Principles and Practices of

Auditing

Unit 1 - Introduction to Audit

Topics covered under this chapter.

• Origin of Audit• Meaning• Definition• Purpose and Functions of Audit• Factors responsible for growth of Auditing • Advantages & Limitations of Audit• Difference between Book Keeping, Accountancy and Audit• Objects of Audit – Primary and Secondary Objectives

Topics covered under this chapter.

• Errors and Location of Errors• Position of Auditors in relation to Errors and Frauds• Different types of Audit and their advantages • Statutory Audit, Partial Audit, Cash Audit, Interim Audit, Balance

Sheet Audit, Cost Audit, Occasions Audit• Investigation – Meaning • Difference between Investigation and Auditing• Investigation regarding business purchase and investments

Origin of Audit • Historical records show that Egyptians, Greeks and Romans used to

get their public accounts scrutinized by an Independent Official. • Need felt during the Industrial Revolution (mass production &

economies of scale)• Creation of Monitoring Authority (review & correction mechanism)• Emergence of Appraisal Agencies (external firms)• Grew as an independent and professional medium• A class by itself and self regulated discipline

Meaning• Derived from Latin word – “Audire” which means “to hear”• An Auditor – An Individual appointed by the company owners to

check accounts whenever they suspected fraud, to hear the explanation given by the person responsible for financial transactions.• Luca Pacialo – Italian Mathematician – In 1494 – first to mention and

describe the duties & responsibilities of an Auditor• Object of an audit was mainly to see whether the accounting party

has properly accounted for the receipts and payments of cash

Definition of Auditing• ICAI – The independent examination of financial information of any entity,

whether profit oriented or not, and irrespective of its size or legal form, when such examination is conducted with a view to expressing an opinion thereon.• Montgomery, a leading American Accountant – “Auditing is a systematic

examination of the books and records of a business or other organization, in order to ascertain or verify, and to report upon the facts regarding its financial operations and the results thereof”.• Comprehensive Definition – It is an examination of the accounting books and

the relative documentary evidence so that an auditor may be able to find out the accuracy of figures and may be able to make report on the balance sheet and other financial statements which have been prepared from there.

Purpose of Auditing• To conduct careful examination of books of accounts, documents,

records and vouchers• To gather and test the evidence for framing an opinion• To give expert advice for improving efficiency and productivity• To express an opinion on the quality of financial statements• To review operations and performances connected with non financial

areas • To serve as a guide to the management to take future decisions• To understand the usage and allocation of funds

Features and Functions of Auditing

• A Systematic and Scientific examination of the books of accounts• Involves inspecting, comparing, checking, reviewing, ascertaining,

scrutinizing and verifying the vouchers supporting the transaction• Implies the verification that is the physical inspection of the assets and

liabilities of the business as shown in the balance sheet• Examination of the books of accounts prepared by the employees of

the company and examined by an independent person or body or persons• Carried out periodically – quarterly, half yearly, annually

Features and Functions of Auditing

• Prepared on the basis of documentary evidence such as invoices, receipts, vouchers and other accounts related ledgers • Made for the purpose of ascertaining whether the financial figures

found in the books of accounts and the financial statements are authentic, properly authorized and accurate • Requires the Auditor to express his opinion about the truth and

fairness of the financial statement• Applies to business concern as well as non business concern

Factors responsible for growth of Auditing

• Rising importance of Quality, Transparency and Independence • Increase in size of business (level of operations)• Dynamic nature of business (change in technology & processes)• Need for effective fraud detection and risk management procedures• Legislation and regulatory requirements (corporate governance)• Competition from competitors (operational efficiencies & cost

effectiveness) • Impact of IT (computerization of operations & controls)

Advantages or Merits of Auditing

• Verification of the books of accounts and financial statements• Discover and prevent errors or mistakes• Discovery and prevention of frauds or fraudulent activities• Acts as a moral check on the employees of the company• Provides independent opinion about the business condition• Protects the interest of shareholders• Acts as a check on Directors or Management• Provides valuable and expert advice on process & procedures of

accounts

Advantages or Merits of Auditing

• Very useful in settling disputes or legal matters • Audited financial statements are very useful in obtaining loans from

financial institutions • Fire insurance claims and fraud claims can be settled on the basis of

previous years financial accounts• It helps in smooth valuation and assessment of company property during

the sale of business • Audit reports provide correct information and financial status of the

organization• Helps investors in assessment of companies to make investments• Assessment of tax becomes easy for the tax department

Limitations or Demerits of Auditing

• Non detection of certain errors or frauds• Dependence on explanation and information given by the responsible

employees• Conflicts or differences of opinion with auditor, accountants or management • Effect of inflation on financial statements• Management may use corrupt practices to influence the process• No assurance can be given by auditors about company’s future profitability

and prospects• Certain non monetary facts cannot be measured • It may not display the current values of the assets and liabilities

Difference between Book Keeping, Accountancy and Auditing

Book

Kee

ping

1. Recording of business transactions in the books of original entry and ledgers. 2. Done by Junior Clerk or Automated Machines.

Acco

unta

ncy1. Preparation of

trial balance to ascertain arithmetical accuracy of the entries made in the books of accounts.2. Carried out by Accountants.

Audi

ting 1. Analytical and

critical examination of the books of accounts and financial statements to establish authenticity and correctness of the entries found. 2. Undertaken by Qualified Auditors.

Difference between Book Keeping, Accountancy and Auditing

Book

Kee

ping

3. Records and maintains daily business transactions in the ledger books.4. Not governed by any recognized professional body.

Acco

unta

ncy3. Measures and

communicates working results & financial position of the company.4. Not governed by any recognized professional body.

Audi

ting3. Reviews the

measurements and communication of working results.4. Governed by standards laid down by ICAI.

Difference between Book Keeping, Accountancy and Auditing

Book

Kee

ping

5. Based on daily recording of business transaction.6. Required to record day to day business transactions in prescribed manner.

Acco

unta

ncy5. Based on

current recording of business transaction. 6. Required to prepare books of accounts and not expected to find frauds.

Audi

ting5. Retrospective-

Based on past transactions.6. Required to find frauds and provide suggestions.

Objects of Audit – Main or Primary• Examining the system of internal check• Checking arithmetical accuracy of books of accounts, verifying

posting, costing, balancing• Verifying the authenticity and validity of transactions• Checking the proper distinction of capital and revenue nature of

transactions• Confirming the existence and value of assets and liabilities• Verifying whether all the statutory requirements are fulfilled or not• Proving true and fairness of operating results presented in books of

accounts

Objects of Audit – Subsidiary or Secondary

• Detection and Prevention of Errors• Detection and Prevention of Frauds• Under or Over Valuation of Stock• Provide accurate and complete information to Income Tax Authorities• Satisfy the Provisions of the Company’s Act

Types of Errors• Errors of Omission – A transaction has not been recorded in the books of

account either wholly or partially • Errors of Commission – A transaction has been recorded but has been

wrongly entered in the books of original entry or in ledger • Errors of Principle – When entries are not recorded according to the

fundamental principles of accountancy • Compensating Errors – Also known as off setting error, is a type of error

which is counter balanced by any other error or errors• Errors of Duplication – An entry in a book of original entry has been made

twice and has also been posted twice

Location of Errors• Check the totals of the trial balance• Compare the names of accounts in the ledger with the names of accounts

in the trial balance• Total the list of debtors and creditors and compare them with the trial

balance• Compare the items of the trial balance with the items of the trial balance

of the previous year to see if any item has been omitted• Totals of some subsidiary books (Cash, Purchases & Sales Book) may not

have been transferred to the trial balance. Re-check the totals of these books.

Position of Auditors in relation to Errors and Frauds

• It is responsibility of management to prevent errors and frauds• Auditor is not liable for any subsequent discovery of misstatement of

financial information resulting from errors and frauds, if he carried out his duty according to the generally accepted auditing practices• If any errors or frauds are discovered by the Auditor during his audit, he

must see that the errors are corrected and the effect of fraud on financial information of the statements is properly reflected, simultaneously bringing this to the notice of the concerned • Auditor need not sniff for errors and frauds, but if he smells something

about it, he should not leave them carelessly, he may enlarge his extent of checking and if required, he may modify checking procedures accordingly

Different types of Audit & their advantages

• Statutory Audit• Partial Audit• Cash Audit• Interim Audit• Balance Sheet Audit• Cost Audit• Occasions Audit

Statutory Audit• It refers to the audit of accounts of a business enterprise carried out

compulsorily under the provision of a Statute of Law. • Any audit carried on as per the requirement of law is called as a Statutory

Audit.• All Companies have to get their accounts audited as per the provisions of

the Company’s Act of 1956.

Advantages of Statutory Audit• In case of Joint Stock Company, SA enables the shareholder to know the

truth and fairness of the assertion made by the management in the financial statements of the Company• In case of a Trust, SA protects the interest of the beneficiaries against

possible frauds by the trustee and also protects the interest of the trustee who may not possess adequate knowledge of the principles of accounting or the trust laws• In case of a Co-operative Society, SA helps or serves to maintain proper

books of accounts and check frauds committed by the managing committee and protect the members

Partial Audit• An audit which is conducted considering the particular area of accounting

is called Partial Audit• Under PA, audit of all books of accounts is not conducted• Company may conduct audit of any transaction – Cash, Stock, Debtor,

Creditor etc. • An Auditor should conduct audit of that transaction as per the scope

determined by the agreement • He signs the report clearly stating that the engagement is Partial Audit

Cash Audit• It is a type of accounting audit that focuses on cash transactions

conducted between an identified start date and end date. • This type of audit may be considered full or partial, depending on

whether only certain transactions are evaluated or if every cash transaction relevant to the audit period is scrutinized.• Purpose of a CA is to ensure that all investigated transactions have

been conducted in compliance with Generally Accepted Accounting Procedures and that the transactions were in accordance with the policies and procedures of the company involved.

Advantages of Cash Audit• It focuses on the type of cash deposits or contributions that are

received and how they are recorded in the accounting records.• Along with addressing cash receipts, it will look closely at any type of

disbursements made as cash transactions, making sure those disbursements are properly documented and were done with proper authorization.• It will make sure that the receipts and disbursements involved line up

so that the amount of cash that is shown as being on hand or deposit is justified by the combination of cash transactions.

Interim Audit• An audit which is conducted in between the two annual audits with a

view to find out interim profits to enable the company to declare an interim dividend is known as Interim Audit.• It is an audit conducted during the fiscal year usually as a means of

minimizing the work and time involved in concluding the audit after the fiscal year.

Advantages of Interim Audit• It is very useful to publish interim figures • Helps in detection of errors and frauds in time• Acts as a moral check on staff / employees, they may not commit frauds

as IA can happen anytime during the year• Smoothen the process of final audit• Helps in implementation of suggestions by Auditor • Preparation of proposed interim dividends made easy• Entry / Exit of a partner – correct position of company is determined • Useful to management in fixing the selling price of goods and services

Balance Sheet Audit• It is an evaluation of the accuracy of information found in a company’s

balance sheet. • It involves a number of checks as auditors conduct this evaluation based

on supporting documents. • Involves verification of the value of assets, liabilities, the balances of

reserves and provisions and the amount of profit earned or loss suffered by a firm during the year. • It is a condensed statement that shows the financial position of an entity

on a specified date, usually the last day of an accounting period.• It is used to detect irregularities or weaknesses in a company’s accounting

system.

Cost Audit• It is the verification of cost accounts and check on the adherence to cost

accounting plan.• It ascertains the accuracy of cost accounting records to ensure that they in

conformity with cost accounting principles, plans, procedures and objectives.• Verification of the accuracy of the cost accounts, cost reports, cost

statements, cost data and costing techniques.• Aims to identify the undue wastage or losses and ensure that costing system

determines the correct and realistic cost of production.• Provides useful information to the management regarding regulating

production, economical method of operation, reducing cost of operation and reformulating cost accounting plans.

Advantages of Cost Audit• Management will get reliable data for it day to day operations like price fixing,

control, decision making• A close and continuous check on all wastages will be kept through a proper

system of reporting to management• Inefficiencies in the working of the company will be brought to light to

facilitate corrective action• System of budgetary control and standard costing will be greatly facilitated• Helps in the detection of errors and fraud• Reliable check on the valuation of closing stock and work in progress• Assists government to fix the price of the contract at a reasonable level• Facilitates in settlement of trade disputes

Occasions Audit• It is conducted when there is need of it.• The owners can decide to check their accounts occasionally.• The audit period is not regular but on certain occasions audit becomes

due. • It is concerned with improving the quality of products, reduction of

product cost, health & welfare of employees, fair wages, prices, profits, energy & material conservation, population control, water treatment & cleanliness, etc. • Purpose is to check the reliability of the books of accounts for

compilation of final accounts and balance sheet, it is not a special type of audit but it’s a part of whole audit.

Investigation – Meaning • An inquiry into the accounts of a business for a special purpose. • It is an examination of the books of accounts of a business to know its

actual financial position or earning capacity. • Taylor and Perry – “Investigation involves inquiry into facts behind the

books and accounts, into the technical, financial and the economical position of the business or organization”.• It is a kind of special audit with a limited or extended scope according to

the purpose for which it is conducted.

Difference between Investigation and Auditing

Audi

ting1. Conducted on behalf of

Shareholders or Proprietors.2. It is compulsory for a Company. 3. Carried out periodically – quarterly, half yearly & annually.4. Regular statutory procedure. 5. Audit Report – Management.6. Auditor – Mentions his satisfaction/concerns of the books of accounts on compliance matters. Inve

stiga

tion1. Conducted on behalf of

outsiders who intend to purchase the business or wish to lend money. 2. It is not compulsory. 3. Carried out only if required.4. It is a Special enquiry. 5. Investigation Report – Interested Authorities. 6. Investigator - Shares his findings and recommendations with the client.

Investigation regarding business purchase

• Why does the vendor sell the business? Is it a genuine case of sale?• Whether it is worthwhile to purchase the business.• What is the trend of the business? Statement for past years.• Whether the assets have been properly valued and sufficient depreciation has

been provided on these assets.• Whether the company goodwill is appropriately valued.• Whether sufficient provision has been made for bad / doubtful debts.• Whether the liabilities have been properly valued and that they have not been

shown at a lower figure.• Whether the accounts have been previously audited. Examine Auditor’s report.

Investigation regarding business purchase

• Whether the working capital is sufficient and reserves are adequate.• Whether the plant and machinery are old or new.• Whether any technical knowledge or skill is required for the business to be

taken over. Whether client possesses such a skill.• Whether trade restrictions have affected recent purchases and sales.• Whether there is much competition in the business which is proposed to be

taken over.• Whether the vendor will be allowed to carry on the same type of business. • Whether the customers are a set of friends of the vendor who will cease

patronizing the business after it has been sold to his client.

Investigation regarding investments • Investigator will do Valuation of shares for investment purposes. • On the basis of the Average Profits in the previous years.• On the basis of the Net Assets of the Company. • Generally valued at market price or book value.• Study the conditions prevailing in the money market.• Ascertain the level of dividends payable and security of amount invested in the

purchase of shares. • Memorandum of Association and Articles of the Company must be scrutinized

to ascertain the rights of different classes of shareholders. • Sometimes, based on findings, Auditor is asked to fix the fair value of the shares

to be paid by the shareholders.