Summary of Study Note – 5

Auditing Basics − 1
Definition and Meaning of Auditing :
Auditing is a systematic examination of the books and records of any
organization in order to verify the financial operations and transactions. An
auditor verifies the entry passed by an accountant and accounts prepared by
him. Thus auditing begins where accounting ends.
Auditing is an examination of the books of accounts and vouchers of a
business to enable the auditor to satisfy him/her self 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 whether the profit and loss a/c gives a true and fair view of
the profit and loss for the financial period according to the best of information
and explanation given to him/her and as shown by the books of accounts.
Auditing is systematic examination of books, records and statements to
determine whether the generally accepted accounting policies have been
followed.
From the above it is clear that the meaning of an Audit contains :
1. It is an examination of books of accounts of a business.
2. It is done by some person having required qualification of being an
auditor.
3. It is done with the help of vouchers, documents, information and
explanations given by the clients (auditee) to the auditor.
4. The auditor reports that :
(i) The Balance sheet shows a true and fair view of the state of affairs
of business.
(ii) The Profit and loss a/c shows the true and fair view of the profit or
loss for the financial period
(iii) The books are properly maintained and accounts have been
prepared as per law of the land;
(iv) If he is not satisfied then in what respect he is not satisfied.
Audit Evidence :Audit evidence is the base on which report and judgment of
auditor depends. There are nine (may be more) types of evidences:
Types of Evidence :
1. Physical examination of various things shown in the books
2. Written or oral confirmation from third independent parties;
3. Documents prepared inside and outside of the organization;
4. Formal and informal statements by persons of the organization;
5. Computations and calculations performed by the auditor;
6. Satisfactory internal control procedures
7. Subsequent action taken by enterprise and others
8. Records with no indications of irregularities;
9. Inter-relationship of the examined data.
The evidences can be grouped under the following two heads :
(a) Analytical Evidence : These evidences are internal to the
organization and consist of journals, subsidiaries books, manuals,
codes, reconciliation statements etc. These evidences support the
data appearing in the books of accounts and in financial statements.
(b) Corroborative Evidence : (corroborate means to prove to be true
lRpizekf.kr djuk) These evidences are external to organization and
prove certain data to be true. These consist of invoices, confirmations,
 cancelled cheques, statements of outside parties and similar
documents.
Obtaining Evidence Or Methods of evidence The auditor obtains the
evidence in the following five ways :
(a) Inspection (b) Observation (c) Enquiry and Confirmation (d) Computation
(e) analytical review.
Audit Techniques : Collected evidences are examined by using audit
techniques. Audit technique is a method to examine the various evidences.
Worded differently, the audit techniques are the tools used to get the reliable
information from evidence while conducting audit. There are seven audit
techniques (may be more) namely :
1. Physical examination
2. Confirmation
3. Vouching (comparing documents with records)
4. Calculation and Computation
5. Re-tracking the books
6. Scanning (detailed and close examination)
7. Enquiry, Explanation and Getting Information
Accounting Standards : You should remember the following Accounting
Standards

Accounting Standards
AS-1 Disclosure of Accounting policies
AS-2 Valuation of inventories
AS-3 Cash Flow Statements
AS-4 Contingencies and events occuring after Balance sheet date
AS-5 Net Profit or Loss for the period,Prior period items and changes in accounting policie

AS-6 Depreciation Accounting

AS-7 Construction Contracts
AS-8 Accounting for Research and Development (withdrawn)
AS-9 Revenue Recognition
AS-10 Accounting for Fixed assets

AS-11 The effect of changes in foreign exchange rates

AS-12 Accounting for Govt. Grants
 AS-13 Accounting for Investments
AS-14 Accounting for Amalgamations
AS-15 Employees Benefits
AS-16 Borrowing cost
AS-17 Segment Reporting
AS-18 Related Party Disclosures
AS-19 Leases
AS-20 Earning Per Share

AS-21 Consolidated Financial Statements

AS-22 Accounting for taxes on income
AS-23 Accounting for investment in Associates in Consolidated Financial Statem
AS-24 Discontinuing Operations
AS-25 Interim Financial Reporting

AS-26 Intangible Assets

AS-27 Financial Reporting of Interests in Joint Venture
AS-28 Impairment of Assets
AS-29 Provisions, Contingent Liabilities and Contingent Assets
AS-30 Financial Instruments, Recognition and Measurement
AS-31 Financial Instruments Presentation
AS-32 Financial Instruments Disclosures
You must also remember the following Cost Accounting Standards (CAS):
CAS − Classification of Costs
1
CAS − Capacity Determination
2
CAS − Overheads
3
CAS − Cost of Production for captive consumption
4
CAS − Determination of average transportation cost
5

You must also remember the following International Financial Reporting

Standards IFRS
IFRS − 1 :First time adoption of International Financial Reporting Standards
(IFRS)
IFRS − 2 :Share based payments
IFRS − 3 : Business Combinations
IFRS − 4 : Insurance Contracts
IFRS − 5 : Non-current assets held for sale and discontinued operations
IFRS − 6 : Exploration for and evaluation of mineral assets
IFRS − 7 : Financial Instruments disclosures
IFRS − 8: Operating Segmetns.
GAAS / GAAP : Generally Accepted Auditing Standards / Principles : The
auditor does auditing on the basis of certain laws, standards, principles, guide
notes etc. Such standards and principles on the basis of which the auditor
conducts his/her audit work and gives his/her report, are called GAAS /
GAAP.
GAAS : The auditor is supposed and required to follow the following
standards (GAAS) while conducting his/her audit work and reporting his/her
findings :
1. General Standards :
(i) Independence : The auditor must be totally independent of the organization
of which s/he is auditor.
(ii) Due care : The auditor should exercise due care while performing his/her
duty as auditor.
2. Field Work Standards :
(i) Planning and Supervision : Auditor must plan the audit work properly and
supervise it during the conduct of audit work.
(ii) Internal Control :The nature, scope and depth of audit work depends upon
the efficiency and efficacy of internal control of the organization. The auditor
must evaluate the internal control system properly.
(iii) Evidences : Evidences are the grounds on which audit stands. The auditor
should collect, examine and evaluate the audit evidence properly.
3. Reporting Standards :
(i) Financial Statements : Auditor has to certify whether the financial
statements have been prepared following the GAAS / GAAP. If not, what are
the reasons and what are the deviations.
(ii) Consistency : He has to certify whether the GAAS/GAAP have been
consistently followed up to the current year.
(iii) Disclosure : if auditor does not make any adverse comment, the financial
statements are assumed to be reasonably correct.
(iv) Obligation : (obligation means compulsion, debt, duty, requirement,
commitment etc). The auditor is obliged (required) to give his report with his
opinion after concluding the audit. If s/he is not able to form an opinion,
reasons for the same must be furnished along with the report.
GAAP : The auditor is supposed and required to follow the following
principles (GAAP) while conducting his/her audit work and reporting his/her
findings :
(i) Integrity and Independence
(ii) Confidentiality
(iii) Skills and Competence
(iv) Work performed by others
(v) Documentation
(vi) Planning
(vii) Evidence
(viii) Conclusion and Reporting
Comparison of Indian GAAP with US GAAP
Particulars Indian GAAP US GAAP
1. Financial Prepared as per schedule VI Prepared to satisfy the
Statements of Company's Act 1956 disclosure requirement
of US accounting
standards.
2. Fixed assets Revaluation of assets is Revaluation is not
permitted permitted except in
some cases.
3. Depreciation Based on Schedule XVI of Based on the useful life
Company's Act 1956 of the asset
4. Investment in Prohibited (except in buy Permitted and is shown
own shares back of shares) as reduction in share
capital
5. R & D Can be capitalised subject to Treated as expenses
Expenditure certain conditions except for plant &
machinery
6. Goodwill Only purchased goodwill is Capitalised and
capitalised and amortized amortized over the
over the expected period of expected period of
benefit. benefit.
7. Goodwill written Can be written off in The maximum period of
off period maximum period of 5 years benefit is 40 years.
8. Pre-operative All expenses before They are expenses if
expenses commercial production are they are not of capital
treated as pre-operative and nature.
capitalised
9. Assets and Disclosure in current and Disclosure in current
Liabilities long-term component is not and long-term
mandatory component is
mandatory.
10. Exchange rate Taken as revenue profit/loss All gains and losses are
fluctuations for revenue items. Taken as taken to revenue
capital profit/loss for capital statement. No
nature items. capitalization whatever.
11. Foreign Gains or losses due to Gains and losses due to
currency fluctuations are of revenue fluctuations are shown
transaction nature as separate items of
 share capital.
12. Related party No specific disclosures are Detailed disclosures are
transactions required. requirement in financial
statements.

Concept of materiality in auditing :

In auditing, the term material has different meaning. Material means that
which is noticeable, that which can not be ignored. This item is a material item
means this item should be taken into account and should not be ignored.
Auditor in auditing has to constantly judge any item or transaction as material
or not. Obviously if auditor thinks a particular item as material item, s/he would
call for more information relating to that material item.
According to AS 1, materiality means the capacity of an item to influence the
decision of the user. If the knowledge of an item in a financial statement,
might influence the decision of the user of that financial statement, the item is
a material item.
According to AAS 13 : ' Information is material, if its misstatement (i.e.
omission or incorrect statement) could influence the decision of user of that
information.'
Materiality depends on the size and nature of the firm and also on the auditor.
One item may be material for one auditor or firm which may be ignored by
other auditor or firm. AAS − 13 on 'Audit Materiality' requires that the auditor
should consider materiality and its relationship with audit risk while conducting
and concluding an audit.
Some material items :
1. Mistake discovered in valuation of stock;
2. Calculation of depreciation, interest, amortization etc;
3. Non-disclosure of abnormal items and extraordinary items;
4. Non-disclosure of items which are required to be disclosed by law.
Materiality and Audit Risk :
In auditing, risk means the condition that the auditor can give his/her opinion
and statement based on incorrect, incomplete and inefficient information.
More clearly, Audit risk is the risk which occurs when auditor gives his/her
opinion on the basis of incorrect, incomplete and inefficient information.
According to AAS 6 '' Audit Risk'' means, the risk that the auditor gives an
inappropriate or incorrect opinion when the financial statements are materially
misstated. This audit risk includes the following three types of risk :
Inherent risk : Some errors will always remain whatever the quantum and
scope of audit be.
Control risk : Whatever may the internal control system, some error will not be
controlled and will escape the system.
Detection risk : Some errors will always escape and will not be detected by
the auditor.
Inverse relationship between materiality and audit risk :
The audit risk and materiality move in opposite direction i.e. the higher the
materiality level, the lower the audit risk. The auditor takes this inverse
relationship into account while determining the nature, timing and scope of
audit work and procedure. The auditor accepts a particular materiality level
and simultaneously takes the corresponding audit risk.
AAS- 13 on ''Audit Materiality'' requires that the auditor should consider
materiality and its relationship with audit risk when conducting and concluding
an audit. According to this standard, information is material if its misstatement
could influence the economic decisions of users taken on the basis of
financial information. Materiality depends on the size and nature of the item
and its assessment is a matter of professional judgement. The concept of
materiality recognises that some matters either individually or collectively are
relatively more important for a 'true and fair view' presentation of financial
statements in conformity with the recognised accounting policies, procedures
and practices. The concept of materiality is subjective in nature, an item may
be material for an enterprise while it may be ignored as immaterial for some
other organization. There is inverse relationship between the degree of audit
risk and materiality i.e. the higher the materiality lower the audit risk and vice-
versa. The auditor takes the inverse relationship between audit risk and
materiality into consideration while planning the nature, timing and extent of
audit procedures. The assessment of auditor may undergo change during the
conduct the audit, if during the audit he feels that his prior assessment needs
to be revised in the light of new facts. More extensive tests of controls and
modifying the substantive test procedures may be adopted if during audit
some facts surface demanding the same.