Unit – 1

Introduction  to Principles of Auditing and Audit Process.

1.1 Financial  Statements

1. Item included in Financial Statement : According to Standard  on Auditing (SA)200  by the ICAI, the term “General Purpose Financial Statement” [FS] includes –

a. A balance sheet,

b. A statement of profit and loss,

c. A cash flow of statement (wherever applicable),

d. Statement and explanatory notes which from part thereof; and

e. Supplementary schedules and information based on such statement.

While  the auditor is responsible for forming and expressing his opinion on the financial statement, the responsibility for their preparation of the management of the enterprise. Management is primarily responsible for the preparation of the financial statements.

1.2 Users of Financial Information

1.3 Meaning

The term  Audit is derived from the Latin word’ audire’ which means to hear. In traditional times, auditors used to ‘hear’ accounts read out by the book keeper. The final accounts of a business concern are used by various persons such as the owners, shareholders, investors , creditors, lenders, Government etc for different purpose. All these users need to be sure that the final accounts prepared by the management are reliable. An auditor is an independent expert who examines the account of a business concern and report whether the final account are reliable or not.

Definition:-

ICAI “Auditing is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon’’.

‘’Auditing is a systematic and independent examination of data, statements, records, operations and performances ( financial or otherwise ) of an enterprise for a stated purpose.’’ [General Guidelines on Internal Auditing]

Features of Auditing:

1. Audit is a systematic and scientific examination of the books of account of a business.
2. Audit is undertaken by an indepent person or body of person who are duly qualified for the job.
3. Audit is a verification of the results shown by the profit and loss account and the state of affairs as shown by the balance sheet
4. Audit is a critical review of the system of accounting and internal control,

e. Audit is done with the help of vouchers, document, information and explanations received from the authorities.

f.  The auditor has to satisfy himself with the authenticity of the financial statement and report the they exhibit a true an d fair view of the state of affairs of the concern.

g.  The auditor has to inspect, compare, check, review, scrutinize the voucher supporting the transactions and examine correspondence, minute books of share holder, directors, Memorandum of  Association and Articles of association etc in order to establish correctness of the books of accounts.

1.4 Objectives of Auditing

SA200 issued by ICAI states that the objective of audit of financial statement is to enable an auditor to express an opinion on such financial statement. A financial Audit has the basic object of examining whether the account are true and fair. It has an incidental object of detecting errors and fraud.

1. Basic Object - True and Fair View:- SA 200 states that the auditor’s opinion helps in determination of true and fair view of the financial position and operating results of an enterprise. The auditor gives an opinion on whether the final accounts give a true and fair view if the affairs of the concern i.e. whether the balance sheet gives a true and fair view if the financial position of the concern as at end of the year and the profit and loss account gives a true and fair view it the profit and loss for the year.

2. Incidental Object - Detection Of Errors And Frauds :-  The main objective of a financial audit is to report on the truth and fairness of the final account. Since the final account are based on the books of accounts, the incidental objective of audit is to ensure that the final account tally with the books of account. While conducting the audit, the auditor has to vouch the transactions, verify the assets and liabilities and study the internal control. During such vouching , verification etc an auditor may come across errors or fraud. He then takes proper action . He should ensure that the accounts are free errors and frauds so as to give a true and fair picture of the affairs of the concern.

3. Not Object - However, it is not the object of audit to give a guarantee that all is well with the concern. A clean audit reaper does not imply the the management has been efficient or that the business will continue to be profitable in future and so on . Thus it not the objective of the audit to give an opinion on the future prospects of business or on the efficient or effectiveness of the management.

1.5 Errors

“Errors “means an unintentional mistake in financial information. It is an inadvertent or innocent mistake in the books and records.

A “Fraud” on the other hand, is a deliberate and mala fide mistake.

Both errors are known as “misstatement”. A misstatement also covers wrong grouping or presentation.

An Error may be

1. Errors of Principle
2. Clerical Errors. Clerical Errors are further classified into:
   1. Errors of Omission
   2. Errors of Commission
   3. Compensating Errors and
   4. Errors of Duplication Errors of Principle:-

1. Errors of Principle

An Errors of Principle occurs when the transaction is not  recorded according to the basic principle of accounting. The debit or credit is gives to the wrong head of account. These errors do not affect the trail balance , but they affect the true fair view of accounts.

For instance:

1. Over valuation or under valuation of assets.

2. Treating revenue expenses as capital expenditure and vice versa.

3. Ignoring pre-paid or outstanding expenses, Income Income received in advance or income accrued.

B. Clerical Errors:-

a. Errors of Omission :- An errors of omission occurs when a transaction is omitted from books either wholly or partly .If a transaction is partially omitted, the trial balance would not tally and the errors can be detected . If a transaction is wholly omitted, the trial balance would still tally and it would be difficult to detect such error.

b. Errors of Commission:- A Errors of Commission occurs when a transaction is entered in the books but wrongly such errors may be

(a) Mathematical Errors (b) Casting Errors or  (c) Posting errors.

• Mathematical Errors:- Mathematical Errors may occur in voucher, books ,ledger, trial balance and so on. Thus , in a Purchase bill, 1000 NO.x10 may be calculated as 10000Rs. Instead of Rs.10000.

• Casting Errors:- Casting Errors,i.e.errors in totalling, carry-forward, extension etc. May occur in Day Book, Ledger or the Trial Balance. Thus ,in Purchase Register, while totalling all bills for  month a bill of RS.1000 may be taken as RS.10000.

• Posting errors.:- Posting errors. Occur while posting  amount from Registers into the Ledger. Thus ,a purchase bill of RS. 10000 on Mr. A maybe (1) posted to Mr.A’s  A/c for RS.100000. Or (2)posted on the debit side instead of credit side of Mr.A’s A/c, or (3)posted to Mr.B’s A/c.

c. Compensating Errors:- Compensating Errors occur when the effect of one error is compensated by another error. Thus one error cancel the effect of another error and there is no final net effect  on the account. For example: One purchase bill no. 120 for RS. 10000 on A is posted into account of B and another purchase bill no. 220 for RS.10000 on posted into the account of A. The posting error in the bill is compensated by the posting error in the second bill. These errors cancel each other and do not affect the trial balance.

d. Errors of Duplication:- Errors of Duplication occur when a transaction is recorded twice in the book of original entry. The  posting is also done twice. Thus, a purchase Bill for RS. 1000 may be recorded twice in the purchase register.

1.6 Frauds

The Standard on Auditing (SA) 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statement “ defines the term ‘fraud’ as “ intentional act by one or more individuals among management , those charged with governance, employees, or third parties, involving the user of deception to obtain an unjust or illegal advantage”. For the purpose of the SA, the auditor is concerned with fraud that causes a material misstatement in the financial statement.

Two types of intentional misstatement are relevant to the auditor-

1. Fraudulent Financial Reporting
2. Misappropriation Of Assets.

A. Fraudulent Financial Reporting:-

1. Not Recording Transactions.:-Transaction may not be recorded at all. Such fraud occurs when an error of omission in intentional.
2. Recording Dummy Transaction :- Dummy transaction may be recorded . Such fraud occurs when an Error of Commission is intentional.
3. Misapplication of Accounting Policies:- Accounting policies may be applied wrongly such fraud occurs. When an errors of Principle is Intentional.

B. Misappropriation Of Assets.

1. Misappropriation of Cash:-

a. From Cash Received: By not recording cash received at all or recording only part amount as received and pocketing the balance . This is an intentional Error of Omission.

b. By Teeming and Lading: Pocketing the first receipt from party A and showing second  receipt from party b as received from A , then showing third receipt from party C as received from B  and so on and using the money meanwhile.

c. From Cash Payment: Cash may be misappropriated out of cash payment by recording dummy or excess payment.

d. From Cash Balance: Cash may be actually stolen or embezzled out of the cash in hand lying in the cash box.

2. Misappropriation of Goods:-

a. From Goods Received: Goods received may be misappropriated by not recording goods received at all or recording only part quantity as received and misappropriating the balance.

b. From Goods Despatched: Good may be misappropriated out of despatches any recording dummy or excess sales.

c. From Stock in Hand: Goods may be actually stolen out of the stock in hand lying in the warehouse.

1.7 Window Dressing

Window dressing means the skill of presenting the account in way that creates a  good impression. In window dressing, the account are made in such a way as to show a much better condition than the actual condition. The profits and the net  worth are overstated in the final account.

Why window dressing is done:-

      Mislead investor & lenders

      Hide losses

      Higher commission

How window dressing is done:-

1. Overstatement of Assets
2. Understatement of Liabilities                    

Objections Against Window Dressing :-

1. No true and fair view

Balance sheet & profit and loss account fails to disclose the actual working results of the concern during the year.

2.      Shareholder Suffer

The shareholders do not get to know the picture of the value of their investments.

3.      Hides Inefficiency of Management

Window dressing helps management to hide its inefficiency.

4.      Fraud by Management

The management may defraud company by siphoning off the profit created through window dressing.

5.      Against Companies Act, 2013

Window dressing is against the provisions of the companies Act. If window dressing is done by the company , it would be against the provisions of schedule III to the companies Act,2013.

1.8 Secret Reserve

Secret Reserve means “The amount by which the net worth has been deliberately understated- a hidden reserve. Such a condition exists where the assets are omitted or undervalued or where liabilities are overstated”

Why Secret Reserve is done:-

1. Mislead investor & lenders

2. Hide losses

3. Higher commission

4. Fraud

Objections Against Secret Reserve:-

1. No true and fair view

Balance sheet profit and loss account fails to disclose the actual working results of the concern during the year.

2.      Against Companies Act, 2013

Secret Reserve may is against the provisions of the companies Act. If Secret Reserve is done by the company , it would be against the provisions of schedule III to the companies Act,2013.

3.      Shareholder Suffer

The shareholder do not get to know the picture of the value of their investor.

4.      Fraud by Management

The management may defraud company by siphoning off the profit created through window dressing.

5.      No Check on Assets

In case of loss by fire where such hidden asset are destroyed, the company would not get full compensation from the insurance company.

1.9 What is the responsibility of the auditor with respect to errors and frauds?

ANS:-Error is an unintentional mistake which results in miss statement of books of account. Frauds means intentional or deliberate misrepresentation of financial information by management or any employee or any third party with an objective t cheat others or make illegal gains standards on auditing (SA) 240’ issued by ICAI lays down the responsibilities of an auditor regarding errors and frauds in the financial statements, which are summarised as follows:

1. PRIMARY RESPONSIBILITY OF MANAGEMENT:- Management is primarily responsible for prevention and detection of errors and frauds by implementing a good internal control system.
2. AUDITORS’S RESPONSIBLITY:- Detection of errors and fraud is a secondary objective of an audit . However, the auditor should take steps to detect errors & frauds and ensure that the accounts are free from major errors and frauds. For the accounts to be true and fair, it is important that they are free from major errors and frauds.
3. CARO:- Under companies Auditor Report Order (CARO)2003, THE AUDITOR IS REQUIRED TO REPORT WHETHER ANY FRAUD IS NOTICED AND IF SO THEN THE AUDITOR HAS TO REPORT:

1. THE NATURE OF THE FRAUDS

2. THE AMOUNT INVOLVED

4.      ERRORS AND FRAUDS:- When any error is confirmed , auditor should ensure that management has rectified the same , Further ,when any fraud is confirmed ,auditor should report the same to an appropriate persons.

5.      AUDITOR NOT TO BE HELD RESPONSIBLE:- The auditor cannot be held responsible for undetected errors and frauds if he had taken reasonable steps detect them.

1.10 Advantages of Auditing

1. Assurance of true and fair account:- Audit provides an assurance to the various users of final account such as owners, management , creditors , lender, investors , Government etc. Audit ensures that the final account are reliable and authentic.
2. True and Fair Balance sheet:- The user of account can be sure that the assets  and liabilities shown in the audited balance sheet , show the true financial position of the concern as it is i.e. neither more nor less. Thus , there is neither any Window Dressing nor any Secret Reserves in an audited balance sheet.
3. True and Fair Profit and Loss Account:- The user can be confident that the  audited profit and loss account shows the true amount of profit and loss as it is i.e. neither more nor less.
4. Tally with books:- The audited final account can be be taken to tally with the books of account. Thus, the income-tax officer can start with the figure of the audited book profit, make adjustment and compute the taxable income. An outside user need not go through the entire books
5. As per Law:-  The audited  final account scan be presumed to follow the rules and requirements laid down by law.
6. As per Standard of Accounting and Auditing Practices:- The audited final account follow the standard accounting and auditing principle laid down by professional bodies. Thus audited accounts are based on objective standard and not on personal whim and fancies of a particular accountant or auditor.
7. Disclose All Material Facts:- The audited final account disclose all material facts. Thus a user can rely on the audited accounts to disclose all material facts useful for making decision of lending, investment etc.
8. Moral Check on Employees:- Audit techniques such as vouching , verification of cash , stock assets etc , as moral check on employees forcing them to keep the accounts up to date and free from any error or fraud. Audit keeps the staff on their toes.
9. Advice on System Taxation, Finance:- The auditor can also advices the client about the Accounting System. Internal Control ,Internal Checks, Internal Audit, Taxation, Finance etc.
10. Facilities Comparison:- Audited Account of different year facilities comparison over a period to determine trend in sales etc.

1.11 Inherent Limitations of Audit

ANS: Auditing refers to examination of accounting and financial records to ascertain and give opinion whether such records show true and fair view or not.

The following are the limitation of audit:

1. MAY BE MISLED BY WORK OF OTHERS:- The auditor cannot have all the knowledge in all the fields’ .There he has to depend on reports or work done by other such as lawyer’s engineer’s internal auditor which might be misleading.
2. IT MAY NOT NE POSSIBLE TO CHECK IN DETAIL:- Due to time constraints and large volumes of business it is not possible for the auditor to check each and every transaction. He may check some areas of the audit on sample basis.
3. THE ACCOUNT STAFF MAY NOT BE CO-OPERATIVE:- The accounts staff may consider the auditor to be an enemy who comes to point out their mistakes. Therefore they may not co-operate with him. On the other hand, they may also be relaxed and complacent in their work knowing that the auditor will rectify all that has been done wrongly.
4. AUDIT EVIDENCE IS NOT CONCLUSIVE:- Audit evidence which is collected by the auditor during the audit aids in giving an opinion. It is persuasive in nature. It is no conclusive Audit evidence gives reasonable assurance and not complete assurance.
5. TRANSACTION NOT RECORDED CANNOT BE AUDITED:- The books of account and other documents presented to the auditor is the only matter which the auditor has to depend and work on. His opinion shall be based on financial statement prepared on the basis of data provided to him. If there are transactions which are not recorded at all, it won’t come under the audit scanner.
6. INDEPENDENCE ISSUE ALWAY’S EXISTS:- The auditor gets fees from his clients for auditing their books of account. Auditor who has a major portion of their income from few clients might not issue a negative or qualified audit report. The auditor might fear that he might be replaced by some other auditor.
7. NOT ALL FRAUD CAN BE DETECTED:- A fraud which has been planed deeply by the management in order  to deceive the users of financial statements may be very difficult to detect even for an auditor with good experience.
8. OPINION IS SUBJECTIVE:- There are many guidelines and case laws which aid the auditor in giving an opinion. However, eventually , he has to use his own skill and judgement in giving an opinion on the financial statement . Thus , there is an element of subjectivity involved. In simple words, the opinion of different auditors may be different.

1.12 What are Principles of audit laid down in SA200 by the ICAI?

ANS:- SA-200 issued but ICAI lays down the basis principles which governs audit. They are explained as follows:

1. Principle of Integrity, Objectivity And  Independence

1. Integrity implies that auditor should be honest & sincere in his professional work.
2. Independence implies that auditor should be free from any interest which may lead to an improper opinion in a company where the owner or any accounts officers is a relative of the auditors.
3. Objectivity implies that auditor must be fair and should not be bias in his approach.

2.      Reporting and Conclusion

The auditor should review and asses the conclusions draw from the audit evidence. Based on the conclusion drawn the auditors’ report should contain an opinion on financial statement which may be unqualified or qualified or adverse.

3.      Internal Control And Accounting System

The auditor should study and evaluate the internal control system it should understand the accounting system adopted by the management to perform, the audit more effectively.

4.      Need for Documentation

The auditor should document matters relating to audit to prove that the audit was carried out in accordance with the basic principles governing audit.

5.      Confidentiality

The auditor should maintain confidentiality of information acquired during his work. He should not disclose any such information to a third party without specific permission of client.

6.      Individuals With Skill And Competence

The audit should be performed with professional care by individuals having adequate training, experience, skill and competence.

7.      Planning

The auditor  should plan his work to conduct audit in effective and timely manner . An auditor may prepare an audit program for his purpose. Te auditor may also revise the audit program whenever required in the interest of the audit.

8.      Lawyers , Audit Staff And Work Done By Other Auditor

The auditor can delegate work to assistance or use work performed by other auditor and experts. However, he should satisfy himself that work done by other is reliable by carrying out necessary audit procedures.

9.      Evidence

The auditor should obtain sufficient and appropriate evidence through vouching of transaction, verification of assets and liabilities and other audit procedures . The opinion of the auditor should be based on the audit evidence collected during the audit.

1.13 What are the various types of audit?

ANS:- Auditing refers to examination of accounting and financial records to ascertain and give opinion whether such records show true and fair view or not.

The following are the types of audit:-

1. Statutory Audit
2. Non:– statutory Audits or voluntary Audits

1. STATUTORY AUDITS :- As the name suggests audit are  audits which are compulsory under a statute i.e. law. The audit is governed by the provision of the respective law. The auditor has to follow the provision of the law while conducting the audit.

2.      NON- STATUTORY AUDIT:- Non statutory Audits are audits that are not compulsory i.e. organization may get such audits conducted voluntarily .

The following are example of certain non- statutory audits

1. Systems Audits
2. Operations Audits
3. Management Audits
4. Environmental Audits
5. Internal Audits.

TYPES OF  AUDIT

CONCURRENT AUDIT

Meaning:-

The system of concurrent in the banks was introduced by the reserve bank of India in October 1993.  Concurrent audit is defined by the RBI as “ an examination which is contemporaneous with the occurrence of transaction or is carried out near there to as possible. It attempt  to shorten the  interval between a transaction and its examination by an independent person.

Objectives:-

1. To supplement efforts of the Banks in carrying out simultaneous internal checks.
2. To perform substantive checking in key areas and rectification of definiteness in the earliest possible period.
3. To reduces the interval between a transaction and its examination by an independent person.
4. To improve the functioning of the branch.
5. Compliance with internal control.
6. Identification of areas activities requiring corrective action and urgency.

Scopes:-

1)      The transactions are properly records/ documented and vouched.

2)      The irregularities are rectified immediately.

3)      The system and procedures of the bank are implemented properly.

4)      The transaction are performed or decision are taken by the head office and the RBI.

5)      The delegated authority is exercised and the same is within the terms and conditions of the delegated authority.

Reporting:-  The concurrent auditors may report the minor irregularities, wrong calculation, etc. to the Branch Manager for on the spot rectification and reporting compliance. If these irregularities are not within a week, these may be reported to the Controlling offices.

1.14 Audit Programme

It is desirable that in respect of each audit and more particularly for bigger audits an audit programme should be drawn up. Audit programme is nothing but a list of examination and verification steps to be applied and set out in such a way that the inter-relationship of one step to another is clearly shown and designed. In other words, an audit programme is a detailed plan of applying the audit procedures in the given circumstances with instructions for the appropriate techniques to be adopted for accomplishing the audit objectives.

1. To start with, an auditor having regard to the nature, size and composition of the business and the dependability of the internal control and the given scope of work, should frame a programme which should aim at providing for a minimum essential work which may be termed as a standard programme. This programme may be altered in case of any abnormal situations.
2. The assistant engaged in the job should be encouraged to keep an open mind beyond the programme given to him. He should be instructed to note and report significant matters coming to his notice, to his seniors or to the partners or proprietor of the firm engaged for during the audit.
3. There should be periodic review of the audit programme to assess whether the same continues to be adequate for obtaining requisite knowledge and evidence about the transactions.
4. The utility of the audit programme can be retained and enhanced only by keeping the programme as also the client’s operations and internal control under periodic review so that inadequacies or redundancies of the programme may be removed
5. As a basic feature, audit programme not only lists the tasks to be carried out but also contains a few relevant instructions, like the extent of checking, the sampling plan, etc. So long as the programme is not officially changed by the principal, every assistant deputed on the job should unfailingly carry out the detailed work according to the instructions governing the work.
6. An audit programme consists of a series of verification procedures to be applied to the financial statements and accounts of a given company for the purpose of obtaining sufficient evidence to enable the auditor to express an informed opinion on such statements.

For the purpose of programme construction, the following points should be kept in view:

• Stay within the scope and limitation of the assignment.
• Determine the evidence reasonably available and identify the best evidence for deriving the necessary satisfaction.
• Apply only those steps and procedures which are useful in accomplishing the verification purpose in the specific situation.
• Consider all possibilities of error.
• Co-ordinate the procedures to be applied to related items.

Advantages of an Audit Programme

1. It provides the assistant carrying out the audit with total and clear set of instructions of the work generally to be done.
2. It is essential, particularly for major audits, to provide a total perspective of the work to be performed.
3. Selection of assistants for the jobs on the basis of capability becomes easier when the work is rationally planned, defined and segregated.
4. Without a written and pre-determined programme, work is necessarily to be carried out on the basis of some ‘mental’ plan. In such a situation there is always a danger of ignoring or overlooking certain books and records. Under a properly framed programme, the danger is significantly less and the audit can proceed systematically.
5. The assistants, by putting their signature on programme, accept the responsibility for the work carried out by them individually and, if necessary, the work done may be traced back to the assistant.
6. The principal can control the progress of the various audits in hand by examination of audit programmes initiated by the assistants deputed to the jobs for completed work.
7. It serves as a guide for audits to be carried out in the succeeding year.
8. A properly drawn up audit programme serves as evidence in the event of any charge of negligence being brought against the auditor. It may be of considerable value in establishing that he exercised reasonable skill and care that was expected of professional auditor.

Disadvantages of Audit Programme

The work may become mechanical and particular parts of the programme may be carried out without any understanding of the object of such parts in the whole audit scheme.

1. The programme often tends to become rigid and inflexible following set grooves; the business may change in its operation of conduct, but the old programme may still be carried on. Changes in staff or internal control may render precaution necessary at points different from those originally decided upon.
2. Inefficient assistants may take shelter behind the programme i.e. defend deficiencies in their work on the ground that no instruction in the matter is contained therein.
3. A hard and fast audit programme may kill the initiative of efficient and enterprising assistants.

All these disadvantages may be eliminated by imaginative supervision of the work carried on by the assistants; the auditor must have a receptive attitude as regards the assistants; the assistants should be encouraged to observe matters objectively and bring significant matters to the notice of supervisor/principal.

1.15 Audit Working Papers

The audit working papers constitute the link between the auditor’s report and the client’s records. According to SA-230 , Audit Documentation refers to the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached (terms such as “working papers” or “work papers” are also sometimes used). The objects of an auditor’s working papers are to record and demonstrate the audit work from one year to another.

Audit documentation serves a number of purposes:

• Assisting the engagement team to plan and perform the audit.
• Assisting members of the engagement team responsible for supervision to direct and supervise the audit work, and to discharge their review responsibilities in accordance with SA 220.
• Enabling the engagement team to be accountable for its work.
• Retaining a record of matters of continuing significance to future audits.
• Enabling the conduct of quality control reviews and inspections in accordance with SQC 1.
• Enabling the conduct of external inspections in accordance with applicable legal, regulatory or other requirements.

Working papers are varied in nature. They may be recorded on paper or on electronic or other media. Examples include:

• Audit programmers.
• Analyses.
• Issues memoranda.
• Summaries of significant matters.
• Letters of confirmation and representation.
• Checklists.
• Correspondence (including e-mail) concerning significant matters.

The auditor may include abstracts or copies of the entity’s records (for example, significant and specific contracts and agreements) as part of working papers. Working papers, however, is not a substitute for the entity’s accounting records.

The auditor need not include in audit documentation superseded drafts of working papers and financial statements, notes that reflect incomplete or preliminary thinking, previous copies of documents corrected for typographical or other errors, and duplicates of documents.

Oral explanations by the auditor, on their own, do not represent adequate support for the work auditor performed or conclusions the auditor reached, but may be used to explain or clarify information contained in the working papers.

The foundation of all working paper can be traced to:

• The basic constitutional documents like Memorandum and Articles of Association, Partnership Deed, Trust Deed, etc.;
• The contents of the minute books;
• The contents of the balance sheet and the statement of profit and loss; and
• The letter of engagement.

Form and Content of Working Papers: Working papers should record the audit plan, nature, timing and extent of auditing procedures performed, and the conclusions drawn from the evidence obtained.

The form, content and extent of working papers depend on factors such as:

1. The size and complexity of the entity.
2. The nature of the audit procedures to be performed.
3. The identified risks of material misstatement.
4. The significance of the audit evidence obtained.
5. The nature and extent of exceptions identified.
6. The need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or audit evidence obtained.
7. The audit methodology and tools used.

• Working papers should be designed and properly organized to meet the circumstances of each audit and the auditor’s needs in respect thereof.
• Working papers should be sufficiently complete and detailed for an auditor to obtain an overall understanding of the audit.
• The extent of the documentation is a matter of professional judgment since it is neither necessary nor practical that every observation, consideration or conclusion is documented by the auditor in his working papers.
• All significant matters which require the exercise of judgment, together with the auditor’s conclusion thereon, should be included in the working papers.
• The auditor should satisfy himself that these working papers have been properly prepared. Examples of such working papers are detailed analysis of important revenue accounts, receivables etc.
• In the case of recurring audits, some working paper files may be classified as permanent audit files which are updated currently with information of continuing importance to succeeding audit, as distinct from current audit files which contain information relating primarily to the audit of a single period.

1. PERMANENT FILE

A permanent audit file normally includes:

1. Information concerning the legal and organizational structure of the entity. In the case of a company, this includes the Memorandum and Articles of Association. In the case of a statutory corporation, this includes the Act and Regulations under which the corporation functions.
2. Extracts or copies of important legal documents, agreements and minutes relevant to the audit.
3. A record of the study and the evaluation of the internal controls related to the accounting system. This might be in the form of narrative descriptions, questionnaires or flow charts, or some combination thereof.
4. Copies of audited financial statements for previous years.
5. Analysis of significant ratios and trends.
6. Copies of management letters issued by the auditor, if any.
7. Record of communication with the retiring auditor, if any, before acceptance of the appointment as auditor.
8. Notes regarding significant accounting policies.
9. Significant audit observations of earlier years.

B.    CURRENT FILE

The current file normally includes:

1. Correspondence relating to acceptance of annual reappointment.
2. Extracts of important matters in the minutes of Board Meetings and General Meetings as relevant to audit.
3. Evidence of the planning process of the audit and audit programmed.
4. Analysis of transactions and balances.
5. A record of the nature, timing and extent of auditing procedures performed, and the results of such procedures.
6. Evidence that the work performed by assistants was supervised and reviewed.
7. Copies of communication with other auditors, experts and other third parties.
8. Letters of representation or confirmation received from the client.
9. Conclusions reached by the auditor concerning significant aspects of the audit, including the manner in which exceptions and unusual matters, if any, disclosed by the auditor’s procedures were resolved or treated.
10. Copies of the financial information being reported on and the related audit reports.

1.16 Audit Note Book

An audit note book is usually a bound book in which a large variety of matters observed during the course of audit are recorded. It is thus a part of the permanent record of the auditor available for reference later on, if required. The audit note book also provides a valuable help to the auditor in picking up the links of work when the concerned assistant is away or the work is stopped temporarily because in it are recorded along with observations, the various queries, explanations obtained and evidence seen, while queries remaining undisputed of would be noted for follow up. It is more satisfactory in some ways, however, to use loose sheets for entering queries and notes which, subsequently, on being punched, may be filed in a special query file maintained for each client or along with the clients’ accounts and papers, separately for each year.

Significant matters observed during the course of audit, a record of which should be kept in the Audit Note Book:

1. Audit queries not cleared immediately e.g. Missing receipts, vouchers, etc.
2. The mistakes or irregularities observed during the course of audit e.g. Cases of failure to comply with the requirements of the Companies Act, 2013 or the provisions contained in the Memorandum or Articles; a change in the basis of valuation of finished inventory and work-in-progress or in the computation of depreciation; failure to provide adequate depreciation, etc.
3. Unsatisfactory book-keeping arrangements, costing method, internal or financial administration or organization.
4. Important information about the company which is not apparent from the accounts.
5. Special points requiring consideration at the time of verification of final accounts.
6. Important matters for future reference.

Specimen of entries in an Audit Note Book to indicate the manner in which entries in those books ought to be made:

Queries-Vouchers-Cash Book Payment

The making of intelligent enquiries on the accounts under audit is an important part of the work of an auditor. However, to guard against the client’s staff being required to provide explanation and information which are unnecessary or which could be ascertained otherwise junior members of the audit staff should be allowed to raise audit queries only after obtaining the prior approval of the senior in charge.

The audit notes constitute important evidence of matters considered by the auditor during the course of the audit, some of which may not find a place in his report submitted to the shareholders or directors, for the reason that on the basis of an explanation given to him by the management, he, on being satisfied, decided to drop them. As such, audit notes can be an important defence for the auditor in the event of an action for negligence in the discharge of his duties being subsequently brought against him.

Audit notes can also serve as a guide in framing audit programmed in the future as they indicate the weaknesses in the system of the client which specially need to be watched.

Also, it is desirable that the audit notes, whether they are kept in a book or in loose sheets, should bear a reference to the particular item of work in the audit programmed, and as far as practicable, all notes relating to the particular work in the programmed should be kept together in the systematic order.

1.17 INTERNAL CONTROL

***(INTERNAL CONTROL= INTERNAL CHECK+INTERNAL AUDIT)

MEANING

SA 400 issued by the Institute of Chartered Accountants of India (ICAI) deals with the study and evaluation of Internal Control in connection with an audit. It defines internal Control as “all the policies and procedures adopted by the management of a concern to ensure the orderly and efficient conduct of its business.”

PURPOSE, ADVANTAGES AND OBJECTIVES

The objective of internal control i.e. accounting Controls and Operational Controls are as follows.

1. Accounting controls
   1. All transactions are duly authorized, properly recorded and recorded promptly.
   2. The accounting policies adopted by the management in respect of stock valuation, depreciation etc. are implemented.
   3. The assets of the concern are safeguarded; the assets are not used or sold without proper authorization and are verified regularly.
   4. Errors and frauds are prevented and detected.
   5. The books of accounts are complete and accurate.
   6. The final accounts are reliable and ready in time.

2.      Operational or Administrative Controls

Operational Controls aim to ensure that the management policies in respect of the operations and administration of the concern are implemented. This in turn ensures that the business is conducted in an orderly and efficient manner. Examples of operational controls are Quality Control, Budgetary Control, Internal Check, Internal Audit, Quantitative Controls etc.

AUDITORS DUTIES

SA 400 makes the following recommendations in this regard:

1. Responsibility of Management

Basically, the management is responsible for establishing and operating the Internal Control system.

2.      Auditor’s Duty

The auditor’s duty is to study system, check whether the system was actually in operation during the year and evaluate the system to ascertain how much he can rely upon it.

3.      Need for Evaluation

An auditor needs to evaluate internal control system to achieve the objectives.

4.      Steps in evaluation

a)      Understand the System: In the first stage, the auditor should understand the system of Internal Control. He can understand the system with the help of manuals, discussions with managers or the technique of Flow Charts.

b)     Test Application: He should check whether the controls were actually applied in practice. He can check some transactions in depth. Thus he can take up some sales transactions and check all the documents right from the sales order to the receipt from debtors.

c)      Evaluate the system: He should judge, on the basis of above tests, whether he can rely on the system and if so to what extent.

5. Communicate Weakness to Management

a)      The material weakness in internal controls should be communicated to the management by the auditor. Material weakness means the absence of adequate controls that increase the possibility of errors and frauds in the financial statements.

b)     Such communication should be in writing.

INHERENT LIMITATIONS OF INTERNAL CONTROL

All the objectives of internal control, listed above, may not be actually achieved, because of its following limitations.

1. Costs

Cost of implementing control procedure may be much more than its benefits.

2.      Human Error

A control procedure may not prove effective due to human errors e.g. Carelessness of employees, mis-understanding of instructions, wrong judgments etc.

3.      Collusion

Even if duties are divided among different employees, they may collude (work together fraudulently).

4.      Misuse

An employee responsible for a particular function may misuse his authority.

5.      Manipulation by Management

Manipulation and misappropriation by top management will defeat the very purpose of internal control.

1.18 INTERNAL CHECK

MEANING

Guidance Note of ICAI: internal checking is the system of allocation of responsibility, division of work, and methods of recording transactions, whereby the work of an employee is checked continually by correlating it with the work of others. An essential feature is that no one employee has exclusive control over any transaction(s).

FEATURES

1. Internal check is part of the system of internal controls.
2. Internal check is the system of allocation of responsibility and division of work.
3. The work is divided in such a way that the work of one employee is independently cross-checked with the work of other employees. It is a kind of internal Audit carried out by the staff itself at the very stage of doing the work.
4. The work is divided in such a way that no employee has exclusive control over any transactions. A single employee deals with only one aspect and not the entire transaction.

Internal Check aims to detect and prevents errors and frauds.

1.19 INTERNAL AUDIT

MEANING

SA 610 issued by the Institute of Chartered Accountants of India (ICAI) defines Internal Audit as follows: Internal audit is a separate component of internal Control established to determine whether other Internal controls are well designed and properly operated.

OBJECTIVES

1. Review of accounting system and Internal controls
2. Examination of Accounting controls
3. Examinations of Operational controls
4. Physical verification

3.SCOPE / FUNCTIONS OF INTERNAL AUDIT

1. Monitoring of internal control
2. Examination of financial and operating information
3. Review of operating activities
4. Review of compliance with laws and regulations
5. Risk management
6. Governance

BASIC PRINCIPLES GOVERNING INTERNAL AUDIT

Standard on Internal Audit (SIA) 2, Basic principles Governing Internal audit, issued by the Council of the Institute of Chartered Accounts of India lays down the following:

**(SAME AS THE PRINCIPLES OF AUDIT)

INTERNAL AUDIT VS. EXTERNAL AUDIT