Master of Business Administration

Semester IIIMF0010 –Security

Analysis & Portfolio Management- 4 Credits

(Book ID: B1208)Assignment

Set- 1 (60 Marks)Note: Each Question

carries 10 marks. Answer all the questions.

Q1. Explain the modes of investment

Q2. This distribution of returns for share Y and the market portfolio M is given below Returns (%) Probability Y Z 0.30 30 -10 0.40 20 20 0.30 0 30

You are required to calculate the expected return of security Y and the market portfolio, the covariance between the market portfolio and security Y and beta for the security. Hint:ERp= 17 ; Covariance PM = - 168.0 ; Beta= -0.636 Q3. Briefly explain the Dow Theory Q4. Explain the strategies for overcoming psychological biases Q5. List the major types of investment risks. Q6. How are the factors identified for APT?

Master of Business AdministrationSemester III

MF0010 –Security Analysis & Portfolio Management- 4 Credits(Book ID: B1208)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer all the questions.

Q1. Explain the modes of investment?

Answer: There are different types of securities conferring different sets of rights on the investors and different conditions under which these rights can be exercised. The various avenues for investment ranging from riskless to high risk investment opportunities consist of both security and non-security form of investment. As an investor you have a wide variety of investment alternatives available to choose

Security form of investment (Marketable) • Equity shares  • Bonds/Debentures         • Money Market Instruments • Mutual funds scheme 

Marketable / Security form of investments:  The term „Security‟ is generally used for those documents evidencing liabilities of the issuer. When you buy a financial instrument say fixed deposit from a bank, you are issued a document called Fixed Deposit Receipt or Certificate. This receipt is a liability to the bank as the bank has to safe guard the investment; provide interest for using the funds and to return back the invested amount on maturity. This document also outlines the rights of the investor and sets conditions under which the investor can exercise his or her rights. Security forms of investment are those instruments which are transferable and traded in any organized financial market.

Equity Shares:  Equity shares represent ownership capital. An equity shareholder enjoys both ownership stake and residual interest in income & wealth. The issue of equity shares could be in the form of initial public offer, rights issue, bonus issue, preferential allotment and private placement.  Investors has a choice to select equity shares which are broadly differentiated as blue chip shares, growth shares, income shares, cyclical shares and speculative 

Bonds/Debentures: Bonds represent long-term debt instruments. The issuer of a bond promises to pay a stipulated payment (interest and principal) to the bond holder. Bond

indenture is a contract between the issuer and the bond holder, which specifies the detail of the issue such as par value of the bond, its coupon rate, maturity period, maturity date, call/put options etc. Internationally, a secured corporate debt instrument is called a corporate bond while an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt instrument is referred as debentures although they are secured.  Government bonds are issued by Central and State Governments. These bonds are called gilt edged securities. There are different types of bond – Straight bonds, Zero coupon bonds, Floating rate bonds, bonds with embedded options, commodity linked bonds etc. These are dealt in detail in the later units.

Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called M.M Instruments. The important money market instruments are:a) Treasury Bills b) Commercial paper c) Certificate of deposits d) Repurchase Agreements – Repos & Reverse Repos

Mutual Funds:  Mutual funds are also known as indirect investments. It is an alternative route of buying equity shares or fixed income securities through various schemes floated by mutual funds companies. There are three broad types of mutual fund schemes. 1) Equity schemes 2) Debt schemes 3) Balance schemes Non Security form of financial Investment: Non security form of investments are neither transferable nor traded in any organized financial market

Non – Security form of investment  (Non-marketable financial assets)  • National saving scheme  • National saving certificate • Recognized provident fund • Public provident fund • Post office saving scheme • National pension scheme • Corporate fixed deposit • LIC • Unit scheme of UTI • Bank Fixed deposit / recurring deposit

 Life Insurance Policies: Life insurance may be viewed as an investment which suffices the protection and savings needs of an investor. Policies that provide protection

benefits are designed to protect the policy holders from the financial consequences of unwelcome events such as death/long term sickness/accidents/disability etc.  Policies that are designed as savings contracts allow the policyholders to build up funds to meet specific investment objectives such as income for a particular event, retirement planning or repayment of a loan.  The important types of insurance policies in India are Endowment assurance policy, Money back policy, Term assurance policy, Unit linked Plan, Deferred Annuity and Whole life policy.

Bank Deposits: Bank deposits are the simplest and most common form of investment. There are various kinds of deposit accounts: current account, savings account and fixed deposit account. The deposit made in current account does not earn any interest while deposit made in savings account and fixed deposit accounts earn interest. The interest rate depends upon the tenure. Bank deposit enjoys high liquidity due to premature withdrawals. Also loans can be raised on the fixed deposit certificates. Deposit Insurance Corporation provides guarantee to all deposits in schedule bank up to Rs.100000 per depositor of a bank. 

Post office Accounts : There are various types of accounts namely post office savings account, post office time deposit account, Monthly income schemes, Kisan Vikas Patra, National Savings Certificates. Some are pure savings schemes, while others are tax savings schemes.

Corporate Fixed Deposits Certain large and small corporates raise funds through fixed deposits form the public. While fixed deposits mobilized by manufacturing companies are regulated by Company Law board and fixed deposit mobilized by finance companies are regulated by Reserve bank of India. A manufacturing firm can mobilize up to 25 percent of its net worth in the form of fixed deposit from public and an additional 10 percent of its net worth from its shareholders. The interest rates on company deposits are higher than those on bank fixed deposits.

Employee Provident Fund Scheme: Employee Provident Fund is an important component of savings for a salaried person. Each employee has a separate provident fund account in which both the employer and employee are required to contribute a certain sum of money on a monthly basis.  While the contribution made by the employer is fully tax exempt, the contributions made by the employee is eligible for tax deductions under Sec 80C. The provident fund contribution earns compound interest rate that is totally exempt from taxes. The balance in provident fund account is fully exempt from wealth tax and it is not subject to attachment under any order or decree of a court.

Public Provident Fund Scheme This scheme of post office is the most attractive investment option. Individuals and HUFs can invest in this scheme. The investment period is 15 years and the minimum deposit is Rs100 per year and the maximum permissible deposit per year is Rs.70000. Deposits in a PPF account is eligible for tax

concession under Sec 80C.The deposit earns a compounded interest rate of 8 percent per annum which is totally exempt from tax. 

Q3. Briefly explain the Dow Theory

Answer:

The Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. Following Dow's death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented Dow theory, based on Dow's editorials. Dow himself never used the term Dow theory nor presented it as a trading system.

The six basic tenets of Dow theory as summarized by Hamilton, Rhea, and Schaefer are described below.

Six basic tenets of Dow theory1. The market has three movements

(1) The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. (2) The "medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement. (3) The "short swing" or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement.

2. Market trends have three phases

Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority demanding

(absorbing) stock that the market at large is supplying (releasing). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).

3. The stock market discounts all news

Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow theory agrees with one of the premises of the efficient market hypothesis.

4. Stock market averages must confirm each other

In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.

5. Trends are confirmed by volume

Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.

6. Trends exist until definitive signals prove that they have ended

Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current

trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.

Q4. Explain the strategies for overcoming psychological biases.

Answer:

Understand the biases: Pogo, the folk philosopher created by the cartoonist Walt Kelly, provided an insight that is particularly relevant for investors, we have met the enemy and it’s us. So, understand your biases (the enemy within) as this is an important step in avoiding them.

Focus on the Big Picture: Develop an investment policy and put it down on paper. Doing so will make you react less impulsively to the gyrations of the market.

Follow a Set of Quantitative Investments Criteria: It is helpful to use a set of quantitative criteria such as the price-earnings ratio being not more than 15, the price to book ratio being not more than 5, the growth rate of earnings being at least 12 percent, and so on. Quantitative criteria tend to mitigate the influence of emotion, hearsay rumor and psychological biases.

Diversify: If you own a fairly diversified portfolio of say 12 to 15 stocks from different industries, you are less prone to do something drastically when you incur losses in one or two stocks because these losses are likely to be offset by gains elsewhere.

Control Your Investment Environment: If you are on a diet, you should not have tempting sweets and savories on your dining table. Likewise if you want to discipline your investment activity, you should regulate or control your investment environment. Given below are some ways of doing so:

1. Check your stocks only once every month2. Trade only once every month and preferably on the same day of the month3. Review your portfolio once or twice a year

Strive to Earn Market Returns: Seek to earn returns in line with what the market offers. If you strive to out perform the market, you are likely to succumb to psychological biases.

Review Your Biases Periodically: Once in a year review your psychological biases. This will throw up useful pointers to contain such biases in future.

The central assumption of the traditional finance model is that people are rational. The behavioral finance model, however, argues that people often suffer from cognitive and emotional biases and act in a seemingly irrational manner.

The important heuristic driven biases and cognitive errors that impair judgment are: representativeness, over confidence, anchoring aversion to ambiguity and innumeracy. Representativess refers to the tendency to form judgments based on stereotypes. People tend to be over confident and hence over estimate the accuracy of their forecasts. Thanks to anchoring, also called conservatism people are often unwilling to change an opinion even though they receive new information that is relevant. People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. People have difficulty with numbers.

Proponents of traditional finance believe that framing is transparent implying that investors can see through all the different ways cash flows might be described. In reality behavior tends to be frame de-pendent. This means that the form used to describe problem has a bearing on decision making. Frame dependence stems from a mix of cognitive and emotional factors.

The prospect theory describes how people frame and value a decision involving uncertainly. People feel more strongly about the pain from a loss than the pleasure from an equal gain about two and half times as strongly. This phenomenon is referred to as loss aversion. Because of loss aversion, the manner in which an outcome is described either in the vocabulary of gains or the vocabulary of losses has an important bearing on decision making.

Traditional finance holds that wealth in general and money in particular must be regarded as ‘fungible’ and every financial decision should be based on a rational calculation of its effects on overall wealth position. In reality, people tend to separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance to them.

Ideally, investors should pay attention to changes in their total wealth over their investment horizon. In reality, however, investors engage in ‘narrow framing’ – they focus on changes in wealth that are narrowly defined, both in a cross sectional as well as temporal sense. Since people are loss averse, narrow framing leads to myopic risk aversion.

Q5. List the major types of investment risks.

Answer:

Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss.

A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, "Portfolio Selection".

Asset-backed risk

Risk that the changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security. Risks include interest rate, term modification, and prepayment risk.

Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly or indirectly use or rely on repo, forward commitment, or derivative instruments.

Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaprojects". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where – due to cost overruns, schedule delays, etc. – the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt.

Foreign investment risk

Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk.

This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk:

Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:

o Widening bid-offer spreado Making explicit liquidity reserveso Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities: o Cannot be met when they fall due

o Can only be met at an uneconomic priceo Can be name-specific or systemic

This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:

Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change.

Interest rate risk is the risk that interest rates or the implied volatility will change. Currency risk is the risk that foreign exchange rates or the implied volatility will change, which

affects, for example, the value of an asset held in that currency. Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied

volatility will change.

Operational risk

Reputational risk Legal risk IT risk

Model risk

DiversificationMain article: Diversification (finance)

Financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of diversification.

The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it, but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that Index Funds have been developed that invest in equities in proportion to the weighting they have in some well known index such as the FTSE.

However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not "fully diversified". Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.

A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the Late-2000s recession when assets that had previously had small or even negative correlations[9] suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way [10]

Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. The is also the risk that as an investor or fund manager diversifies their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations.

HedgingHedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium.

Q6. How are the factors identified for APT?

Answer:

In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line.

Risky asset returns are said to follow a factor structure if they can be expressed as:

where

is a constant for asset is a systematic factor is the sensitivity of the th asset to factor , also called factor loading, and is the risky asset's idiosyncratic random shock with mean zero.

Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.

The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

where

is the risk premium of the factor, is the risk-free rate,

That is, the expected return of an asset j is a linear function of the assets sensitivities to the n factors.

Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity),

Arbitrage is the practice of taking positive expected return from overvalued or undervalued securities in the inefficient market without any incremental risk and zero additional investments.

The capital asset pricing model and its extensions are based on specific assumptions on investors’ asset demand. For example:

Investors care only about mean return and variance. Investors hold only traded assets.

Arbitrage mechanics

In the APT context, arbitrage consists of trading in two assets – with at least one being mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap.

Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

A correctly priced asset here may be in fact a synthetic asset - a portfolio consisting of other correctly priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset. The arbitrageur creates the portfolio by identifying x correctly priced assets (one per factor plus one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset.

When the investor is long the asset and short the portfolio (or vice versa) he has created a position which has a positive expected return (the difference between asset return and portfolio return) and which has a net-zero exposure to any macroeconomic factor and is therefore risk free (other than for firm specific risk). The arbitrageur is thus in a position to make a risk-free profit:

Identifying the factors

As with the CAPM, the factor-specific betas are found via a linear regression of historical security returns on the factor in question. Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies. As a result, this issue is essentially empirical in nature. Several a priori guidelines as to the characteristics required of potential factors are, however, suggested:

1. their impact on asset prices manifests in their unexpected movements2. they should represent undiversifiable influences (these are, clearly, more likely to be

macroeconomic rather than firm-specific in nature)3. timely and accurate information on these variables is required4. the relationship should be theoretically justifiable on economic grounds

Chen, Roll and Ross (1986) identified the following macro-economic factors as significant in explaining security returns:

surprises in inflation; surprises in GNP as indicated by an industrial production index; surprises in investor confidence due to changes in default premium in corporate bonds; surprise shifts in the yield curve.

As a practical matter, indices or spot or futures market prices may be used in place of macro-economic factors, which are reported at low frequency (e.g. monthly) and often with significant estimation errors. Market indices are sometimes derived by means of factor analysis. More direct "indices" that might be used are:

short term interest rates; the difference in long-term and short-term interest rates; a diversified stock index such as the S&P 500 or NYSE Composite Index; oil prices gold or other precious metal prices Currency exchange rates

APT and asset management

The linear factor model structure of the APT is used as the basis for many of the commercial risk systems employed by asset managers.

Master of Business Administration

Semester IIIMF0011 – Mergers &

Acquisitions - 4 Credits(Book ID: B1209)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer

all the questions.

Q1. Explain the types of mergers. Q2. Firm X is having value of Rs 400 lakh and value of the firm Y is 150 lakh. If the two firms combine, the estimated cost savings would have present value of Rs 60 lakh. Firm X will have to make payments equal to Rs 170 lakh while making the acquisition. What will be the value of Synergy, Costs and Net Gain from the Merger? Hint: Value of Synergy=60 lakhs , cost = 20 Lakhs , Net gain = 40 lakhs Q3. Merger should be a capital budgeting decision. Explain. Q4. Explain international joint ventures. What are reasons of joint venture failure? Q5. The following is the balance sheet of XYZ Ltd: Liabilities Rs. Assets Rs. Share Capital: 6000 Equity Shares of Rs. 100 each, fully paid

6,00,000 Goodwill 70,000

General Reserve 2,50,000 Plant and Machinery

4,60,000

Profit & Loss Appropriation A/c

80,000 Furniture and Fittings

1,02,000

Bills Payable 70,000 Stock 4,36,000 Sundry Creditors 2,45,000 Debtors 1,34,000 Preliminary Expsenses 20,000 Cash at Bank 23,000 12,45,000 12,45,000

If (i) ABC Ltd. purchases the business of XYZ Ltd. (ii) Goodwill is valued at Rs. 2,00,000 while stock is valued at Rs. 4,16,000. Other assets are considered worth their book values. (iii) ABC Ltd. does not take over Cash at Bank (iv) Consideration is to be discharged in the form of 90,000 fully paid equity shares of Rs. 10 each, valued at par and the balance in cash. Calculate the consideration. Hint : Consideration= 900000 and cash balance 97000= total 997000.

Q6. Explain the key regulatory provisions of M&A under: (a) FEMA, 1999 (b) Listing Agreement

Master of Business AdministrationSemester III

MF0011 – Mergers & Acquisitions - 4 Credits(Book ID: B1209)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer all the questions.

Q1. Explain the types of mergers.

Answer: Mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture. The distinction between a "merger" and an "acquisition" has become increasingly blurred in various respects (particularly in terms of the ultimate economic outcome), although it has not completely disappeared in all situations.

An acquisition is the purchase of one business or company by another company or other business entity. Consolidation occurs when two companies combine together to form a new enterprise altogether, and neither of the previous companies survives independently. Acquisitions are divided into "private" and "public" acquisitions, depending on whether the acquireee or merging company (also termed a target) is or is not listed on public stock markets. An additional dimension or categorization consists of whether an acquisition is friendly or hostile.

Achieving acquisition success has proven to be very difficult, while various studies have shown that 50% of acquisitions were unsuccessful.[1] The acquisition process is very complex, with many dimensions influencing its outcome.[2]

Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees and shareholders. It is normal for M&A deal communications to take place in a so-called 'confidentiality bubble' wherein the flow of information is restricted pursuant to confidentiality agreements.[3] In the case of a friendly transaction, the companies cooperate in negotiations; in the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target's board has no prior knowledge of the offer. Hostile acquisitions can,

and often do, ultimately become "friendly", as the acquiror secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer and/or through negotiation.

"Acquisition" usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger occurs when a privately held company (often one that has strong prospects and is eager to raise financing) buys a publicly listed shell company, usually one with no business and limited assets.[4]

There are also a variety of structures used in securing control over the assets of a company, which have different tax and regulatory implications:

Types of M&A by functional roles in market

The M&A process itself is a multifaceted which depends upon the type of merging companies.

- A horizontal merger is usually between two companies in the same business sector. The example of horizontal merger would be if a health cares system buys another health care system. This means that synergy can obtained through many forms including such as; increased market share, cost savings and exploring new market opportunities. - A vertical merger represents the buying of supplier of a business. In the same example as above if a health care system buys the ambulance services from their service suppliers is an example of vertical buying. The vertical buying is aimed at reducing overhead cost of operations and economy of scale. - Conglomerate M&A is the third form of M&A process which deals the merger between two irrelevant companies. The example of conglomerate M&A with relevance to above scenario would be if health care system buys a restaurant chain. The objective may be diversification of capital investment.

Arm's length mergers

An arm's length merger is a merger: 1. approved by disinterested directors and 2. approved by disinterested stockholders:

″The two elements are complementary and not substitutes. The first element is important because the directors have the capability to act as effective and active bargaining agents, which disaggregated stockholders do not. But, because bargaining agents are not always effective or faithful, the second element is critical, because it gives the minority stockholders the opportunity to reject their agents' work. Therefore, when a merger with a controlling stockholder was: 1) negotiated and approved by a special committee of independent directors; and 2) conditioned on an affirmative vote of a majority of the minority stockholders, the business judgment standard of review should presumptively apply, and any plaintiff ought to have to plead particularized facts

that, if true, support an inference that, despite the facially fair process, the merger was tainted because of fiduciary wrongdoing.

Strategic Mergers

A Strategic merger usually refers to long term strategic holding of target (Acquired) firm. This type of M&A process aims at creating synergies in the long run by increased market share, broad customer base, and corporate strength of business. A strategic acquirer may also be willing to pay a premium offer to target firm in the outlook of the synergy value created after M&A process.

Q2. Firm X is having value of Rs 400 lakh and value of the firm Y is 150 lakh. If the two firms combine, the estimated cost savings would have present value of Rs 60 lakh. Firm X will have to make payments equal to Rs 170 lakh while making the acquisition. What will be the value of Synergy, Costs and Net Gain from the Merger?

Hint: Value of Synergy=60 lakhs , cost = 20 Lakhs , Net gain = 40 lakhs

Q3. Merger should be a capital budgeting decision. Explain.

Answer:

The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash flow to the firm will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a capitalbudgeting analysis.

For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has. First, since a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm. Second, the principles underlying the capital budgeting process also apply to other corporate decisions, suchas working capital management and making strategic mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with management's primary goal of maximizing shareholder value.

The capital budgeting process has four administrative steps:

Step 1: Idea generation. The most important step in the capital budgeting process is generating good project ideas. Ideas can come from a number of sources including senior management, functional divisions, employees, or outside the company.

Step 2: Analyzing project proposals. Since the decision to accept or reject a capital project is based on the project's expected future cash flows, a cash flow forecast must be made for each project to determine its expected profitability.

Step 3: Create the firm-wide capital budget. Firms must prioritize profitable projectsaccording to the timing of the project's cash flows, available company resources, and the company's overall strategic plan. Many projects that are attractive individually may not make sense strategically.

Step 4: Monitoring decisions and conducting a post-audit. It is important to follow up on all capital budgeting decisions. An analyst should compare the actual results to the projected results, and project managers should explain why projections did or did not match actual performance. Since the capitalbudgeting process is only as good as the estimates of the inputs into the model used to forecast cash flows, a post-audit should be used to identify systematic errors in the forcasting process and improve company operations.

Categories of Capital Budgeting Projects

Capital budgeting projects may be divided into the following categories:

Replacement projects to maintain the business are normally made without detailed analysis. The only issues are whether the existing operations should continue and, if so, whether existing procedures or processes should be maintained.

Replacement projects for cost reduction determine whether equipment that is obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary in this case

Expansion projects are taken on to grow the business and involve a complex decision making process since they require an explicit forecast of future demand. A very detailed analysis is required

New product or market development also entails a complex decision making processthat will require a detailed analysis due to the large amount of uncertainty involved

Mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenueproducing projects undertaken by the company

Other projects. Some projects are not easily analyzed through the capital budgetingprocess. Such projects may include a pet project of senior management (e.g., corporate perks), or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects)

Q4. Explain international joint ventures. What are reasons of joint venture failure?

Answer:

A joint venture (JV) is a business agreement in which parties agree to develop, for a finite time, a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets. There are other types of companies such as JV limited by guarantee, joint ventures limited by guarantee with partners holding shares.

In European law, the term 'joint-venture' (or joint undertaking) is an elusive legal concept, better defined under the rules of company law. In France, the term 'joint venture' is variously translated as 'association d'entreprises', 'entreprise conjointe', 'coentreprise' or 'entreprise commune'. But generally, the term societe anonyme loosely covers all foreign collaborations. In Germany, 'joint venture' is better represented as a 'combination of companies' (Konzern).

With individuals, when two or more persons come together to form a temporary partnership for the purpose of carrying out a particular project, such partnership can also be called a joint venture where the parties are "co-venturers".

The venture can be for one specific project only - when the JV is referred to more correctly as a consortium (as the building of the Channel Tunnel) - or a continuing business relationship. The

consortium JV (also known as a cooperative agreement) is formed where one party seeks technological expertise or technical service arrangements, franchise and brand use agreements, management contracts, rental agreements, for one-time contracts. The JV is dissolved when that goal is reached.

Some major joint ventures include Dow Corning, MillerCoors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

A joint venture takes place when two parties come together to take on one project. In a joint venture, both parties are equally invested in the project in terms of money, time, and effort to build on the original concept. While joint ventures are generally small projects, major corporations also use this method in order to diversify. A joint venture can ensure the success of smaller projects for those that are just starting in the business world or for established corporations. Since the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project, as well as the resulting profits.

Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties must be committed to focusing on the future of the partnership, rather than just the immediate returns. Ultimately, short term and long term successes are both important. In order to achieve this success, honesty, integrity, and communication within the joint venture are necessary.

n the era of the Internet, finding opportunities for exploiting an idea is sizeable together with remote, or advertised, communicating. There are also the blogging networks as well the social networking sites and search engines. There are also other venues to find a JV partner such as seminars, exhibitions, directories and the plain newspaper advertising of opportunities. One should not forget websites which have become prosperous like eBay and Amazon.com, Wikipedia, YouTube to name the most obvious. Forming JVs with distributor and marketing agencies is possible in this flat world to market a product. But finding an entrepreneur for a JV is another task.

Nonetheless, there are risk-takers- venture capitalists, angel investors and venture managers (see: Carried interest) – especially in the high-tech industries like IC chips or biotechnology. Although they typically exit once an idea or an opportunity proves itself, there are watchful funds and investors who could go in for a JV.

Joint ventures have also become more prominent in the world of alternative investments since the financial crisis began in 2007. In an Opalesque.TV[2] video, Tim Krochuk of hedge fund GRT Capital Partners describes how hedge funds have begun teaming up with traditional long-only asset managers in joint ventures to provide alternative capabilities to existing traditional asset management firms. The emergence of these joint ventures continues the trend of alternative investments becoming a larger piece of traditional portfolios.

Formulating the JV is a series of steps, one which needs a lot of work and yet, at the same time, precision. One can here only underline the steps or information that will be needed by the JV candidate. They are: [3]

the objectives, structure and projected form of the joint venture, including the amount of investment and financing arrangements and debt

the JV's products, their technical description and usage alternate production technologies estimated cost of equipment estimated product price(s) costing market analysis for the product, inside and outside the 'territory' analysis of competition projected sales and methods of distribution details of offered site, including output projections, transport and warehousing, testing

and quality control, by-products and waste;- supply, utility, and transport requirements; estimated technology transfer costs foreign exchange projections (where applicable) staff requirements and training financial projections environmental impact social benefit

While the following offers some insight to the process of joining up with a committed partner to form a JV, it is often difficult to determine whether the commitments come from a known and distinguishable party or an intermediary. This is particularly so when the language barrier exists and one is unfamiliar with local customs, especially in approaches to government, often the deciding body for the formation of a JV or dispute settlement.

The ideal process of selecting a JV partner emerges from:

screening of prospective partners short listing a set of prospective partners and some sort of ranking due diligence – checking the credentials of the other party availability of appreciated or depreciated property contributed to the joint venture the most appropriate structure and invitation/bid foreign investor buying an interest in a local company

Companies are also called JVs in cases where there are dominant partners together with participation of the public. There may also be cases where the public shareholding is substantial but the founding partners retain their identity. These companies may be 'public' or 'private' companies. It would be out of place to describe them, except to say there are many in India.

Further consideration relates to starting a new legal entity ground up. Such an enterprise is sometimes called 'an incorporated JV', one 'packaged' with technology contracts (knowhow, patents, trademarks and copyright), technical services and assisted-supply arrangements.

The consortium JV (also known as a cooperative agreement) is formed where one party seeks technological expertise or technical service arrangements, franchise and brand use agreements,

management contracts, rental agreements, for 'one-time' contracts, e.g., for construction projects. They dissolve the JV when that goal is reached.

In the U.K and India - and in many Common Law countries - a joint-venture (or else a company formed by a group of individuals) must file with the appropriate authority the Memorandum of Association. It is a statutory document which informs the outside public of its existence. It may be viewed by the public at the office in which it is filed. A sample can be seen at wikimedia.org. Together with the Articles of Association, it forms the 'constitution' of a company in these countries.

The Articles of Association regulate the interaction between shareholders and the directors of a company and can be a lengthy document of up to 700,000+ pages. It deals with the powers relegated by the stockholders to the Directors and those withheld by them, requiring the passing of ordinary resolutions, special resolutions and the holding of Extraordinary General Meetings to bring the Directors' decision to bear.

A Certificate of Incorporation [5] or the Articles of Incorporation [6] is a document required to form a corporation in the US (in actuality, the State where it is incorporated) and in countries following the practice. In the US, the 'constitution' is a single document. The Articles of Incorporation is again a regulation of the Directors by the stock-holders in a company.

By its formation the JV becomes a new entity with the implication:

that it is officially separate from its Founders, who might otherwise be giant corporations, even amongst the emerging countries

the JV can contract in its own name, acquire rights (such as the right to buy new companies), and

it has a separate liability from that of its founders, except for invested capital it can sue (and be sued) in courts in defense or its pursuance of its objectives.

On the receipt of the Certificate of Incorporation a company can commence its business.

JV companies are the preferred form of corporate investment but there are no separate laws for joint ventures. Companies which are incorporated in India are treated on par as domestic companies.

The above two parties subscribe to the shares of the JV company in agreed proportion, in cash, and start a new business.

Two parties, (individuals or companies), incorporate a company in India. Business of one party is transferred to the company and as consideration for such transfer, shares are issued by the company and subscribed by that party. The other party subscribes for the shares in cash.

Promoter shareholder of an existing Indian company and a third party, who/which may be individual/company, one of them non-resident or both residents, collaborate to jointly

carry on the business of that company and its shares are taken by the said third party through payment in cash.

Private companies (only about $2500 is the lower limit of capital, no upper limit) are allowed] in India together with and public companies, limited or not, likewise with partnerships. sole proprietorship too are allowed. However, the latter are reserved for NRIs.

Through capital market operations foreign companies can transact on the two exchanges without prior permission of RBI but they cannot own more than 10 percent equity in paid-up capital of Indian enterprises, while aggregate foreign institutional investment (FII) in an enterprise is capped at 24 percent.

The establishment of wholly owned subsidiaries (WOS) and project offices and branch offices, incorporated in India or not. Sometimes, it is understood, that branches are started to test the market and get its flavor. Equity transfer from residents to non-residents in mergers and acquisitions (M&A) is usually permitted under the automatic route. However, if the M&As are in sectors and activities requiring prior government permission (Appendix 1 of the Policy) then transfer can proceed only after permission.

Joint ventures with trading companies are allowed together with imports of secondhand plants and machinery.

It is expected that in a JV, the foreign partner supplies technical collaboration and the pricing includes the foreign exchange component, while the Indian partner makes available the factory or building site and locally made machinery and product parts. Many JVs are formed as public limited companies (LLCs) because of the advantages of limited liability.

JVs are expected in the nuclear industry following the NSG waivers for nuclear trade. The nuclear power industry has been witnessing several JVs. The country has set an imposing target of achieving an installed capacity of 20 GW by 2020 and 63 GW by 2030. The total size of the Indian nuclear power market will be around $40 billion by 2020 with a growth rate (AAGR) of 9.2% in installed nuclear capacity during 2008–20. The total investments made are to a tune of around $1.30 billion following the Indo-US nuclear deal in 2008. There is a group of industries reserved for the small-scale sector wherein foreign investment cannot exceed 24%, and if does, then approval is necessary from the FIPB, and the unit loses its 'smallness' and requires an industrial license.

There are many JVs. lying outside of this discussion – Hindusthan Unilever-Unilever, Suziki-Govt. of India (Maruti Motors), Bharti Airteli-Singapore Telecom, ITC-Imperial Tobacco, P&G Home Products, Whirlpool, having financial participation with the financial institutions and the lay public which are monitored by SEBI (Securities and Exchange Board of India), also an autonomous body. This lies outside this discussion.

Under the country's laws, a public company must:

Have at least seven shareholders Have at least three directors Obtain government approval for the appointment of its management. Have both a "trading certificate" and certificate of incorporation before commencing its

business. Publish also a prospectus (or file a statement) before it can start transact business. Hold statutory meetings

There are several other provisions contained in the Companies Act 1956 which also need to be followed.

Royalty payments and capitalization

For the automatic route, RBI allows:

Lump sum payments not exceeding US$2 million.

Royalty payable is limited to 5% for domestic sales and 8% for exports, without any restriction on the duration of the royalty payments. The royalty limits are net of taxes and are calculated according to standard conditions. Payments are made through RBI.

The royalty is calculated on the basis of the net ex-factory sale price of the product, exclusive of excise duties, minus the cost of the standard bought-out components and the landed cost of imported components, irrespective of the source of procurement, including ocean freight, insurance, custom duties, etc.

Issue of equity shares against lump sum fees and royalty fees is permitted.

Q5. The following is the balance sheet of XYZ Ltd:

Liabilities

Rs.

Assets

Rs.

Share Capital: 6000 Equity Shares of Rs. 100 each, fully paid

6,00,000

Goodwill

70,000

General Reserve

2,50,000

Plant and Machinery

4,60,000

Profit & Loss Appropriation A/c

80,000

Furniture and Fittings

1,02,000

Bills Payable

70,000

Stock

4,36,000

Sundry Creditors

2,45,000

Debtors

1,34,000

Preliminary Expsenses

20,000

Cash at Bank

23,000

12,45,000

12,45,000

If (i) ABC Ltd. purchases the business of XYZ Ltd. (ii) Goodwill is valued at Rs. 2,00,000 while stock is valued at Rs. 4,16,000. Other assets are considered worth their book values. (iii) ABC Ltd. does not take over Cash at Bank (iv) Consideration is to be discharged in the form of 90,000 fully paid equity shares of Rs. 10 each, valued at par and the balance in cash.

Calculate the consideration.

Hint : Consideration= 900000 and cash balance 97000= total 997000.

Q6. Explain the key regulatory provisions of M&A under: (a) FEMA, 1999 (b) Listing Agreement

Answer:

Laws Regulating Mergers And Acquisition In India

A merger is a combination of two companies where one corporation is completely absorbed by another corporation. The less important company loses its identity and becomes part of the more important corporation, which retains its identity. It may involve absorption or consolidation.

Merger is also defined as amalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities and the stock of one company stand transferred to Transferee Company in consideration of payment in the form of:(i) Equity shares in the transferee company,(ii) Debentures in the transferee company, (iii) Cash, or (iv) A mix of the above mode

Motives Behind Mergers Of The Company(i) Economies of Scale: This generally refers to a method in which the average cost per unit is decreased through increased production(ii) Increased revenue /Increased Market Share: This motive assumes that the company will be absorbing the major competitor and thus increase its to set prices.(iii) Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock brokers customers, while the broker can sign up the bank’ customers for brokerage account. (iv) Corporate Synergy: Better use of complimentary resources. It may take the form of revenue enhancement and cost savings. (v) Taxes: A profitable can buy a loss maker to use the target’s tax right off i.e. wherein a sick company is bought by giants.(vi) Geographical or other diversification: This is designed to smooth the earning results of a company, which over the long term smoothens the stock price of the company giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders.

Types Of MergersFrom the perception of business organizations, there is a whole host of different mergers. However, from an economist point of view i.e. based on the relationship between the two merging companies, mergers are classified into following:(1) Horizontal merger- Two companies that are in direct competition and share the same product lines and markets i.e. it results in the consolidation of firms that are direct rivals. E.g. Exxon and Mobil, Ford and Volvo, Volkswagen and Rolls Royce and Lamborghini(2) Vertical merger- A customer and company or a supplier and company i.e. merger of firms that have actual or potential buyer-seller relationship eg. Ford- Bendix(3) Conglomerate merger- generally a merger between companies which do not have any common business areas or no common relationship of any kind. Consolidated firma may sell related products or share marketing and distribution channels or production processes.

On a general analysis, it can be concluded that Horizontal mergers eliminate sellers and hence reshape the market structure i.e. they have direct impact on seller concentration whereas vertical and conglomerate mergers do not affect market structures e.g. the seller concentration directly. They do not have anticompetitive consequences.

The circumstances and reasons for every merger are different and these circumstances impact the way the deal is dealt, approached, managed and executed. .However, the success of mergers depends on how well the deal makers can integrate two companies while maintaining day-to-day operations. Each deal has its own flips which are influenced by various extraneous factors such as human capital component and the leadership. Much of it depends on the company’s leadership and the ability to retain people who are key to company’s on going success. It is important, that both the parties should be clear in their mind as to the motive of such acquisition i.e. there should be censusad- idiom.

Profits, intellectual property, costumer base are peripheral or central to the acquiring company, the motive will determine the risk profile of such M&A. Generally before the onset of any deal, due diligence is conducted so as to gauze the risks involved, the quantum of assets and liabilities that are acquired etc.

Laws Regulating MergerFollowing are the laws that regulate the merger of the company:-(I) The Companies Act , 1956 Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations, mergers and the procedure to be followed for getting the arrangement, compromise or the scheme of amalgamation approved. Though, section 391 deals with the issue of compromise or arrangement which is different from the issue of amalgamation as deal with under section 394, as section 394 too refers to the procedure under section 391 etc., all the section are to be seen together while understanding the procedure of getting the scheme of amalgamation approved. Again, it is true that while the procedure to be followed in case of amalgamation of two companies is wider than the scheme of compromise or arrangement though there exist substantial overlapping.

The procedure to be followed while getting the scheme of amalgamation and the important points, are as follows:-

(1) Any company, creditors of the company, class of them, members or the class of members can file an application under section 391 seeking sanction of any scheme of compromise or arrangement. However, by its very nature it can be understood that the scheme of amalgamation is normally presented by the company. While filing an application either under section 391 or section 394, the applicant is supposed to disclose all material particulars in accordance with the provisions of the Act.

(2) Upon satisfying that the scheme is prima facie workable and fair, the Tribunal order for the meeting of the members, class of members, creditors or the class of creditors. Rather, passing an order calling for meeting, if the requirements of holding meetings with class of shareholders or the members, are specifically dealt with in the order calling meeting, then, there won’t be any subsequent litigation. The scope of conduct of meeting with such class of members or the shareholders is wider in case of amalgamation than where a scheme of compromise or arrangement is sought for under section 391

(3) The scheme must get approved by the majority of the stake holders viz., the members, class of members, creditors or such class of creditors. The scope of conduct of meeting with the members, class of members, creditors or such class of creditors will be restrictive some what in an application seeking compromise or arrangement.

(4) There should be due notice disclosing all material particulars and annexing the copy of the scheme as the case may be while calling the meeting.

(5) In a case where amalgamation of two companies is sought for, before approving the scheme of amalgamation, a report is to be received form the registrar of companies that the approval of scheme will not prejudice the interests of the shareholders.

(6) The Central Government is also required to file its report in an application seeking approval of compromise, arrangement or the amalgamation as the case may be under section 394A.

(7) After complying with all the requirements, if the scheme is approved, then, the certified copy of the order is to be filed with the concerned authorities.

(II) The Competition Act ,2002 Following provisions of the Competition Act, 2002 deals with mergers of the company:-(1) Section 5 of the Competition Act, 2002 deals with “Combinations” which defines combination by reference to assets and turnover (a) exclusively in India and (b) in India and outside India.

For example, an Indian company with turnover of Rs. 3000 crores cannot acquire another Indian company without prior notification and approval of the Competition Commission. On the other hand, a foreign company with turnover outside India of more than USD 1.5 billion (or in excess of Rs. 4500 crores) may acquire a company in India with sales just short of Rs. 1500 crores without any notification to (or approval of) the Competition Commission being required.

(2) Section 6 of the Competition Act, 2002 states that, no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void. All types of intra-group combinations, mergers, demergers, reorganizations and other similar transactions should be specifically exempted from the notification procedure and appropriate clauses should be incorporated in sub-regulation 5(2) of the Regulations. These transactions do not have any competitive impact on the market for assessment under the Competition Act, Section 6.

(III) Foreign Exchange Management Act,1999The foreign exchange laws relating to issuance and allotment of shares to foreign entities are contained in The Foreign Exchange Management (Transfer or Issue of Security by a person residing out of India) Regulation, 2000 issued by RBI vide GSR no. 406(E) dated 3rd May, 2000. These regulations provide general guidelines on issuance of shares or securities by an Indian entity to a person residing outside India or recording in its books any transfer of security from or to such person. RBI has issued detailed guidelines on foreign investment in India vide “Foreign Direct Investment Scheme” contained in Schedule 1 of said regulation.

(IV) SEBI Take over Code 1994SEBI Takeover Regulations permit consolidation of shares or voting rights beyond 15% up to 55%, provided the acquirer does not acquire more than 5% of shares or voting rights of the target company in any financial year. [Regulation 11(1) of the SEBI Takeover Regulations] However, acquisition of shares or voting rights beyond 26% would apparently attract the notification procedure under the Act. It should be clarified that notification to CCI will not be required for consolidation of shares or voting rights permitted under the SEBI Takeover Regulations. Similarly the acquirer who has already acquired control of a company (say a listed company), after adhering to all requirements of SEBI Takeover Regulations and also the Act, should be exempted from the Act for further acquisition of shares or voting rights in the same company.

(V) The Indian Income Tax Act (ITA), 1961 Merger has not been defined under the ITA but has been covered under the term 'amalgamation' as defined in section 2(1B) of the Act. To encourage restructuring, merger and demerger has been given a special treatment in the Income-tax Act since the beginning. The Finance Act, 1999 clarified many issues relating to Business Reorganizations thereby facilitating and making business restructuring tax neutral. As per Finance Minister this has been done to accelerate internal liberalization. Certain provisions applicable to mergers/demergers are as under: Definition of Amalgamation/Merger — Section 2(1B). Amalgamation means merger of either one or more companies with another company or merger of two or more companies to form one company in such a manner that: (1) All the properties and liabilities of the transferor company/companies become the properties and liabilities of Transferee Company.(2) Shareholders holding not less than 75% of the value of shares in the transferor company (other than shares which are held by, or by a nominee for, the transferee company or its subsidiaries) become shareholders of the transferee company.

The following provisions would be applicable to merger only if the conditions laid down in section 2(1B) relating to merger are fulfilled:(1) Taxability in the hands of Transferee Company — Section 47(vi) & section 47(a) The transfer of shares by the shareholders of the transferor company in lieu of shares of the transferee company on merger is not regarded as transfer and hence gains arising from the same are not chargeable to tax in the hands of the shareholders of the transferee company. [Section 47(vii)](b) In case of merger, cost of acquisition of shares of the transferee company, which were acquired in pursuant to merger will be the cost incurred for acquiring the shares of the transferor company. [Section 49(2)]

(VI) Mandatory permission by the courtsAny scheme for mergers has to be sanctioned by the courts of the country. The company act provides that the high court of the respective states where the transferor and the transferee companies have their respective registered offices have the necessary jurisdiction to direct the winding up or regulate the merger of the companies registered in or outside India.

The high courts can also supervise any arrangements or modifications in the arrangements after having sanctioned the scheme of mergers as per the section 392 of the Company Act. Thereafter the courts would issue the necessary sanctions for the scheme of mergers after dealing with the application for the merger if they are convinced that the impending merger is “fair and reasonable”.

The courts also have a certain limit to their powers to exercise their jurisdiction which have essentially evolved from their own rulings. For example, the courts will not allow the merger to come through the intervention of the courts, if the same can be effected through some other provisions of the Companies Act; further, the courts cannot allow for the merger to proceed if there was something that the parties themselves could not agree to; also, if the merger, if allowed, would be in contravention of certain conditions laid down by the law, such a merger also cannot be permitted. The courts have no special jurisdiction with regard to the issuance of writs to entertain an appeal over a matter that is otherwise “final, conclusive and binding” as per the section 391 of the Company act.

(VII) Stamp duty Stamp act varies from state to State. As per Bombay Stamp Act, conveyance includes an order in respect of amalgamation; by which property is transferred to or vested in any other person. As per this Act, rate of stamp duty is 10 per cent.

Intellectual Property Due Diligence In Mergers And AcquisitionsThe increased profile, frequency, and value of intellectual property related transactions have elevated the need for all legal and financial professionals and Intellectual Property (IP) owner to have thorough understanding of the assessment and the valuation of these assets, and their role in commercial transaction. A detailed assessment of intellectual property asset is becoming an increasingly integrated part of commercial transaction. Due diligence is the process of investigating a party’s ownership, right to use, and right to stop others from using the IP rights involved in sale or merger ---the nature of transaction and the rights being acquired will

determine the extent and focus of the due diligence review. Due Diligence in IP for valuation would help in building strategy, where in:-(a) If Intellectual Property asset is underplayed the plans for maximization would be discussed.(b) If the Trademark has been maximized to the point that it has lost its cachet in the market place, reclaiming may be considered.(c) If mark is undergoing generalization and is becoming generic, reclaiming the mark from slipping to generic status would need to be considered.(d) Certain events can devalue an Intellectual Property Asset, in the same way a fire can suddenly destroy a piece of real property. These sudden events in respect of IP could be adverse publicity or personal injury arising from a product. An essential part of the due diligence and valuation process accounts for the impact of product and company-related events on assets – management can use risk information revealed in the due diligence.(e) Due diligence could highlight contingent risk which do not always arise from Intellectual Property law itself but may be significantly affected by product liability and contract law and other non Intellectual Property realms.Therefore Intellectual Property due diligence and valuation can be correlated with the overall legal due diligence to provide an accurate conclusion regarding the asset present and future value

Legal Procedure For Bringing About Merger Of Companies(1) Examination of object clauses:The MOA of both the companies should be examined to check the power to amalgamate is available. Further, the object clause of the merging company should permit it to carry on the business of the merged company. If such clauses do not exist, necessary approvals of the share holders, board of directors, and company law board are required. (2) Intimation to stock exchanges:The stock exchanges where merging and merged companies are listed should be informed about the merger proposal. From time to time, copies of all notices, resolutions, and orders should be mailed to the concerned stock exchanges. (3) Approval of the draft merger proposal by the respective boards:The draft merger proposal should be approved by the respective BOD’s. The board of each company should pass a resolution authorizing its directors/executives to pursue the matter further. (4) Application to high courts:Once the drafts of merger proposal is approved by the respective boards, each company should make an application to the high court of the state where its registered office is situated so that it can convene the meetings of share holders and creditors for passing the merger proposal. (5) Dispatch of notice to share holders and creditors:In order to convene the meetings of share holders and creditors, a notice and an explanatory statement of the meeting, as approved by the high court, should be dispatched by each company to its shareholders and creditors so that they get 21 days advance intimation. The notice of the meetings should also be published in two news papers.(6) Holding of meetings of share holders and creditors:A meeting of share holders should be held by each company for passing the scheme of mergers at least 75% of shareholders who vote either in person or by proxy must approve the scheme of merger. Same applies to creditors also.(7) Petition to High Court for confirmation and passing of HC orders:

Once the mergers scheme is passed by the share holders and creditors, the companies involved in the merger should present a petition to the HC for confirming the scheme of merger. A notice about the same has to be published in 2 newspapers.(8) Filing the order with the registrar:Certified true copies of the high court order must be filed with the registrar of companies within the time limit specified by the court.(9) Transfer of assets and liabilities:After the final orders have been passed by both the HC’s, all the assets and liabilities of the merged company will have to be transferred to the merging company.(10) Issue of shares and debentures:The merging company, after fulfilling the provisions of the law, should issue shares and debentures of the merging company. The new shares and debentures so issued will then be listed on the stock exchange.

Waiting Period In MergerInternational experience shows that 80-85% of mergers and acquisitions do not raise competitive concerns and are generally approved between 30-60 days. The rest tend to take longer time and, therefore, laws permit sufficient time for looking into complex cases. The International Competition Network, an association of global competition authorities, had recommended that the straight forward cases should be dealt with within six weeks and complex cases within six months. The Indian competition law prescribes a maximum of 210 days for determination of combination, which includes mergers, amalgamations, acquisitions etc. This however should not be read as the minimum period of compulsory wait for parties who will notify the Competition Commission. In fact, the law clearly states that the compulsory wait period is either 210 days from the filing of the notice or the order of the Commission, whichever is earlier. In the event the Commission approves a proposed combination on the 30th day, it can take effect on the 31st day. The internal time limits within the overall gap of 210 days are proposed to be built in the regulations that the Commission will be drafting, so that the over whelming proportion of mergers would receive approval within a much shorter period.The time lines prescribed under the Act and the Regulations do not take cognizance of the compliances to be observed under other statutory provisions like the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (‘SEBI Takeover Regulations’). SEBI Takeover Regulations require the acquirer to complete all procedures relating to the public offer including payment of consideration to the shareholders who have accepted the offer, within 90 days from the date of public announcement. Similarly, mergers and amalgamations get completed generally in 3-4 months’ time. Failure to make payments to the shareholders in the public offer within the time stipulated in the SEBI Takeover Regulations entails payment of interest by the acquirer at a rate as may be specified by SEBI. [Regulation 22(12) of the SEBI Takeover Regulations] It would therefore be essential that the maximum turnaround time for CCI should be reduced from 210 days to 90 days.

ConclusionWith the FDI policies becoming more liberalized, Mergers, Acquisitions and alliance talks are heating up in India and are growing with an ever increasing cadence. They are no more limited to one particular type of business. The list of past and anticipated mergers covers every size and

variety of business -- mergers are on the increase over the whole marketplace, providing platforms for the small companies being acquired by bigger ones. The basic reason behind mergers and acquisitions is that organizations merge and form a single entity to achieve economies of scale, widen their reach, acquire strategic skills, and gain competitive advantage. In simple terminology, mergers are considered as an important tool by companies for purpose of expanding their operation and increasing their profits, which in façade depends on the kind of companies being merged. Indian markets have witnessed burgeoning trend in mergers which may be due to business consolidation by large industrial houses, consolidation of business by multinationals operating in India, increasing competition against imports and acquisition activities. Therefore, it is ripe time for business houses and corporates to watch the Indian market, and grab the opportunity.

Master of Business Administration

Semester IIIMF0012 –Taxation

Management- 4 Credits(Book ID: B1210)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer

all the questions.

Q1. Tax planning may be effective in every area of business management. Discuss some of the important areas where tax planning may be attempted. Q2. When minors are not allowed to be employed under the Constitution of India, can a minor still have income? If yes then how? Analyse the exemption from income-tax available in the case of a minor child.

Q3. Profit and Loss A/c of CS and Daughters, a partnership firm is as follows:

Other Information: a) Out of municipal taxes of Rs. 10,000; Rs. 6,000 was payable on 31.3.2011 and the same was paid on 30.6.2011. b) Sales tax includes a sum of Rs. 10,000 payable on 31.3.2011. Rs. 6,000 was paid on 31.7.2011 and Rs. 4,000 was paid on 30.11.20 although the due date of payment under the Sales Tax Act was 14.5.2011. Compute: a) The book profit b) The maximum amount of remuneration deductible u/s 40(b) c) The total income of the firm assuming that the maximum remuneration allowable u/s 40(b) is paid to the partners. d) Also state the income from the firm which will be taxable in the hands of the partners. Hint: Book profit= 2,79,000; maximum amount of remuneration=1,64,100; Total Income= 1,71,100; Total Income of each partner as business income =Rs.1, 00,050 Q4. Write a note on income from capital gain Q5. Discuss the taxable services under the service tax. Q6. Sameer who is a person with disability submits the following information. Compute (a) the taxable income; (b) the tax payable for the assessment year 2010-11.

Rs. i) Salary per annum 180,000 ii) Rent received per month 3,500 iii) Dividend from cooperative society 1,000 iv) Interest on bank deposits 8,000 v) Interest on Government securities 1,000 vi) Winnings from lotteries (gross) 4,000 vii) NSC (VIII issue) purchased during the year 10,000 viii) Deposit under PPF Scheme 30,000 He earned a long-term capital gain of Rs.12,000 on sale of gold during the year. Hint: Total Income = 145,400 ; Tax payable = 5710

Master of Business AdministrationSemester III

MF0012 –Taxation Management- 4 Credits(Book ID: B1210)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer all the questions.

Q1. Tax planning may be effective in every area of business management. Discuss some of the important areas where tax planning may be attempted.

Answer:

Tax avoidance is the legal utilization of the tax regime to one's own advantage, to reduce the amount of tax that is payable by means that are within the law. The term tax mitigation is a synonym for tax avoidance. Its original use was by tax advisors as an alternative to the pejorative term tax avoidance. The term has also been used in the tax regulations of some jurisdictions to distinguish tax avoidance foreseen by the legislators from tax avoidance which exploits loopholes in the law. The United States Supreme Court has stated that "The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted."

Tax evasion, on the other hand, is the general term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means. Both tax avoidance and evasion can be viewed as forms of tax noncompliance, as they describe a range of activities that are unfavorable to a state's tax system.[

Country of residence

One way a company may chose to avoid taxes is by establishing their company or subsidiaries in an Individuals may also avoid tax by moving their tax residence to a tax haven, such as Monaco, or by becoming a perpetual traveler. However some countries, such as the U.S., tax their citizens, permanent residents, and companies on all their worldwide income. In these cases, taxation cannot be avoided by simply transferring assets or moving abroad.

Double taxation

Most countries impose taxes on income earned or gains realized within that country regardless of the country of residence of the person or firm. Most countries have entered into bilateral double taxation treaties with many other countries to avoid taxing nonresidents twice—once where the income is earned and again in the country of residence (and perhaps, for US citizens, taxed yet again in the country of citizenship)—however, there are relatively few double-taxation treaties with countries regarded as tax havens

Legal entities

Without changing country of residence (or, if a U.S. citizen, giving up one's citizenship), personal taxation may be legally avoided by the creation of a separate legal entity to which one's

property is donated. The separate legal entity is often a company, trust, or foundation. These may also be located offshore, such as in the case of many private foundations. Assets are transferred to the new company or trust so that gains may be realized, or income earned, within this legal entity rather than earned by the original owner. If assets are later transferred back to an individual, then capital gains taxes would apply on all profits. Also income tax would still be due on any salary or dividend drawn from the legal entity.

For a settlor (creator of a trust) to avoid tax there may be restrictions on the type, purpose and beneficiaries of the trust. For example, the settlor of the trust may not be allowed to be a trustee or even a beneficiary and may thus lose control of the assets transferred and/or may be unable to benefit from them.

Legal vagueness

Tax results depend on definitions of legal terms which are usually vague. For example, vagueness of the distinction between "business expenses" and "personal expenses" is of much concern for taxpayers and tax authorities. More generally, any term of tax law, has a vague penumbra, and is a potential source of tax avoidance.[2]

Tax shelters

Tax shelters are investments that allow, and purport to allow, a reduction in one's income tax liability. Although things such as home ownership, pension plans, and Individual Retirement Accounts (IRAs) can be broadly considered "tax shelters", insofar as funds in them are not taxed, provided that they are held within the Individual Retirement Account for the required amount of time, the term "tax shelter" was originally used to describe primarily certain investments made in the form of limited partnerships, some of which were deemed by the U.S. Internal Revenue Service to be abusive.

The Internal Revenue Service and the United States Department of Justice have recently teamed up to crack down on abusive tax shelters. In 2003 the Senate's Permanent Subcommittee on Investigations held hearings about tax shelters which are entitled U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND FINANCIAL PROFESSIONALS. Many of these tax shelters were designed and provided by accountants at the large American accounting firms.

Examples of U.S. tax shelters include: Foreign Leveraged Investment Program (FLIP) and Offshore Portfolio Investment Strategy (OPIS). Both were devised by partners at the accounting firm, KPMG. These tax shelters were also known as "basis shifts" or "defective redemptions."

Prior to 1987, passive investors in certain limited partnerships (such as oil exploration or real estate investment ventures) were allowed to use the passive losses (if any) of the partnership (i.e., losses generated by partnership operations in which the investor took no material active part) to offset the investors' income, lowering the amount of income tax that otherwise would be owed by the investor. These partnerships could be structured so that an investor in a high tax bracket could obtain a net economic benefit from partnership-generated passive losses.

In the Tax Reform Act of 1986 the U.S. Congress introduced the limitation (under 26 U.S.C. §   469 ) on the deduction of passive losses and the use of passive activity tax credits. The 1986 Act also changed the "at risk" loss rules of 26 U.S.C. §   465 . Coupled with the hobby loss rules (26 U.S.C. §   183 ), the changes greatly reduced tax avoidance by taxpayers engaged in activities only to generate deductible losses.

voidance also reduces government revenue and brings the tax system into disrepute, so governments need to prevent tax avoidance or keep it within limits. The obvious way to do this is to frame tax rules so that there is no scope for avoidance. In practice this has not proved achievable and has led to an ongoing battle between governments amending legislation and tax advisors' finding new scope for tax avoidance in the amended rules.

To allow prompter response to tax avoidance schemes, the US Tax Disclosure Regulations (2003) require prompter and fuller disclosure than previously required, a tactic which was applied in the UK in 2004.

Some countries such as Canada, Australia and New Zealand have introduced a statutory General Anti-Avoidance Rule (GAAR). Canada also uses Foreign Accrual Property Income rules to obviate certain types of tax avoidance. In the United Kingdom, there is no GAAR, but many provisions of the tax legislation (known as "anti-avoidance" provisions) apply to prevent tax avoidance where the main object (or purpose), or one of the main objects (or purposes), of a transaction is to enable tax advantages to be obtained.

In the United States, the Internal Revenue Service distinguishes some schemes as "abusive" and therefore illegal.

In the UK, judicial doctrines to prevent tax avoidance began in IRC v Ramsay (1981) followed by Furniss v. Dawson (1984). This approach has been rejected in most commonwealth jurisdictions even in those where UK cases are generally regarded as persuasive. After two decades, there have been numerous decisions, with inconsistent approaches, and both the Revenue authorities and professional advisors remain quite unable to predict outcomes. For this reason this approach can be seen as a failure or at best only partly successful.

In the UK in 2004, the Labour government announced that it would use retrospective legislation to counteract some tax avoidance schemes, and it has subsequently done so on a few occasions, notably BN66. Initiatives announced in 2010 suggest an increasing willingness on the part of HMRC to use retrospective action to counter avoidance schemes, even when no warning has been given.[13]

In 2008, the charity Christian Aid published a report, Death and taxes: the true toll of tax dodging, which criticised tax exiles and tax avoidance by some of the world's largest companies, linking tax evasion to the deaths of millions of children in developing countries.[14] However the research behind these calculations has been questioned in a 2009 paper prepared for the UK Department for International Development.[15] According to the Financial Times there is a growing trend for charities to prioritise tax avoidance as a key campaigning issue, with policy makers across the world considering changes to make tax avoidance more difficult.[16]

In 2010, tax avoidance became a hot-button issue in the UK. An organisation, UK Uncut, began to encourage people to protest at local high-street shops that were thought to be avoiding tax, such as Vodafone, Topshop and the Arcadia Group.[1

Q2. When minors are not allowed to be employed under the Constitution of India, can a minor still have income? If yes then how? Analyse the exemption from income-tax available in the case of a minor child. Answer:

A tax exemption is an exemption from all or certain taxes of the nation in which part of the taxes that would normally be collected from an individual or an organization are instead foregone.

The unit provides you the better understanding of exempted income. Normally a tax exemption is provided to an individual or organization which falls within a class which the government wishes to promote economically, such as charitable organizations. Tax exemptions are usually meant to either reduce the tax burden on a particular segment of society in the interests of fairness or to promote some type of economic activity through reducing the tax burden on those organizations or individuals who are involved in that activity. In certain cases, the Income tax Cat, 1961 provides exemption to pay the tax.

Objectives

After studying this unit, you should be able to:

         Define exempted income

         State the tax provisions for income exempt from tax

         Explain the term tax holidays

 

2.2 Income Exempt from Tax

All receipts which give rise to income are taxable unless they are specifically exempted from tax under the Act. Such exempted incomes are enumerated in Section 10 of the Act. Figure 2.1 depicts important exempted incomes.

Figure 2.1: Important Exempted Incomes

The income under Section 10 is exempt from tax, as they do not form part of total income. The burden of proving that a particular income falls with in this section is on assessed.

The following are some of the types of income that are exempted under u/s 10.

Chapter II of the Income-tax Act contains a number of provisions in Sections 10 to 13A which exclude various kinds of incomes from the purview of taxation.

1. Section 10 enumerates a number of incomes at one place, which are otherwise incomes, but which are not to be included in the income for the purpose of taxation under the Income-tax Act provides that the agricultural income will be considered for the purpose of determining the rate of tax levied on non-agricultural income.

2. Agricultural Income is exempt from tax if it comes within the definition of “agricultural income” as given in Section 2(1A)

3. Subject to the provisions of 64(2), any sum received by an individual as a member of a HUF, where such sum has been paid out of the income of the family, or, in the case of any impartible estate, where such sum has been paid out of the income of the estate belonging to the family.

4. In the case of a person being a partner of a firm which is separately assessed as such, his share in the total income of the firm. (upto A.Y. 92-93 it is taxable)

5. In case the income of an individual includes the income of his minor child in terms of Section 64(1A), such an individual shall be entitled to exemption of Rs. 1,500/- in respect of each minor child if the income of such minor is includible under Section 64(1A) exceeds that amount.

6. Any income arising from the transfer of a capital asset being a unit of US 64and where the transfer of such assets takes place on or after 1.04.2002, shall be exempt from tax. This exemption is applicable whether US 64 Unit is long term capital asset or short term capital asset.

7. Any income by way of dividends received from Domestic Company. As per Section 2(22A), Domestic Company means an Indian Company, or any other company which, in respect of its income liable to tax under this Act, has made the prescribed arrangements for the declaration and payment, within India, of the dividends (including dividends on preference shares) payable out of such income

8. Section 10A exempts the income of any newly established undertaking in a free trade zone.

9. Section 10B exempts the income of any newly established 100% export oriented undertaking.

10. Section 11 exempts the income of any charitable or religious trust or institution. 11. Section 12 deems voluntary contributions to a charitable or religious trust or institution as

the income from property held under the trust and, thus, exempts the contributions received by any charitable or religious trust or institution.

12. Section 13A exempts the income of political parties.

13. Section10(35) Income from Units, i.e. Income received in respect of units of Mutual Fund specified under clause (23D); or Income received in respect of units from the Administrator of the specified undertaking; or Income received in respect of units from the specified company

It may please be noted that Transfer of the above mentioned Units are not exempt under this provision.

14. Long Term Capital Gains arising on transfer of equity shares or units of equity oriented mutual fund is not chargeable to tax from the assessment year 2005-06 if such transaction is covered by securities transaction tax.

Mutual Fund as defined u/s. 10(23D) i.e. Mutual fund registered under the SEBI Act, 1992, Mutual fund set up by Public Sector Bank, Public Financial Institution or Authorised by the RBI and subject to such conditions as the Central Govt. may by notification in the Official Gazette, specify in this behalf.

15. Gratuity exempt u/s. 10(10) are as under for different class of employee:

a) Government Employee – Fully exempt b) Non Govt. Employee covered by the Payment of Gratuity Act, 1970:

                                    i)    15 day’s salary based on salary last drawn for each year of service

                                   ii)    Rs. 3, 50,000                                  iii)    Gratuity actually received

Least of the above three is exempt.

c) Non-Govt. employee and not covered by the payment of Gratuity Act, 1970                                     i)       Rs. 3,50,000                                    ii)       Half month’s average salary for each completed year of service                                  iii)       Gratuity actually received

Least of the above three is exempt.

 

16. Amount received (Compensation) at the time of voluntary retirement or separation is exempt from tax if the following conditions are satisfied:

a) Compensation is received at the time retirement or termination.

b) Compensation is received by an employee of the specified undertakings.

c) Compensation is received in accordance with the scheme of voluntary retirement/separation which is framed in accordance with prescribed guidelines.

d) Maximum amount of exemption is Rs. 5,00,000/-

17. House rent allowance is exempt from tax under Sec10 (13A).The least of the following three is exempt from tax :

a) An amount equal to 50% of salary where residential house is situated in Metro Cities and an amount equal to 40% of salary where residential house is situated at any other places.

b) HRA received by the employee in respect of the period during which rental accommodation is occupied by the employee during the previous year.

c) The excess of rent paid over 10% of salary

To understand more clearly you can classify the income under Section 10 as follows:

A) Incomes which are not to be included in the income without any further consideration, and

B) Incomes which are not to be included in the income on satisfaction of some further condition or conditions.

The same are summarised in the Table 2.1.

 

 

Table 2.1: Income Exempt from Tax

Section Nature of Income Exemption limit, if any

1 2 3 10(1) Agricultural income   10(2) Share from income of HUF   10(2A) Share of profit from firm   10(3) Casual and non-recurring

receipts Winnings from races Rs. 2500/- other receipts Rs. 5000/-

10(10D) Receipts from life Insurance Policy

 

10(16) Scholarships to meet cost of education

 

10(17) Allowances of MP and MLA.

For MLA not exceeding Rs. 600/- per month

10(17A) Awards and rewards     i) from awards by

Central/State Government

 

  ii) from approved awards by others

 

  iii) Approved rewards from Central & State Governments

 

10(26) Income of Members of scheduled tribes residing in certain areas in North Eastern States or in the Ladakh region.

Only on income arising in those areas or interest on securities or dividends

10(26A) Income of resident of Ladakh

On income arising in Ladakh or outside India

10(30) i) Subsidy from Tea Board under approved scheme of replantation

 

10(31) ii) Subsidy from concerned Board under approved Scheme of replantation

 

10(32) Minor’s income clubbed with individual

Upto Rs. 1,500/-

 

 

10(33) Dividend from Indian Companies, Income from units of Unit Trust of India and Mutual Funds, and income from Venture Capital Company/fund.

 

10(A) Profit of newly established undertaking in free trade zones electronic hardware technology park on software technology park for 10 years (net beyond 10 year from 2000-01)

 

10(B) Profit of 100% export oriented undertakings manufacturing articles or things or computer software for 10 years (not beyond 10 years from 2000-01)

 

10(C) Profit of newly established undertaking in I.I.D.C or I.G.C. in North-Eastern Region for 10 years

 

Income from Interest 10(15)(i)(iib)(iic) Interest, premium on 

redemption or other payments from notified securities, bonds, Capital investment bonds, Relief bonds etc.

To the extent mentioned in notification

10(15)(iv)(h) Income from interest payable by a Public Sector Company on notified bonds or debentures

 

10(15)(iv)(i) Interest payable by Government on deposits made by employees of Central or State Government or Public Sector Company of money due on retirement under a notified scheme

 

10(15)(vi) Interest on notified Gold Deposit bonds

 

 

10(15)(vii) Interest on notified bonds of local authorities

 

Income from Salary 10(5) Leave Travel assistance/

concession Not to exceed the amount payable by Central Government to its employees

10(5B) Remuneration of technicians having specialised knowledge and experience in specified fields (not resident in any of the four preceding financial years) whose services commence after 31.3.93 and tax on whose remuneration is paid by the employer

Exemption in respect of income in the from of tax paid by employer for a period upto 48 months  

10(7) Allowances and perquisites by the government to citizens of India for services abroad

 

10(8) Remuneration from foreign governments for duties in India under Cooperative technical assistance programmes. Exemption is provided also in respect of any other income arising outside India provided tax on such

 

income is payable to that Government.

10(10) Death-cum-retirement Gratuity-

 

  i) from Government     ii) Under payment of

Gratuity Act 1972 Amount as per Sub-sections (2), (3) and (4) of the Act.

  iii) Any other Upto one-half months salary for each year of completed service.

10(10A) Commutation of Pension-     i) from government,

statutory Corporation etc.

 

 

  ii) from other employers Where gratuity is payable - value of 1/3 pension.  Where gratuity is not payable - value of 1/2 pension.

  iii) from fund set up by LIC u/s 10(23AAB)

 

10(10AA) Encashment of unutilised earned leave

 

  i) from Central or State government

 

  ii) from other employers Upto an amount equal to 10 months salary or Rs. 1,35,360/- which ever is less

10(10B) Retrenchment compensation

Amount u/s. 25F (b) of Industrial Dispute Act 1947 or the amount notified by the government, whichever is less.

10(10C) Amount received on voluntary retirement or termination of service or

Amount as per the Scheme subject to maximum of Rs. 5 lakh

voluntary separation under the schemes prepared as per Rule 2BA from public sector companies, statutory authorities, local authorities, Indian Institute of Technology, specified institutes of management or under any scheme of a company or Co-operative Society

10(11) Payment under Provident Fund Act 1925 or other notified funds of Central Government

 

10(12) Payment under recognised provident funds

To the extent provided in rule 8 of Part A of Fourth Schedule

 

 

10(13) Payment from approved Superannuation Fund

 

10(13A) House rent allowance least of-     i) actual

allowance     ii) actual rent in

excess       of 10% of salary

    iii) 50% of salary in       Mumbai, Chennai,       Delhi and Calcutta       and 40% in other       places

10(14) Prescribed [See Rule 2BB (1)] special allowances or benefits specifically granted to meet expenses wholly necessarily and exclusively incurred in the performance of duties

To the extent such expenses are actually incurred.

10(18) Pension including family pension of recipients of notified gallantry awards

 

Exemptions to Non-citizens only 10(6)(i)(a) and (b)

i) passage money from employer for the employee and his family for home leave outside India

 

  ii) Passage money for the employee and his family to ‘Home country’ after retirement/ termination of service in India.

 

10(6)(ii) Remuneration of members of diplomatic missions in India and their staff, provided the members of staff are not engaged in any business or profession or another employment in India.

 

10(6)(vi) Remuneration of employee of foreign enterprise for services rendered during his stay in India in specified circumstances provided the stay does not exceed 90 days in that previous year.

 

10(6)(xi) Remuneration of foreign Government employee on training in certain establishments in India.

 

Exemptions to Non-residents only   Refer Chapter VII

(Para 7.1.1)  

  Chapter VIII (Para 8.4)     Chapter IX     Chapter X (Para 10.4)  

Exemptions to Non-resident Indians (NRIs) only   Refer Chapter XI   Exemptions to funds, institutions, etc. 10(14A) Public Financial

Institution from exchange risk premium received from person borrowing in foreign currency if the amount of such premium is credited to a fund specified in Section 10(23E)

 

10(15)(iii) Central Bank of Ceylon from interest on securities

 

10(15)(v) Securities held by Welfare Commissioners Bhopal Gas Victims, Bhopal from Interest on securities held in Reserve Bank’s SGL Account No. SL/DH-048

 

10(20) any local Authority (a)  Business income derived from Supply of water or electricity any where. Supply of other commodities or service within its own jurisdictional area.

    (b) Income from house property, other sources and capital gains.

10(20A) Housing or other Development authorities

 

10(21) Approved Scientific Research Association

 

10(23) Notified Sports Association/ Institution for control of cricket, hockey, football, tennis or other notified games.

 

10(23A) Notified professional association/institution

All income except from house property, interest or dividends on investments and rendering of any specific services

10(23AA) Regimental fund or Non-public fund

 

10(23AAA) Fund for welfare of employees or their dependents.

 

10(23AAB) Fund set up by LIC of India under a pension scheme

 

10(23B) Public charitable trusts or registered societies approved by Khadi or Village Industries commission

 

10(23BB) Any authority for development of khadi or village industries

 

10(23BBA) Societies for administration of public, religious or charitable trusts or endowments or of registered religious or charitable Societies.

 

10(23BBB) European Economic Community from Income from interest, dividend or capital gains

 

10(23BBC) SAARC Fund   10(23C) Certain funds for relief,

charitable and promotional purposes, certain educational or medical institutions

 

10(23D) Notified Mutual Funds   10(23E) Notified Exchange Risk

Administration Funds  

10(23EA) Notified Investors  

Protection Funds set up by recognised Stock Exchanges

10(23FB) Venture capital Fund/ company set up to raise funds for investment in venture Capital undertaking

Income from invest-ment in venture capital undertaking

10(23G) Infrastructure capital fund, or infrastructure capital company

Income from dividend, interest and long term capital gains from investment in approved infrastructure enterprise

10(24) Registered Trade Unions Income from house property and other sources

10(25)(i) Provident Funds Interest on securities and capital gains from transfer of such securities

10(25)(ii) Recognised Provident Funds

 

10(25)(iii) Approved Superannuation Funds

 

10(25)(iv) Approved Gratuity Funds    10(25)(v) Deposit linked insurance

funds  

10(25A) Employees State Insurance Fund

 

10(26B)(26BB) and (27)

Corporation or any other body set up or financed by and government for welfare of scheduled caste/ scheduled tribes/backward classes or minorities communities

 

10(29) Marketing authorities Income from letting of godown and warehouses

10(29A) Certain Boards such as coffee Board and others

 

and specified Authorities

Q3. Profit and Loss A/c of CS and Daughters, a partnership firm is as follows: Particulars Rs. Particulars Rs. Establishment and other expenses

3,00,000 Gross Profit 6,60,000

Interest on capital to partners @ 24% p.a.

48,000 Rent from House Property

60,000

Interest on loan to partners @ 20%

20,000 Interest from Government securities

32,000

Interest on loan to Mr. C @ 24% 24,000 Municipal taxes of let out house property

10,000

Repairs of the house property 5,000

Donations to National Children’s Fund

10,000

Remuneration to partners 2,00,000 Int. on money borrowed for investment in Govt. securities

10,000

Sales tax 25,000 Net Profit 1,00,000 Winter / November 2011

7,52,000 7,52,000

Other Information: a) Out of municipal taxes of Rs. 10,000; Rs. 6,000 was payable on 31.3.2011 and the same was paid on 30.6.2011. b) Sales tax includes a sum of Rs. 10,000 payable on 31.3.2011. Rs. 6,000 was paid on 31.7.2011 and Rs. 4,000 was paid on 30.11.20 although the due date of payment under the Sales Tax Act was 14.5.2011. Compute: a) The book profit b) The maximum amount of remuneration deductible u/s 40(b) c) The total income of the firm assuming that the maximum remuneration allowable u/s 40(b) is paid to the partners. d) Also state the income from the firm which will be taxable in the hands of the partners. Hint: Book profit= 2,79,000; maximum amount of remuneration=1,64,100; Total Income= 1,71,100; Total Income of each partner as business income =Rs.1, 00,050

Q4. Write a note on income from capital gain Answer:

INCOME FROM CAPITAL GAINS

1. Chargeability u/s 45

Profits or gains arising from the transfer of a capital asset is chargeable to tax in the year in which transfer take place under the head "Capital Gains".

Definitions

Transfer: Sec. 2(47): Transfer in relation to a capital asset includes sale, Exchange, or relinquishment of the asset or extinguishment of any rights therein or the compulsory acquisition thereof under any law or conversion of the asset by the owner in stock-in-trade of a business carried on by him or the maturity or redemption of a zero coupon bond.

Capital Asset: Sec. 2(14): Capital Asset means property of any kind (Fixed, Circulating, movable, immovable, tangible or intangible) whether or not connected with business or profession.

Exclusions —

a. Stock-in-trade

b. Personal effects of the assessee

c. Agricultural land in a rural area

d. 6½% Gold Bonds, 1977 or 7% Gold Bonds, 1980 or National Defence Bonds, 1980 issued by the Central Government

e. Special Bearer Bonds, 1991 issued by the Central Government.

f. Gold Deposit Bonds issued under Gold Deposit Scheme 1999

Short-term capital asset: Sec. 2(42A): means a capital asset held by an assessee for not more than thirty six months immediately preceding the date of its transfer. However, in the following cases, an asset, held for not more than twelve months, is treated as short-term capital asset—

a. Quoted or unquoted equity or preference shares in a company

Circular No. 495 dated 22.9.1987 explaining amendments by Finance Act, 1987 whereby unquoted shares of a private limited company also if held more than 12 months falls in the category of LTCG. Also Refer the Judgment in 120 TTJ 699 for unquoted shares held for less than 36 months.

b. Quoted Securities

c. Quoted or unquoted Units of UTI

d. Quoted or unquoted Units of Mutual Funds specified u/s. 10(23D)

e. Quoted or unquoted zero coupon bonds

Long-term capital asset: Sec. 2(29A): means a capital asset which is not a short-term capital asset

2. Year of chargeability to tax

Capital gains are generally charged to tax in the year in which ‘transfer’ takes place. Exceptions —

a. Sec. 45(1A) — Insurance Claim — In the year of receipt.

b. Sec. 45(2) — Conversion of capital asset into stock-in-trade — In the year of actual sale of the stock.

c. Sec. 45(5) — Compulsory acquisition — When consideration or part thereof is first received.

Exempt Capital Gains under Section 10

10(33) : Transfer of US 64 on or after April 1, 2002

10(37) : Compulsory acquisition of Urban Agriculture Land where consideration is received after March 31, 2004.

10(38) : Long-term capital gain arising on transfer on or after October 1, 2004 of equity shares or units of equity oriented mutual

fund and the STT is paid at the time of transfer.

3. Computation of capital gains (Sec. 48)

The method of computation depends on the nature of capital asset transferred. It is as follows:—

Short-term Capital Gain Long-term Capital Gain

A. Find out Full Value of Consideration

A. Find out Full Value of Consideration

B. Deduct: B. Deduct:

(i) expenditure incurred wholly and exclusivelyin connection with such Transfer.(ii) Cost of Acquisition (iii) Cost of Improvement(iv) Exemption provided by Ss. 54B, 54D & 54G, 54GA

(i) expenditure incurred wholly and exclusively in connection withsuch Transfer.(ii) Indexed Cost of Acquisition(iii) Indexed Cost of Improvement(iv) Exemption provided by Ss. 54, 54B, 54D, 54EC, 54ED, 54F & 54G, 54GA

C. (A-B) is short-term capital gain C. (A-B) is a long-term capital gain

4. Full value of consideration for transfer of land or building or both: Sec. 50C

Higher of the followings:—

a. Full value of the consideration received or accruing

b. Value adopted or assessed (w.e.f. 1st day of October, 2009 the word "or assessed" shall be substituted by "or assessed or assessable") by any authority of a State Government for the purpose of payment of stamp duty in respect of such transfer.

5. Indexed Cost of acquisition = Cost of acquisition * Cost inflation index for the financial year In which the asset is transferred/ Cost inflation index for the first financial year in which the asset was held by the assessee or the year beginning on 1.4.1981, whichever is later or the year of Improvement of the asset

However, in case of Bonds, Debentures except capital indexed bonds depreciable assets, and for non-residents even if they are long term capital assets the benefit of indexation is not available.

Cost inflation Index

Financial Year

Cost Inflation Index

1981-82 100

1982-83 109

1983-84 116

1984-85 125

1985-86 133

1986-87 140

1987-88 150

1988-89 161

1989-90 172

1990-91 182

1991-92 199

1992-93 223

1993-94 244

1994-95 259

1995-96 281

1996-97 305

1997-98 331

1998-99 351

1999- 389

2000 2000-01 406

2001-02 426

2002-03 447

2003-04 463

2004-05 480

2005-06 497

2006-07 519

2007-08 551

2008-09 582

2009-10 632

2010-11 711

2011-12 785

Computation of Long Term Capital Gains on Shares both Equity and Preference, Listed or Unlisted and Debentures:

Capital Assets  

If transaction is covered by STT at the time of transfer   

IF it is not covered by STT

 

Long Term

Without indexation

With indexation

Listed equity shares covered by Sec. 10(36) 0% 0% 0%

Listed equity shares not covered by Sec. 10(36)

0% 10% 20%

Unlisted equity shares NA  NA 20%

Listed Preference shares NA 10% 20%

Unlisted Preference shares NA NA 20%

Listed Debenture NA 10% NAUnlisted Debenture NA 20% NA

CAPITAL GAIN IN CASE OF CONVERSION OF A PRIVATE COMPANY OR AN UNLISTED PUBLIC COMPANY INTO AN LLP:

Sec. 47(XIIIb)

This section provides that conversion of a private company or unlisted public company into an LLP in accordance with Secs. 56 and 57 of the LLP Act will not be regarded as transfer, if following conditions are fulfilled :

a. All the assets and liabilities of the company become the assets and liabilities of the LLP.

b. All the shareholders of the company become the partners of the LLP and their profit sharing ratio and the capital contribution in the LLP are in the same proportion as their shareholding in the company on the date of conversion.

c. Shareholders of the company do not receive any consideration or the benefit, directly or indirectly, other than share in the profit and capital contribution in the LLP.

d. For a period of at least five years from the date of conversion, the erstwhile shareholders of the company in aggregate are entitled to at least 50% of the profits of the LLP.

e. The total sales, turnover or gross receipts in the business of the company in any of the three years preceding the year of conversion do not exceed Rs. 60 lakhs.

f. For a period of three years from the date of conversion, the accumulated profits of the company on the date of conversion are not paid to any partner of the LLP, whether directly or indirectly.

Sec. 47A (4)

This section provides that if any of the conditions in (a) to (f) above are not complied with, then the profits arising from transfer of capital assets or intangible assets on conversion of the company to the LLP not charged under Sec. 45 shall be taxed in the hands of the LLP in the year in which the conditions are violated.

Sec. 49

It provides that cost of acquisition of the capital assets acquired by the LLP in the process of conversion shall be deemed to be the cost for which the converted company had acquired the assets.

CAPITAL GAINS - VARIOUS EXEMPTIONS DETAILS

Section 54 54B 54D 54EC (a) Kind of assets

transferredLong-term CapitalAssets being HouseProperty used forresidential purpose

Land used foragricultural purposes

Land and Building orany right therein used by an industrial undertakingcompulsorily acquiredunder any law

Any Long Term CapitalAssets

(b) Eligible Assessees Individual & HUF

Individual & HUF

All All

(c) Condition ofperiod ofholding oforiginal Asset

3 years 2 years 2 years 1 year for Shares, ListedSecurities, Units of UTI/Mutual Fund specifiedu/s 10(23D), Zerocoupon bonds, 3 yearsfor any other capitalassets

(d) Condition ofutilization ofconsideration

Purchase ofResidential Housewithin 2 years afteror 1 year prior todate of transfer: orconstruction ofresidential housewithin 3 years fromthe date of transfer

Purchase ofAgricultural Landwithin 2 years fromthe date of transfer

Purchase/constructionof land, building, orany right thereinwithin 3 years from thedate of transfer byway of compulsoryacquisition for thepurpose of shifting/re-establishing/setting up anotherindustrial undertaking

Investment of whole orany Part of Capital Gainin ‘specified assets’ asstipulated in the section.Investment should bemade within 6 monthsfrom the date of transfer

(e) Exempt The amount Lower of the Lower of the Capital Lower of the

Amount of gainor, the cost of newasset, whichever isless

CapitalGain or the Cost ofacquisition of newagricultural land

Gain or the Cost ofacquisition of newland and building

CapitalGain or the investmentin specified assets subject to a maximum of Rs. 50 lakhs.

(f) Other requirements See notes 1, 2 & 4

Assessee or hisparents must haveused the land foragricultural purposefor preceding twoyears

See notes 1, 2 & 4Must have beenused for business ofindustrial undertakingfor preceding 2 years

See notes 1, 2 & 4Rebate u/s 88 ordeduction u/s 80C not to be granted for the same investment. New Asset must be retained for aperiod of 3 years

CAPITAL GAINS - VARIOUS EXEMPTIONS DETAILS

Section 54F 54G 54GA(a) Kind of asset transferred Any long term

capital asset other than residential house

Land or Building or any right therein or Plant or Machinery in Urban Area used for the business

Land or Building or any right therein or Plant or Machinery in Urban Area used for the business

(b) Eligible Assessees Individual & HUF Industrial undertakings in urban area shifting to an area other than urban area

Industrial undertakings in urban area shifting to any Special Economic Zone

(c) Condition of period of holding of original asset

1 year for Shares, ListedSecurities, Units of UTI/Mutual Fund specifiedu/s 10(23D), Zero-couponbonds, 3 years for othercapital assets

No period specified

 

No period specified

 

(d) Condition of utilization of consideration

Purchase of Residential House

Acquire similar assets & incur

Acquire similar assets & incur

within 2 years after or 1 year prior to date of transfer; or construction of residential house within 3 years from date of transfer

expenses on shifting original asset, within 1 year before, or 3 years from the date of transfer

expenses on shifting original asset, within 1 year before, or 3 years from the date of transfer

(e) Exempt Amount Refer Note No. 5 The amount of gain or the aggregate cost of new asset, and shifting expenses, whichever is lower

The amount of gain or the aggregate cost of new asset, and shifting expenses, whichever is lower

(f) Other Requirements Must not own more than 1 residential house other than the new asset on the date of transfer of original asset

Must have been shifted to non-urban area. See Notes 1 & 2

See Notes 1, 2, 3 and 4

NOTES

1. In case New Asset is transferred before 3 years from date of purchase/construction, the Capital Gains exempted earlier will be chargeable to tax in year of transfer of new asset.

2. In order to avail the exemption, gains are to be reinvested, before the due date of return u/s 139(1). If the amount is not so reinvested, it is to be deposited on or before that date in account of specified bank/institution and it should be utilised within specified time limit for purchase/construction of new asset.

3. U/s 54F Capital Gains exempted earlier shall be chargeable to tax — if a) If the assessee purchases within 2 years or constructs within 3 years any residential house other than the one in which reinvestment is made & b) If the new asset is transferred within a period of 3 years from the date of its purchase/construction.

4. As per Section 54H, where the transfer is by way of compulsory acquisition, the period available for acquiring the new asset u/ss. 54, 54B, 54D, 54EC and 54F shall be computed from the date of receipt of compensation and not the date of transfer.

5. If cost of new house is more than the net consideration of original asset, the whole of the gains is exempt. If cost of specified asset is less than net consideration, proportionate amount of the gains will be exempt i.e. Capital Gain X cost of New Asset/Net consideration on sale of asset.

Q5. Discuss the taxable services under the service tax. Answer:

From the beginning of the 1990s, manufacturing and other sectors subsidised the growing service sector. But in the Finance Bill, 1994, the government introduced the levy of service tax. Today, the service sector constitutes 54 per cent of the gross domestic product and is hugely important to the economy. Given its size, it seems only right that it contributes to the government coffers.

This sounds fine in principle. Yet, there are several problems with the levy of service tax. First, there is no set definition for 'service.' Also, the levy of the tax is through the implementation of various amendments to the Finance Act, 1994. Given the importance and scope of this tax, a separate legislation ought to be enacted and the word 'service' should be defined.

Expanded scope: When service tax was introduced, it covered just three services. In little over a decade it has expanded to cover 96 services from which the government hopes to collect Rs 34,500 crore (Rs 345 billion). Among others, the taxable services today include the services of chartered accountants, courier, transport of goods and even banking services.

The rate of service tax has also gone up from 5 per cent in 1994 to 12 per cent today. Though the impact of service tax is increasing, the pinch is not really felt because it is an indirect tax collected as part of total value of the service. The bad news is that the finance minister said the ultimate tax rate will be 16 per cent.

He has also indicated that he wants a merger of the taxes on goods and the services by introducing a goods and services tax (GST) with effect from 1 April, 2010.

What does this mean? It's good news for the government, but it means that the service receiver will ultimately have to pay more for the services. The government has made a provision for granting rebates for input services, but this does not benefit the common man who does not provide any services.

What's covered: With the expanded scope of the tax, practically every service is subject to tax. It is more than likely that in the next few years, all services will have to pay the tax except for a few essential services. At least, this will reduce uncertainty about what comes under the service tax net.

So what services are outside the purview of service tax now? At present, there's no levy on loans given by banks, institutions or corporates. However, other ancillary services connected with granting loans such as processing charges and scrutiny fees are subject to service tax.

Leasing and hire purchase for consumer durables and cars now come under the service tax net. Any person engaged in the business of finance lease, equipment lease and hire purchase will have to pay service tax only on the interest component embedded in the instalment; it has been provided that the tax will be payable on 10 per cent of the equated monthly installments (EMI) representing interest.

The maintenance of computer software, computerised data processing service, services provided by call centres and medical transcriptions, which were so far exempt, are now treated as taxable services.

Service tax will now have to be paid by construction contracts for commercial and residential units, as well as for repair, renovation and maintenance work related to property. But the enthusiasm for the tax may be unbridled in some cases.

For instance, the director-general of service tax in Mumbai [ Images ] stated that the tax would have to be paid on the sale value of a flat or office. This order has been challenged and a verdict is expected soon.

The legalities: The import of service is covered under Section 65(105). If the service provider is located outside India [ Images ], the recipient of the taxable service located in India is liable to pay service tax. However, this interpretation of the section may not be legally sustainable as it sought to include service providers who were not residents of India and whose services were not consumed in the country.

The government now plans to introduce Section 66A, which will cover only service providers outside India who provide a service consumed and used within the country.

Because there was some confusion regarding the definition of 'commercial concern,' the word 'person' has been used instead of 'commercial concern.' This means that taxable services provided by individuals also will be subject to tax.

In some cases, the service provider has the option to pay service tax by availing abatement, which meant he could take input credit of service tax paid on input services. It is now proposed that if the provider avails of the abatement benefit, he will not get input credit in respect of input services.

But this is not fair, since abatement is given in relation to such services where certain materials and goods are used in the execution of the contract, and value-added tax (VAT) or works contract tax is applicable on the portion of the material used.

In respect of the service portion, the tax is payable following the abatement formula. The withdrawal of input credit will result in an additional liability on the service provider.

In case of non-payment of the tax, the excise officer has been given the power to attach the property of the service provider, pending adjudication of the show cause notice with the previous approval of the commissioner of central excise. There's a similar provision, sparingly used, in the

Income Tax Act -- the business community hopes that the same moderation will be exercised by the excise officers.

The officers also have the power to attach and collect the amount due and payable by any person to a service provider who has not paid the tax. This is similar to the 'garnishee powers' provided in the IT Act.

Exempted services: Earlier, some service providers had been allowed to stay out of the tax net. However, the finance minister has withdrawn the exemption granted to these providers.

General insurance, where the premium is received from reinsurance, from domestic or overseas and all premiums booked outside India will be now in the tax net. For chartered accountants, company secretaries and cost accountants, only certain services were taxable. Now all the services provided by such persons will be taxable from 1 March 2006. Services provided before will not be subject to service tax, even if payment is received after 1 March 2006.

A service provider who provides taxable services and receives less than Rs 4 lakh (Rs 400,000) per annum need not pay the tax and cannot charge customers service tax. This provision is often misused by unscrupulous providers who charge service tax even though they do not pay it. Recipients who pay service tax should insist upon a tax invoice from the provide

Master of Business Administration

Semester IIIMF0013 –Internal Audit and Control- 4 Credits

(Book ID:B1211)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer

all the questions.

Q1. Discuss, in brief, the advantages and limitations of auditing. Q2. What is internal check? Explain with example. Q3. Discuss about the codes of ethics of internal auditor Q4. Explain the use of Sampling technique in Internal audit

Q5. Explain the internal control system in banks. Q6. Discuss about the Computer Assisted Audit Techniques (CAATs).

Master of Business AdministrationSemester III

MF0013 –Internal Audit and Control- 4 Credits(Book ID:B1211)

AssignmentSet- 1 (60 Marks)

Note: Each Question carries 10 marks. Answer all the questions.

Q1. Discuss, in brief, the advantages and limitations of auditing. Answers:Auditing is the analysis of the financial accounts/records, by a qualified accountant, and procedures of a firm or organisation. This is essential in order to gain a fair perspective on the company's financial statements. With auditing, potential investors and creditors can look at the financial statements to

decide whether to invest in a business or not. Auditing is important as it also protects the public from scams and corrupt business procedures.

The advantages for a business audit are:1. Gain a strong sense of internal control.2. Identify key areas for improvement in your company.3. Test out the performance of new technology.4. Evaluate threats, economy, efficacy and quality.5. Realise fraudulent occurrences in the business.6. Analyse and understand your firms' financial data.7. The public are protected from corruption.

The disadvantages of a business audit are:1. It does not take into account the productivity and the skills of the employees of the business.2. The financial data is never current and does not reveal much about the present financial position of a company.3. Different accountants use different techniques, therefore it would be hard to compare audits between companies who have used different accountants.4. For smaller companies, hiring an accountant/firm to carry out an audit can be costly.5. A bad audit can discourage investment.6. Can be time consuming to answer the auditor's questions and the business may not work to maximum capacity.Carrying out an audit is essential because for public listed companies it is important that an audit is carried out to ensure that the companies are using fair policies prescribed by law and the public’s money is in safe hands. The basic advantage of an audit is that it makes it easier to compare different companies as the auditors express their opinions about the fairness of procedures. Of a company is given a good opinion then it means that it is following the law. It also helps in following certain standards. An audit will keep the managers from trying to indulge in fraudulent practices as it is a means of accountability. It testifies to reliability and integrity of the results. The only disadvantage of an audit can be the costs involved because you have to pay the auditors and also ensure that you maintain detailed records of all the transactions which involve a lot of costs

Q2. What is internal check? Explain with example.

Answer:Accounting procedure or physical control to safeguard assets against loss due to fraud or other irregularities. Internal check is an element of internal control.Weak internal check mechanisms mandate a greater degree of auditing procedures. An example of internal control is segregating the record keeping for an asset and its physical custody, such as in the case with inventory and cash. No one individual should have complete control over a transaction from beginning to end. Internal checks make it difficult for an employee to steal cash or other assets and concurrently

cover up by entering corresponding amounts in the accounts.An example of internal check is the establishment of input and output controls within a data processing department. A group or person has the responsibility of checking control totals provided by the user department with those generated during the processing of the data. Examples of physical controls are guards and gates to restrict access.

According to the COSO Framework, everyone in an organization has responsibility for internal control to some extent. Virtually all employees produce information used in the internal control system or take other actions needed to affect control. Also, all personnel should be responsible for communicating upward problems in operations, noncompliance with the code of conduct, or other policy violations or illegal actions. Each major entity in corporate governance has a particular role to play:

Management: The Chief Executive Officer (the top manager) of the organization has overall responsibility for designing and implementing effective internal control. More than any other individual, the chief executive sets the "tone at the top" that affects integrity and ethics and other factors of a positive control environment. In a large company, the chief executive fulfills this duty by providing leadership and direction to senior managers and reviewing the way they're controlling the business. Senior managers, in turn, assign responsibility for establishment of more specific internal control policies and procedures to personnel responsible for the unit's functions. In a smaller entity, the influence of the chief executive, often an owner-manager, is usually more direct. In any event, in a cascading responsibility, a manager is effectively a chief executive of his or her sphere of responsibility. Of particular significance are financial officers and their staffs, whose control activities cut across, as well as up and down, the operating and other units of an enterprise.

Board of Directors: Management is accountable to the board of directors, which provides governance, guidance and oversight. Effective board members are objective, capable and inquisitive. They also have a knowledge of the entity's activities and environment, and commit the time necessary to fulfill their board responsibilities. Management may be in a position to override controls and ignore or stifle communications from subordinates, enabling a dishonest management which intentionally misrepresents results to cover its tracks. A strong, active board, particularly when coupled with effective upward communications channels and capable financial, legal and internal audit functions, is often best able to identify and correct such a problem.

Auditors: The internal auditors and external auditors of the organization also measure the effectiveness of internal control through their efforts. They assess whether the controls are properly designed, implemented and working effectively, and make recommendations on how to improve internal control. They may also review Information technology controls, which relate to the IT systems of the organization. There are laws and regulations on internal control related to financial reporting in a number of jurisdictions. In the U.S. these regulations are specifically established by Sections 404 and 302 of the Sarbanes-Oxley Act. Guidance on auditing these controls is specified in PCAOB Auditing Standard No. 5 and SEC guidance, further discussed in SOX 404 top-down risk assessment. To provide reasonable assurance that internal controls

involved in the financial reporting process are effective, they are tested by the external auditor (the organization's public accountants), who are required to opine on the internal controls of the company and the reliability of its financial reporting.

Staff and junior managers may be involved in evaluating the controls within their own organisational unit using a control self-assessment.

Control activities may also be explained by the type or nature of activity. These include (but are not limited to):

Segregation of duties - separating authorization, custody, and record keeping roles of fraud or error by one person.

Authorization of transactions - review of particular transactions by an appropriate person. Retention of records - maintaining documentation to substantiate transactions. Supervision or monitoring of operations - observation or review of ongoing operational

activity. Physical safeguards - usage of cameras, locks, physical barriers, etc. to protect property,

such as merchandise inventory. Top-level reviews-analysis of actual results versus organizational goals or plans, periodic

and regular operational reviews, metrics, and other key performance indicators (KPIs). IT Security - usage of passwords, access logs, etc. to ensure access restricted to

authorized personnel. Top level reviews-Management review of reports comparing actual performance versus

plans, goals, and established objectives. Controls over information processing-A variety of control activities are used in

information processing. Examples include edit checks of data entered, accounting for transactions in numerical sequences, comparing file totals with control accounts, and controlling access to data, files and programs.

Control precision

Control precision describes the alignment or correlation between a particular control procedure and a given control objective or risk. A control with direct impact on the achievement of an objective (or mitigation of a risk) is said to be more precise than one with indirect impact on the objective or risk. Precision is distinct from sufficiency; that is, multiple controls with varying degrees of precision may be involved in achieving a control objective or mitigating a risk.

Precision is an important factor in performing a SOX 404 top-down risk assessment. After identifying specific financial reporting material misstatement risks, management and the external auditors are required to identify and test controls that mitigate the risks. This involves making judgments regarding both precision and sufficiency of controls required to mitigate the risks.

Risks and controls may be entity-level or assertion-level under the PCAOB guidance. Entity-level controls are identified to address entity-level risks. However, a combination of entity-level and assertion-level controls are typically identified to address assertion-level risks. The PCAOB set forth a three-level hierarchy for considering the precision of entity-level controls.[7] Later

guidance by the PCAOB regarding small public firms provided several factors to consider in assessing precision.

Q3. Discuss about the codes of ethics of internal auditorAnswer:

There is no specific qualification for an internal auditor as per law. As we have discussed earlier, the internal auditor is appointed by the management of the company. Obviously, before appointing someone as internal auditor, management looks for the following attributes in him.

The internal auditor should possess necessary expertise to evaluate business control systems, especially financial and accounting controls. Accounting and finance expertise remain the basic criteria to appoint an internal auditor. Ultimately, it’s the financial viability, which matters for long term existence of any enterprise.

The internal auditor is also expected to evaluate the operational performance of an enterprise. This requires a basic knowledge of the technology and commercial practices adopted by the business. He should have a basic knowledge of commerce, economics, laws, taxation, cost accounting, quantitative methods and information technology.

As a part of Management, Internal Auditor must have a thorough knowledge of management theories and practices. He should know how to deal with people. Often, he has to criticize his own colleague. He should be able to put across criticism in such a manner as would make it acceptable even to person being criticized. He should be unbiased in reporting and show a strong professional approach.

Above all, the internal auditor should be a person of high integrity and ethics.

After above general discussions on qualification of internal auditor, we will disclose certain specific provisions of Indian Law regarding appointment of Internal Auditor.

i) Bye Laws 10.3 of NSDL states that every participant shall ensure that an internal audit is conducted in respect of the operations of the depository by a qualified Chartered Accountant or a company secretary holding a certificate of practice, at intervals of not more than three months and a copy of the internal audit report shall be furnished to the depository.

ii) The Companies (Auditor’s Report) Order (CARO), 2003 [Clause 4(vii): In the case of Listed Companies and/or other companies having a paid up capital and reserves exceeding Rs. 50 lakhs as at the commencement of the financial year concerned, or having an average annual turnover exceeding 5 crores rupees for a period of three consecutive financial years immediately preceding the financial years concerned, whether the company has an internal audit system commensurate with it; size and nature of its business.

iii) Sec. 58/ZF of Companies Act, 1956: Every “Producer Company” shall have internal audit of its accounts carried out, at such interval and in such manner as may be specified in articles, by a Chartered Accountants as defined in clause (b) of sub-section (1) of section 2 of the Institute of Chartered Accountants Act, 1949, “Producer Company” means a body corporate having objects or activities specified in section 581 B and registered as Producer Company under this Act.

Duties of auditor under this part (Sec. 581 ZG)

Without prejudice to the provisional contained in Section 227, the auditor shall report on the following additional matters relating to the producer company, namely:

1. The amount of due along with particulars of bad debts if any;

2. The verification of cash balance and securities;

3. The details of assets and liabilities;

4. All transactions which appear to be contrary to the provisions of this part;

5. The loans given by the producer company to the directors;

6. The donations or subscription given by the producer company;

7. Any other matter as may be considered necessary by the auditor.

Self Assessment Questions

1. The internal auditor is appointed by the management of the company. (True/False)

2. Every “Producer Company” shall have internal audit of its accounts carried out, at such interval and in such manner as may be specified in articles, by Chartered Accountants. (True/False)

4.3 Independence of Internal Auditor

You know that internal audit is an independent appraisal activity. But, as internal auditor is an appointee, his independence always remains doubtful. Yet, it cannot be denied that independence of an internal auditor is crucial for effective discharge of his duties.

This can be achieved only if he is given the requisite organizational position and if he possesses the required degree of objectivity.

1. Organizational Position: A proper organizational position for the internal auditing department ensures its relative independence so that it can carry out its work freely and deliver unbiased and

impartial report. An ideal organizational structure of an internal audit department is given in Figure 4.1:

Fig. 4.1

Figure 4.1 clearly reveal that in ideal situation the head of internal audit (in our figure: internal Audit Manager) should directly report to the Managing Director. This will ensure his independence in the organization. The Institute of Internal Auditors has also stated that, “the organizational status of the internal auditing department should be sufficient to permit the accomplishment of its audit responsibilities.”

2. Objectivity: Objectivity brings independence and independence brings objectivity. Both are two sides of the same coin. You are objective when you are impartial and unbiased. The same is applicable to Internal Auditor also. He should not assume any functional responsibilities in the organization. Otherwise his duty to review and repot will be biased. The Institute of Internal Auditors has opined that even designing, installing and operating the systems are not audit functions and they are likely to impair audit objectivity.

The Internal Auditor’s job is not to execute but to review, and advise. Some precautions on the part of internal auditor may preserve his independence and objectivity:

a) The internal auditor should always be and appear to be independent of the functions that he is auditing.

b) The internal auditor should necessarily follow the key fundamental principles of audit viz. integrity, objectivity and professional diligence.

c) Before taking any work, an internal auditor must honestly consider whether it involves threats to his independence.

d) During preparation of his report, internal auditor should be completely impartial and unbiased.

Self Assessment Questions

3. Objectivity brings independence but independence does not bring objectivity. (True/False)

4. The Internal Auditor’s job is not to execute but to review, and advise. (True/False)

4.4 Relationship between Internal and External Auditors

The scope and objectives of an internal audit are determined by the management while the external auditor has to carry out his functions under some statutory requirements. Hence, the objectives of Internal Audit and statutory audit are different. The main objective of statutory auditors is to express an opinion on true and fairness of financial statements. The report of statutory auditors is based on historical data.

The objectives of internal audit are much wider. The key responsible areas of internal auditor are operational audits, management audits, review of processes, practices and procedures etc.

In spite of the difference in the objectives of internal audit and external audit, there is ample scope of a gainful cooperation and coordination between external auditor and internal auditor.

Please refer Para 3.6 of unit 3 for a detail study on this topic.

4.5 Code of Ethics for Internal Auditor

In his book “Practical Guide for Internal Audit” R.S. Adukia has scholarly explained about the code of ethics for internal auditor which is as follows:

“This code of ethics sets the minimum requirements for the performance and conduct of internal auditors. This code applies to all internal auditors but does not supersede or replace the requirement on individual to comply with ethical codes issued by professional institutes of which they are members or student members and any organizational codes of ethics or conduct.”

There are four main principles:

1. Integrity: The internal auditor should demonstrate integrity in all aspects of their work. Their integrity establishes an environment of trust, which provides the basis for reliance on all activities carried out by the internal auditors.

2. Objectivity: Objectivity is a state of mind that has regard to all considerations relevant to the activity or process being examined without being unduly influenced by personal interest or the views of others. Internal auditors should display professional objectivity when providing opinions, assessments and recommendations.

3. Confidentiality: Internal auditors must safeguard the information they receive in carrying out their duties. There must not be any unauthorized disclosure of information unless there is a legal or professional requirement to do so.

4. Competency: The internal auditor should make use of his/her knowledge, skills and practical experience necessary for auditor’s activity performance.

They should not accept or perform work that they are not competent to undertake, unless they have received adequate training and support to carry out the work to an appropriate standard.

Achieving compliance with code of ethics

i) Security integrity: The internal auditor should:

a) Perform his/her job honestly, diligently and with responsibility.

b) Perform his/her profession in harmony with the acts and other generally binding regulations.

c) Avoid any illegal activity and performing any activity discrediting the internal auditor’s profession.

d) Respect the legal and ethical objectives of the organizations.

e) Take care that his/her integrity should not be compromised.

ii) Objectivity: The internal auditor should:

a) Avoid taking part in activities or relations which may damage, or might be understood as damaging his/her unbiased assessment including activities or relations which may be in conflict with public interests.

b) Avoid accepting anything that may damage or might be understood as damaging his/her objective professional assessment.

c) Protect his/her objectivity against political influence.

d) Disclose all substantial facts known to him/her that being undisclosed might misrepresent the conclusions on activities or events assessed.

iii) Observing Confidentiality: The internal auditor should:

a) Be careful when using and protecting information he/she gathered when auditing.

b) Avoid disclosing and making use of the information obtained during the auditor’s activities performance in order to damage the interests of other person or organization.

c) Avoid making use of the information obtained during the auditor’s activities for personal enrichment or in a way which would be in conflict with the law or which would damage legitimate and ethical interests of the organization.

iv) Demonstrating Competence:

a) It is a pre-requisite that all internal audit staff is aware of and understand:

1. The organization’s aims objectives, risks and governance arrangements.

2. The purpose, risks and issues affecting the service area to be audited.

3. The terms of reference for the audit assignment so that there is a proper appreciation of the parameters within which the review be conducted.

4. The relevant legislation and other regulatory arrangement that relate to the service area to be audited.

b) The internal auditor should keep educating himself constantly in order to have a good command of internal audit techniques and auditor standards necessary for obtaining, examining and evaluating the information.

v) Maintaining Audit Independence: Internal auditors should be independent of the activities they audit. Internal auditors are considered independent when they can carry out their work freely and objectively. Independence permits internal auditors to render the impartial and unbiased judgments essential to the proper conduct of audits. This is achieved through organizational status and objectivity. Independence stands for an internal auditor being able to take a stand and report on materiality issues, uninfluenced by any favors coercion or undue influence.

4.6 Quality of Internal Audit Personnel

What should be the qualities of Internal Audit Personnel? There is no universal answer to this question. We can only generalize about the qualities of internal Audit Personnel. It has been observed that internal auditors and independent auditors often belong to the same professional organization and are subject to the same professional regulations. Hence apart from professional qualification and experiences, the qualities of audit personnel should be same.

The Institute of Chartered Accountants of India (ICAI) has issued “SA-220-Quality Control for Audit Work” with an objective to establish standards on quality control as to the policies and

procedures regarding of an audit firm for audit work generally, and procedures regarding the work delegated to assistants on an individual audit.

The standard is equally applicable to an internal audit department also. The head of internal audit department should regularly review the quality of audit work based on the standard mentioned below. Important extract of SA 220 are given below.

Important terms

a) “The Auditor” means the person with final responsibility for the audit.

b) “Audit Firm” mean either the partners of a firm providing audit services or sole practitioner providing audit services.

c) “Personnel” means all partners and professionals staff engaged in the audit practice of the firm.

d) “Assistant” means personnel involved in an individual audit other than the auditor.

Audit firm

1. The audit firm should implement quality control policies and procedures designed to ensure that all audits are conducted in accordance with the standards on auditing.

2. The objectives of the quality control policies to be adopted by an audit firm will ordinarily incorporate the following:

a) Professional requirements: Personnel in the firm are to adhere to the principles of independence, integrity, objectivity, confidentiality and professional behavior.

b) Skills and competence: The firm is to be staffed by personnel who have attained and maintain the technical standards and professional competence required to enable them to fulfill their responsibilities with due care.

c) Assignment: Audit work is to be assigned to personnel who have the degree of technical training and proficiency required in the circumstances.

d) Delegation: There is to be sufficient direction, supervision and review of work at all levels to provide reasonable assurance that the work performed meets appropriate standards of quality.

e) Consultation: Whenever necessary, consultation within or outside the firm is to occur with those who have appropriate expertise.

f) Monitoring: The continued adequacy and operational effectiveness of quality control policies and procedures is to be monitored.

3. The firm’s general quality control policies and procedures should be communicated to its personnel in a manner that provides reasonable assurance that the policies and procedures are understood and implemented.

Individual audits

4. The auditor should implement those quality control procedures which are, in the context of the policies and procedures of the firm, appropriate to the individual audit.

5. The auditor, and assistants with supervisory responsibilities, will consider the professional competence of assistants performing work delegated to them when deciding the extent of direction, supervision and review, appropriate for each assistant.

6. Any delegation of work to assistants would be in a manner that provides reasonable assurance that such work will be performed with due care by persons having the degree of professional competence required in the circumstances.

Direction

7. Assistants to whom work is delegated need appropriate direction. Direction involves informing assistants of their responsibilities and the objectives of the procedures they are to perform. It also involves informing of matters, such as the nature of the entity’s business and possible accounting or auditing problems that may affect the nature, timing and extent of audit procedures with which they are involved.

8. Audit programme is an important tool for the communications of audit directions. Time budgets and the overall audit plans also helpful in communicating audit directions.

Supervision

9. Supervision is closely related to both direction and reviews and may involve elements of both.

10. Personnel carrying out supervisory responsibilities perform the following functions during the audit:

a) Monitor the progress of the audit to consider whether:

i) Assistants have the necessary skills and competence to carry out their assigned tasks;

ii) Assistants understand the audit directions; and

iii) The work being carried out in accordance with the overall audit plan and the audit programme.

b) Become informed of and address significant accounting and auditing questions raised during the audit, by assessing their significance and modifying the overall audit plan and the audit programme as appropriate; and

c) Resolve any differences of professional judgment between personnel and consider the level of consultation that is appropriate.

Q4. Explain the use of Sampling technique in Internal audit

Answer:

A reliability assessment of the organization's internal control system involves deciding how much evidence to gather. Because an examination of all underlying control data is not always feasible, auditors must often draw samples, audit the items selected, and extrapolate the results to the larger population.

Either a statistical or nonstatistical approach to sampling is acceptable under The IIA's International Standards for the Professional Practice of Internal Auditing and The American Institute of Certified Public Accountants' (AICPA's) Professional Auditing Standards. The use of statistics, however, will help auditors develop sample plans more efficiently and assess sample results more objectively than nonstatistical methods alone. Even a well-designed nonstatistical sample cannot measure the risk that the sample is not representative of the population - a distinct advantage of statistically based sampling plans. Moreover, increased regulatory requirements to provide greater assurance over internal accounting controls and company demands for greater productivity from their audit shops make statistical sampling a necessary part of the internal auditor's tool kit. Fortunately, auditors can use statistical sampling techniques without any detailed knowledge of classical statistical theory and still accomplish their audit objectives.

ATTRIBUTE SAMPLING

Attribute sampling plans represent the most common statistical application used by internal auditors to test the effectiveness of controls and determine the rate of compliance with established criteria. The results of these plans provide a statistical basis for the auditor to conclude whether the controls are functioning as intended, reflecting either control compliance or noncompliance - a binary (yes/no) proposition.

In developing an attribute sampling plan, the auditor must first define the audit test objective, population involved, sampling unit, and control items to be tested. For example, if the auditor's objective is to determine the percentage of sales orders lacking credit approval, the population will consist of all sales orders within a given period. Each sales order becomes the sampling unit, and sales order credit approval represents the control attribute to be tested.

STATISTICAL CRITERIA

The auditor must consider four statistical parameters to determine an appropriate sample size to select for the planned control test: confidence level, expected deviation rate, tolerable rate, and population. Although guided by assessed risk, inquiries of the audit client, and prior audit experience, each parameter is ultimately based on professional auditor judgment.

Confidence Level

The sample's confidence level refers to the reliability the auditor places on the sample results. Confidence levels of 90 percent to 99 percent are common. A 95 percent confidence level means the auditor assumes the risk that five out of 100 samples will not reflect the true values in the population.

The auditor's assessment of the control environment contributes to the level of risk the auditor is willing to assume. At a 95 percent confidence level, 5 percent — the complement of the confidence level — reflects the auditor's risk of "assessing control risk too low."

Expected Deviation Rate

The expected deviation rate represents the auditor's best estimate of the actual failure rate of a control in a population. The rate usually is based on client inquiries, changes in personnel, process observations, prior year test results, or even the results of a preliminary sample.

Tolerable Rate

The tolerable rate defines the maximum rate of noncompliance the internal auditor will "tolerate" and still rely on the prescribed control. Many auditors will coordinate with their audit client before establishing a tolerable level. Client control objectives help determine the nature and frequency of deviations that can occur and still allow reliance on the control.

Population

The population contains all items to be considered for testing. Each must have an unbiased chance of selection to ensure the final sample is representative of the population. For large populations containing thousands of items, population size will cause little impact on total sample size and is often irrelevant for audit sample planning.

APPLICATION OF THE METHODOLOGY

In a test of sales orders for appropriate credit approval, suppose the auditor estimates a 1.5 percent expected deviation rate of missing credit approvals relative to total sales orders, establishes a tolerable rate of 6 percent, and accepts a 95 percent confidence level that the sample results will reflect missing credit approvals fairly in the population. To calculate sample size, the auditor could use a variety of tools and techniques, including manual computations, statistical tables, and commercial software packages. For the statistical parameters provided, a sample size of 103 sales orders would be needed based on the "Statistical Sample Sizes for Test of Controls" chart below.

Each of the sales orders selected for audit must be randomly drawn to prevent bias in the sample results. Simple random sampling, such as choosing sales orders based on a random-number table, is the most common selection technique. Systematic selection - picking every nth sales order - is also acceptable if the first item sampled is randomly selected, though the results may be skewed if missing credit approvals occur in a systematic pattern. Because the random nature of the selection process will protect the validity of the statistical inferences, simple random sampling is normally the preferred method.

After selecting a sample of sales orders, the auditor would compare the documented credit approvals against the operating procedures in place, noting exceptions and performing other audit steps as necessary in light of sales order protocols unique to the business. Special consideration should be given to data anomalies resulting from the selection process. For example, missing sales order documentation should be treated as an audit exception because the condition implies that control over credit approvals has not been applied as prescribed. Alternatively, voided sales orders should be replaced by orders that have not been voided. Mere voiding of a sales order does not alone suggest a weakness in control over credit approval. 

Based on these procedures, suppose four sales orders lacked appropriate credit approval in the sample test. The auditor would project these results to the sales order population by calculating the upper deviation rate, a statistical estimate of the maximum deviation rate in the population. This rate can be determined using a simple statistical table or a manual or computer-generated computation. Based on the sample size and number of deviations found, the upper deviation rate in the sales example would be approximately 9 percent based on the "Statistical Sampling Results Evaluation Table for Tests of Controls" chart below.

AUDIT CONCLUSION

To form a statistical conclusion about the control tested, the auditor must compare the upper deviation rate to the tolerable rate in the sampling plan. If the upper deviation rate is less than the auditor's tolerable rate, the auditor would consider the control effective. Alternatively, if the upper deviation rate exceeds the auditor's tolerable rate, the auditor would consider the control ineffective. In the sales order example, the upper deviation rate(9 percent) exceeds the auditor's tolerable rate (6 percent). Therefore, the auditor would advise management not to rely on the control, concluding with 95 percent certainty that the rate of missed credit approvals exceeds the tolerable rate.

All audit sampling plans use the upper deviation rate as the basis for an audit conclusion because it includes an allowance for sampling risk, which provides protection against undetected deviations. For nonstatistical sampling plans, only the sample deviation rate can form the basis for an audit conclusion - a limitation of the nonstatistical approach.  

WORKPAPER OBJECTIVES

As with all audit procedures, the auditor must appropriately document the work performed. For a statistical sampling plan, the auditor's workpapers should include the essential elements, including the nature of the control tested (in the earlier example, sales order credit compliance

with organizational procedure); details of the population and sampling unit (prior-year sales orders and related credit approvals); the control deviation (missing credit approvals); the statistical parameters used (including the deviation and tolerable rates); the sample size; and the evaluation of results. The auditor's documentation should also describe how the audit test steps were performed, and should provide a list of the actual deviations found (namely, in our example, the missing credit approvals).

AUDITOR JUDGMENT

Regardless of the sampling approach used, professional auditor judgment must always govern the quality of the audit evidence. Even with statistical sampling, auditors must exercise judgment in determining the appropriate statistical parameters to use for a valid audit conclusion. Nonetheless, a statistical approach to evidence gathering, such as attribute-based sampling, will normally provide a more objective basis for evaluating sample results than nonstatistical techniques and enhance the quality of auditors' reporting to management.

Q5. Explain the internal control system in banks.

Answer:INSTRUCTIONS TO BANKS CONCERNINGINTERNAL CONTROL SYSTEMSA) Instructions to provide the Central Bank of Kuwait with the“Management Letter” prepared by the external auditors.B) Instructions to local banks concerning their internal control systems.C) General guidelines manual for the bank’s internal control systems, andexternal auditors’ evaluation reports thereof.D) Instructions regarding establishment of a system to evaluate and managerisks which a bank might encounter in its activities.E) Circular to all local banks on basel committee’s Operating GuideConcerning Risks associated with the settlement of FX transactions, andthe mechanisms proposed to the public and private sectors for containingthese risks.F) Circular to Banks for refraining from assigning the assessment of theAdequacy of its internal control systems or any other technical oradvisory tasks, to the audit offices that perform auditing work for thebank.G) Circular to banks for refraining from entrusting the assessment of theadequacy of its Internal Control Systems or any other technical oradvisory tasks of an auditing nature, to companies that have legal oreconomic ties with the Audit Offices that Perform Audit Work for theBank.H) Guiding principles issued by the based committee for good practice inthe management and control of operating risks at banks.I) Circular concerning the principles of good corporate governance in

financial institutions.J) Circular concerning the need for following the guidelines of BaselCommittee's Paper on Principles of e-banking risks management.K) Circular regarding .the need for following guidelines issued by BaselCommittee in April 2005 on the establishment of the compliancefunction and its role in banks.L) Circular concerning the enhancement of the aspects of banks internalcontrol systems, by taking the necessary actions to rectify thedeficiencies revealed in the applications of some information technologysystems or general controls system in some banks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls1Jumada Al-Aula 22, 1415 HOctober 27, 1994THE GENERAL MANAGER,Instructions to provide the Central Bank of Kuwait with the“Management Letter” to be prepared by external auditors *I would like to refer to the meeting No. (2/1994) held on July 11, 1994between the Governor and the Chairmen of local banks, whereby the CentralBank of Kuwait asked the banks to provide it with the report prepared by theexternal auditors for management purposes, namely the “ManagementLetter”.Meanwhile, I would like to advise you that the Central Bank of Kuwait hasnot received the above mentioned report, although more than 3 months havepassed since it was requested .Accordingly, you are kindly required to provide us with the aforesaid reportwithin one week from the date of this letter .Best Regards,Hameed Ahmed Al-RasheedManager of Supervision Department* Circulated to all local banks.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.A- Instructions to provide the Central Bank of Kuwait with the “Management Letter” prepared by the external auditors.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls2Thu Al-qi'da 16, 1415 HApril 16, 1995THE GENERAL MANAGER,Instructions to local banksconcerning their internal control systems *Within the framework of the activities undertaken by the local banking andfinancial institutions, and given the rapid and increasing developments ofoperations concluded in the various money and financial markets, and therelation of such developments to the activities of the local banking andfinancial institutions, and due to their positive or adverse reflection on suchinstitutions overall performance, it has become mandatory to have a writteninternal control system duly approved by the top management of the said

units. Procedures and rules of such a system should be sufficiently clear andeffective to ensure the protection of the aforesaid units against any adverseconsequences from errors committed by their personnel, or from noncompliancewith or not properly understanding the developments in thebanking and financial market activities. Nevertheless, a highly efficientinternal control system would realize the following objectives :(1) Assets of the banking and financial institutions should be protectedagainst any losses resulting from misuse or disposal thereof. Disposalof the assets must be concluded in accordance with the resolutions andrecommendations issued by the boards of directors of such institutions .(2) The risks involved in the banking and financial operations should beproperly monitored, evaluated and followed-up .* Circulated to all local banks.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.B- Instructions to local banks concerning their internal control systems.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls3(3) The operations recorded in the books of the banking and financialinstitutions should be carried out in consistence with the proceduresspecified by such institutions’ managements, and should be entered inthe records in accordance with the International Accounting Standardsand any other regulating criteria determined by the Central Bank ofKuwait.Within this context, and given Central Bank’s plan to ensure the availabilityof efficient internal control systems at the banking and financial institutions,your bank is required to take the following procedures :(1) Requesting your bank’s external auditor to evaluate your bank’s existinginternal control systems in accordance with the commonly acceptableaudit rules, and to provide us with a copy of the external auditor’s reportin this connection .(2) The audited closing financial statements should include a separatedetailed report prepared by your bank’s external auditor on the internalcontrol systems of your bank commencing from the fiscal year 1995.Such a report should identify the extent of the efficiency of such systemsin the light of your bank’s operations during the audited year .Best Regards,Hamad AbdulMohsen Al-MarzouqActing Manager of Supervision DepartmentINSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.B- Instructions to local banks concerning their internal control systems.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls4GOVERNORRajab 3, 1417 HNovember 14,1996THE CHAIRMAN,The general guidelines manual for the bank’s internalcontrol systems, and external auditors’ evaluation reports thereof

I would like to advise you that the Central Bank of Kuwait Board ofDirectors, at its meeting held on November 10, 1996, has approved “TheGeneral Guidelines Manual for the Banks’ Internal Control Systems and forExternal Auditors Evaluation Reports thereof”. The said Manual includesinstructions regarding the general requirements which the banks’ InternalControl Systems should satisfy .We attach herewith a copy of the said Manual, where your bank shallurgently come into compliance with the requirements contained in thecurrently implemented internal control system by your bank. Auditors’Reports prepared in the manner specified in the Manual shall be requested aseffective from fiscal year 1997.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.The Law, Supervisory & Regulatory Instructions & ControlsGeneral guidelines manual for internal control systems of banks, andaudited reports on the Evaluation thereofSECTION ITEM DESCRIPTIONONE INTRODUCTIONTWO ACCOUNTING RECORDS AND OTHER RECORDS∗ Introduction∗ General requirements∗ Information for managementTHREE INTERNAL CONTROL SYSTEMS∗ Introduction∗ General requirements∗ Controls in Information Technology Systems∗ Internal auditFOUR SCOPE OF AUDITED EXAMINATIONS AND REPORTS∗ Introduction∗ Scope review∗ The required reportFIVE ∗ FORMANT OF EXTERNAL AUDITORS’ REPORT ON ACCOUNTING,AND OTHER RECORDS AND INTERNAL CONTROL SYSTEMS28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & ControlsThe general guidelines manual for the banks’ internal control systemsand external auditors’ evaluation reports thereofSECTION ONEIntroduction1 - Under the provisions of Article "71" of Law No. (32) of year 1968concerning Currency, the Central Bank of Kuwait and the Organizationof Banking Business, the Central Bank requires that banks registered inKuwait should maintain adequate internal control systems that

commensurate with the size, nature and scope of the bank’s variousactivities. Banks should be committed to implement such systems tomanage the risks which they face in their day-to-day business .2 - It is the responsibility of banks’ board of directors and seniormanagement to ensure that accounting records, other records andinternal control systems are adequately maintained.3 - The Central Bank of Kuwait requires that all Kuwaiti banks shouldprovide it with reports on the adequacy of their internal control systemsprepared by local audit firms, whether acting in the capacity of externalauditors or not on an annual or other basis determined by the CentralBank of Kuwait.It is the responsibility of these “external auditors” to provide theiropinions and remarks on whether the regulations and internal controlsystems of the bank are sufficient enough in quality and quantity tomanage the risks that the bank faces in its day-to-day business.Thus, the external auditors are basically required to point out where theinternal controls systems are not adequate during examination periods,and submit relevant recommendations .28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.The Law, Supervisory & Regulatory Instructions & Controls- The purpose of this Manual is to provide guidance on the Central Bank’srequirements in relation to records and internal control systems thatshould be observed by all local banks to assist these banks to establishand implement sound internal control systems, and in particular toassist external auditors appointed by local banks to report on theadequacy of the records and systems of banks.These guidelines confirm the scope and nature of the financialinformation and data that should be considered in the accountingrecords and other records to be submitted to the bank’s management.Further, they should confirm the areas and nature of the internal controlsystems and the purposes for which such systems have been set by thebank management.These guidelines are prepared in such a manner to be:(a) sufficiently comprehensive to encompass the wide range of activitiesundertaken by local banks, whether those related to the balance sheetitems or off-balance sheet items, and whether exercised by the banksfor their own account or for the account of third parties.(b) relevant to the circumstances of both commercial and specializedbanks which undertake activities in varying degrees of volume andcomplexity .5 - The requirements and conditions for adequate accounting records andother records, and internal control systems to be maintained, shall applyonly to the banks registered in Kuwait, inclusive of the foreign branchesand subsidiaries that exercise banking business. It shall be taken intoaccount the circumstances and requirements established in compliancewith the laws and regulations currently in effect in the countries where

such branches and subsidiaries operate.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls8SECTION TWOAccounting records and other recordsIntroduction6 - The scope and nature of the accounting records and other records whichare required for the business to be conducted in a prudent manner shouldbe commensurate with the bank’s needs and particular circumstancesand should have regard to the manner in which the business isstructured, organized and managed, to its size and the nature, volumeand degree of complexity of its transactions and business areas. Aproper method shall be adopted for maintaining such records (whether interms of place or responsibility), in such a way to help those in charge tomanage the bank’s daily operations in a prudent manner.General requirements7 - This Manual does not aim at providing a comprehensively-detailed list ofthe types and forms of the accounting records and other recordsappropriate for each bank. Its purpose is to determine the generalrequirements that should be met in the aforesaid records to ensure properand systematic progress of work.The general requirements, which should be met in the accountingrecords and other records, are as follows:(a) record on a timely basis and in an orderly fashion every transactionand commitment which the bank enters into with sufficientinformation thereof to explain :(1) their nature and purposes;(2) any assets and/or liabilities, actual or contingent, whichrespectively arise or may arise therefrom; and(3) any income and/or expenditure, current and/or deferred, whichmay arise therefrom.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls9(b) Provide details, as appropriate, for each transaction and commitment,showing:(1) other participating parties whether totally or partially;(2) the amount and currency;(3) type of contract (new or renewal), value and settlement orrepayment dates;(4) the contracted interest rates of an interest-rate transaction orcommitment;(5) the contracted exchange rate of a foreign-exchange transaction or

commitment;(6) the contracted commission or fee payable or receivable together withany other related payments or collections;(7) the nature and current estimated value of any security or collateralfor a loan or other facilities; alongwith the physical location anddocumentary evidence of such collateral; and(8) statement of the assets provided by the bank as collateral in the caseof any borrowing from a third party.(c) Book-keeping and maintaining of the financial data and businessinformation, related to the bank’s activities in various areas, should bekept in such a manner so as to be extracted promptly to enablemanagement to achieve the following :(1) monitor the quality of and safeguard the bank’s assets, includingthose held as custodian ;(2) identify, quantify, control and manage its exposures or theoverdrawn positions by related counterparties across all bankproducts;(3) identify, quantify, control and manage its exposures and businessrisks, most important of which are : credit risks, liquidity risks,interest rates risks and foreign exchange risks and other market risksacross all products;(4) rationalize and monitor the performance of all aspects of its businesson an up-to-date basis; and(5) make timely and informed decisions;28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls10(d) Records should contain details of overdraft or exposure limits authorizedby management which should be appropriate to the type, nature andvolume of business undertaken (See item 10 / f). These limits should,where relevant, include the trading limits for each customer, sector, orcountry, the trading limits to accommodate the settlement risks,securities trading position limits as well as limits on the level of intradayand overnight open trading positions in foreign exchange operations,futures, options, swap agreements and future (or forward) interest rateagreements (FRAs) and limits of the maturity mismatches to encounterliqudity risks and interest rate risks, in a manner which ensuresavailability to necessary information on actual excesses to the said limitsto be readily, accurately and regularly measured;(e) Records should contain details of the factors considered, the analysisundertaken and the authorization or rejection by management of loans,advances or other credit exposure; and(f) Provision of necessary information on details of every transactionentered into in the name of or on behalf of a third party, whether thebank is acting as an agent or trustee .Information for management

8 - Every bank should prepare all data and information for directors andmanagement so that they can monitor, assess and control theperformance of its business, its financial position and the risk to whichit is exposed. Such information should be prepared on the bank as anindependent or individual unit and, where appropriate, on aconsolidated basis to cover all the subsidiaries.The frequency with which information is prepared, its level of detailand the amount of narrative analysis and explanation will depend uponthe level of management to which it is addressed. Some types ofinformation will be needed on a more frequent basis than others and itmay be appropriate for some to be presented on a basis of breaches ordeviations from agreed limits by way of exception reports, explainingsuch special cases.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls11Due regard should also be paid to the general requirements mentionedabove in Item (7) concerning the provision of information to bank’smanagement .9- It is the responsibility of directors and senior management to lay down asuitable information system, the quality and quantity of the requiredinformation, and to decide the management levels who should receive it.In general, appropriate management information should be provided tosome or all the following recipients :(a) The Board of Directors of the bank;(b) The executive officers who, either jointly or severally, are responsibleunder the immediate authority of the directors for the conduct of thebusiness of the bank; and(c) The managers responsible for exercising supervisory functions orformaintaining accounting records and other records.10 - This information should in particular include the following :(a) The financial position of the bank;(b) The operational results of the business both on a cumulative basis andby discrete period, and to give a comparison with budgets andprevious corresponding periods;(c) Analysis of assets and liabilities showing how they have been valued;(d) Analysis of off-balance sheet item positions, showing how they havebeen valued;(e) Analysis of income and expenditure, showing how they are relatedtodifferent categories of assets and liabilities and off-balance sheetpositions; and(f) Types of bank’s exposure to each risk, as compared to the relevantlimits set by bank management .28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.

CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls12SECTION THREEInternal control systemsIntroduction11 - The scope and nature of effective internal control systems for properand systematic progress of work should be consistent with the bank’sspecial needs and conditions, and should take into account the natureand size of the business, the diversity of operations, the volume andsize of transactions and degree of complexity, the degree of riskassociated with each area of operation, the amount of control exercisedby senior management over day-to-day operations, the degree ofcentralization in work management and the extent of reliance oninformation technology. In this regard, attention should be paid to theextent of conformity or proportion between the efforts of implementingthe procedures or applying various control systems, or maintainingthereof on one side, and the expected or attained benefits, whetherfinancial or non-financial, on the other.The internal control systems must be designed to provide reasonableassurance of realizing the underlying objectives, as there should benecessary assurance that all bank’s revenues accrue to its benefit, allexpenditure is duly authorized and properly disbursed, all assets areadequately safeguarded, all liabilities are recorded, all statutoryrequirements relating to the provision of accounts are complied withand all prudential reporting conditions are strictly adhered to in such amanner for providing management information.General requirements12- It is a responsibility of directors and management to set up, review,monitor and test the bank’s systems of internal control on a regularbasis in order to assure their effectiveness on a day-to-day basis andtheir continuing relevance to the business. In many banks an internalaudit function will assist management by providing an independentreview of such systems (see Items 26-30 below).28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls1313- This Manual does not aim at presenting a comprehensive list of internalcontrol procedures, which would then be applicable to any bank, nor isit possible to prepare a detailed list of particular procedures whichshould be undertaken, where appropriate, by all local banks. However,it aims at specifying the general requirements, which should beavailable in effective internal control systems to ensure the soundprogress of banking business.14- The internal control systems adopted in the banks should providereasonable assurance that :(a) The business is conducted in an orderly and prudent manner in

adherenceto established policies and limits.(b) Transactions are entered into according to the established authority .(c) Monitoring and control systems are in place to enable the managementtosafeguard the assets and control the liabilities of the business.Assurance should also be there to availability of procedures andmeasures to minimize the risk of loss from irregularities, fraud orerror, and which ensure that the adopted systems are capable ofpromptly and readily identifying those losses when they occur.(d) The accounting records and other records of the local bank shouldprovide complete, accurate and timely information (in the mannerreferred to under SECTION TWO of this Manual) .(e) Management is able to monitor on a regular and timely basis thefinancial positions’ elements (capital adequacy of the bank, itsliquidity, its profitability, the quality of its assets and the associatedrisks) (See Item 10).(f) Systems and controls are in place which allow the bank’s managementto identify and assess the risk of loss encountered by the bank in theconduct of various areas of business so that :28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls141- The risks can be monitored and controlled on a regular andtimely manner .2- Appropriate provisions can be made for bad and doubtful debts,and for any other risks, either on or off-balance sheet items.(g) Management is able to prepare all returns made to the Central Bank ofKuwait accurately, and in accordance with the Central Bank’sinstructions and to submit them on a timely basis .15 - The following are the most important control areas and issues that eachbank should address in order to create an effective internal controlsystem:(a) organizational structure;(b) performance monitoring and control procedures;(c) segregation of duties and responsibilities;(d) authorization and approval;(e) completeness and accuracy;(f) safeguarding assets; and(g) manpower.The following items (from No. 16 to 22) will address such elements asfollows:Organizational structure16 - Banks should formulate and document the organizational structureappropriate to the size and nature of various banking activities. Such astructure should demonstrate the job standards and neededadministrative committees and their interrelation with the Board ofDirectors, in addition to defining and allocating responsibilities,

identifying lines of reporting for all aspects of the bank’s operations,including the key controls and giving outline job descriptions ingeneral. Special emphasis should be laid on the managerial positions inthis regard.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls15Performance monitoring and control procedures17 - A bank should have procedures in place to ensure that relevant andaccurate management information covering the financial position andperformance of the bank and the exposures which the bank has enteredinto are provided to appropriate levels of management on a regular andtimely basis (See Items 8-10).Procedures should also be in place to ensure compliance with thebank’s policies and practices, including any limits on delegatedauthority referred to in Item (16), along with statutory, and supervisoryrequirements .Segregation of duties and responsibilities18 - A prime means of internal control is the separation of thoseresponsibilities or duties which would be applied in such a manner thatprohibits a single individual from recording and processing a completetransaction. Segregation of the duties reduces the risk of intentionalmanipulation or error and increases effectiveness of the element ofauditing functions and control process.The functions and tasks which need to be segregated so that each ofthem would be carried out by a different staff shall be listed as follows:(a) authorization or approval of transactions(b) execution (processing & inputting)(c) settlement of payments(d) valuation(e) reconciliation, or settlement of suspense transactions(f) possession of assets(g) recording28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls16Where appropriate (for example, loans or treasury transactions) the abovefunctions should be separated both physically and organizationally. Accessto computerized accounting or monitoring/recording systems by bank staffshould be selective (eg. a marketing officer may not input customer’s limitsor transactions for dealing with or be allowed to record details of deals).Also, in the case of computer-based systems, systems development and dailyoperations (such as transactions processing or payments) should beseparated.

Authorization and approval19 - All transactions should require authorization or approval by anappropriate person based on assigned authorities and responsibilities. Itshall be observed that the authorities entrusted are proportionate withthe responsibilities of various staff levels, taking into consideration thenature, size and degree of complexity of the bank’s operations.Completeness and accuracy20 - Banks should set up controls to ensure that all transactions to berecorded and processed have been authorized, are correctly recorded,and are accurately processed in compliance with the establishedprocedures.Such regulations and controls should basically include checking theaccounting and arithmetical accuracy of the amounts of entries againstthe document records; checking valuation processes, settlement ofsuspense transactions or reconciliations (including not just internallybetween various registers and accounts, but also externally withcounterparties), control accounts and trial balances.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls17Safeguarding assets21 -A bank should set up controls to ensure that access (whether directly orindirectly) to assets or information is limited to authorized personnel.These controls are of particular importance in the case of valuable, andportable assets, which can be exchanged or disbursed, and assets heldby the bank as custodian.Manpower22 - The bank must adopt relevant policies and procedures to ensure thatpersonnel have capabilities commensurate with their responsibilities.The proper functioning of any system depends on the competence andintegrity of those operating it. The qualifications, recruitment andtraining policies as well as the innate personal characteristics of thepersonnel involved are important features to be considered in setting upany control system. Due regard in this context should be paid to therequirements of Article (68) of Law No. (32) of year 1968 (as amendedunder Amiri Decree Law No. (36) of year 1992) concerning BoardDirectors, head of executive staff, and his deputies and assistants.Controls in an information technology environment23- The information held in electronic form within a bank’s informationtechnology systems is a valuable asset that needs to be protected againstunauthorized persons for the purpose of accessing to records anddisclosing of information. Such a protection is required to avoid risks ofirresponsible or unauthorized usage of banks’ information. The internalcontrol elements described above apply equally to operationsundertaken in the both manual and electronic environments althoughthere are additional risks associated with electronic environments,

which shall be addressed in the following paragraph.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls18It is the responsibility of management to understand the extent to whicha bank relies upon electronic information to assess the value of suchinformation and to establish an appropriate system of controls.The Central Bank of Kuwait recognizes that proper control will usuallybe achieved by a combination of manual and automated regulations, thebalance of which will vary between banks, reflecting the need for eachbank to study the proper regulations and their cost so as to achieve thecontrol objectives effectively.24 - The type of risk most often associated with the use of informationtechnology in banking and financial systems may be classified asfollows :(a) Fraud and theft :-Access to information and systems can createopportunities for the manipulation of data in order to create or concealsignificant financial losses. Additionally, information can be stolen,even without its physical removal or awareness of the fact, which maylead to loss of competitive advantage. Such unauthorized acts can becommitted by persons with or without legitimate access rights to therecords and information .(b) Errors :-Although errors most frequently occur during the manualentry or inputting of data and the development or amendment ofsoftware, errors can be introduced at every stages in the life cycle ofan information system. Therefore, adequate attention should be paid tothe review and checking procedures .(c) Interruption and failure :-The components of electronic systems arevulnerable to interruption or failure; without adequate contingencyarrangements, this can lead to serious operational difficulty and/ordrastic financial loss .(d) Misinformation :-Problems may emerge in systems that have beenpoorly specified or inaccurately developed. These problems mightbecome immediately evident, but can also pass undetected for a periodduring which they could undermine the veracity of supposedly soundinformation. This is a particular risk in systems where audit trails arepoor and the processing of individual transactions are difficult tofollow .28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls19Information security25 - Banks management should be aware of their responsibility to establishand maintain a climate of security awareness and vigilance as to the

importance of security measures throughout the bank.In particular, it should give consideration to :(a) Adopt a security information policy, comprising standards, proceduresand responsibilities, designed to ensure that arrangements areadequate and appropriate; and(b) Provide security education and training, designed to make all relevantstaff aware of the need for, and their role in supporting, good securitypractice for such information and the importance of protecting bank’sassets.Internal audit26 - Internal audit represents an integral part of the systems of internalcontrol whose rules are established and maintained by the bank’smanagement and may provide independent assurance over the integrityand effectiveness of such systems .27 - The existence of an independent Internal Audit Function for local banksis mandatory, which the local banks should meet so as to provide anindependent evaluation of the efficiency and accuracy of the adoptedcontrols and systems.The scope and objectives of internal audit are dependent upon thejudgment of management as to its own needs and duties, in the light ofthe size and structure of the bank and the risks inherent in its business.Important considerations in assessing the effectiveness of internal auditinclude several factors, most importantly: the extent of independencefrom the executive management, adequacy of scope and frequency ofthe audit, adequacy of audit procedures, its reporting systems and thequality of its audit staff (see paragraphs 29 and 30 below).28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls2028 - The most important internal audit functions within the internal controlarena are as follows:(a) review of accounting records and other records and the internalcontrol environment;(b) review of the appropriateness, scope, efficiency and effectiveness ofthe adopted internal control systems;(c) detailed testing of transactions and balances to ensure that specificcontrol objectives have been met;(d) review of the implementation of management policies; and limitsestablished at the bank; and(e) special investigation for the bank’s management .29 - The bank’s management should ensure that the internal audit functionis appropriately structured and resourced, where the informationnecessary for performing such functions are available so as to enable itto provide the independent appraisal of internal control regulations.There should be clearly defined terms of reference in respect of internalaudit functions (audit by-laws, audit manual, etc). Internal audit

independence should be assured by determining the audit reporting lineand thereafter the parties to which the audit reports should besubmitted, namely an obligation to report regularly to the bank’s boardof directors or the bank’s audit committee (formed by the bank’s board)the internal audit may also report directly to the chairman of the board,taking into consideration that in the cases where the internal auditreports to the audit committee, it shall advise the board of directors, atleast twice a year, on the audit’s major findings and on the actionstaken in their respect. Nevertheless, in cases where the internal auditreports are submitted to the chairman of the board, the chairman shallpresent the audit report (or a summary thereof comprising the mostimportant audit findings) to the board of directors at its next meeting.Once agreed, audit reports should be circulated more widely to theappropriate department heads. Generally, management or bankdepartments must be given a sufficient time period to respond in areport to the audit comments.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls21Generally, internal audit should not have authority or responsibility forthe activities it audits (i.e. internal audit should not administer internalcontrols but only check on their adequacy and efficiency of suchsystems).30 - Appropriate arrangements should be made to enable the Internal Auditto have unrestricted access to all bank’s activities, records, property andpersonnel to the extent necessary for the effective completion of itswork. The internal audit function should be staffed with individualswho are appropriately qualified or the function either by holdingprofessional qualifications or by having the requisite practicalexperience.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls22SECTION FOURScope of examination and auditors’ reportsIntroduction31 - The examination of accounting records, systems and controls willnormally cover a twelve-month period. The first step will arise from anannual letter of instruction from the Central Bank of Kuwait to theconcerned bank requiring it to furnish the Central Bank with the subjectreport, and defining therein the scope of examination and any otherrelevant instructions. In compliance with such a notification, theconcerned bank shall send an assignment letter to the external auditor tocarry out the tasks required and prepare the requested report. A copy of

this letter shall be sent to the Central Bank of Kuwait.32 - The external auditors appointed by a bank and approved by the CentralBank will be required to form their opinion on whether the bank’saccounting records and other records and internal control systems havebeen maintained by management during the period examined inaccordance with the Central Bank’s requirements stipulated in thisManual in respect of adequacy of the accounting records, other recordsand internal control systems . In forming this opinion, they will beexpected to have regard to the nature, scope and scale of the businessundertaken by the bank .33 - Where during the course of their work, the external auditors find outthat one of the Manual requirements is not, or has not been fulfilled, bythe concerned bank and believe that the matter is likely to be ofmaterial significance for the exercise of the Central Bank’s supervisoryfunctions, the matter should be reported by the external auditors to theconcerned bank, which in turn should pass the information to theCentral Bank of Kuwait without undue delay. Where the externalauditors believe that a serious matter should be reported as a matter ofurgency, they should request the concerned bank to report the matterimmediately to the Central Bank of Kuwait to this effect.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls2334 - The circumstances giving rise to an opinion qualified by exceptions orcases of reservation include those where :(a) certain records and systems do not exist and the external auditorsconsider that they should exist in order to assist management toconduct the business of the bank in a prudent manner on a day-to-daybasis;(b) there is, or has been, a significant weakness in, or failure of, certainrecords or systems during the period examined; or(c) the external auditors are unable to form an opinion on a particularaspect of the records and systems and therefore wish for the matter tobe discussed jointly at a tripartite meeting with the Central Bank ofKuwait .35 - The Central Bank of Kuwait does not require external auditors to reportall omissions, weaknesses and failures however minor in the existence,nature, scope and effectiveness of records and systems. Rather, itrequires them to report those, which individually or collectively in theiropinion do not enable them to give reasonable assurance that therequirements set out in this Manual are satisfied.The Central Bank of Kuwait expects the external auditors to indicate intheir reports any form of repeated deficiencies detected in theirprevious examinations.Scope review36 - When the Central Bank of Kuwait commissions a full scope review, it

expects the external auditors to consider the adequacy of theaccounting records and other records and internal control systems,including the internal audit function, throughout the bank.In addition, the external auditors should consider whether the bank’sprocedures are adequate to prevent and detect any money-launderingcases, and submit reports on suspicions related thereto. (See alsorecommendations applicable related to combating money launderingissued in February 1994) .28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls2437- The banks may, in consulation with its external auditors and with theagreement of the Central Bank of Kuwait, commision the externalauditors to carry out a limited scope examination of the records andinternal control systems in one year on one or more of the bank’s areasof activities and confine their reports to such area(s), as part of a rollingaudit programme of examinations spread over a number of years as analternative to a comprehensive or “full scope” examination whichcovers all the areas and activities of the bank each year.38- The Central Bank of Kuwait does not expect the external auditors toexamine or evaluate the bank management’s resolutions and projectionsrelevant to banking affairs.The required report39 - The external auditors should submit their reports to the board ofdirectors in the case of a Kuwaiti bank or to the General Manager in thecase of a Kuwait branch of an overseas-incorporated bank and shouldtake the form of the proforma report set out in SECTION FIVE of thisManual.The Central Bank requires the examining auditors to give an overallassessment of the control environment for each business area whichthey have been asked to examine. The external auditors, unlessexempted in the scope assignment letter, should give limitedbackground information on the examined business area including anorganizational structure, nature and approximate volume of transactions(where appropriate), in addition to the key risks faced by the bank andthe key controls in operation.40- Where the external auditors’ report is qualified by exceptions, thereport should clearly set out the risks which the bank runs by notcorrecting the existing weakness, with an indication of the severity ofthe weakness and its adverse impacts should it not be corrected. Theactual time frame for complying with each recommendation is a matterto be decided between the bank concerned and the Central Bank ofKuwait, although this should be discussed at a trilateral meeting.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.

CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls2541- The report should be completed, with such remarks and comments asthe bank’s management see fit to make, and submitted to the CentralBank of Kuwait by the bank within the time scale laid down by theCentral Bank of Kuwait, but not later than four months after end of theperiod examined.The comments of the bank’s managements should be sent to theexternal auditors at the same time as these comments are submitted tothe Central Bank of Kuwait.If the external auditors conclude, after discussing the matter with thebank, that they will give a qualified opinion, the bank must immediatelyinform the Central Bank of Kuwait in writing requesting a tripartitemeeting therefore. The bank should also send the external auditors acopy of the same letter.If the bank, for whatever reasons, is unable to submit a report to theCentral Bank of Kuwait within the required period, it should inform theCentral Bank in writing of the reasons for the delay, as soon as the bankbecomes aware the deadline will not be met.42- The required report format to be submitted to the bank’s board ofdirectors (see the format contained in SECTION FIVE) has beendesigned on the basis that it will be prepared by a Kuwaiti audit firm.If exceptionally, a report from the home country’s external auditors orhome country’s supervisors is accepted by the Central Bank of Kuwait,the said report would be made on the same basis and terms as therequired report.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls26SECTION FIVEFormat of the external auditors report on Accountingrecords and other records and internal control systems to besubmitted to bank board of directorsTo: The Board of Directors of Bank ........ K.S.C.In accordance with your letter of assignment dated / /199, we haveexamined the accounting records and other records and internal controlsystems of your Bank, which were in existence during the year/period ended/ /199, as related to (please mention the activities and locations whichhave been examined) .Our examination has been carried out with regards to the Central Bank ofKuwait’s General Guidelines Manual dated / /199 and in accordance withInternational Auditing Standards.We would like to indicate that you as Directors of ...... Bank K.S.C. areresponsible for establishing and maintaining adequate accounting systems,other records and internal control systems for your bank, taking into accountthat the related cost of such systems should commensurate with the benefits

expected from implementation thereof. It shall be observed that the objectiveof this report is to provide reasonable, (but not absolute), assurance thatassets are safeguarded against loss from unauthorized use or disposition, thatbanking risks are properly monitored and evaluated, that transactions areexecuted in accordance with established authorization procedures and arerecorded properly, and to enable you to conduct the business in a prudentmanner, with care and caution.Because of inherent limitations in any accounting and internal controlsystem, errors or irregularities may nevertheless occur and not be detected ortraced. Also projection of any evaluation of the systems to future periods issubject to the risk that management information and control procedures maybecome inadequate because of changes in conditions or that the degree ofcompliance with those procedures may deteriorate.In our opinion, having regard to the nature and scale of the business, duringthe year/ period ended ………..28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls27EitherThe accounting records and other records and internal control systemsexamined by us were established and maintained in accordance with therequirements of the General Guideline Manual issued by the Central Bank ofKuwait on / /199 (with the exception of the matters set out in the Appendixattached to this report) .Or :The accounting records and other records and internal control systemsexamined by us were not established and maintained in accordance with therequirements of the General Guidelines Manual issued by the Central Bankof Kuwait on / /199 for thereasons set out in the Appendix attached to thisreport .Kuwait on: / /199Name : …………Auditors’ License No.: ………Category : ……….Member of : …………Signature : …………28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.C- General guidelines manual for the bank’s internal control systems, and external auditors’ evaluation reports thereof.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls28GOVERNORSafar 21, 1418 HJune 26, 1997THE CHAIRMAN,Circular to all local banks(1)

No. (2/BS/37/1997)I would like to refer to issues raised in the meeting held on 12/5/1997 withthe Chairmen of the local banks regarding each bank’s situation in respect of“Risk Management” and assessment of “Asset Risk Management” thatmight be encountered by the banks. In addition, the meeting has discussedthe Central Bank’s requirements regarding banks’ internal control systems,particularly those related to the systems of risk assessment and management,contained in the “General Guidelines Manual for the Banks’ Internal ControlSystems, and Auditors’ Evaluation Reports thereof” sent to your bankattached with the letter dated 14/11/1996, requesting full compliance as earlyas possible with the essential conditions therein.Due to the importance of this issue, the Central Bank of Kuwait asserts thatdue and sufficient care should be paid for establishing a system to be basedon professional and practical principles for assessing and managing the riskswhich might be encountered by your bank throughout its various activities.It would be adequately convenient to consider the concept of establishing aspecialized unit for this purpose, where competent staff with the necessarycapabilities and facilities should be maintained for proper performancethereof.Correspondingly, the Risk Assessment and Management System to beapplied by your bank should encompass the rules and regulations that securerealization of the following:(1) Circular dated 13/10/2003 was issued concerning guiding principles Committee for good practice in themanagement and control of operating risks at banks.28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.D- Instructions regarding establishment of a system to evaluate and manage risks which a bank might encounter in its activities.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls291- Identify and specify types and volume of risks to be encountered by thebank in its various activities, most important of which are the risksrelated to: credit, liquidity, interest rates, foreign exchange and marketrisks. In this connection, banks shall follow the formats and methods ofevaluating the risks matching with the bank’s volume and nature ofactivities, and level of diversification and complication of its operations.2- To secure for the bank’s senior management all data and informationrequired to identify and evaluate loss risks to be encountered by the bankin its various fields of activities in such a manner so as to assist inmanaging and monitoring the risks in a regular way, and in the suitabletime; and to specify the provisions appropriate to problem debts and toany other risks, whether related to balance items and off-balance items.Preparation of such data shall be concluded at level of bank as anindependent unit, and at consolidated level containing the bank’ssubsidiaries, when required.3- The system’s outputs should include volume and types of exposures thatmight be encounted by the bank throughout its activities.Finally, your bank shall comply with the above requirements as early as

possible, not later than end of 1997, and furnish the Central Bank of Kuwaitwith all measures implemented in this concern.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTIONS TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS.D- Instructions regarding establishment of a system to evaluate and manage risks which a bank might encounter in its activities.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls30GOVERNORSafar 2, 1421 HMay 24, 2000THE CHAIRMAN,Circular To All Local BanksThe Settlement and Payments Systems Sub-committee of Basle Committeepassed an operating guide in January, 2000, on “FX Transactions SettlementRisks Control”, which addressed the risks associated with the arrangementsadopted in the banks in respect of settlement of the FX transactions, and theproposed work mechanisms for the both public and private sectors, in orderto contain such risks, through various guidance papers specially prepared forthis purpose.Within this context, it is worth mentioning that the Central Bank of Kuwaitsupport the attention given to this issue by the Basle Committee and all othercentral banks within the (G10) group. Central Bank of Kuwait also urgesyour bank to ascertain the adequacy and efficiency of its FX transactionssettlement arrangements, in a manner that achieves integrity and strength ofyour bank’s financial position, the adequacy of its liquidity ratios andfinancial solvency in general.We would also like to confirm the contents of our circular No.(2/BS/37/1997) dated 26/6/1997, requiring the local banks to developadvanced systems to measure and manage the risks which they would beexposed to in the areas of their various activities, through establishingspecialized units comprising the necessary expertise and personnel toperform the function in the desired manner.In addition to the aforesaid, your bank’s efforts must focus on containing therisks associated with the said transactions through adopting workmechanisms which would help your bank ascertain adequacy of the systemsadopted to manage risks of the FX transactions settlements, properlymeasure the risks of the FX operations settlements, and check the adequacyof the control and follow-up systems of the obligations resulting from theFX trading transactions.28- INSTRUCTIONS TO BANKS REGARDING INTERNAL CONTROL SYSTEMS.E- Circular to all local banks on Basel Committee’s Operating Guide Concerning Risks associated with the Settlement of FXTransactions, and the Mechanisms Proposed to the Public and Private Sectors for Containing these Risks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls31In order to advise your bank of the practical applications currently available

for management and measurement of the FX transactions settlements risks,enclosed please find a diskette containing the following informative papers:1. Description of practical steps that bank and other trading institutions cantake.2. Joint industry providers of bilateral netting services.3. Guidelines for foreign exchange settlement netting (NYFEC).4. IFEMA agreement and accompanying documentation (IFEMA).5. Settlement Risk in Foreign Exchange Transactions; CPSS; March, 1996.6. Reducing Foreign Exchange Settlement Risks: Progress Report; CPSS;July 1998.In case your bank desires to obtain further information on this issue, pleasevisit the internet site of the subject committee.www.bis.org/publ/index.htmWith my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTIONS TO BANKS REGARDING INTERNAL CONTROL SYSTEMS.E- Circular to all local banks on Basel Committee’s Operating Guide Concerning Risks associated with the settlement of FXtransactions, and the mechanisms proposed to the public and private sectors for containing these risks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls32GOVERNORJumada Al-Akhir 6, 1423 HAugust 14, 2002THE CHAIRMAN,Circular to All local BanksI wish to point out that according to the “General Guidelines Manual onLocal Banks Internal Control Systems and External Auditors Reports on theAssessment of these Systems” – endorsed by the Central Bank of KuwaitBoard of Directors in its meeting on 10/11/1996 and sent to you on14/11/1996 - it is mandatory to obtain the Central Bank of Kuwait approvalof the auditors entrusted with both the assessment of your bank’s internalcontrol systems as per the manual requirements, and the preparation of therequested relevant report.To enhance the independence of the auditing function entrusted by thebank’s General Assembly to auditors, and in order to achieve the highestpossible shareholders’ confidence in the auditors reports on the bankfinancial data, your bank shall not assign the assessment of its internalcontrol systems to audit offices that perform audit work or any othertechnical or advisory tasks for the bank. It is noted that in order to obtain theCentral Bank of Kuwait approval of an auditor for carrying out the auditfunction or assessment of the bank’s internal control systems, that auditorshall be part of an international audit office.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTION TO BANKS REGARDING INTERNAL CONTROL SYSTEMS.F- Circular to banks for refraining from assigning the assessment of the adequacy of its internal control systems or any other

technical or advisory tasks, to the audit offices that perform auditing work for the bank.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls33GOVERNORSha'aban 10, 1423 HOctober 16, 2002THE CHAIRMAN," Circular to All local Banks "Further to the Central Bank of Kuwait circular dated 14/8/2002 to banksprohibiting them from assigning the assessment of their internal controlsystems or any other technical or advisory tasks, to audit offices that performaudit work for the bank.And, pursuant to the provisions of Article (20) of the Decree law No. (5) foryear 1981 regarding the exercise of the auditing profession, which prohibitsauditors from exercising any other occupation conflicting with that ofauditing, particularly the occupations distinctly mentioned in that article.We wish to clarify that your bank shall refrain from assigning theassessment of the adequacy of its internal control systems or any othertechnical or advisory tasks, to the audit offices that perform audit work forthe bank, whilst also not assigning other technical or advisory tasks ofauditing nature (such as designing accountancy records, providing advice onalternative accountancy treatments) to companies that have legal oreconomic ties with these offices, whether such ties are through jointownership or joint management.Therefore, your bank may entrust these companies with only other technicalor advisory tasks of no auditing nature (such as the preparation offeasibility studies, action plan review, developing the salaries and wagesstructure, and the provision of advise on personnel recruitment)With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTION TO BANKS REGARDING INTERNAL CONTROL SYSTEMSG- Circular to banks for refraining from entrusting the assessment of the adequacy of its internal control systems or any othertechnical or advisory tasks of an auditing nature, to companies that have legal or economic ties with the audit offices thatperform audit work for the bank.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls34GOVERNORSha'aban 17, 1424HOctober 13, 2003THE CHAIRMAN," Circular to All Local Banks"Guiding principles for sound practices for the managementand supervision of operational risk at banksBasel Committee for Banking Supervision issued a set of Principles forSound Practices for the Management and supervision of Operational Risk inbanks. The main areas covered by these principles are as follows:

(1) Stressing the importance of defining operational risk as belonging to adistinct category of risks alongside credit, market and interest rate risks.The Committee is adopting that approach, in keeping with the maindevelopment trends in the operational risk issue.(2) Determining the principles underlying sound practice in the managementand supervision of operational risk in banks, and the role of the Board ofDirectors and Senior Management in setting up, endorsing and applyingadequate framework in this regard, including policies and procedures,.(3) That each bank – independently of the size of its business – lays downpolicies and procedures (framework), to determine, evaluate andsupervise operational risk, as part of the overall risk management system,in line with the Basel Committee’s directives.(4) That banks adequately disclose information to allow market participantsto evaluate banks’ approach to managing operational risk.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls35In keeping with the policy adopted by Central Bank of Kuwait for thealignment of Kuwaiti banking business with international practices in thatfield, we have attached hereto a copy of the mentioned guiding principles,for your observance of the requirements provided therein, at the earliestpossible convenience. In this context, we wish to stress the content ofCentral Bank of Kuwait instructions provided in the general guidelinesmanual on internal control, issued on 14/11/1996, along with the instructionsissued on 26/6/1997, in regard to establishing a specialized unit and settingup a system for the assessment and management of risks, in fulfillment ofthe needed supervisory regulations for managing risks at banks in general.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls36Guiding principles for sound practices for the managementand supervision of operational riskGeneral principles and definitions1 - Over the last few years, the banking business witnessed incessantquantitative and qualitative changes in regard to products and services.These developments were accompanied with the application of advancedand complex technologies in the electronic processing of data andinformation, and paralleled by an increase in operating risks at banks,whereby these risks developed into a distinct category alongside thecategories of credit, market and interest rate risks.

Within the context of subjecting these developments to the internationalrules and standards applied in banking business, the Basel Committeeissued guidelines to banks, encompassing principles of sound practice forthe management and supervision of operational risk. Such guidelines arebased on those principles.2 - Operational risk has been defined as the “ risk of loss resulting frominadequate or failed internal processes people and systems or fromexternal events “.Examples of these risks include risks deriving from the electronicprocessing of data, and those deriving from over-extended usage ofelectronic banking, along with risks concerning system security, breachof confidentiality, fraudulent operations perpetrated from inside oroutside the institution, misuse of clients’ information, as well as risksassociated with banks’ mergers, shift in systems’ usage, moneylaundering,practices of illicit activities, and damage to physical assets orproperty due to deliberate acts of violence or natural disasters, in additionto risks resulting from vendor disputes, risks concerning salaries andcompensation claims, and legal risks.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls373 - Though the term ‘Operational Risk’ may have a variety of meaningswithin the banking industry, and though the policies required formanaging these risks may vary among banks in light of the divergence insize and nature of business, as well as the difference in levels ofrelatedness among the components of each bank’s business, there are stillseveral elements common to them all, which constitute the structure ofoperational risk management, regardless of the differential in businesssize among banks.This requires each bank to determine the operational risk whichconstitute the main reasons of operating losses, along with laying downthe policies and procedures that are appropriate for the management andsupervision of these risks, and in tune with the size and nature of eachbank’s business, within the context of managing all types of risks whichthe bank is exposed to.4 - Though it is noted that the issue of operational risk is not new to banks,an important current trend in that regard is represented in the efforts ofinternational financial standards to set up systems and instrumentsfor managing theses risks as belonging to a distinct category, at anequal level with the management of other risk categories.*Principles of Sound Practice for the Managementand Supervision of operational riskConsidering the general principles and definitions, banks have thefollowing obligations:First : Laying down policies and procedures for the management of

operating risks, including the principles of how operational risk isto be identified, assessed, monitored and controlled. These policiesshall be regularly endorsed and reviewed by the Board ofDirectors.Second: Subjecting the policies and procedures for the management ofoperating risks to effective and comprehensive internal audit byqualified auditors. The Board of Directors shall ensure that thescope and periodicity of audit are commensurate with the level ofbank’s exposure to operating risks, and that the audit reportsindicate the extent of effectiveness of these policies.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls38Third : Applying policies and procedures for the management ofoperational risk, as a consistent effort between the organizationunits at the bank, along with informing all staff members andofficials of all aspects involved into the management of theserisks; The bank’s senior management is considered responsible forlaying down and applying these policies, along with theirdevelopment to fit the management of operational risk associatedwith the bank’s products and activities.The Senior Management shall ensure that individuals incharge of managing operational risk are in constant contactwith those in charge of managing credit and market risks,within a coordinated framework that serves the objectives ofmanaging the bank’s overall risks.Fourth: Identify and assess the operational risk inherent in all materialproducts, activities, processes and systems. An adequateassessment procedures should be taken before introducing newproducts. Within that context, the bank shall be aware of theinternal factors influencing operational risk, such as the bank’sstructure, the nature of its activities, and its human resources,along with identifying and evaluating the relevant external factors,such as changes in banking work and developments in informationtechnology.When assessing operational risk, the bank shall identify the areasof weakness and strength in its operating procedures andregulations. In order to enhance the efficiency of riskmeasurement, each bank may develop its particular workingmethods, so as to transform qualitative operating risks intoquantitative measurement risks.Fifth : Applying appropriate measures to monitor the various aspects ofoperational risk likely to entail high losses, and providing seniormanagement and the Board of Directors with regular reporting ofpertinent information.

28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls39Within this context, the bank may use indicators that provide earlywarning of any increase in risk levels, with a view to confrontingand containing these risks. The level of monitoring shall becommensurate with the risks involved and the frequency, and thenature of the change in the operating environment.Feedback from oversight of risks, shall be in the form of reportssubmitted to the Board of Directors by the Unit in charge of RisksManagement and Internal Auditing. These reports shallcomprehensively highlight all risks’ aspects and the promptmeasures necessitated in remedying them.Sixth: Carrying out a periodic review of the risk limitation, and thecontrol strategies, along with adjusting these strategies in light ofthe development in overall risks at the bank.Within this context, the bank shall determine the risks to besubjected to control, develop documented policies for the systemapplied in their management, identify those activities whose riskscan be handled through insurance, and firmly establish theconcepts underlying an integrated internal control system for thebank’s activities. Additionally, the bank shall grant particularsignificance to internal control whenever operating risks becomemore prominent, such as when the bank starts up new activities, ordevelops or launches products which are not part of its coreactivities, or channels these products to non-conventional markets.Seventh: Laying down contingency and business continuity plans, so as toguarantee the continuity of bank’s business at minimum loss, incase of disruption in activity.Within this context, banks should have in place emergency plans,encompassing potential risk scenarios, in the event of failure ofinstruments, equipment and communication networks. These plansshall also be periodically reviewed to allow for their amendment,as required by developments in the bank’s business or in thebanking environment.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls40Eighth: Banks shall persevere in their efforts for developing and usingbetter applications in the management of operational risk, so as toensure a level of supervision that maintains the safety and securityof banks at all times.

Ninth: Banks shall publicly disclose sufficient information to allowmarket participants to evaluate the bank’s approach in managingoperational risk. The level of disclosure shall be commensuratewith the size of the bank’s operations, their nature and the types ofrisks associated thereto.Tenth: Banks shall submit reports on the evaluation of their policies andprocedures in regard to managing operational risk. These reportsshall be prepared by the auditors in charge of evaluating internalcontrol systems, based on the instructions of the Central Bank ofKuwait issued on 14/11/1996, and subsequent instructions in thisregard.13/10/200328- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSH- Guiding principles issued by the Basel Committee for good practice in the management and control of operating risks atbanks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls41GOVERNORRabi Al-Awal 14, 1425 HMay 3, 2004THE CHAIRMAN,Circular to all local banks and investment companiessubject to the Central Bank of Kuwait (CBK) supervisionPrinciples of Good Corporate Governancein Financial InstitutionsCorporate Governance rose to the forefront of issues handled by theeconomic administrations of countries worldwide over the last few years,following the financial crises which befell major shareholding corporationsand affected confidence in the soundness of their management and thereliability of their published financial results, along with bringing aboutother negative consequences. Interest in that issue also increased, with theseparation of management from ownership becoming more dominant inmodern corporations, and leading to potential conflicts of interests betweenmanagement and shareholders.Banks and investment companies in the State of Kuwait operate in asupervisory and regulatory environment that provides a legislativeframework propitious to the sound management of these institutions,particularly as supervisory regulations and instructions issued by CentralBank of Kuwait address the various aspects of banking and financialactivities of these institutions’. However, as substantial risks ascribed tounsound corporate management practices materialize every now and themworldwide, the issue of good corporate governance has been gaining furtherprominence. Consequently, Central Bank of Kuwait considered it importantto issue directives to banks and investment companies that are directlyrelated to the issue of good corporate governance in financial institutions, soas to back up the controls mentioned in its previous instructions with regardto good governance principles, and complement these instructions with an

additional set of principles of good corporate governance in banks andinvestment companies.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls42Attached is a copy of these directives, noting that the application thereofshould clearly reflect in the management structure, as well as the policiesand practices, of banks and investment companies. We hope that thesedirectives will provide an incentive for financial institutions in the State ofKuwait to apply the best practices of corporate governance.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls43Directives to banks and investment companies regardingprinciples of good governance in financial institutionsDirectives and general principles1. Over the last three decades, the world witnessed significanttransformation in the private sector’s role in economic development andjob creation. Meanwhile, more countries adopted the market system asa guide for their economic policy. These developments coincided withan increased awareness of the role of corporations in economic lifeand individuals’ welfare.There has also been an increase in awareness in the importance given tothe issue of good corporate governance, especially as separation ofownership and management in modern corporations became morewidespread, thus entailing potential conflicts of interest between themanagement and shareholders.In the last few years, this issue ranked first on the agenda of theeconomic administrations in various countries, as a result of thefinancial crises which befell major shareholding corporations andaffected confidence in the soundness of management in thesecorporations, the reliability of their published financial results, andconsequently the true value of their shares in the securities markets, inaddition to other negative consequences. Consequently, the currenttrends in the good governance of listed corporations stresses that thesecorporations are part of an integrated economic system whichinfluences and is influenced by the domestic, regional and internationalenvironments, thus necessitating the performance of control andauditing tasks. This has further confirmed the significance of internaland external auditing functions, and the Board’s responsibilities in theformation of auditing committees to efficiently monitor corporation’soperations and to enhance the efficiency and effectiveness of theBoard’s participation in operations control.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMS

I- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls442. According to the OECD’s Ministerial Council’s definition of‘Corporate Governance’ – which is also one approved by the BaselCommittee for Banking Supervision, Corporate Governance involves“a set of relationships between a company’s management, its board, itsshareholders, and other Stakeholders. Within that definition, thesesprinciples mentioned that corporate governance shall also provide thestructure through which the objectives of the company are set, and themeans of attaining those objectives and monitoring performance aredetermined. Good corporate governance should provide properincentives for the board and management to pursue objectives that arein the interests of the company and shareholders and should facilitateeffective monitoring, thereby encouraging firms to use resources moreefficiently.”Thereby, corporate governance is based on striking a balancebetween the powers vested in the corporation’s management andthe protection of shareholders and stakeholders’ rights. Goodgovernance and transparency are among the core foundation ofcorporate management.3. Review of the set of principles mentioned in the OECD’s paper oncorporate governance, and the principles and directives issued by theInstitute of International Finance on corporate governance andtransparency in emerging markets, and the principles and directivesmentioned in the Basel Committee paper on enhancing corporategovernance for banking organizations, good corporate governancecover the following main areas. Protecting shareholders’ right andthe equitable treatment of shareholders, respecting and protectingstakeholders’ rights, defining the responsibilities of the Board andExecutive Departments, in addition to disclosure, transparency andgood practice, along with stressing the importance of the role ofInternal and External auditing and auditing committees.4. Within the areas covered by the good governance principles, thelegislative and regulatory framework applied in the State of Kuwait -particularly Law No. (32) of Year 1968 concerning Currency, theCentral bank of Kuwait and the Organization of Banking Business, andthe set of regulations and instructions issued by the Central bank ofKuwait (CBK) regarding the various activities of financial institutionscoversmany important aspects pertaining to good governance in28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls45financial institutions. Furthermore, the Commercial Companies LawNo. (15) for year 1960, and the laws issued in regard to regulating theKuwait Stock Exchange (KSE) and the decisions issued by KSE’smanagement, also encompass several controls and provisions connected

to the main areas underpinning the principles of good corporategovernance in the State of Kuwait.5. As the issue of corporate governance is commanding increasingattention internationally, due to the graveness of risks occurring ininternational markets from time to time, as a result of unsoundpractices, Central Bank of Kuwait considered it important to issuedirectives to banks and investment companies in regard to goodcorporate governance in financial institutions, in order to stress theprinciples encompassed in its previous relevant instructions, and tocomplement these instructions by additional principles that CentralBank of Kuwait deemed appropriate in the matter of good practice atbanks or investment companies.Following are the main areas underlying the good corporate governanceprinciples to be applied by banks and investment companies, noting that theabove mentioned general directives and principles provide the basis forencouraging financial institutions in the State of Kuwait to imply the bestpractices connected thereto.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls46First: protecting shareholders rights andequitable treatment of shareholdersThe financial institutions’ framework, policies and practices, shallconform with the controls and procedures provided for in the laws,regulations and instructions issued by the various supervisoryauthorities, in regard to protecting shareholders rights and theequitable treatment of shareholders, as follows:1. Protecting basic shareholders’ rights in regard to ownership registration,conveyance or transfer of shares; participation and vote in generalshareholder meetings; sharing in the profits of the corporation; and,obtaining information on the corporation on a timely and regular basis.2. Confirming shareholders’ right to be sufficiently informed of and toparticipate in decisions concerning changes in the company’sMemorandum of Agreement and Articles of Association includingamendments to the company’s capital, by issuing new shares toshareholders or issuing shares under the employee share options orthrough the repurchase of shares, in addition to decisions concerningextraordinary transactions that affect the destiny of the company or theconduct of its business, such as mergers, sale of a tangible portion ofthe company’s assets, or giving up the company’s subsidiary.3. Confirming and ensuring that shareholders participate effectively ingeneral shareholder meetings and are informed of the voting rules andprocedures, including furnishing shareholders with informationconcerning the date and agenda of general meetings, before areasonable time of the meeting taking place, so as to enable them toprepare for the requirements of the representation system (proxyvoting). The date and venue of the meeting shall be published publicly,

according to the laws, regulations and instructions issued in this regard.4. Capital structures and arrangements that enable certain shareholders toobtain a degree of control disproportionate to their equity ownershipshould be disclosed.5. The corporate governance framework should ensure that allshareholders, including minority and foreign shareholders are treatedequitably, and allowed to question the Board’s decisions and to obtainredress for violation of their rights.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls47Second: the role of stakeholdersStakeholders are those individuals, institutions and bodies connected to thefinancial institution (such as depositors, borrowers, creditors, investors,employees, and the society as a whole). In this area, enhancing goodcorporate governance requires the following:1. The institution framework, its policies and practices shouldrecognize the rights of stakeholders as established by the laws,regulations and instructions issued in this regard, and encourage cooperationbetween corporations and stakeholders in supportingdevelopment, creating jobs for the national manpower, and thefostering of the financial soundness of these corporations.Financial institutions shall realize that an important aspect of goodgovernance is to ensure funds’ inflows. Therefore, final success is thefruit of a joint effort by several parties, namely depositors, borrowers,employees, investors and others who have working relationships withthese institutions. Banks and financial institutions shall realize that theirinterest lies in the long term into supporting wealth creation through jointcooperation and all stakeholders’ participation.Worth mentioning is that Law No. (32) of Year 1968 concerningCurrency, the Central bank of Kuwait and the Organization of BankingBusiness, and the set of regulations and instructions issued by the Centralbank of Kuwait (CBK) regarding the exercise of the activities of financialinstitutions, encompass controls and principles that provide necessaryprotection to stakeholders’ rights, particularly the rights of depositors,borrowers and shareholders, so as to guarantee the safeguard of thefinancial positions of these institutions and to activate these institutions’role in serving the society and the economic development process.Therefore, these institutions’ abidance by controls provided for in theregulations and instructions issued by the Central Bank of Kuwait inregard to the exercise of their activities, constitute the general frameworkfor the main areas underlying good corporate governance in financialinstitutions.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls48

2. The institution framework, its policies and practices should ensure therights of stakeholders to obtain effective redress for violation of theirrights, as provided for by the relevant laws.3. Where stakeholders participate in the corporate governance process, theyshould have access to relevant information, according to the nature oftheir participation.Third: disclosure and transparencyA strong disclosure regime is a pivotal feature of market-basedmonitoring of companies and is central to shareholders’ ability toexercise their voting rights.Disclosure is considered a powerful tool for influencing the behavior ofcompanies and for protecting investors. The stronger a disclosure regime,the more effective it will be in contributing to the enhancement ofconfidence in the capital markets. Shareholders and potential investorsrequire access to accurate and material information in sufficient detail forthem to assess the management of companies, and make appropriateinvestment decisions.Material information can be defined as information affecting the price of thecompany’s shares or information whose omission or misstatement couldinfluence the economic decisions taken by users of information.Within this context, the enhancement of good corporate governance infinancial institutions requires that the corporate framework shouldencompass an adequate mechanism which ensures that timely andaccurate disclosure is made on all material matters regarding thecorporation, including the corporation’s financial situation, performance,results of activities, changes in ownership, and management of the company.Additionally, disclosure encompasses any other matters required by the lawsand instructions issued in this regard, particularly the disclosurerequirements mentioned in Central Bank of Kuwait instructions in regard tothe exercise of financial institutions’ various activities, and the instructionsissued in regard to the Kuwait stock Exchange.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls49These principles support the timely disclosure of all material developmentsthat arise between regular reports. They also support simultaneous reportingof information to all shareholders in order to ensure their equitabletreatment.Disclosure should include as a minimum all information and data requiredby the laws and instructions issued in this regard, such as:1. The financial and operating results of the company, represented in thebalance sheet, the profit and loss statement, the cash flow statement andnotes to the financial statements, noting that the goals of that disclosureare to provide the essential information and data on the basis of whichshares are valued, and to enable appropriate monitoring of theinstitutions’ performance.2. Ownership structure by major shareholders and others that control the

institution. Disclosure of such information is One of the basic rights ofinvestors.3. Members of the Board and key executives, and their remuneration,including benefits extended to them by virtue of the share optionschemes. Such information is necessary for investors to evaluate theexperience and qualifications of the members of the Board and keyexecutives, and assess any potential conflicts of interest that might affecttheir judgment.4. Material issues regarding employees and other stakeholders that maymaterially affect the performance of the institution.5. Nature and size of dealings with stakeholders who have influence orcontrol over the institution, including management employees in seniorpositions.6. Disclosure of the institution’s structures and policies, regarding theapplication of corporate decisions and policies, and the division ofauthority between shareholders, management and board members. Suchdisclosure is important for the assessment of a company’s management.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls507. Company objectives and policies relating to business ethics, and itscommitments towards the environment and the public. Disclosure of suchinformation may be important to better evaluate the relationship betweencompanies and the communities in which they operate.8. Systems and mechanisms applied by the institution in managing andcontrolling the various risks associated with banking and financialbusiness. Disclosure of these systems is a requirement for evaluating theinstitution’ management in regard to controlling those risks, and forassessing the extent and size of risks the institution may be exposed to inlight of the size and nature of its activities.9. Financial statements shall be prepared and disclosed in accordance withthe International accounting Standards, or any approved relevantstandards, according to the various supervisory authorities’ decisions,particularly according to the Central Bank of Kuwait instructionsregarding the external auditor’s reports.10. The institution shall ensure that channels for disseminating informationprovide for users’ access thereto, in a timely manner and at a fair cost.Fourth: responsibilities of the board and executive managementResponsibilities of the boardThe institution framework should ensure the strategic guidance of thecompany, the effective monitoring of management by the Board, andthe Board’s accountability to the company and the shareholders.The main requirement of good governance is exemplified in a Board whichdelivers its responsibilities in line with the institutions’ objective, and infurtherance of its significant activities. Within this context, the application ofgood corporate governance in financial institutions requires from the Boardto exercise its functions in the fulfillment of the following responsibilities:

28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls51Core responsibilities1. The Board should exercise its functions, through joint and independentaction. Board members should devote sufficient time to theirresponsibilities, and act in good faith, with due diligence and care, andin the best interest of the company and the shareholders.2. Where Board decisions concern shareholders’ affairs, the Board shouldtreat all shareholders fairly.3. The Board should ensure compliance that the interests of stakeholdersare taken into account in the performance institutions’ activities, incompliance with the law and instructions issued to that effect.4. Board members should base their decisions on relevant, accurate andtimely information.Strategy and planning5. Board members should select executive staff on the merit ofeducational qualifications and the possession of the required experiencein the area of banking and finance, while observing the provisions onqualifications controls according the law and instructions issued by thevarious supervisory authorities in this regard.6. The Board shall lay down the institution’s corporate strategy, annualplans of action, performance objectives, in addition to the policies formanaging and monitoring various risks, by drawing on the executivemanagement staff, or on external experts and advisors if need be.7. Reviewing and directing the institution’s strategy, work plan, andannual planning, along with monitoring the execution and applicationof plans, and assessing actual against targeted performance.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls52Organizational structure and internal control8. The Board shall endorse an organizational structure which fits thenature of the institution’s business and activities, and provides theneeded organizational controls for the execution of the strategyendorsed by the Board, by means of defining each organizational unit’sobjectives, functions, responsibilities, in addition to setting the lines ofcommunications for administrators at various levels, so as to achievedual control and separation of duties; thereby avoiding conflict betweenfunctions and operating risks. This necessitates making available usermanuals, policies and procedures for the execution and monitoring ofoperations, along with setting job descriptions for all position levels,and defining the required qualifications and experience for holders ofthese positions.9. the Board shall periodically make sure that the internal control systemshave the required adequacy and effectiveness for safeguarding the

institution’s property and assets, and shall ensure the accuracy of theinstitution’s financial statements and the efficiency of its operationsfrom the administrative, financial and accounting perspectives, alongwith ascertaining that such controls provide the needed protectionagainst any illicit interference from inside or outside the institution.10. The Board shall ascertain that the internal audit function is independentand internal auditors are competent, and that the scope, procedures andperiodicity of audit are commensurate with the level of risks associatedwith the institution’s various activities. The Board shall appoint thehead and staff of the internal audit, and define their privileges to ensurethe principles of audit independence and competency.For better effectiveness the Board shall benefit from the audit notes,and require from the external auditor to assess the efficiency of internalcontrol. The Board shall consider both the internal and external auditingimportant supervisory instruments and avail of the audit reports as anindependent review of the information submitted to the Board by theExecutive Management.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls53Oversight of executive management11. The Board shall evaluate the Executive Management’s performance anddetermine its ability with regard to executing the internal controlpolicies and procedures, evaluating achievements against targetedresults, and making necessary amendments accordingly.12. The Board shall oversee the major capital expenditures, review keyexecutive and Board members remuneration, and ensure a transparentremuneration process.13. The Board shall draw on the Executive Management’s expertise in theexecution of the Board’s decisions, without however interfering withthe Executive Management’s responsibilities. Contribution of a Boardmember to the execution of the Board’s decisions shall be by virtue of aproxy issued by the Board and subject to the latter’s perusal of what hasbeen achieved in this regard.14. The Board shall ascertain the Executive management’s compliance withthe laws and instructions issued by the various supervisory bodies, aswell as with the Boards’ decisions, regarding the institution’s variousactivities, so as to protect it from non-compliance risk.Professional practices and management of conflicts of interests15. The Board shall manage and monitor potential conflicts of interest ofmanagement, Board members and shareholders, including misuse ofcorporate resources and abuse in related party transactions.16. The Board shall observe the confidentiality of customers’ informationand data, according to the provisions of the laws and instructions issuedby supervisory bodies in this regard.17. Board members shall not make use information that becomes availableto them about the situation of the institution, for achieving personal

interests or the interests of other connected parties.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls54Responsibilities of the board towards shareholders and supervisorybodies18. The Board is responsible towards shareholders, and other concernedparties and bodies, for the integrity of the institutions financialstatements and the results of its activities. These data shall betransparent and objective, and disclose all transactions with connectedparties, according to the laws, decisions and instructions issued in thisregard.19. The Board is responsible towards the supervisory authority of thesoundness of the institution’s financial position, and the protection ofshareholders and depositors’ rights. The Board is responsible of theintegrity and transparency of financial data and information submittedto CBK, and shall ascertain the institutions’ abidance by the laws,decisions and instructions issued by CBK in this regard.Compensation of board members20. The Board members’ financial compensation package (remuneration,allowances, etc.) shall be commensurate with the importance andburdens of their charges, and constitute for them an incentive toexercise their functions as may best serve the interest of the institutionand its shareholders., and abide by their responsibilities in this regard;nonetheless, such compensation package shall not be overstated.Role and responsibilities of the executive managementThe institution’s Executive Management encompasses the Chief ExecutiveOfficer –which is the General Manager- and its assistants for the variousoperations, along with the administrative and technical committees formedaccording to written and authorized decisions.Within the context of the exercise of good governance in financialinstitutions, the responsibilities of the executive management are as follows:1- Propose work strategies, plans and policies for the institution’s bankingand financial operations, subject to Board’s approval. Such policies shallbe based on adequate experience in that area.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls552- Executing the Board’s approved policies in regard to the institution’svarious activities and operations, and laying down appropriatemechanisms to ascertain abidance by the responsibility of applying thesepolicies.3- Any important Board’s decision shall be taken in participation with oneor more, key individual from the Executive Management.4- Providing the Board with regular financial and administrative reports onthe application of the Board’s approved policies, the progress of the

institution’s activities and the result of its operations, along withcomparing actual with targeted performance rates, determining deviationsand causes thereof, and presenting any suggestions for the modificationand activation of these policies, as needed.The Executive Management shall abide by the transparency andobjectivity principle in the reports it submits on the institution’soperations.5- The Executive Management shall be responsible for ensuring compliancewith the laws, regulations and circulars issued by the Central Bank ofKuwait and other supervisory bodies regarding the activities andoperations carried out by the institution, so as to avoid its exposure tonon- compliance risks, such as penalties, financial losses, and reputationrisks. The Executive Management shall lay down the needed policies forascertaining such compliance.6- The Executive Management shall operate according to professionalethics’ standards, and lay down the needed instruction for the applicationof these standards by all staff members. Additionally, the ExecutiveManagement shall, whenever needed, include in its policies, the controlsfor the abidance by professional ethics’ standards.7- The Executive Management shall prepare the institution’s financialstatements according to the International Accounting Standards, or anyapproved or issued standards in this regard.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls56Fifth: auditing committeeand the committees issued from the boardThe effective oversight of the institutions operations requires from the Boardto form sub-committees as needed for enhancing the efficiency andeffectiveness of participation in operations’ oversight.The formation of Auditing Committees in banks and financial institutionsare considered a requirement of good governance, and are a top priority inthese corporations’ policies.According to good governance practices and relevant internationaldirections, the formation of these Committees and the determination of thefunctions thereof, shall be undertaken within the following framework:1- The Committee shall be formed by Board’s decision, and encompassthree members (chairman and two members) elected by the Board amongthose of its non-executive members with adequate expertise in theanalysis of financial statements. The Committee will remain operationalthrough the Board’s tenure. The Board shall also set the remuneration ofthe Committee members’ as it deems appropriate.2- The Auditing Committee shall operate under the Board’s oversight, andshall provide the Board with reports and recommendations based on itsfindings in the exercise of its functions.3- The core functions of the Auditing Committee shall encompass:• Overseeing the external auditing of the institution’s activities,

reviewing audits’ comprehensiveness and verifying the occurrence ofcooperation between external auditors in case of more than oneexternal auditor.• Overseeing internal auditing; reviewing and approving audits’comprehensiveness and periodicity of.• Receiving audit reports and ensuring that proper measures are taken toredress any reported deficiency in supervision.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls57• Ascertaining the institution’s compliance with policies, laws andinstructions.• Reviewing the adequacy of the institution’s internal auditingregulations, including the policies and procedures relevant to soundpractice in the management and control of various types of risks.• Reviewing the bank’s financial statements before their submission tothe Board, to ensure that CBK’s instructions are abided by.• Providing the Board with periodic reports on internal and externalauditing matters.4- The Auditing Committee shall meet at least once every three months, oras need arises, or at the request of its other two members; whereby themeeting will be legal if attended by at least two members.The head of the Internal Auditing shall participate in the regular meetingsof the Auditing Committee. The Auditing Committee may invite anyindividual from within the institution, to avail of his opinion whendiscussing a certain matter.5- The Board’s Secretary will be the Auditing Committee’s secretary andtake minutes of its meetings. These minutes, along with the minutes ofthe Board meetings, shall be part of the institution’s records.Formation of other committeesIt is appropriate for a financial institution to consider – according to the sizeand nature of its activities- the need for forming other committees issuedfrom the Board, to contribute to more effective control by the Board over theimportant operations at the institution, e.g. the formation of a hiringcommittee with the duty of selecting a managerial staff whose qualities andqualifications are appropriate for the institution’s activity, and acompensation committee which will set remunerations and compensations inline with the interest of the institution and its shareholders.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSI- Circular concerning the principles of good corporate governance in financial institutions.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls58Thu Al-qi'da 1, 1422 HJanuary 14, 2002THE GENERAL MANAGER," Circular to all Local banks "It has been noticed during the past few years that some local banks compete

on extending electronic banking services (E-banking) through the Internet.Despite the advantages the Internet provides for both banks and customers,yet e-banking involves multiple risks that do not considerably differ fromthose of other typical traditional banking services, but the respective bankshould be fully aware of such risks and should develop appropriate means tomanage them and to take precautionary actions in relation thereto.Within this context , the Basle Committee passed in May 2001 a paperentitled “Principles of e-Banking Risks Management”. This paper comprised14 principles which constitute a directory model to be used for ascertainingthe integrity of e-banking at the respective bank.The principles of managing e-banking risks are classified into three generaland interrelated categories:a- Supervision and control of board of directors and top management.b- Monitoring controlsc- Management of legal risks and reputation risks.Since your bank has launched the e-banking services, such services must beguided by the principles addressed in Basle Committee paper, noting thatthose principles do not represent the minimum nor the best availableapplication. Accordingly your bank has to initiate all procedures and systemsthat ensure proper management of those operations. Additionally, yourinternal control systems should cover and be consistent with the types ofsuch operations.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSJ- Circular concerning the need for following the guidelines of Basel Committee's Paper on Principles of e-banking risksmanagement.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls59You may have a copy of the Principles of e-banking Risks Managementfrom the website of International Bank for Settlements on the Internet:www.bis.orgBest Regards,Ibrahim Ali Al-QadhiManager of Supervision Department28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSJ- Circular concerning the need for following the guidelines of Basel Committee's Paper on Principles of e-banking risksmanagement.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls60DEPUTY GOVERNORJumada Al-Akhir 4, 1426 HJuly 10, 2005THE CHAIRMAN,“Circular to all local banks”Guidelines on the Establishment of the Compliance Functionand its Role in BanksThe Basel Committee on Banking Supervision issued in April 2005 a paper

comprising a set of principles entitled “Compliance and the ComplianceFunction in Banks”.In order for the Central Bank of Kuwait to ensure further organization of thebanking business and its direction in the manner conducive to the soundnessand integrity of the financial position of banking system’s units, and in orderto ensure that such units shall not be exposed to any crises that may arisefrom non-compliance with the banking rules and regulations in conductingtheir business, and since the mentioned guidelines on the establishment of acompliance unit, as presented by the Basel Committee, are complementaryto the Central Bank of Kuwait’s methodology of ensuring the compliance ofthe banking business in Kuwait with the best international practices in thisregard, we recommend that you visit the website of the Bank forInternational Settlements - Basel Committee on Banking Supervision :www.bis.org/publ/bcbs113.htm to review the mentioned paper and toseek the guidance of those principles.With my best regards,DR. NABEEL AHMED AL MANNA’E28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSK- Circular regarding .the need for following guidelines issued by Basel Committee in April 2005 on the establishment of thecompliance function and its role in banks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls61GOVERNORRamadhan 4, 1427 HSeptember 26, 2006THE CHAIRMAN," Circular to All Local Banks "Despite the tangible progress local banks have achieved in technologicalapplications and the positive reflections of these applications on the level ofcustomer service, yet the inspection carried out on local banks has revealed anumber of gaps in some aspects of the internal control systems in somelocal banks. These gaps relate to the applications of some IT systems or thegeneral control systems. This requires the respective banks to take thenecessary actions for bridging such gaps, while taking the followingregulatory controls into consideration, given the risks involved:1) Some banks have not got the ratification of their boards of directors forthe Disaster Recovery and Business Continuity Plans. These plans arealso not updated to reflect the latest activities and products of the bankthat should be incorporated into such plans. Furthermore, it was alsoobserved that some banks have not tested the subject plans to ensure theirefficiency.2) It was noticed in some cases that the powers delegated to the users of abanking system of some banks give the employees a set of delegationlevels to enter, execute and amend the data - a case which is in conflictwith the principle of segregation of duties. This is the result of giving suchemployees new delegated powers without canceling the previousdelegations that are in conflict with the new ones and with the principle of

dual control. Moreover, it was also noticed that there are active delegatedauthorities for some systems users whose service with some bankbranches has ended. This situation requires banks to review the powersdelegated to the systems users, so as to take the necessary correctiveactions.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSL- Circular concerning the enhancement of the aspects of banks internal control systems, by taking the necessary actions torectify the deficiencies revealed in the applications of some information technology systems or general controls system insome banks.CHAPTER TWO: The Law, Supervisory & Regulatory Instructions & Controls623) The inspection revealed, in some cases, that there are control gaps inthe credit cards issuance system. It was noticed that these cards aredelivered to customers in an “Active” status. The cards are also keptfor certain period in non-sealed envelopes pending delivery tocustomers. This situation requires the local banks to observe variousrelevant regulatory controls, such as activating such cards bycustomers only after the date of receipt, as well as in relation toproviding dual control and cards delivery procedures.4) It was also noticed that the funds recovered to the favor of customersafter the settlement of disputes on some customers card transactions,are transferred to the respective customers accounts only after a longperiod from the date of posting such amounts into the bank accounts.Such a period may extend to more than six months. Therefore, banksmust refund these amounts to customers without any delay and duringa period not exceeding one month from the date of recovering theamounts.5) In the area of checking the data of the report on suspicioustransactions, it was noticed that the statement of financial transactionsreport electronically transmitted to the Central Bank of Kuwait on adaily basis (and which include the FCT file and the LCT file foramounts equivalent to or exceeding KD 3,000, or the equivalent inforeign currency), does not include in some cases all the transactionscarried out in the bank. This situation requires the local banks toensure regular consistency of the report.6) The Central Bank of Kuwait noticed that the internal audit plans ofsome banks do not include sufficient coverage of certain importantareas of the IT systems. This situation requires banks to give dueattention to internal audit of IT systems.28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSL- Circular concerning the enhancement of the aspects of banks internal control systems, by taking the necessary actions torectify the deficiencies revealed in the applications of some information technology systems or general controls system insome banks. The Law, Supervisory & Regulatory Instructions & Controls

63Although most of the above mentioned observations relate to the InternalControl Systems in regard of which the Central Bank of Kuwait issued itsinstructions to local banks, particularly the guidelines on internal controlsystems, and the circulars issued with respect to corporate governance andmanagement and control of operational risks, yet given the special natureand significance of the subject observations, the respective banks mustenhance the controls applied in this respect.With my best wishes,SALEM ABDUL AZIZ AL-SABAH28- INSTRUCTION TO BANKS CONCERNING INTERNAL CONTROL SYSTEMSL- Circular concerning the enhancement of the aspects of banks internal control systems, by taking the necessary actions torectify the deficiencies revealed in the applications of some information technology systems or general controls system in some banks.

Q6. Discuss about the Computer Assisted Audit Techniques (CAATs). Answer:

COMPUTER ASSISTED AUDIT TECHNIQUES (CAATS)Introduction1. The overall objectives and scope of an audit do not change when an audit is conducted in acomputer information systems (CIS) environment. The application of auditing procedures may,however, require the auditor to consider techniques known as Computer Assisted AuditTechniques (CAATs) that use the computer as an audit tool for enhancing the effectiveness andefficiency of audit procedures. CAATs are computer programs and data that the auditor uses as

part of the audit procedures to process data of audit significance, contained in an entity'sinformation systems.2. The purpose of this Guidance Note is to provide guidance in the use of CAATs. ThisGuidance Note describes computer assisted audit techniques including computer tools,collectively referred to as CAATs. This Guidance Note applies to all uses of CAATs when acomputer of any type or size is involved whether that computer is operated by the entity or by athird party.Description of Computer Assisted Audit Techniques (CAATs)3. Computer Assisted Audit Techniques (CAATs) are important tools for the auditor inperforming audits. CAATs may be used in performing various auditing procedures, including thefollowing:tests of details of transactions and balances, for example, the use of audit software forrecalculating interest or the extraction of invoices over a certain value from computerrecords;analytical procedures, for example, identifying inconsistencies or significant fluctuations;tests of general controls, for example testing the set-up or configuration of the operatingsystem or access procedures to the program libraries or by using code comparison software tocheck that the version of the program in use is the version approved by management ;sampling programs to extract data for audit testing;tests of application controls, for example, testing the functioning of a programmed control;andreperforming calculations performed by the entity’s accounting systems.4. CAATs allow the auditor to give access to data without dependence on the client, test thereliability of client software, and perform audit tests more efficiently. CAATs are computerprograms and data that the auditor uses as part of the audit procedures to process data of audit2significance contained in an entity’s information systems. CAATs may consist of packageprograms, purpose-written programs, utility programs or system management program.Regardless of the origin of the programs, the auditor substantiates their appropriateness andvalidity for audit purposes before using them. A brief description of the programs commonlyused is given below.Package Programs are generalized computer programs designed to perform data processingfunctions, such as reading data, selecting and analyzing information, performing calculations,creating data files and reporting in a format specified by the auditor.Purpose-Written Programs perform audit tasks in specific circumstances. These programsmay be developed by the auditor, the entity being audited or an outside programmer hired bythe auditor. In some cases, the auditor may use an entity's existing programs in their originalor modified state because it may be more efficient than developing independent programs.Utility Programs are used by an entity to perform common data processing functions, such assorting, creating and printing files. These programs are generally not designed for auditpurposes, and therefore may not contain features such as automatic record counts or controltotals.System Management Programs are enhanced productivity tools that are typically part of asophisticated operating systems environment, for example, data retrieval software or codecomparison software. As with utility programs these tools are not specifically designed forauditing use and their use requires additional care.Details of some of the techniques used are mentioned in the Appendix.

Considerations in the Use of CAATs5. When planning an audit, the auditor may consider an appropriate combination of manualand computer assisted audit techniques. In determining whether to use CAATs, the factors toconsider include:the IT knowledge, expertise and experience of the audit team;the availability of CAATs and suitable computer facilities and data;the impracticability of manual tests;effectiveness and efficiency; andtime constraints.Before using CAATs the auditor considers the controls incorporated in the design of the entity’scomputer systems to which CAAT would be applied in order to determine whether, and if so,how, CAATs should be used.3IT Knowledge, Expertise and Experience of the Audit Team6. Auditing and Assurance Standard (AAS) 29, “Auditing in a Computer Information SystemsEnvironment” deals with the level of skill and competence the audit team needs to conduct anaudit in a CIS environment. It provides guidance when an auditor delegates work to assistantswith CIS skills or when the auditor uses work performed by other auditors or experts with suchskills. Specifically, the audit team should have sufficient knowledge to plan, execute and use theresults of the particular CAAT adopted. The level of knowledge required depends on“availability of CAATs” and “suitable computer facilities”.Availability of CAATs and Suitable Computer Facilities7. The auditor considers the availability of CAATs, suitable computer facilities and thenecessary computer-based information systems and data. The auditor may plan to use othercomputer facilities when the use of CAATs on an entity’s computer is uneconomical orimpractical, for example, because of an incompatibility between the auditor’s package programand entity’s computer. Additionally, the auditor may elect to use their own facilities, such as PCsor laptops.8. The cooperation of the entity’s personnel may be required to provide processing facilities ata convenient time, to assist with activities such as loading and running of CAAT on the entity’ssystem, and to provide copies of data files in the format required by the auditor.Impracticability of Manual Tests9. Some audit procedures may not be possible to perform manually because they rely oncomplex processing (for example, advanced statistical analysis) or involve amounts of data thatwould overwhelm any manual procedure. In addition, many computer information systemsperform tasks for which no hard copy evidence is available and, therefore, it may beimpracticable for the auditor to perform tests manually. The lack of hard copy evidence mayoccur at different stages in the business cycle.Source information may be initiated electronically, such as by voice activation, electronicdata imaging, or point of sale electronic funds transfer. In addition, some transactions, suchas discounts and interest calculations, may be generated directly by computer programs withno specific authorization of individual transactions.A system may not produce a visible audit trail providing assurance as to the completenessand accuracy of transactions processed. For example, a computer program might matchdelivery notes and suppliers’ invoices.In addition, programmed controlled procedures, such as checking customer credit limits, mayprovide hard copy evidence only on an exception basis.

4A system may not produce hard copy reports. In addition, a printed report may contain onlysummary totals while computer files retain the supporting details.Effectiveness and Efficiency10. The effectiveness and efficiency of auditing procedures may be improved by using CAATsto obtain and evaluate audit evidence. CAATs are often an efficient means of testing a largenumber of transactions or controls over large populations by:analyzing and selecting samples from a large volume of transactions ;applying analytical procedures; andperforming substantive procedures.11. Matters relating to efficiency that an auditor might consider include:the time taken to plan, design, execute and evaluate CAAT;technical review and assistance hours;designing and printing of forms (for example, confirmations); andavailability of computer resources12. In evaluating the effectiveness and efficiency of CAAT, the auditor considers the continuinguse of CAAT application. The initial planning, design and development of CAAT will usuallybenefit audits in subsequent periods.Time Constraints13. Certain data, such as transaction details, are often kept for a short time and may not beavailable in machine-readable form by the time auditor wants them. Thus, the auditor will needto make arrangements for the retention of data required, or may need to alter the timing of thework that requires such data.14. Where the time available to perform an audit is limited, the auditor may plan to use CAATbecause its use will meet the auditor’s time requirement better than other possible procedures.Using CAATs15. The major steps to be undertaken by the auditor in the application of CAAT are to:(a) set the objective of CAAT application;(b) determine the content and accessibility of the entity’s files;(c) identify the specific files or databases to be examined;(d) understand the relationship between the data tables where a database is to be examined;5(e) define the specific tests or procedures and related transactions and balances affected;(f) define the output requirements;(g) arrange with the user and IT departments, if appropriate, for copies of the relevant files ordatabase tables to be made at the appropriate cut off date and time;(h) identify the personnel who may participate in the design and application of CAAT;(i) refine the estimates of costs and benefits;(j) ensure that the use of CAAT is properly controlled;(k) arrange the administrative activities, including the necessary skills and computer facilities;(l) reconcile data to be used for CAAT with the accounting and other records;(m) execute CAAT application;(n) evaluate the results;(o) document CAATs to be used including objectives, high level flowcharts and runinstructions; and(p) assess the effect of changes to the programs/system on the use of CAAT.Testing CAAT

16. The auditor should obtain reasonable assurance of the integrity, reliability, usefulness, andsecurity of CAAT through appropriate planning, design, testing, processing and review ofdocumentation. This should be done before reliance is placed upon CAAT. The nature, timingand extent of testing is dependent on the commercial availability and stability of CAAT.Controlling CAAT Application17. The specific procedures necessary to control the use of CAAT depend on the particularapplication. In establishing control, the auditor considers the need to:(a) approve specifications and conduct a review of the work to be performed by CAAT;(b) review the entity’s general controls that may contribute to the integrity of CAAT, forexample, controls over program changes and access to computer files. When suchcontrols cannot be relied on to ensure the integrity of CAAT, the auditor may considerprocessing CAAT application at another suitable computer facility; and(c) ensure appropriate integration of the output by the auditor into the audit process.18. Procedures carried out by the auditor to control CAATs applications may include:(a) participating in the design and testing of CAAT;6(b) checking, if applicable, the coding of the program to ensure that it conforms with thedetailed program specifications;(c) asking the entity’s staff to review the operating system instructions to ensure that thesoftware will run in the entity’s computer installation;(d) running the audit software on small test files before running it on the main data files;(e) checking whether the correct files were used, for example, by checking externalevidence, such as control totals maintained by the user, and that those files werecomplete;(f) obtaining evidence that the audit software functioned as planned, for example, byreviewing output and control information; and(g) establishing appropriate security measures to safeguard the integrity and confidentialityof the data.When the auditor intends to perform audit procedures concurrently with online processing, theauditor reviews those procedures with appropriate client personnel and obtains approval beforeconducting the tests to help avoid the inadvertent corruption of client records.19. To ensure appropriate control procedures, the presence of the auditor is not necessarilyrequired at the computer facility during the running of CAAT. It may, however, provide practicaladvantages, such as being able to control distribution of the output and ensuring the timelycorrection of errors, for example, if the wrong input file were to be used.20. Audit procedures to control test data applications may include:controlling the sequence of submissions of test data where it spans several processing cycles;performing test runs containing small amounts of test data before submitting the main audittest data;predicting the results of the test data and comparing it with the actual test data output, for theindividual transactions and in total;confirming that the current version of the programs was used to process the test data; andtesting whether the programs used to process the test data were the programs the entity usedthroughout the applicable audit period.21. When using CAAT, the auditor may require the cooperation of entity staff with extensiveknowledge of the computer installation. In such circumstances, the auditor considers whether thestaff improperly influenced the results of CAAT.

722. Audit procedures to control the use of audit-enabling software may include:verifying the completeness, accuracy and availability of the relevant data, for example,historical data may be required to build a financial model;reviewing the reasonableness of assumptions used in the application of the tool set,particularly, when using modeling software;verifying availability of resources skilled in the use and control of the selected tools; andconfirming the appropriateness of the tool set to the audit objective, for example, the use ofindustry specific systems may be necessary for the design of audit programs for uniquebusiness cycles.Documentation23. The various stages of application of CAATs should be sufficiently documented to provideadequate audit evidence.24. The audit working papers should contain sufficient documentation to describe CAATapplication, including the details set out in the sections below.(a) PlanningCAAT objectives;CAAT to be used;Controls to be exercised; andStaffing, timing and cost.(b) ExecutionCAAT preparation and testing procedures and controls;Details of the tests performed by CAAT;Details of inputs (e.g., data used, file layouts), processing (e.g., CAATs high-levelflowcharts, logic) and outputs (e.g., log files, reports);Listing of relevant parameters or source code; andRelevant technical information about the entity's accounting system, such as file layouts.8(c) Audit EvidenceOutput provided;Description of the audit work performed on the output;Audit findings; andAudit conclusions;(d) OtherRecommendations to the entity management; andIn addition, it may be useful to document suggestions for using CAAT in future years.Arrangements with the Entity25. The auditor may make arrangements for the retention of the data files, such as detailedtransaction files, covering the appropriate audit time frame.26. In order to minimize the effect on the organization's production environment, access to theorganisation's information system facilities, programs/systems and data should be arranged wellin advance of the needed time period27. The auditor should also consider the effect of these changes on the integrity and usefulnessof CAAT, as well as the integrity of the programs/system and data used by the auditor.Using CAATs in Small Entities28. Although the general principles outlined in this Guidance Note apply in small entity ITenvironments, the following points need special consideration:

(a) The level of general controls may be such that the auditor will place less reliance on thesystem of internal control. This will result in greater emphasis on tests of details oftransactions and balances and analytical review procedures, which may increase theeffectiveness of certain CAATs, particularly, audit software.(b) Where smaller volumes of data are processed, manual methods may be more cost effective.(c) A small entity may not be able to provide adequate technical assistance to the auditor,making the use of CAATs impracticable.(d) Certain audit package programs may not operate on small computers, thus restricting theauditor’s choice of CAATs. The entity’s data files may, however, be copied and processedon another suitable computer.

Master of Business Administration Semester III MB0050 – Research Methodology- 4 Credits

(Book ID: B1206) Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions

Q 1. Why should a manger know about research when the job entails managing people, products, events, environments, and the like? [10 Marks] Q 2. a. How do you evolve research design for exploratory research? Briefly analyze. [5 marks]. b. Briefly explain Independent dependent and extraneous variables in a research design. [5 Marks] Q 3. A. Differentiate between ‘Census survey’ and ‘ Sample Survey’. [5 Marks] b. Analyze multi-stage and sequential sampling. [5 Marks]

Q 4. List down various measures of central tendency and explain the difference between them? [10 marks]. Q.5. Select any topic for research and explain how you will use both secondary and primary sources to gather the required information. [10 marks] Q 6. a. Explain the role of Graphs and Diagrams? [5 Marks] b. What are the Types and General rules for graphical representation of data? [5 Marks]

Master of Business AdministrationSemester III

MB0050 – Research Methodology- 4 Credits(Book ID: B1206)

Assignment Set- 1 (60 Marks)Note: Each question carries 10 Marks. Answer all the

questions

Question 1: Why should a manger know about research when the job entails managing people, products, events, environments, and the like?

Answer:

Research simply means a search for facts – answers to questions and solutions to problems. It is a purposive investigation. It is an organized inquiry. It seeks to find explanations to unexplained phenomenon to clarify the doubtful facts and to correct the misconceived facts. Research is the organized and systematic inquiry or investigation which provides information for solving a problem or finding answers to a complex issue.

Research in business:

Often, organization members want to know everything about their products, services, programs, etc. Your research plans depend on what information you need to collect in order to make major decisions about a product, service, program, etc. Research provides the needed information that guides managers to make informed decisions to successfully deal with problems.

The more focused you are about your resources, products, events and environments what you want to gain by your research, the more effective and efficient you can be in your research, the shorter the time it will take you and ultimately the less it will cost you.

Manager’s role in research programs of a company:

Managing people is only a fraction of a manager's responsibility - they have to manage the operations of the department, and often have responsibilities towards the profitability of the organization. Knowledge of research can be very helpful for a good manager.

Question 2:

a. How do you evolve research design for exploratory research? Briefly analyze.

b. Briefly explain Independent, dependent and extraneous variables in a research design.

Answer:

a. Research design for exploratory research:

Research simply means a search for facts – answers to questions and solutions to problems. It is a purposive investigation. It is an organized inquiry. It seeks to find explanations to unexplained phenomenon to clarify the doubtful facts and to correct the misconceived facts. Although any typology of research is inevitably arbitrary, Research may be classified crudely according to its major intent or the methods.

It is also known as formulating research. It is preliminary study of an unfamiliar problem about which the researcher has little or no knowledge. It is ill-structured and much less focused on pre-determined objectives. It usually takes the form of a pilot study. The purpose of this research may be to generate new ideas, or to increase the researcher’s familiarity with the problem or to make a precise formulation of the problem or to gather information for clarifying concepts or to determine whether it is feasible to attempt the study. Katz conceptualizes two levels of exploratory studies. “At the first level is the discovery of the significant variable in the situations; at the second, the discovery of relationships between variables.”

b. Independent and dependent and extraneous variables in a research design:

The research designer understandably cannot hold all his decisions in his head. Even if he could, he would have difficulty in understanding how these are inter-related. Therefore, he records his decisions on paper or record disc by using relevant symbols or concepts. Such a symbolic construction may be called the research design or model. A research design is a logical and systematic plan prepared for directing a research study.

Dependent and Independent variables: A magnitude that varies is known as a variable. The concept may assume different quantitative values, like height, weight, income, etc. Qualitative variables are not

quantifiable in the strictest sense of objectivity. However, the qualitative phenomena may also be quantified in terms of the presence or absence of the attribute considered. Phenomena that assume different values quantitatively even in decimal points are known as „continuous variables‟. But, all variables need not be continuous. Values that can be expressed only in integer values are called „non-continuous variables‟. In statistical term, they are also known as „discrete variable‟. For example, age is a continuous variable; whereas the number of children is a non-continuous variable. When changes in one variable depends upon the changes in one or more other variables, it is known as a dependent or endogenous variable, and the variables that cause the changes in the dependent variable are known as the independent or explanatory or exogenous variables. For example, if demand depends upon price, then demand is a dependent variable, while price is the independent variable.

And if, more variables determine demand, like income and prices of substitute commodity, then demand also depends upon them in addition to the own price. Then, demand is a dependent variable which is determined by the independent variables like own price, income and price of substitute.

Extraneous variable:

The independent variables which are not directly related to the purpose of the study but affect the dependent variable are known as extraneous variables. For instance, assume that a researcher wants to test the hypothesis that there is relationship between children’s school performance and their self-concepts, in which case the latter is an independent variable and the former, the dependent variable. In this context, intelligence may also influence the school performance. However, since it is not directly related to the purpose of the study undertaken by the researcher, it would be known as an extraneous variable. The influence caused by the extraneous variable on the dependent variable is technically called as an „experimental error‟. Therefore, a research study should always be framed in such a manner that the dependent variable completely influences the change in the independent variable and any other extraneous variable or variables.

Question 3: a. Differentiate between ‘Census survey’ and ‘ Sample Survey’b. Analyse multi-stage and sequential sampling.

Answer:

a. Difference between Census survey and Sample Survey

Census Survey Sample Survey

A census measures absolutely everyone in the whole country. This obviously means that a census survey is a much bigger exercise in nature and procedures

A part of the population is known as sample

Census survey also is a very time consuming exercise as information needs to be collected from each and every individual from the population.

On the other hand, sample survey is easier as a representative sample is taken from the population and the results obtained are extrapolated to fit the entire population.

There are times and requirements where governments have to indulge in census survey even if it is time consuming and very expensive as it needs to formulate policies and welfare programs for the population. For example, when a government has to count heads of the population

Sample surveys cannot count the number of people in the country but when government is planning on a welfare program for cancer patients, it can conduct a sample survey of some of the cancer patients and then extrapolate the results on the section of the population that is undergoing treatment for cancer.

Census survey is more accurate. there is margin for error in sample survey

b. Analyse multi-stage and sequential sampling:

Multi-stage sampling:

In multi-stage sampling method, sampling is carried out in two or more stages. The population is regarded as being composed of a number of second stage units and so forth. That is, at each stage, a sampling unit is a cluster of the sampling units of the subsequent stage. First, a sample of the first stage sampling units is drawn, then from each of the selected first stage sampling unit, a sample of the second stage sampling units is drawn. The procedure continues down to the final sampling units or population elements. Appropriate random sampling method is adopted at each stage. It is appropriate where the population is scattered over a wider geographical area and no frame or list is available for sampling. It is also useful when a survey has to be made within a limited time and cost budget. The major disadvantage is that the procedure of estimating sampling error and cost advantage is complicated.

Sequential sampling:

Sequential sampling is a non-probability sampling technique wherein the researcher picks a single or a group of subjects in a given time interval, conducts his study, analyses the results then picks another group of subjects if needed and so on. This sampling technique gives the researcher limitless chances of fine tuning his

research methods and gaining a vital insight into the study that he is currently pursuing. There is very little effort in the part of the researcher when performing this sampling technique. It is not expensive, not time consuming and not workforce extensive.

This sampling method is hardly representative of the entire population. Its only hope of approaching representativeness is when the researcher chose to use a very large sample size significant enough to represent a big fraction of the entire population. Due to the aforementioned disadvantages, results from this sampling technique cannot be used to create conclusions and interpretations pertaining to the entire population.

Question 4: List down various measures of central tendency and explain the difference between them?

Answer:

Measures of Central Tendency:

The term central tendency refers to the "middle" value or perhaps a typical value of the data, and is measured using the mean, median, or mode. Each of these measures is calculated differently, and the one that is best to use depends upon the situation.

Analysis of data involves understanding of the characteristics of the data. The following are the important characteristics of a statistical data:

Central tendency Dispersion Skew ness Kurtosis

In a data distribution, the individual items may have a tendency to come to a central position or an average value. For instance, in a mark distribution, the individual students may score marks between zero and hundred. In this distribution, many students may score marks, which are near to the average marks, i.e. 50. Such a tendency of the data to concentrate to the central position of the distribution is called central tendency. Central tendency of the data is measured by statistical averages. Averages are classified into two groups.

1. Mathematical averages 2. Positional averages

Statistical Averages

Mathematical averages Positional averages

Arithmetic mean Median Geometric mean Mode Harmonic mean

Arithmetic mean, geometric mean and harmonic mean are mathematical averages. Median and mode are positional averages. These statistical measures try to

understand how individual values in a distribution concentrate to a central value like average. If the values of distribution approximately come near to the average value, we conclude that the distribution has central tendency.

Difference between Mean and Median:

Mean (Mathematical averages) Median (Positional averages)

When the sample size is large and does not include outliers, the mean score usually provides a better measure of central tendency.

The median may be a better indicator of the most typical value if a set of scores has an outlier. An outlier is an extreme value that differs greatly from other values.

The mean is the most commonly-used measure of central tendency. When we talk about an "average", we usually are referring to the mean

The median often is used when there are a few extreme values that could greatly influence the mean and distort what might be considered typical.

The mean is simply the sum of the values divided by the total number of items in the set

The median is determined by sorting the data set from lowest to highest values and taking the data point in the middle of the sequence

Question 5: Select any topic for research and explain how you will use both secondary and primary sources to gather the required information.

Answer:

For performing research on the literacy levels among families, the primary and secondary sources of data can be used very effectively. More specifically the

primary sources of data collection is suggested in this regard. Because personal data or data related to human beings consist of:

1. Demographic and socio-economic characteristics of individuals: Age, sex, race, social class, religion, marital status, education, occupation income, family size, location of the household life style etc.

2. Behavioral variables: Attitudes, opinions, awareness, knowledge, practice, intentions, etc.

3. Organizational data consist of data relating to an organizations origin, ownership, objectives, resources, functions, performance and growth.

4. Territorial data are related to geo-physical characteristics, resource endowment, population, occupational pattern infrastructure degree of development, etc. of spatial divisions like villages, cities, talluks, districts, state and the nation.

The data serve as the bases or raw materials for analysis. Without an analysis of factual data, no specific inferences can be drawn on the questions under study. Inferences based on imagination or guess work cannot provide correct answers to research questions. The relevance, adequacy and reliability of data determine the quality of the findings of a study.

Data form the basis for testing the hypothesis formulated in a study. Data also provide the facts and figures required for constructing measurement scales and tables, which are analyzed with statistical techniques. Inferences on the results of statistical analysis and tests of significance provide the answers to research questions. Thus, the scientific process of measurements, analysis, testing and inferences depends on the availability of relevant data and their accuracy. Hence, the importance of data for any research studies

The sources of data may be classified into:

a. Primary sourcesb. Secondary sources.

Primary Sources of Data:

Primary sources are original sources from which the researcher directly collects data that have not been previously collected e.g.., collection of data directly by the researcher on brand awareness, brand preference, brand loyalty and other aspects of consumer behaviour from as ample of consumers by interviewing them,. Primary data are first-hand information collected through various methods such as observation, interviewing, mailing etc.

Advantage of Primary Data:

It is original source of data It is possible to capture the changes occurring in the course of

time. It flexible to the advantage of researcher. Extensive research study is based of primary data

Disadvantage of Primary Data:

Primary data is expensive to obtain It is time consuming It requires extensive research personnel who are skilled. It is difficult to administer

Methods of Collecting Primary Data:

Primary data are directly collected by the researcher from their original sources. In this case, the researcher can collect the required date precisely according to his research needs, he can collect them when he wants them and in the form he needs them. But the collection of primary data is costly and time consuming. Yet, for several types of social science research required data are not available from secondary sources and they have to be directly gathered from the primary sources. In such cases where the available data are in appropriate, inadequate or obsolete, primary data have to be gathered. They include: socioeconomic surveys, social anthropological studies of rural communities and tribal communities, sociological studies of social problems and social institutions. Marketing research, leadership studies, opinion polls, attitudinal surveys, readership, radio listening and T.V. viewing surveys, knowledge-awareness practice (KAP) studies, farm managements studies, business management studies etc. There are various methods of data collection. A ‘Method’ is different from a ‘Tool’ while a method refers to the way or mode of gathering data, a tool is an instruments used for the method. For example, a schedule is used for interviewing. The important methods are (a) observation, (b) interviewing,(c)mail survey,(d)experimentation,(e) simulation and (f) projective

technique. Each of these methods is discussed in detail in the subsequent sections in the later chapters.

Secondary Sources of Data:

These are sources containing data which have been collected and compiled for another purpose. The secondary sources consists of readily compendia and already compiled statistical statements and reports whose data may be used by researchers for their studies e.g., census reports , annual reports and financial statements of companies, Statistical statement, Reports of Government Departments, Annual reports of currency and finance published by the Reserve Bank of India, Statistical statements relating to Co-operatives and Regional Banks, published by the NABARD, Reports of the National sample survey Organization, Reports of trade associations, publications of international organizations such as UNO, IMF, World Bank, ILO, WHO, etc., Trade and Financial journals newspapers etc.

Secondary sources consist of not only published records and reports, but also unpublished records. The latter category includes various records and registers maintained by the firms and organizations, e.g., accounting and financial records, personnel records, register of members, minutes of meetings, inventory records etc.

Features of Secondary Sources:

Though secondary sources are diverse and consist of all sorts of materials, they have certain common characteristics. First, they are readymade and readily available, and do not require the trouble of constructing tools and administering them

Second, they consist of data which a researcher has no original control over collection and classification. Both the form and the content of secondary sources are shaped by others. Clearly, this is a feature which can limit the research value of secondary sources. Finally, secondary sources are not limited in time and space. That is, the researcher using them need not have been present when and where they were gathered

Use of Secondary Data:

The second data may be used in three ways by a researcher. First, some specific information from secondary sources may be used for reference purpose. For example, the general statistical information in the number of co-operative credit societies in the country, their coverage of villages, their capital structure, volume of business etc., may be taken from published reports and quoted as background information in a study on the evaluation of performance of cooperative credit societies in a selected district/state.

Second, secondary data may be used as bench marks against which the findings of research maybe tested, e.g., the findings of a local or regional survey may be compared with the national averages; the performance indicators of a particular bank may be tested against the corresponding indicators of the banking industry as a whole; and so on.

Finally, secondary data may be used as the sole source of information for a research project. Such studies as securities Market Behaviour, Financial Analysis of companies, Trade in credit allocation in commercial banks, sociological studies on crimes, historical studies, and the like, depend primarily on secondary data. Year books, statistical reports of government departments, report of public organizations of Bureau of Public Enterprises, Censes Reports etc., and serve as major data sources for such research studies

Advantages of Secondary Data:

Secondary sources have some advantages:

Secondary data, if available can be secured quickly and cheaply. Once their source of documents and reports are located, collection of data is just matter of desk work. Event he tediousness of copying the data from the source can now be avoided, thanks to Xeroxing facilities.

Wider geographical area and longer reference period may be covered without much cost. Thus, the use of secondary data extends the researcher’s space and time reach.

The use of secondary data broadens the data base from which scientific generalizations can be made.

Environmental and cultural settings are required for the study. The use of secondary data enables a researcher to verify the findings bases

on primary data. It readily meets the need for additional empirical support. The researcher needs not wait the time when additional primary data can be collected.

Disadvantages of Secondary Data:

The use of a secondary data has its own limitations.

The most important limitation is the available data may not meet our specific needs. The definitions adopted by those who collected those data may be different; units of measure may not match; and time periods may also be different.

The available data may not be as accurate as desired. To assess their accuracy we need to know how the data were collected.

The secondary data are not up-to-date and become obsolete when they appear in print, because of time lag in producing them. For example, population census data are published two or three years later after compilation and no new figures will be available for another ten years.

Finally, information about the whereabouts of sources may not be available to all social scientists. Even if the location of the source is known, the accessibility depends primarily on proximity. For example, most of the unpublished official records and compilations are located in the capital city, and they are not within the easy reach of researchers based in far off places.

Evaluation of Secondary Data:

When a researcher wants to use secondary data for his research, he should evaluate them before deciding to use them.

1) Data Pertinence:

The first consideration in evaluation is to examine the pertinence of the available secondary data to the research problem under study. The following questions should be considered.

What are the definitions and classifications employed? Are they consistent?

What are the measurements of variables used? What is the degree to which they conform to the requirements of our research?

On the basis of above consideration, the pertinence of the secondary data to the research on hand should be determined, as a researcher who is imaginative and flexible may be able to redefine his research problem so as to make use of otherwise unusable available data.

2) Data Quality:

If the researcher is convinced about the available secondary data for his needs, the next step is to examine the quality of the data. The quality of data refers to their accuracy, reliability and completeness. The assurance and reliability of the available secondary data depends on the organization which collected them and the purpose for which they were collected. What is the authority and prestige of the organization? Is it well recognized? Is it noted for reliability? It is capable of collecting reliable data? Does it use trained and well qualified investigators? The answers to these questions determine the degree of confidence we can have in the data and their accuracy. It is important to go to the original source of the secondary data rather than to use an immediate source which has quoted from the original. Then only, the researcher can review the cautionary and other comments that were made in the original source.

3) Data Completeness:

The completeness refers to the actual coverage of the published data. This depends on the methodology and sampling design adopted by the original organization. Is the methodology sound? Is the sample size small or large? Is the sampling method appropriate? Answers to these questions may indicate the appropriateness and adequacy of the data for the problem under study. The question of possible bias should also be examined. Whether the purpose for which the original organization collected the data had a particular orientation? Has the study been made to promote the organization’s own interest? How the study was conducted? These are important clues. The researcher must be on guard when the source does not report the methodology and sampling design. Then it is not possible to determine the adequacy of the secondary data for the researcher’s study.

Question 6: a. Explain the role of Graphs and Diagrams?b. What are the Types and General rules for graphical representation of data?

Answer:

a) Role of Graphs and Diagrams:

In presenting the data of frequency distributions and statistical computations, it is often desirable to use appropriate forms of graphic presentations. In additions to tabular forms, graphic presentation involves use of graphics, charts and other pictorial devices such as diagrams. These forms and devices reduce large masses of statistical data to a form that can be quickly understood at the glance. The meaning of figures in tabular form may be difficult for the mind to grasp or retain. “Properly constructed graphs and charts relieve the mind of burdensome details by portraying facts concisely, logically and simply.” They, by emphasizing new and significant relationship, are also useful in discovering new facts and in developing hypothesis. The device of graphic presentation is particularly useful when the prospective readers are non-technical people or general public. It is useful to even technical people for dramatizing certain points about data; for important points can be more effectively captured in pictures than in tables. However, graphic forms are not substitutes for tables, but are additional tools for the researcher to emphasize the research findings. Graphic presentation must be planned with utmost care and diligence. Graphic forms used should be simple, clear and accurate and also be appropriate to the data. In planning this work, the following questions must be considered.

a. What is the purpose of the diagram? b. What facts are to be emphasized?

c. What is the educational level of the audience? d. How much time is available for the preparation of the diagram? e. What kind of chart will portray the data most clearly and accurately?

Role of Graphs:

Because graphs provide a compact, rhetorically powerful way of representing research findings, recent theories of science have postulated their use as a distinguishing feature of science. Studies have shown that the use of graphs in journal articles correlates highly with the hardness of scientific fields, both across disciplines and across subfields of psychology.

Role of Diagrams:

Recent technological advances have enabled the large-scale adoption of diagrams in a diverse range of areas. Increasingly sophisticated visual representations are emerging and, to enable effective communication, insight is required into how diagrams are used and when they are appropriate for use. The pervasive, everyday use of diagrams for communicating information and ideas serves to illustrate the importance of providing a sound understanding of the role that diagrams can, and do, play. Research in the field of diagrams aims to improve our understanding of the role of diagrams, sketches and other visualizations in

communication, computation, cognition, creative thought, and problem solving. These concerns have triggered a surge of interest in the study of diagrams.

The study of diagrammatic communication as a whole must be pursued as an interdisciplinary endeavor. Diagrams attract a large number of researchers from virtually all related fields, placing the conference as a major international event in the area.

b) Types and General rules for graphical representation of data:

Graphical representation is done of the data available. This is very important step of statistical analysis. We will be discussing the organization of data. The word 'Data' is plural for 'datum'; datum means facts. Statistically the term is used for numerical facts such as measures of height, weight and scores on achievement and intelligence tests.

Graphs and diagram leave a lasting impression on the mind and make intelligible and easily understandable the salient features of the data. Forecasting also becomes easier with the help of graph. Thus it is of interest to study the graphical representation of data.

The graphical representation of data is categorized as basic five types:1) Bar graph2) Pie graph3) Line graph4) Scatter plot5) Histogram

Examples of graphical representation of data:Let us see some examples of graphical representation of data.1) Bar chart:A Bar chart (or diagram) is a graphical representation of data using bars (rectangles of same width).It is one dimensional in which case only the height of the rectangle matters.

year 1931

1941

1951

1961 1971 1981

population of a place

6000

7600

8900

12000

13500

18000

Solution: scale: Y axis 1 cm = 1000 years   

                                                                                  2) Graphical Representation of Histogram:

A histogram (or rectangular diagram or block diagram) is a graphical representation of a frequency distribution in the form of rectangles one after the other with height proportional to the frequencies.

It is two dimensional in which case the height as well as width of the rectangle matters.Que:Represent the following data by means of a Histogram: 

Age( in years)

20-25

25-30

30-35

35-40

40-45

45-50

50-55

Number of workers

3 4 5 6 5 4 3

 

3) Frequency Polygon of a Line Graph:

A frequency polygon can be constructed for a grouped frequency distribution, with equal-interval, in two different ways:

Method I: Represent the class-marks along the x-axis. Represent the frequencies along y-axis. Join these points, in order, by straight lines. The points at each end is joined to the immediate higher(or lower) class mark

at zero frequency so as to complete the polygon.

Method II: Represent a histogram of the given data. Join the mid points of the tops of the adjacent rectangles by straight lines. The mid points at each end are joined to the immediate higher (or lower) at

zero frequency so as to complete the polygon. The two classes, one at each end, are to be included.

Construct a frequency polygon for the following data:

 

Monthly pocket expenses of a student

0-5

5-10

10-15

15-20

20-25

25-30

30-35

35-40

Number of students 10 16 30 42 50 30 16 12

 Solution:Here we have 

Monthly pocket expenses of a student(in $)

class- marks Number of students

0-5 2.5 10

5-10 7.5 16

10-15 12.5 30

15-20 17.5 42

20-25 22.5 50

25-30 27.5 30

30-35 32.5 16

35-40 37.5 12

  

 

4) Cumulative Frequency Curve(ogive):

The Cumulative frequency curve for a grouped frequency distribution is obtained by plotting the points and then joining them by a free-hand smooth curve.This is also known as ogive.

Method: Form the cumulative frequency table. Mark the upper class limits along the x-axis. Mark the cumulative frequencies along the y-axis. Plot the points and join them by a free-hand smooth curve.

Draw a cumulative frequency curve for the following data: 

Marks 0-4 4-8 8-12 12-16

16-20

Number of students

4 6 10 8 4

The cumulative frequency table is as follows: 

Marks Number of students

cumulative frequency

0-4 4 4

4-8 6 4+6=10

8-12 10 10+10=20

12-16 8 20+8=28

16-20 4 28+4=32

Total 32  

 Joining these points by a free-hand smooth curve, we have the following cumulative frequency curve:

5) Pie-chart or Pie-graph:

It is drawn by first drawing a circle of a suitable radius and then dividing the angle of 360 degree at its centre in proportion to the figures given under various heads.Solution:<AOB = 14 x 360 /100  =  50.4<COD = 29 x 360 /100  =  104.4<EOF = 16 x 360 /100  =  57.6<BOC = 16 x 360 /100  =  57.6<DOE = 17 x 360 /100  =  61.2<FOA = 8 x 360 /100  =  28.8Take a circle with centre O and unit radius.

Master of Business Administration - MBA

Semester IIIMB0051 – Legal Aspects of

Business - 4 Credits(Book ID: B1207)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer

all the questions.

Q.1 Distinguish between fraud and misrepresentation. Q.2 What are the remedies for breach of contract? Q.3 Distinguish between indemnity and guarantee? Q.4 What is the distinction between cheque and bill of exchange? Q.5 Distinguish between companies limited by shares and companies limited by guarantee. Q.6 What is the definition of cyber crime?