Saturday, February 16, 2013

Introduction to Audit

Meaning and Definition of Audit:
The word audit is derived from the Latin word “AUDIRE” which means to hear. Initially auditor was a person appointed by the owners to check account whenever the suspected fraud, he was to hear explanation given by the person responsible for financial transactions. Emergence of joint stock companies changed the approach of auditing as ownership was pestered from management. The emphasis now is clearly on the verification of accounting date with a view on the reliability of accounting statement.

In the words of Spicier and Pegler ,“An audit is such an examination of the books, accounts and vouchers of a business as it enable the auditor to satisfy that the Balance Sheets is properly drawn up, so as to give a true and fair view of the state of the affairs of the business and whether the profit and loss accounts gives a true and fair view of the profit or loss for the financial period according to the best of his information and explanations given to him and as shown by the books, and if not, in what respects he is not satisfied”. 

In the words of Montgomery,”Auditing is a systematic examination of the books and records of a business or other organization, in order to ascertain or verify and report upon the facts regarding its financial operation and the result thereof”. 

In the words of Lawrence R. Dicksee,”An audit is an examination of records undertaken with a view to establishing whether they correctly and completely reflect the transactions to which they relate. In some circumstances it may be necessary to ascertain whether the transactions are supported by authority. 

In the words A.W. Hanson,”An audit is an examination of such records to establish their reliability and the reliability of statement drawn from them”. 

In the words of R.B. Bose,”Audit may be said to the verification of the accuracy and correctness of the books of accounts by independent person qualified for the job and not in any way connected with the preparation of such accounts”. 

The main purpose of Auditing or object is to find the opinion of an auditor about the correctness and reliability of accounts and the financial position of the business concern. For this purpose auditor has to check the arithmetical accuracy of the books of account and to find out that whether the transactions entered in the books of account are correct or incorrect. This is done by various methods like inspecting comparing and checking. So all that work that is done by the auditor ensures him that figures are facts.

From the above definitions it is clear that the auditor’s basic duty is to examine the accounts and its arithmetical accuracy. He must ensure than the financial statements depicts true and fair view of the state of affairs of the business. Since, Auditing is a full and critical examination of the books of accounts to find out their accuracy. That is why it is said that  auditing begins where accounting ends.

a)      Scope:  Accounting is concerned with preparing of financial statements. Auditing is concerned with checking of financial statements.

b)      Purpose: The purpose of accounting is to show the performance and financial statement. The purpose of auditing is to certify the true and fair view of financial statement.

c)       Nature: Accounting is concerned with current data. It constructive in nature. Auditing is concern with past data. It is analytical nature.

d)      Knowledge: Accounting works requires that accountant must have accounting knowledge. Auditing work required that an auditor must have accounting as well as auditing knowledge.

e)      Status: The accountant is permanent employee of the business. The auditor is an independent person.

f)       Start: The work of an accountant starts when the work of bookkeeper ends. The work of an auditor starts hen the work of an accountant ends.

g)      Qualification: An accountant may not be a Chartered Accountant as per law. An auditor must be Chartered Accountant for public companies.

h)      Principles: The accounting principles include going concern accrual consistency and prudence. The auditing principles include independence, objectivity, full disclosure and materiality.

i)        Methods: The accounting methods include depreciation, amortization and valuation. The auditing method include manual and computerized.

j)        Techniques: Accounting technique includes depreciation rate interest rate and installment payment. Auditing technique include vouching, verification and valuation.

k)      Rules: Accounting is not governed by any code of conduct laid down by any institute. Auditing is governed by code of conduct as laid down by institute of chartered accountants.

l)        Necessity: Accounting is necessity of every business entity whether small or large. Auditing is not necessity of every business.

m)    Report: The accounting work requires no report to any party. The auditing work requires separate report to shareholders director or owners.

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

Objectives of Auditing.
Auditors are basically concerned with verifying whether the account exhibit true and fair view of the business. The objectives of auditing depend upon the purpose of his appointment. There are two main objectives of auditing.
1.       Primary objective and
2.       Secondary or incidental objective.

Primary Objective.
The primary objective of an auditor is to respect to the owners of his business expressing his opinion whether account exhibits true and fair view of the state of affairs of the business. It should be remembered that in case of a company, he reports to the shareholders who are the owners of the company and not tot the director. The auditor is also concerned with verifying how far the accounting system is successful in correctly recording transactions. He had to see whether accounts are prepared in accordance with recognized accounting policies and practices and as per statutory requirements.

Secondary Objective:
The following objectives are incidental to the main objective of auditing:

A) Detection and prevention of errors: errors are mistakes committed unintentionally because of ignorance, carelessness. Errors are of many types:

a.       Errors of Omission: These are the errors which arise on account of transaction into being recorded in the books of accounts either wholly partially. If a transaction has been totally omitted it will not affect trial balance and hence it is more difficult to detect. On the other hand if a transaction is partially recorded, the trial balance will not agree and hence it can be easily detected.

b.      Errors of Commission: When incorrect entries are made in the books of accounts either wholly, partially such errors are known as errors of commission. E.g.: wrong entries, wrong Calculations, postings, carry forwards etc such errors can be located while verifying.

c.       Compensating Errors: when two/more mistakes are committed which counter balances each other. Such an error is known as Compensating Error. E.g.: if the amount is wrongly debited by Rs 100 less and Wrongly Credited by Rs 100 such a mistake is known as compensating error.

d.      Error of Principle: These are the errors committed by not properly following the accounting principles. These arise mainly due to the lack of knowledge of accounting. E.g.: Revenue expenditure may be treated as Capital Expenditure.

e.      Clerical Errors; A clerical error is one which arises on account of ignorance, carelessness, negligence etc.

f.        Location of Errors: It is not the duty of the auditor to identify the errors but in the process of verifying accounts, he may discover the errors in the accounts. The auditor should follow the following procedure in this regard:
                                 i.      Check the trial balance.
                               ii.      Compare list of debtors and creditors with the trial balance.
                              iii.      Compare the names of account appearing in the ledger with the names of accounting in the trial balance.
                             iv.      Check the totals and balances of all accounts and see that they have been properly shown in the trial balance.
                               v.      Check the posting of entries from various books into ledger.

B) Deduction and Prevention of Fraud: A fraud is an Error committed intentionally to deceive/ to mislead/ to conceal the truth/ the material fact. Frauds may be of 3 types.

a.       Misappropriation of Cash: This is one of the majored frauds in any organisation it normally occurs in the cash department. This kind of fraud is either by showing more payments/ less receipt. The cashier may show more expenses than what is actually incurred and misuse the extra cash. E.g.: showing wages to dummy workers. Cash can also be misappropriated by showing less receipts E.g.: not recording cash sales. Not allowing discounts to customers. The cashier may also misappropriate the cash when it is received. Cash received from 1st customer is misused when the 2nd customer pays it is transferred to the 1st customer’s account. When the 3rd customer pays it goes forever. Such a fraud is known as “Teaming and Lading”. To prevent such frauds the auditor must check in detail all books and documents, vouchers, invoices etc.

b.      Misappropriation of Goods: Here records may be made for the goods not purchase not issued to production department, goods may be used for personal purpose. Such a fraud can be deducted by checking stock records and physical verification of goods.

c.       Manipulation of Accounts: this is finalizing accounts with the intention of misleading others. This is also known as “WINDOWS DRESSING”. It is very difficult to locate because it is usually committed by higher level management such as directors. The objective of WD may be to evade tax, to borrow money from bank, to increase the share price etc.

To conclude it can be said that, it is not the main objective of the auditor to discover frauds and irregularities. He is not an insurance against frauds and errors. But if he finds anything of a suspicious nature, he should probe it to the full.

Scope of Audit
The scope of audit is increasing with the increase in the complexities of the busines. It is said that long range objectives of an audit should be to serve as a guide to the management future decisions.

Today most of the economic activities are largely conducted through public finance. The auditor has to see whether these larger funds are properly used. The scope of audit encompasses verification of accounts with a intention of giving opinion on its reliability. Hence it covers cost audit, management audit, social audit etc. It should be remembered that an auditor just expressed his opinion on the authenticity of the account. He has no power to take action against anybody, in this regard its said that “an auditor is a watch dog but not a blood hound”.

The auditor can determine the scope of an audit of financial statements on the basis of various factors. Factors which affects the scope of Audit are as follows:

a.      Legal Requirements: The auditor can determine the scope of an audit of financial statements in accordance with the requirements of legislation, regulations or relevant professional bodies. The state can frame rules for determining the scope of audit work. The auditor can follow all the law applicable on the audit work while checking the accounts of a business concern.

b.      Entity Aspects: The audit should be organized to cover all aspects of the entity as far as they are relevant to the financial statement being audited. A business entity has many areas of working. A small entity may have few functions while a large concern has many functions. The auditor has duty to go through all the functions of a business. The audit report should cover all function so that the reader may know about all the working of a concern.

c.       Reliable Information: The auditor should obtain reasonable assurance as to whether the information contained in the underlying accounting record and other source data is reliable and sufficient as the basis for preparation of the financial statements. The auditor can use various techniques such as compliance test and substance test to test the validity of data.

d.      Proper Communication: The auditor should decide whether the relevant information is properly communicated in the financial statements. Accounting is an information system so facts and figures must be so presented that reader can get information about the business entity. The auditor can mention this fact in his report. The principles of accounting can be applied to decide about the disclosure of financial information in the statements.

e.       Evaluation: The auditor assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source date by making a study and evaluation of accounting system and internal controls to determine the nature, the nature, extent and timing of other auditing procedures.

f.        Comparison: The auditor determines whether the relevant information is properly communicated by comparing the financial statement with the underlying accounting records and other source data to see whether they properly summarized the transaction and events recorded therein. The auditor can compare the accounting record with financial statement in order to check that same has been processed for preparing the final accounts of a business concern.

g.      Judgments: The auditor determines whether the relevant information is properly communicated by consideration the judgement that management has made in preparing the financial statements, accordingly, the auditor assesses the selection and consistent application of accounting policies, the manner in which the information has been classified and the adequacy of disclosure. The auditor must have the quality of judgement when accounting books to not provide true data.

h.      Evidence: The audit evidence available to auditor is persuasive rather than conclusive in nature. Due to judgment and persuasive evidence absolute certainty in auditing is really attainable. That is why the auditor can express an opinion as true and fair instead of exact and cent percent correct. The personal judgments affect the value of many items. The value of such items becomes an opinion so cent percent accuracy is not there.

i.        Errors: The auditor may get an indication that some fraud or error may have occurred which could result in material misstatement would curse the auditor to extend his procedures to confirm or dispel his suspicion. It is the duty of auditor to check cent percent items in order to discover the error in accounting books and other records when he smells any doubt. He should clear the doubt or confirm it while going through the record.

Types of Audit
a.       Statutory Audit: any audit carried on as per the requirement of law is called as a statutory audit. e.g.: all companies have to get their accounts audited as per the provision of the company’s Act of 1956.

b.      Periodical/ Annual Audit: it is a kind of audit where the auditor verifies the account at the end of the financial year. He starts the audit work after the closure of financial year. This is a common audit and is mostly used by small organizations.

c.       Interim audit: It is an audit conducted in the middle of the accounting year before the accounts are closed. In other words any audit conducted between two financial audits is known s interim audit. The objective is to get periodical results, to declare interim dividend.

d.      Partial Audit: when an auditor is asked to audit only a part of the account system. It is called partial audit. E.g.: he may be asked to audit only the payment side of cash book.

e.      Balance sheet audit: it’s a kind of partial audit and is concerned with the verification of only those items appearing in the Balance Sheet. It is more popular in the USA. Infact while verifying BS items the auditor verifies/ checks all related items/accounts.

f.        Cost audit: cost audit is defined as the verification of cost accounting records. Data and techniques for its accuracy and authenticity. It gets as effective managerial tool for the detection of errors and frauds in cost accounting records. The companies act implies the central government to order cost audit incase of specifies companies.

g.       Management audit: Management audit may be defined as a comprehensive examination of an organizational structure of a company, institution/government and its plans and objectives it means of operations and use of human and physical facilities. The main objective of mgt audit is to see how far the objectives of mgt are fulfilled. It aims to ascertain whether sound mgt prevails throughout the organisation and evaluates its efficiency in the system of its operation.

h.      Continuous audit(CA): A continuous audit is one in which the auditor visits his client’s office at regular intervals throughout the year to verify the account. The objective of CA may be-
                                             i.            To get final account audited immediately after the closure of accounting year.
                                           ii.            When the business is very large.
                                          iii.            When interval control system is into effective.
                                         iv.            When regular final accounts are required.

Adavantages of Auditing

A. Benefits of Business: Business may get many advantages of conducting audit by a qualified auditor. The advantages are discussed below:

(a) True and Fair view: With the help of audit of accounts, it is possible get a true and fair view of the financial position of the business.

(b) Detection of errors and frauds: If books of accounts are audited, errors and frauds can be detected and necessary action can be taken to prevent it.

(c) Moral pressure on the employees: If audit is conducted by the organization, employees should be cautions and there should be a moral pressure on them. As a result, chances of errors and frauds will be minimized.

(d) Proper accounting control: A system of regular audit helps the organization to maintain proper books of accounts regularly and books of accounts are kept up to date.

(e) Acceptable evidence: Audited accounts are very strong financial document acceptable to many interested parties e.g. taking loan from financial institution, determination of income tax, sales tax, amalgamation of companies, determination of purchase consideration, admission, retirement, death of a partner etc.

(f) Increase in goodwill: Audit of business on a regular basis increases confidence to the interested parties and general public. As a result goodwill of the business increases.

B. To the Owner: The owners of the business are also interested to know the financial position of the business. There are discussed below:

(a) Benefit to the sole proprietor: In case of large business, the proprietor can get a true and fair view of the accounts maintained by his employees and also able to know the state of affairs and profit made by him. The proprietor is also benefited for getting loan from financial institutions, to pay income tax etc.

(b) Benefits to the partners: Shareholders are the owners of a company. With the help of audited accounts help to the partners to settle their unsettled disputed, for taking loan from financial institutions, to get off the books of accounts maintained by the employees etc.

(c) Benefits to the shareholders: Shareholders are the owners of a company. With the help of audited accounts they get a real picture of the financial position of The company and they can assure that business is running efficiently.

(d) Benefit to the non-profit seeking organizations: There are different non-profit seeking organizations e.g., charitable institution, club, religious institute, school, college etc. This organization run with public money. Whether public money is properly utilized or not can be revealed from the audited accounts.

C. To the third parties: Besides business and the owners, there are different outside interested parties who required audited accounts for different purposes: These are:

(a) Government may be interested to get the audited accounts to show the deficiency of the business for giving grant and subsidy.

(b) Financial institutions sections loan to the organization on the basis of verification of financial soundness form the audited accounts.

(c) Tax authorities may depend on audited accounts for determination of income tax, sales tax, excise duty etc.

(d) Prospective buyers who want to invest money in shares and debentures of a company may rely on audited accounts.

(e) Creditors who supply goods to the business may asses the solvency and liquidity position of the business on the basis of audited accounts.

(f) For settlement of insurance claim, insurance companies can barely on audited accounts.

Inherent Limitations of Auditing
                The objective of an audit of financial statements is to enable an auditor to express an opinion on such financial statements which helps in determination of the true and fair view of the financial position and operating results of an enterprise. But such expression by the auditor is neither an assurance as to the future viability of the enterprise nor the efficiency or effectiveness with which management has conducted affairs of the enterprise. Further, the process of auditing is such that it suffers from certain inherent limitations, i.e., the limitation which cannot be overcome irrespective of the nature and extent of an audit procedure. The inherent limitations are:

                I. First of all, auditor’s work involve exercise of judgment, for example, in deciding the extent of audit procedures and in assessing the reasonableness of the judgment and estimates made by the management in preparing the financial statements. Further much of the evidence available to the auditor can enable him to draw only reasonable conclusions there from. The audit evidence obtained by an auditor is generally persuasive in nature rather than conclusive in nature. Because of these factors, the auditor can only express an opinion. Therefore, absolute certainty in auditing is rarely attainable. There is also likelihood that some material misstatements of the financial information resulting from fraud or error, if either exists, may not be detected.

                II. The entire audit process is generally dependent upon the existence of an effective system of internal control. Further, it is clearly evident that there always be some risk of an internal control system failing to operate as designed. No doubt, internal control system also suffers from certain inherent limitations. Any system of internal control may be ineffective against fraud involving collusion among employees or fraud committed by management. Certain levels of management may be in a position to override controls; for example, by directing subordinates to records transactions incorrectly or to conceal them, or by suppressing information relating to transactions. Such inherent limitations of internal controls system also contribute to inherent limitations of an audit.

                Generally following are the Limitations of auditing
       1. Non-detection of errors/frauds:- Auditor may not be able to detect certain frauds which are committed with malafide intentions.

2. Dependence on explanation by others:- Auditor has to depend on the explanation and information given by the responsible officers of the company. Audit report is affected adversely if the explanation and information prove to be false.

3. Dependence on opinions of others:- Auditor has to rely on the views or opinions given by different experts viz Lawyers, Solicitors, Engineers, Architects etc. he can not be an expert in all the fields

4. Conflict with others: - Auditor may have differences of opinion with the accountants, management, engineers etc. In such a case personal judgement plays an important role. It differs from person to person.

5. Effect of inflation : - Financial statements may not disclose true picture even after audit due to inflationary trends.

6. Corrupt practices to influence the auditors :- The management may use corrupt practices to influence the auditors and get a favourable report about the state of affairs of the organisation.

7. No assurance :- Auditor cannot give any assurance about future profitability and prospects of the company.

8. Inherent limitations of the financial statements :- Financial statements do not reflect current values of the assets and liabilities. Many items are based on personal judgement of the owners. Certain non-monetary facts can not be measured. Audited statements due to these limitations can not exhibit true position.

9. Detailed checking not possible :- Auditor cannot check each and every transaction. He may be required to do test checking.