Auditing

Unit I
Introduction to Auditing
Meaning and Definition of Auditing
The word Audit is derived from Latin word “Audire” which means ‘to hear’. Auditing is
the verification of financial position as disclosed by the financial statements. It is an
examination of accounts to ascertain whether the financial statements give a true
and fair view financial position and profit or loss of the business. Auditing is the
intelligent and critical test of accuracy, adequacy and dependability of accounting
data and accounting statements. Different authors have defined auditing differently,
some of the definition are:
“Auditing is an examination of accounting records undertaken with a view to
establishment whether they correctly and completely reflect the transactions to which
they purport to relate.” -L.R

“Auditing is concerned with the verification of accounting data determining the

accuracy and reliability of accounting statements and reports.” - R. Mautz

“Auditing is the systematic examination of financial statements, records and related

operations to determine adherence to generally accepted accounting principles,
management policies and stated requirement.” -R.E

Objectives of Auditing
The objectives of auditing are changing with the advancement of business
techniques. Earlier it was only to check the correctness of receipts and payments.
The objectives of the auditing have been classified under two heads:
1. Main objective
2. Subsidiary objectives

Main Objective: The main objective of the auditing is to find reliability of

financial position
and profit and loss statements. The objective is to ensure that the accounts reveal a
true and fair view of the business and its transactions. The objective is to verify and
establish that at a given date balance sheet presents true and fair view of financial
position of the business and the profit and loss account gives the true and fair view
of profit or loss for the accounting period. It is to be established that accounting
statements satisfy certain degree of reliability. Thus the main objective of auditing is
to form an independent judgement and opinion about the reliability of accounts and
truth and fairness of financial state of affairs and working results.
Subsidiary objectives : The subsidiary objectives of the auditing are:
1. Detection and prevention of fraud: the one of the important subsidiary objective of
auditing is the detection and prevention of fraud. Fraud refers to intentional
misrepresentation of financial information. Fraud may involve: a. Manipulation,
falsification or alteration of records or documents b. Misappropriation of assets. c.
Suppression of effect of transactions from records or documents. d. Recording of
transactions without substance. e. Misapplication of accounting policies
2. Detection and prevention of errors: is another important objective of auditing.
Auditing ensures that there is no mis-statement in the financial statements. Errors
can be detected through checking and vouching thoroughly books of accounts,
ledger accounts, vouchers and other relevant information.
Importance of Auditing
Importance of auditing can be judged from the fact that even those organizations
which are not covered by companies Act get their financial statements audited. It has
become a necessity for every commercial and even non- commercial organization.
The importance of auditing can be summed in following points:
a. Audited accounts help a sole trader in knowing the value of the business for the
purpose of sale. b. Dispute over correctness of profits can be avoided. c.
Shareholders, who do not know about day-to-day administration of the company ,
can judge the performance of management from audited accounts. d. It helps
management in detecting and preventing errors and frauds. e. Management gets
advice on financial affairs from the auditors. f. Long and short term creditors depend
on audited financial statements while taking decision to grant credit to business
houses. g. Taxation authorities depend on audited statements in assessing the
income tax, sales tax and wealth tax liability of the business. h. Audited accounts are
useful for the government while granting subsidies etc. i. It can be used by insurance
companies to settle the claims arising on account of loss by fire. j. Audited accounts
serve as a basis for calculating purchase consideration in case of amalgamation and
absorption. k. It safe guards the interests of the workers because audited accounts
are useful for settling trade disputes for higher wages or bonus.
6. Government Audit: Audit of government offices and departments
A separate department is maintained by government of India known as Accounts
and Audit Department. This department is headed by the Comptroller and Auditor
General of India. This department works only for the government offices and
departments. This department cannot undertake audit of non-government concerns.
Its working is strictly according to government rules and regulations.

On the basis of time the audit can be of following types:

1. Interim Audit: When an audit is conducted between two annual audits,
such audit is known as Interim audit. It may involve complete checking of
accounts for a part of the year. Sometimes it is conducted to enable the
board of directors to declare an Interim dividend. It may also be for the
purpose of dealing with interim figures of sales.
2. Continuous Audit: The Continuous Audit is conducted throughout the
year or at the
regular short intervals of time. “ A continuous audit involves a detailed examination
of all the transactions by the auditor attending at regular intervals say weekly,
fortnightly or monthly, during the whole period of trading.” - T. Batliboi “A continuous
audit is one where the auditor or his staff is constantly engaged in checking the
accounts during the whole period or where the auditor or hiss staff attends at regular
or irregular intervals during the period.” -R Williams

Advantages of continuous Audit:

a. Complete checking of all the records: Since the audit is carried out
throughout the year, sufficient time is available for detailed checking. Any
enquiry and doubt arising in the course of audit can be tackled in a better
way.
b. Proper planning: Auditor can plan his audit work in a systematic manner.
He can evenly spread his work throughout the year. It will improve
efficiency of auditor.
c. Early detection of frauds and errors: The work of auditor becomes easier
for detecting frauds and errors, otherwise it will involve more time.
d. Up-to-date accounts: The efficiency of account staff will increase and
their work will be up-to-date and accurate.
e. Valuable suggestions: Continuous audit will help the auditor to
understand the technicalities of business. This will help the auditor to make
suggestions for the improvement of business.
f. Preparation of interim accounts: Interim accounts can be prepared
without much delay. It will help the Board of Directors to declare interim
dividend.

Disadvantages of Continuous Audit:

a. Expensive: It is an expensive system as it may not suit the budget of
small
organizations.
b. Dislocation of routine work: Frequent visits by auditor may dislocate the
smooth flow of office work.
c. Alteration of Figures: after the accounts have been audited, the figures
may be fraudulently altered by the staff.
d. Losing link in the audit work: As the work is not completed continuously,
the auditor may lose continuity and certain questions and inquires may be
left unanswered.
3. Final Audit: Final Audit means when the audit work is conducted after the
close of financial year. A final audit is commonly understood to be an audit
which is not commenced until after end of the financial period and is then
carried on until completed.
4. Balance Sheet Audit: Balance Sheet Audit relates to the verification of
various items of balance sheet such as assets, liabilities, reserves and
surplus, provisions and profit and loss balance. The procedure under this
audit is to follow a backward process. First the item is located in balance
sheet, and then it is located in original record for the purpose of verification.

On the basis of objectives the audit can be of following types:

1. Internal Audit: It implies the audit of accounts by the staff of the
business. Internal audit
is an appraisal activity within an organization for the review of the accounting,
financial and other operations as basis for protective and constructive service to the
management. It is a type of control which functions by measuring and evaluating the
effectiveness of other types of control. It deals primarily with accounting and financial
matters but it may also properly deal with matters of operating nature.
2. Cost Audit: Cost Audit is the verification of the correctness of cost
accounts and
adherence to the cost accounting plans. Cost Audit is the detailed checking of
costing system, techniques and accounts to verifying correctness and to ensure
adherence to the objectives of cost accounting.
3. Secretarial Audit: Secretarial Audit is concerned with verification
compliance by the company of various provisions o Companies Act and
other relevant laws. Secretarial audit report includes a. Whether the books
are maintained as per companies act, 2013.

Appointment of an Auditor
Appointment of Auditor in case of Sole proprietor: The appointment of Auditor
in case of
sole trader is done by the owner of the business. In case of sole traders the auditor
generally acts as an accountant who also prepares accounts besides checking their
accuracy. As He is appointed by an individual he must get clear instructions from his
client in writing as to what he is expected to do. His work and its scope will depend
upon the agreement with his client since the appointment of an auditor is not under
any statute, therefore the rights and the duties will depend upon the agreement.
Appointment of Auditor in case of partnership: The Auditor of a partnership
firm is made
by the mutual consent of all the partners
Appointment of Companies Auditors: The provisions regarding appointment of
the auditor
are contained in section 139 of Companies Act 2013
1. Appointment of auditor by members [sec 139(1)]: a. A company shall appoint
an individual or a firm as an Auditor at the first annual general meeting and each
subsequent sixth annual general meeting. b. Such auditors shall hold office till
conclusion of sixth annual general meeting. c. Such appointment shall be placed
before the members at each annual general meeting for ratification.

2. Period for which the appointment is made [sec 139(2)]:

a. An individual can be appointed for a term no more than five years. b. An audit firm
can be appointed for a consecutive term not more than two terms of five years. c. An
individual or a firm which has completed its term shall not be eligible for
reappointment as auditor in the same company for five years from the completion of
term.

3. Appointment of auditor of Government companies (sec 139 (5)): The

comptroller and Auditor general shall in respect of financial year appoint an auditor
duly qualified within 180 days from the commencement of financial year who shall
hold office till conclusion of annual general meeting.

4. Appointment of First Auditor by Board of Directors [sec139 (6)]: The first

auditor of a company other than government company shall be appointed by the
board of directors within 30 days of registration of company. If the board fails to
appoint first auditor it shall inform the members of company who shall appoint auditor
within 90 days at extra ordinary general meeting who shall hold the office till
conclusion of first annual general meeting.

5. Appointment of First Auditor of Government Company [sec 139 (7)]: The first
Auditor of a Government Company shall be appointed by Comptroller and Auditor
general within 60 days of registration of company. In case of its failure to appoint first
auditor, then board of directors shall appoint auditor within next 30 days. The
company shall inform the members if
the board fails to appoint first auditor who shall appoint the auditor within 60 days at
extra ordinary general meeting who shall the office till conclusion of the first general
meeting.

6. Casual vacancy of an Auditor [sec 139 (8)]: a. The casual vacancy of auditor,
except in case of Government Company, shall be filled by the board of directors
within 30 days but if it arises as a result of resignation of the auditor it shall be
approved by company at general meeting convened within 3 months o
recommendation of board. Such auditor shall hold office till conclusion of next annual
general meeting. b. Casual vacancy in case of Government Company shall be filled
by Comptroller and Auditor General within 30 days if he fails to fill the vacancy, the
board shall fill the vacancy within next 30 days.

Reappointment of a retiring auditor [sec 139 (9)]: Such an auditor can be

reappointed at annual general meeting if. a. He is not disqualified for
reappointment. b. He has not given notice to company of his unwillingness. c. A
special resolution has not been passed at annual general meeting appointing some
other person or providing expressly that he shall not be reappointed. All the above is
subject to the provisions of sec 139 (1)

Qualifications of an Auditor:
1. A person shall be eligible for the appointment of an auditor of a company only if he
is a chartered accountant.

2. Where a firm including a limited liability partnership is appointed as an auditor of a

company, only the partners who are chartered accountants shall be authorized to act
and sign on behalf of firm.

Disqualifications of an Auditor:
The following persons shall not be eligible for the appointment as an
auditor of a company:
1. An officer or employee of the company.

2. A person who is a partner, or who is in employment or an officer or employee of

the company.

3. A person or a firm who, whether directly or indirectly has business relationship

with the company, or subsidiary of such holding company or associate company of
such nature as may be prescribed.

4. A person whose relative is director or is in the employment of the company as

director or key managerial personnel.

5. A person who is in full time employment elsewhere or a person or a partner of a

firm holding appointment as its auditor, if such persons or partner is at the date of
such appointment or reappointment holding appointment as auditor of more than 20
companies.

6. Right to be indemnified : for many purposes, an auditor is considered to be an

officer of the company. An officer has a right to be indemnified out of the assets of
the company against any liability.

Duties of an Auditor: Duties under section 143 (1):

a. The auditor has a duty to enquire whether loans and advances made by the
company have been properly secured whether the term and the conditions there of
are prejudicial to the interest of the company or its members. b. Duty to enquire
whether assets of the company being shares or debentures and other securities
have been sold at a price less than at which these were purchased. c. Whether any
shares have been allotted for cash, whether cash actually received and whether the
position in the account books and balance sheet is correct, regular and not
misleading.
 Duties under section 143 (2):
The auditor has the duty to report the members of the company, the accounts
examined by him and every financial statement to be laid before the company in the
general meeting. The auditor shall state in his report to the best of his information
and knowledge, the said accounts and financial statements whether give a true and
fair view or not, of the state of company’s affairs
Duties under section 143(3):
1. He has the duty to sought and obtain all information and explanation which are
necessary for his audit.
2. He has a duty to ensure that the books of accounts as required by law have been
kept by the company.
3. He has a duty to see whether the company has adequate internal financial control
systems in place and their operative effectiveness.
4. He has a duty to ensure whether the company’s balance sheet and profit and loss
account dealt within the report or in agreement with the books of account and
returns.

Liabilities of an Auditor:
The liabilities of an auditor can be summed under following heads:
1. Civil liabilities
2. Criminal Liabilities

1. Civil Liabilities:
(I) Liability for Negligence: The liability of an auditor arises where it is
proved that his
client has suffered a loss due to his professional negligence. The auditor may be
held personally liable, if it is proved, that had he exercised reasonable care and skill,
he must have discovered the discrepancy. In a case it was held that if an auditor fails
to show as much skill and diligence as is expected of a man of ordinary prudence, he
must suffer the consequences.
(ii) Liability for misfeasance: According to section (340), the court may
assess damages
against delinquent director and other officers of the company, including an auditor for
misfeasance or breach of trust. In case of an auditor who also comes within the
definition of officer in section 2 (59) for purpose of the section, if he is guilty of
neglect of duty or misfeasance, so as to cause loss of company in any way,
proceedings may be taken under this section against him either independently or
other officers or jointly with them. This section provides a simple way to the company
to recover damages where an auditor or any other officer of the company is guilty of
misfeasance. The time limit for bringing an action is 5 years.
2. Criminal Liabilities:
i) Mis-statement in prospectus section 34: Where an auditor makes false
 statement with material particulars in returns, reports, prospectus or other
statements knowingly it to be false or omits any material facts knowing them to be
false, he shall be punishable with imprisonment for a minimum term of 6 months
extendable to 10 years.
ii) Non compliance by auditor with section 143 and 145: If the auditor does
not
comply with section 143 and 145 regarding making his report or signing or
authentication of any document and makes willful neglect on his part he shall be
punishable with imprisonment up to 1 year and with fine not less than twenty
thousand extendable to five lakhs.
In case an auditor knowingly or willfully with the intension to deceive the company or
shareholders or creditors or tax authorities, he shall be punishable with imprisonment
up to 1 year and fine not less than 1 lakh extendable up to twenty five lakhs.
iii) Failure to assist in the investigation section 217 (6): Where the central
Government appoints an inspector to investigate the affairs of the company, it is the
duty of the auditor to preserve and produce to the inspector all books and papers
relating to the company. If an auditor fails to assist the inspector in investigation he
shall be punishable with imprisonment up to 1 year and with fine not less than twenty
five thousand extendable to 1 lakh
iv) Penalty for falsification of books section 336: Any officer including
auditor of
a company which is being wound up, with an intention to defraud or deceive any
person, destroys, mutilates, alters, falsifies any books, papers or securities. He shall
be punishable with imprisonment for
clarified with the client or the chief editor. The Audit note book is used for recording
important points to be included in the auditor’s report.
Contents of an Auditor’s Note Book:
1. A list of books of accounts maintained.
2. The names, duties and responsibilities of principal officers.
3. The particulars of missing receipts and vouchers.
4. Mistakes and errors detected.
5. The points which need clarifications and explanations.
6. The points deserving the attention of the auditor.
7. Various totals and balances.
8. The Points to be a part of auditor’s report.

Advantages of Audit Note book:

Some of the advantages of the audit note book are.
1. It ensures the uniformity and helps in knowing the amount of work performed.
2. Important matters relating to the audit work may be easily recalled.
3. Facilities and preparation of the audit report.
4. In case of the assistant in charge is changed, no difficulty is faced in continuing the
incomplete work.
5. The responsibility of the errors undetected can be fixed on clerk concerned.
6. The audit note book shows the extent of the interest and pain taken by the audit
staff. It helps in their appraisal.
7. It ensures that the audit programme has been sincerely followed. Deviations can be
noticed.
8. It is reliable evidence in the court of law, If an auditor has to defend himself.

Audit working papers

Meaning and Definition
The term audit working papers designate the files of analysis, summaries, comments
and correspondence built by an auditor during the course of the field work of an audit
engagement. These papers contain essential facts about the accounts which are
under audit.
According to Arnold W. Johnson, ‘’ Audit working papers are the written private
materials, which an auditor prepares for each audit. They describe the accounting
information which he receives from his client, the methods of examination used, the
conclusions (and reasons thereof) and the financial statements.”
According to Jack C. Robertson , “Working papers are auditor’s own evidence of
compliance with generally accepted auditing standards and of the decisions
respecting all procedures necessary in the circumstances unique to the audit
engagement.”
They consist of draft copies of trial balances, adjusting entries, accounts analysis,
schedules of debtors and creditors summaries of reconciliation statements,
certificates of official comments, copies of correspondence between auditors and
debtors, creditors and bank, detailed schedule of items like depreciation, inventories
previous audit reports, important quarries with explanation audit programme and
other important materials.
Objectives of Audit working papers
The working paper serves following purposes:
1. They represent the volume of work performed by the auditor and his staff, which
helps in preparing the report.
2. They show the extent of adherence to accounting principles and auditing standards.
3. They are useful as evidence against the charge of negligence.
4. They act as guide for subsequent examinations.
5. They enable the auditor to know the weakness of the internal check system in
operation as also the accounting system.
6. They assist the auditor in coordinating and organizing the work of audit clerks.
7. They assist in planning and performance of audit work.

Internal Control
Meaning and Definition
 Internal control is a broad term with a wide coverage. It covers the control of whole
management system. Internal control involves a number of checks and controls
exercised in a business to ensure its efficient and economic working.
According to The American Institute of Certified Public Accountants , “Internal
control comprises of the plan of organization and all the coordinate methods and
measures adopted within a business to safeguard its assets, check the accuracy and
reliability of its accounting data to promote operational efficiency and to encourage
adherence to prescribed managerial policies.”
The system of internal control can be defined as, “the plan of organization and all the
methods and procedures adopted by the management of an entity to assist in
achieving the management’s objectives of ensuring, as far as practicable, the orderly
and efficient conduct of its business.”
All the definitions of internal check give a common idea about system organized
within the concern itself, wherein the work of one employee is automatically checked
up by the other and the possibility of error or fraud is reduced to the minimum.
Objectives of internal check:
1. To exercise moral pressure over the staff.

2. To ensure that the accounting system produces reliable and adequate

information.

3. To provide protection to the resources of the business against fraud, carelessness

and in efficiency.

4. To distribute work in such a manner that no business is left unrecorded.

5. To allocate duties and responsibilities of each clerk in such a way that he may
held responsible for particular fraud or error.

6. To increase the efficiency of clerks because the allocation of duties is based on

the principle of division of labour.

7. To detect errors and frauds easily if it is committed, because in an efficient internal

check system, there is a provision for independent checking.

Advantages of Internal Check:

1. Proper division of work: internal check entails a proper and rational distribution of
work among the members of staff of the enterprise keeping in view their individual
qualifications, experience and area of specialization.
2. Detection of errors and frauds: since no individual worker is allowed to handle a
job completely from the beginning to the end, and the work of each clerk is
automatically checked by the other, this helps in the early detection and discovery of
errors and frauds.
3. Increased efficiency coupled with economy: A good system of internal check
increases the efficiency of work among the staff and leads to overall economy.
4. Convenience to auditor: where an organization is operating the system of internal
check, the statutory auditor may conveniently avoid detailed checking of the
transactions. He may apply a few tests here and there and can relieve himself from
detailed checking.
5. Accuracy of the accounts can be relied upon: If there is a good system of internal
check the owner of the concern may rely upon the genuineness and accuracy of the
accounts.
6. Increase in Profits: overall efficiency and economy in operations result in more
profits- thus ensuring larger dividends for the owners or shareholders.
Internal Check With Regard To Sales:
The system of internal check regarding sales should take care of following:
1. On receipt of the order, it should numbered and preserved in Orders Received Book
with full particulars.
2. The Despatch Department should be given a copy of the order with necessary
particulars.
3. The Despatch Department should take steps to pack the goods as per order.
4. The statement of goods as prepared by the Despatch Department should be
checked with the customer’s order and then invoice will be prepared in triplicate by
means of carbon papers.
5. A responsible official should check the invoice particularly the rates charged and
calculations made.
6. With the help of the copy of invoices entries should be made in Sales Day Book.
7. On dispatch of the goods records should be made in the Goods Outward Book.
8. Two copies of the invoice may be sent to customer who will return one of them after
signing it. It will serve the purpose of delivery note. Third copy will be retained for
further reference.
9. Entries should be made in Goods inward Book for all the goods returned by the
customers. Credit notes should be prepared and should be duly checked and
initialed by the responsible official.
10. With the help of credit notes, records should be made in the Sales Return Book.

Internal Check With Regard To Purchases:

1. Requisition: the procedure for issuing purchase requisitions should be specified.
The head of the department, who is need of goods, should fill a requisition slip duly
signed and then should send to the purchase department. The details about the
quality, quantity and the time by which the goods must be supplied be clearly
mentioned in the requisition slip. 2. Enquiry: Purchases department makes an
enquiry about terms and conditions of the purchases from different suppliers for
these purposes tenders are generally invited. But, who shall open and accept the
tenders, should be clearly specified. As rule lowest tender should be accepted and
decision be taken. 3. Purchase Order: the purchase department places orders which
should be recorded in the purchase order book. Four copies of purchase order
should be prepared. One copy will be sent to vendor, the second to the store
department, third to the accounting department and fourth will be retained by the
purchase department itself. A responsible officer should review the purchase order,
before signing by the authorized person or director. 4. Receipt of goods: on receipt of
goods, the purchase department should properly inspect them, and after an entry in
the goods inward (receipt) book, the same should be sent to the stores. Concerned
 department should be informed about the receipt of goods. 5. Making the payments:
the purchase department should thoroughly check the invoices and send the same
to accounting department for payment. The accounting department should compare
the invoice with the purchase order and incoming inspection report and
4. All receipts should be acknowledged by means of printed receipts. Counter-foils of
all the receipts issued should be properly maintained. Unused receipt must be kept
with some responsible officer.
5. Spoiled receipts should be cancelled and not torn off. If some alterations is made in
the receipts already written, it should be properly initialed.
6. Copies of receipts previously issued must be marked duplicate.
7. Some responsible persons of the firm should verify the balance of cash by carrying
out a surprise physical check from time to time.

CASH PAYMENTS:
1. The person in charge of making payments should have no connection with the
receipts of cash.
2. All payments should, as far as possible be by chance cheques excluding petty cash
payments. The cheques drawn for payment should be order cheques and as far as
practicable they should be crossed.
3. Arrangements should be made to ensure that the vouchers supporting payments
cannot be presented for the payments twice, such vouchers should be stamped as
paid before the cheques are signed.
4. An official should check up the statements received from creditors and verify with the
invoices and ledger accounts only after proper verifications cheques should be
drawn in favour of the creditors.
5. For sanctioning the payments of special nature, only directors and senior officers
should be empowered.
6. Bank reconciliation statements should be prepared to reconcile bank and cash
balances from time to time by some authorities other than the cashier.
7. Bank cheques must be held under lock and key with a responsible officer.
8. Receipts duly signed and stamped should be obtained for each payment.
9. Receipts so obtained should be properly arranged and maintained through proper
filing system.
10. To ensure the availability of cash discounts, monthly or periodic payments should be
made on the fixed dates.

Unit 3
Vouching and Audit of Financial Statements

Vouching
Meaning and Definition
Vouching is concerned with examining documentary evidence to ascertain the
authenticity of entries in the books of accounts. In other words it is an inspection by
the auditor of evidence supporting the transactions made in the books. Vouching is a
technique used by an auditor to judge the truth of entries appearing in the books of
accounts. Some important definitions of vouching are:
 “Vouching means testing the truth of items appearing in the books of original
entry.” – J. Batliboi
“Vouching is an act of comparing entries in the books of accounts with
documentary evidence in support thereof.” - Dicksee

From the above definitions we can conclude that vouching is a technique in which an
auditor verifies authenticity and authority of transactions recorded in the books and
on the basis of which he submits a report, indicating that accounts are correct, free
from errors or fraud and complete.
Objectives of Vouching:
1. All the transactions which are connected with the business have been recorded in
the books of accounts properly.
2. To verify that all transactions recorded in the books of accounts are supported by
documentary evidence.
3. The vouchers which support the entries are legally valid from the view point that they
are authentic, addressed to the business and properly dated.
4. To verify that no fraud or error has been committed while recording the transaction in
books of accounts.
5. The vouchers have been processed carefully through various stages of internal
check system.
6. While recording the transaction whether distinction has been made between capital
and revenue items.
7. Whether accuracy has been observed while totaling, carrying forward and recording
an amount in the account.