CHAPTER

Introductory
LEARNING OBJECTIVESs
After going through this chapter, you should be able to:
Understand what and why of auditing.
Have a sketch of early developments of auditing profession in India.
Get an idea ofpost-Independence influences on development of auditing in India.
Know the meaning and concept of auditing.
Distinguish between Book keeping, Accountancy and Auditing.
Learn the principles of auditing.
Classify audit based on different criteria.
Describe the qualifications and qualities of auditor.

1.1. WHAT IS AUDITING

(a) Audit means a system of checksVOt

Auditing is a system of checks on persons handling money or assets belonging to others. it
has existed in India for long, Early rulers had at least two
record of their money matters
independent persons maintaining
to prevent errors and or fraud.
(b) When audit only meant persons of integrity okaying the accounts read to them
by businessman
Earlier, the owner or employee of a business entity would
only read out his accounts to
person(s) of known integrity. A nod from them would mean all was well with the ac-
counts.
Hearing was the key to the system of checking. That is why audit has its origin in
the Latin word "audire, that means to hear.

(c) Audit got legal recognition with

emergence of Joint Stock Company
Formation of Joint Stock
Company was admission of the fact that it was beyond a single or
few individuals to own
resources and bear unlimited
business. The law on
liability for debts or payables of a
companies gave them an identity difterent from the company and
limited their liability. As the
company grew in size, there was
ship and management. This necessitated protection of interestsseparation
between owner
of nunmerous members by
providing for independent check of company accounts by an
person. English Companies Act of 1862
independent and qualihed
became the first law to provide for a watchdog
(auditor) to examine company's financial
dealings.
2 Principles and Practice of Auditing

1.2. POST-INDEPENDENCE DEVELOPMENTS

passed on to profession itse

Management and control of profession of Chartered Accoun
a Accountants Act. It set up the Institute
accountants and
1 , Indian Parliament passed Chartered of chartered
elected representatives includes prescrib-
a n t s ot india (ICAI). The
Council of ICAI comprises affairs of ICAI. It
controls the
Council m a n a g e s and code of conduct
for them. It
Central Government. The
nominees
of of members, and setting
a professional
and Accounting
standards of education and training Standards (SA),
ng Assurance
Statements on Auditing,
Auditing and
has iSsued a number of recommendatory
are
mandatory for auditors while some ike
Standards (AS). Most of these
a r e
management processes,
assumed the of
role examining
feature is that auditing has audit, cost
As of now, a notable audit, pertormance
management
of financial transactions.
There is also provision for
propriety
audit and tax audit.

(b) Qualifications of auditor and trained char-

an independent person duly qualified
According to Companies Act only Over the years,
there has been
tered accountant, can act as statutory auditor of a company. requirements as
auditor, as also
enlargement of duties, rights and liabilities of
considerable
for cost audit by cost ac-

annual accounts and audit report. There is also provision

regard
countants in case of specifhed companies. audit in case of
tax
Income tax Act, for compulsory
Then, there is provision also under
a business or profession in certain cases.
environment.
(c) Auditing in Electronic Data Processing (EDP)
and storing of financial transac-
in modern times, growing use of computers in processing
financial information. For ex-
requires the auditor to apply new techniques verify
to
tions
he not find physical evidence to examine
ample, due to on-line system transactions, may or vis-
the transactions. He will also not have a visible audit trail of particular transactions,
files and
ible physical output. Central location of data may tempt client-staff to change data
is not secure, unauthorized persons
programs without a trace. Also, if the computer system
may reach secret information and use it to client disadvantage or corrupt it altogether.

MEANING OF AUDITING

1.3. DEFINITIONS OF AUDITING

Auditing is concerned with determination of accuracy and reliability of financial and other
records and statements. Below, important definitions ofauditing
(a) Spicer and Pegler
"An audit is an examination ot books, accounts and vouchers of a business. The object is to
enable auditors to satisfy themselves that Balance Sheet is properly drawn up, gives a true
and fair view of state of afairs of business, and Proht and Loss Account gives a true and fair
view of profit and loss of financial period, according to his information and explanations
given to him and as shown by books. II not, reasons why he is not satisfied"
 Introductory

(b) F.R.M. De Paula

An audit denotes examination of Balance Sheet and Profit and Loss A/c prepared by oth-

ers, together with books, accounts and vouchers relating thereto. The examination is in
such a manner that auditor may satisfy himself and honestly report that, in his opinion,
e Balance Sheet is properly drawn up to exhibit a true and correct view of state of affairs
ot particular concern, according to information and explanations given to him and as
shown by books"
(c) Institute of Chartered Accountants of India (ICAl)
In the revised SA 200, "Overall
Objectives of Independent Auditor and Conduct of Audit in
accordance with Standards on Auditing" the ICAI
says the objective of an audit is for the
auditor to express opinion on whether the financial
statements are prepared and presented
in accordance with the
applicable financial reporting framework, and whether financial
statements are presented
fairly and give a true and fair view of the profit or loss, financial
condition and cash-flow of the entity.
In other words, auditing is a
systematic and independent
examination of data, state-
ments, records, operations and
ed purpose. In any
performances (financial or otherwise) of an entity for a stat-
auditing situation, auditor perceives and examines the assertions in finan-
cial statements, collects evidence
from inside and outside sources, evaluates the assertions
based on evidence, formulates his opinion and expresses it through his audit
report.
1.4. IMPORTANT FEATURES OF AUDITINNG
(a) It systematic examination of books of account and financial statements
means

The books of account

may be: Ledger, Subsidiary books, Journal, and financial statements,
Profit and Loss A/c (or, Income and
i.e.,
Expenditure Alc), Balance Sheet (or Statement of
Affair), and Cash Flow Statement. Audit involves review of internal control,
vant enquiries and tests, and
making rele-
vouching verification, analytical review, external confirma
tions, and examination of financial statements. Audit extends to
all operations and perfor-
mance of entity, whether financial or otherwise. According to ICAI, auditing is not
an
restricted to accounting records. It extends to
this
managerial performance, cost records, etc. In
includes evaluation of Management Processes and Functions.
sense, it

quirements under Sec.143 and amended CARO 2015have introduced the Reporting
re-

ety and fnancial prudence as part of audit examination. aspects of propri

(6) Examination should be bya chartered accountant
A person
qualified to be auditor should first be a chartered accountant. 'The
Act prescribes other tests of Companies
The foremost
qualifications, competence and independence of an auditor.
thing is that he should not be in a position that in any way
independence which may tempt him to act in a biased manner. This meanscompromises
his
also be that same that he cannot
company's officer or
employee, or employee or partner ot any officer
employee of the
company. His or
independence will be affected if he owes the company, 1or
 4Principles and Practice of Auditing
to the company for someone
Same companies more than 75,00,000 or provides surety e
who group
owes the company a sum exceeding 71,00,000. A company, being an artificial person

cannot be auditor but a limited liability partnership registered as

such, can act as auditor.

(c) Examination based on proper evidence

Audit involves examination of evidential documents. These may be invoices, cash memos.
They
documents, etc. also include
agreements, letters, money receipts, property ownership
intormation and explanations provided by authorized representatives of the client. An audj.
tor may also independently collect evidence from outside sources, such as confirmations

from bankers, lenders, credit suppliers, debtors, etc.

(d) Auditor expresses opinion on truth and fairness of assertions in financial statements.
According to SA-200 (now amended), audit examination enables the auditor to express
his opinion on truth and fairness of financial statements prepared by the management of
the entity. To this end, he must ensure two things. One, that maintenance of books of ac-
count is systematic and as per the relevant law enacted by Government and the regula-
tory pronouncements issued by ICAI. Two, financial statements based on accounts, give
a true andfair vicw of results ofoperations (profit or loss) state of affairs of business (Bal-
ance Sheet showing assets and liabilities) and cash-flow. This has led to development of
several new techniques to assess risk factors associated with EDP, and tormulation of ap-
propriate audit plan.
However, audit opinion is not an assurance regarding future viability of the entity or ef-
ficiency or effectiveness of its management.

PRINCIPLES OF AUDITING

1.5. STANDARDS ON AUDITING

SA-200 prescribes Basic Principles Governing and Audit. However, application of these
principles will depend on nature of the audit carried out, i.e., whether it is legally compul-
sory, or at the option of the client As responsibility for preparation and
ancial statements rests with top-end
presentation of h-
management and officers of the client, the dishonest
and unscrupulous among them may
falsify accounts and misuse funds and assets. They
may do so to mislead stakeholders (owners, shareholders, lenders, credit suppliers and
investors) by painting a rosy picture about profits and financial health of the entity, or to0
make illegal gains for themselves. When detected, both the management and auditors will
have to bear adverse consequences of their
malpractices.
Satyam Fraud: Lack of honesty, diligence by auditor
In 2009, the managing director of
Satyam Computers hearing the call of his conscience,
disclosed a massive fraud committed by him in the financial
statements of the
nact ceveral years. The disclosure jolted stakeholders of the company
company in India and
abroad. The Balance Sheet of the cOmpany snowed bank deposits falsely increased to 94%
 Introductory 5

of the actual sum and debtors of the

company to 7490 crore as against a paltry Rs. 2,000.
Liabilities of the also grossly understated. The Securities and
company were
Exchange Board
of India (SEBI) said the audit firm, PricewaterhouseCoopers, routinely failed to follow the
bastc procedures to confirm
the bank balance and debtors and
statements. The result: SEBI fined the auditors a only relied on directors
Thousand Dollars. huge sum, One crore and
Seventy-f1ve
Had the default
by auditors come to notice after enactment of Companies Act 2013,
they would have been subject to fine between 25,000 and 71,00,000. And if they had com-
mitted the offence willfully with the intention to
deceive the company or its shareholders,
creditors, or tax authorities, the
and a fine between R25,000 and
punishment would have been imprisonment for one year
5,00,000, or both.
Principles laid down in SA-200
(1) Integrity, objectivity and independence
The auditor should be a
person of integrity, i.e., he should be honest, sound,
person ot principles. He must not accept any evidence or statement at facerighteous,
and a
value, whoever
may give it, without fully satisfying himself about its
He needs to be objective, that is to
dependability.
say, he must be fair, impartial, just, open-minded,
sober and unprejudiced. His role is that of a
watchdog, carefully verifying any evidence
obtained by him or made available to him. However, he should not
be bloodhound, doubt-
ing and distrusting every evidence, statement or explanation.
Moreover, he should be independent of his client-entity or any person connected with it.
He is appointed by the client-entity but this does not mean he should
He is accountable to a whole lot of persons, owners,
obey theircommands.
partners, shareholders, debenture/
bond holders, credit suppliers, debtors, prospective investors, and Government, as also the
pubic at large. He can be independent only if he does not have any relationship with the cli-
ent or its staff that may give him monetary benefit, such as by being an employee or partner
of any director, or an
employee of the company, or owing money to the company exceeding
5,00,000, or acting as surety for anyone in the company for an amount exceeding?1,00,000.
(There are lot many other disqualifications for which refer Chapter 12.)
Then alone, he can freely and fearlessly give his opinion on affairs of the entity. If he does
not approach his work without fear or favor, he will be guilty of misconduct and bear civil/
criminal liability vis-à-vis owners/shareholders, even third parties. Auditors of scandal-
ridden Satyam and Enron are facing civil and criminal charges in India and abroad, because
they turned a blind eye to wrongdoings by top management.
It is noteworthy that independence is a state of mind, it is an indivisible quality. An in-
dependent person would maintain his independence against every person or situation and
in all circumstances. Independence cannot be selective-in one situation acting indepen-
dent and in another not only be independent
acting as slave. Further, auditor should but
should be seen as independent by all persons who rely on his report in their dealings with
the company.
 6 Principles and Practice of Auditing
(2) Auditors Duty to
Report Fraud to Central Government
in the course ol per
Under Companies Act 2013, an auditor has to be extra cautious. Iffraud
fraud isis being, has
or has
being, or
udt, he has reason to believe that an offence involving
ha employees of the company, ne must
Committed against the companv, by oficers or
as
report it to the Central Government within the time and
the
manner pre-
ately This will also apply to
SCrlbed. Failure to do so may invite fine or imprisonment, or both.
the cost auditor and company secretary of the company.
(3) Confidentiality
his
the course of his work, auditor will come across data and information, whicn
several
n In such a
Cnent may not like to be revealed to outsiders, particularly to his competitors.

case, the auditor should respect client concerns. He should share

such data/information
or under professional obliga-
ony with
clients specific permission, or if it is required by lawclient
tions. An auditor disclosing secret formula or strategy of his entity to another Would
invite penal provisions.
(4) Skills and competence
An auditor needs proper skills and competence. He will acquire skills through prescribed
education and training. His competence will come from experience while working under
seniors. However, acquisition of skills and competence cannot be one-off exercise. He
should keep updating himself on legal provisions, as also regulations and pronouncements
of the Central Government and ICAI.
(5) Reliance on work performed by others
it may not be possible for auditor to conduct an audit all by himself. He has to delegate work
to his staff (articled/audit clerks). In case a company has branch(es) outside India, he should
audit their accounts himself or get it done by an accountant or any other person who is
qualified to audit branch office under the law of that country. In his report, he may appro-
priately deal with the report of the foreign branch auditor, and his rights and duties for the
branch audit or branch auditor will be as prescribed.
(6) Documentation
As per SA 230, "Documentation', documentation refers to working papers prepared, ob-
tained and kept in his custody by the auditor for purposes of audit. Documents examined
by him may be books of account, financial statements, minute books, contracts, deeds, or
any other statutory books. Nature of documentation may be different depending on the
nature of audit, nature of business of the entity, types of records, reliability of internal
control system, and so on.
The auditor should retain working papers of every audit engagement to prove, i f and
when required, that audit carried out by him has been as prescribed by relevant laws, änd

Standards (SA and AS) issued by ICAI.

According to SA-230, working papers are the property of the auditor; however, the ch-
ent-entity may ask for copies or extracts ot the same. He may keep these with him tor
 Introductory 7

period as per professional norms, (not less than seven years) but may have to part with
them if any legal or
regulatory body directs him to do so.
(7) Audit planning
According to SA-300, "Audit planning" before commencing an audit, the auditor should
plan it efticiently and effectively. He can do so only if he has adequate knowledge of the fol-
lowing
(a) Purpose and scope of audit. An audit may be statutory or non-statutory in
nature, related to any specific purpose, like
or

assets
making an investment, or valuation of
and liabilities. In a statutòry audit, the law applicable to the entity determines
the scope and nature of his examination and his
duties and liabilities. However, in a
non-statutory limited purpose audit, his duties and liabilities will be as defined in the
letter of engagement.
(b) Knowledge of client business: According to SA-315, "Identifying and Assess-
ing the Risks of Material Misstatement through Understanding the Entity and its
Environment" the auditor should identify the risks of material misstatements and
understand the events, transactions
and practices which in his opinion may affect
financial statements, audit examination, or his
ers, visit to client
report. Annual report to sharehold-
premises, accounting manual, working papers of previous year,
management and organization structure, changes in accounting practices, work of
Ato
dot Vinternal auditors, employees of client, are some of the sources for this
purpose.
(c) Development of audit plan: Factors to determine this will be terms of
onpOe engagement,
legal liabilities and duties, accounting policies of client, fixing of materiality levels for
audit, planning of audit procedures, evaluation of work of internal auditors, other
auditors and experts, distribution of work among joint auditors, and deciding on
staff requirements. It will also involve
determining areas of audit, kinds of checking,
naming audit staff for various work, verification of assets, and coordination of work.

(8) Audit evidence

According SA-500, "Audit Evidence', the auditor should obtain sufticient appropriate
to
evidence in support of his opinion on the truth and fairness of financial statements. He
should decide the necessary procedures to comply with SA-500.
(a) Audit evidence mnay be internal or external. It may also be visual, oralor
He should rely on internal evidence
documentary.
(such as books of account, financial statements, re
ports,minutes, explanations from management/employees, etc) only if he is satistied about
the effectiveness of the internal control system operated by the company. External evidence
(such as confirmations from lenders, bankers, debtors, creditors, etc.) is often
should be subject to careful
genuine but
testing.
As tor assets, only visual evidence should be acceptable. Personal inspection of the as-
sets, where possible, is an example of this. Oral evidence, whether from internal or external
Sources, needs careful verification. Documentary evidence is often reliable but that too re
quires careful cross-checking.
 8
Principles and Practice of Auditing
or
() probable degree ot risk misstate
O Adequacy of evidence. This will depend on
applcaton
) materiality of the item; (iit) past experience: (iv) results
obtained by
and
dudit procedures; and (v) the trend indicated by accounting
ratios anaiysis
vIaence is only persuasive, not conclusive proof. In any case, sufficient appropriateevi
reasonably knowledge-
e cannot be anabsolute proof. Evidence must be such that any lair.
statements are true and
aDie person would conclude that assertions made in financial

(9) Accounting system and internal controls

internal con-
t tor the Management accounting system and suitable
to maintain proper
is records maintained by
Ihe auditor should secure a list of books of account and other
rOs. also ascertain, through
client-entity and acquaint him with the accounting system. He should functional.
compliance procedures, whether related internal controls are in place and properly
transaction
system prescribes that purchase
a
For example, suppose the internal control
should pass through three checkpoints: in that case the auditor should pick up a few pur-
chase transactions to assure that this indeed is the case. If he finds in ernal control system
reliable, he may cut down on substantive procedures requiring detailed testing of transac-

tions and balances as also analysis of relevant ratios to find significant fluctuations.
(10) Audit conclusion
Examination of audit evidence, coupled with his knowledge of business of client entity, will
enable the auditor to reach conclusions to express his opinion on its financial statements.
His conclusions will be about the following
(a) Financial statements comply with accepted financial practices. Client-entity has pre
pared required financial information on consistent application of generally accepted
financial practices, such as account classification, analysis of transactions, distinction
between capital and revenue, provision of depreciation, verification and valuation of
stock, etc.
(b) Information in financial statements is consistent with legal requirements. Information
provided in the financial statements meets the requirements of relevant legal provi-
sions and ICAI regulations.
(c) Financial statements contain adequate disclosure of all important information. Client
entity has made adequate disclosure of all material information as per financial re-
porting framework, subject to legal and regulatory requirements as applicable.

(11) Audit report

According to SA-700, "Auditor's Report on Financial Statements, an audit report
expresses
the auditor's opinion on the truth and fairness of results
of operations the entity (as
of
shown in Profit and Loss A/c) and its financial condition (as shown in Balance
sides Cash Flow Statement. He also reports on the status of maintenance of
Sheet), be-
cords as prescribed by relevant government laws and pronouncements of ICAL
accounting re-
auditor's report is a valuable
An document for people who rely on it to make business
decisions relevant to the audited enuty, ne 15nember of a
reputed profession. 'This imposes
p
 Introductory 9

several ethical and legal responsibilities on him. As in case of any other professional,
has Taith in his integrity, competence, objectivity, and independence pubic
and believes that he
Will work to
protect and promote interests of all stakeholders in the business. 'The auditor
must make every effort to live
up to public expectations. His morally and legally correct
age inspires confidence in his
opinion on financial statements.
im
Statements providing8 Persons/entities who use the information
financial information for the purpose(s) as indicated
Who uses the
informa-|1. Management of busines entity, to monitor performance and take
tion and why? routine decisions policy and
2. Shareholders, partners, and
proprietors, to monitor business
their results and financial condition of the operations,
3. Banks and financial institutions, to evaluateentity.
financial condition. performance, profitability and
4. Creditors to assess whether it would be
prudent
entity.
to provide credit to the |
5. Customers, to determine whether it would benefit doing business with
entity. the
6. Government, to monitor whether the entity is serving social
ing taxes on time. good, and pay-
7. Rating and research, to undertake research and rate the
entity in the industry. performance of the
However, opinion expressed by him is not an assurance on
ciency or effectiveness of its Management. There are reasons forviability
of the entity or effi
this. One, the auditor may
be wrong in judging the extent of audit
procedures while conducting his audit. Two, the
Management may have misjudged on selection of
sentation of financial statements. Three, evidence appropriate accounting policies or pre-
gathered by auditor is generally persua-
sive, not conclusive. Four, there may be weaknesses in
internal control system that may be
exploited by employees or even by the top management. Five, an auditor cannot test check
every business transaction because that will be both
audit does not costly and time-consuming. So, an
give fool-proof
assurance that there are no misstatements, errors or fraud in
the accounts.
Lastly, the auditor cannot pass judgment on the efficiency and effectiveness ot
Management because that would be subjective in nature. May be, the
tential to be more
Management has po-
efficient and effective and make the entity still more
profitable.
DISTINCTION BETWEEN BOOKKEEPING, ACCOUNTING AND AUDITING
1.6. BOOK-KEEPINGG
Book keeping means maintenance of a regular, correct and systematic record of
transactions in appropriate books of account. It includes- day-to-day
books, such as Cash Book, Purchase day book, Sales (a) Entering transactions in relevant
etc.; (6) day book, Purchase/Sales Return Book,
Posting them to relevant accounts in the Ledger; and (c) Totaling and balancing
counts. Much of the work of a ac
Overall direction and bookkeeper is clerical in nature and its
performance is under
supervision of an accountant.
 10 Principles and Practice of Auditing

1.7. ACCOUNTING

(a) What is accounting?

Accountancy deals with folowmg
ends.
i t a h c y begins where bookkeeping that there is
correct
to ensure
Lheck the work done by a bookkeeper, in other words,
4 record of all financial transactions in books of account. relevant
transaction in
ensure that there is
record of each
0) Prepare a Trial Balance, to
accounts.
Profit and Loss APpro-
statements (namelv, Profit and
Loss A/c,
(C) Prepare financial to show the results of
priation A/c, Balance Sheet and Cash-Flow Statement),
business operations and financial
condition of business.
entries.
(d) Pass adjustment and rectification assets from
unauthorized

a suitable accounting system to

protect business
(e) Design under relevant law.
and improper use, and comply with legal requirements

(b) When auditor cannot act as accountant of his

on the date ap-
act According to Sec. 141(3), if
as an accountant.
An auditor cannot
like account
associate company) is engaged in services
pointment he or his subsidiary (or of any financial in-
design and implementation
ing and book keeping, or internal audit,
or
be appointed
the company, he cannot
formation services, or management services, etc. to
auditor of that company.
Distinction between Accounting and Auditing
Auditing
Accountancy analytical and critical ex-
1. It is concerned with collection, clasification, 1. It is concerned with
of financial records and
statements.
amination
summarization and communication of finan-
cial data communication
of profit | 2. It reviews measurement and
2. It measures business events in terms
condition of business. of financial results and condition
or loss and financial
enti- . The auditor is an independent and profession-
3. The accountant is an employee of entity,
tled to regular salaries. ally competent outsider, hired fora fee.
to submit a report con-
required to submit a re-4. Theauditor required
is
4. The accountant is not

port on financial statements prepared by taining his opinion on truth and fairness of as-
sertions made in financial statements.
them.
5. The accountant, being an employee of entity, | . Appointment of auditor takes place every year.
works on a permanent basis.

1.8. AUDITING

Auditing has a object. One, examination ofbooks of account, systematically and

three-fold
evidence in support of entries in books of account. Three, verify-
analytically. Two, checking
ino authenticity of
assertions in hnancial statements, Most important duty of an auditor is
Balance Sheet and Cash/Fund Flaw
in his opinion, Profit and Loss A/c,
to report whether,
ot results of operations and financial position
a true and fair prcture of
Statement represent
 Introductory 11

business, and books and records of business are as

ments of ICAI.
required by relevant law and pronounce
According to Mautz and Sharaf, "relationship of auditing to accounting is close, yet they
are different in nature; they are business associates, not parent and child.
1.9. DISTINCTION BETWEEN INVESTIGATION AND AUDITING
Often, people confuse auditing as a form of
investigation. The fact is the two are quite dif-
ferent in many ways. Below, the distinction between
investigation and auditing:
Distinction between Investigation and Audit
Points of distinction
Investigation Auditing
Scope Decision about the nature and|In a statutory audit, determination of its|
scope of investigation is by the|scope is by the relevant law. In private audit,|
entity who orders it. it is by the entity.
Object To determine certain facts or/To seek auditor's opinion on truth and fair-|
|causes which require investiga-|ness of financial statements and compliance
tion. with legal and regulatory provisions.
Time coverage Depends on need and causes of| Covers the accounting year followed by the|
investigation. entity.
Approach to workk Examine the facts and causes, no| Gather data and information to express opin-
matter how and where to get thelion on truth and fairness of assertions in fi-|
evidence for it. nancial statements.
Work program Flexible, liable to change as situa-Generally, there is a fixed format.
|tion unfolds.
Disclosure Circumstances that led to the|As laid down in law.
cause of investigation
Report To the entity who ordered inves-|To owners as per format laid down in rele-
tigation. There is no .standard |vant law.
pattern of reporting.

CLASSIFICATION OF AUDIT

1.10. TYPES OF AUDIT

Based on the purpose of examination of accounts, classification of audit may be as follows:

1. Independent audit
2. Internal audit
Government audit
Specific audit
For detailed discussion, see chapter 3, "Classification of Audit"

QUALIFICATION AND QUALITIES OF AUDITOR

lo be an auditor, a person must possess professional qualifications as also personal qualities
of head and heart.
12 Principles and Practice of Auditing

1.11. STATUTORY QUALIFICATIONS

examinations
conducted by Insti-
a chartered He must pass
s t be
c accountant.
practicing chartered
accoun-
rCnartered Accountants, and undergo training undera
Lant. He must also secure a
accountancy. Furthe, ne
certificate to take up public practice of
must not suffer any disqualification for appointment as atuditor,

MIX OF
1.12. ACADEMIC AND PERSONAL QUALIFICATIONS-AUDITING A
SEVERAL DISCIPLINES
An auditor has to perform a variety of functions. To be able to do so, he must possess sev
eral qualities-some tangible, others not so tangible. He may acquire some of these qualities
through formal education and training, while others he will himselflearn during his experi-

ence in the school of life.

For example, through formal education, he can gain knowledge of financial and cost ac-

countancy, business laws, production systems, mathematics, statistics, general management,

financial management, marketing management, and human resource management.
Personai qualities, like honesty, integrity, tact, common sense, communication skills, are
either inborn or learnt through experience and interaction with others.

1.13. PROFESSIONALQUALITIES
Auditing is not a profession standing on its own. It has drawn on several disciplines, such as:
(a)
Knowledge of financial accounting He should know basic concepts of accounting
different systems of accounting, and their function in a business. He should update
himself about developments in the field of accounting. He should be familiar withh
the principles of determination of
periodic income, recognition of revenue and cap
ital items of income and expenditure, inventory valuation,
depreciation, equity mea-
Surement, content and presentation of financial statements, etc.
He must be aware of audit and
accounting standards (SA and AS) issued by ICAI
and ensure that financial statements
prepared by his client are in accordance with
mandatory standards.
(b) Knowledge of cost accounting: He should know concepts ot cost
direct and indirect costs, cost allocation, allocation
ot overheads,
accounting such as
and standard costing,
cost budgetary control, etc. He should also know how to
apply cost accounting
principles to decision-making, such
"make-or-buy any
as,
product, "repair or re-
place any asset,' product mix, inventory control, etc.
fci Knowledge of accounts of business under audit:
He should be familiar
tem and techniques of accounting in the entity under audit.
with the sys-
(Knowledee of business laws: He should have knowledge of the laws
nerships, companies, trusts, ageneies, lactories, eStates, governing part-
property,
derstand the relationship between entral and State laws, and
etc. He should un-
statutory and o
mon law. He should know how to apply the
principles ot law to accounting
and
auditing situations.
 Introductory 13
(e) Knowledge of production systems: He should be aware of the
nature of
production planning and processes, and how cost production,
under audit. accounting relates to the entity
J) Knowledge of economics: He should be familiar with
fects of economic
factors on business units,
principles of economics-ef
competition, etc. relationship between demand and price,
g) Knowledge of mathematics and statistics: He
should have working
mathematical and statistical methods of knowledge of
solving business problems by quantitative
techniques.
(h) Knowledge of general management: He should have
nization
a broad
understanding of orga-
theory and behavior, decision-making process, individual and
ior, and group behav-
(i)
authority-responsibility relationships.
Knowledge of financial management: He should have
methods used in financial analysis. This would knowledge of concepts and
help
entity under audit, and effects of depreciation and
him evaluate capital needs of the
taxes on
() Knowledge of marketing management: He should be familiar availability of funds.
with methods of pric
ing, relative merits and demerits of various channels of distribution, and how ac-
counting can be used to sort out
marketing problems.
(k) Knowledge of human behavior: The auditor interacts with his own and the
staff in connection with his work. He should know how to deal company's
with persons having dif-
ferent levels of knowledge, intelligence,
experience,
socio-economic background, etc.
1.14. PERSONAL QUALITIES
(a) Honesty and integrity: He should be honest and morally correct in his behavior. He
should be cautious and careful to avoid errors, and exercise due diligence in his work.
He should perform audit duties without fear or favor and not submit to
any tempta-
tion or pressure from officials of the entity or anyone connected with it.
(6) Tactfulness: He should be firm, yet tactful with his client and his staf. He should
know when, what and how to speak or write anything that may be necessary yet in-
convenient, and have courage of conviction to stand his ground.
(c) Alertness: He should be conscious, aware and wakeful in his work. He should know
what has happened and be able to foresee what might happen in future
(d) Sound judgment: Exercise of judgment is basic to any audit. The auditor should be
able to judge the relevance and importance of any evidence, audit program and audit
procedures.
(e) Sense of responsibility: Public confidence in auditing profession arises from awide
spread impression that it follows best standards of performance and is ever conscious
ot responsibility to public interest. Therefore, in both thinking and behavior, the au-

ditor should try to live up to his public image.

Due diligence: The profession of an auditor is like a zealous mistress that makes ex
work diligently under
acting demands on his time, energy and attention. He must
time pressure, meeting deadlines to perform the tasks on hand.
 14 Principles and Practice of Auditing

ecttve communication: He should he able to communicate effectively, both orauy De

shouldu
his language
WTiting. Particularly in the matter ofreport writing,
simple, clear, logical and lucid.
obUst common sense: The auditor should have sound common sense. wInout
but lacking ability
e would be a mere technician, knowing evervthing about his job
to apply his knowledge to specific situations.

ADVANTAGES OF AUDIT

1.15. ADVANTAGES OF AUDIT FOR DIFFERENT STAKEHOLDERS

(a) How the entity under audit stands to benefit
Benefits to the entity under audit are as follows:
of books of
(7) Employees work with due diligence. Employees in charge of maintenance
account and records are regular, careful and systematic in their work. They knOw the

auditor and his staff are breathing down their neck.

Errors
(ii) Fear of surprise visits by auditor keeps a check on errors and fraud by employees.
and traud committed by employees are liable to quick detection. Fear of unexpected
visit by auditor will exercise moral check on employees; else, they might feel tempted
to manipulate books to misappropriate cash and/or gocds.
(in) Creditors rely on audited accounts to provide credit to business. Audited accounts are
a reliable indicator of the state of financial affairs of the entity. Based on them, the
entity can obtain easy loans and credit from banks and suppliers.
(iv) Audited accounts make tax assessment easy. Tax authorities rely on audited ac
counts. This makes it easy for them to determine tax liability of the entity in re
spect VAT, etc.
of income tax, wealth tax, excise, sales tax, service tax,
(v) Financial worth of business determined by audited accounts. In case of proposed ac
quisition of a business as a going concern, audited accounts make it easy to deter-
mine purchase consideration.
(vi) Employees easily convinced about profitability ofbusiness. Audited statements provide a
reliable basis for resolution of disputes as regards wages or bonus payments to workers.
(vit) Audited accounts facilitate settlement of insurance claims. In case of loss or damage to
business property, audited accounts facilitate determination of claims against insurers.
(vii) Entity can know about weaknesses of internal control system. For management of the
entity, audit examination helps to identity and correct weaknesses of the existing

system of internal check and internal control.

indicalor of compliance with legal obligations. Audit examina.
(ix) Audited accounts
are
tion brings to light whether the entity 1s meeting necessary legal obligations on
of account.
maintenance of proper books
expertise of auaitor Staft of the entity can benefit fram
f The entity staff can gain from
of auditor in several ways, such a0
professional competence and experience
 Introductory 15
of internal control system, maintenance of
accounts and compliance with legal and
tax-related issues.
(b) Advantages for Owners of Business
() For sole proprietor, auditing serves as proof there is no error or
case
of sole proprietary concern, for which audit is not
a fraud in accounts. In
receipts or turnover exceeds the prescribed limit, audited compulsory unless its gross
serve as
proot that there is proper accounting of all businessstatements of accounts
there is no error or fraud. transactions and that
(ii) Inpartnership, auditing assures partners of proper
partners. În partnership firm, for which again audit management
is not
of business by active
receipts or turnover exceeds the prescribed limit, audited compulsory unless its gross
of accounts serve as evidence
proper management of business by active
Audited accounts also help in settlement partners and employees of the firm.
of accounts in case of admission,
or death of
any partner, or in case of dissolution of the firm retirement
(ii) For shareholders of company or for whatever reason.
nance by the
cooperative society, audit provides proof of goodgover-
Board/Managing Committee. In a joint stock and a cooperative
society, for which audit is compulsory, audited statementscompany
efficient management of business affairs and proof that there is
serve as
that their investment is in safe hands.
(c)Advantagesfor Others
Outsiders rely on audited statements for various
dited statements of a business to purposes. Banks and lenders rely on au-
sanction loans to it. Insurers rely on them to settle
in respect of lost/ claimns
damaged business assets. For determination
sales tax, wealth tax etc., tax authorities of liability under income tax,
tax generally rely on audited statements to
determine
liability of the entity.
LIMITATIONS OF AUDITING
1.16. INBUILT CONSTRAINTS OF AUDITING
(a) Traditional approach,
though now it has changed substantially
Traditionally, auditing has been synonymous with procedures and
techniques of checking,
ticking, totaling, vouching, verification, etc. In this sense, it excluded
areas, such as finances, several important
managerial efficiency and effectiveness, propriety of business deal-
ings, business ethics, etc.. However, in
its scope to include present era of globalization, auditing has expanded
corporate governance, business risk analysis, unfair trade
eftects of business
operations on environment, and so on. practices,
(b) Auditing is a post-mortem activity, though now it is
becoming ante-mortem
Auditing begins where accountancy ends. "The auditor is nowhere
ing or balancing of books of account. It is not around at the time ot cast-
possible for hinm to discover manipulations by
16 Principles and Practice of Auditing

may escape his atteen

clever, highly placed oficials. In the event, many questionable dealings
tion even after careful audit examination.

c) Dependence on inside information, though the auditor can even look for
evidence outside
Books of account and financial statements do not tell the whole story about business trans-
and explanation from
actions. An auditor has necessarily to seek additional information
various personnel of the entity. There may be a question mark on authenticity
of such infor-
themselves involved in
mation and explanations, particularly if the source personnel are
not reveal cor-
manipulation of books of account. Therefore, even audited statements may
rect or complete picture of the state of affairs of the entity.

(d) External evidence may not be trustworthy, though there is way to crosscheck it
An auditor can tap external sources of evidence. However, such evidence may not always be
forthcoming or wholly reliable. A debtor of business may provide wrong infornmation about
the debt owed by him. The company lawyer may twist facts to say the company is under no
obligation to pay any claim or damages. The people valuing an asset may over- or under-
value it. n the circumstance, even audited accounts may lack authenticity.

(e) Audit staff may use faulty procedures or techniques

Collection of adequate evidence in support of any assertion in books of account wil
depend on the types of audit techniques employed for purpose. Where an audit tech-
nique is not consistent with the nature or with the method of record
type of entity, or

keeping followed by it, it will not provideright kind of evidence. As a result, even au-
dited accounts may not tell the entire story. This is more likely if the auditor who is
simultaneously engaged in audits of many organizations, large and small, complex and
simple, with different methods of record keeping.
(f) Failure to detect clever manipulation in financial statements may cause
misleading audit opinion
The auditor gives his opinion on truth and fairness of assertions in financial statements
based on his examination, relying on appropriate audit techniques. However, at times
faulty financial statements may cloud his personal opinion and fair assessment. In the
event, audited statements may not showa true and fair picture of business.

REVIEW QUESTIONS
 CHAPTER

Objects of Audit 2
LEARNING OBJECTIVES:
After going through this chapter, you should be able to:
Understand the Evolution of Audit Objectives.
Know the Objectives of
Audit.
Understand the primary objective of
expression of opinion
assertions made in financial statements of an
on the truth and fairness of
entity.
Detect and prevent fraud
(including computer fraud) and errors.
Understand the types of errors and fraud and auditor's
responsibility as regards them.

2.1. EVOLUTION OF AUDIT OBJECTIVES

(a) Audit objectives evolved with evolution of business organisation

How far have we travelled from the times when men
of integrity only heard the business
accounts read out to them by the businessman, and their
nod became proof that every
thing was right with his accounts. No physical checking,
no for oral
asking or documen-
tary evidence, no seeking any explanation from officials of the client, no
confirmation from
outsiders, there was absolute trust in what the businessman read. But that was a time when
people trusted each other. People trust each other even today but they do not do it
They do it after a qualified independent person (auditor) has examined the accounts blindly.
and
given his clean report. And he does so within the rules prescribed for him
by law and the
regulator.
(b) Need for independent opinion on truth and fairness of presentation in financial
statements
This is because financial statements are prepared by the Management and
sharehold-
ers have absolutely no say in it. Can the accounts be falsified; can the
Management or
came hich-end officials commit fraud for personal gain? 'T'here are several instances
hac heen done. Take the case of Satyam Computers, where the
managing director
fddled with the accounts to show that the company was in the pink of health, Or the
giant power firm, Enron, where directors had joined partnership firms and loans oiv.

en to them by the company did not appear in its Balance Sheet.

 Objects of Audit 19

Evolution of Audit Objectives

Period Stated audit objectives Extent of Importance of internal
Ancient - 1850
Detection offraud. verification control
Detailed. Not recognized.
1850 1905 Detection of fraud; Detection
of Some tests, primarily | Not recognized.
clerical errors. detailed.
1905 1933 Determination of truth of
reported | Detailed testing. Slightly recognized.
financial position; Detection of|
fraud and errors.
1933 -1940
Determination of fairness of report-| Testing. Awakening of interest.
| ed financial position.
1940 Determination of truth and
fairness|Testing. Substantial emphasis.
of reported financial position.
(Source: Accountant, October, 1962)

OBJECTS OF AUDIT
2.2. EXPRESSING OPINION ON FINANCIAL STATEMENTS
The objects of audit are as follows:
Primary: Examine the reliability and validity of financial statements to enable the auditor
to express his
opinion on truth and fairness of presentations therein.
Secondary: Detect and prevent errors and fraud in accounts that are the basis of financial
statements.
Audit objectives Means to achieve objectives
Primary Expressing opinion on truth and fair-|Examine the reliability and
-

ness of
validity of assertions in
presentations in financial statements financial statements, through vouching, verifica-|
tion, analytical review, confirmations, etc.
Secondary -

Detect and prevent errors and fraud

|Evaluate the effectiveness of internal control sys-
| tem, internal check and internal audit

(a) Opinion on truth and fairness of assertions in financial statements

According to SA-200A, "Objectives and Scope of Audit of Financial Statements", the objective
of audit of financial statements
(Profit and Loss A/c and Balance Sheet) is to enable the audi-
tor to express his opinion truth
on and fairness of assertions made in financial statements. Sec.
143 of Companies Act requires a company auditor to state whether in his opinion-
(a) Balance Sheet of company gives a true and fair view of state of company's affairs as at
the end of its financial
year; and
6) Profit and Loss A/c gives a true and fair view of profit or loss for the financial year.
(b) Procedure and techniques to arrive at opinion
To express his opinion, the auditor must first make a systematic examination of
fhnancia
statements and accounts and records prepared as per Accounting Standards (AS) and Stan-
dards on Auditing (SA) issued by ICAI, including statutory requirements in the relevant
 20
Principles and Practice of Auditing
dW ie should evaluate the internal control system, including internal check and internal
audit, for its effectiveness and
i e should compliance.
obtain a written representation from Management and others charged with gov.
C e where they accept their responsibility for the design, implementation of maintenance
nternal control to prevent and detect fraud. Also, that they have disclosed to him the results
O their assessment of the risk of material misstatements arising from fraud, and their knowl-
cage of the fraud or suspected fraud affecting the entity involving management, employees and

oners. Ihey should also share with him their

fraud as communicated by employees, former
knowledge of allegations of fraud or suspected
employees,
ACcording to amended Companies (Auditor's Report)analysts, regulators,2015, in case of a
Order (CARO)
etc.

specified company (whether public or

and size, the private), the auditor must report that, given its nature
company has maintained an appropriate system of internal audit and observed
the rules
prescribed in the internal control system of the If the compliance
dures reveal
any departure from the internal control company. proce
checking of the transactions. system, he should take detailed up
What is a
specified company? See Chapter 3, Sec. 3.5.
(c) Opinion is not an assurance on financial
viability company or quality of its
of
management
An auditor's
opinion is only with respect to truth and fairness of assertion
tion of
enterprise as made in Balance Sheet and results its of financial posi-
Loss A/c and Cash Flows. It is of operations as stated in Profit and
not an assurance about
future viability of the
ciency and effectiveness with which its entity, or effi-
Management may conduct its affairs.
2.3. DETECTION AND PREVENTION OF ERRORS AND
FRAUD
Errors and fraud can cause material
difference between error and fraud is misstatements in financial
whether the misstatement is
statements. An important
care, or it is intentional and
deliberate. It is necessary that the innocent or due to lack of
while conducting audit, auditor has skeptical attitude
suspecting that material
statements. This is despite that he has no misstatements may be there in
past financial
statements. He should accept the records and experience with the client to disbelieve his
apparently no reason to distrust the statements.documents only if he believes that there is
Material misstatements may be by of
financial picture of business or to way misleading financial reporting to hide the real
misappropriate assets tor personal gain or to
client business. However, even where an auditor injure the
suspects fraud, or is able
currence, he is not obliged to determine whether fraud has to identify its oc-
actually occurred.
2.4. ERRORS
(al Errors are unintentional, Without an
objective to
statements, or to siphon off cash or assets
mislead readers of
financial
An error may be anyunintenl1oat
Arithmetical or other stKE
or
a' mistakes; mis-aescription
n books of account
(ii) whether hy
Oversight or
misinterpretation of facts: or
 Objects of Audit 21
ii) Misapplication of accounting policies. An accepted rule is that an
nocent and error is
not deliberate. However, if it be
generally in
fraud. appears to willful, it assumes the character of a

(b) Types of errors

Classification of errors may be as follows:
1.Clerical errors, which
may further fall under (a) Errors of
commision. omission, (6) Errors of
2. Errors of
principle
3. Compensating errors

1. Clerical errors
A clerical error may be--(a)
Wrongly recording transaction in books of
a
such as Purchases Book or Sales
Book; (6) original entry,
(c) Wrong totaling or balancing of a Wrong posting of any transaction to Ledger; or
mission.
Ledger account. It may be an error of omission or comn-
(a) Error of omission. It occurs
when there is omission in enteringa
Such error is easy to detect either transaction in book
of account, either a
wholly or partially.
account itself, or
during analytical checking. In case of complete omission during writing of the
from books of record, error of a transaction
may be difficult to detect. Because, if
altogether omitted from Ledger, it will not reflect in agreement ofposting of a transaction is
Trial Balance.
ple, if there is no entry of a credit For exam-
debit in Purchases Account and no
purchase in Purchases
Day Book, then there will be no
credit in Supplier's A/c. This omission will
Trial Balance; it will come to not affect
light onlywhen Purchases A/c and Stock A/c are detail-checked.
However, if there is a partial record of a transaction in the
there will be mismatch in Trial Balance. For Ledger,
to detect because the error will be easy
Alc is recorded but no debit in example, if credit sale in Sales
to sale amount and
Buyers A/c, then Trial Balance will show excess credit
equal
then the error can be nailed.
(b) Error of commission. It may occur
during
original entry, or while posting it to Ledger. Errors recording
of a transaction in a book of
in totaling and
in carrying forward totals
to Trial Balance, are also errors of
balancing of accounts or
examples of such errors: commission. The following are
(i) Where a transaction has been
a
incorrectly recorded either wholly or partially, e.g., if
credit purchase of Rs. 520 has been
recorded in Purchases Day Book as Rs. 250
(such error will not affect Trial
Balance.)
(ii) Where a transaction is
incorrectly posted in Ledger, e.g., if there is an entry of a
credit sale of Rs. 250 in both the concerned
accounts (on debit side of Customers Alc
and on credit side of Sales
A/c) as Rs. 520. Such error will also not affect Trial Bal-
ance.
However, if error is by way of incorrect posting in one account,
correct though there is
positing in theother account, Trial Balance will reveal it
by showing excess
debit or excess credit.
Same will be the case where posting takes
account and not in the other. place only in one
22 Principles and Practice of Auditing

i ) If there is incorrect totaling or balancing of Ledger accounts. Here, in either case,

mistake will affect Trial Balance,
(iv) If an error occurs in entering balances in Trial Balance. In this case error will reflect
in Trial Balance.
()Ifthere has been an error of duplication, i.e., double recording of the same transac-
tion. This may be due to failure of clerks to cancel the relevant vouchers and in-
voices soon after entering them in books of original entry. Errors of this nature
would not distort Trial Balance. Careful vouching is the only way to locate such
errors.

Often
Nature and Characteristics of Errors
unintentional, not intended
to mis-|An
intentional error will be fraud.
leador cheat readers.
Self-evident, detectable during account |Not self-evident, not detectable
preparation, such as, omission of cheque tion, during account prepara-
issued will show up preparation of bank|
on
a
only analytical check will uncover them
reconciliation statement.
Errors of omission or
commission,
fined to single account, will show in con-|Complete
mis- | and
omission of a transaction, errors of
principle,
match of Trial Balance. self-adjusting compensating
Trial Balance, hence detectable
errors will not
affect
only by analytical check.
2. Errors of principle
An error of
principle occurs when there is neglect of
ciples while recording generally accepted accounting prin-
any transaction in books of account.
clerks are not able to It be because
and correctly distinguish between capital andmay accounting
expenditure. However, revenue nature of
business by overstatement orsometimes this may be done to hide the real state of receipts
The following are some understatement of profits or losses. affairs of
(a) The entity shows
examples of errors of principle:
revenue
expenses are expenditure as capital expenditure,
a
shown as capital
charge profits and go to reduce
on or vice
versa. Revenue
ital account, it will expenditure, profhts.
e.g., it current repairs to
If any
revenue
expense is
increase
Profit and Loss A/c will machinery
profits as also book value of the are shown on cap
not show a true
Balance Sheet a true and
fair
and fair
picture of results of machinery.
As such,
(b) Where there picture of financial operations, nor
to ignore legal
is
suppression of identity of an item position.
requirements or for of expenditure. It will
different account, e-g, wages
any other reason, happen when,
Repairs A/c. While debited to expenditure
in such Advertising
expenditure Alc, or appears under a
it would
falsify and distort financial a case
would advertising
constitute a chargeexpenses to
i
Where expenditure statements.
appearsas
beriefit granted. lt on profits,
est paid to a creditorto his happens where there is
charge on profits, it results in personal account, such that
increasing assets position, instead of debit of inter-a
constituting
 Objects of Audit 23

(d) Where valuation of assets is not as per

take place to overstate or
geneAaccepted accounting principles. It may
understate profits andfinancial position of business.
3. Compensating errors
A
compensating error hides or reduces the effects of other errors. For example, on face of it,
a matched Trial Balance may lead to the conclusion that business transactions have been all
correcthy recorded and posted. However, in reality, there might be a number of errors hid-
den in books of account which stand covered
by compensating errors.
To illustrate: Suppose, a credit sale ofR1,000 to X has correct
debit to his account, but
in Sales A/c the credit is of Rs.
entry 100 only, that means a short credit of 7900. If this
were the only error, it would reflect in disagreement of Trial Balance. However, if there is
another error of short debiting of another transaction in the same or different account,
there will be a short debit of 7900, or more. Now, if other short debits total up z900, these
may be equal to the amount of initial short credit of 900. Which means Trial Balance
would not reflect the errors and would delightfully match. On other hand, if
subsequent
short debits exceed 7900, Trial Balance would show disagreement, but like the
tip. an
iceberg. it would hide more than it reveals but what it hides would have much accounting
significance.
2.5. HOW TO DETECT ERRORS
Strictly speaking, it is not a part of an auditor's duty to locate errors. Yet, he has to do it to
be able to report his opinion on truth and fairness of financial statements. Therefore, when
faced with a difference in Trial Balance, auditor should take following steps to locate errors
responsible for it:
1. Check and recheck totals of Trial Balance.
2. Divide the amount of difference in Trial Balance by figure 2 (two) and see if any
items on debit side equal to that sum has been wrongly entered on credit side. It
may also be that there may be posting of any items on credit side equal to that sum
on debit side.

3.Ascertain whether there is transfer of balances of all Ledger accounts to Trial Bal-
ance
4. Ascertain on basis of nature of certain accounts (which always have either a debit or
credit balance) whether these have been posted to correct side of Trial Balance.
5. See if there is correct totaling of various Ledger accounts.
6. Ascertain whether there is posting to Ledger accounts of all entries recorded in

original books of account, and also that there is correct totaling of original books
of entry.
7. Check up opening balances in Ledger accounts brought forward from previous
year.
8. Compare items of Trial Balance with items appearing in Trial Balance of previous
year, to see if any item has been left out, and if so, why.
 24 Principles and Practice of Auditing
to total of credits.
journal entries to that total of debits is equal
ensure
eCk be due to followng:
0 . lt errors are still not
located, then the difference may
is likely that
9 (nine), then it
difference in Trial Balance is divisible by
a nere 12 for 21, 24 for 42,
36 for 63, and so
may be misplacement of figures, say
on.
mistake in totaling.
10, 1,000 is often due to a
A n error of a round sum, like

2.6. DETECTION AND PREVENTION OF FRAUD

According to AS 240
Fraud means an intentional act to falsify accounts.
2. It may be committed by one or more individuals.
3. Such individuals may be part of Management or charged with governance, or em-
ployees or third parties.
The act must involve the use of deception to obtain an unjust or illegal advantage or
to cause harm to business.
5. The reason why fraud takes place are the events or conditions that induce a motive
or pressure to commit fraud or there is an opportunity to commit fraud.

2.7. TYPES OF FRAUD

According to AS 240, "The Auditor's Responsibilities relating to Fraud in an Audit of Finan-
cial Statements, fraud may be committed in any of following ways:

(a) Misappropriation or embezzlement of cash

Misappropriation of cash means wrongful conversion or application of cash. Embezzlement
means any misuse of anothers property by any person who has been entrusted with it, or in
whose hands such property has lawfully come. Misappropriation or embezzlement of cash
may be committed in any of following ways
1. Cash sales not recorded in books of account.
2. False entries made in accounts of customers as regards bad debts, discount, rebate, etc.
3. Entering payment received from one customer against another.
4. Showing payments against purchases never made.
5. Non-recording of credit notes for purchase returns.
6. Non-recording of bills of exchange discounted.
7. Non-recording of money received against unusual sales, e.g, sale of furniture, junk,
substandard goods, etc.
8. Non-recording of unusual money receipts such as donations.
9. Recording other payments never made.
To detect fraud by way of misappropriation or embezzlement of cash, auditor should
carefully compare entries in Cash 5oOK WIth those in Kougn Cash Book, counterfoils in
Money Receipts Book, and original evidence in form of vouchers, invoices, salary reoister.
wages sheet, etc.
 Objects of Audit 25

Distinction between Errors and Fraud

Points ofdistinction Errors Fraud
Motive Often unintentional Always intentional

Persons responsible Employees charged with

Management or persons
governance, though sometimes there may
also be involvement of employees
Cause Carelessness or ignorance of prin-Presenting false picture of good or poor
ciples of accounting performance of company

Types (a) Clerical errors comprising er- Fraud by Management aims to hide real
rors of omission or commission, state of affairs of business from share-
(b) Errors of principle, (c) Com-| holders and public. Fraud by employees
pensating errors, (d) Errors of Du- will be by way of misappropriation of
plication cash or goods

(b) Misappropriation or misuse of goods

Misappropriation of goods may take place by recording purchases of larger quantities than
actually received. Alternatively, by appropriating balance quantity that benefits the guilty, in
each case for unlawful personal gain.
Fraud by way of misappropriation of goods is easier to commit in case of high-priced
low-weight goods. It is easier to carry them out secretly without much fear of detection.
Detection of fraud of this nature can be possible by proper maintenance of accounts of pur-
chases and sales, regular stocktaking, strict check on incoming and outgoing goods, and
periodic comparison between percentages of gross profit to sales, in respect of different
periods. Frisking or personal checking of outgoing staf may also help detect such fraud.

(c) Fraudulent treatment or falsification of accounts

Fraud by manipulation and falsification of accounts and financial statements takes place
when a person-
(a) Makes or causes to make a false entry in business records;
(b) Alters, erases, removes or destroys an existing entry in business records, going against
his legal duty or his official position; or
(c) Prevents making a correct entry or causes its omission.
Generally, commission of fraud by manipulation or falsification of accounts is with the
consent or connivance of persons holding high positions in business. Its object is to exag-
gerate or underplay profits and financial position of business. For example, the motive in
showing increased profits may be to push up prices of company's shares and securities, im
press shareholders, avail easy terms from creditors, and attract prospective investors. As
against this, understatement of profits may be to avoid tax liability, keep competitors away
a fall
and induce in share prices so that those doing insider trading may buy up large num-
ber of shares at reduced
prices.
Overstatement of profits may be by way of
(a) Providing lower or no depreciation on business assets;
 26 Principles and Practice of Auditing
of liabilntred,
Over-valuation of assets or under-valuation
(c) Showing revenue expenditure as capita
a) Omitting items of expenditure; and
vears' income against
current years expenaiture.
Accounting past or future
AS
against this, understatement of profits takes place by
(a) Providing excessive depreciation;
(6) Undervaluation of assets or overstatement of liabilitiess

(c) Showing capital expenditure as revenue;

(d) Omission of items of expenditure; and
income.
ACcounting past or future years' expenses against current years
(d) Teeming and lading
This method or practice, also called delayed accounting or lapping, involves allocation of one
customers payment to another's account to balance the books. This practice may be contin-
ued until it is discovered through internal control system.
A common feature of this is that the amount received from a subsequent customer is
credited to the earlier debtor's account so that one debtor's account does not show an out-
standing balance for a long time. And this practice is continued till the time the original
misappropriated amount is finally replaced, or until the cashier is caught.
When payment is received by cheques and they are split up to record payments, it is
called splitting cheques. By splitting cheques, a lower amount is credited to the debtor and
the rest is misappropriated. Fronm small beginnings, this kind of practice may lead to a dis-
turbing large fraud.

(e) Computer frauds

A computer fraud involves making an unlawful benefit through embezzlement. Or, falsifi-
cation of accounts to increase or decrease prohts by means of
tampering with computer
data files, programs, media, etc. Growing numbers of personal
computers, telecommunica-
tion and networking, have led to change in the nature and occurrence of
computer frauds.
Earlier, only people working in the computer department of the entity could commit com-
puter frauds. Now, even outsiders can manage to do so by hacking and
ized access to computer systems. Use of credit cards/debit cards/ETM cards
gaining unauthor-
owned by oth
ers, accessing information relating to business strategy, are fast
becoming common. The
only way to prevent computer frauds is to install an eftective internal control system manned
by skilled computer personnel.

(f) Window-dressin9
It means the practice of arranging disclosure of assets and liabilities in
such a way that af-
fairs of business as shown in a subsequent Balance Sheet does not
of business.
truly represent normal
financial position
Window-dressing may take place in any of following ways:

(a) Sales and income of subsequent year may be recorded in current

year.