UNIT I

Introduction to Auditing

1.1         BASIC

Introduction to Auditing

Financial statements:  They are records showing the financial activities and performance of a company which are audited by government agencies, accountants, firms etc. Mainly Financial statements include Balance sheet, Income statement and Cashflow statement.

1. Balance sheet: Provides an overview of assets, liabilities and stockholders equity. In short we can say that it depicts the overall financial position of a company at the end of every year.
2. Income statement: Focuses on a company’s revenues and expenses for a particular period. It shows the net income of a company by subtracting expenses from revenues.
3. Cash flow statement: Summarises the cause of changes in cash positions of a business enterprises between two balance sheet dates. It focuses attention on cash changes only. It shows the sources of cash and its uses.
4. Fund flow statement: A statement which shows the sources from which the funds are received and the uses to which these have been put.
5. Statement of retained earnings: It shows the appropriation of earnings like dividend paid, transfer to reserve, etc. The balance in this account will show the amount of profit retained and carried forward.
6. Schedules: The schedules of fixed assets, investments, fixed assets, debtors, etc. are prepared to give details about these transactions. Schedules are used as a part of financial statements.

Users of Financial information

1. Management: Through financial statements they can control the cost to a great extent and also they can identify the stronger and weaker positions of the company. The management is able to decide the course of action to be adopted in future.

2.     Creditors: The creditors will be interested in the short-term solvency of the concern. So the financial statements will enable the creditors to access the short term solvency position of the concern.

3.     Investors:  The financial statements will help the investors to analyse the present financial position and study the prospects of the concern.

4.     Government: the financial statements are used to access the tax liability of business enterprise. These statements enable the government to find out whether the business is following various regulations or not.

5.     Bankers: It will help the bankers to analyse the repaying capacity of the customer in accordance with the loan they have sanctioned. The banker will analyse the financial strength and profitability of the concern.

• Auditing

The term auditing is derived from the Latin word ‘Audrie’ which means to hear. The original objective of auditing was to detect and prevent errors. In India the companies act 1913 made audit of company accounts compulsory.

 According to Spicer and Pegler “Auditing is such an examination of books of accounts and vouchers of business, as will enable the auditors to satisfy himself that the balance sheet is properly drawn up, so as to give a true and fair view of the state of affairs of the business and that the profit and loss account gives true and fair view of the profit/loss for the financial period, according to the best of the information and explanation given to him and as shown by the books; and if not, in what respect he is not satisfied”.

Prof. L.R.Dicksee. "auditing is an examination of accounting records undertaken with a view to establish whether they correctly and completely reflect the transactions to which they relate”.

OBJECTIVES OF AUDITING

There are two main objectives of auditing. The primary objective and the secondary or incidental objective.

 a. Primary objective – as per Section 227 of the Companies Act 1956, the primary duty (objective) of the auditor is to report to the owners whether the balance sheet gives a true and fair view of the Company’s state of affairs and the profit and loss A/c gives a correct figure of profit of loss for the financial year.

b. Secondary objective – it is also called the incidental objective as it is incidental to the satisfaction of the main objective. The incidental objective of auditing are: i. Detection and prevention of Frauds, and ii. Detection and prevention of Errors. Detection of material frauds and errors as an incidental objective of independent financial auditing flows from the main objective of determining whether or not the financial statements give a true and fair view.

As the Statement on auditing Practices issued by the Institute of Chartered Accountants of India states, an auditor should bear in mind the possibility of the existence of frauds or errors in the accounts under audit since they may cause the financial position to be mis-stated. Fraud refers to intentional misrepresentation of financial information with the intention to deceive.

 Frauds can take place in the form of manipulation of accounts, misappropriation of cash and misappropriation of goods. It is of great importance for the auditor to detect any frauds, and prevent their recurrence. Errors refer to unintentional mistake in the financial information arising on account of ignorance of accounting principles i.e. principle errors, or error arising out of negligence of accounting staff i.e. Clerical errors.

EXPRESSION OF OPINION

When we speak of the objective, we rationalize the thinking process to formulate a set of attainable goals, with reference to the circumstances, feasibility and constraints. In money matters, frauds and errors are common place of occurrence. Apart from this, the statements of account have their own purpose and use of portraying the financial state of affairs. The objective of audit, naturally, should be to see that what the statements of account convey is true and not misleading and that such errors and frauds do not exists as to distort what the accounts should really convey.

Till recently, the principal emphasis was on arithmetical accuracy; adequate attention was not paid to appropriate application of accounting principles and disclosure, for ensuring preparation of accounting statement in such a way as to enable the reader of the accounting statement to form a correct view of the slate of affairs. Quite a few managements took advantage of the situation and manipulated profit or loss and assets and liabilities to highlight or conceal affairs according to their own design. This state of affairs came up for consideration in the Royal Mail Steam Packet Company’s Case as a result of which the Companies Acts of England and India were amended in 1948 and 1956 respectively to require the auditor to state inter alia whether the statements of account are true and fair. This is what we can take as the present day audit objective.

The implication of the substitution of “true and fair” need to be understood. There has been a shift of emphasis from arithmetical accuracy to the question of reliability to the financial statements. A statement may be reliable even though there are some errors or even frauds, provided they are not so big as to vitiate the picture. The word “correct” was somewhat misplaced as the accounting largely consists of estimates. However, you should not infer that the detection of errors and frauds is no longer an audit objective; it is indeed an audit objective because statements of account drawn up from books containing serious mistakes and fraudulent entries cannot be considered as a true and fair statement.

To establish whether the financial statement show a true and fair state of affairs, the auditors must carry out a process of examination and verification and, if errors and frauds exist, they would come to his notice in the ordinary course of checking. But detection of errors of frauds is not the primary aim of audit; the primary aim is the establishment of a degree of reliability of the annual statements of account. If there remains a deep-laid fraud in the accounts, which in the normal course of examination of accounts may not come to light, it will not be construed as failure of audit, provided the auditor was not negligent in the carrying out his normal work. This principle was established as early as in 1896 in the leading case in Re-Kingston.

Detection of frauds and Errors

The term fraud means wilful misrepresentation or deliberately committed mistake in accounts for personal gain. In the context of accounting, fraud means two things.

1. Misappropriation of cash
2. Fraudulent manipulation of accounts.

Fraud covers the following:

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:

1. by not providing any depreciation or less depreciation or more depreciation; or

2. by under valuation or over-valuation of assets and liabilities; or

3. by showing fictitious sales or purchases or returns in order to show more profits or less

profits whatever the case may be ; or

4. by showing revenue expenditure to capital account or vice versa.

5. by the utilization of secret reserves during a period when the concern has made less or no profit without disclosing fact to shareholders.

Auditor’s duty with regard to detection and prevention of frauds and errors.

The legal perception of auditor’s duty with regard to detection and prevention of frauds and errors

has undergone various charges. Initially, it was based on the decision given in kingston cotton mills co.

[1896] case. The learned. Judge Lopse summed up auditor’s duty by stating, “Auditor is a watchdog,

not a blood hound. This statement implies.

1. In case of a limited company, an auditor is appointed by the shareholders. Thus, he is expected

to play the role of a watch do on their behalf and should look after their interests.

2. Unlike a blood bound the duty of the auditor is verification and not detection. If he finds out

something suspicious during the course of audit, he should enquire the matter in detail and inform the

shareholders about it. But if he does not discover any such suspicious matter, he is fully justified in

trusting and relying an representations made by the employees of the company. In briefly, in case of

errors and frauds, the auditor has a duty of reasonable care only.

In recent years, auditor’s duty has been extended in some cases, besides shareholders, to third

parties. But the condition is that his negligence is proved. This is in recognition of public pressure on

auditors to take more responsibility for detection of fraud in pursuance of their role of lending credibility

to financial statements. The judgement in ‘Headly Byrne and Co. Ltd. V. Heller and partners Ltd. Co.

(1963) recognised for the first time the liability of professionals including company auditors towards third parties.

Detecting fraud and errors by auditors.

Case studies Detecting Fraud and Errors by Auditors

 Already in the planning stage of the audit, the auditor should assess the risk of errors or fraud that can generate a material impact on the financial statements. Thus, based on the audit risk assessment, the auditor should develop audit procedures for identifying all material errors and fraud misstating the financial statements. Usually, if the auditor suspects the existence of fraud or errors Annales Universitatis Apulensis Series Oeconomica, 11(1), 2009 120 with material impact, he expands the scope of auditing procedures, until he is convinced that the misstatement has been either corrected, or properly disclosed in the audited financial statements. ISA 240 (redrafted) provides that the auditor’s objectives in identifying fraud are the following: to identify and assess the risks of material misstatement of the financial statements due to fraud; to obtain sufficient appropriate audit evidence about the assessed risks of material misstatements due to fraud, through designing and implementing appropriate responses; and to respond appropriately to identified or suspected fraud. Despite his efforts, the auditor is subject to the inherent risk that some material errors in the financial statements may not be identified, even if the audit is properly planned and performed. In the business world, the percentage of identifying fraud is small considering the legislation in force and the modern means for preventing and finding it.

According to ISA 240 (redrafted), the primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the company and management. It is important that those charged with governance and management place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty and ethical behaviour, which can be reinforced by an active oversight by those charged with governance. In exercising oversight responsibility, those charged with governance consider the potential for override of controls or other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in order to influence the perceptions of analysts as to the company’s performance and profitability. The auditor is not and can not be held responsible for fraud and errors, but through his work he can play a positive role in preventing fraud and errors, by deterring their occurrence. The fraud character of an operation can be established only in court, so that, since the auditor has no responsibility to prove fraud from a legal point of view, his concerns are directed rather towards actions suspicious of fraud, than proven fraud. The conditions and events that increase the risk of fraud or errors refer primarily to the gaps in the functioning of accounting and internal control systems or to inconsistencies of internal controls.

Limitations of Auditing

Truly speaking an audit should have no limitation of its own. It is designed to protect the interestof all parties who are interested in the affairs of the business. If these is any short coming arising therefrom, it may be due to its narrow scope of application in its related field of operations and un-extendeddesignation of the concept. The audit has following limitations.

1. Lack of complete picture—The audit may not give complete picture. If the accounts areprepared with the intention to defraud others, auditor may not be able to detect them.

2. Problem of Dependence—Sometimes the auditor has to depend on explanations, clarificationand information from staff and the client. He may or may not get correct or completeinformation.

3. Existence of error in the audited accounts—Due to time and cost constraints, the auditor cannot 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.

4. Exercise of judgement—The nature, timing and extent of audit procedures to be performedis a matter of professional judgement of the auditor. The same audit work can be done bytwo different auditors with difference in sincerity & personal judgement.

5. Diversified situations—Auditing is considered to be a mechanical work. Auditors may notbe in a position to frame audit programme which can be followed in all situations.

6. Lack of Expertise—In some situations, an auditor has to take opinion of experts on certainmatters on which he may not have expert’s knowledge. The auditor has to depend upon such reports which may not be always correct.

7. Limitations of internal control—The auditor can only report on the truth and fairness of thefinancial statements. But other problems relating the management and control may not bepossible to be covered by the auditor. Examples of such problems or limitations of internalcontrol are cast-ineffectiveness, manipulations by management, etc.

8. Influence of management on the auditor—This is also come of the limitations of the auditthat the auditor is influenced by the doings of those in management. The reason is that he is appointed by the share holders and directors who pay him remuneration or fee.             

KEY TAKEAWAYS:

1. Auditing is an examination of accounting records undertaken with a view to establish whether they correctly and completely reflect the transactions to which they relate.
2. When we speak of the objective, we rationalize the thinking process to formulate a set of attainable goals, with reference to the circumstances, feasibility and constraints.

1.2        ERRORS AND FRAUDS

Introduction

The purpose of any financial statements audit is to enable the auditor to express an opinion based on the financial statements, whether they are prepared and presented, in all material respects, in accordance with the applicable financial reporting framework. In accordance with the relevant regulations, the auditor must act in accordance with the requirements of the «Code of Ethics for Professional Accountants», issued by the International Federation of Accountants (IFAC), to carry out audit in accordance with International Standards on Auditing (ISA), to plan and perform an audit with an attitude of professional suspicion or doubt recognizing the idea that in certain circumstances the financial statements may be materially misstated. Misstatements of the financial statements can arise either as a result of fraud or of an error. The factor that distinguishes between fraud and error is whether the action that led to the distortion of financial statements is intentional or unintentional.

Fraud

 According to the auditing standard 240, the term fraud refers to an action with intentional act by one or more individuals among management, employees or third party action which results in an erroneous interpretation of financial statements. In practice, there can be identified two types of intentional misstatements, which should be covered by the auditor: misstatements resulting from fraudulent reporting and misstatements resulting from misappropriation of assets. Whatever form it manifests, fraud requires the existence of certain incentives or pressures to commit fraud and a certain awareness of the operation.

 Error

 The term error refers to an unintentional mistake occurred in the financial statements, such as math or accounting mistakes in the accounting records and data related; oversight or misinterpretation of facts; misapplication of accounting policies. Practitioners in the field of financial audit identified a number of errors in the audit, among which (OanaBendovski, 10 common errors identified during the statutory audit of financial statements, Financial Audit Magazine No.7/2014):

a. Erroneously transferring the reserve from the Revaluation Reserve Account (105) to the reserve account representing surplus from reserves revaluation (1065)

 b. Registration of costs/revenues from services provided in a different financial year from the one in which the service was provided

c. Registration of purchase/delivery of commodity in a different financial year from the one in which the actual transfer of rights and obligations for the commodity occurred

d. Incorrectly reducing accounts payable balances with debit balances on advances granted.

e. Presentation of performance guarantees as commercial debt.

f. Omissions in the distinct presentation of related party transactions in the financial statements

g. The erroneous cancelation of provisions and adjustments for depreciation

h. The erroneous registration of received trade discounts

i. The revaluation of receivables and payables in foreign currencies at the end of the fiscal year

j. Omissions in the formation of adjustment for receivables depreciation.

Types of Errors

A. Clerical Errors: Clerical errors are those which result on account of wrong posting that is postingan 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 orpartially not recorded in books of account. For example, goods purchased from Sunny were not recorded anywhere in account books. This error will not affect the agreement of TrialBalance. But if posting is not done in one of the accounts, this will affect the agreement of TrialBalance.

(ii) Errors of Commission: Errors of commission take place when some transaction in incorrectly recorded in books of account. Following are the examples of such errors:

(i) Error in the books of Original Entry.

(ii) Debiting or crediting one account instead of the other.

These two errors do not affect the agreement of Trial Balance,

(iii) Wrong balancing of an account.

(iv) Error in writing amount in an account. For example, debiting Subash’ s Account

with Rs. 1000/- instead of Rs. 100/-.

(v) Casting of the same amount to two accounts.

(vi) Posting of an amount on the wrong side.

(vii) Posting in one account and omitting of posting in the other account.

(viii) Error in carrying forward the total of a subsidiary book or an account from one page to the other.

These errors affect the agreement of Trial Balance.

B. Errors of principle: Errors of Principle take place when a transaction is recorded without havingregard to the fundamental principles of book-keeping and accountancy. For example a capital expenditure, say expenses incurred in constructing a building to store items, may be treated as a revenue expenditure or vice versa,Sometimes adjustments are not taken into consideration while preparing Final Accounts. These areerrors of principle. These errors, however, do not affect the agreement of the Trial Balance.

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 Ramu’s account was to be debited with Rs.

50, but it was debited with Rs. 100 similarly Sethu’s account was debited with Rs. 50, 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 thebooks which he is required to check and audit as this is the work of an accountant but in many casesthe auditor is frequently asked to discover the errors, specially so, when the accountant is unable tolocate 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 havebeen recorded in the trial balance.

3. Total the list of debtors and creditors and compare them with the trial balance.

4. If the books are maintained on the self-balancing system, see that the total of different accountsagrees 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. Thisis done to avoid the putting of the debit balance on the credit side of the trial balanceor vice versa.

7. It is possible that the totals of some subsidiary books, e.g. Cash book, Sales book etc. might nothave been transferred to the trial balance. Recheck the totals of these books.

ISA 240 the Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements recognises that misstatement in the financial statements can arise from either fraud or error. The distinguishing factor is whether the errors which are seen in the misstatement was intentional or unintentional.

It is important and we all know that fraud is a criminal activity. It is not only the role of an auditor to determine whether fraud has  occurred but also the responsibility of a country's legal system. Auditors must be aware of the impact of both fraud and error on the accuracy of the financial statements.

Fraud can be of two types they are;

• fraudulent financial reporting - intentionally misstating the accounts to show the company better by hiding its actual worse stage.
• misappropriation of assets - the theft of the company's assets such as cash or inventory.

The external auditor's responsibilities

The external auditor is responsible for obtaining reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, whether caused by fraud or error. Therefore, the external auditor has some responsibility for considering the risk of material misstatement due to fraud.

In order to achieve this auditors must maintain an attitude of professional scepticism(professional doubt). This means that the auditor must recognise the possibility that a material misstatement due to fraud could occur, regardless of the auditor's prior experience of the client's integrity and honesty.

ISA 315 Identifying and Assessing the Risks of material misstatement through Understanding the Entity and Its Environment goes further than this general concept and requires that engagement teams discuss the susceptibility of their clients to fraud. The engagement team should also obtain information for use in identifying the risk of fraud when performing risk assessment procedures.

To be able to make such an assessment auditors must identify, through enquiry, how management assesses and responds to the risk of fraud. The auditor must also enquire of management, internal auditors and those charged with governance if they are aware of any actual or suspected fraudulent activity.

Despite these requirements, owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements may not be detected, even when the audit is planned and performed in accordance with ISAs. The risks in respect of fraud are higher than those for error because fraud may involve sophisticated and carefully organised schemes designed to conceal it.

Reporting fraud

If the auditor identifies a fraud they should communicate the matter on a timely basis to the appropriate level of management (i.e. those with the primary responsibility for prevention and detection of fraud). If the suspected fraud involves management the auditor shall communicate such matters to those charged with governance. If the auditor has doubts about the integrity of those charged with governance they should seek legal advice regarding an appropriate course of action.

In addition to these responsibilities the auditor must also consider whether they have a responsibility to report the occurrence of a suspicion to a party outside the entity. Whilst the auditor does have an ethical duty to maintain confidentiality, it is likely that any legal responsibility will take precedent. In these circumstances it is advisable to seek legal advice.

Directors' responsibilities

The directors have a primary responsibility for the prevention and detection of fraud. By implementing an effective system of internal control they should reduce the possibility of undetected fraud occurring to a minimum.

The directors should be aware of the potential for fraud and this should feature as an element of their risk assessment and corporate governance procedures. The audit committee should review these procedures to ensure that they are in place and working effectively. This will normally be done in conjunction with the internal auditors.

Internal auditors may be given an assignment:

• to assess the fraud, or if a fraud has been discovered,
• to assess its consequences and
• to make recommendations for prevention in the future.

Audit procedures

As well as adopting an attitude of professional scepticism the auditor is required to perform the following procedures in light of the risk of fraud:

• Discussion amongst the engagement team regarding the susceptibility of the client to fraud;
• Consider the risk of fraud when documenting and testing internal controls;
• Enquiring of management how they: assess the risk of fraud; and identify and respond to the risks of fraud;
• Enquiring of management whether they have any knowledge of actual or suspected frauds;
• Enquiring of internal audit whether they have any knowledge of actual or suspected frauds;
• Enquiring of those charged with governance how they exercise oversight of management's process for identifying and responding to the risk of fraud; and
• Enquiring of those charged with governance whether they have any knowledge of actual or suspected frauds.

KEY TAKEAWAYS:

1. The term fraud refers to an action with intentional act by one or more individuals among management, employees or third party action which results in an erroneous interpretation of financial statements.
2. The term error refers to an unintentional mistake occurred in the financial statements, such as math or accounting mistakes in the accounting records and data related; oversight or misinterpretation of facts; misapplication of accounting policies.

1.3   PRINCIPLES OF AUDIT

Although a public auditor can also examine non-financial information, such as compliance with company policies or environmental regulations, the majority of audit workis concerned with the financial statements. The financial statements audited under inter-national standards are the balance sheets, income statements and cash flow statementsand the notes thereto. The first International Standard on Auditing, ISA 1 (ISA 200) 18discusses the principles governing an audit of financial statements.

AAS-1 describes the basic principles, which govern the auditor's professional responsibilities and which should be complied with whenever an audit is carried out. These are:-

1. Integrity, objectivity and independence: The auditor should be straightforward, honest and sincere in his approach to his professional work. He must be fair and must not allow prejudice or bias to override his objectivity. He should maintain an impartial attitude and appear to be free of any interest which might be regarded. Whatever it's actual effect, as being incompatible with integrity and objectivity.

 2. Confidentiality: The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is legal or professional duty to disclose. It is remarked that an auditor should keep his ears and eyes open but his mouth shut.

3. Skill and competence: The audit should be performed and the report prepared with due professional care by persons who have adequate training, experience and competence. This can be acquired through a combination of general education, technical knowledge obtained through study and formal courses concluded by a qualifying examination recognized for this purpose and practical experience under proper supervision.

4. Work performed by others: When the auditor delegates work to assistant* or uses work performed by other auditors or experts, he will continue to be responsible for forming and expressing his opinion on the financial information. At the same time he is entitled to rely on work performed by others provided he exercises adequate skills and care and is not aware of any reason to believe that he should not have relied. The auditor should carefully direct, supervise & review work delegated by assistants. He should obtain reasonable assurance that work performed by other auditors or experts is adequate for this purpose.

5. Documentation: The auditor should document matters, which are important in providing evidence that the audit was carried out in accordance with the basic principles.

6. Planning: The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. Plans should be based on knowledge of client's business. They should be further developed and revised, if required, during the course of audit.

7. Audit evidence: The auditor should obtain sufficient  audit evidence through the performance of compliance and substantive test procedure. It will help him to draw reasonable conclusions there from the financial information he got.

8. Accounting system & internal control: The auditor should gain an understanding of the accounting system and related internal controls. He should study and evaluate the operation of those internal controls upon which he wishes to rely in determining the nature, timing and extent of other audit procedures.

9. Audit conclusions and reporting: The auditor should review and assess the conclusions drawn from the audit evidence obtained and from his knowledge of business of the entity as the basis for the expression of his opinion on the financial information.

1.4        TYPES OF AUDIT

Audit is the examination or inspection of various books of accounts by an auditor followed by physical checking of inventory to make sure that all departments are following documented system of recording transactions. It is done to ascertain the accuracy of financial statements provided by the organisation.

1. Continuous Audit

 According to spicer and pegler “A continuous Audit which is also known as detailed 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.” Thus, a continuous audit involves the conducting of audit of accounts throughout the year at regular intervals, fixed or otherwise, of say, one month or months. The accounts in such a case are subjected to audit as and when they are prepared. Such an audit is necessary only for big business houses.

Continuous Audit is applicable in case of following business concerns:

(i)                where final accounts are prepared just after the close of the financial year, as in the case of a bank.

(ii)              where the transactions are many in number and thus it becomes necessary to get them audited at regular intervals.

(iii)           where the system of internal check in operation is not satisfactory.

(iv)            where the statements of accounts are prepared after every month or quarter to be presented.

(v)              where sales effected are very large.

2.     Interim Audit

Interim audit is one which is conducted in between the two annual audits for some interim purpose, say, to enable a company to declare an interim dividend. This kind of audit involves a complete checking of the accounts prepared by a company for a part of the year to the date set of interim accounts, say, quarterly or half-yearly accounts.

3.     Balance Sheet Audit

A balance sheet audit is an evaluation of the accuracy of information found in a company's balance sheet.  After a balance sheet audit, you can use the analyses to detect irregularities or weaknesses in your company's accounting system.

Under such an audit, the auditor checks capital, reserves, assets, liabilities, etc., given in the Balance Sheet. Those items of Trading and Profits and Loss Account are also checked which have a bearing on the Balance Sheet items. For example, the purchase of goods on credit will increase the liabilities to creditors, increase the stock and will be shown in the Trading Account as an increase in purchases and closing stock. So this item will have to be verified. This type of audit can be successful in those business concerns where efficient system of internal check and control is in operation. Such an audit is popular in U.S.A.

Concurrent audit

Usually concurrent audit is conducted for bank branches, depending upon the quantum of advances given. It also depends upon bank to bank and their risk taking capability. Concurrent audit is conducted to monitor day to day bank operations so that all the compliances and security measures are being followed. Concurrent audit involves daily account opening checking, cash balance, income leakage, BCP & DRP analysis, NPA tracking, laws compliance compliance, various authorisations and all.

In some particular banks, scope of concurrent audit is very well defined to focus on the areas they are most concerned with. Now a days more and more branches are coming under the review of concurrent audit due to alarming rise of NPAs in all banks. So now banks are hiring more and more concurrent auditors to ensure their operational efficiency and profitability.

Annual Audit

Kind of audit whether the author verifies the account at the end of every financial year. This is a common audit and is mostly used by small organisations.

1.5        MISCELLANEOUS

1. Advantages of Independent Audit

The fact that audit is compulsory by law, in certain cases by itself should show that there must be some positive utility in it. The chief utility of audit lies in reliable financial statement on the basis of which the state of affairs may be easy to understand. Apart from this obvious utility, there are other advantage of audit. Some or all of these are of considerable value even to those enterprises and organization where audit is not compulsory, these advantages are given below:

(a) It safeguards the financial interest of persons who are not associated with the management of the entity, whether they are partners or shareholders.

 (b) It acts as a moral check on the employees from committing defalcations or embezzlement.

(c) Audited statements of account are helpful in setting liability for taxes, negotiating loans and for determining the purchase consideration for a business.

 (d) This are also use for settling trade disputes or higher wages or bonus as well as claims in respect of damage suffer by property, by fire or some other calamity.

(e) An audit can also help in the detection of wastage and losses to show the different ways by which these might be checked, especially those that occur due to the absence of inadequacy of internal checks or internal control measures.

(f) Audit ascertains whether the necessary books of accounts and allied records have been properly kept and helps the client in making good deficiencies or inadequacies in this respects.

(g) As an appraisal function, audit reviews the existence and operations of various controls in the organizations and reports weakness, inadequacy, etc., in them.

(h) Audited accounts are of great help in the settlement of accounts at the time of admission or death of partner.

 (i) Government may require audited and certificated statement before it gives assistance or issues a licence for a particular trade.

Qualities of an Auditor

So far we have discussed the question of formal qualifications of an auditor. But it is not enough to realise what an auditor should be. He is concerned with the reporting on financial matters of business and other institutions. Financial matters inherently are to be set with the problems of human fallibility; errors and frauds are frequent. The qualities required, according to Dicksee, are tact, caution, firmness, good temper, integrity, discretion, industry, judgment, patience, clear headedness and reliability. In short, all those personal qualities that goes to make a good businessman contribute to the making of a good auditor. In addition, he must have the shine of culture for attaining a great height. He must have the highest degree of integrity backed by adequate independence. In fact, AAS-1 mentions integrity, objectivity and independence as one of the basic principles. He must have a thorough knowledge of the general principles of law which govern matters with which he is likely to be in intimate contact. The Companies Act, 1956 and the Partnership Act, 1932 need special mention but mercantile law, specially the law relating to contracts, is no less important. Needless to say, where undertakings are governed by a special statute, its knowledge will be imperative; in addition, a sound knowledge of the law and practice of taxation is unavoidable.

He must pursue an intensive programme of theoretical education in subjects like financial and management accounting, general management, business and corporate laws, computers and information systems, taxation, economics, etc. Both practical training and theoretical education are equally necessary for the development of professional competence of an auditor for undertaking any kind of audit assignment. The auditor should be equipped not only with a sufficient knowledge of the way in which business generally is conducted but also with an understanding of the special features peculiar to a particular business whose accounts are under audit. AAS-8 on ‘Audit Planning’ emphasises that an auditor should have adequate knowledge of the client’s business.

The auditor, who holds a position of trust, must have the basic human qualities apart from the technical requirement of professional training and education. He is called upon constantly to critically review financial statements and it is obviously useless for him to attempt that task unless his own knowledge is that of an expert. An exhaustive knowledge of accounting in all its branches is the sine qua non of the practice of auditing. He must know thoroughly all accounting principles and techniques. Auditing is a profession calling for wide variety of knowledge to which no one has yet set a limit; the most useful part of the knowledge is probably that which cannot be learnt from books because its acquisition depends on the alertness of the mind in applying to ever varying circumstances, the fruits of his own observation and reflection; only he who is endowed with common sense in adequate measure can achieve it. Lord Justice Lindley in the course of the judgment in the famous London & General Bank case had succinctly summed up the overall view of what an auditor should be as regards the personal qualities. He said, “an auditor must be honest that is, he must not certify what he does not believe to be true and must take reasonable care and skill before he believes that what he certifies is true”.

Difference between Auditing and Accounting

The difference between Accountancy and Auditing is as follows :

 1. 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.

2. An accountant is an employee of the business while an auditor is an independent outsider.

3. 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.

4. 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. 5. An auditor can be changed from year to year but an accountant is not, as he is usually a permanent employee of the business.

Accountancy

 Accountancy begins where book-keeping ends.” It means that an accountant comes into the picture only when the book keeper has done his job. The functions of accountant can be classified as under :

(i)                Checking the work of book-keeper.

(ii)              Preparation of trial balance,

(iii)           Preparation of Trading and Profit and loss Account.

(iv)            Preparation of balance sheet,

 Passing entries for rectification of errors and making adjustments. An accountant is supposed to be an expert in the accounting procedures as he has to examine analytically the final accounts. But it is not necessary for him to pass the chartered Accountant’s examination. He it’s not supposed to submit his report after the completion of work.

Auditing

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 explanations submitted to him. An auditor has to satisfy himself after due verification and 3 complete. Checking of accounts as to whether the transactions entered into the books are accurate. An auditor 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.

Difference between Audit and Investigation

An audit is the inspection, examination or verification of a person, organization, system, process, enterprise, project or product. It is used to determine the authenticity and validity or to ensure that a process is being followed. Also, an audit is mainly used in accounting to ensure the validity and reliability of information in the statements and that the information is free from material error. An audit can be done anytime.

An investigation is the process of detailed examination of activities so as to achieve certain objectives. It is the act of investigating; or is the study to enquire about a particular thing. It is an important factor in journalism for investigating various cases. It is the best method to tackle or identify the case; and make a thorough report about the case. Investigation is made in suspected places. In this, the main focus is on an inquiry into the accounts and financial matters of a business and to the overall aspects of it.

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.

True and Fair View

An audit of accounts by an independent expert assures the outside users that the accounts are proper and reliable. The outsiders can rely on the accounts if the auditor reports that the accounts are true and fair.

The accounts are said to be true and fair:

1. When the profit and loss shown in the profit and loss account is true and fair, and

2. Also when the value of assets and liabilities shown in the balance sheet is true and fair.What constitutes true and fair is not defined under any law. However, the following general guidelines may be laid down in connection with true and fair.

a)     Conform to accounting principles: The books of accounts must be kept according to the normally accepted accounting principles such as the concept of entity, continuity, periodical matching of costs and revenue, accrual and double entry system etc.

b)    No window dressing or secret reserves: The accounts must show the financial position and the profit or loss as they are. I.e. there is neither an overstatement nor an understatement. There should be in other words neither window dressing nor secret reserves. In window dressing the accounts are made in such a way as to show a much better condition than the actual condition. The profit and the net worth are overstated.

The accounts are said to show true and fair view when the accounts show only the actual conditions as it is. i.e. the profit and the net worth are shown as they are.

In order to show a true and fair view the auditor should ensure that:

1. The final accounts agree with the books of accounts.

2. The provision for depreciation is proper. 

3. The closing stock is physically verified and valued properly.

4. Intangible assets like goodwill, patents, preliminaryexpenses or other deferred     revenue expenses are written off properly.

5. Proper provision is made for bad and doubtful debts.

6. Capital expenses is not treated as revenue expenses and vice versa.

7. Capital receipts are not treated as revenue receipts.

8. Effect of changes in rate of foreign exchange on value of assets and liabilities is recorded in the books properly.

9. Contingent liabilities are not treated as actual liabilities and vice versa.

10. Provision is made for all known losses and liabilities

11. A reserve is not shown as a provision and vice versa

12. Cut off transactions are recorded properly, so that all sales invoices are matched with goods delivered and all purchase invoices are matched with goods received.

13. Transactions are recorded on accrual basis, i.e. outstanding expenses, prepaid expenses, income accrued and advance income are recorded properly.

14. Expected or anticipated gains are not credited to the profit and loss account.

15. Effect of events after the balance sheet date on the value of an asset and liability is disclosed in the accounts properly

16. The exceptional or non-recurring transactions are disclosed separately in the accounts.

3. Disclose all material facts:

The books of accounts must disclose all material facts regarding revenue, expenses, assets and liabilities. Material means important and essential. The disclosure of important matters in the accounts helps the users in taking business decisions. There should be neither suppression of vital facts nor mis-statements.

4. Legal requirements:

In case of limited company the account must disclose the matters required to be disclosed under the Companies Act. The final accounts must be in the format prescribed under Schedule VI of the Companies Act, 1956. Special companies such as banks, insurance, electricity supply companies prepare accounts as prescribed under special laws. A co-operative society, a trust etc. must also prepare the accounts as required under relevant laws.

 5. Requirements of Institute of Chartered Accountants of India:

The accounts must also be in accordance with the various guidelines prescribed by the ICAI. These guidelines are contained in the statements, standard and guidance notes issued by the institute from time to time.

1.6 ACCOUNTING CONCEPTS RELEVANT TO AUDITING

Introduction

At the time of conducting an audit , the auditor should have to consider materiality and its relation with audit. The purpose is to establish standard on the concept of materiality and its relationship with audit risk.

MATERIALITY:

1. Information is material if its misstatement (i.e., omission or erroneous Statement) could influence the economic decisions of users taken on the Basis of the financial information. Materiality depends on the size and Nature of the item, judged in the particular circumstances of its misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which the information must have if it is to be useful.

2.     The objective of an audit of financial information prepared within a framework of recognized accounting policies and practices and relevant statutory requirements, if any, is to enable the auditor to express an opinion on such financial information. The assessment of what is materiality of professional judgment.

3.     The concept of materiality recognizes that some matters, either individually or in the aggregate, are relatively important for true and fair presentation of financial information in conformity at 40 both the overall financial information level and in relation to individual account balances and classes of transactions. Materiality may also be influenced by other considerations, such as the legal and regulatory requirements, non-compliance with which may have a significant bearing on the financial information, and consideration relating to individual account balances and relationships. This process may result in different levels of materiality depending on the matter being audited.

4.     Although the auditor ordinary establishes an acceptable materiality level to detect quantitatively material misstatements, both the amount (quantity) and nature (quality) of misstatements need to be considered.

An example of a qualitative misstatement would be the inadequate

 or improper description of an accounting policy when it is likely that auser of the financial statements would be misted by the description.

5. The auditor needs to consider the possibility of misstatements of relatively small amounts that, cumulatively, could have a material effect on the financial information.

For example, an error in a month-end (or other periodic) procedures could be an indication of a potential material misstatement if that error is repeated each month or each period, as the case may be

Materiality should be considered by the auditor when-

 (a) Determining the nature, timing and extent of audit procedures;

 (b) Evaluating the effect of misstatements.

GOING CONCERN:

1. The purpose of this Auditing and Assurance standard (AAS) is to establish standards on the auditor’s responsibilities in the audit of financial statements regarding the appropriateness of the going concern assumption as a basis for the financial statements.

2. When planning and performing audit procedures and in evaluating the results thereof, the auditor should consider the appropriateness of the going concern assumption underlying the preparation of the financial statements.

3. The auditor’s report helps establish the credibility of the financial statements. However, the auditor’s report is not a guarantee as to the future viability of the entity.

4. An entity’s continuous as a going concern for the foreseeable future, generally a period not to exceed one year after the balance sheet date, is assumed in the preparation of financial statements in the absence of information to the contrary. Accordingly, asset and liabilities are recorded on the normal course of business. If this assumption is unjustified, the entity may not be able to realize its assets at the recorded amounts and there may be changes in the amounts and maturity dates of liabilities. As a consequence, the amounts and classification of assets and liabilities in the financial statement may need to be adjusted.

APPROPRIATENESS OF THE GOING CONCERN ASSUMPTION

1. The auditor should consider the risk that the going concern assumption may no longer be appropriate.
2. II. Indications of risk that continuance as a going concern may be questionable could come from the financial statements or from other sources. Examples of such indications that would be considered by the auditor are listed below. This listing is not all-inclusive nor does the existence of one or more always signify that the going concern assumption needs to be questioned.

REFERENCES:

1. ‘Auditing and Assurance services’ by Alvin A. Arens and Randal J. Elder
2. ‘The Why and How of Auditing’ by Charles B. Hall