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Auditing

Site: School of Open Learning Course: Paper-9: Income Tax & Auditing Book: Auditing Printed by: Guest user Date: Tuesday, 13 March 2018, 10:18 AM

Table of contents

1 Undergraduate Courses 2 Lesson 1 INTRODUCTION 3 Lesson 2 Internal Check, Internal Audit And Internal Control 4 Lesson 3 Audit Process 5 Lesson 4 Vouching 6 Lesson 5 Verification 7 Lesson 6 Company Audit 8 Lesson 7 Appointment, Powers, Duties And Liabilities of the Auditor Appointment

2 Lesson 1 INTRODUCTION

Lesson 1 INTRODUCTION Origin of Auditing The origin of auditing may be traced back to the 18th century when the practice of large-scale production was developed as a result of Industrial Revolution. It is found that some systems of checks and counter checks were applied for maintaining accounts of public institutions, as early as the days of the ancient Egyptians, the Greek and the Romans. The growth of Accounting profession in India is of a quite recent origin. It was an outcome of the Indian companies Act, 1913 which prescribed for the first time the qualifications of an auditor. Due to rapid growth in the size of business firms, it has become necessary that the accounts must be checked and audited by an independent person, known as auditor especially in case of joint-stock companies where the shareholders are drawn from far off places. That is why it becomes necessary to assure them that their investment is safe and that the directors and the managing directors etc. handling capital and accounts, have presented true and correct accounts. Definition of Audit The word "audit" is derived from the Latin word "audire" which means "to hear". In olden times, whenever the owners of, a business suspected fraud they appointed certain persons to check the accounts. Such persons sent for the accountants and "heard" whatever they had to say in connection with the accounts. Since then there have been lot of changes in the scope and definition of audit. The following are some of the definitions of audit given by some writers: According to spicer and Pegler, "An audit may be said to be such an examination of the books, accounts and vouchers of a business as will enable the auditor to satisfy himself that the balance sheet is properly drawn-up, so as to give a true and fair view of the state of the affairs of the business, and whether the profit and Loss Accounts gives a true and fair view of profit or loss for the financial period, according to the best of his information and the explanations given to him and as shown by the books and if not, in what respect he is not satisfied" R.B. Bose has defined as audit as "the verification of the accuracy and correctness of the books of account by independent person qualified for the job and not in any way connected with the preparation of such accounts." M.L. Shandily has defined auditing as "inspecting, comparing, checking, reviewing,

vouching ascertaining scrutinising, examining and verifying the books of account of a business concern with a view to have a correct and true idea of its financial state of affairs". From a closed scrutiny of the definitions given by various writers, it would be evident that these are different methods of saying a particular thing but still there is a lot of similarity therein. However, audit may be defined as :

1. an intelligent and a critical examination of the books of account of a business which,
2. is done by an independent person or body of persons qualified for the job,
3. With the help of vouchers, documents, information and explanations received from the authorities, so that,
4. the auditor may satisfy himself with the authenticity of financial accounts prepared for a fixed term and ultimately report that, (i) the Balance Sheet exhibits a true and fair view of the state of affairs of the concern, (ii) the Profit and Loss Account reveals the true and fair view of the profit or loss for the financial period, and (iii) the accounts have been prepared in conformity with the law. In short, an audit implies an investigation and a report. Difference between Accountancy and Auditing The difference between Accountancy and Auditing is as follows :
5. Accountancy is mainly concerned with the preparation of summary and analysis of the records prepared by the book-keeper for this, an accountant has to prepare trial balance and then annual accounts. On the other hand, Auditing means the verification of book entries and accounts to find out their accuracy. So the auditor's work is to find out whether the final accounts exhibit a true and fair view of the state of affairs of the concern or not and to report his findings to the share holders.
6. An accountant is an employee of the business while an auditor is an independent outsider.
7. As an employee of business, an accountant draws his monthly salary regularly from the business itself while an auditor is paid a remuneration agreed upon between him and his client.
8. An accountant is not expected to have a knowledge of auditing but for an auditor, it is very essential to possess a thorough knowledge of accountancy.

It is said, "where accountancy ends, auditing begins." It is sightly said. An auditor has to verify the entries passed by the accountant and the final accounts prepared by him. Thus, auditing is the checking of the accounts of a business with the help of vouchers, documents and the information given to him and the explainations submitted to him. An auditor has to satisfy himself after due verification and complete. Checking of accounts as to whether the transactions entered into the books are accurate. An auditer is required to submit his report to the effect whether or not the balance sheet is a true and fair representation of the existing state of affairs of a business concern. Thus, an auditor should have the proper knowledge of accounting principles. That is why he should be a chartered Accountant. He has to express his impartial opinion in his report which he can not give unless he satisfies himself completely with the proper recording of transactions. Thus, auditing is based on accountancy and not accountancy on auditing. An auditor must be well familiar with the principles and practical aspects of accountancy but it is not necessary for an accountant to be an expert in the audit work. The following table makes the distinction clear among book-keeping accountancy and Auditing. (a) Book-keeping 1. Journalizing. (Recording & Balancing) 2. Posting into Ledger. (the Practical Part) 3. Totalling of different accounts in the Ledger, and 4. Balancing,

5. Checking the work of the Book-keeper.
6. Preparation of Trial Balance, (b) Accountancy 7. Preparation of Trading & Profit & laws account, (summary and Analysis) 8. Preparation of Balance sheet, (Theoretical part) 9. Passing entries for rectification of errors and making adjustments, (c) Auditing 10. Checking the work done by the accountant. (Examination of Records) (the Analytical part) Audit and Investigations There is a lot of difference between auditing and investigation which is as follows :

1. Audit is conducted to find out whether the balance sheet is properly drawn up and exhibits a true and fair view of the state of affairs of the business while investigation means a searching enquiry with certain object in view, e.g.; to find out the profit earning capacity, or the financial position of a concern or a fraud and the extent thereof.
2. Investigation covers several years, say, 3,5, and 7 years to find out the average earning capacity, financial position, etc. of a concern while audit usually relates to one year.
3. Investigation may be carried out on behalf of outsiders who either want to purchase the business, to become partners, to advance loans or to purchase the shares of a firm. Audit is always conducted on behalf of proprietors only. However investigation may also be carried out on behalf of proprietors in case fraud is suspected.
4. Audited accounts are further investigated for some special purpose in view while investigated accounts are not audited in the ordinary course.
5. Audit is legally compulsory, specially in case of companies, but investigation is voluntary and depends upon the necessity of some purpose in view. Objects of an Audit The main object of audit is to verify the accounts and to report whether the Balance Sheet and the Profit and Loss Account have been drawn up properly according to the companies Act and whether they exhibits a true and fair view of the state of affairs of the concern. For this, an auditor has to discover errors and frauds. As such the subsidiary objects of audit are : (i) Detection and Prevention of errors, (ii) Detection and Prevention of frauds. The difference between an error and fraud is that error generally arises out of the innocence or carelessness on the part of those responsible for the preparation of accounts, while fraud involves some intention to gain out of manipulating records. Types of Errors A. Clerical Errors : Clerical errors are those which result on account of wrong posting that is posting an item to a wrong account, totalling and balancing. Such errors may again be subdivided into: (i) Errors of Omission : An error of omission takes place when a transaction is completely or partially not recorded in books of account. For example, goods purchased from Narendra Kumar were not recorded any where in account books.

C. Compensating Errors :- Compensating errors arise when an error is counter balanced or compensated by any other error so that the adverse effect of one on debit (or credit) side is neutralised by that of another on credit (or debit) side. For example Rani's account was to be debited with Rs. 10, but it was debited with Rs. 100 similarly Shyam's account was debited with Rs. 10 instead of Rs. 100. Both these errors compensate each other's deficiency and will not affect the agreement of the Trial Balance. Detection of Errors :- Although it is not the duty of the auditor to trace and locate errors in the books which he is required to check and audit as this is the work of an accountant but in many cases the auditor is frequently asked to discover the errors, specially so, when the accountant is unable to locate such errors. While locating errors, the auditor should take note of following devices :-

1. Check the totals of the trial balance.
2. Compare the names of the accounts in the ledger with the names of the accounts as have been recorded in the trial balance.
3. Total the list of debtors and creditors and compare them with the trial balance.
4. I f the books are maintained on the self-balancing system, see that the total of different accounts agrees with the total of these accounts with the balance of accounts as recorded in the trial balance.
5. Compare the items of the trial balance with the items of the trial balance of the previous year to see if any item have been omitted.
6. Whatever the difference is in the trial balance, see if there is any item of this amount. This is done to avoid the putting of the debit balance on the credit side of the trial balance or vice versa.
7. It is possible that the totals of some subsidiary books, e.g. Cash book, Sales book etc. might not have been transferred to the trial balance. Recheck the totals of these books. Detection and Prevention of Fraud Fraud means false representation or entry made intentionally or without being in its truth with a view to defraud somebody. Detection of fraud is considered to be one of the important duties of an auditor. Fraud may be of three types 1

1. Misappropriation of Cash : It is easier to misappropriate cash, therefore the auditor will have to pay particular attention towards cash transaction. Cash may be misappropriated by, (a) Omitting to enter any cash which has been received; or (b) Entering less account than what has been actually received; or (c) making fictitious entries on the payment side of the cash book; or (d) entering more amount on the payment side of the Cash Book than what has been actually paid. In order to discover fraud under (a) and (b) above, the auditor should check the debit side of the cash book with rough cash book, salesmen's reports, counterfoils of the receipt books, agent's returns and other original records while the fraud under (c) and (d) can be discovered by reference to the vouchers, wage sheets, salary book invoices, etc.
2. Misappropriation of Goods :- This type of fraud is very difficult to detect especially when the goods are less bulky and are of higher value. Proper methods of keeping accounts in regard to purchases and sales, stock, taking, periodical checking of stocks, comparing the percentage of gross profit to sales of two periods, necessity for collusion will help to avoid misappropriation of goods.
3. Fraudulent Manipulation of Accounts : This type of fraud is more difficult to discover as it is usually committed by directors or managers or other responsible officials. That is why the auditor should be very careful in detecting such frauds. He should carry out the routine checking and vouching most carefully and make searching, tactful and intelligent enquiries. Such a fraud is committed with the following two objects :- (a) Showing more profits than what actually they are so as to increase the commission payable on the basis of profits, borrow money by showing a better position, to attract more subscribers for the sale of the shares of the company etc. or (b) Showing less profits than what actually they are so as to purchase shares in the market at a lower price ; or to reduce or avoid the payment of income tax or to mislead a prospective buyer of the business etc. The accounts may be manipulated in a number of ways which are as follows:
4. by not providing any depreciation or less depreciation or more depreciation; or
5. by under valuation or over-valuation of assets and liabilities; or

1. The accounts of a business and its financial position can be examined by an independent and qualified auditor.
2. Quick discovery of errors and frauds—Errors and frauds are located very easily and at early stage. Therefore, chances of their repetition are reduced to the minimum.
3. Moral check on the Employees—Through auditing, the staff maintaining accounts become more alert and careful in keeping future accounts up-to-date.
4. Loans and credit can easily be obtained from banks and other money lenders on the basis of properly audited accounts.
5. The business itself enjoys better reputation due to audited accounts.
6. In case of Advice to the management—regular audit, the auditor can come into close touch with the working of the business & thus, can give suggestions the management to improve it in case he is asked to do so.
7. Audit is useful in case of a business managed by some agent or representative of its owner.
8. Uniformity in accounts if the accounts have been prepared on a uniform basis, accounts of one year can be compared with other years and if there is any discrepancy, the cause may be enquired into. B. For the owners of Business
9. If the business is owned by a sale trader, he can rely well on the audited and on his accounts clerks who are responsible for maintaining accounts.
10. In case of partnership firm, its partners can utilize the audited accounts to settle their disputes in regard to adjustment of capital and valuation of goodwill at the time of admission, retirement and death of a partner.
11. In case of a joint stock company. Shareholders living at distant places can rely on audited accounts and can be sure of their investment being sage with the company.
12. In case of a trust, its trustees can easily make their position clear before others by getting the accounts audited by an dutside auditor. C. For others
13. Filling of Income Tax Return—Income Tax authorities generally accept the profit & loss account that has been prepared by a qualified auditor and they do not go into details of

accounts.

2. Settlement of Insurance claim—In case of fire, flood and the like unexpected happenings, the insurare company may settle the claim for loss or damages on the basis of audited accounts of the previous year.
3. Sales Tax payments—The audited books of accounts may generally be accepted by the sales tax authorities.
4. Payment of wealth-tax, expenditure-tax etc.—The taxation authorities can also rely on audited accounts for the purpose of imposing wealth tax, expenditure-tax etc.
5. Actions against Bankruptcy and insolvency—The audited accounts of a business can be produced in support of a legal case before the court. It forms a basis to determine action in bankruptcy and insolvency cases.
6. Future trends of the business—The future trends of the business can be assessed with certainty from the audited books of accounts. Limitations of Auditing Truly speaking an audit should have no limitation of its own. It is designed to protect the interest of all parties who are interested in the affairs of the business. If these is any short coming arising there from, it may be due to its narrow scope of application in its related field of operations and un-extended designition of the concept. The audit has following limitations.
7. Lack of complete picture—The audit may not give complete picture. If the accounts are prepared with the intention to defraud others, auditor may not be able to detect them.
8. Problem of Dependence—Sometimes the auditor has to depend on explanations, clarification and information from staff and the client. He may or may not get correct or complete information.
9. Existence of error in the audited accounts—Due to time and cost constraints, the auditor can not examine all the transactions. He uses sampling to check the transactions. As a result, there may be errors & frauds in the audited accounts even after the checking by the auditor.
10. Exercise of judgement—The nature, timing and extent of audit procedures to be performed is a matter of professional judgement of the auditor. The same audit work can be done by two different auditors with difference in sincerity &

appointment of auditors to check the accounts of the trusts. In some of the state in India, Public Trust Acts, (for example, the Bombay Public Trust Act, 1950 etc.) have been enacted which provide for compulsory audit of the accounts of trust by qualified auditors. (iii) Audit of other institutions :- There are other corporate bodies such as electricity and gas companies which has been formed under their respective statutes. There is another set of public bodies in the name of public corporations, for example, Reserve Bank of India, Industrial Financial Corporation, etc.; Which work according to the various Acts passed for the purpose. All these institutions fully recognise the significance of a professional audit which is compulsory for them. The powers, duties and liabilities of auditors are also well defined and fixed by statues.

2. Private Audit The institutions which are private in character also get their accounts audited by some qualified auditors. As such an audit is not required by statute, it is known as private audit. There may be three types of such institutions which are as follows : (i) Audit of the accounts of Sole Trader :- The appointment of an auditor in case of a proprietary concern rests absolutely on the proprietor. His rights, duties and nature of work will depend upon the terms given in the agreement. Such an auditor must get clear instruction in writing by his client as to what he has to do and how he has to proceed so that he can be held responsible for any charge of negligence and by producing the agreement, he can protect himself against such a charge. (ii) Audit of the Accounts of partnership Firms :- In case of a partnership firm, the auditor is appointed by agreement between the partners. His rights, duties and liabilities are also defined by mutual agreement and can be subjected to modification. (iii) Audit of the accounts of other individuals and institutions :- There are other individuals, e.g., rent collectors, estate managers, etc., who have large income and huge expenditure. The qualified auditors are appointed by these individuals in order to verify various accounts prepared by the accountants.
3. Government Audit The Government maintains a separate department in the name of accounts and audit department which performs the audit of its different departments and offices. This department is headed by the Comptroller and Auditor General of India who is assisted by different officials at various levels.

The duties and liabilities of such auditors are not defined by statue. They are not public auditors and hence can not be appointed auditors for public concerns. They are meant for Government departments and as such, they work according to departmental rules and instructions.

4. Internal Audit By virtue of the organizational pattern, some business institutions appoint auditors who are made responsible to have a constant and regular review of their accounts. Such auditors are of a permanent nature and are known as internal auditors. Such auditors, besides checking the accounts are required to report also as to how the system of accounting can be improved and the system of internal check be made economical and efficient. They can not be appointed as public auditors or external auditors and hence are not required to submit their reports in the manner in which external auditors do. In short internal audit is the examination of books of account which is conducted by the salaried officials of a business known as internal auditors throughout the year. The scope of internal audit is a bit different. It is more closely related to managerial functions than to accounting duties. From Practical Point of View : All those forms in which audit is often conducted practically by business houses are as follows :-
5. Continuous Audit or Detailed Audit.
6. Periodical audit or Final Audit or complete Audit.
7. Interim Audit.
8. Occasional Audit.
9. Partial Audit.
10. Balance Sheet Audit.
11. Cash Audit.
12. Cost Audit.
13. Continuous Audit or Detailed Audit :- According to spicer and pegler "A continuous Audit is one where the auditors staff is occupied continuously on the accounts the whole year round, or where the auditor attends at intervals, fixed or otherwise, during the currency of the financial year, and performs an interim audit; such audits are adopted where the work involved is considerable, have many points in their favour, although they are subject to certain disadvantages."

Disadvantages :

1. Alteration of figures: Figures in the books of account which have already been checked by the auditor at his previous visit, may be altered by a dishonest clerk to defraud the accounts.
2. Dislocation of client's work: As the auditor visits frequently, it may dislocate the work of his client and cause inconvenience to the latter.
3. Expensive: It is an expensive system of audit as such an audit is carried on throughout the financial year at regular intervals.
4. Queries may remain outstanding : As there may be a long interval between the two visits, the audit clerk may lose the link between the past and present work and the queries which he wanted to-make may remain outstanding.
5. Mechanical work: Under such an audit, the work of the auditors becomes mechanical and his frequent visits may also cause boredom to him. Precautions to guard against its disadvantages :
6. The auditor should issue clear instructions to the effect that the audited figures should not be changed without bringing itto his notice. If some alteration is necessary it should be done by passing rectification entries in the journal.
7. He should try to check the accounts of similar nature in one and continuous sitting as far as possible and if not possible he should check the transaction up to a particular date. He should also note important totals and balances up to that date in his diary and compare them at his next visit,
8. The auditor should prepare an exhaustive programme to prevent any loop- holes.
9. The explanations of important questions which he finds unsatisfactory should be noted in his note-book and efforts should be made to get the matters settled.
10. He should go through the past work and alterations, if any, before he begins his work.
11. The checking of impersonal accounts should be undertaken at the time of final audit because the fraud in personal accounts can easily be made by passing false entries in the impersonal accounts,
12. Special ticks should be used by the auditor while checking altered figures,
13. He should pay surprise visits so that the clerks of the client may not know the exact date of the visit of the auditor.
14. Periodical of Final or Complete Audit:- That system under which the auditor takes up his work of checking the books of account and other related documents, only at the end of the accounting period when the transactions for the whole

period are completely recorded, balanced and a Trading profit and Loss Account and the Balance Sheet have been prepared, is known as periodical or final audit, He would complete his audit work in one continuous session or without any interval, In other words the auditor visits his client only once a year and goes on checking the accounts and other related documents until the audit work for the whole of the period is completed. Advantages :

1. The Work of audit does not present any inconvenience and dislocation in the work of the concern as the auditor comes only once a year.
2. It is less expensive and more useful for small business concerns than continuous audit.
3. In periodical audit the work of the auditor can be finished quickly and within a reasonable time.
4. The audit work does not become mechanical for the auditor.
5. Undue collusion is not established between the auditor and the clerks. Disadvantages :
6. In periodical audit, detailed checking of accounts is not possible.
7. There is a greater chance of errors and frauds in accounts as the auditor visits his client only once a year and not at regular intervals.
8. If such a audit is undertaken in large concerns it takes more time to complete the audit and hence presentation of auditor's report to the shareholders is delayed. But shareholders are usually very anxious for the dividends which cannot be declared until the final accounts have been prepared and audited. Therefore, such an audit is not practicable for big concerns. Difference between continuous Audit and final Audit
9. Under continuous audit, the auditor or his staff, for the purpose of checking the accounts, visits his client's at regular or irregular interval during the financial year. On the other hand, in case of final audit, he visits the cilent only at the end of the accounting period.
10. In continuous audit, the audit work is carried on almost simultaneously with the recording of transactions, while in final audit, accounts are audited much after their recording.
11. Continuous audit is commenced and carried on before the close of the financial period to which it is related. While final audit is undertaken when all the accounts have been recorded, balanced and a Trading and Profit and Loss Account and the Balance Sheet have been prepared.