8onK

5 BANK
Chapter
1
Audit
INTRODUCTIODN
DEFINITION OF AUDITING
It is not easy to define the word 'audit'
audire which means 'to hear. In the olden
precisely. The word audit is
derived from
only i.e. whether the person days, a
person was appointed to audit Latin wor
busines owner has done his job
responsible for
recording cash receipts and payments on the cash transaction=
word audit has a wider properly or not.
Hence it was behalf o
meaning. merely a cash audit. But now the
Auditing is the verification of financial
Profit and Loss Account. It is an position as is disclosed by the Balance Sheet and
and profit and loss accounts
examination of accounts to ascertain th-
give a true and fair view of financial whether the balance shee
business. For this purpose, all the business position and profit or loss of th-
recorded must be examined. transactions and the manner in which these ar

Auditing is the intelligent and critical test

of accuracy,
accounting data and accounting statements. It is concerned adequacy and dependability
with examination of
determine the extent of accuracy of profit and loss account and balance accounting datat
sheet prepared from suc?
data. Auditors enjoy a distinctive
professional status in the society because of specialised functio
of auditing. Professional accountants by
auditing, certify financial statements of organisationa
audited financial statements gain confidence of shareholders and other
interested in th
persons
organisation.

IMPORTANT DEFINITIONS OF AUDITING:

"Auditing is concerned with the verification of accounting data determining the accuracy and
reliability of accounting statements and reports." -R.K. Mautz
"Auditing is an examination of accounting records, undertaken with a view, to establishment
whether they correctly reflect the transactions to which they purport to relate."
and completely
-L.R. Dicksee
establish their reliability and reliability of
"An audit is examination of such
an records, to
-A.W. Hanson
statements drawn from them."
records and related operations
the systematic examination of financial statements,
"Auditing is management polices or stated
to determine adherence to generally accepted accounting principles, -R.E. Schlosser
requirement."
auditing as is an investigation of some statements of
"Auditing
An other writer has defined to make a report on
so as to enable an auditor
figures involving examination of certain evidence
statement."
 1.2
Introduction

Lass e n audit is the verification of financial statement, usually a Balance Sheet and rot&
stt COunt in the light of certain accounting principles to establish whether or n S true
statement and
correctly drawn up.
-R.R. Comber

DOve definitions provide some information about the meaning of auditing. Audng may
be defined as
i s a thorough, intelligent, systematic and critical examination o f accounting ate

5 uoe
hindependent
e accounts have to be prepared by the accountant and audit
person with requisite qualification.
h e examination ofaccounts may be made throughout the yearor periodicaliy
4. h is done with the help of relevant records, vouchers, documents, informatons and

eaplanations from the authorities.

5. The auditor has to satisfy
himself and report whether o r not :

(i)the profit & loss account reveals true viewandfair of profit or loss of the perio
(i) the balance sheet exhibits a of me
(ii)
true and fair view offinancial position
books of accoumts have been maintained and accounts have been preparea ds per
conee
the provisions of law.
n the wider scope the audit may include the audit of non-financial matters like audit ot
policies, operations, efficiency etc. In such cases the auditor has the role of advisor. It may De

Concluded that audit is the critical and intelligent examination of recorded facts-financial or no

tinancial to give attestation or expert opinion thereon. In nut shell auditing is the process o
and investigate the truth and to repor
checking
Thereon
vouching
the
the
financial data and systems to
as per requirements of his appointment.
Auditing involves the following steps :
i) A study of organisation and its structure.

(i) Analysis and review of systems of accounting and internal control.

(iii) Testing arithmetical accuracy of records and collection and evaluation of evidence in

support of transactions.
(iv) Verificaton of state of affairs disclosed by the balance sheet and profit or loss disclosed
by profit and loss account.
true and fair view.
(v) Preparation of report, expressing opinion whether accounts present a
Elements of Audit
On the basis of various definitions of auditing, the following are the elements of audit:

1) systematic and independent examination of records,

It is statements and performance of
an enterprise by a qualified person.
(ii) The audit should be conducted in unbiased manner with the purpose to express whether
financial statements present true and fair view.
communication with client and outsiders
(iii) The evidence in the form of voucher, written
examining books of
and physical verification of assets should be evaluated while
accounts and records of the client.
of auditor regarding truthfulness
(iv) The audit report is prepared expressing the opinion
to the client or shareholders.
and fairness of the financial statements and is presented
 Introduction 1.3
BOOK-KEEPING, AccoUNTANCY, AUDITING AND INVESTIGATION
the
In the carlier days Book-keeping. Accountancy and Auditing were
considered as
aspects of the term accountancy. This was the time when there was no demarcation between the
three
duties of the book-keeper and the accountant. But with the increase in trade, commerce and
industrial activities,. book-keeping and accountancy have become separate functions. The
following steps explain the distinction:
(a) Book-Keeping i) Journalising.
(Recording and Balacing) (i) Posting to the ledger.
iii) Totalling of various accounts in the ledger.
(iv) Balancing of ledger accounts.
b) Accountancy (v) Rectification of errors.
(Summary and Analysis) (vi) Preparing the Trial Balance.
(vii) Preparing Trading Profit and Loss Account.
(vii) Preparing Balance Sheet.
(c) Auditing (ix) Checking and verification of work done. by auditor.
(Verification of Records)
BOOK-KEEPING

Book-keeping is the art of recording day-to-day transactions systematically in the books of

accounts. This part of work is performed by the book-keeper. His job includes journalising.
posting, totalling and balancing of ledger accounts. Whole of the work of book-keeper is
mechanical involving use of principles of double entry system. A person with simple knowledge
of double entry system can perform this job.

ACCOUNTANCY
Work of accountancy starts where book-keeping ends. It is not wrong to say
"Accountancy begins where Book-Keeping ends."
The job of accountant starts when book-keeper has finished his job. The accountant has to
satisfy himself that the transactions have been recorded and posted to the ledger properly. The
work of accountant is to check arithmatical accuracy of accounts prepared by book-keeper by
preparing trial balance. If any error or omission arises it shall be rectified. Finally accountant is to
prepare Trading Profit and Loss Account and the Balance Sheet, incorporating necessary
adjustments there in. It may be summed up that accountancy involves the following steps:
(i) To check the work done by the book-keeper, to ensure that all the transactions have
been recorded in the books of accounts.
(i) To prepare trial balance to ascertain that all the transactions are recorded properly and
to make available balance of each account for preparing final accounts.
(i) To prepare trading profit and loss account indicating results of various transactions
during the year and the balance sheet to indicate financial position at the end of the
year.
(iv) To make various adjustments in the books of accounts regarding the transactions and
errors which are located after preparing the trial balance.
 1.4
Introduction
V T o design suitable accounting system to provide information as per the requirements of

to protect
business assets
Act. Sales Tax Act and Income Tax Act etc. and
es
from
unauthorised and improper use.

AUDITING
"A a c c o u n t a n t has
completed his work an
g begins,
ccountancy ends". After the to prepare the
the work done by a c c o u n t a n t . It is not the duty of auditor
Veily verification of accounts prepared
by
Concerned with critica! examination and of certification of
for the purpose
" n ndependent person appointed specifically completed financial statements
Oners. Auditing presupposes the existence
of the fact
prepared by the accountant. After submit a report of
his work, auditor has to
completing dand fair
w h e t h e r or not profit and loss account and balance s h e e t exhibit true a position of the

business
Aauditor must be a competent person, well versed in various accouning auu
Principles. As per the provisions of Companies Act he must be qualified Chartered ACCOuntan
varnous
auditor has checked and
verified thoroughiy
p O T t must be prepared only after the
accounting records.
An accountant cannot perform the function o f an auditor. He cannot certiiy unc d u a

Statements as corect and present true and fair view, Auditing is always based
on
accountancy
There is clear cut demarcation between the two.

Apfel's Trustees Vs. Annan, Dextor and Co. (1926)

in tracing Out a
t w a s held that firm of accountant can't be held responsible for negligence
fraud as their duty was to prepare final accounts for the purpose of income tax.

Leach Vs. Stockes Bros. & Pim (1937) ue

accounts
lt was held that accountants were not negligent preparing profit and loss
in tTOm
to do.
materials supplied to them and the instructions given specifically stated what they were

TIt can be said that it is not the part of accountant's duty to audit the accounts.
be
luxury." This statement may
said, "Accounting is necessity where as auditing is
lt is a

made from the viewpoint of the following arguments.

of funds and thereby
(1) Expenses and remuneration paid for the audit work is wastage
profits are reduced.
there is wastage of time.
(ii) During audit procedures, normal routine work is disrupted and
errors and frauds have been
detected.
(1i) With audit of accounts, there is no surety that all
he is to observe a number of
It may look unnecessary burden on the businessman as
(iv) as

formalities.
benefits of
The above arguments are baseless and do not have much relevance in context of

auditing.
statements do not find
No doubtaccounting is necessity but without auditing accounting
It be in case of small business where
nuch recognition, so auditing is still more important. may
ccounts are maintained in crude form and control is exercised by the owners themselves, auditing
valuable
nay not be necessity or a legal requirement but still audit of accounts may provide
 AC I N G VS.

The point of difference between Accountancy and Auditing can be as follows

Basis of Diference Accountancy Auditing
. Nature It is constructive in nature as it is It is analytical in nature and is
concerned with compilation of concerned with checking and
accounting information for preparing verification of financial statements.
Profit and Loss Account and Balancec

Shect.
Its scope is restricted to preparation It is determined by the agreement
2. Scope
financial statements and their between auditor and his client.
of
interpretation.
No formal qualification has been An auditor must be a qualified
3.Qualification Chartered Accountant.
recommended.

find The main object is to ascertain truth

4. Object The main object is to out

and fairness of financial statements

operating results financialand
and comment there on.
position of the business.
where book-keeping ends. It starts where accountancy ends.
5. Commencement It starts

to The Auditor has to submit a report

6. Reporting The Accountant is not required
submit a report on the accounts and about correctness and presentation
statements prepared by him. of accounts audited by him.

The Accountant is paid monthly | The Auditor gets a fixed amount as

7. Basis of Remune-
his client.
per agreement with
ration salary.
The Auditor is an independent
8. Appointment The Accountant is employee of the
on contractual
outsider appointed
business.
basis for a year.

to An Auditor must have knowledge of

9. Level of An Accountant is not required
accounting as well as audi
Knowledge have knowledge of audit techniqus
techniques and procedures.
and procedures.
th
work is conduced The Audit may be conducted at
10. Duration The accounting th
throughout the year. end of the year or throughout
year.

AUDITING AND INVESTIGATION

It
purpose in mind. r

of books of account is conducted with a specific

An investigation position, extent of
fraud
an inquiry relating
to earning capacity, financial
over
nisappropriation etc.
 1.6
Introducti
nC variOUs points of difference between auditing andinvestgation are as follows :
Basis of Diference Investigation
Auditing
1. Scope The main purposc of auditing is to Investigations have ceriain
specified
objects, like future
carning capacity
sce whether the balancc shect shows
truc and fair vicw of statement of cxlent of suspected fraud and amis
affairs of the busincss and the prolit appropriations, matters concemin
purchase of business. ing
and loss account shows truc and fair
VICW of operating results during the

ycar.
2. Period covered Audit of accounts is usually for a Investigation covcrs scveral years sav
2, 3 or 5 ycars to find out averape
financialycar.
carning capacity, inancial position
etc.

3. Statutor Audit of accounts is statutory Tnvestigation of accounts may or may

Requirement require-ment as per Companies Act, not be statutory requirement under
Companies Act, 2013.
2013.
4. Initiated by Investigation may be
Audit is always initiated by nornally
carried out on behalf of outsiders who
Outsiders or proprietors only.
either want to purchase the business
Proprietors
or to become partners, to advance
loans etc.

5. Investigation of In the ordinary sense investigated The audited accounts are further
audited accounts accounts are not audited. investigated for some special purpose
inview.
6. Evidence In case of auditing, the auditor is The investigator looks for substantive
concerned only with_prima facie evidence and even conclusive
evidence are also seen.
evidence
7. Qualification Audit of companies can only be The investigator may not be
conducted by a qualified Chartered necessarily a qualified Chartered
Accountant.
Accountant.
OBJECTIVES OF AUDITING
The principal objectives of auditing are changing with the advancement of business
techniques. Earlier it was only to check the correctness of receipts and payments, which was
extended to detection of frauds. The methods of auditing of accounts have improved, the detection
of frauds is simply an incidental object. The main objective is not detection of frauds and errors,
unless the auditor is appointed for only this purpose.
This main object of the audit is to find the reliability of financial position and profit and loss
statements.

The purpose of the opinion is to assure otheis that current, objective standards of information
and presentation have been observed. Standards to which both profession and public bodies have
contributed for many years, standard designed to provide readers of financial statements with useful
information." -Kohler
 1.7
Introductlon
accounts reveal a true and
fair view of the business
oday the main object to ensure that the ascertaining the reliability ot
This leads to greater emphasis being placed on
and
its transactions. the the assets and liabilities and
accounts are drawn up and also on veritying
records from which -Taylor & Perry
transactions within the accounts."
of auditing is to state
whether
AS per 143 of the Companies Act, 2013 the main object
Section of
balance sheet, of the financial state of affairs
accounts give a "true andfair view" in case of the profit or loss
ne of profit and loss account, of
company at the end of financial year and in case
the
for its financial year judgement and
of auditing is to form an independent
I can be concluded that the main object state of affairs
and
and truth and fairness of financial
opinion about the reliability of
accounts

working results.
Audit
Objects of a n

Subsidiary Objects
Main Object Detection and prevention of fraud
I.
Verification of accounts of errors
II. Detection and prevention
and finarcial statements.

(A) Main Object of Audit date balance shee

audit is and establish that at a given
to verify
The main object of an and loss accoun
of the business and the profit
and fair view of financial position
presents true
It is to be established tha
or loss for the accounting period.
the true and fair view of profit
gives
certain degree of reliability.
accounting statement satisfy
accounts are kept according t=
under Companies Act that whether the books of
It is required
true and fair view of the state of
affairs of the company.
the Act and whether they show
to conduct an independent
review of financial statement about their reliability-
/The auditor has
internal control and intermal
the auditor must examine the system of
;toform such an opinion, entered in the book=
arithmetical accuracy of books of accounts, validity of transactions
check,
values of assets and liabilities.
and confirm the existence and
of accounts, the auditor must
To judge the accuracy of the books

i) assess of internal control;

the system

(i) verify the accuracy of posting,balancingetc.

(i) confirm the validity of transaction wih supporting documents;
and items;
distinction has been made between capital
revenue
(iv) ascertain whether
(v) confirm existence of assets and liabilities.
maintenance of books and records have bee
(vi) ascertain all statutory requirements of
complied with.
Audit
(B) Subsidiary Objects of an
I. Detection and Preventon of Fraud
intentional misrepresentation of financial information by one or more
Fraud refers to
employees or third parties. Fraud may involve:
individuals among management,
 1.8
introductio
a) manipulation, falsification or alteration of records or documents,

(b)misappropriation of assets.
c)suppression or omission of effect of transactions from records or documents.
dy
recording of transactions without substance.
(c)
misapplication of accounting policies.
When something is being done with an intent to deceive, to mislead or to conceal the truth
S an art of fraud. It is false representation or entry which is made with some mischiev"it
objectives intentionally to defraud certain persons. Frauds are more dificult to detect vous
than
unintentional crrors. Detection of fraud is one of the principal functions of the auditors. Ftal
may be divided into following categories
Frauds

Misappropriation of Cash Misappropriation of Goods Manipulation of Accounts

1. Embezzlement or Misappropriation of Cash. Misappropriation of cash is usually done
by theft of cash receipts, petty cash. cheques, negotiable instruments, showing fictitious payments
t oworkers. creditors. purchases etc. Misappropriation of cash is very easy. A person with a little
etfort can misappropriate cash particularly in large scale business where contact between the
owners of business and the person handling cash is not very close. Particularly when a person is
not subject to any form of check, such person has a number of opportunities and methods of
committing frauds, but in a small business the possibility of such fraud remaining undetected is
remote. But with the increase in size of business, the opportunities of committing fraud also
increase because the owners of the business have no direct control over receipts and payments of
cash. The transactions relating to the receipt of cash are omitted from the records or recorded with
the lesser amount in the cash book, thereby all such cash or a part of it is pocketed by the cashier
Similarly, false payments of cash or over payments of cash are shown in the cash book. A strict
control system shall be adopted for receipts and payments of cash so that work of one clerk is
automatically checked by another. This technique of audit is known as internal check.
A number of examples of misappropriation of cash can be quoted
(i) Recordingfictitious purchases and thereby cash involved therein is mis-appropriated.
(ii) Omitting credit note received from the suppliers and discount allowed by them.
(ii) Showing payment of wages to dunmmy workers in the wage sheet thereby mis-
appropriating cash involved therein.
(iv) Various receipts like bad debts recovered, sale of scrap or rejected stock may be
concealed.
(v) Omitting the records of donation receipts by recording lower amounts on the counter
foils of receipt book.
(vi) The credit sales may not be recorded and money received from customers pocketed.
(vii) Cash sales may not be recorded at all and money received therefrom may be mis-
appropriated customers pocketed.
(viii) Teeming and Lading' method may be adopted in which money received from a
customer is pocketed and when later on money received from another customer may be
Introduction 1.9
shown as received from the former customer. This process may be continued for a long
time till the fraud is detected.
(ix) Cash received sale or retum or V.P.P. may be
from pocketed.
(x) Certain false payment may be shown on the credit side of cash book or excess amount
of payments may be shown.
2. Misappropriation of goods. The mis-appropriation of goods is easy in case of a business
which produces or deals in goods of high value and less bulky. Usually businessmen do not bother
much for defalcation of goods as compared to mis-appropriation of money. This type of mis-
appropriation is difficult to detect unless proper records are maintained. Defalcation of goods can
be done by
(a) Issuing false credit notes to customers for sale returns and such goods are mis-
appropriated.
(b) Goods may be stolen by employees from the godowns.
It is not easy to detect mis-appropriation of goods. Only the efficient system of record
keeping, periodical checking, internal check and adequate security arrangements will be helpful to
avoid mis-appropriation of goods.
Where such systems are efficient and good, two or more persons must have committed such
fraud, thereby it becomes more difficult to detect. Mis-appropriation of goods can be detected by
thorough checking of records and physical verification of stocks as well as purchases and sales
very carefully.
3. Manipulation of Accounts. This type of fraud is committed by upper level of management
with the different objectives to mislead certain parties within or outside the business. Whenever
such fraud is committed it usually involves large amounts and is intentional. This type of fraud is
usually committed by Managers, Directors, Board of Directors etc.
Usually falsification of accounts is done without
misappropriation of cash or goods. By
making false entries in respect of expenses, sales, purchases, valuation of stocks etc., the business
accounts are falsified which may not result in similar
mis-appropriations.
Mainly, two types of motives are behind such manipulations
(a) Showing low profits than the actual ones
) To give a
wrong impression about success of the business to competitors.
(i) To reduce or avoid payment of income tax.
(ii) To purchase shares at a lower price in the market.
(b) Showing more profits than what
actually they
are
i) The manager may get more commission if such commission is calculated on the basis
of profits earned.

(i) To sell the

shares at a high price by
hold shares of the company.
declaring
higher dividends, this is done when such
person
(ii) The services of such persons may be retained
by showing more profits to the
shareholders thereby the confidence of shareholder is maintained.
(iv) To mislead financial institutions for
the business is shown better than what
obtaining further credit, the financial position of
it is.
actually
 1.10
introduction
to attract more
shares to the public,
en ihe company is in the process of issuing
sbscribers for such shares.
to show credit worthiness
to creditors, bankers etC.
may be done inflated rate of dividend,
i g h profits may be shown than what
actually are, to declare
devices
alsification of Accounts may be resoried by using following
be inflatced or suppressed.
1)rchases or expenses may

(11) Sales or other incomes may be inflated or suppressed.

(1) Stocks may be over or under-valucd.

expenses.
Omssion of cxpenses outstanding or prepaid
of adjustment
or omitted altogether.
Depreciation assets may be over orunder charged
on

undervalued.
) A s s c t s or liabilitics may be over or
or vice-versa.
as revenue expenditure
(V)
Treating capital expenditure reserves of previous years
deflate the profits or secret
C) Seeret may be created to
reserves
of shareholders.
without the knowledge
may be used to inflate the profits
or prepaid
incomes of previous year may not be
(X) Outstanding expenses of current year
adjusted to increase the profits.
incomes of current year may not
expenses of the previous year
or prepaid
(x)
Outstanding
be adjusted to inflate profits of the current year.
business is shown in such a way that it
(xi) Window Dressing. The financial position of the
of mis-representation
seems better than what actually
it is. Window dressing is more
than fraud. it may be done in any of the following ways:
current year may be shown as of
next year.
(a) Purchases of
(b) Income of the preceding year may be shown as of the current year.
may be shown as
of next year.
(c) Expenses of current year
term liabilties.
(d) Showing short term liabilities as long
(e) Charging revenue expenses as capital expenditure.
DOver-valuation of closing stock.

(8) Over-valuation of assets or undervaluation of liabilties.

1. Detection and Prevention of Errors

Generally erors are the result of carelessness on the part of the person preparing the accounts.
Auditor should be
Sometimes errors may be the result of fraudulent manipulation of accounts)
to be an error. During the
very careful because sometimes an accounting manipulation may appear
course of auditing. errors may be detected, though auditing does not ensure detection of all errors
and frauds.In case of sole traders and partnership firms, detection of errors and frauds is an

important objective.
An error is an unintentional mistake or misdescription in the books of accounts or records
whether by way of:
a ) Clerical or mathematical mistake in record or data,

Ab) Oversight or misrepresentation of facts or

c Misapplication of accounting policies.
Introduction 1.11

An is
error
generally taken to be innocent and not delibrate.

Classification of Errors

Errors of Errors of Errors of Errors of Compensating

Principle Omission Commission Duplication Errors
1. Errors of Principle
When principles of book-keeping, and accountancy are not followed in the treatment and
recording of item of a transaction.it is known as error of principle. Following are the examples of
such types of errors
(a) Item of income posted to a personal account like rent received credited to the personal
account of the person making payment, it will reduce the profits and increase creditors
in the balance sheet.
(6) Item of expenses posted to personal account like rent paid to landlord posted to the
debit of his account thercby profits will increase as well as debtors in the balance sheet.
(c) Wrong allocation of expenditure between capital and revenue, Revenue expenditure
may be treated as capital expenditure and vice Repairing of plant and
debited or charged to machinery account instead of
versa.
machinery
repairs account, it will inflate the
profits and increase value of plant and machinery in the balance sheet. It will not show
true and correct view of financial
position
of business.
(d) Revenue items posted to a wrong account when salaries are posted to
general expenses being posted to advertisement account. These errors wages account oor
do not affect the
net profits of a business but correct
picture of business accounts is not available.
(e) When valuation of various assets is not
made as per the
valuation of stock, investments, principles of accountancy like
and plant machinery etc. These errors have great
impact on the financial statements prepared for the business.
( Some other errors of principle debts:
i ) wrong provision for doubtful debts
(i) providing inadequate depreciation.
(ii) providing excess
depreciation.
(iv) wrong
provision for outstanding expenses or prepaid
In the above expenses.
examples the treatment of an item is not
accounting principles. Sometimes such errors are committed according to generally accepted
accounts. Ultimate with the object of
purpose of such may be to inflate or
deflate
manipulation of
may be committed unintentionally. profits. Sometimes these errors
Such errors are not
disclosed in the trial balance, debit and credit sides of
same. Such errors can be
detected by thorough transaction are
Errors of principle afect the checking of each and
every transaction.
reliability of financial statement.
2. Errors of
Omission
When a transaction is omitted fully
are known as errors of
or
partially from books of accounts, such
omission.JUsually it arises due to mistake of clerk. types of errors
Where the transaction is
 ntroauci
uction
totally omitted from the books, it will not affect trial balance, and hence becomes more difficult to
detect. Such errors can be detected only by careful scrutiny.
Following are the examples when the transactions are fully omitted from the books of
accounts

A) Omission of purchases from Purchases Day Book,

i) Omission of sales from Sales Day Book.

(iii) Omitting the entry for charging depreciation in the books.
iv) Rent or interest for cleven months, the remaining amount which is unpaid or

outstanding has not been recorded in the books.

The above transactions ought to have been recorded in the books of accounts but due to
mistake or oversight or carelessness, have been totally omitted from the books. Such mistakes can
be detected by careful checking and verification. Such omission of transactions may he
unintentional or otherwise.
In certain cases the transactions are partially recorded. These errors may affect trial balance.

partially omitted from the books of

Following are the examples when the transactions are
accounts.

i) Entry for purchases omitted from the account of supplier or total of purchases day book
omitted to be posted to purchases account.

is omitted from the account of customer or total of sales day book

(i) Entry for sale
omitted to the posted to sales account.

(iii) Omission of cash receipts or payments to be posted to ledger from cashbook.

of omission there must be 12 entries on the debit

easy to locate, such as
Some of the errors are

is less than 12, the auditor

side of salary or rent account during one year. If the number of entries
can easily locate the omission. But
those omissions, which are completely omitted from the
of vouchers may help the auditor to
books, are difficult to locate. Thorough checking of sequence
locate such omission. Attention must always be drawn if
there is a big break in the series of
vouchers. Omission of purchase vouchers from the books is difficult to locate. But when payment

purchase entry appears in the account of such supplier, the

is made to a supplier for which no
omission can be located.
otherwise. But in both the cases, profit or loss of the
Errors of omission may be intentional or

year is affected.

3. Errors of Commission

When entries made in the books of original entry or ledger are incorrect, wholly or partially,
these arise due to negligence in recording of some
such errors are of commission.) Usually errors

errors may or may not affect trial balance,

business transactions in the bóoks of accounts. These
be intentional or otherwise.
profitand loss account and balance sheet. These errors may
Following are the examples of errors of commission
purchased Goods for
Wrong recording in the book of original entry-wholly or partially.
1,000 recorded in purchases day book as 100 or goods of 500 purchased from
book. Such do not affect
M. & Co. recorded as from N. & Co. in Purchases day errors

trial balance.
 1.13
Introductlon
(b) Wrong totalling of book of original entry-while totaling sales day book or purcnase
short and
is totalled 7 100
day book mistake is made in the total. Sales day book total
the credit side
will affect trial balance.
accordingl posted to the ledger. This error

100.
will be short by 7 100. It will also lower the profit by
1000 posted to customer s
or posting to the wrong account. Sales
of
CwrOng posting side short by
difference being debit
account asT00. Trial balance will reveal the this
Sohan's account,
Mohan posted to debit of
900. salce
Similarly 500of goods
to
error will not be revealed by trial balance.
account it may be wrongly
(aPosting to wrong side of an account,
instead of debiting an their
& Co. posted to the debit of
purchases from X
credited and vice versa. Say
revealed by trial balance.
account. This error of omission will be trial
accounts to the
trial balance. While preparing
forward of balances of correct. The
(C) Wrong carry may not be
from the ledger
of accounts
balance, carry forward of balances thc wrong amount or
on the wrong
be carried forward with on the
balances of may
accounts
balance may be shown
discount account debit
side of trial balance. For example,
in
account of 180 may be shown
debit balance of an
credit side of trial balance
or a

108 or 100.
the trial balance as 7 18
or
credit sales to X
transaction. For example,
book used for recording a to Y & Co. were
() Wrong subsidiary book or credit purchases
& Co. were recorded
in purchases day disclosed by trial
commission will not be
recorded insales book. This error of
day-
balance. twice in the book
When a transaction is posted
(g) Qther examples of errors of commission. in the ledger is made twice
or balance of account
or posting to account
of original entry
trial balance.
is shown twice in the

4. Error of Duplication will

recorded twice and also posted
twice in the ledger. an
)Such error

transaction is copies of
When a sends the invoice in duplicate
and both the
trial
affectbalance. Sometimes supplier
not
the bill are recorded separately.
and comparing of vouchers
It is more difficult to locate such
errors. Only thorough checking account
While going through an
books of original entry will reveal such errors.
with entries in the with the same
same side are appearing
if two entries on the
will reveal errors of duplication,
amount.

5. Compensating Errors
error.
such error is known as compensating
another error,
(When an error offsets the effect of trial balance, hence can't be located by it. Following
are

do not affect agreement of

These errors

the examples of such errors

of his account is under-totalled by
X's A/c is debited with 7 90 short and credit side
)
90. over-casting of an other
of one account is compensated by
Sometimes under-casting over-totalled by-
) under- totalled by 100 and Y's A/c is
A/c is
account, such as X's
100.
and casting. Some of these
error=

checking the totals, posting

These errors can be located by
may affect the profits of the year.
 1.14 Introduction
How to Detect Errors ?
How an auditor can detect an error when he is called upon to do so although it is not his duty.
an
auditor does so, he does it as an accountant not as an auditor. Location of an error depends
on environment in the organisation. He may pass a small difference provided that he has satisfied
Dimself that books have been thoroughly examined. But there is always a danger in passing such
error.

The auditor may take following points into consideration while detecting an error:

.Ivarious books are maintained on self balancing system, errors can be located by
scrutiny of such books.
2. If self balancing system is not used, then the trial balance should be checked and ledger
accounts balances shall be compared with those shown in trial balance. It is possible
some balances in the ledger might not have been transferred to trial balance.
3. Check the totals of trial balance. It is possible that there may be totalling mistake.
4. Compare the balances of accounts in trial balance with balances of accounts in the
ledger. It is possible that some balances or accounts might not have been properly
transferred to trial balance.
5. In case there is any difference in trial balance, see if there is any account having similar
balance which is not taken to trial balance. Half the difference in trial balance and
compare it with balance of an account, as the accounts balance may be taken on the
wrong side in trial balance.
6. Ascertain the nature of account asset account, expense accounts, reserve for discount on
creditors accounts always have debit balance; ensure that these are shown in the proper
column of trial balance. Similarly liabilities accounts, income accounts, capital accounts
and reserves have credit balances and must be shown in credit column of trial balance.
7. If still there remains difference in trial balance, check the balances of ledger accounts
with trial balance.
8. Examine the totalling and balancing of each account in the ledger and see that balances
are carried forward to the next page.
9. Total the list of creditors and debtors and compare it with the balance shown in trial
balance.
10. Verify the total of subsidiary books and their posting to ledger.
11. Compare items of trial balance with the items of trial balance of previous year to see if
any account balance is omitted.
12. An eror of Re. 1, T 100, F 1000 may be due to wrong totalling.
13. If the difference is in rupees or paise, it may be due to wrong balancing or wrong
posting.
14. See that all journal entries are posted to ledger.
15. If self-balancing ledger system is maintained, see that balances in control account tally
with total of balances of personal accounts of the ledger.
16. Over and above all this, intensive and careful verification of subsidiary records,
vouchers and ledger is the only remedy for locating an error.
Introduction 1.15
BLOOD HOUND
AUDITOR IS WATCHDOG, NOT A
(Auditor's Duty) was made
the above reference
If the famous case of Kingston Cotton Mills Company (1986)

by the learned Judge Lopse L. J. work with suspicion,

or
wih the
to approach his or is
"An auditor is not bound to be detective
watch-dog but not
a blood-hound. He
something wrong. He a is representauon
foregone conclusion that there is and is entitled to rely
upon their
in believing tried servants of the company
Justified
provided he takes reasonable care."
drawn from the judgement: of the
The following conclusions can be c a r e of
interests of the
owners

auditor must take whenever

The the
(i) An auditor is a watch dog.
owners

alert and inform

to remain
its effort to detect
business. The watch dog is kept by owners

he should
make every
by
is the position of a n auditor, this should be
conducted
arises. Same
any suspicion interest of his client. All
can protect
the
erTorsand frauds so that he full-
hound. He is
the auditor honestly and tactfully. auditor is not that
of blood
thei
blood-hound. Duty of and is
entitled to rely
upon
i ) Auditor is
not a wh
of the company harm those
the tried s e r v a n t s the part of his duty to
justified in believing reasonable care.
It is not He shall n
misappropriation.
he takes or
representation provided for negligence sincere and
hone-
found responsible systematic,
or are auditor must be
have been found guilty The
whose work
he is to certify.
harm the persons
duties. Not only
his work. of auditors's
while conducting important part future. Such ja
and frauds is ensured in
an

of errors should be
The detection
but also their prevention the officers
who
and frauds committed
are
by
of such or frauds
errors
detection
because such
errors

difficult for him,

sincere.
is really responsible
and
to be honest,
presumed
Frauds financial
stateme-

of Errors and mis-statement in the

Detection
(i) material for detecti
that there is
no
skill and care

has to ensure
certain degree of books-
The auditor to exercise
vouching thoroughly
frauds. He has
from e r r o r s
and
through checking and
arising accomplished i n f o r m a t i o n and
data available.
This c a n be
frauds. relevant
e r r o r s and vouchers and
other
to certify
the financ
accounts, his o w n field
accounts, ledger expertise of checks
knowledge and and levels of
has professional decide the degree
to correct
The auditor truth. He has certifies the
a c c o u n t s as

f a i n e s s and he
and frauds. If
their whici
as to or fraud
detection of for an e r r o r
statements errors

for responsible
be applied can't be held
scrutiny to and belief, he
his knowledge
the best of statements.

the financial
still there in
Frauds completing
the a-
of Errors and and frauds. After
Prevention errors to pre-
various ways
(ii) directly to prevent
regarding
cannot do anything suggestions
Auditor client making by be
advise his
can
suggestions
auditor can that. The
work, the is asked for
and frauds
in future if he
errors
systems.
Changes in accounting is taken
(a) Control Systems.
Internal minimised if his
advice

Improvement
in can be
(b) and frauds
chances of errors

the
In future,
 Introduction
nroduction
mplemented in right spirit. The visits made by the auditor to check accounts keep moral check on
h e staft
engaged in preparing the accounting books. They know that accounts are finally to he
audited and any fraud or error will be detected.
The Institute of Chartered Accountants of India has expressed that while conducting an audit
he auditor shall keep in mind that there is every possibility of existence of fraud or
misappropriations or irregularities in the accounts. The auditor's report may not fully disclose the
above unless, he is careful about these items at the time of audit. If the audit is conducted with the
sole object of discovering a fraud, it will take lot of time and auditor may not be able to complete
his work in time.
By signing the auditor's report, auditor's does not guarantec that no fraud exists. If he has
conducted audit with due care and skill as per professional standards expected from him, the
auditor can't be held responsible for not detecting a fraud.
The auditor shall follow the following standards while performing his duties
1. He shall assess the internal control system in force and verify its working.
2. It shall be ensured that accounting principles are followed while recording the business
transactions.
3. It shall be examined whether policies of management have been followed while
recording accounting transactions.
4. It shall be examined that various accounts have been prepared as per provisions of
Companies Act.
5. It shall be checked whether Profit & Loss Account and Balance Sheet exhibit true and
fair view of state of affairs of the concern.
Whether an auditor is responsible for the non-detection of errors and frauds will depend on
thefollowing factors
1. He has fulfilled his duty as per the prevailing standards of profession.
2. He has used a reasonable degree of skill, care and intelligence while performing his
work.
3. He has taken into consideration all such materials which can lead to a suspicion about
some error or fraud.
4. A damage or loss has arisen on account of negligence on his part.
5. He has believed a substantial accuracy in the statement of accounts.
The auditor cannot check each and every financial transaction, test checks are applied on the
material items, which are subject to certain degree of risk. Frauds are committed which are
difficult to be detected within a short period. Sometimes management may also commit
irregularities thereby making false representation intentionally which cannot be detected by
auditor easily. Management is responsible to introduce internal control system to reduce chances
of frauds and errors. The evidence available to auditor may not be conclusive in all cases. All
these instances make it difficult for auditor to detect errors and frauds. In all such circumstances,
the auditor will be taken as performed his duty if he has applied reasonable skill and diligence as
is required in his profession. The auditor is expected to audit the accounts as per generally
accepted auditing practices. The auditor is relieved of any mis-statement due to errors and frauds
as indicated in the audited financial statements. The degree of care, skill and diligence will be
aetermined by the specific circumstances of each case.
Introduction 1.17

It can be concluded regarding position of audior in regard to frauds and errors:

(a) If the auditor has carried out the audit as per generally accepted auditing principles. ne

is not liable for mis-statement of financial information.

(b) If any fraud or error is discovered during the course of audit, he should see that errors
are corrected and information about fraud is reflected in his report. The fact must be

brought to the notice of all concerned at the earliest.

(C) As a watch dog he shall not unnecessarily sniff for errors or frauds, but if something

wrong smells out, he shall not overlook it carelessly. The verifications and checking
must be widened to bring out any error or fraud.
and
(d) We should not forget that it is the responsibility of management to prevent frauds
errors.

QUALITIES OF AN AUDITOR
as auditor of a limited company.
Only the qualified Chartered Accountant can be appointed be
He must have adequate skill and qualities to conduct his
work efficiently. Above all he should
a man of integrity and character.
The auditor must possess the following qualifications and qualities:
of all aspects of
principles and practice
1. The auditor must have thorough knowledge of has to
with all systems of accountancy in use. As he
accountancy. He must be familiar
understand their method of preparation.
deal with different accountacy systems, he must
transactions no or inadequate information may
2. He has to be tactful because for certain
from his clients.
be available he has to extract such information tactfully
laws as per the various cases decided
3. He must have thorough knowledge of audit case
decisions are helpful in conducting audits and
by Courts in and outside India. These
determining the scope of his powers and duties.
industrial administration
4. He should have adequate knowledge of financial management,
and business organisation.
believe to be true
5. An auditor must be honest i.e. he must not certify what he does not
certifies is true
and he must take reasonable care and skill before he believes what he
(Lord Justice Lindley).
6. While discharging his duties, he must act impartially and not influenced by others,
directly or indirectly.
7. He should be able to understand the technical details of business whose accounts he is
enquiries from the client as well as
going to audit. For this purpose he may make certain
visit place of work of his client.
8. He must have upto date knowledge of Companies Act and Mercantile Laws.
9. He must have thorough knowledge of Principles of Economics and Economic

Legislations because these affect the business whose account he has to audit.
10. He must be familiar with Principles and Practice of Cost Accounting for performing
Cost Audits.
11. His decision must not be affected when his own interest clash with his duty towards his
elient. In such situation he shall be bold enough to discharge his duties bonestly and
faithfully. It will enhance his reputation in future.
 1.18
Introductlon
2. circumstances of suspicion arise it is his duty to probe them to the bottom. This is the
case when he comes to do his duty, he is bound to assume that he is dealing with
fraudulentand dishonest people.
13. From time to time he should seck clarification on the matters which he is not able to
understand from the information provided to him.
14. He should have high moral standards and should not accept and sign a report or
statement which he does not helieve to be true and fair.
15. He should be hardworking, systematic and methodical.
16. He must have adequate common sense.
17. He must have capacity to hear arguments of others
18. He should not disclose the secrets of his clicnt.
19. He should have adequate skill and courage to write audit report correctly, clearly,
concisely and forcefully.

SCOPE OF AUDITING
As we know, auditing is concerned with verification of accounting data and determining the
reliability and accuracy of financial statements. In the carlier days the objective of audit was
detection of frauds and now it is extended to determining true and fair view of financial
statements as well as detection and prevention of frauds. Along with this, new concepts of
auditing are coming up like Tax Audit, Cost Audit, Management Audit, Operational Audit ctc. All
this has enhanced the scope of audit. All the countries of the world have come out with various
legislations to frame rules and regulations for the conduct of independent audits. The purpose of
auditing has been extended to audit of cost accounts management policies, managerial efficiency
etc. Even non-business organisation avail the services of professional auditors and get their
accounts audited.
The main purpose of financial audit is that auditor has to detect errors or omissions
committed by accountant and his staff while preparing financial statements and to certify the
correctness of financial statements. For all this proper verification of accounts must be made,
otherwise the results obtained will not be reliable. Due to various reasons and ways accounting
books may be inaccurate or incorrect. Auditor has to bring all this to the notice of owners of the
business,
The auditor should not only check the accuracy of accounts but should also satisty himself
whether the books of accounts show atrue position" (London and General Bank (1895)case
Verification of accounting data involves:
(i) Examination of arithmetical accuracy of accounts.
(ii) Verification of books of accounts by comparing it with vouchers, invoices, day book,
minute books, correspondence etc.
(i) Verification and valuation of assets and liabilities as shown in the balance sheet.
(iv) On the basis of findings, reporting to clients.
In fact, circumstances of each case will determine the extent to which an auditor should
conduct examination of account. Scope of auditing will depend on the following:
6) The terms of reference under the contract for audit will determine what is required to be
done
 1.19
I n t r o d u c t i o n

case of limited company, the

audit report shal be justified by the work of audit. In
i) The an annual general meeting.
on annual statements before
auditor has to submit his report
audit work is determined as per
the discretion of auditor. The
extent of
gii) The are no hard and fast rules.
of cach case will determine it as there
circumstances
determine extent to which
auditor shall review internal control system as it will
(iv) The
accounting data is reliable. data.
checks may be conducted to determine the arithmetical accuracy of account
()Test
data.
shall ask for supporting evidence for accounting
(vi) The auditor
entries passed in the books. A
The auditor shall satisfy himself about the correctness of
(vii)
shall be exercised in this regard.
reasonable degree of skill and care
an information the matter
shall be properly and
In case of suspicion regarding
(viii)
thoroughly probed.
involves bringing out
an auditor are
determined by scope of audit which
In fact duties of
inaccuracies in the books
of accounts.

Techniques of Audit
the
used bythe auditor along with obtaining and accumulating
The methods and means
The auditor's most commonly use the following
evidence, all are part of audit techniques.
techniques:
1. Checking of posting and casting.
of various assets.
2. Counting and physical examination
evidence available as well as from other sources.
3. Confirmation of transaction from
4. Making enquiry.
5. Scrutiny at the end of year.

6. Re-computation of various calculations already made.

7. Tracing of Balances caried forward in the subsequent period.
8. Bank Reconciliation Statements used for Banking transactions.

BASIC PRNCIPLES GOVERNING AN AUDIT

The basic principles which govern the professional responsibilities of auditor which should be
complied with whenever an audit is conducted. Various principles are explained as follows
1. Integrity, objectivity and independence. "The auditor should be honest and sincere
towards his work. He must maintain objectively without any basic or prejudice. He must have
impartial attitude, free from any interest while conducting an audit.
2. Confidentiality. The information acquired during an audit should be kept confidential. It
shall not be disclosed to third party without permission from client or when he is legally or
professional bound to do so.
3. Skill and competence. Audit work shall be conducted by the persons who have adequate
training, experience and competence in auditing. They also need to be aware continously of
developments in accounting, auditing and statutory rules and regulations as amended from time to
ime.
 1.20

4. Work Introduction
on
performed
inancial information
by others. The auditor remains
Oher auditors. He
when he delegates audit work responsible for expressing his opinion
to assistants or used the work
is done by
permitted to rely on work done by others
arc and there is
no reason not to provided he exercises due skills
and
Dranch audit who place such reliance. In case an other auditor has
was
appointed by the company, he must make reference thereof in his conducted
S.
Documentation. The auditor must prepare report.
and preserve all the documents
conducting an audit. These may be used as evidence that audit was conducted as per the
while
principles. basic
6.
Planning. To conduct the audit in time and
efficiently the auditor should
The audit plan should cover: plan his work.
(a) client's
accounting system. policies and internal control system.
(6) what extent lInternal Control
to
System can be relied upon.
(c) determining the audit
procedure to be used.
(d) coordinating the audit work.
7. Audit evidence. The auditor should obtain
sufficient appropriate evidence before
conducting an audit. It should be obtained by subtantive and compliance procedure. Substantive
procedure will provide evidence of completeness, accuracy and validity of data produced by
accounting system whereas compliance procedure will indicate whether internal control system is
used as stated.
8. Accounting system and internal control. Management is responsible for maintaining an
adequate accounting system and incorporating internal controls as per the requirement of
business. On the basis of accounting system and internal controls used in the business, the auditor
will determine the nature, timing and the extent of audit procedures to be applied.
9. Audit Conclusion and Reporting. The auditor should express his opinion on financial
statements on the basis of his review and assessment of audit evidence and knowledge of
business. It involves overall conclusion as to whether:
(a) financial information has been prepared using acceptable accounting policies, which
have been applied consistently.
(b) financial information complies with relevant regulation and statutory requirements.
(c) there is adequate disclosures of all material matters relevant to the proper presentation
of financial information, subject to statutory requirements, where applicable.
The audit report should be prepared expressing a clear opinion on financial information. The
report should be prepared as per the term and contents prescribed by law, regulation or agreement.
An unqualified report means that auditor is satisfied in all material reports of above. In case of

qualified report, an adverse opinion is given regarding any or all of the above matters along with
the reasons.

ADVANTAGES OF AN AUDIT

Importance of auditing be judged from the fact that even those organisations which are
can
not covered by Companies Act, get their financial statements audited. It has become a necessity
interested to know the
for every commercial and even non-commercial orgaisation. People are
true facts about their business which are helpful to them
for future planning and improvements in
operations.
 Sold trader is
maintain healthy interested in knowing whether the 1.21
true relations among the business is conducted efficiently
financial statement must partners, case of
in or not. To
ownership and management in be made
known to every partnership business, it is important that
to-day administration. join stock partner. Because of
separation of
Sharcholders would companies, shareholders do not have
properly used or not. like know whether the amount
to knowledge of day-
audited from a Answer for all such invested by theme is
qualificd auditor. questions can be obtained by getting the accounts

Advantages of an Audit

For Owners of For the For the For the

Business& For Others
Management Creditors Government
Shareholders
Bodies
J. For the Businessmen and Shareholders
) In caseof sold trader, he can
on
depend
the basis of audited accounts
on the audited accounts. He can
value his business
for the purpose of sale of business
or for
new partner. admitting a
i) Dispute over the correctness of
audited accounts will be useful in
profits can be avoided. In case of partnership firm,
retirement of a partner.
valuing goodwill and business on admission and
(ii) Shareholders, who do not know about
day-to-day administration of the company, can
judge the
performance management
of from audited accounts.
(iv) Shareholders can value their shares on the basis of
audited financial statements.
2For the Management
) It helps the management is detecting and
preventing errors and frauds.
(ii) It keeps the accountants and staff
know
vigilant while preparing books and records as they
in advance that
all the accounts
are to be audited.
(ii) Claims due to fire, theft and accident can be estimated from audited accounts.
iv) Management gets advice on financial affair from the auditors who have expert's
knowledge.
(v) Because the audited accounts are uniformly prepared over the year, comparison of such
statement becomes easier.
3. For the Creditors
) Long-term and short-term creditors can depend on audited financial statements while
taking decision to grant credit to business houses.
4. For the Government Bodies
i) Taxation authorities depend on audited statements in assessingtheincome-tax, sales-tax
and wealth-tax liability of the business.
(ii) Audited accounts can be produced in the Court to provide an evidence.
(ii) Audited accounts are useful for the government while granting subsidies etc.
 1.22
Introduction
S. For Others
( ) t can be used by insurance companies to settle the claims arising on account ofloss by
fire.
(ii) In of
case
amalgamation and absorption, the purchasing company can calculate
purchase consideration on the basis of audited accounts.
(ii) It safeguards the interests of the workers because audited accounts are useful for
settling trade disputes for higher wages or bonus

Limitations of Audit
The audit of accounts suffers from several limitations also. Some of the limitations are as
follows:
1. The audit may not give complete picture. If the accounts are prepared with bad
intentions and for that fraud is committed, auditor may not be able to fully unearth
them.
2. Sometimes the auditor has to depend on explanations, clarifications and information
from staff and client. He may or may not get correct or complete information.
3. Under law, shareholder's appoint an auditor, but in fact directors appoint him. Under
such situation he may not be an independent auditor.
4. Auditor has to seek opinion of experts on certain matters on which he may not have
expert's knowledge. The auditor has to depend upon such reports which may not be
always correct.

5. The auditing may not serve its purpose unless the auditors are independentand bold
Lack of these qualities may force him to give clean report even though certain
discrepancies existed.
6. Auditing is considered as a mechanical work. Auditors may not frame audit programme
from the viewpoint of particular situation.
7. Auditing is a post-mortem examination. What is the use of such examination when
events have already happened ?
8. It is very difficult to verify certainitems ie. stock-in-trade.
9 Success of audit depends on the sincerity with which auditor has performed his duties.

WUESTIONS
Multiple Cholce Questions
1. The primary objective of an indeperident financial audit is
(a) Detection and prevention of errors
(b) Detection and prevention of frauds
(c) Both (a) and (b)
audited
(d) To express opinion by auditor about truth and fairness of financial statements
by him.
2. The basic responsibility for prevention and detection of frauds and errors is of
(a) Management (b) Auditor
(c) Accountant (d) Company seeretary