= a 2 Principles and Practice of Auditing T: 1.2. POST-INDEPENDENCE DEVELOPMEN S$ rofession passed onto profession itself ‘Act, It set up the Institute of Chartere, , In 1949, Indian Parliament passed Chartere se reson pen } ipresentatives Bbc ou tants of India (ICAI). The Council of ICAI ¢ d r ee of Central Government. The Council manages and controls the affairs of ICAI. It includes , and setting @ professional code of conduct fo, } iditing and Assurance Standards (SA), and Acc,,,, ing standards of education and training of members i Statements on Auditing, AU Sara ienthns itors while some are recommendatory. Standards (AS). Most of these are mandatory for audi _ ‘Asof now, a notable feature is that auditing has ‘assumed the role of examining management proce;., ision for management audit, performance audi, propriety of financial transactions. There is also, provi (a) Management and control of p! .d Accountants -omprises elect audit and tax audit. (b) Qualifications of auditor According to Companies Act only an tered accountant, can act as statutory considerable enlargement of duties, rights regard annual accounts and audit report. countants in case of specified companies. Act, for compulsory tax audit in case ‘Then, there is provision also under Income tax a business or profession in certain cases. () Auditing in Electronic Data Processing (EDP) environment. In modern times, growing use of computers in processing and storing of financial transac tions requires the auditor to apply new techniques to verify financial information. For ex- ample, due to on-line system transactions, he may not find physical evidence to examine the transactions. He will also not have a visible audit trail of particular transactions, or vis Staff to change data files and ible physical output. Central location of data may tempt clie programs without a trace. Also, if the computer system is not secure, unauthorized persons may reach secret information and use it to client disadvantage or corrupt it altogether. independent person dély qualified and trained «), auditor of a company, Over the years, there has b. and liabilities of auditor, as also requirement ‘There is also provision for cost audit by cost « MEANING OF AUDITING 1.3. QeFinrions OF AUDITING Auditing is concerned with determination of accuracy and reliab: lity ic her records and statements. Below, important definitions of tp y Keenan! ee (a)SpicerandPegler - ethane and vouchers ofa business. The object is to “An audit is an examination of books, accounts enable auditors to satisfy themselves that Balance Sheet is properly drawn up, gives a true (oss Account gives a true and fair and fair view of state of affairs of business, and Profit and L view of profit and loss of financial period, according to his information and explanations given to him and as shown by books. If not, reasons why he is not satisfied”Introductory 3 |. De Paula dit denotes examination of Balance Sheet and Pre I 0 ; rofit and Loss A/c prepared by oth- Gee OOKS, Abeoiints and Vouchers relating thereto, The examination is in oi at auditor may satisfy himself and honestly report that, in his opinion, ce Sheet is properly drawn up to'exhibit a true and correct view of state of affairs aan according to information and explanations given to him and as te of Chartered Accountants of India (ICAI) ised SA 200, “Overall Objectives of Independent Auditor and Conduct of Audit in ni with Standards on Auditing? the ICAI says the objective of an audit is for the r to express opinion on whether the financial statements are prepared and presented ace with the applicable financial reporting framework, and whether financial nts are presented fairly and give a true and fair view of the profit or loss, financial \d cash-flow of the entity. rds, auditing is a systematic and independent examination of data, state- operations and performances (financial or otherwise) of an entity for a stat- ny auditing situation, auditor perceives and examines the assertions in finan- ts, collects evidence from inside and outside sources, evaluates the assertions n evidence, formulates his opinion and expresses it through his audit report. IRTANT FEATURES OF AUDITING eans systematic examination of books of account and financial statements Rai 6 ah pe 2 +h ; it may be: Ledger, Subsidiary books, Journal, and financial statements, Alc (on, mn and Expenditure A/c), Balance Sheet (or Statement of ‘Cash Flow Statement Audit involves review of internal control, making rele- and tests, vou ind verification, analytical review, external confirma- a ion of financial statements. Audit extends to all operations and perfor- | entity, whether financial or otHerwise. According to ICAI, auditing is not ounting records. It extends to managerial performance, cost records, etc. In i evaluation of Management Processes and Functions. Reporting re- 1d amended CARO 201Shave introduced the aspects of propri- as part of audit examination, d accountanh he Compani ner tests of qualifications, ence and independént® of an audito is that he should not be in a position that {njany way compromises his may tempt him to ct in a biased manne ‘means that he cannot iny’s officer or em or employee‘or partner of any officer or ye independence will be affected if he owes the company, foral errors, which may further fall under (4) Errors of omission, (b) Errors of or may be—(a) Wrongly recording a transaction in books of original entry, es Book or Sales Book; (b) Wrong posting of any transaction to Ledger; or or balancing ofa Ledger account, It may be an error of omission or com- “omission. It occurs when there is omission in entering a transaction in a book ither wholly or partially. Such error is easy to detect either during writing of the during analytical checking. In case of complete omission of a transaction error may be difficult to detect. Because, if posting of a transaction is ‘from Ledger, it will not reflect in agreement of Trial Balance. For exam- try of a credit purchase in Purchases Day Book, then there will be no Account and no credit in Supplier's A/c. This omission will not affect ome to light only when Purchases A/c and Stock A/c are detail-checked. a partial record ofa transaction in the Ledger, the error will be easy ere will be mismatch in Trial Balance. For example, if credit sale in Sales -no debit in Buyer's A/c, then Trial Balance will show excess credit equal ‘then the error can be nailed. jission. It may occur during recording of a transaction in a book of posting it to Ledger. Errors in totaling and balancing of accounts or s to Trial Balance, are also errors of commission. The following are tion has been incorrectly recorded either wholly or partially, e.g., if ‘of Rs. 520 has been recorded in Purchases Day Book as Rs. 250 | not affect Trial Balance.) i ae is incorrectly posted in Ledger, e.g., if there is an entry of a ‘Rs, 250 in both the concerned accounts (on debit side of Customers Alc dit side of Sales A/c) as Rs. 520. Such error will also not affect Trial Bal- syer, if error is by way of incorrect posting in one account, though there is it ‘the other account, Trial Balance will reveal it by showing excess excess credit. Same will be the case where posting takes place only in one _22. Principles and Practice of Auditing ounts. Here, in either ca,, (ii) If there is incorrect totaling or balancing of Ledger acc e mistake will affect Trial Balance, ‘ (i) If an error occurs in entering balances in Trial Balance, in Trial Balance, the same transa (» Ifthere has been an error of duplication, je, double recording oft Bi: cel the relevant vouchers and jn, Thi be due to failure of clerks to can s Eanes entering them in books of original entry. tae oe ee would not distort Trial Balance, Careful vouching is the only way Ey errors. In this case error will refle.; Nature and Characteristics of Errors Often unintentional, not intended to mis-] An intentional error will be fraud, lead or cheat readers. i | Self-evident, detectable during account| Not self-evident, not detectable during account prepara preparation, such as, omission of a cheque | tion, only analytical check will uncover them issued will show up on preparation of bank reconciliation statement. prac | Errors of omission or commission, con-|Complete omission of a transaction, errors oF principle, fined to single account, will show in mis-| and self-adjusting compensating errors will not affect| match of Trial Balance, ‘Trial Balance, hence detectable only by analytical check. | 2. Errors of principle An error of principle occurs when there is neglect of generally accepted accounting prin- ciples while recording any transaction in books of account. It may be because accounting clerks are not able to correctly distinguish between capi ital and revenue nature of receipts and expenditure. However, sometimes this may be done to hide the real state of affairs of business by overstatement or understatement of Profits or losses. ‘The following are some examples of errors of. Principle: (a) The entity shows revenue expenditure as capi “xpenses are a charge on profits and go to reduce profits, If iets eapheh Gapenuanigie 8 © Pl . AT any revenue expense is ital account, it will increase ippears as est paid to a eon to hig benefit granted. i happens where there is debit of inter- Personal account, such that instead of constituting a creasing assets POsition:Objects of Audit 23 valuation of assets is not as per generally accepted accounting principles. It may place to overstate or understate profits atid financial position peli * iting error hides or reduces the effects of other errors. For example, on face of it, Balance may lead to the conclusion that business transactions have been all ded and posted. However, in reality, there might be a number of errors hid- xs of account which stand covered by compensating errors. Suppose, a credit sale of 1,000 to X has correct debit to his account, but the credit entry is of Rs. 100 only, that means a short credit of 2900. If this y error, it would reflect in disagreement of Trial Balance. However, if there is rror of short debiting of another transaction in the same or different account, short debit of £900, or more. Now, if other short debits total up 7900, these to amount of initial short credit of 900. Which means Trial Balance ‘the errors and would delightfully match. On other hand, if subsequent 2900, Trial Balance would show disagreement, but like the tip of an ide more than it reveals but what it hides would have much accounting PRauTaR Daa 9 ECTERRORS not a part of an auditor's duty to locate errors. Yet, he has to do it to ‘opinion on truth and fairness of financial statements. Therefore, when ce in Trial Balance, auditor should take following steps to locate errors of difference in Trial Balance by figure 2 (two) and see if any it side equal to that sum has been wrongly entered on credit side. It there may be posting of any items on credit side equal to that sum. ances of all Ledger accounts to Trial Bal- ji i bit or of nature of certain accounts (which always have either a del ¢) whether these have been posted to correct side of Trial Balance. 1 Ledger accounts. ‘ oi ere is posting to Ledger accounts of all entries recorded in Persad abe se is correct totaling of original books accounts brought forward from previous APE SIA ‘appearing in Trial Balance of previous ‘so, why.iting 34 Principles and Practice of Aud Jes of accounting and legal requirements. ‘The finin, inciples ; F aifcebmessslitlael of the famaserient as “apa resus ofy hel Gan ad toe M and Cash Flow and Fund Flow ‘atement he finan? erations (Profit and an ed Sheet) The auditor’ opinion on the truth and fairnes off position of the entity Sar Ei and confidence among persons who look to them for oe nancial mai eg: bea (shareholders in case of company), creditors, Investors, gover, ous reasons, €.g., mity with generally accepted i mental agencies, and the public, (c) Why an auditor needs independence? If stakeholders in client-entity rely on audited fina of professional expertise of the auditor. It is also enterprise, as required by law and ICAI regulatio} express his opinion without fear or favor, Independence does not mean he sh transaction and its record in the books of account. It only means that he must function i, a fair and impartial manner, vis-a-vis not only the Management/Owners but also al ‘those who have, or propose to have, interest in the client enterprise. The need for independenc, of a company auditor has also found recognition in the Company Law which Provide. that a person shall not be qualified to be an auditor of a company if he has any interes; financial or otherwise, in the company or its Management/Persons in charge of its gover- nance, incial statements, it is not Merely becay, because he is independent of the clieny ns. His independence ensures that he ¢2, 3.4. TYPES OF INDEPENDENT AUDIT Based on the structure of the entity under audit, classification of independent audit may beas: 1. Statutory (legally compulsory) audit, 2. Private audit, and 3. Social audit, 45 Statutory Audit (a) Statutory audit is compulsory for certain enterprises Where audit in the case of an entity is compulsory under any law, i it. Itis pre- ee pn ry Y law, itis statutory audit, tis pre 1. Companies governed by Companies Act, 2013 or an receding OF Banking companies governed by Banking Regulation ae 1949, — ai Ceetticity Supply Companies governed by Electricity Supply Act, 1948. 4 saat Societies registered under Co. erative Societies re 1 a pa lic and haritable trusts Tegistered under Re igious and Other Endowments Acts. . Societies Tegistered under Societies Registration Act, 1860. Le, 7 Ment Deparimenis” "P4* # Act of Paciament oso Legislature and Govers a 7Classification or Types of Audit 35 (b) Important features of Statutory audit First, where any law prescribes an audit, the shareholders/owners of the entity concerned cannot make it optional even by a unanimous vote. They also cannot restrict the scope of audit. Secondly, only a person properly qualified under the law can conduct statutory audit. In India, for example, only a chartered accountant holding a certificate of public practice of accountancy can be an independent auditor. He must also not suffer from any disqualification(s) laid down in law. Thirdly, his rights, duties and liabilities are as prescribed by law. Owners/management of the client entity cannot limit them. Fourthly, an independent auditor is there to safeguard interests of shareholders/owners and also third parties. He is not there to protect the management (or persons charged with governance), who are responsible to prepare the accounts and other records and present the financial statements of the entity. (¢) Advantages of Statutory audit Compulsory statutory audit is important to all those associated with the enterprise. In case ofa joint stock company, for example, shareholders may not have ability to understand the data presented by management in financial statements. They only rely on auditor for his opinion on management claims regarding results of business operations (Profit and Loss A/c) and financial position (Balance Sheet) of the enterprise. Audit is also beneficial for creditors, bankers, credit suppliers, prospective investors and government departments etc., concerned with the company. related ny seta ds In case of trusts, a compulsory audit is necessary to protect the interests of beneficiaries ible fraud by trustees. It also safeguards trustees who may not possess adequate aid eleva rust a. 3 9910 9 ‘accounting and re pene i ' ites Regaonpet Introductory 13 (e) Knowledge of production systems: He should be aware of the nature of production, production planning and processes, and how cost accounting relates to the entity under audit. (f) Knowledge of economics: He should be familiar with principles of economics—ef- fects of economic factors on business units, relationship between demand and price, competition, ete, (g) Knowledge of mathematics and statistics: He should have working knowledge of mathematical and statistical methods of solving business problems by quantitative techniques. (h) Knowledge of general management: He should have a broad understanding of orga~ nization theory and behavior, decision-making process, individual and group behav- ior, and authority-responsibility relationships. (i) Knowledge of financial management: He should have knowledge of concepts and methods used in financial analysis. This would help him evaluate capital needs of the entity under audit, and effects of depreciation and taxes on availability of funds. (j) Knowledge of marketing management: He should be familiar 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 company’s staff in connection with his work. He should know how to deal 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. (b) Tactfulness: He should be firm, yet tactful with his client and his staff. He should know when, what and how to speak or wrife anything that may be necessary yet in- convenient, and have courage of conviction to stand his ground. (0) 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. (@ 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 a wide- spread impression that it follows best standards of performance and is ever conscious "of responsibility to public interest. Therefore, in both thinking and behavior, the au- - ditor should try to live up to his public image. __ (f) Due diligence: The profession of an auditor is like a zealous mistress that makes ex- acting demands on his time, energy and attention. He must work diligently under time pressure, meeting deadlines to perform the tasks on hand,ractice of Auditing 72. Principles and Pr d effective. Internal audit is petformeq byag ee onal appointed by the Audit Com, ion j, -d by the entity is effic ita : sear accountant or any’ peels ie opanibeittitendt oy i the company. Board of directors of tl that of the external auditor. ITY 4.19. POINTS OF SIMILAR B d internal audits are closely similar as regards—(a) > Of intern,y External and intern: ment of adequacy and effectiveness of accounting system to a pemetiveaad (c) Verification of assets and liabilities; and (d) Means of exam, its ou 3 eg. observation, inquiry, statistical analysis, testing, etc. 4.20, POINTS OF DISSIMILARITY External and internal audits differ in the following respects: (a) Internal audit not compulsory, but amended CARO 2015 makes it so in Certain c, In case of a company, which is under legal obligation to have audit of its accounts, apy ment of an external (statutory) auditor is compulsory. However, internal audit is nor pulsory. But under amended Companies (Auditor's Report) Order, CARO, 201 5, in ca 8 specified company, internal audit has become compulsory. This is because the con auditor is required to state in his report that the company has an appropriate internal ; (b) Internal auditor is an employee of, or specially hired by entity; not so the external auditor ‘The external auditor is independent of the entity which engages him. An internal audit often an employee of the enterprise, or an outside accounting firm €specially engaged the purpose, / (©) Entity determines Scope of internal audit of external lawand regulations ue terthe Determination of the scope of, external audit is by th linatio 'e law applicable to the entity. It cann e unde an gre ane a of eae external audit, Bettina, of scoy u eer €n the entity and the auditor. How. 5 inati ) of internal audit is by the Management and itmay enlarge or Geneon” ’ (d) Internal auditor is accountable toMa Owners of business and interesteg third pon An external auditor's "esponsibility is primaril while external Auditor is to Y to owners of the tit ted cates cas tity who have appoit on the faith of hig opiate may also extend to interested third parties Ra Rave acte ternal auditor, who 4 al statements examined Sein ORT tcc weineeame Row9.20. OBJECT OF VOUCHING f outstanding assets, form an opinion on Ww! that include prepaid expense 8 hhether there is true and fair », The object of vouching of Present revenue expenditure, is to the it Balance Sheet. the Seth of this aspect will reveal whether there is any attempt on the part of dy influence the profit figure by questionable means. For sn when the business is well, the client may be tempted to debit to current year’s Profit and Loss Alcal including those attributable to subsequent years. On the other hand, in the Year of performance of business, he may be extra keen to treat as prepaid expenses even actually belong to the current year, turning a blind eye to the fact that it amounts to, ment of current year's liability. , ‘The following are some examples of outstanding assets: 9.21. PREPAID INSURANCE Insurance premium is always payable in advance, usually for the whole term of the Thus, if premium is paid for the year ending 31st March, and the client closes his account on 31st December, then every year there will be prepayment of premium of months. In other words, part of the benefit of current year’s expenditure will be the subsequent year. q While vouching prepaid insurance, the auditor should examine all insurance during the year and examine—(a) Prepaid balance at beginning of the year; (#) payments (or refunds) during the year; (c) Write-off of expenses ; and (d) Prepal at end of the year. The premium amount relevant to current year should be debited it and Loss A/c and that relevant to next year should be carried forward to next Premium A/c should only show premium payable for the current and that ane subsequent year should be debited to Prepai urn, shold in Balance Sheet as an asset, ibis IE: i ub a: : Further, while the auditor is not i \ suran sets owned by client, he mould 2 aaa ane i : é s ‘ompare the ? : bring to client’s notice all cases of. oer gaa ;Pr 4.22. PREPAID RENT ; ordinarily, rent is payable ‘on a monthly basis, and the amount of ward may not be large. While vouching prepayment of rent, the auditor should | concerned with Sessa of we agreements for properties used by client and these have proper disclosure in financial statements, Not that showing toad asets as his own assets, Hrd site toh stn As for prepaid rent, he should examine the opening and closing balances of ‘Prepaid Rent A/c’ of the current year, with that of the past year, as the amount paid during the year. ‘The amount of rent paid during the year should not include the amount of rent for the next year. The correct way to do this is to credit Rent A/cand debit Prepaid Rent Account and the jatter should appear as asset in Balance Sheet. 9.23. LICENCE FEES There is often advance payment of fees for licenses or permits. Also, there is capitalization of the amount paid for writing it off over subsequent years during which the benefit of payment will be available. To vouch such payments, the auditor should examine the agreement under which the payments have taken place. He should also ascertain the period for which the benefit of payment will be available. Thus, there should be carry-forward to subsequent year(s) of the amount of prepayment, and it should be shown as asset in Balance Sheet. irae i 9.24. PREPAID SUBSCRIPTIONS—MEMBERSHIP DUES The auditor should examine the list of prepayments, particularly items of an unusual na- ture, considering the nature of client's business. He should also examine past year's pay- ments and ascertain the reasons for major variations, if any. In case of large payments, he | should test-check a few for their reasonableness. Only subscriptions relating to current year should appear on credit side of Profit and Loss Af 10se for subsequent year(s) should go to debit side of ‘Prepaid Subscription Alc, wit priate disclosure on liability side of Balance Sheet. gene z 9.25. ADVANCE PAYMENT OF COMMISSION TO EMPLOYEES ‘The client may advance money to employees to meet expenses incurred by them relating to | s. The actual expenditure incurred by them would enter the books as and accounts, Ifa part of such money is unaccounted, it should appear as as- d to salespersons as advance against future commission should be treated the ui dually, the balances standing to the credit of salespersons may look small, but the aggregate may be a large sum. As such, vouching of individual balances, particu- larly unusually large ones, needs careful vouching by auditor. He should also compare these with past years balances and ascertain the reasons for major variations, ifany. Where i he should test-check a few payments to satisfy him as regards their validity ands and Practice of Auditing 150 Principle: GE , . PREPAID POSTA\ i Brey . 9.26. P nt involved in this case is not reste “ ene ans 20 enn Usually, the anno check the expenditure before an ein However, he should that it is in agreement with amounts recordeq ey stamps to see tha am me asaya machines are in use, he should examin egister of dai a see that it confirms the amounts stated therein. 9.27. DEFERRED REVENUE EXPENDITURE iture which, though revenue in nature, may involve a Telatively large aie as will be available in subsequent years. Ste of such expenditure Preliminary expenses; (6) Discount on issue of shares and debentures; (c) research and development; (4) Expenditure on patent development and Perfecting (including costs to defend or pursue infringements); and (e) Expenditure on prem. plant rearrangement or relocation expenses etc. 1 3 Expenses of this nature generally pass through normal accounting procedures not easy to distinguish from other expenses. However, the client may keep separate of such expenses duly classified, such as expenditure on special purchases or services, While vouching deferred revenue expenditure, the auditor must first see sumption of future benefits from such expenditure is valid. Also, he should extent of benefit to see that it justifies the expenditure being written off over the estimated benefit. Ifhe finds the Presumption untenable, he should advise the client o oe Peers the current year itself. If his advice is not heeded, he should f eee y DARED L he does find sufficient appropriate evidence about the ee future if should vouch the expenditure by mat : Y reference to th 7 of terials which the client seeks to defer € source, e.g., wages, purchase may charge all wages Paid for Research the year, the Department has onl, example, at year-end, he tion though, initially, he ha routine and deferred estimate. The auditor’s duty j supported by adequate relate ee ae iMeAsr32 Principles and Practice of Auditing 3.2. GENERAL AND SPECIFIC AUDIT (a) General audit An audit examination may be general or specific. A general os an > ai Of busine, financial and otherwise, Further sub-classification of, general au ay 1. Independent audit, whether prescribed by law or optional, at the instance of, Owner(, Or persons charged with governance of business, 2. Internal audit, 3. Specific audits. 4. Government audit. 5. Social audit. Scope of audit | Duties, rights, liability of auditor Reporting requiremen, To express oj Pinion on Sial statements based On evaluation of evi- | dence collected To report to Manage- | ment on functioning of entity and offer Sugges- tions as necessary Report on quarterly, yearly results of Operations to enable - | Management to declare interim dividend, if anyIntroductory 45 control system, ‘ maintenance of accounts and compliance with legal and elated issues, ges for Owners of Business Proprietor, auditing serves as proof there is no error or fraud in accounts. In Sole proprietary concern, for which audi ipts or turnover exceeds the prescribed lim ‘proof that there is proper accounting ¢ ‘no error or fraud, ip, auditing assures partners of Proper management of business by active In partnership firm, for which again audit is not compulsory unless its gross ‘or turnover exceeds the prescribed limit, audited accounts serve as evidence er management of business by active partners and employees of the fier accounts also help in settlement of accounts in case of admission, retirement ‘of any partner, or in case of dissolution of the firm for whatever reason olders of company or cooperative Society, audit provides proof of good gover # by the Board/Managing Committee. Ina joint stock company and a cooperative p for which audit is compulsory, audited statements serve as. proof that there is management of business affairs and that their investment is in safe hands 2s for Others ‘on audited statements for various purposes. Banks and lenders rely on au- ats of a business to sanction loans to it. Insurers rely on them to settle claims / damaged business assets, For determination of liability under income tax ax etc., tax authorities generally rely on audited statements to determine entity. it is not compulsory unless its gross nit, audited statements of accounts of all business transactions and that LIMITATIONS OF AUDITING ISTRAINTS OF AUDITING fig