Introductory : LEARNING OBJECTIVES 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 of post-independence influences on development of auditing in india 2 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. | 2 Describe the qualifications and qualities of auditor. 1.1. WHAT IS AUDITING (a) Audit means a system of checks 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 independent persons maintaining record of their money matters 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 liability for debts or payables and business. The law on companies gave them an identity different from the ee limited their liability. As the company grew in size, there was separation eeembers by ship and management. This necessitated protection of interests of endeat and qualified Providing for independent check of company accounts by an in Dae for a watchdog Person. English Companies Act of 1862 became the first law to P) (auditor) to examine company’s financial dealings.2 Prince 12. POST-INDEPENDENCE DEVELOPMENTS on to profession itself the Institute of Chartered Accoun. ered accountants and (a) Management and control of profession passed 1 passed Chartered Accountants Act. It set up the Council of ICAT comprises elected representatives of chart ole the affairs of ICAL It includes prescrib code of conduct for them. It ament. The Council manages and contr J setting a professional ¢ Standards (SA), and Accounting and training of members, and 1 Auditing, Auditing and Assuranc or auditors while some are recommendatory. management processes, like Statement AS). Most of these are mandatory fi able feature is that auditing has assumed the role of examining for management aud Jit, performance audit, cost asactions, There is also provision f (b) Qualifications of auditor © Companies Act only an independent person di -an act as statutory auditor of a company. nt of duties, rights and liabilities of au counts and audit report. There is also provisi ts in case of specified companies. rovision also under Income tax sion in certain cases. luly qualified and trained char- Over the years, there has been ditor, as also requirements as ion for cost audit by cost ac- count rable enlargemen ‘Act, for compulsory tax audit in case of (c) Auditing in Electronic Data Processing (EDP) environment. times, growing use of computers in processing and storing of financial transac- « the auditor to apply new techniques to verify financial information. For ex- on-line system transactions, he may not find physical evidence to examine ns. He will also not have a visible audit trail of particular transactions, or vis- output. Central location of data may tempt client-staff to change data files and g nout 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. MEANING OF AUDITING 1.3. DEFINITIONS OF AUDITING pees Js concerned with determination of accuracy and reliability of financial and other records and statements. Below, important definitions of auditing: (a) Spicer and Pegler “An audit is an examination of books, accounts and vouchers of a business. The object is 0 enable auditors to satisfy themselves that Balance Sheet is properly drawn up, gives a true and fair view of state of affairs of business, and Profit and Loss Account gives ee and fair 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” "Introductor (by ERM.De Paula ee “an audit a Gramination of Balance Sheet and P; with books, ace ers, sta ee eerie and vouchers relating thereto, The exa gach a manner that 3 T may satisfy himself and honestly report th famination sin the Balance Sheet is properly drawn up to exhibit a true and im t vi ws fi eae - wartict conc Re C and correct view of state o Mppaticular concer. according, fo information and explanation ee Srguen by books planations given to him and as rofit and Loss A/c prepared by oth- (c) Institute of Chartered Accountants of India (ICAI) inthe revised SA 200, “Overall Objectives of Independent Auditor and Conduct accordance with Standards on Auditing,” the ICAI says the objective of on awe ete auditor to express opinion on whether the financial statements are prepared ind a in accordance with the applicable financial reporting framework, and eee i statements are presented fairly and give a true and fair view of the profit or loss, finan condition and cash-flow of the entity. ~ In other words, auditing is a systematic and independent examination of data, state- ments, records, operations and performances (financial or otherwise) of an entity for a stat ed purpose. In any 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. 4.4. IMPORTANT FEATURES OF AUDITING (a) It means systematic examination of books of account and financial statements The books of account may be: Ledger, Subsidiary books, Journal, and financial statements, Le. Profit and Loss A/c (or, Income and Expenditure A/c), Balance Sheet (or Statement of Affair), and Cash Flow Statement. Audit involves review of internal control, making rele~ vant enquiries and tests, vouching and verification, analytical review, external confirma- tions, and examination of financial statements. Audit extends to all operations and perfor- mance of an entity, whether financial or otherwise. According to ICAL, auditing 1s not restricted to accounting records. It extends to managerial performance, cost records, ete. In this sense, it includes evaluation of Management Proce and Functions. Reporting re quirements under Sec,143 and amended CARO 2015have introduced the aspects of propri- ety and financial prudence as part of audit examination. (b) Examination should be by a chartered accountant A person qualified to be auditor should first be a chartered accountant Act prescribes other tests of qualifications, competence and independence ‘The foremost thing is that he should not be in a position that in any way compromise independence which may tempt him to act in biased manner: This means that he ca a also be that same company’s officer or employee, ot employee of PATTY of any officer employee of the company. His independence will be allected [he Companies ofan auditor. mises his Fhe owes the company, for4 Principles and Practice of Auditing same group eee more than 25,00,000 or provides surety to the company for someone wl ten € company a sum exceeding 71,00,000. A company, being an artificial persox, 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 agreements, letters, money receipts, property ownership documents, etc They also inclu information and explanations provided by authorized representatives of the client. An aud; tor may also independently collect evidence from outside sources, such as confirmation, from bankers, lenders, credit suppliers, debtors, ete (d) Auditor expresses opinion on truth and fairness of assertions in financial statements, 200 (now amended), audit examination enables the auditor to expr airness of financial statements prepared by the managem the entity. To this end, he must ensure two things. One, that maintenance of books of ac. Jaw enacted by Government and the regula. count is systematic and as per the relevant tory pronouncements issued by ICAI. Two, financial statements based on accounts, gv: a true and fair view of results of operations (profit or loss) state of affairs of business (Bal d cash-flow. This has led to developme: ance Sheet showing assets and liabilities) an several new techniques to assess risk factors associated with EDP, and formulation of ap- propriate audit plan. However, audit opinion is not an assurance regarding future viability of the entity or et- ficiency or effectiveness of its management. PRINCIPLES OF AUDITING According to his opinion on truth and fa 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 comp: sory, or at the option of the client. As responsibility for preparation and presentation ot nancial statements rests with top-end management and officers of the client, the dishonest and unscrupulous among them may falsify accounts and misuse funds and assets. The! 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, oF © make illegal gains for themselves. When detected, both the management and auditors "" 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 conscien disclosed a massive fraud committed by him in the financial statements of the comp” several years. The disclosure jolted stakeholders of the company in India * alance Sheet of the company showed bank deposits falsely increased t0° over past abroad. The BIntroductory 5 of the actual sum and debtors of the company to 2490 crore as against a paltry Rs. 2,000. Liabilities of the company were also grossly understated. The Securities and Exchange Board of India (SEBI) said the audit firm, PricewaterhouseCoopers, routinely failed to follow the basic procedures to confirm the bank balance and debtors and only relied on directors’ statements. The result: SEBI fired the auditors a huge sum, One crore and Seventy-five Thousand Dollars. Had the default by auditors come to notice after enactment of Companies Act 2013, they would have been subject to fine between 225,000 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 punishment would have been imprisonment for one year and a fine between £25,000 and %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, righteous, and a person of principles. He must not accept any evidence or statement at face value, whoever may give it, without fully satisfying himself about its dependability. He needs to be objective, that is to 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 obey their commands. He is accountable to a whole lot of persons, owners, 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 25,00,000, or acting as surety for anyone in the company for an amount exceeding 71,00,000. (There are lot many other disqualifications for which refer Chapter 12.) sor Ithed Then alone, he can freely and fearlessly give his opinion on affairs of the entity e loes not approach his work without fear or favor, he will be guilty of misconduct an ie an criminal liability vis-a-vis owners/shareholders, even third parties. Auditors by san al 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. a : : It is noteworthy na iaeenened isa state of mind, itis an indivisible quality ae a dependent person would maintain his independence against epee ae a indepen- in all circumstances. Independence cannot be een be independent but dent and in another acting as slave. Further, auditor should no ae their dealings with should be seen as independent by all persons who rely on his repo! the company.t Fraud to Ce entral Government 2013, an auditor has to be extra cautious. If in the course of per. t. he has reason (© believe that an offence involving fraud is bene ict has t j against the company, by officers or employees of the company, Ne must Pt to the Central Government within the time and the manner as pre. © may invite fine or imprisonment, or both. This will also apply to any secretary of the company. 2) Auditor's Duty fo Report Under Companies Act forming audi been, committed immediately report it scribed. Failure to do s the cost auditor and comp; (3) Confidentiality the course of his work, auditor will come across several data and information, which his acne man not like to be revealed to outsiders, particularly to his competitors. In such 2 ¢. the auditor should respect client concerns. He should share such data/information Jy with client’ specific permission, or if it is required by law or under professional obliga. An auditor disclosing secret formula or strategy of his client entity to another would rvite 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 f i d by him may be b y by the auditor for purposes of audit, Documents examine’ y him may be books of account, financial statements, minute books, contracts, deeds, 0" any other statutory books. Nature of documentation may be different depending oD the nature of audit, nature of business of the entity, types of records, reliability of inter control system, and so on, 7 ‘The auditor should retain working papers of every audit engagement to prove, if and when required, that audit carried out by him has been as prescribed by relevant laws, 3 Standards (SA and AS) issued by ICAI. According to SA-230, working papers are the property of the auditor; however, the die . a ent-entity may ask for copies or extracts of the same, He may keep these with him °°. Introductory 7 period as per professional norms, (not less than se , them if any legal or regulatory bod: a Y directs him to do so. (7) Audit planning According to SA-300, “Audit Planning” p, fore 6 ; plan it efficiently and effectively, He 8: before com lowing: (a) Purpose and Scope of audit. An audit may be st nature, or related to any Specific purpose, like makin, assets and liabilities. Ina stat i ‘ statutory audit, the law appli the scope and nature of his examination and his dutie non-statutory limited purpose letter of engagement. (b) Knowledge of client business: According to SA-315, “ ing the Risks of Material Misstate years) but may have to part with 6 an audit, the auditor should adequate knowledge of the fol- ‘atutory or non-statutory in an investment, or valuation of cable to the entity determines Sand liabilities. However, in a audit, his duties and liabilities will be as defined in the Identifying and Assess- » transactions and practices which in his opinion may affect financial statements, audit examination, or his report. Annual report to sharehold- ers, visit to client premises, accounting manual, working papers of previous year, management and organization structure, changes in accounting practices, work of internal 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 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 to SA-500, “Audit Evidence’, the auditor should obtain sufficient appropriate 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 may be internal or external. It may also be vi ual, oral or documentary He should rely on internal evidence (such as books of account, financial ee = Ports, minutes, explanations from management/employees, etc) only if he ee about the effectiveness of the internal control system operated by the company. External evid : ee (such as confirmations from lenders, bankers, debtors, creditors, etc.) is often genuine should be subject to careful testing. oe ars pec! the as- As for assets, only visual evidence should be acceptable. Pe rsonal in fee tone tthe a Sets, where possible, is an example of this. Oral evidence, whether trom interns pate Sources, needs careful verification, Documentary evidence is often reliable a quires careful cross-checking.8 Principles and Practice of Auditing (b) Adequacy of evidence. Thi lence. This will dey able de meni eas Oba vill depend on (i) probable degree of risk of misstat 2 ¢ item; (iii) past experience; (iv) results obtained by applica of audit procedures; and (v) the ‘i Dy application Evidence is onk i ¢ trend indicated by accounting ratios and analysis dence cannot we ly persuasive, not conclusive proof. In any case, sufficient appropriate ey, dence can e an absolute proof. Evidence must be such that any reasonably knowledge Person would conclude that assertions made in financial statements are true and fair, (9) Accounting system and internal controls Itis for the Management to maintain proper accounting system and suitable internal con trols. The auditor should secure a list of books of account and other records maintained by client-entity and acquaint him with the accounting system. He should also ascertain, through compliance procedures, whether related internal controls are in place and properly functional For example, suppose the internal control system prescribes that a purchase transaction 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 internal 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, wil 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 o! stock, etc. (b) Information in financial statements is consistent with legal requirements. Information provided in the financial statements meets the requirements of relevant legal prov! sions and ICAI regulations. (c) Financial statements contain adequate disclosure of all important informatio entity has made adequate disclosure of all material information as per financi porting framework, subject to legal and regulatory requirements as applicable. yn. Client al re- (11) Audit report According to SA-700, “Auditor's Report on Financial Statements’, an audit report express’ the auditor's opinion on the truth and fairness of results of operations of the entity (* shown in Profit and Loss A/c) and its financial condition (as shown in Balance Sheet), be sides Cash Flow Statement. He also reports on the status of maintenance of accounting be cords as prescribed by relevant government laws and pronouncements of ICAL. ‘An auditor's report is a valuable document for people who rely on it to ma decisions relevant to the audited entity. He is member of a reputed profession. ‘This imp ke busines osefand 1 Introductory 9 several on re leeal fexponubiitien an tin Asin cane of ‘i has faith 19 Bis ITER TY, Competency Objectivity, and 4 \ any other professional, public will work to protect and promote interes sy All staked ai Hendlenee must make every effort to live Up to public akehotdery expect age inspires confidence in Ms opinions an | and believes that he “1 the business, atone. Hin mora MANGAL statements the auditor ally and legally correct inn Statements providing Jinancial information ‘Who uses the informa |. Management of by ness entity, tion and why? routine decisions 2 Shareholders, partners, and propricturs, Iwonitr t thetr results and financial condithen ef 4 Banks and financial inst financial condition 4. Creditors to aw Persons/entitivs wha we the information Jo8 the prurpusels) as indicated HOmOniOL perforin take policy and | A the entity Mutions, to evaluate perfor H10e, profitability and whether Ht would be prudent to 4 | provide credit to the entity, 5. Customers, to determine whether it would benef doing business with the | entity, 6. Government, to monitor whether the entit ing taxes on time | 7. Rating and research, to undertake rese: entity in the industr y isserving social good, and pay. | arch and rate the performance of the | — —— 7 J However, opinion expressed by him is not an assurance on viability of the entity or effi ciency or effectiveness of its Management. ‘There are reasons for 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 appropriate accounting policies or pre sentation of financial statements. ‘Three, evidence gathered by auditor is generally persua sive, not conclusive. Four, there may be weaknesses in internal control system et my x exploited by employees or even by the top management. Five, an auditor cannot Lets beck every business transaction because that will be both costly and sim nea ie audit does not give fool-proof assurance that there are no misstatements, ene e the accounts. Lastly, the auditor cannot pass judgment on the eff eas eae : ee Management because that would be subjective in nature. May be, the Manage f : table tential to be more efficient and effective and make the entity still more profitable UDITING DISTINCTION BETWEEN BOOKKEEPING, ACCOUNTING AND Al 1.6. BOOK-KEEPING Book keeping means maintenance of a regular, correct Entering transactions in relevant transactions in appropriate books of account. It includes: (a) a Purchase/Sales Return Book, books, such as Cash Book, Purchase day book, Sales day = io Totaling and balancing ac tc; (b) Posting them to relevant accounts in the Ledgers and and its performance is under counts. Much of the work of a bookkeeper is clerical in nature « overall direction and supervision of an accountant y-to-day and systematic record of day-to-d10 Principles and Practice of Auditing 1.7. ACCOUNTING (a) What is accounting? Accountancy begins where bookkeeping ends, Accountancy deals with following: (a) Check the work done by a bookkeeper, in other words, to ensure that there is correct record of all financial transactions in books of account () Prepare a Trial Balance, to ensure that there is record of each transaction in relevant accounts () Prepare financial statements (namely, Profit priation A/c, Balance Sheet and Cash-Flow business operations and financial condition of business: (a) Pass adjustment and rectification entries. (c) Design a suitable accounting system to protec and improper use, and comply with legal requireme! and Loss Ale, Profit and Loss Appro Statement), to show the results of t business assets from unauthorized nts under relevant law. (b) When auditor cannot act as accountant ‘An auditor cannot act as an accountant. According to Sec. 141(3), if on the date of his ap- pointment he or his subsidiary (or associate company) is engaged in services like account. ing and book keeping, or internal audit, or design and implementation of any financial in- formation services, or management services, etc. to the company, he cannot be appointed auditor of that company. Distinction between Accounting and Auditing ‘Auditing ‘Accountancy T tis concerned with analytical and critical ex 7. It is concerned with collection, classification, summarization and communication of finan- cial data It measures business events in terms of profit or loss and financial condition of business. The accountant is an employee of entity, enti- tied to regular salaries. The accountant is nof required to submit a re- port on financial statements prepared by them. ‘the accountant, being an employee of entity, works on a permanent basis. 1.8. AUDITING Auditing has a three-fold object. One, analytically. Two, ing auther to report whether, in his Statement represent a true an‘ examination of books of account, syste! checking evidence in support of entries in books of account. Three, nticity of assertions in financial statements, Most important duty of an au opinion, Profit and Loss A/c, Balance Sheet and Cash/Fun' d fair picture of results of operations and financial pos! amination of financial records and statements. 2. It reviews measurement and communication of financial results and condition 3, The auditor is an independent and profession ally competent outsider, hired for a fee. 4, The auditor is required to submit a report con taining his opinion on truth and fairness ofa sertions made in financial statements. 5, Appointment of auditor takes place every year matically and verily” itor 8 Flow itionbusiness, and books and records of business are as re. ments of ICAL. According to Mautz and Sharaf, “rel ationship of Introductory 14 quired by relevant law and pronounce 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- Below, the distinction between investigation and auditing: ferent in many ways. Distinction between Investi gation 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 causes which require investiga- tion, To seek auditor’s opinion on truth and fair- ness of financial statements and compliance with legal and regulatory provisions. Time coverage Depends on need and causes of investigation. Covers the accounting year followed by the entity, Approach to work Examine the facts and causes, no matter how and where to get the evidence for it. Gather data and information to express opin- ion on truth and fairness of assertions in fi- 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 examin ation of accounts, 1. Independent audit 2: a 4, Internal audit Government audit Specific audit classification of audit may be as follows: For detailed discussion, see chapter 3, “Classification of Audit. QUALIFICATION AND QUALITIES OF AUDITOR al qualifications as also pers To be an auditor, a person must possess profession of head and heart. onal qualities42. Principles and Practice of Auditing 1.11. STATUTORY QUALIFICATIONS ‘An auditor must be a chartered accountant. He must pass examin: tute of Chartered Accountants, and undergo training: under a Prac emer tant. He must also secure a certificate to take up public practice of accou! must not suffer any disqualification for appointment as auditor, 1.12. ACADEMIC AND PERSONAL QUALIFICATIONS—AUDITING AMI SEVERAL DISCIPLINES An auditor has to perform a variety of functions. To be able to do so, he st eae ee eral qualities—some tangible, others not so tangible. He may acquire some re es through formal education and training, while others he will himself learn during his experi- ence in the school of life. For example, through fori k dge countancy, business laws, production systems, mathematics, statistics, financial management, marketing management, and human resource management. Personal qualities, like honesty, integrity, tact, common sense, communication skills, are either inborn or learnt through experience and interaction with others. ations conducted by Insti- cticing chartered accoun Further, he IX OF mal education, he can gain knowledge of financial and cost ac- general management, 1.13. PROFESSIONAL QUALITIES 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 with 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) eee should know concepts of cost accounting such as and Bacar ane ‘ae ‘ation, allocation of overheads, standard costing, , tc. He should also know how to apply cost accounting principles to decision-making, such as, “ > nb » “make-or-buy any product”, “repaii e- place any asset,’ product mix, inventory control, etc. wae: es (c) Knowledge of accounts of business it under audit; He should iliar wi : tem and techniques of accounting in the entity under audit keeaie . (d) Knowledge of business laws: He should have knowledge of the laws governing part- nerships, companies, trusts, agencies, factori , y es, estates, property - derstand the relationship between Central and State i fatd scsinnpend a mon law. He should know how to app} an ly the principle : auditing situations. ples of law to accounting and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. (A) 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 companys 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 write anything that may be necessary yet in- convenient, and have courage of conviction to stand his groun ; ' (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 a Score . i sic it. The itor S! (d) Sound judgment: Exercise of judgment is basic to any audit i e oe Seite able to judge the relevance and importance of any evidence, audit prog procedures. (e) Sense of responsibility: Pu spread impression that it fol 8 of responsibility to public interest. Therefore, ditor should try to live up to his public tnage - (f) Due diligence: The profession of an auditor is ae Lae acting demands on his time, energy and See oaeks on hand. time pressure, meeting deadlines to perform 6 rises ff a wide- blic confidence in auditing profession ises from < sever conscious lows best standards of performance and iS °°" SET jn both thinking and behavior ss that makes ex- valous mistre ee diligently under must work14 Principles and Practice of Auditing (g) Effective co: icatic a “Ye communication: He should be able to co writing. Particularly in the matter of ee eel aer a aes clear, logical and lucid atter of report writing, his language should be 1) Robust comi The audi he would bea more ta the auditor should have sound common sense. Without it, Rees echnician, knowing everything about his job but lacking ability pply 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: (i) Employees work with due diligence. Emplo account and records are regular, careful an auditor and his staff are breathing down their neck. (ii) Fear of surprise visits by auditor keeps a check on errors and fraud by employees. Errors and fraud 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 isappropriate cash and/or goods. (iii) 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 obtain easy loans and credit from banks and suppliers. .ssment easy. Tax authorities rely on audited ac- counts, This makes it easy for them to determine tax liability of the entity in re- spect of income tax, wealth tax, excise, sales tax, service tax, VAT, etc. (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 of business. ‘Audited statements provide a reliable basis for resolution of disputes as regards wages or bonus payments fo workers. (vii) Audited accounts facilitate settlement of insurance claims, In case of loss or damage t0 business property, audited accounts facilitate determination of claims against insurers. Entity can know about weaknesses of internal control system. For management of the audit examination helps to identify and correct weaknesses of the existing system of internal check and internal control. (ix) Audited accounts are indicator of compliance with legal obligati tion brings to light whether the entity is meeting necessary f account maintenance of proper books of aces ; ‘The entity staff can gain from expertise of auditor, Staff of the entity can benefit from eens d experience of auditor in several ways, such as, appraist professional competence and exp yyees in charge of maintenance of books of dd systematic in their work. They know the to manipulate books to mi entity can (iv) Audited accounts make tax asse (viii) entity, jons. Audit examina- legal obligations 0”Inuoductory 15 of internal control system, m, aintenance tax-related issues, © of accounts and compliance with legal and (b) Advantages for Owners of Business (i) For sole proprietor, auditing serves as proof there is no el of a sole proprietary Proof there is no error or fraud in accounts. in ‘ conce oie nee Cn a for which audit is not compulsory unless its gross eee ek the prescribed limit, audited statements of accounts St as a C18 proper accounting ot y of all by Ps Gene i business transactions and that ership, ¢ 2 assures (ii) In parine ae on USSUTeS Partners of proper management of business by active riners. In partnership V1 ; : parine a F os vip firm, for which again audit is not compulsory unless its gross receipts or turnover exceeds the prescribed limit, audited 1 of proper management of business by active partne accounts serve as evidence { sand employees of the firm Audited accounts also help in settlement of accounts in case of admission, retirement or death of any partner, or in case of dissolution of the firm for whatever reason (iii) For shareholders of company or cooperative society, audit provides proof of good gover- nance by the Board/Managing Committee. In a joint stock company and a cooperative society, for which audit is compulsory, audited statements serve as proof that there is efficient management of business affairs and that their investment is in safe hands. (c) Advantages for Others Outsiders rely on audited statements for various purposes. Banks and lenders rely on au- dited statements of a business to sanction loans to it. Insurers rely on them to settle claims in respect of lost / damaged business assets. For determination of liability under income tax, sales tax, wealth tax etc., tax authorities generally rely on audited statements to determine tax 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 a ticking, totaling, vouching, verification, etc. In this sense, it excluded several impor ot areas, such as finances, managerial efficiency and effectiveness, propriety of business io ; ings, business ethics, etc.. However, in present era of globalization, auditing ue its scope to include corporate governance, business risk analysis, untair trade practices, effects of business operations on environment, and so on ‘em activity, though now it is becomin u here around at the time of cast- o discover manipulations by ante-mortem (6) Auditing is a post-mort 9 Auditing begins where account \ ing or balancing of books of account. [t is not po ancy ends. The auditor is now! ble for him t16 Principles and Practice of Auditing clever, highly placed officials ighly placed officials, In the event, many questionable dealings may escape tion even after careful audit examination ate, (¢) 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 tra actions, An auditor has necessarily to seek additional information and explanation fon various personnel ofthe entity. ‘Ihre may bea question mark on authenticity of such nj, mation and explanations, particularly if the source personnel are themselves involved in manipulation of books of account. Therefore, even audited statements may not reveal cx, 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 information abou: 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. In 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 will depend on the types of audit techniques employed for purpose. Where an audit tech- nique is not consistent with the nature or type of entity, or with the method of record keeping followed by it, it will not provide right 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 show a true and fair picture of business. ( REVIEW QUESTIONS Objective Type State in brief whether t 1. Auditing is concerned with verificati he following statements are true: -agits ion of the correctness of financial data and determining i* curacy. 2. Auditing is an examination of operations conducted by management.Introductory 17 ted statements help the bankers in d deciding itor needs to have knowledge of “deciding on grant of oan to the enterprise Am aaditor is supposed £0 submit his report to the Central ¢ al Government tor is to be held responsible for any e a rrors or fraud in th e accounts of the company. o. Auli eM pnat audits af aie 10 aut by an independent audit Plectromis cate processing makes it easier to commit errors and fraud resence gathere . : prs and fraud § Tipjence gathered fron internal sources is often mote reliable t ee able than that obtained from outside sfiticate from banks as to cred io, Acertitical as to credit balance held by client is an external SOUTEE Id by client is an example of evidence obtained from Ly. Accounting begins where auditing ends, 1 The auditor or the firm of which he is partner can prepar. i prepare fi a sof ¢ 0 ich he has been appointed auditor, Ce Short-answer Type 1. What is an audit? > an aust concerned with propriety of business conduct? (Hint: No, however recent amendments te Sec, 143 of Companies Act 2013 and amended CARO, have introduced this element in the con” cept of audit.) 5, Briefly discuss the Basic Principles governing an Audit as laid down in SA-200 whether physical or electronic 4. What is audit evidence? (Hint: Internal and external documents, relating to transactions.) Briefly distinguish betwee! What is computer fraud? etc.) Se 8. Do you agree that there are inherent limitations of audit? 9. Enumerate the qualities of an auditor. 10. Can a company restrict the rights of a company auditor? 11. Comment: “Audit opinion is not an assurance as to the future viability or effectiveness with which Management has conducted the affairs of the entity tor’s judgmental error about audit procedures, ‘and the Management’ about accountin preparing financial statements; ‘moreover, nature of evidence being persuasive, not conclusive; further, control; lastly, auditor cannot check each tion in audit will be as effective as internal detail because of paucity of time and increase in cost.) .n internal audit and statutory audit (Hint: Alteration or deletion of data files or programs, corrupting files. of the entity or the efficiency (Because of audi- ng policies and hand every transac Essay Type . Define auditing and explain its a . What are the objectives and scope . “Auditing is persuasive in nature and no . Briefly explain the difference between auditing and act 1 2. 3. 4 5, What are the objects of audit? 6. 7 8. vantages. of audit accor ot conclusive.” C countancy 200? ding to SA ly examine this statement ations of auditing. of frauds? uss general qualities of an auditor int dd limit regard to detection bloodhound?’ Dis . Discuss in brief advantages an he context . What is the auditor's duty with “An auditor is a watchdog, nota of this statement.Objects of Audit _ LEARNING OBJECTIVES: After going through this chapter, you should be able to: > Understand the Evolution of Audit Objectives. 2 Know the Objectives of Audit. > Understand the primary objective of expression of opi assertions made in financial statements of an entity. © Detect and prevent fraud (including computer fraud) and errors. s responsibility as regards them. nion on the truth and fairness of > Understand the types of errors and fraud and auditor 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 asking for oral 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 blindly. They do it after a qualified independent person (auditor) has examined the accounts 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 ion i statements f presentation in financial 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 some high-end officials commit fraud for personal gain? There are several instances this has been done. Take the case of Satyam Computers, where the managing director fiddled 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 giv en to them by the company did not appear in its Balance Sheet.Objects of Audit 19 [hr ‘ importance of interna . "portance of internal eee Not recognized Primarily | Not recognized Detection of fraud | Detection of fraud: | clerical errors Detailed Detection of | Some tests, detailed 1908 - Determination of | peer on of teat of "ported Detailed testing | stighth fection of | | coy | fraud and errors fon off Uy owed jos 0 | 5 | 1933 -1940 | Determinatic N of fairness of report. | T; | ed financial position esting | Awakening of interest 1940 - | Determination of truth and fairness Testing | [of reported financial position, | | Substantial emphasis Source: Accountant, October, 1962) 1 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. Means to achieve objectives ] Examine the reliability and validity of assertions in | | Audit objectives | Primary - Expressing opinion on truth and fair- | ness of 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 cbiective of audit of financial statements (Profit and Loss A/c and Balance Sheet) Svan audi- tor to express his opinion on truth and fairness of assertions made in finane ae 7 =m S 143 of Companies Act requires a company auditor to state whether in his opinio' wa f f si Fe ys qurs (a) Balance Sheet of company gives a (rue and fair view of state of companys aff the end of its financial year; and a (b) Profit and Loss A/c gives a true and fair view (b) Procedure and techniques to arrive at opinion ‘or must first make ds prepared as per is stat asat of profit or loss for the financial year. a systematic examination of fo “accounting Standards (AS) and stan- tutory requirements 19 the releva To express his opinion, the audit statements and accounts and recor aera dards on Auditing (SA) issued by ICAI, includin2 SORELLE ON FAUT, law. He should evaluate the internal control system, including internal check and inte, audit, for its effectiveness and compliance. a He should obtain a written representation from Management and others charged with y ernance where they accept their responsibility for the design, implementation of eines of internal control to prevent and detect fraud. Also, that they have disclosed to him the rae of their assessment of the risk of material misstatements arising from fraud, and their knw, edge of the fraud or suspected fraud affecting the entity involving management, employees and others. They should also share with him their knowledge of allegations of fraud or suspecte fraud as communicated by employees, former employees, analysts, regulators, etc. According to amended Companies (Auditor's Report) Order (CARO) 2015, in case of, specified company (whether public or private), the auditor must report that, given its nature and size, the company has maintained an appropriate system of internal audit and obsery the rules prescribed in the internal control system of the company. If the compliance proce dures reveal any departure from the internal control system, he should take up detail checking of the transactions. What is a specified company? See Chapter 3, Sec. 3.5. (c) Opinion is not an assurance on financial viability of company or quality of its management An auditor's opinion is only with respect to truth and fairness of assertion of financial posi tion of enterprise as made in Balance Sheet and results of its operations as stated in Profit and Loss A/c and Cash Flows. It is not an assurance about future viability of the entity, or effi- ciency and effectiveness with which its Management may conduct its affairs. 2.3. DETECTION AND PREVENTION OF ERRORS AND FRAUD Errors and fraud can cause material misstatements in financial statements. An important difference between error and fraud is whether the misstatement is innocent or due to lack o/ care, or it is intentional and deliberate. It is necessary that the auditor has skeptical attitude while conducting audit, suspecting that material misstatements may be there in financia! statements, This is despite that he has no past experience with the client to disbelieve his statements. He should accept the records and documents only if he believes that there apparently no reason to distrust the statements. Material misstatements may be by way of misleading financial reporting to hide the real financial picture of business or to misappropriate assets for personal gain or to injure the client business. However, even where an auditor suspects fraud, or is able to identify its 0¢ currence, he is not obliged to determine whether fraud has actually occurred. 2.4. ERRORS (a) Errors are unintentional, without an objective to mislead readers of financial statements, or to siphon off cash or assets An error may be any unintentional mistake or mis-description in books of account whether by way of — (i) Arithmetical or other mistakes; (ii) Oversight or misinterpretation of facts: °"Objects of Audit fit) Misapplication of accountin, * nocent and not deliberate. How fraud. 8 policies. An accepted rule is th: e at an error i: x ever if appears to be willful, it ee assumes the character of a (b) Types of errors Classification of errors may be as follows 1. Clerical errors, which may er fi c : nay further fall under (a) Errors of omis commission. mission, (b) Errors of Errors of principle Co g errors 1. Clerical errors A derical error may be—(a) Wrongly i y gly recording a transaction in books of original en ; S entry, such as Purchases Book or Sales Book; (b) Wrong posting of any transaction to Ledger; or ¢) Wrong totaling or balancing of. er account. ay be an error of omission or com bal: 'g of a Ledger account. It m: ry be as f omission or cor _ (a) Error of omission. It occurs when there is o1 account, either wholly or partially. Such error is easy to detect either during writing of the count sel Soom Sor ae, ie case of complete omission of a transaction letect. Because, if posting of a transaction is - omitted from Ledger, it will not reflect in agreement of Trial Balance. For exam- ple, if there is no entry of a credit purchase in Purchases Day Book, then there will be no debit in Purchases Account and no credit in Supplier's A/c. This omission will not affect al Balance; it will come to light only when Purchases A/c and Stock A/c are detail-checked. However, if there is a partial record of a transaction in the Ledger, the error will be easy t because there will be mismatch in Trial Balance. For example, if credit sale in Sales 2 recorded but no debit in Buyer’s A/c, then Trial Balance will show excess credit equal to sale amount and then the error can be nailed. (b) Error of commission. It may occur during recording of a transaction in a book of original entry, or while posting it to Ledger. Errors in totaling and balancing of accounts or in carrying forward totals to Trial Balance, are also errors of commission. The following are examples of such errors: (i) Where a transaction has been incorrectly recorded either wholly or partially, a credit purchase of Rs. 520 has been recorded in Purchases Day Book as (such error will not affect ‘Trial Balance.) (ii) Where a transaction is incorrectly posted in Ledger, ¢g vee and on credit side of Sales A/c) as Rs, 520. Sucl merror will So ot though theres ance. However, if error is by way of incorrect posting in a al t by showing e correct positing in the other account, ‘Trial Balance ual ere lace eigi debit or excess credit. Same will be the case where posting ' account and not in the other. mission in entering a transaction in a book , if there is an entry of a of Customer's A/c one22 Principles and Practice of Auditing (ii 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 Balan in Trial Balance. (v) If there 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. original entry. Errors of this nature ching is the only way to locate such ce, In this case error will reflect voices soon after entering them in books of would not distort Trial Balance. Careful vou errors. Nature and Characteri: se ‘Anin will be fraud. | Often unintentional, not intended to mis-| An intentional erro! lead orcheat readers. ‘Selfevident, detectable during account | Preparation, such as, omission of a cheque issued will show up on preparation of bank detectable during account prepara. Not self-evident, not heck will uncover them tion, only analytical cl | reconciliation statement. ‘Errors of omission or commission, con- fined to single account, will show in mis- Complete omission of a transaction, errors of principle, and self-adjusting compensating errors will not affect Trial Balance, hence detectable only by analytical check. | match of Trial Balance. 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 capital 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 capital expenditure, or vice versa. Revenue expenses are a charge on profits and go to reduce profits. If any revenue expense shown as capital expenditure, e.g., if current repairs to machinery are shown on cap- ital account, it will increase profits as also book value of the machinery. As such, Profit and Loss A/c will not show a true and fair picture of results of operations, no! Balance Sheet a true and fair picture of financial position. (b) Where there is suppression of identity of an item of expenditure. It will happen when, to ignore legal requirements or for any other reason, expenditure appears under different account, e.g., wages debited to Advertising A/c, or advertising expenses to Repairs A/c. While expenditure in such a case would constitute a charge on profits it would falsify and distort financial statements. (c) Where expenditure appears as benefit granted. It happens where there is debit of intel” est paid to a creditor to his personal account, such that instead of constituting * charge on profits, it results in increasing assets position.Objects of Audit 23 (d) Where valuation of assets is not as per generally accepted accounting Principles. It may take place to overstate or understate profits and financial position of business. 3. Compensating errors A compensating error hides or reduces thi ¢ effects of other errors. For example, on face of it. a matched Trial Balance may lead to the c ‘onclusion that business transactions have been all correctly 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 of 21,000 to X has correct debit to his account, but in Sales A/c the credit entry is of Rs. 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 2900, or more. Now, if other short debits total up 7900, these may be equal to the amount of initial short credit of 2900. Which means Trial Balance would not reflect the errors and would delightfully match. On other hand, if subsequent short debits exceed 2900, Trial Balance would show disagreement, but like the tip of 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: - 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. - Ascertain whether there is transfer of balances of all Ledger accounts to Trial Bal- ance. - 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. See if there is correct totaling of various Ledger accounts : ' - 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, - : Check up opening balances in Ledger accounts brought forward from previous year. f previ 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. w > w a ad24 Principles and Practice of Auditing 9. Check journal entries to ensure that total of debits is equal to total of credits. 10. If errors are still not located, thei . ; n the difference may be due to following: (a) If difference in ‘Trial Balance is divisible by 9 (nine), then it is likely thay there may be misplacement of figures, say 12 for 21, 24 for 42, 36 for 63, and so on. (b) An error of a round sum, like 10, 1,000 is often due to a mistake in totaling, 2.6. DETECTION AND PREVENTION OF FRAUD According to AS 240— 1 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. 4, 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 another's 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 Book with those in Rough Cash Book, counterfoils in Money Receipts Book, and original evidence in form of vouchers, invoices, salary registef wages sheet, etc.Distinction between Errors and Fraud Points of distinction Errors Fraud Motive Often unintentional ‘Always intentional Persons responsible | Employees Management or persons charged with 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 staff 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 oF causes its omission. 7 Generally, commission of fraud by manipulation or falsification of. aptene is with ae consent or connivance of persons holding high positions in business. Its ; ject eae gerate or underplay profits and financial position of business. Reais eel ne showing increased profits may be to push up prices of company’s s! fear ee m press shareholders, avail easy terms from creditors, and aa nee eee against this, understatement of profits may be to avoid tax ae Lake m a and induce a fall in share prices so that those doing insider trading Yy ber of shares at reduced prices. Overstatement of profits may (a) Providing lower or no depreciation on be by way of— business assets;26 Principles and Practice of Auditing b) Over- a eee of assets or under-valuation of liabilities; : wing revenue expenditure as capital; f ; pe items of expenditure; and , ©) Accounting past or future years’ income against current years expenditure. As against this, understatement of profits takes place by— (a) Providing excessive depreciation; (b) Undervaluation of assets or overstatement of liabilities; (c) Showing capital expenditure as revenue; (@) Omission of items of expenditure; and (e) Accounting past or future years’ expenses against current year’s income. (d) Teeming and lading This method or practice, also called delayed accounting or customer's payment to another's account to balance the bos ued until it is discovered through internal control system. ived from a subsequent customer is ‘A common feature of this is that the amount rece credited to the earlier debtor's account so that one debtor's account does not show an out- ice is continued till the time the original standing balance for a long time. And this practi 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 dited to the debtor and called splitting cheques. By splitting cheques, a lower amount is cre the rest is misappropriated. From small beginnings, this kind of practice may lead toa dis- turbing large fraud. lapping, involves allocation of one ‘oks. This practice may be contin (e) Computer frauds ‘A computer fraud involves m; cation of accounts to increase or decrease profits by means data files, programs, media, etc. Growing numbers of personal co! 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 gaining unauthor- ized access to computer systems. Use of credit cards/debit cards/ETM cards 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 effective internal control system manned by skilled computer personnel. aking an unlawful benefit through embezzlement. Or, falsifi- of tampering with computer puters, telecommunica- (f) Window-dressing It means the practice of arranging disclosure of as: fairs of business as shown in a subsequent Balance Sheet does not truly represe! financial position of business. Window-dressing may take place in any of following ways: (a) Sales and income of subsequent year may be recorded in current year. sets and liabilities in such a way that af nt normaOnjorts of Audi 27 (by Gowda nent on “sale or return” basin may be recorded as regular wales, (e) Loans given fo directors and other managerial persons may he recorded ay repald at the year end, ond then again shown an advanced to same personnel at the beginning, of next year 7) Jyeatment of normal revenue expenditure as deferred revenue expenditure (¢) Business assets deprechited at lower than usual rates. 28. AUDITOR'S POSITION AS REGARDS FRAUD AND ERRORS. (a) Auditor need not go about searching for fraud and errors Primary object of an audit is to render an opinion on truth financial statements, He has only to identify material mins cial statements. It is not to se vation in id fairness of pr tements that may affect finan rch for fraud and error, as commonly believed (b) How far auditor is responsible for fraud and errors SA 240, “Auditor's Responsibilities relating to Fraud in an Audit of Financial Statements,” says intentional misstatements relevant to the auditor are (/) fraudulent financial reporting; and (ii) misstatements resulting from misuse of assets. In some cases he may suspect or even identify the occurrence of fraud, but he does not legally determine whether fraud has actually taken place. He is only required to obtain reasonable assurance that the financial statements overall are free from material misstatements caused by fraud or error. It is the Management's responsibility to prevent and detect fraud. It should therefore maintain and continuously operate an effective system of internal control. But it should be remembered that this can only reduce, and not altogether climinate, the possibility of fraud and error. Planning of audit examination should be such that there is reasonable expectation of detection of material misstatements in financial information resulting from fraud and error. If the client-entity uses computers to maintain records of financial transactions, the auditor should take particular care to see that the computer system is secure and there is no access to it by unauthorized persons. Computer fraud can be by way of deletion of data files, pro- grams, corrupting the existing files or downloading secret financial information. An audit suffers from certain inherent limitations. Sample checking of transactions may exclude areas and transactions affected by fraud and error. Audit evidence in certain cases may not be conclusive. Moreover, misstatements resulting from fraud are more difficult to discover as compared to those resulting from error, because of clever planning and skilful concealment by perpetrators. ‘The auditor should therefore be skeptical, aware that there is Possibility of fraud and error despite management's representation claiming that their sys- tem of accounting is fool-proof and allows no fraud or error to creep into the accounting. () Factors that might cause fraud and errors Risk of fraud and error increases by factors, such as— (a) Weakness in internal control system and non-compliance with identified control pro- cedures;