ensure there is adequate knowledge of the
entitys customers. For example, the policies and procedures should require that
the entity obtain identification and basic background information on their
clients, describe the clients' source of wealth and lines of business, request
references, handle referrals, and identify suspicious transactions. The entity
should also have adequate written credit policies and procedures that address,
among other things, money laundering related issues, such as lending secured by
cash collateral.
Risk management practices and monitoring systems should stress the

importance of the acquisition and retention of documentation relating to clients,
and the importance of due diligence in obtaining follow-up information where
needed to verify or corroborate information provided by a customer or his or her
representative. Inherent in sound private banking operations is the need to
comply with any customer identification requirements. The information systems
should be capable of monitoring all aspects of an entity's private banking
activities. These include systems that provide management with timely
information necessary to analyze and effectively manage the private banking
business, and systems that enable management to monitor accounts for
suspicious transactions and to report any such instances to law enforcement
authorities and banking supervisors as required by regulations or laws.
763
IAPS 1006 APPENDIX
AUDITING
Provision of superior levels of banking services to individuals, typically people with

high net worth, is commonly known as private banking. Such individuals may often
be domiciled in a country different from that of the bank. Before auditing private
banking activities, the auditor understands the basic controls over these activities.
The auditor considers the extent of the entitys ability to recognize and manage the
potential reputational and legal risks that may be associated with inadequate
knowledge and understanding of its clients personal and business backgrounds,
sources of wealth, and uses of private banking accounts. The auditor considers the
following:
The auditor considers the assessed levels of inherent and control risk related to
private banking activities when determining the nature, timing and extent of
substantive procedures. The following list identifies many of the common audit risk
factors to consider when determining the nature, timing and extent of procedures to
be performed. Since private banking frequently involves asset management activities
the audit risk factors associated with asset management activities are also included
below.
Compliance with regulatory requirements. Private banking is highly regulated in

many countries. This may be a consideration for regulatory reporting by the
client, reports directly by the auditor to regulators and also from the point of
view of the reputation and financial risk that may occur in the event of
regulatory breaches by the bank. Also, the nature of private banking activities
may increase the banks susceptibility to money laundering, and thus may have
increased operational, regulatory, and reputational risks, which may have audit
implications.
Confidentiality. This is generally a feature of private banking. In addition to the

normal secrecy which most countries accord bank/client relationships, many
jurisdictions where private banking is common have additional banking secrecy
legislation which may reduce the ability of regulators, taxing authorities or
police, from their own or other jurisdictions, to access client information. A
bank may seek to impose restrictions on an auditors access to the names of the
banks private clients, affecting the auditors ability to identify related party
transactions. A related issue is that the bank may be requested by a client not to
send correspondence, including account statements (hold mail accounts). This
may reduce the auditors ability to gain evidence as to completeness and
accuracy and, in the absence of adequate alternative procedures, the auditor
considers the implications of this for the auditors report.
Management fraud. The tight confidentiality and personal nature of private

banking relationships may reduce the effectiveness of internal controls that
provide supervision and oversight over staff who deal with private clients
affairs. The high degree of personal trust that may exist between a client and
their private banker may add to the risk in that many private bankers are given
some degree of autonomy over the management of their clients affairs. This
risk is exacerbated to the extent private clients may not be in a position to verify
their affairs on a regular basis as explained above.
Services designed to legally transfer some degree of ownership/control of assets

to third parties, including trusts and other similar legal arrangements. Such
arrangements are not confined to private banking relationships, however, they
are commonly present in them. For the bank, the risk is that the terms of the trust
or other legal arrangement are not complied with or do not comply with the
applicable law. This exposes the bank to possible liability to the beneficiaries.
Controls in this area are particularly important, given that errors are often
identified only when the trust or other arrangement is wound up, possibly
IAPS 1006 APPENDIX
764
decades after its creation. Private bankers often are also involved in preparing
wills or other testamentary documents, and act as executors. Improper drafting
of a will may carry financial consequences to the bank. Controls should exist in
this area and in the area of monitoring executor activity. The auditor considers
whether there are any undisclosed liabilities in respect of such services.
Confidentiality requirements may affect the auditors ability to obtain sufficient
appropriate audit evidence, and if so, the auditor considers the implications for
the auditors report. Finally, trust and similar arrangements provided by private
banks are often outsourced to third parties. The auditor considers what audit risk
factors remain for outsourced services, the procedures needed to understand the
risks and relationships and assess the controls over and within the outsourced
service provider.
Credit risk. Credit risk is often more complex when private banking services are
provided because of the nature of their customers borrowing requirements. The
following services often make credit risk difficult to judge: structured facilities
(credit transactions with multiple objectives which address client requirements
in areas such as tax, regulation, hedging, etc.); unusual assets pledged as security
(for example, art collections, not readily saleable properties, intangible assets
whose value is reliant on future cash flows); and reliance placed on personal
guarantees (name lending).
Custody. Private banks may offer custodial services to clients for physical
investment assets or valuables. The related audit risk factors are similar to those
set out below under Asset Management.
The following risk factors are provided as considerations in planning the strategy and
execution of the audit of a banks asset management activities. Included in this area
are fund management, pension management, vehicles designed to legally transfer
some degree of ownership/control of assets to third parties such as trusts or other
similar arrangements etc. This list is not exhaustive as the financial services industry
is a rapidly changing industry.
When both the asset manager and the assets themselves are not both audited by
the same audit firm. The performance of an asset manager and the assets
themselves generally are closely linked. It is easier to identify and understand
the implications of an issue arising in one entity on the financial statements of
the other if both are audited by the same firm, or if arrangements have been
made to permit an appropriate exchange of information between two audit firms.
Where there is no requirement for both the assets and the asset manager to be
audited, or where appropriate access to the other audit firm is not possible, the
auditor considers whether he is in a position to form a complete view.
765
IAPS 1006 APPENDIX
AUDITING
Asset Management
Fiduciary responsibility to third parties. Mismanagement of third party funds

may have a financial or reputational effect on an asset manager. Matters falling
into this category may include:
Improper record keeping;
Inadequate controls over the protection and valuation of assets;
Inadequate controls to prevent fund manager fraud;
Inappropriate physical and/or legal segregation of client funds from the

managers funds or other clients funds (often a regulated aspect);
Inappropriate segregation of client investments from the managers own

investments (either personal or corporate or both) or other clients
investments;
Inappropriate segregation of bank staff engaged in asset management duties

and those engaged in other operations;
Non-compliance with mandates from clients or the investment policy under

which funds were supposed to be managed; and
Failure to comply with reporting requirements (contractual or regulatory) to

clients.
Consideration is given to the policies and controls over client acceptance;

investment decisions; compliance with client instructions; conflicts of interest;
compliance with regulations; segregation and safeguarding of funds and proper
reporting of client assets and transactions.
Fund manager remuneration. There is a heightened potential for fund managers

to make imprudent or illegal business decisions based upon a desire for personal
gain through a bonus or incentive arrangement.
Technology. Technology is critical to the operation of most asset management

companies therefore an examination is made of the security, completeness and
accuracy of data and data input where computer controls are being relied on for
audit purposes, as well as the overall computer control environment.
Consideration is given as to whether appropriate controls exist to ensure
transactions on behalf of clients are separately recorded from the banks own
transactions.
Globalization and international diversification. These are features of many asset

managers and this may give rise to additional risks due to the diversity of
practice among different countries regarding matters such as pricing and custody
rules, regulations, legal systems, market practices, disclosure rules and
accounting standards.
IAPS 1006 APPENDIX
766
Glossary of Terms
Some financial reporting frameworks allow banks to
manipulate their reported income by transferring amounts
to non-disclosed reserves in years when they make large
profits and transferring amounts from those reserves when
they make losses or small profits. The reported income is
the amount after such transfers. The practice served to
make the bank appear more stable by reducing the
volatility of its earnings, and would help to prevent a loss
of confidence in the bank by reducing the occasions on
which it would report low earnings.
Nostros
Accounts held in the banks name with a correspondent

bank.
Provision
An adjustment to the carrying value of an asset to take

account of factors that might reduce the assets worth to
the entity. Sometimes called an allowance.
Prudential Ratios
Ratios used by regulators to determine the types and

amounts of lending a bank can undertake.
Stress Testing
Testing a valuation model by using assumptions and

initial data outside normal market circumstances and
assessing whether the models predictions are still
reliable.
Vostros
Accounts held by the bank in the name of a correspondent

bank.
AUDITING
Hidden Reserves
767
IAPS 1006 APPENDIX
Reference Material
The following is a list of material that auditors of banks financial statements may
find helpful.
Basel Committee on Banking Supervision:
Publication 30: Core Principles for Effective Banking Supervision. Basel, 1997.
Publication 33: Framework for Internal Control Systems in Banking Organisations.
Basel, 1998.
Publication 55: Sound Practices for Loan Accounting and Disclosure. Basel, 1999.
Publication 56: Enhancing Corporate Governance in Banking Organisations. Basel,
1999.
Publication 72: Internal Audit in Banking Organisations and the Relationship of the
Supervisory Authorities with Internal and External Auditors. Basel, 2000
Publication 75: Principles for the Management of Credit Risk. Basel, 2000.
Publication 77: Customer Due Diligence for Banks. Basel, 2001.
Publication 82: Risk Management Principles for Electronic Banking. Basel, 2001.
Publications of the Basel Committee on Banking Supervision can be downloaded
from the website of the Bank for International Settlements: http://www.bis.org.
International Accounting Standards Board:
IAS 30: Disclosures in the Financial Statements of Banks and Similar Financial
Institutions. London, 1999.
IAS 32: Financial Instruments: Disclosure and Presentation. London, 2000.
IAS 37: Provisions, Contingent Liabilities and Contingent Assets. London, 1998.
IAS 39: Financial Instruments: Recognition and Measurement. London, 2000.
In addition a number of IFAC member bodies have issued reference and guidance
material on banks and the audits of the financial statements of banks.
IAPS 1006 APPENDIX
768

2008 Hanbook IAPS 1006

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INTERNATIONAL AUDITING

PRACTICE STATEMENT 1006

Audit Objectives ............................................................................................

Agreeing the Terms of the Engagement ........................................................

Planning the Audit .........................................................................................

Internal Control ..............................................................................................

Performing Substantive Procedures ............................................................... 71-100

Appendix 4: Risks and Issues in Securities Underwriting and Securities

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

International Auditing Practice Statement (IAPS) 1006, Audits of the Financial

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

The purpose of this Statement is to provide practical assistance to auditors

In many countries, banking supervisors require that the auditor report

For the purpose of this Statement, a bank is a type of financial institution

Banks commonly undertake a wide range of activities. However, most

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

This Statement is intended to highlight those risks that are unique to

Banks have the following characteristics that generally distinguish them

They have custody of large amounts of monetary items, including cash

They often engage in transactions that are initiated in one jurisdiction,

They engage in a large volume and variety of transactions whose value

They ordinarily operate through networks of branches and departments

Transactions can often be directly initiated and completed by the

They often assume significant commitments without any initial transfer

They are regulated by governmental authorities, whose regulatory

Customer relationships that the auditor, assistants, or the audit firm

They generally have exclusive access to clearing and settlement

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

They may issue and trade in complex financial instruments, some of

Special audit considerations arise in the audits of banks because of matters

The particular nature of the risks associated with the transactions

The scale of banking operations and the resultant significant exposures

The extensive dependence on IT to process transactions.

The effect of the regulations in the various jurisdictions in which they

The continuing development of new products and banking practices

This Statement is organized into a discussion of the various aspects of the

Typical warning signs of fraud in banking operations;

Typical internal controls, tests of control and substantive audit

Financial ratios commonly used in the analysis of a banks financial

Risks and issues in securities operations, private banking and asset

ISA 200, Objective and General Principles Governing an Audit of

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

The objective of the audit of a banks financial statements conducted in

Agreeing the Terms of the Engagement

As stated in ISA 210, Terms of Audit Engagements:

The need for sufficient expertise in the aspects of banking relevant to

The need for expertise in the context of the IT systems and

The adequacy of resources or inter-firm arrangements to carry out the

The use and source of specialized accounting principles, with particular

Any requirements contained in the law or regulations applicable to

AUDITS OF THE FINANCIAL STATEMENTS OF BANKS

Pronouncements of the banking supervisory and other regulatory

Pronouncements of relevant professional accounting bodies, for

Pronouncements of the Basel Committee on Banking Supervision;

The contents and form of the auditors report on the financial

The nature of any special communication requirements or protocols

The access that bank supervisors will be granted to the auditors

Planning the Audit