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STUDY MATERIAL

COURSE : III B.COM (CA) ‘A’

SEMESTER : V
SUBJECT : PRINCIPLES OF AUDITING
UNIT : I
FACULTY : Dr. SASIREKHA .S

UNIT – I: Auditing - Origin – Definition – Types – Advantages and Limitations –

Qualities of an Auditor – Audit Programmers.

INTRODUCTION
Though the concept of auditing has been existing since for a very long period but the
traces of actual audit happening has been found or it would be related only to the middle age
period. The present day auditing system came into existence during the 18 th century, the
auditing system during this period underwent a major change and the basic reason for this
change was caused by large scale industrial revolution.
The present day setup though based on 18th century setup has undergone some major
changes, the present day auditing system not only helps the auditor to prepare correct statement
of affairs but also the system has been devised in such a manner that it prevents any errors and
also deducts fraud or cheating. The basic objective of the present day auditing system is to
provide a true and correct trial balance. Profit & loss a/c and B/S of a company.

ORIGIN AND EVOLUTION

The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an
auditor used to listen to the accounts read over by an accountant in order to check them

Auditing is as old as accounting. It was in use in all ancient countries such as Mesopotamia,
Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.
Arthasashthra by Kautilya detailed rules for accounting and auditing of public finances.

The original objective of auditing was to detect and prevent errors and frauds Auditing evolved
and grew rapidly after the industrial revolution in the 18th century with the growth of the joint
stock companies the ownership and management became separate. The shareholders who were
the owners needed a report from an independent expert on the accounts of the company
managed by the board of directors who were the employees.
The objective of audit shifted and audit was expected to ascertain whether the accounts were
true and fair rather than detection of errors and frauds.

In India the companies Act 1913 made audit of company accounts compulsory

With the increase in the size of the companies and the volume of transactions the main objective
of audit shifted to ascertaining whether the accounts were true and fair rather than true and
correct. Hence the emphasis was not on arithmetical accuracy but on a fair representation of
the financial efforts

The companies Act.1913 also prescribed for the first time the qualification of auditors

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The International Accounting Standards Committee and the Accounting Standard board of the
Institute of Chartered Accountants of India have developed standard accounting and auditing
practices to guide them. accountants and auditors in the day to day work

The later developments in auditing pertain to the use of computers in accounting and auditing.

4In India the companies Act 1913 made audit of company accounts compulsory with the
increase in the size of the companies and the volume of transactions the main objective of audit
shifted to ascertaining whether the accounts were true and fair rather than true and correct.
Hence the emphasis was not on arithmetical accuracy but on a fair representation of the
financial efforts the companies Act.1913 also prescribed for the first time the qualification of
auditors The International Accounting Standards Committee and the Accounting Standard
board of the Institute of Chartered Accountants of India have developed standard accounting
and auditing practices to guide them. Accountants and auditors in the day to day work the later
developments in auditing pertain to the use of computers in accounting and auditing. In
conclusion it can be said that auditing has come a long way from hearing of accounts to taking
the help of computers to examine computerized accounts

DEFINITION
The term auditing has been derived from the Latin word. “Audire” – means to hear. In
olden days the accountants used to read the accounts at the court of the kings. The Noble men
heard it therefore the term ‘auditing’ means to hear was derived.
The concept of auditing was for the first time published by Italian Luca Pacialo. He
published the concept of auditing through a double entry system of book keeping in 1494. In
this book, for the first time the author clearly brought out the duties and responsibilities of an
auditor.
According to Spicer and Pegler. Who have defined, “an audit as such as examinations
of the books, accounts and vouchers of a business as will enable the auditor to satisfy himself
that the balance sheet is properly drawn up, so as to give a true and a fair view of the state of
the affairs of the business and whatever the profit and loss account give a true and fair view of
the profit or loss for the financial period, according to the best of the information and
explanation given to him and as shown by the books and if not, in what respect he is not
satisfied”.
According to Montgomery, a reading American accountant defines auditing as,
“auditing is a systematic examination of the books and records of a business or organization,
in order to as certain or verify and to report upon the facts regarding its financial operations
and the results thereof”.

GENERAL OBJECTIVES
The main objective of an audit and of an auditor is to find out whether the books of
accounts, balance sheet and the profit and loss a/c have been properly drawn out according to
the companies Act 1956. He must make sure that it is fair and proper while performing his
duty, the auditor has to carefully analyze and examine in order to discover any error to fraud
the following are the basic concept, which all also the main objectives of an audit.
1. Detection and prevention of errors
2. Detection and prevention of frauds

1. Detection and Prevention of Errors:

Detection and prevention of errors sometimes while analyzing the statements the
auditor may find certain errors. If they are innocent errors or errors committed mistakenly
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auditor must take steps to prevent such type of errors in the future. But at time some errors may
look like innocent ones but they have been wontedly created to do some fraud or creating.

a. Clerical errors.
These errors normally arise because of wrong posting totaling or balancing. This could
be divided into two categories.
(i) Error of omission
(ii) Error of commission

(i)Errors of omission
Here, the transaction is not fully recorded or partly recorded or some parts are omitted.
E.g. rent of 12 months received only 11 months recorded.
Purchase or sales entry totally omitted.

(ii) Error of commission

In this category, the transactions are wrongly entered.
Eg: Purchase invoice of Rs. 1250 entered in the purchase book as Rs. 1520.

b. Error of Principles.
These errors arise whenever the entries are not recorded according to the fundamentals
principles of accountancy.
e.g:- Wrong allocation of expenditure between capital and revenue, ignoring outstanding assets
and liabilities, valuation of assets against the principles of book keeping.
These errors are done wontedly or unknowingly, wontedly means to cheat or fraud.

c. Compensating errors or off setting errors.

In this category where one error is counter balanced by any other error or errors. E.g
Mr. A’s account was to be debited for Rs. 100, but debited for Rs. 10. Mr. B’s account was to
be debited for Rs. 10, but it is debited for Rs. 100. Both accounts have been counter balanced
because the total sum tarries exactly Rs. 110.
Again an overcastting of an account may be counter balanced by under casting of
another account to the same extent. These are dangerous and difficult to guard. These errors
don’t affect trail balance or profit and Loss a/c, therefore detection or finding out of such errors
is difficult.

d. Error of duplication
Such errors arise whenever an entry in a book of original entry has been made twice
and has also been posted twice.

Location of errors or identifying the errors.

1. Check the totals of the trial balance.
2. Compare the names of the accounts in the ledger with the names of accounts recorded
in the trial balance.
3. Total the list of debtors and the list of creditors which has to be compared with the trial
balance.
4. If the books are maintained according to the self balancing system, we must make sure
that the totals of different accounts agree with the totals of the ledger, trial balance etc.
5. Compare the items of the trial balance with the items of the trial balance of the previous
year because omissions might have taken place in the previous year itself.
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6. Whenever the difference in the trial balance is half of its value we must check whether
there is any item of this value. This is done to find out the correct balances.
7. We must check the totals of the subsidiary books.
Eg. cash book, sales book, purchase book and so on.

2. Detection and Prevention of Fraud

Fraud means false representation or entry which has been made purposely or
intentionally in order to defraud or chat some people. Detection of fraud is concerned to be one
of the important functions of an auditor. The organizations can setup an internal check system
which aims to prevent fraud, even after this if the auditor is not satisfied with the system and
also doubts any form of cheating then auditor must go in for a thorough checking of accounts.
Auditor must bring out any new device or a new system in order to prevent such cheating in
future.
The following are the common ways by which fraud can take place.
1. Embezzlement of cash.
2. Misappropriation of goods.
3. Fraudulent manipulation of accounts.

1. Embezzlement of cash
Cash can be taken away or misappropriated by the employees by using any one of the
following methods.
(a) Omitting to inter any cash which has been received.
(b) Entering less amount than the actual amount which has been received
Eg. Rs. 1000 received but only Rs. 800 recorded.
(c) Making imaginary entries or fictitious entries on the payment side.
(d) Entering more amount of payment on cash book than actually what is paid
e.g., Rs. 1000 paid but entry shows Rs. 1500 as paid.

2. Misappropriation of goods.
This commonly takes place whenever the organization maintains a huge stock or
whenever it is quite difficult to correctly assess the total value of the goods: then in these cases.
The employees of the organization take advantage, which lead to misappropriation of goods.
Misappropriation can be prevented by the organization only if they maintain a proper
accounting system to the satisfaction of auditor internal check system should be strong to
prevent misappropriation.

3. Fraudulent of fraud is of a complex nature

This is normally done by people at the top level like the directors or superior officers;
such type of fraud is done in order to show:
(a) More profit to the company when it is actually very low or nil.
(b) In order to maintain the share value of the company in the market
(c) In order to get more financial assistance from banks or financial institution.
(d) To attract more subscribers to subscribe for the shares or to purchase debentures.
(e) To maintain goodwill among the public
The above are the found out in any organization when the company is making less
profit.
In certain cases when a company is making very good profit, the company may show less
income, according to law this is also treated as fraud, this is done in order to
(i) Purchaser the shares of the company in the market at a lower price.
(ii) In order to reduce the income tax payment.
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(iii) In order to provide wrong information to the competing companies whenever

competition is high.
Note: - For errors
In spite of the above steps, still the error could not be detected or found out, then we
can state that the error may be because if the following reasons.
1. An error can arise when Rs.1 or Rs. 10 or Rs. 100 is rounded off (very frequently) this
may automatically lead to a wrong total. If by chance the different is in rupees or in
paise, error may be because of wrong postings.
2. An error can also take place where a number is divisible by numbers like
Eg: Instead of writing 54, we could write as 52. this could be misplacement errors.

Methods or resorting to the false accounts

1. By not providing any depreciation or providing less depreciation or providing more
depreciation.
2. By under valuation or overvaluation of assets and liabilities.
3. by showing fictitious (imaginary) sales or purchase or returns in order to show more or
less profit-this method is very rarely used.
4. By using the secret reserves during the period when there is no profits or whenever
there is less profit, the reserve is utilized in such a way without disclosing the truth to
the shareholders.
5. By sharing revenue expenditure to capital account or sharing the capital expenditure to
revenue account.
6. By crediting revenue a/c with the income which will be received only in next year or
in future.

FEATURES OF AUDITING
a. Audit is a systematic and scientific examination of the books of accounts of a business;
b. Audit is undertaken by an independent person or body of persons who are duly qualified for
the job.
c Audit is a verification of the results shown by the profit and loss account and the state of
affairs as shown by the balance sheet.
d. Audit is a critical review of the system of accounting and internal control.
e. Audit is done with the help of vouchers, documents, information and explanations received
from the authorities.
f. The auditor has to satisfy himself with the authenticity of the financial statements and report
that they exhibit a true and fair view of the state of affairs of the concern.
g The auditor has to inspect, compare, check, review, scrutinize the vouchers supporting the
transactions and examine correspondence, minute books of share holders, directors,
Memorandum of Association and Articles of association etc., in order to establish correctness
of the books of accounts.

AUDIT TYPES

MEANING:

Audit is not legally obligatory for all types of business organizations or institutions. On this
basis audits may be of two broad categories i.e., audit required under law and voluntary audits.
(i) Audit required under law : The organizations which require audit under law are the
following:
(a) Companies governed by the Companies Act, 1956;
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(b) Banking companies governed by the Banking Regulation Act, 1949;

(c) Electricity supply companies governed by the Electricity supply Act, 1948;
(d) Co-operative societies registered under the co-operative Societies Act, 1912;
(e) Public and charitable trusts registered under various Religious and Endowment Acts;
(f) Corporations set up under an Act of parliament or State Legislature such as the Life
Insurance Corporation of India.
(g) Specified entities under various sections of the Income-tax Act, 1961.
(ii) In the voluntary category are the audits of the accounts of proprietary entities, partnership
firms, Hindu undivided families, etc. in respect of such accounts, there is no basic legal
requirement of audit. Many of such enterprises as a matter of internal rules require audit. Some
may be required to get their accounts audited on the directives of Government for various
purposes like sanction of grants, loans, etc. But the important motive for getting accounts
audited lies in the advantages that follow from an independent professional audit. This is
perhaps the reason why large numbers of proprietary and partnership business get their
accounts audited.

Government companies have some special feature which will be seen later.

INTERIM AUDIT:
An audit that is taken up between two annual audits is called an Interim Audit. A specific
date, as per the client’s requirement is taken into account, e.g. 30th September, 31st
December, etc. a trial balance is drawn and verified with a view to prepare financial
statement. Financial statement are prepared and authenticated for the interim audit period.
Assets and liabilities are verified for interim balance sheet purposes. Independence is
considered less independent than the statutory Auditor; generally an employee of the
enterprise will be the internal auditor. In the interim audit no format is prescribed. It depends
on the nature of work, coverage and audit observations.

CONTINUOUS AUDIT:
A continuous audit is one in which the auditor’s staff is engaged continuously in checking the
accounts of the client, during the whole year round or when for the purpose, the staff attends
at quite frequent intervals say weekly basis during the financial period. A continuous audit is
preferred for the following reasons: i. It makes it possible for the management to exercise a
stricter control over the accounts in as much as one is able to check sooner the causes of any
errors of frauds uncovered by such an audit. ii. The frequent attendance by the staff deters
persons so inclined, from committing a fraud. iii. The accounting staff of the client is
motivated to keep the books of account up-to-day.

ADVANTAGES OF AN AUDIT
The following concepts are considered to be some of the important advantages of an
audit. Following are some of it.
1. Errors and frauds are located at a carry date, so in future such mistakes could be
avoided. Audit helps quick and easy discovery of mistake or error.
2. Whenever auditing is done regularly and properly, it makes the accountant, clerk etc.
to be regular and vigilant in their work because they have to submit upto date
information to the auditor.
3. Money can be easily borrowed from banks or financial institution only if the company
maintains a proper audited statement of accounts.
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4. Whenever a company want to claim or want to make any insurance claim, the insurance
company will require audited statement from the company for the purpose of settlement
of the insurance claim.
5. If by chance the business has to be sold out, it is very much difficult to be sold without
a proper auditing statement, whenever the purchaser or the seller wants to know the
correct value of assets and Liabilities Company has to submit proper audited statement.
6. For the purpose of paying tax or for submission of any statement like profit and loss a/c
or balance sheet, it must be audited by a qualified auditor for tax submission.
7. Auditor also provides technical advices to the management if the management requests
it; the auditor can also provide advice for developmental purposes, though it is not a
duty of an auditor.
8. The sales tax authorities accept only the audited statements for the purpose of settling
sales tax.
9. A properly audited statement of accounts is very much useful for the company to
compare the details of the previous years with the details of the current year and if there
is any mistake that could also be checked in by referring old statement and thereby
rectifying the error.
10. In case of a partnership business, audited statement of accounts play a vital role in
settling the accounts of a deceased partner.
11. Whenever the company goes to the courts of law (applicable all over the world) to solve
any problem, the court will accept only a properly audited statements for the purpose
of settlement of a case.

LIMITATIONS OF AN AUDIT
1. Conceptual restriction.
2. Post mortem of prepared accounts
3. Dependents on inside information
4. Inadequate or faulty external evidence.
5. Application of faulty techniques.
6. Formation of faulty judgement

1. Conceptual restriction
Auditor has to follow the laid out rules and regulations whenever he prepares
accounting statements, he is not permitted to violate or go against the laid out rules.
e.g., the rules like principles of accountancy, economics, and business management rules
Though it can act as a guideline for the auditor but in preparation certain modifications
may be required but the law does not permit such modification. So he is forced to accept the
concept as it is which may not be suitable at that point.
2. Post mortem of prepared accounts
Auditing can be compared to a post mortem because the auditor prepares the statement
of affairs only on the spent out amount or on the expenditure only. Therefore, even if any
expenditure is illegal or unacceptable the organization cannot recover because it has been spent
out. Therefore, auditing is like examining the dead expenses or used money.
3. Dependents on inside information
Whenever auditor has to prepare any statement or needs any information or explanation
or classification the auditor has to totals depend only on the organization or on the members of
the organization, this makes auditor dependent on his staff members of the client.
4. Inadequate or faulty external evidence
The major problem faced by any auditor is that whenever any information is provided
or given to him at times can be in adequate or wrong: it can be done voluntarily by the members
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of the company or at times without the knowledge any wrong information can be passed on to
the auditor, this may lead to preparation of wrong statements.
E.g Forged hotel bells, forged expense voucher or bills etc.
5. Application of faulty techniques
Because of restricted rules and regulations, the auditor may be forced to adopt certain
principles which may not be required at that point of time or may not be necessary at all. In
such a situation, the statement prepared also might become incorrect or improper.
6. Formation of faulty judgment
Whenever any wrong information is provided to the auditor and him also without
knowing the mistake utilizes it in the preparation of accounts and submits a statement, that
statement will be wrong and the judgment or solution is also wrong.

QUALITIES OFAN AUDITOR

So far we have discussed the question of formal qualifications of an auditor. But it is not
enough to realize what an auditor should be. He is concerned with the reporting on financial
matters of business and other institutions. Financial matters inherently are to be set with the
problems of human fallibility; errors and frauds are frequent. The qualities required,
according to Dicksee, are tact, caution, firmness, good temper, integrity, discretion, industry,
judgment, patience, clear headedness and reliability. In short, all those personal qualities that
goes to make a good businessman contribute to the making of a good auditor. In addition, he
must have the shine of culture for attaining a great height. He must have the highest degree of
integrity backed by adequate independence. In fact, AAS-1 mentions integrity, objectivity
and independence as one of the basic principles.

He must have a thorough knowledge of the general principles of law which govern matters
with which he is likely to be in intimate contact. The Companies Act, 1956 and the
Partnership Act, 1932 need special mention but mercantile law, specially the law relating to
contracts, is no less important.

Needless to say, where undertakings are governed by a special statute, its knowledge will be
imperative; in addition, a sound knowledge of the law and practice of taxation is unavoidable.

He must pursue an intensive programme of theoretical education in subjects like financial and
management accounting, general management, business and corporate laws, computers and
information systems, taxation, economics, etc. Both practical training and theoretical
education are equally necessary for the development of professional competence of an auditor
for undertaking any kind of audit assignment.

The auditor should be equipped not only with a sufficient knowledge of the way in which
business generally is conducted but also with an understanding of the special features
peculiar to a particular business whose accounts are under audit. AAS-8 on ‘Audit Planning’
emphasizes that an auditor should have adequate knowledge of the client’s business. The
auditor, who holds a position of trust, must have the basic human qualities apart from the
technical requirement of professional training and education.

He is called upon constantly to critically review financial statements and it is obviously

useless for him to attempt that task unless his own knowledge is that of an expert. An
exhaustive knowledge of accounting in all its branches is the sine qua non of the practice of
auditing. He must know thoroughly all accounting principles and techniques.
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Auditing is a profession calling for wide variety of knowledge to which no one has yet set a
limit; the most useful part of the knowledge is probably that which cannot be learnt from
books because its acquisition depends on the alertness of the mind in applying to ever varying
circumstances, the fruits of his own observation and reflection; only he who is endowed with
common sense in adequate measure can achieve it.

Lord Justice Lindley in the course of the judgment in the famous London & General Bank
case had succinctly summed up the overall view of what an auditor should be as regards the
personal qualities. He said, “An auditor must be honest that is, he must not certify what he
does not believe to be true and must take reasonable care and skill before he believes that
what he certifies is true”.

MEANING OF AUDIT PROGRAMME

MEANING:
It is desirable that in respect of each audit and more particularly for bigger audits an audit
programme should be drawn up. Audit programme is nothing but a list of examination and
verification steps to be applied set out in such a way that the inter-relationship of one step to
another is clearly shown and designed, keeping in view the assertions discernible in the
statement of account produced for audit or on the basis of an appraisal of the accounting
records of the client. In other words, an audit programme is a detailed of the accounting
records of applying the audit procedures in the given circumstances with instructions for the
appropriate techniques to be adopted for accomplishing the audit objectives. Businesses vary
in nature, size and composition; work which is suitable to one business may not be suitable to
be rendered by the auditor are the other factors that vary from assignment to assignment.
Because of such variations, evolving one audit programme applicable to all business under all
circumstances is not practicable. However it becomes a necessity to specify in details in the
audit programme the nature of work to be done so that no time will be wasted on matters not
pertinent to the engagement and any special matter or any specific situation can be taken care
of.

An audit programmed consists of a series of verification procedures to be applied to the

financial statements and accounts of a given company for the purpose of obtaining sufficient
evidence to enable the auditor to express an informed opinion on such statements. For the
purpose of programmed construction, the following points should be kept in view:

1. Stay within the scope and limitation of the assignment.

2. Determining the evidence reasonable available and identify the best evidence for
deriving the necessary satisfaction.
3. Apply only these steps and procedures which are useful in accomplishing the
verification purpose in the specific situation.
4. Consider all possibilities of error.
5. Co-ordinate the procedures to be applied to related items.

Amplification is not necessary of the above points except the one under evidence: that is the
very basis for formulation of opinion and an audit programmed is designed to provide for that
by prescribing procedures and techniques. What is best evidence for testing the accuracy of
any assertion is a matter of expert’s knowledge and evidence. This is the primary takes before
the auditor when he draws up the audit programmed. Transactions are varied in nature and
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impact; procedures to be prescribed depend on prior knowledge of what evidence is

reasonable available in respect of each transaction.

FACTORS ADVANTAGES AND DISADVANTAGES OF AUDIT PROGRAMME

FACTORS
While construction an audit programmed, the Auditor should keep the following points in his
mind-
1. to operate within the scope and limitations of the assignment.
2. To determine the evidence reasonably available and identify the best evidence for deriving
the necessary satisfaction.
3. To apply only those steps and procedures, which are useful in accomplishing the
verification purpose in the specific situation.
4. To consider all possibilities of error.
5. To co-ordinate the procedures to be applied to related items.

ADVANTAGES OF AUDIT PROGRAMME

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

DISADVANTAGES OF AUDIT PROGRAMME

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

b. The programmed often tends to becomes rigid and inflexible following set grooves; the
business may change in its operation of conduct, but the old programmed may still be carried
on. Changes in staff or internal control may render precaution necessary at points different
from those originally decided upon.

c. Inefficient assistants may take shelter behind the programmed i.e., defend deficiencies in
their work on the ground that no instructions in the matter is contained therein.
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d. A hard and fast audit programmed may kill the initiative of efficient and enterprising
assistants.

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

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