Introduction to Audit

- Abhishek Jha
 History of Audit
• Phase -1 (1840-1920)
• Phase-2 (1920-1960)
• Phase-3(1960-1990)
• Phase-4(1990 till date)
 History of Auditing in India
• Companies Act 1913
• 1932 constitution of Accounting Board
• Charted Accountants Act 1949
• Companies Act 1956
• Manufacturing and other companies order
1975
• Companies Act 2013
 Definition of Auditing
• According to ICAI
• “Auditing is defined as a systematic and independent
examination of data, statements, records, operations
and performances of an enterprise for a stated
purpose. In any auditing situation the auditor
perceives and recognises the propositions before him
for examination, collects evidence, evaluate the same
on this basis formulates his judgement which is
communicated through his audit report.”
 Objective of Auditing
• Primary Objective(expression of opinion)
• Secondary Objective(Detection of errors and
frauds)
 Types of Errors
• Error of Principle
• Error of Omission
• Error of Commission
• Compensating Error
 Fraud
• Misappropriation of Asset
• Misappropriation of goods
• Misappropriation of cash
 Principles governing An Audit
• Integrity
• Confidentiality
• Skill and Competence
• Work performed by others
• Documentation
• Planning
• Audit evidence
• Accounting System and internal control
• Planning
• Audit conclusions and Reporting
 Advantages of Audit
• Authenticity of Accounts
• Detection of errors and frauds
• Identification of loopholes
• Acceptable to taxation authorities
• Increased creditworthiness
• Settlement of dispute among partners
• Settlement of insurance claims
• Helpful in making comparisons
• Accounts department becomes vigilant
 Limitations
• Time consuming
• Frauds not detected
• Costly
• Depends on judgement
• All frauds can not be detected
• Dependence on others
 Qualities of an Auditor

• Integrity
• Objectivity
• Independence
• Confidentiality
• Skills
• Responsible
• Intelligent
• Vigilant
• Communication skills
 An Auditor is a watchdog and not a blood hound

•In the case of a limited company, an auditor is appointed

by the company’s shareholders. He is expected to work on
their behalf in the role of a watchdog and should look
after their best interests.
•Unlike a bloodhound, the auditor’s main duty is towards
verification of the client’s books rather than detection.
During the course of his audit, if he finds something
suspicious, he should extend his audit procedures to
examine the matter in detail and should communicate the
same to the shareholders. However, in the absence of any
such suspicious circumstances, he is completely justified
in relying upon the representations made by the client’s
staff and management. When it comes to fraud and error,
he has to exercise reasonable care only.
 Features of an Auditor
• An agent: The auditor is an agent of the
company’s members assigned to execute tasks
outlined in (a) the Companies Act, (b) the
company’s Articles of Association, and (c) the
audit engagement between the auditor and the
client.
• Not an advisor: An auditor is not a company
advisor. It is not his responsibility to advise the
board of directors or the shareholders.
 Different types of audits

• Internal Audits. Internal audits assess internal

controls, processes, legal compliance, and the
protection of assets. ...
• External Audits. ...
• Financial Statement Audits. ...
• Performance Audits. ...
• Operational Audits. ...
• Employee Benefit Plan Audits. ...
• Single Audits. ...
• Compliance Audits.
 Difference Between Accounting and Auditing
Accounting
Definition
Accounting is referred to as the process of
recording, classifying, summarising and
interpreting the financial transactions,
statements to determine the financial
position of an organisation
Purpose
Accounting is done with the purpose of
showing the position, profitability and
performance of the business entity or
organisation
Objective
To determine profit and loss of the
organisation or the financial position of an
organisation for a period
Mode of operation
Accounting is done on a daily basis, as
transactions happen on a daily basis for any
business
Performed by
Accounting is done by accountants
Sequence
Accounting starts at the end of bookkeeping Auditing starts at the end of accounting
Auditing
Auditing is referred to as the process of
examining the financial records such as
transactions and statements of an
organisation in order to find any
discrepancies during the process of recording
of the transactions and also to verify the
accuracy of the records
Auditing is done to verify the accuracy of
data presented by accounting. It is done with
the purpose of revealing to what extent the
true and fair view of records is maintained in
the transactions
To determine the correctness of all the
recorded transactions
It is a periodical assessment and is done
monthly, quarterly or yearly
Auditing is done by auditors
 Types of Audit 1/3
Internal Audit

• Internal audits are performed by the employees of a company or

organization. These audits are not distributed outside the
company. Instead, they are prepared for the use of management
and other internal stakeholders.
• Internal audits are used to improve decision-making within a
company by providing managers with actionable items to improve
internal controls. They also ensure compliance with laws and
regulations and maintain timely, fair, and accurate financial
reporting.
• Management teams can also utilize internal audits to identify flaws
or inefficiencies within the company before allowing external
auditors to review the financial statements.
 Types of Audit 2/3
• Performed by external organizations and third parties,
external audits provide an unbiased opinion that internal
auditors might not be able to give. External financial audits
are utilized to determine any material misstatements or
errors in a company’s financial statements.
• External audits are important for allowing various
stakeholders to confidently make decisions surrounding the
company being audited.
• The key difference between an external auditor and an
internal auditor is that an external auditor is independent. It
means that they are able to provide a more unbiased opinion
rather than an internal auditor, whose independence may be
compromised due to the employer-employee relationship.
 Types of Audit 3/3
• Government audits are performed to ensure that financial
statements have been prepared accurately to not
misrepresent the amount of taxable income of a company.
• Within the U.S., the Internal Revenue Services (IRS) performs
audits that verify the accuracy of a taxpayer’s tax returns and
transactions. The IRS’s Canadian counterpart is known as the
Canada Revenue Agency (CRA).
• Audit selections are made to ensure that companies are not
misrepresenting their taxable income. Misstating 
taxable income, whether intentional or not, is considered tax
fraud. The IRS and CRA now use statistical formulas and
machine learning to find taxpayers at high risk of committing
tax fraud.
 Case Study - 1
Toshiba, a 140-year-old pillar of Japan Inc, is caught up in the country's biggest accounting scandal since 2011. In
2011, Olympus Corp was embroiled in a scandal. In July 2015, Toshiba Corp president Hisao Tanaka and his two
predecessors quit after investigators found that the company inflated earnings by at least $1.2 billion during the
period 2009-2014. Toshiba is one of the early adopters of the corporate governance reforms initiated in Japan. The
corporate governance structure met corporate governance standards. Time and again cases of corporate
governance failures have provided evidence that good corporate governance structure does not necessarily lead to
good corporate governance. Organisation culture is a critical determinant of the quality of corporate governance.

Some of the observations of the independent investigation committee of the company on internal audit demand
discussion and debate.

The investigation committee observes, "According to the division of duties rules of Toshiba, the corporate audit
division is in charge of auditing the corporate divisions, the companies, branch companies, and affiliated companies.
However, in reality the corporate audit division mainly provided consultation services for the 'management' being
carried out at each of the companies, etc (as part of the business operations audit), and it rarely conducted any
services from the perspective of an accounting audit into whether or not an accounting treatment was appropriate.“

The observations of the committee give the impression that the fault of the internal audit in Toshiba was that it
focused on consultation service rather than assurance service. Should internal audit avoid providing consultation
service? I do not think so. It was not the fault of the internal audit that it provided consultation service. The fault
was that it did not pay attention to accounting audit.

In Toshiba, the top management used to set targets that are unachievable. There was excessive pressure from the
top management to achieve those targets.
 Case Study – 1 (Cont1)
The variable pay is a significant portion of the total pay. The compensation of executive officers comprises a
base compensation based on title and a role compensation based on work content. Forty per cent to 45 per
cent of the role compensation is based on performance of the overall company or business department.
'Challenge' to achieve unachievable targets and performance-based pay provide enough motivation to manage
earnings. Therefore, accounting audit should have been a focus area for internal audit.

Internal audit can function independently only if the audit committee is capable, independent and effective,
and the internal auditor reports to the audit committee.

In Toshiba, the audit committee was neither capable nor independent. The three external members of the audit
committee had no knowledge of finance and accounting. An ex-Chief Financial Officer (CFO), who was the CFO
during the timeframe when accounting irregularities occurred, was the only whole time member of the audit
committee. Therefore, the internal audit was not independent of the management. Earnings management had
the tacit approval of the top management. Therefore, it is not surprising that accounting audit was excluded
from the scope of internal audit. It is incorrect to infer that the accounting audit did not receive the attention of
the internal audit because its focus was on providing consultation service.
 Case Study – 1 (Cont2)
Contemporary literature defines internal audit as 'assurance and consulting service'. The issue is of
balancing between consultation service and assurance service. Problem arises when the internal auditor
forgets that the internal audit is primarily an assurance function. The consultation service flows from the
assurance service. Although, the primary objective of operation audit is to obtain assurance that the internal
control that is installed to achieve operation objectives is adequate and operating effectively, the auditees
look to the internal auditor for suggestions and consultancy. Such consultation service is a by-product of the
assurance service. Auditees should not be denied the benefits of internal auditor's understanding of the
industry and the business, and the challenges before the auditees in achieving operation objectives.
Exclusion of consultation service from the scope of internal audit would result in sub-optimal utilisation of
internal audit resources.

Organisation culture also determines the effectiveness of internal audit. The investigation committee
observes, "A corporate culture existed at Toshiba whereby employees could not act contrary to the intent of
their superiors". In such a culture an upright internal auditor cannot survive, particularly if he is not
independent of the management. Perhaps, it is the reason that the internal audit in Toshiba had chosen the
easy path of focusing on 'consultation service' only without reporting internal control weaknesses.

Internal auditor is the 'eyes and ears' and 'go-to man' of the audit committee. Therefore, internal audit
failure leads to corporate governance failure.
 Audit Case Study - 2
• Fraud is a practice that can make businesses to undergo some massive losses. It is noteworthy
that a small company like XYZ has a small operating capital that could diminish drastically if
not well managed. Fraud cases such as skimmed payments from customers, cash theft,
improper handling of petty cash and misuse of the company’s credit cards are some of the
practices that can lead to total failure of a company.
• It is quite expensive for a small business like XYZ Ltd to create an internal audit department,
however, the company can create a system that checks and controls the financial operations
and the company employees. An informal internal audit process would somewhat reduce fraud
cases resulting from personal interests (Chi & Huang 2011). It is noteworthy that the parent
company would have split due to extreme cases of fraud.
• Prevention of fraud through an informal audit exercise would enable the small XYZ Company
to prosper and grow into a big multinational company and even surpass the projected turnover
of £2.8 million in the first year of trading.
• It is important for the company to create a program that would help in monitoring employees
and enforce strict rules regarding any employee who is found guilty of committing fraud
cases. The establishment of an internal audit would facilitate the above-mentioned practices
though a persistent analysis of the company’s operations.
 Audit Case Study -2 (Cont1)
Testing and monitoring of internal controls
• An Informal internal audit calls for recurrent analysis of the
operations within a company. The habitual analysis enables the
company’s operations to occur smoothly, where, the employees
are kept on toes to offer the best of services. A small company
like XYZ Ltd can employ auditors who would design, modify,
and control the internal activities of the company.
• Though auditing, the company is able to streamline its activities
in a manner that would enable it to achieve its goals and
objectives (Holm & Zaman 2012). Essentially, XYZ Ltd is a
profit making company that would aim at generating the
maximum profits possible.