Chapet 1 nature of audit

sachin mavi (m CA-FINAL m hun) (75 Points)

02 June 2014

Nature of Auditing

Learning Objective

After studying this chapter, you will be able to :

♦

Understand the functional classifica

tion and qualities of an auditor

♦

Define audit and understand the objectives of

audit, basic principles covering audit etc

♦

Distinguish between auditing and investigation

♦

Understand different types of audit and relati

onship of auditing with other disciplines.

1.1 Introduction

Historically, the word ‘

auditing

’ has been derived from Latin word “

audire

” which means “

hear

”. In fact, such an expression conveyed the manner in which the auditing was conducted

during ancient time. However, over a period

of time, the manner of conducting audit has

undergone revolutionary change.

According to

Dicksee

, traditionally auditing can be unde

rstood as an examination of

accounting records undertaken with a view to es

tablishing whether they

completely reflect the

transactions correctly for the related purpose. But

this is not the end of matter. In addition the

auditor also expresses his opinion on the char

acter of the statements of accounts prepared

from the accounting records so examined as to

whether they portray a true and fair picture.

Auditing along with other disciplines such as

accounting and law, equips you with all the

knowledge that is required to en

ter into auditing as a profession. No business or institution can

effectively carry on its activi

ties without the help of proper records and accounts, since

transactions take place at different points of

time with numerous persons and entities. The

effect of all transactions has to be recorded and suitably analysed to see the results as

regards the business as a whole. Periodical statements of account are drawn up to measure

the success or failure of the activities in achieving the objective of the organisation. This would

be impossible without a systematic record of

transactions. Financial st

atements are often the

basis for decision making by the management and for corrective action so as to even closing

down the organisation or a part of it. All this

would be possible only if the statements are

reliable; decisions based on wrong accounting

statements may prove very harmful or even

fatal to the business. For example, if the business has really earned a profit but because of

wrong accounting, the annual accounts show a lo

ss, the proprietor may take the decision to

1.2 Auditing and Assurance

sell the business at a loss. T

hus from the point of view of

the management itself, authenticity

of financial statements is essential. It is mo

re essential for those who have invested their

money in the business but cannot take part in its management, for example, shareholders in a

company, such persons certainly need an assurance that the annual statements of accounts

sent to them are fully reliable. It is auditing wh

ich ensures that the accounting statements are

authentic. In today’s economic environment,

information and accountabi

lity have assumed a

larger role than ever before. As a resu

lt, the independent audit of an entity’s financial

statements is a vital service to investors,

creditors, and other participants in economic

exchange.

To correctly understand the role of auditing, yo

u must understand the nature and purpose of

the financial statements. ‘Financi

al statements’ is a set of documents which show the result of

business operation during a period - how the result was achieved and the position of assets

and liabilities on the given date. Progress made or success achieved during a certain period

can also be readily ascertained

from such a set of documents. It also makes an implied

representation that it has been properly prepared, shows correct figures and the figures are

set against correct descripttion and context.

Regardless of the type of entity - whether in the

public or private sector or whether for profit or

not - all entities use economic resources to

pursue their goals. Financial statements enable an

entity’s management to provide useful information about its financial position at a particular

point of time and the results of its operations and its changes in financial position for a

particular period of time. External financial repor

ting for these entities is directed toward the

common interest of various users.

However, you must be clear on one point. The statements of account are viewed by different

interests from different angles; consequently a statement prepared primarily for the use of the

owners may not be wholly useful to interest of other users. For example, management may need

more detailed information on matters considered critical by it, the investors and financial analysts

are keen to see the projected image of the presen

t state of affairs. Government would look for

inadmissible items under the taxation laws, etc. Separate statements of accounting highlighting the

information needed by the interested parties, other than the owners cannot be expected to be

prepared in the ordinary course unless the same is specially called for. This makes the preparation

of the financial statements more onerous becaus

e other users of the statement would use the

information subject to such modifications and enquiry as would be considered necessary to meet

their respective objective. But they must have an honest assurance that the statements have been

properly compiled, prepared and presented to adhere to the requirements of owners. The auditor

can accomplish this by a process of examination and appraisal.

Further, it may be noted that the management is

responsible for establishing an accounting

system to identify, measure, record and adequately

disclose an entity’s transactions and other

events that affect its financial position and re

sults of operations. Management is responsible

for selecting accounting principles that appropriately reflect events that occur and for making

other accounting estimates and judgments. Th

is responsibility is not lessened by an

independent audit.

Nature of Auditing 1.3

1.2 Definition of Auditing

According to General Gui

delines on Internal Auditing iss

ued by the ICAI, “Auditing is defined

as a systematic and independent examination of data, statements, records, operations and

performances (financial or otherwise) of an

enterprise for a stated purpose. In any auditing

situation, the auditor perceives and recognises

the propositions before him for examination,

collects evidence, evaluates the same and on th

is basis formulates his judgment which is

communicated through his audit report.”

The nature of the propositions which an auditor is called upon to review varies. Thus an

auditor may review the financial statements of an en

terprise to ascertain whether they reflect a

true and fair view of its state of affairs and of

its working results. In another situation, he may

analyse the operations of an enterprise to appraise

their cost-effectiveness and in still another,

he may seek evidence to review the managerial performances in an enterprise. In yet another

type of audit, the auditor may examine whether th

e transactions of an enterprise have been

executed within the framework of certain st

andards of financial propriety. However, the

variations in the propositions do not change

the basic philosophy of auditing, though the

process of collection and evaluation of evidence and that of formulating a judgment thereon

may have to be suitably modified.

“An audit is independent examination of financial

information of any entity, whether profit

oriented or not, and irrespective of its size or legal form, when such an examination is

conducted with a view to expressing an opini

on thereon.” The person conducting this process

should perform his work with knowledge of the

use of the accounting statements discussed

above and should take particular care to ensure that nothing contained in the statements will

ordinarily mislead anybody. This he can do

honestly by satisfying himself that:

(i) the accounts have been drawn up with reference to entries in the books of account;

(ii) the entries in the books of account are adequately supported by underlying papers and

documents and by other evidence;

(iii) none of the entries in the books of ac

count has been omitted in the process of

compilation and nothing which is not in the books of account has found place in the

statements;

(iv) the information conveyed by the

statements is clear and unambiguous;

(v) the financial statement amounts are prope

rly classified, described and disclosed in

conformity with acc

ounting standards; and

(vi) the statement of accounts taken as an integrated whole, present a true and fair picture

of the operational results and of

the assets and liabilities.

The aforesaid definition is very

authoritative. It makes clear that the basic objective of

auditing,

i.e.,

expression of opinion on financial statements does not change with reference to

nature, size or form of an entity. The definiti

on given above is restrictive since it covers

financial information aspect only. However, the

scope of auditing is not restricted to financial

1.4 Auditing and Assurance

information only, but, today it extends to variet

y of non-financial areas as well. That is how

various expressions like marketing audit, pe

rsonnel audit, efficiency

audit, production audit,

etc. came into existence. Students may note th

at study material deals wi

th various aspects of

financial audit only unless otherwise specified.

1.3 Standards on Auditing

1.3.1 International Auditing an

d Assurance Standards Board:

In 1977, the

International Federation of Accountants (IFAC) wa

s set up with a view to bringing harmony in

the profession of accountancy on an international

scale. In pursuing this mission, the IFAC

Board has established the International Audi

ting and Assurance Standards Board (IAASB) to

develop and issue, in the public interest and

under its own authority, high quality auditing

standards for use around the world. The IFAC Board has determined that designation of the

IAASB as the responsible body, under its own aut

hority and within its stated terms of

reference, best serves the public interest

in achieving this aspect of its mission.

The IAASB functions as an independent standard-setting body under the auspices of IFAC.

The objective of the IAASB is to serve the public interest by setting high quality auditing

standards and by facilitating the convergence of international and national standards, thereby

enhancing the quality and uniformity of practice throughout the world and strengthening public

confidence in the global auditing and assurance profession. The IAASB achieves this

objective by:

Establishing high quality audi

ting standards and guidance for financial statement audits

that are generally accepted and recognized

by investors, auditors

, governments, banking

regulators, securities regulators and ot

her key stakeholders across the world;

Establishing high quality standards and guidanc

e for other types of assurance services

on both financial and non-financial matters;

Establishing high quality standards and guidance for other related services;

Establishing high quality standards for qualit

y control covering the scope of services

addressed by the IAASB; and

Publishing other pronouncements on auditing and assurance matters, thereby advancing

public understanding of the roles and res

ponsibility of profes

sional auditors and

assurance service providers.

The IAASB’s Pronouncements:

The IAASB’s pronouncements

govern audit, review, other

assurance and related services engagements th

at are conducted in accordance with

International Standards. They do not override the local laws or regulations that govern the

audit of historical financial st

atements or assurance engagements on other information in a

particular country required to be followed in ac

cordance with that count

ry’s national standards.

In the event that local laws or regulations differ from, or conflict wi

th, the IAASB’s Standards

on a particular subject, an engagement conducted in accordance with local laws or regulations

Nature of Auditing 1.5

will not automatically

comply with the IAASB’s Standards.

A professional accountant should

not represent compliance with the IAASB’s Standards unless the professional accountant has

complied fully with all of those relevant to the engagement.

1.3.2 Auditing and Assu

rance Standards Board:

The Institute of Chartered

Accountants of India is a member of the IFAC

and is committed to work towards the imple-

mentation of the guidelines issued by the IFAC. The Institute of Chartered Accountants of

India constituted the Auditing Practices Commit

tee (APC) in 1982. The main function of the

APC is to review the existing auditing prac

tices in India and to develop Statements on

Standard Auditing Practices (SAPs) so that thes

e may be issued by the Council of the Insti-

tute. While formulating the SAPs in India, the APC gives due consideration to the international

auditing guidelines issued by the

IAPC and then tries to integrat

e them to the extent possible

in the light of the conditions and practices prevailing in India. While formulating the SAPs, the

APC takes into consideration the applicable la

ws, customs, usages and business environment

in India. In July, 2002, the Auditing Practi

ces Committee has been converted into an Auditing

and Assurance Standards Board (AASB) by the Council

of the Institute, to be in line with the

international trend. A significant step has

been taken aimed at bringing in the desired

transparency in the working of the Auditing and Assurance Standards Board, through

participation of representatives of various segm

ents of the society and interest groups, such

as, regulators, industry and academics. The nomenclature of SAPs had also been changed to

Auditing and Assurance Standards (AASs).

A major development in the field of auditing has

been the issuance of revised and /or redrafted

International Standards on Auditing pursuant to

the Clarity Project of IAASB. The objective of

this project is to improve the clarity of Inte

rnational Standards on Auditing (ISAs). The IAASB

aims to set high quality international

auditing and assurance standards that are

understandable, clear and capable of consistent application, thereby serving to enhance the

quality and uniformity of practice worldwide.

The Auditing and Assura

nce Standards Board has

also laid out a strategy to match step with

the IAASB Clarity Project. In the year 2007, the

Board issued several revised/new Standards

pursuant to the IAASB Clarity Project.

Renaming, Re-numbering and Categorisation of Auditing and Assurance Standards

The Auditing and Assurance Standards Board, in 2007, adopted the

Revised Preface to

Standards on Quality Control, Auditing, Revi

ew, Other Assurance and Related Services.

terms of the Revised Preface, the Auditing and Assurance Standards are now renamed based

on the type of assurance provided by

the engagement undertaken by a member, viz.,

(i)

Standards on Auditing (SAs)

- to be applied in the audit of hi

storical financial information

(ii)

Standards on Review Engagements (SREs)

- to be applied in the review of historical

financial information

(iii)

Standards on Assurance Engagements (SAEs)

- to be applied in assurance

engagements, engagements dealing with subject ma

tters other than historical financial

information

1.6 Auditing and Assurance

(iv)

Standards on Related Services (SRSs)

- to be applied to engagements to apply agreed

upon procedures to information and other related services engagements such as

compilation engagements

Further, there is also a mother standard on

quality control. In addition, each of the above

group of Standards has been allotted a numerical series as follows and the Standards

pertaining to a particular group is allotted a number from that numerical series:

Type of Standard Numerical Series

Standards on Quality Control 01-99

Standards on Auditing 100-999

Standards on Review Engagements 2000-2699

Standards on Assurance Engagements 3000-3699

Related Services 4000-4699

The Standards on Auditing have also been further divided into seven categories

Based on the aspect of audit engagement addressed by them and each of these categories

has a unique numerical series allotted. Therefore, a standard pertaining to a particular aspect

of audit would be allotted a number from that relevant numerical series. These categories and

series are as follows:

Aspect of Auditing Covered

Numerical Series

Introductory Matters

100 - 199

General Principles and Responsibilities

200 – 299

Risk Assessment and Response to Assessed

Risk

300 - 499

Audit Evidence

500 – 599

Using Work of Others

600 - 699

Audit Conclusions and Reporting

700 - 799

Specialised Areas

800 - 899

The Council of the ICAI has issued following

Quality Control and Engagement Standards

S.No

No. of

Standard

Title of the Standard

Effective

Date

1 SQC 1 Quality Control for Fi

rms that Perform Audits and

Reviews of Historical Financial Information, and

Other Assurance and Related Services Engagements

April 1,

2009

2 SA 200 Overall Objectives of the Independent Auditor and

the Conduct of an Audit in Accordance with

Standards on Auditing

April 1,

2010

3 SA 210 Agreeing the Terms of Audit Engagements

April 1,

2010

Nature of Auditing 1.7

4 SA 220 Quality Control for an Audit

of Financial Statements April 1,

2010

5 SA 230 Audit Documentation

April 1,

2009

6 SA 240 The Auditor’s responsibilities Relating to Fraud in an

Audit of Financial Statements

April 1,

2009

7 SA 250 Consideration of Laws and Regulations in an Audit of

Financial Statements

April 1,

2009

8 SA 260 Communication with Those Charged with

Governance

April 1,

2009

9 SA 265 Communicating Deficiencies in Internal Control to

Those Charged with Governance and Management

April 1,

2010

10 SA 299 Responsibility of Joint Auditors

April 1,

1996

11 SA 300 Planning an Audit of Financial Statements

April 1,

2008

12 SA 315 Identifying and Assessing the Risks of Material

Misstatement through Understanding the Entity and

its Environment

April 1,

2008

13 SA 320 Materiality in Planning and Performing an Audit April 1,

2010

14 SA 330 The Auditor’s Responses to Assessed Risks April 1,

2008

15 SA 402 Audit Considerations Relating to an Entity Using a

Service Organization

April 1,

2010

16 SA 450 Evaluation of Misstatements Identified During the

Audits

April 1,

2010

17 SA 500 Audit Evidence

April 1,

2009

18 SA 501 Audit Evidence - Specific Considerations for Selected

Items

April 1,

2010

19 SA 505 External Confirmations

April 1,

2010

20 SA 510 Initial Audit Engagements-

Opening Balances April 1,

2010

21 SA 520 Analytical Procedures

April 1,

2010

22 SA 530 Audit Sampling

April 1,

2009

23 SA 540 Auditing Accounting Estimates, Including Fair Value

Accounting Estimates, and Related Disclosures

April 1,

2009

1.8 Auditing and Assurance

24 SA 550 Related Parties April 1,

2010

25 SA 560 Subsequent Events

April 1,

2009

26 SA 570 Going Concern

April 1,

2009

27 SA 580 Written Representations

April 1,

2009

28 SA 600 Using the Work of Another Auditor

April 1,

2002

29 SA 610 Using the Work of Internal Auditors

April 1,

2010

30 SA 620 Using the Work of an

Auditor’s Expert April1,

2010

31 SA 700 Forming an Opinion and Reporting on Financial

Statements

April 1,

2011

32 SA 705 Modifications to the Opinion in the Independent

Auditor’s Report

April 1,

2011

33 SA 706 Emphasis of Matter Paragraphs and Other Matter

Paragraphs in the Independent Auditor’s Report

April 1,

2011

34 SA 710 Comparative Information – Corresponding Figures

and Comparative Financial Statements

April 1,

2011

35 SA 720 The Auditor’s Responsibility in Relation to Other

Information in Documents Containing Audited

Financial Statements

April 1,

2010

36 SA 800 Special Considerations-Audits of Financial

Statements Prepared in Accordance with Special

Purpose Frameworks

April 1,

2011

37 SA 805 Special Considerations-Audits of Single Purpose

Financial Statements and Specific Elements,

Accounts or Items of a Financial Statement

April 1,

2011

38 SA 810 Engagements to Report on Summary Financial

Statements

April 1,

2011

39 SRE 2400 Engagements to Review Financial Statements April 1,

2010

40 SRE 2410 Review of Interim Financial Information Performed by

the Independent Auditor of the Entity

April 1,

2010

41 SAE 3400 The Examination of Prospe

ctive Financial Information April 1,

2007

Nature of Auditing 1.9

42 SAE 3402 Assurance Reports on Controls At a Service

Organisation

April 1,

2011

43 SRS 4400 Engagements to Perform Agreed Upon Procedures

Regarding Financial Information

April 1,

2004

44 SRS 4410 Engagements to Compile Financial Information April 1,

2004

A diagrammatic representation of the structur

e of Standards under the new Preface is given

below:

Diagrammatic Representation of the Structure

of Standards Under the New Preface

These Standards will apply whenever an independen

t audit is carried out; that is, in the

independent examination of financial information of

any entity, whether profit oriented or not,

Chartered Accountants Act, 1949,

Code of Ethics and other relevant

pronouncements of the ICAI

Related Services

Framework for Assurance

Engagements

udits and reviews

of Historical

financial

Information

ssurance Engagements

other than audits or

reviews of historical

financial information

Standards on

uditing

(Sas)

100 - 999

Standards on

Review

Engagements

(SREs)

2000-2699

Standards on

ssurance

Engagements

(SAEs)

3000-3699

Standards on

Related Services

(SRSs)

4000- 4699

Standards on Quality Control (SQCs)

Services covered by the pronouncements of the

uditing and Assurance Standards Board under

the authority of the Council of ICA

Assurance Services

1.10 Auditing and Assurance

and irrespective of its size, or legal form

(unless specified otherwise) when such an

examination is conducted with a view to expr

essing an opinion thereon. While discharging

their attest function, it will be the duty of mem

bers of the Institute to ensure that the Standards

are followed in the audit of financial informat

ion covered by their audi

t reports. If for any

reason a member has not been able to perform an

audit in accordance with the Standards, his

report should draw attention to the material

departures therefrom, auditors will be expected to

follow Standards in the audits commencing on or after the date specified in the statement.

Remember all Standards are mandatory from the

date mentioned herein and it is obligatory

upon members of Institute to adhere to these whenever an audit is carried out.

All relevant Standards which are important from

students’ view point have been covered as an

integral part of the text.

Preface to the Standards on Quality Control, Auditing, Review, Other Assurance and

Related Services :

The Preface to the Standards on Qualit

y Control, Auditing, Review, Other

Assurance and Related Services has been issued

to facilitate understanding of the scope and

authority of the pronouncements of the AASB is

sued under the authority of the Council of the

Institute of Chartered Accountants of India (the ICAI).

The ICAI is committed to the goal of enabling th

e accountancy profession in India to provide

services of high quality in the public interest and

which are accepted worldwide. To further this

goal, the ICAI develops and promulgates technical Standards and other professional literature.

The ICAI being one of the founder members of the International Federation of Accountants

(IFAC), the Standards developed and promulga

ted by the AASB under the authority of the

Council of the ICAI are in conformity with th

e corresponding International Standards issued by

the International Auditing and

Assurance Standards Board (IAASB),

established by the IFAC.

The “Due Process” of the AASB for formulation of Standards, Statements, Guidance Notes

and its other pronouncements is reproduced in the

Volume II of the Study Material.

Compliance with Documents Issued by the Institute:

The Institute has, from time to time,

issued ‘Guidance Notes’ and ‘Statements’ on

a number of matters. The ‘Statements’ have

been issued with a view to securing compliance by members on matters which, in the opinion

of the Council, are critical for the proper dischar

ge of their functions. ‘Statements’ therefore

are mandatory. Accordingly, while discharging thei

r attest function, it will be the duty of the

members of the Institute:

(a) to examine whether ‘Statements’ relating to

accounting matters are complied with in the

presentation of financial statements covered by

their audit. In the event of any deviation

from the ‘Statements’, it wi

ll be their duty to make

adequate disclosures in their audit

reports

so that the users of financial statements may be aware of such deviations; and

(b) to ensure that the ‘Statements’ relating to

auditing matters are followed in the audit of

financial information covered by their audit repo

rts. If, for any reason, a member has not

been able to perform an audit in accordance

with such ‘Statements’, his report should

draw attention to the

material departures

, therefrom.

Guidance Notes’ are primarily designed to provide guidance to members on matters which

may arise in the course of their professional work

and on which they may rely in the course of

their professional work and on which they ma

y desire assistance in resolving issues which

may pose difficulty. Guidance Notes are re

commendatory in nature. A member should

ordinarily follow recommendations in a guidance note relating to an auditing matter except

where he is satisfied that in the circumstances of the case, it may not be necessary to do so.

Similarly, while discharging his attest func

tion, a member should examine whether the

recommendations in a guidance note relating to an accounting matter have been followed or

not. If the same have not been followed, the member should consider whether keeping in

view the circumstances of the case, a di

sclosure in his repo

rt is necessary.

1.4 The Auditor

The person conducting audit is known as the auditor; he makes a report to the person

appointing him after due examination of the accounting records and the accounting statement

in the form of an opinion on the financial statements. The opinion that he is called upon to

express is whether the financial statement reflec

t a true and fair view. Auditing, especially of

companies and for public purposes has become

the preserve of persons having recognised

professional training and qualification. In I

ndia, under the authority of the Companies Act,

1956, only Chartered Accountants are professiona

lly qualified for the audit

of the accounts of

companies. Students may note that the provision

relating to restricted state auditors was a

transitory provision and has no relevance now.

Chartered Accountants are in a position to

undertake auditing of almost any accounting as

pect, unlike cost accountants whose sphere

has been restricted to audit of the cost accounting

records and statements. By and large, it is

chartered accountants or a firm whose all pa

rtners are chartered accountants who act as

auditors in India.

1.4.1 Functional Classification of Auditors:

Internal Auditor vs. External Auditor:

On the basis of functional division, auditors ca

n be classified in two broad categories,

namely, external auditors and internal auditors. External auditors are the persons who practise

the profession of accountancy having qualified in the professional examination and are

external

vis-a-vis

the organisation of which they audit

the accounts. The in

ternal auditors, on

the other hand, may also be profes

sionally qualified and are internal

vis-a-vis

the organisation

in which they are appointed to perform specific

work. They are considered internal because

their appointment is done by the management and th

e scope of work is also specified by it.

They may be appointed either on a contract bas

is or as employees to undertake auditing of

the books and records as a part of management control and appraisal system. The external

auditors, on the other hand, are appointed by the owners of the organisation, say,

shareholders of the company and thus they are treated external to the organisation in which

they have been appointed. When an external auditor is appointed under a particular statute,

such auditor may be known as the statutory auditor.

Their scope of work is determined by the

statute under which they have been appointed. An

other significant distinction between the

internal and external auditor is that the former is not considered independent

vis-a-vis

the

1.12 Auditing and Assurance

management of the organisation while the latter is independent of the management of the

organisation which is responsible for the preparation of the books of account. Finally the

scope of work of an internal auditor may ex

tend even beyond the financial accounting and

may include cost investigation, inquiries relating to losses and wastages, production audit,

performance audit, etc. It must be remembered

that the basic foundation of any type of

auditing, whether internal or external, envis

ages that the auditor must be independent of the

activity for which he is going to conduct an

audit. Even though the internal auditor is an

employee yet he must be independent to the extent practicable.

1.4.2 Qualities of an Auditor:

So far we have discussed the question of formal

qualifications of an auditor. But it is not enough

to realise what an auditor should be. He is

concerned with the reporting on financial matters

of business and other institutions. Financial

matters inherently are to be set with the problems of human fallibility; errors and frauds are

frequent. The qualities required, according to

Dicksee, are tact, caution, firmness, good

temper, integrity, discretion, industry, judgement, patience, clear headedness and reliability. In

short, all those personal qualities that go to make a good businessman contribute to the

making of a good auditor. In addition, he must have the shine of culture for attaining a great

height. He must have the highest degree of integrity backed by adequate independence. In

fact, Code of ethics mentions integrity, objectivity and independence as one of the

fundamental principles of professional ethics.

He must have a thorough knowledge of the general principles of law which govern matters

with which he is likely to be in intimate c

ontact. The Companies Act, 1956 and the Partnership

Act, 1932 need special mention but mercantile law,

specially the law relating to contracts, is

no less important. Needless to say, where undertakings are governed by a special statute, its

knowledge will be imperative;

in addition, a sound knowledge of the law and practice of

taxation is unavoidable.

He must pursue an intensive programme of theore

tical education in subjects like financial and

management accounting, general management, business and corporate laws, computers and

information systems, taxation, economics, etc. Both practical training and theoretical

education are equally necessary for the development of professional competence of an auditor

for undertaking any kind of audit assignment.

The auditor should be equipped not only with a sufficient knowledge of the way in which

business generally is conducted but also with an understanding of the special features

peculiar to a particular business whose acc

ounts are under audit. The auditor, who holds a

position of trust, must have the basic human qua

lities apart from the technical requirement of

professional training and education.

He is called upon constantly to critically review

financial statements and it is obviously useless

for him to attempt that task unless his own k

nowledge is that of an expert. An exhaustive

knowledge of accounting in all its branches is the

sine qua non

of the practice of auditing. He

must know thoroughly all accounting principles and techniques.

Lord Justice Lindley in the course of the judgment in the famous

London & General Bank case

Nature of Auditing 1.13

had succinctly summed up the overall view of what an auditor should be as regards the

personal qualities. He said, “an auditor must be

honest that is, he must not certify what he

does not believe to be true and must take reasonable care and skill before he believes that

what he certifies is true”.

1.5 Objectives of Audit

1.5.1 Expression of opinion:

When we speak of the objective, we rationalise the thinking

process to formulate a set of attainable goals, wi

th reference to the circumstances, feasibility

and constraints. In money matters, frauds and

errors are common place of occurrence. Apart

from this, the statements of account have

their own purpose and use of portraying the

financial state of affairs. The objective of audi

t, naturally, should be to see that what the

statements of account convey is true and not misleading and that such errors and frauds do

not exist as to distort what th

e accounts really should convey.

Till recently, the principal emphasis was on arithmetical accuracy; adequate attention was not

paid to appropriate application of accounting principles and disclosure, for ensuring

preparation of accounting statements in such a way as to enable the reader of the accounting

statement to form a correct view of the stat

e of affairs. Quite a few managements took

advantage of the situation and manipulated profit

or loss and assets and lia

bilities to highlight

or conceal affairs according to their own design.

This state of affairs came up for consideration

in the

Royal Mail Steam Packet Company’s Case

as a result of which the Companies Acts of

England and India were amended in 1948 and 1956 respectively to require the auditor to state

inter alia

whether the statements of account are true and fair. This is what we can take as the

present day audit objective. The implication of th

e substitution of “true and correct” by “true

and fair” needs to be understood. There has been a shift of emphasis from arithmetical

accuracy to the question of reliability to the

financial statements. Mind you, a statement may

be reliable even though there are some errors or

even frauds, provided they are not so big as

to vitiate the picture. The word “correct” wa

s somewhat misplaced as the accounting largely

consists of estimates.

However, you should not infer that the detectio

n of errors and frauds is no longer an audit

objective: it is indeed an audit objective becaus

e statements of account drawn up from books

containing serious mistakes and fraudulent entr

ies cannot be considered as a true and fair

statement. To establish whether the financial stat

ements show a true and fair state of affairs,

the auditors must carry out a process of examination and verification and, if errors and frauds

exist they would come to his notice in the ordina

ry course of checking. But detection of errors

and frauds is not the primary aim of audit; the pr

imary aim is the establishment of a degree of

reliability of the annual statements of account.

If there remains a deep laid fraud in the accounts, which in the normal course of examination

of accounts may not come to light, it will not

be construed as failure of audit, provided the

auditor was not negligent in the carrying out his

normal work. This principle was established

as early as in 1896 in the leading case in

Re-Kingston Cotton Mills Co.

1.14 Auditing and Assurance

The nature of audit objectives was also highlighted in the leading case

Re The London and

General Bank Ltd. [1895].

It was held that an auditor must

ascertain that the books of account

show the true financial position of the company.

For the first time, the duties of the company

auditor were spelled out in specific terms. Lord

Justice Lindley observed, “It is no part of an

auditor’s duty to give adv

ice either to directors or shareholders as to what they ought to do. An

auditor has nothing to do with the prudence or

imprudence of making loans without security. It

is nothing to him whether the business of

company is being conducted prudently or

imprudently, profitably or unprofi

tably; it is nothing to him whether dividends are properly or

improperly declared, provided he discharges his own duty to the shareholders. His business is

to ascertain and state the true financial position

of the company at the time of the audit and his

duty is confined to that.”

SA-200 states that the auditor’s opinion on the financial statements deals with whether the

financial statements are prepared, in all materi

al respects, in accordance with the applicable

financial reporting framework. Such an opinion

is common to all audits of financial statements.

The auditor’s opinion therefore does not assure, for

example, the future vi

ability of the entity

nor the efficiency or effect

iveness with which management has conducted the affairs of the

entity. In some cases, however, the applicable

laws and regulations may require auditors to

provide opinions on other specific matters, such as

the effectiveness of internal control, or the

consistency of a separate management report wi

th the financial statements. While the SAs

include requirements and guidance in relation to

such matters to the ex

tent that they are

relevant to forming an opinion on the financi

al statements, the audito

r would be required to

undertake further work if the auditor had additional

responsibilities to provide such opinions.

So it follows from above that it is no part of

the auditor’s duty to probe into the propriety of

business conduct. This contention has been held perfectly valid as it has been asserted that

the conventional financial audit is concerned with

examination of the transactions to ascertain

the true and fair nature of the financial stat

ements. The auditor is merely concerned with

evaluating the evidence in support of transactions but need not examine the regularity and

prudence of various decisions taken by the management.

However, of late, this has undergone a change as

some of the requirements of law introduced

in the past require the company auditor to go

beyond the functions of reporting and express an

opinion about the propriety or prudence of certain

transactions in certain specific areas. Sub-

sections (1A) and (4A) of the section 227 of the Companies Act, 1956 contain various such

matters. It may also be clarified that the usage of words “true and fair” is restricted to certain

countries such as U.K. while in other countries li

ke United States the expression “full and fair”

is prevalent. However both expressions aim to convey same meaning.

On a consideration of what has been discussed, it may be summed up that auditing has the

principal objective of seeing whether or not t

he financial statements portray a true and fair

state of affair and of reporting accordingly. An incidental and secondary, but by no means an

insignificant audit objective, flowing from the

former, is detection of errors and frauds and

making recommendations to prevent their occurrence.

Nature of Auditing 1.15

1.5.2 Errors and Frauds

Accounting is a device for collecting and presenting useful

information in financial terms about a business en

terprise. It should as well be recognised that

accounting data may contain errors for a variety

of reasons, and those who rely on accounting

data frequently have no way of determining for th

emselves the reliability of data presented.

Even today the human element is the most significant element for recording and processing

the accounting data. Human beings as they

are always open to personal failures and

allurement. The audit objective, in the past wa

s, primarily concerned with the detection of

errors and frauds and now, though the general audi

t engagement do not specifically require

their detection, they do not rule them out and in fact stipulate their detection on the premise

that no statements of account can be considered true and fair if substantial errors and frauds

remain to distort the picture. Another presumption about errors and frauds which has wide

recognition, is that the audit techniques and processes, if carried on conscientiously would

bring to light errors and frauds even though the examination was not specifically directed to

reveal them.

In the context of auditor’s role in detection of

frauds, a significant development in the sphere of

management is the installation of control devices by the management to ensure compilation of

reliable statements of account. These are designed to plug the possibilities of errors and

frauds as they provide means for their early detection. It is true that management is

responsible for prevention of errors and frauds.

It can be argued that the auditor’s role in their

detection is very much conditioned by these developments. The auditor can achieve a lot by a

purposeful review of those control systems

and their operation. While conducting audit, the

auditor may come to know the area where contro

l is not foolproof or where control measures

have not been properly operated with a view to ensuring better control over errors and frauds.

In such instances, the auditor may provide the management with practicable suggestions for

alteration or modification of the controls and

checks. This is a safety for the future. It is a

matter of safety for the business because by acting on the expert suggestions, a better

assurance for obtaining reliable accounts is there. It is a safety for the auditor, if in future he is

hauled up before the Court to defend a charge of negligence for non-detection of errors and

frauds; it would be to his defense that he had already made the management aware of the

weaknesses in the book-keeping system and procedures and the management had failed to

act on his suggestions [

Re S. P. Catterson & Sons Ltd.]

If the books of account are not properly maintain

ed and if the control system is weak, the

possibility of frauds and errors are enormous and

the auditor, even with the best of his efforts,

may not be able to detect all of them. The fact is

recognised by the Courts as is obvious from

a study of the various judgments. The auditor’s

performance is judicially viewed by applying

the following tests:

(a) whether the auditor has exercised reasonable

care and skill in carrying out his work;

(b) whether the errors and frauds were such as could have been detected in the ordinary

course of checking without th

e aid of any special efforts;

1.16 Auditing and Assurance

pect the existence of the errors and frauds;

and

(d) whether the error or fraud was so deep laid that the same might not have been detected

by the application of normal audit procedures.

We have so far discussed the general background and the position of the auditors as regards

errors and frauds and we know that the auditor has a certain amount of responsibility for their

detection.

We shall now analyse the causes and nature of

errors and frauds. If an auditor is aware of

these, detection becomes easier in the sense th

at he can direct his enquiry more objectively

and plan his work having regard to general possibility of errors and frauds.

R.K. Mautz, in his book on “Fundamentals of

Auditing” has classified the reasons and

circumstances of errors and he has included fraud in the broad category of errors. The

classifications ar

e the following:

1. Ignorance on the part of employees of accounting developments, generally accepted

accounting principles, appropriate account classification of the necessary reconciling

subsidiary ledgers with contro

lling accounts and of good accounting practices in general.

2. Carelessness on the part of those doing the accounting work.

3. A desire to conceal the effect of defalc

ations of shortages of one kind or another.

4. A tendency of the management to permit prej

udice or bias to influence the interpretation

of transactions or events or their pr

esentation in the financial statements.

5. An ever present desire to hold taxes on income to minimum.

A sixth cause may be added to those Mr. Mautz has

listed and that is more serious in nature.

It is the intentional effort committed by

persons in position of authority to:

(i) show up the picture

depicted by the statements;

(ii) depress the picture depicted by the statements; and

(iii) convert the error

to a personal benefit.

Errors and frauds both distort the true picture

either by omission or by commission but the

distinction between the two lies in intent. Error is an involuntary act whereas fraud is a

deliberate act. Mautz also has classified the types of errors. These are:

1. Self-revealing and not self-revealing

2. Unintentional and intentional

3. Unconcealed and concealed

4. Affecting general ledger balances and not affecting general ledger balances.

Self-revealing errors

: These are such errors the existence of which becomes apparent in the

process of compilation of accounts. A few illustrations of such errors are given hereunder,

Nature of Auditing 1.17

showing how they become apparent.

(i)

Omission to post a part of a journal

entry to the ledger.

Trial balance is thrown out of agreement.

(ii)

Wrong totaling of the Purchase

Control Account (

e.g

., the Sundry Creditors

Account) balances and the aggregate of the

balances in the personal ledger will disagree.

(iii)

A failure to record in the cash book

amounts paid into or withdrawn from

the bank

Bank reconciliation statement will show up

error.

(iv)

A mistake in recording amount

received from X in the account of Y.

Statements of account of parties will reveal

mistake.

From the above, it is clear that certain apparent errors balance almost automatically by double

entry accounting procedure and by following established practices that lie within the

accounting system but not being generally considered to be a part of it, like bank reconciliation

or sending monthly statements of account for confirmation.

Many other errors, however, are not revealed by

either of these possibilities. If an item of

expense which should have been charged to repai

rs account has been charged by mistake to

the building account or if the amount of depreciat

ion is calculated incorrectly, there is nothing

in the book-keeping system which will bring the

error to notice. Such errors are non self-

revealing errors.

Suppose a debit entry is omitted to be posted in the ledger and there are one or more of such

omissions of credit entries which exactly compensate the effect of the former omission, then

another self-revealing error turns to be not so. Such mistakes may remain undetected

indefinitely unless measures aimed at discovering such errors are applied.

Intentional Errors or Frauds:

Fraud is the word used to mean

intentional error. This is done

deliberately which implies that there is intent to

deceive, to mislead or at least to conceal the

truth. It follows that other things being equal,

they are more serious than unintentional errors

because of the implication of dis

honesty which accompanies them.

As per SA-240,

“The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial

Statements”,

two types of intentional misstatements are relevant to the auditor’s

consideration of fraud-misstatements:

(i)

Fraudulent Financial Reporting:

It involves intentional miss

tatements or omissions of

amounts or disclosures in financial statemen

ts to deceive financial statement users.

Fraudulent financial reporting may involve:

Deception such as manipulation, falsification, or alteration of accounting records or

supporting documents from which the finan

cial statements are prepared. For

example, in a period of rising prices, sales contract documents may be ante-dated

1.18 Auditing and Assurance

to record sales at prices lower than the prices at which sales have actually taken

place.

Misrepresentation in, or intentional omission from, the financial statements of

events, transactions or other significant information. For example, goods sold may

not be recorded as sales but included in inventories.

Intentional misapplication of accounting principles relating to measurement,

recognition, classification, presentation, or disclosure. For example, where a

contracting firm follows the ‘completed co

ntract’ method of accounting but does not

provide for a known loss on incomplete contracts.

(ii)

Misappropriation of Assets

: It involves the theft of an

entity’s assets.

Misappropriation

of assets can be accomplished in a variet

y of ways (including embezzling receipts,

stealing physical or intangible assets, or ca

using an entity to pay for goods and services

not received); it is often accompanied by false or misleading records or documents in

order to conceal the fact that the assets are missing.

Therefore, it is clear from the above that the

‘fraud’ deals with intentional misrepresentation

but, ‘error’, on the other hand, refers to uninte

ntional mistakes in financial information.

Intentional errors are most difficult to detect

and auditors generally devote greater attention to

this type because out of long and sometimes unfortunate experience, auditors have developed

a point of view that if they direct their procedur

es of discovering the more difficult intentional

errors, they are reasonably certain to locate the more simple and far more common

unintentional errors on the way. The auditors have also learnt by experience that although

most people are honest under different circumst

ances but they may be unable to resist

temptations. When circumstances are such that

the possibility of being caught is rather

remote, most people are likely to respond to temp

tation. This is a well known aspect of human

behaviour. Auditors while studying the possibility and nature of fraud, must keep this always in

mind and should not make any exception for those who held high offices. Factors, like job

satisfaction in terms of responsibility,

trust and reward, pers

onal habits, temporary

requirements etc., have great bearing on the ma

tter of commission of fraud. These things

generally start in a non-consequential way-often a subordinate staff member first borrows

small amounts from the cash box to meet hi

s temporary difficulty and then gradually it

becomes his habit to borrow in such manner whenev

er he is in difficulty; when he finds that

nobody has even an inkling of the matter, he ventures with far larger amounts which on many

occasions, he finds himself unable to replace. Fraud also takes place in forms other than cash

defalcation, discussed above. It may be misappropriation of goods or manipulation of accounts

with a view to presenting a false state of affairs.

Defalcation of Cash:

Defalcation of cash has been found to perpetrate generally in the

following ways:

(a) By inflating cash payments.

Nature of Auditing 1.19

Examples of inflation of payments:

(1) Making payments again

st fictitious vouchers.

(2) Making payments against vouchers, the amounts whereof have been inflated.

(3) Manipulating totals of wage rolls either by including therein names of dummy

workers or by inflating them in any other manner.

(4) Casting a larger totals for petty cash expenditure and adjusting the excess in the

totals of the detailed columns so that cross totals show agreement.

(b) By suppressing cash receipts. Few Tec

hniques of how receipts are suppressed are:

(1)

Teeming and Lading

: Amount received from a customer being misappropriated; also

to prevent its detection the money rece

ived from another customer subsequently

being credited to the account of the customer who has paid earlier. Similarly,

moneys received from the customer who has paid thereafter being credited to the

account of the second customer and such a practice is continued so that no one

account is outstanding for payment for any length of time, which may lead the

management to either send out a statement of account to him or communicate with

him.

(2) Adjusting unauthorised or fictitious r

ebates, allowances, discounts, etc. to

customer’ accounts and misappropriating amount paid by them.

(3) Writing off as debts in respect of such balances against which cash has already

been received but has been misappropriated.

(4) Not accounting for cash sales fully.

(5) Not accounting for miscellaneous receipts,

e.g.,

sale of scrap, quarters allotted to

the employees, etc.

(6) Writing down asset values in en

tirety, selling t

hem subsequently and

misappropriating the proceeds.

Misappropriation of Goods:

Fraud in the form of

misappropriation of goods

is still more

difficult to detect; for this management has to

rely on various measures. Apart from the various

requirements of record keeping about the physical

quantities and their pe

riodic checks, there

must be rules and procedures for allowing persons inside the area where goods are kept. In

addition there should be external security arrangements to see that no goods are taken out

without proper authority. Goods can be anything in

the premises; it may be machinery. It may

even be the daily necessities of the office like stationery. The goods may be removed by

subordinate employees or even by persons qui

te higher up in the management. Auditors can

detect this by undertaking a thorough and strenuou

s checking of records followed by physical

verification process. Also, by resorting to in

telligent ratio analysis,

auditors may be able to

form an idea whether such fraud exists. For ex

ample, the gross profit ratio adjusted for any

1.20 Auditing and Assurance

recorded change during the year, reveals whether the value of stock is reasonable with

reference to the amount of the sale. Similarly, th

e input-output ratio of production in terms of

physical quantity may reveal whet

her output is normal with reference to the quantity consumed

for production.

Manipulation of Accounts:

Detection of manipulation of accounts with a view to presenting a

false state of affairs is a task requiring great tact and intelligence because generally

management personnel in higher management cadre are associated with this type of fraud

and this is perpetrated in methodical way. This type of fraud is generally committed:

(a) to avoid incidence of income-tax or other taxes;

(b) for declaring a dividend when there are insufficient profits;

to manipulate the value of shares in stock market to make it possible for selected

persons to acquire shares at a lower cost); and

(d) for receiving higher remuneration where managerial remuneration is payable by

reference to profits.

There are numerous ways of committing this type of fraud. Some of the methods are given

below:

(i) inflating or suppressing purchases and expenses;

(ii) inflating or suppressing sales and other items of income,

(iii) inflating or deflating the value of closing stock;

(iv) failing to adjust outstanding

liabilities or prepaid expenses; and

(v) charging items of capital expenditure to

revenue or by capitalising revenue expenses.

Concealed and Unconcealed Errors:

As a general rule, mistakes are unconcealed but

frauds are deliberately concealed. This proposition does not need any elaboration; but

exceptions are in both cases. Mistakes become concealed if compensated by another or more

mistakes in the opposite direction; or it may

even be greatly minimised by that chance

happening. For example, by mistake one or more accounts were short debited by an

aggregate figure of Rs. 30,000 and this short

debit is compensated by chance error or say

short casting or one or more credit accounts to

the tune of say Rs. 30,200 the dimension of

the error would apparently be Rs. 200 by which the trial balance would be thrown out of

agreement and there may be a temptation to think, “the error is small, let us ignore it”. This

attitude towards apparently small errors is

dangerous because its true dimensions remain

concealed and that may render the statements

of account totally unacceptable. Mistakes may

as well be concealed for wrong arithmetical calcul

ations or for a faulty process of verification.

Depreciation and stocks are examples wh

ich immediately come to one’s mind. Wrong

calculation of depreciation or omission to include certain stocks in the inventory or wrong

valuation of stocks is not apparent. Petty cash

defalcation is often unconcealed because petty

1.22 Auditing and Assurance

(iii) Compensating errors - where there are two or more errors which exactly counter balance

each other, so that the trial balance agrees in spite of them.

(iv) Errors of principle - these are errors

arising as a result of transactions having been

recorded in a fundamentally incorrect manner;

for example, a distinction not being made

between capital and revenue income or expenditure.

(v) Procedural errors.

1.5.3 Detection of Fraud and E

rror: Duty of an Auditor:

As per SA-240, “the Auditor’s

Responsibilities Relating to Fraud in an Audit of

Financial Statements”, states that the primary

responsibility for the prevention and detection of fraud rests with both those charged with

governance of the entity and management. It is important that management, with the

oversight of those charged with governance, place a strong emphasis on fraud prevention,

which may reduce opportunities for fraud to take place, and fraud deterrence, which could

persuade individuals not to commit fraud because of the likelihood of detection and

punishment. This involves a commitment to crea

ting a culture of honesty and ethical behavior

which can be reinforced by an active oversi

ght by those charged with governance. In

exercising oversight responsibility, those charged

with governance consider the potential for

override of controls or other inappropriate infl

uence over the financial reporting process, such

as efforts by management to manage earnings in order to influence the perceptions of

analysts as to the entity’s

performance and profitability.

Broadly, the general principles laid

down in the SA may be noted as under:

1. An auditor conducting an audit in accordance with SAs is responsible for obtaining

reasonable assurance that the financial statements taken as a whole are free from material

misstatement, whether caused by fraud or error. As described in SA 200, “

Overall Objectives

of the Independent Auditor and the Conduct of

an Audit in Accord

ance with Standards

on Auditing

,” owing to the inherent limitations of

an audit, there is an unavoidable risk that

some material misstatements of the financial stat

ements will not be detected, even though the

audit is properly planned and performe

d in accordance with the SAs.

2. The risk of not detecting a material misstat

ement resulting from fraud is higher than the

risk of not detecting one resulting from error.

This is because fraud may involve sophisticated

and carefully organized schemes designed to conceal

it, such as forgery, deliberate failure to

record transactions, or intentional misreprese

ntations being made to the auditor. Such

attempts at concealment may be even more difficult to detect when accompanied by collusion.

Collusion may cause the auditor to believe that audit evidence is persuasive when it is, in fact,

false. The auditor’s ability to detect a fraud depends on factors such as the skillfulness of the

perpetrator, the frequency and extent of manipulation, the degree of collusion involved, the

relative size of individual amounts manipulated,

and the seniority of those individuals involved.

While the auditor may be able to identify potential opportunities for fraud to be perpetrated, it

is difficult for the auditor to determine whether misstatements in judgment areas such as

accounting estimates are caused by fraud or error.

3. Furthermore, the risk of the auditor not dete

cting a material misstatement resulting from

Nature of Auditing 1.23

management fraud is greater than for employee fraud, because management is frequently in a

position to directly or

indirectly manipulate accounting

records, present fraudulent financial

information or override control procedures designed to prevent similar frauds by other

employees.

4. When obtaining reasonable assurance, the auditor is responsible for maintaining an

attitude of professional skepticism throughou

t the audit, considering the potential for

management override of controls and recognizing the fact that audit procedures that are

effective for detecting error may not be effective in detecting fraud. The requirements in this

SA are designed to assist the auditor in identi

fying and assessing the risks of material

misstatement due to fraud and in designing procedures to detect such misstatement.

SA-240, further explains by way of example

lists certain risk fact

ors and circumstances

relating to possibility of fraud which may be cons

idered by the auditor are dealt in the following

paragraphs.

Fraud risk factors

may be defined as events or

conditions that indicate an

incentive or pressure to commit fraud or

provide an opportunity to commit fraud.

I Examples of Fraud Risk Factors:

The fraud risk factors identi

fied here are examples of

such factors that may be faced by auditors in a broad range of situations. Separately

presented are examples relating to the two types of fraud relevant to the auditor’s

consideration, i.e., fraudulent financial reporting and

misappropriation of assets. For each of

these types of fraud, the risk factors are furt

her classified based on the three conditions

generally present when material misstatements due

to fraud occur: (a) incentives/pressures,

(b) opportunities, and (c) attitudes/rationalizat

ions. Although the risk factors cover a broad

range of situations, they are only examples

and, accordingly, the auditor may identify

additional or different risk factors. Not all of th

ese examples are relevant in all circumstances,

and some may be of greater or lesser significance

in entities of different size or with different

ownership characteristics or circ

umstances. Also, the order of the examples of risk factors

provided is not intended to reflect their re

lative importance or frequency of occurrence.

Risk Factors Relating to Misstateme

nts Arising from Fraudulent Financial

Reporting:

The following are examples of risk factor

s relating to misstatements arising from

fraudulent financial reporting.

Incentives/Pressures

Financial stability or profitability

is threatened by economic, industry,

or entity operating conditions, such as (or as indicated by):

High degree of competition or market satu

ration, accompanied by declining margins.

High vulnerability

to rapid changes, such as changes in technology, product

obsolescence, or interest rates.

Significant declines in customer demand and in

creasing business failures in either the

industry or overall economy.

Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover

imminent.

1.24 Auditing and Assurance

Recurring negative cash flows from operations

or an inability to generate cash flows from

operations while reporting earnings and earnings growth.

Rapid growth or unusual profitabi

lity especially compared to th

at of other companies in the

same industry.

New accounting, statutory, or regulatory requirements.

Excessive pressure exis

ts for management to meet the requ

irements or expectations of third

parties due to the following:

Profitability or trend level expectations of

investment analysts, institutional investors,

significant creditors, or other

external parties (particularly

expectations that are unduly

aggressive or unrealistic), including expectat

ions created by management in, for example,

overly optimistic press releases or annual report messages.

Need to obtain additional debt or equity financi

ng to stay competitive—including financing

of major research and development or capital expenditures.

Marginal ability to meet e

xchange listing requirements or debt repayment or other debt

covenant requirements.

Perceived or real adverse effects of reportin

g poor financial results on significant pending

transactions, such as business comb

inations or contract awards.

Information available indicates that the personal financial situation of management or those

charged with governance is threatened by the entity’s financial performance arising from the

following:

Significant financial interests in the entity.

Significant portions of their compensation (for example, bonuses, stock options, and earn-

out arrangements) being contingent upon achieving aggressive targets for stock price,

operating results, financial position, or cash flow.

Personal guarantees of debts of the entity.

There is excessive pressure on management or operating personnel to meet financial

targets established by those charged with governance, including sales or profitability

incentive goals.

Opportunities:

The nature of the industry or the entity

’s operations provi

des opportunities to

engage in fraudulent financial reporting that can arise from the following:

Significant related-party transactions not in th

e ordinary course of business or with related

entities not audited or

audited by another firm.

A strong financial presence or ability to dominat

e a certain industry sector that allows the

entity to dictate terms or conditions to

suppliers or customers that may result in

inappropriate or non-arm’s-length transactions.

Assets, liabilities, revenues, or expenses bas

ed on significant estimates that involve

Nature of Auditing 1.25

subjective judgments or uncertainties

that are difficult to corroborate.

Significant, unusual, or highly complex transactions, especially those close to period end

that pose difficult “substance over form” questions.

Significant operations located

or conducted across international

borders in jurisdictions

where differing business environments and cultures exist.

Use of business intermediaries for which there appears to be no clear business

justification.

Significant bank accounts or s

ubsidiary or branch operations in tax-haven jurisdictions for

which there appears to be no clear business justification.

The monitoring of management is not effective as a result of the following:

Domination of management by a single person or small group (in a non owner-managed

business) without compensating controls.

Oversight by those charged with governance over the financial reporting process and

internal control is not effective.

There is a complex or unstable organizational st

ructure, as evidenced by the following:

Difficulty in determining the or

ganization or individuals that ha

ve controlling interest in the

entity.

Overly complex organizational structure invo

lving unusual legal entities or managerial

lines of authority.

High turnover of senior management, legal c

ounsel, or those charged with governance.

Internal control components are defici

ent as a result of the following:

Inadequate monitoring of controls, including au

tomated controls and controls over interim

financial reporting (where exte

rnal reporting is required).

High turnover rates or employment of accounti

ng, internal audit, or information technology

staff that are not effective.

Accounting and information systems that are not effective, including situations involving

significant deficiencies

in internal control.

Attitudes/Rationalizations:

Communication, implementation, support, or enforcement of the

entity’s values or ethical standards by manage

ment, or the communication of inappropriate

values or ethical standards, that are not effective.

Non-financial management’s excessive participation in or preoccupation with the selection

of accounting policies or the determ

ination of significant estimates.

Known history of violations of securities la

ws or other laws and regulations, or claims

against the entity, its senior management, or

those charged with governance alleging

fraud or violations of laws and regulations.

1.26 Auditing and Assurance

Excessive interest by management in maintaining

or increasing the entity’s stock price or

earnings trend.

The practice by management of committing to analysts, creditors, and other third parties

to achieve aggressive or unrealistic forecasts.

Management failing to remedy known significant de

ficiencies in internal control on a timely

basis.

An interest by management in employing i

nappropriate means to minimize reported

earnings for tax-motivated reasons.

Low morale among senior management.

The owner-manager makes no distinction betw

een personal and business transactions.

Dispute between shareholders in a closely held entity.

Recurring attempts by management to justify marginal or inappropriate accounting on the

basis of materiality.

The relationship between management and the current or predecessor auditor is strained,

as exhibited by the following:

•

Frequent disputes with the current or predece

ssor auditor on accounting, auditing, or

reporting matters.

•

Unreasonable demands on the auditor, such as

unrealistic time constraints regarding

the completion of the audit or th

e issuance of the auditor’s report.

•

Restrictions on the auditor that inappropria

tely limit access to people or information

or the ability to communicate effectivel

y with those charged with governance.

•

Domineering management behavior in dealing wi

th the auditor, especially involving

attempts to influence the scope of the auditor’s work or the selection or continuance

of personnel assigned to or c

onsulted on the audit engagement.

Risk Factors Arising from Misstatemen

ts Arising from Misappropriation of

Assets:

Risk factors that relate to misstatements arising from misappropriation of assets are

also classified according to the three c

onditions generally present when fraud exists:

incentives/pressures, opportunities, and attitude

s/rationalization. Some of the risk factors

related to misstatements arising from fraudulen

t financial reporting also may be present when

misstatements arising from misappropriation of assets occur. For example, ineffective

monitoring of management and other deficiencies in internal control may be present when

misstatements due to either fraudulent financial

reporting or misappropriation of assets exist.

The following are examples of risk factors related to misstatements arising from

misappropriation of assets.

Incentives/Pressures

: Personal financial obligations may

create pressure on management or

employees with access to cash or other assets

susceptible to theft to misappropriate those

assets.

Adverse relationships between the entity and empl

oyees with access to cash or other assets

Nature of Auditing 1.27

susceptible to theft may motivate those empl

oyees to misappropriate those assets. For

example, adverse relationships may be created by the following:

Known or anticipated future employee layoffs.

Recent or anticipated changes to employee compensation or benefit plans.

Promotions, compensation, or other rewa

rds inconsistent with expectations.

Opportunities :

Certain characteristics or circumstances may increase the susceptibility of

assets to misappropriation. For example, oppor

tunities to misappropriate assets increase

when there are the following:

Large amounts of cash on hand or processed.

Inventory items that are small in size, of high value, or in high demand.

Easily convertible assets, such as bearer bonds, diamonds, or computer chips.

Fixed assets which are small in size, marketable, or lacking observable identification of

ownership.

Inadequate internal control over assets may increa

se the susceptibility of misappropriation of

those assets. For example, misappropriation

of assets may occur because there is the

following:

Inadequate segregation of duties or independent checks.

Inadequate oversight of senior management expenditures, such as travel and other

reimbursements.

Inadequate management oversight of employees responsible for assets, for example,

inadequate supervision or monitoring of remote locations.

Inadequate job applicant screening of empl

oyees with access to assets.

Inadequate record keeping wi

th respect to assets.

Inadequate system of authorization and approv

al of transactions (for example, in

purchasing).

Inadequate physical safeguards

over cash, investments, inventory, or fixed assets.

Lack of complete and timely reconciliations of assets.

Lack of timely and appropriate documentatio

n of transactions, for example, credits for

merchandise returns.

Lack of mandatory vacations for employees performing key control functions.

Inadequate management understanding of information technology, which enables

information technology employees to perpetrate a misappropriation.

Inadequate access controls over automated reco

rds, including controls over and review of

computer systems event logs.

1.28 Auditing and Assurance

Attitudes/Rationalizations :

Disregard for the need for monitori

ng or reducing risks related to

misappropriations of assets.

Disregard for internal control over misappropr

iation of assets by overriding existing

controls or by failing to take appropriate re

medial action on known deficiencies in internal

control.

Behavior indicating displeasure or dissatisfact

ion with the entity or its treatment of the

employee.

Changes in behavior or lifestyle that may i

ndicate assets have

been misappropriated.

Tolerance of petty theft.

II. Examples of circumstances that in

dicate the possibility of fraud:

The following are

examples of circumstances that may indicate th

e possibility that the fi

nancial statements may

contain a material misstatement resulting from fraud.

Discrepancies in the accounting records, including:

Transactions that are not recorded in a complete or timely manner or are improperly

recorded as to amount, accounting peri

od, classification,

or entity policy.

Unsupported or unauthorized balances or transactions.

Last-minute adjustments that signifi

cantly affect financial results.

Evidence of employees’ access to systems and

records inconsistent with that necessary

to perform their authorized duties.

Tips or complaints to the auditor about alleged fraud.

Conflicting or missing evidence, including:

Missing documents.

Documents that appear to have been altered.

Unavailability of other than photocopied or

electronically transmitted documents when

documents in original form are expected to exist.

Significant unexplained items on reconciliations.

Unusual balance sheet changes, or changes in

trends or important financial statement

ratios or relationships, for example, receivables growing faster than revenues.

Inconsistent, vague, or implausible respon

ses from management or employees arising

from inquiries or analytical procedures.

Unusual discrepancies between the entity

's records and confirmation replies.

Large numbers of credit entries and other adjustments made to accounts receivable

records.

Unexplained or inadequately explained differenc

es between the accounts receivable sub-

Nature of Auditing 1.29

ledger and the control account, or between

the customer statements and the accounts

receivable sub-ledger.

Missing or non-existent cancelled cheques in circumstances where cancelled cheques are

ordinarily returned to the entity with the bank statement.

Missing inventory or physical as

sets of significant magnitude.

Unavailable or missing electronic evidence, inco

nsistent with the enti

ty’s record retention

practices or policies.

Fewer responses to confirmations than anticipated or a greater number of responses than

anticipated.

Inability to produce evidence of key s

ystems development and program change testing

and implementation activities for current-year system changes and deployments.

Problematic or unusual relationships between the auditor and management, including:

Denial of access to records, facilities, cert

ain employees, customers, vendors, or others

from whom audit evidence might be sought.

Undue time pressures imposed by management to

resolve complex or contentious issues.

Complaints by management about the conduct of the audit or management intimidation of

engagement team members, particularly in

connection with the auditor’s critical

assessment of audit evidence or in the

resolution of potential disagreements with

management.

Unusual delays by the entity in

providing requested information.

Unwillingness to facilitate audito

r access to key el

ectronic files for testing through the use

of computer-assisted audit techniques.

Denial of access to key IT operations staff

and facilities, including security, operations,

and systems development personnel.

An unwillingness to add or revise disclosures

in the financial statements to make them

more complete and understandable.

An unwillingness to address identified deficiencies in internal control on a timely basis.

Other

Unwillingness by management to pe

rmit the auditor to meet pr

ivately with those charged

with governance.

Accounting policies that appear to be at variance with industry norms.

Frequent changes in accounting estimates that

do not appear to result from changed

circumstances.

Tolerance of violations of the entity’s Code of Conduct.

1.30 Auditing and Assurance

1.6 Basic Principles

Governing an Audit

The basic principles govern the auditor’s profes

sional responsibilities and should be complied

with whenever an audit is carried out. Complia

nce with the basic principles requires the

application of auditing procedures and reporting

practices appropriate to the particular

circumstances. The basic principles

as stated in this guideline are:

Integrity, objectivity and independence

: The auditor should be straightforward, honest

and sincere in his approach to his professional

work. He must be fair and must not allow

prejudice or bias to override his objectivity. He should maintain an impartial attitude and

both be and appear to be free of any interest which might be regarded, whatever its

actual effect, as being incompatible with integrity and objectivity.

Confidentiality

: The auditor should respect the confidentiality of information acquired in

the course of his work and should not disclo

se any such information to a third party

without specific authority or unless there is

a legal or professional duty to disclose.

Skills and competence

: The audit should be performed and the report prepared with due

professional care by persons who have adequate

training, experience and competence in

auditing. The auditor requires specialised

skills and competence which are acquired

through a combination of general education, knowledge obtained through study and

formal courses concluded by qualifying examination recognised for this purpose and

practical experience under proper supervis

ion. In addition, the auditor requires a

continuing awareness of developments including pronouncements of the ICAI on

accounting and auditing matters, and releva

nt regulations and statutory requirements.

Work performed by others

: When the auditor delegates work

to assistants or uses work

performed by other auditors and experts he

continues to be responsible for forming and

expressing his opinion on the financial informat

ion. However, he will be entitled to rely on

work performed by others, provided he exercises adequate skill and care and is not

aware of any reason to believe that he shoul

d not have so relied. In the case of any

independent statutory appointment to perform the

work on which the auditor has to rely in

forming his opinion, as in the case of the work of branch auditors appointed under the

Companies Act, 1956 the auditor’s report should ex

pressly state the fact of such reliance.

The auditor should carefully di

rect, supervise and review wo

rk delegated to assistants.

The auditor should obtain reasonable assurance th

at work performed by other auditor or

experts is adequate for his purpose.

Documentation

: The auditor should document matters which are important in providing

evidence that the audit was carried out in accordance with the basic principles.

Planning

: The auditor should plan his work to enabl

e him to conduct an effective audit in

an efficient and timely manner. Plans shoul

d be based on knowledge of the client’s

business. Plans should be made to cover, among other things:

(a) acquiring knowledge of the client’s acc

ounting system, policies and internal control

procedures;

Nature of Auditing 1.31

(b) establishing the expected degree of reliance to be placed on internal control;

timing, and extent of the audit procedures

to be performed; and

(d) Coordinating the work to be performed.

Plans should be further developed and revised as necessary during the course of the

audit.

Audit Evidence

: The auditor should obtain suffic

ient appropriate audit evidence through

the performance of compliance and substantive procedures to enable him to draw

reasonable conclusions therefrom on which to base his opinion on the financial

information.

Compliance procedures

are tests designed to obtain reasonable assurance

that those internal controls on which audit reliance is to be placed are in effect.

Substantive procedures

are designed to obtain evidence as to the completeness,

accuracy and validity of the data produced by the accounting system.

They are of two types:

(i) test of details of transactions and balances; and

(ii) analysis of significant

ratios and trends including the resulting enquiry of unusual

fluctuations and items.

Accounting System and Internal Control

: Management is responsible for maintaining an

adequate accounting system incorporating va

rious internal controls to the extent

appropriate to the size and nature of the

business. The auditor should reasonably assure

himself that the accounting system is adequate

and that all the accounting information

which should be recorded has in fact been recorded. Internal controls normally contribute

to such assurance.

The auditor should gain an understanding of

the accounting system and related controls

and should study and evaluate the operation of those internal controls upon which he

wishes to rely in determining the nature

, timing and extent of other audit procedures.

Where the auditor concludes that he can rely on

certain internal controls, his substantive

procedures would normally be less extensive than would otherwise be required and may

also differ as to t

heir nature and timing.

Audit conclusions and reporting

: The auditor should review and assess the conclusions

drawn from the audit evidence obtained and fr

om his knowledge of business of the entity

as the basis for the expression of his opinion

on the financial information. This review

and assessment involves forming an

overall conclusion as to whether :

(a) the financial information has been prepared using acceptable accounting policies,

which have been consistently applied;

(b) the financial information complies with relevant regulations and statutory

requirements;

1.32 Auditing and Assurance

presentation of the financial information, subject to statutory requirements, where

applicable.

The audit report should contain a clear written opinion on the financial information and if the

form or content of the report is laid down in

or prescribed under any agreement or statute or

regulation, the audit report should comply wi

th such requirements. An unqualified opinion

indicates the auditor’s satisfaction in all material

respects with

the matters stated above or as

may be laid down or prescribed under the agreement or statute or regulation as the case may

be.

When a qualified opinion, adverse opinion or a disclaimer of opinion is to be given or

reservation of opinion on any matter is to be made, the audit report should state the reasons

therefore.

1.7 Scope of Audit

The scope of an audit of financial statements

will be determined by the auditor for having

regard to the terms of the engagement, the requirement of relevant legislation and the

pronouncements of the Institute. The terms of

engagement cannot, however, restrict the scope

of an audit in relation to matters which are prescribed by legislation or by the pronouncements

of the Institute.

The audit should be organized to cover adequately all aspects of the enterprise as far as they

are relevant to the financial statements being audited. To form an opinion on the financial

statements, the auditor should be reasonably sati

sfied as to whether the information contained

in the underlying accounting records and other source data is reliable and sufficient as the

basis for the preparation of the financial statements

. In forming his opinion, the auditor should

also decide whether the relevant information is

properly disclosed in the financial statements

subject to statutory requirements, where applic

able. The auditor assesses the reliability and

sufficiency of the information contained in the underlying accounting records and other source

data by :

(a) making a study and evaluation of accounting systems and internal controls on which he

wishes to rely and testing those internal c

ontrols to determine the nature, extent and

timing of other auditing procedures; and

(b) carrying out such other tests, enquiries and other verification procedures of accounting

transactions and account balances as he consid

ers appropriate in the particular circum-

stances.

The auditor determines whether the relevant info

rmation is properly disclosed in the financial

statements by :

(a) comparing the financial statements with the underlying accounting records and other

source data to see whether they prope

rly summarize the transactions and events

recorded therein; and

Nature of Auditing 1.33

(b) considering the judgments that management has made in preparing the financial

statements accordingly, the auditor assessees

the selection and consistent application of

accounting policies, the manner in which t

he information has been classified, and the

adequacy of disclosure.

In forming his opinion on the financial statements, the auditor follows procedures designed to

satisfy himself that the financial statements reflec

t a true and fair view of the financial position

and operation results of the enterprise. The auditor recognizes that because of the test nature

and other inherent limitations of an audit together

with inherent limitations of any system of

internal control, there is an unavoidable risk

that some material misstatements may remain

undiscovered. While in many situations the

discovery of material

misstatement by

management may often arise during the conduct of the audit, such discovery is not the main

objective of audit nor is the

auditor’s programme of work s

pecifically designed for such

discovery. The audit cannot, therefore, be relied

upon to ensure the discovery of all frauds or

errors but where the auditor has any indication

that some fraud or error may have occurred

which could result in material misstatemen

t, the auditor should extend his procedures to

confirm or dispel his suspicions.

The auditor is primarily concerned with items

which either individually or as a group are

material in relation to the affairs of an enterprise. However, it is difficult to lay down any

definite standard by which materiality can be judged. Material items are those which might

influence the decisions of the user of the fi

nancial statements. It is a matter in which a

decision is arrived at on the basis of th

e auditor’s professional experience and judgment.

The auditor is not expected to perform duties wh

ich fall outside the scope of his competence.

For example, the professional skill required of

an auditor does not include that of a technical

expert for determining physical condition of certain assets.

Constraints on the scope of the audit of financial

statements that impair

the auditor’s ability to

express an unqualified opinion on such financial

statement should be set out in his report, and

a qualified opinion or disclaimer of opini

on should be expressed as appropriate.

As per SA 200 “Overall Objectives of the

Independent Auditor and the Conduct of an Audit in

Accordance with Standards on Auditing”, the pu

rpose of an audit is to enhance the degree of

confidence of intended users in the financial statem

ents. This is achieved by the expression of

an opinion by the auditor on whether the financ

ial statements are prepared, in all material

respects, in accordance with an applicable financia

l reporting framework. In the case of most

general purpose frameworks, that opinion is

on whether the financial statements are

presented fairly, in all material

respects, or give a true and fa

ir view in accordance with the

framework. An audit conducted in accordance

with SAs and relevant ethical requirements

enables the auditor to form that opinion.

The auditor’s opinion on the financial statement

s deals with whether the

financial statements

are prepared, in all material respects, in a

ccordance with the applicable financial reporting

framework. Such an opinion is common to

all audits of financial statements. The auditor’s

opinion therefore does not assure, for example, the future viability of the entity nor the

efficiency or effectiveness with which management

has conducted the affairs of the entity. In

some cases, however, the applicable laws and

regulations may require auditors to provide

opinions on other specific matters, such as t

he effectiveness of internal control, or the

consistency of a separate management report wi

th the financial statements. While the SAs

include requirements and guidance in relation to

such matters to the ex

tent that they are

relevant to forming an opinion on the financi

al statements, the audito

r would be required to

undertake further work if the auditor had additional

responsibilities to provide such opinions.

Aspects to Be Covered In Audit

The principal aspect to be covered in an audit c

oncerning final statements of account are the

following :

(i) An examination of the system of accounting

and internal control to ascertain whether it is

appropriate for the business and helps in properly recording all transactions. This is

followed by such tests and enquiries as are considered necessary to ascertain whether

the system is in actual operation. These steps are necessary to form an opinion as to

whether reliance can be placed on the reco

rds as a basis for the preparation of final

statements of account.

(ii) Reviewing the system and procedures to find out whether they are adequate and

comprehensive and incidentally whether material inadequacies and weaknesses exist to

allow frauds and errors going unnoticed.

(iii) Checking of the arithmetical accuracy of

the books of account by

the verification of

postings, balances, etc.

(iv) Verification of the authenticity and validity of transaction entered into by making an

examination of the entries in the books of accounts with the relevant supporting

documents.

(v) Ascertaining that a proper distinction has

been made between items of capital and of

revenue nature and that the amounts of various items of income and expenditure

adjusted in the accounts corresponding to the accounting period.

(vi) Comparison of the balance sheet and profit

and loss account or other statements with the

underlying record in order to see that

they are in accordance therewith.

(vii) Verification of the title,

existence and value of the assets appearing in the balance sheet.

(viii) Verification of the liabilities stated in the balance sheet.

(ix) Checking the result shown by the profit and loss and to see whether the results shown

are true and fair.

(x) Where audit is of a corporate body, confirming that the statutory requirements have been

complied with.

Nature of Auditing 1.35

(xi) Reporting to the appropriate person/body whether the statements of account examined

do reveal a true and fair view of the state of affairs and of the profit and loss of the

organisation.

It will thus be realised that the duties are not li

mited to the verification of the arithmetical

accuracy of the books of account kept by his client; he must also satisfy himself that entries in

the books are true and contain a complete record of all the transactions of the business and

these are recorded in such a manner that their

real nature is revealed. On that account, he

must examine all vouchers, invoices, minutes

of directors or partners correspondence and

other documentary evidence that is available to

establish the nature and authenticity of the

transactions. Besides, he must verify that ther

e exists a proper authority in respect of each

transaction; that each transaction is correctly re

corded, etc. Finally, he must verify that the

form in which the final accounts are drawn up is

the one prescribed by law or is the one that

ordinarily would present a true and fair picture of state of affairs of the business.

1.8 Inherent Limitations of Audit

As per SA 200 “Overall Objectives of the

Independent Auditor and the Conduct of an Audit in

Accordance with Standards on Auditing”, the objec

tives of an audit of financial statements,

prepared with in a framework of recognised

accounting policies and practices and relevant

statutory requirements, if any, is to enable an auditor to express an opinion on such financial

statements. In forming his opinion on the fi

nancial statements, the auditor follows procedures

designed to satisfy him that the financial statemen

ts reflect a true and fair view of the financial

position and operating results of the enterprise. The process of auditing, however, is such that

it suffers from certain limitations, i.e. the lim

itation which cannot be overcome irrespective of

the nature and extent of audit procedures.

The limitations of

an audit arise from:

The Nature of Financial Reporting

: The preparation of financial statements involves

judgment by management in applying the requirements of the entity’s applicable financial

reporting framework to the facts and circumst

ances of the entity. In addition, many

financial statement items involve subjective

decisions or assessments or a degree of

uncertainty, and there may be a range of acceptable interpretations or judgments that

may be made. Consequently, some financial statement items are subject to an inherent

level of variability which cannot be elimin

ated by the application of additional auditing

procedures.

ii.

The Nature of Audit Procedures

: There are practical and legal limitations on the

auditor’s ability to obtain audit evidence. For example:

1. There is the possibility that management or

others may not provide, intentionally or

unintentionally, the complete information that is relevant to the preparation and

presentation of the financial statements or

that has been requeste

d by the auditor.

1.36 Auditing and Assurance

2. Fraud may involve sophisticated and

carefully organised schemes designed to

conceal it. The auditor is nei

ther trained as nor expected to be an expert in the

authentication of documents.

3. An audit is not an official investigation into alleged wrongdoing. Accordingly, the

auditor is not given specific legal powers,

such as the power of search, which may

be necessary for such an investigation.

iii.

Timeliness of Financial Reporting and the Balance between Benefit and Cost:

The

relevance of information, and thereby its value,

tends to diminish over time, and there is

a balance to be struck between the reliability

of information and its cost. There is an

expectation by users of financial statements

that the auditor will fo

rm an opinion on the

financial statements within a reasonable pe

riod of time and at a reasonable cost,

recognising that it is impracticable to address

all information that may exist or to pursue

every matter exhaustively on the assumption that

information is in error or fraudulent until

proved otherwise.

iv.

Other Matters that Affect the Limitations of an Audit:

In the case of certain assertions

or subject matters, the potential effects of the

limitations on the auditor

’s ability to detect

material misstatements are particularly significant. Such assertions or subject matters

include:

Fraud, particularly fraud involving senior management or collusion.

The existence and completeness of related party relationships and transactions.

The occurrence of non-compliance

with laws and regulations.s

Future events or conditions that may cause an entity to cease to continue as a

going concern.

Because of the limitations of an audit, ther

e is an unavoidable risk that some material

misstatements of the financial statements ma

y not be detected, even though the audit is

properly planned and performed in accordance with SAs.

1.9 Auditing And Investigation

To understand auditing in its correct perspecti

ve, one should know how auditing is distinct

from investigation.

Auditing is different from investigation which is another significant service, a professional

accountant renders. Investigation is a critical

examination of the accounts with a special

purpose. For example if fraud is suspected and an accountant is called upon to check the

accounts to whether fraud really exists and if

so, the amount involved, the character of the

enquiry changes into investigation. Investigation may be undertaken in numerous areas of

accounts,

e.g.

, the extent of waste and loss, profitability, cost of production, etc. It normally

concerns only specified areas, but at times, it

may involve the whole field of accounting. Its

essence lies in going into the matter with some pre-conceived notion suited to the objective.

Nature of Auditing 1.37

The techniques fit the circumstances of the

case. For auditing on the other hand, the general

objective is to find out whether the

accounts show a true and fair view.

Audit never undertakes discovery of specific

happenings and is never started with a pre-

conceived notion about the state of affairs. The auditor seeks to report what he finds in the

normal course of examination of the accoun

ts adopting generally followed techniques unless

circumstances call for a special probe: fraud,

error, irregularity, whatever comes to the

auditor’s notice in the usual course of checking

, are all looked into in depth and sometimes

investigation results from the

prima facie

findings of the auditor.

1.10 Types of Audit

Audit is not legally obligatory for all types of

business organisations or institutions. On this

basis audits may be of two broad categories

i.e.,

audit required under law and voluntary

audits.

(i) Audit required under law:

The organisations which requi

re audit under law are the

following:

(a) companies governed by the Companies Act, 1956;

(b) banking companies governed by the Banking Regulation Act, 1949;

by the Electricity Supply Act, 1948;

(d) co-operative societies registered under the Co-operative Societies Act, 1912;

(e) public and charitable trusts register

ed under various Religious and Endowment

Acts;

(g) corporations set up under an Act of Parliament or State Legislature such as the Life

Insurance Corporation of India.

(h) Specified entities under various sections of the Income-tax Act, 1961.

(ii) In the voluntary category are the audits

of the accounts of proprietary entities,

partnership firms, Hindu undivided families, etc.

In respect of such accounts, there is no

basic legal requirement of audit. Many of such

enterprises as a matter of internal rules

require audit. Some may be required to get thei

r accounts audited on the directives of

Government for various purposes like sanction

of grants, loans, etc. But the important

motive for getting accounts audited lies in the advantages that follow from an

independent professional audit. This is per

haps the reason why large numbers of

proprietary and partnership business get thei

r accounts audited. Government companies

have some special features which will be seen later.

As already stated, the auditor should get the sc

ope of his duties and responsibilities defined

by obtaining instructions in writing. Also it is always a wise precaution to state in the report,

accompanying the balance sheets

of proprietary or partnersh

ip firms or other similar

organisations, the nature of the work carried out and explain the important features of the

1.38 Auditing and Assurance

financial statements on which a report has been

made. Furthermore, to ensure that the report

will be brought to the notice of all concerned, th

e accounts should bear reference to the report.

A special reference is necessary for non-profi

t making institutions like schools, clubs,

hospitals. Most of these have some internal

rules to govern their affairs and generally a

provision about the requirement of audit is inserted

. Activity in the nature of business is not

altogether ruled out as a club may sell drinks

and eatables to the members and their guests or

a school may have endowed agricultural property

to yield income. What makes them distinct,

is the absence of the question of division of profit : any surplus which may arise can only be

used for achieving the objects of the instit

ution. Educational institutions, hospitals,

associations, etc., irrespective of any internal

rules, get their accounts audited because most

of them enjoy government or municipal grants and, generally, for this purpose audited

accounts are insisted upon.

Trust, however, stands on a slight

ly different footing; these ma

y be public trusts or private

trusts. Trusts can carry on business as well. In

the majority of cases trustees are private

persons. Trusts generally have two classes of beneficiaries; tenants for life and remainders;

persons to whom the accounts are of the s

upreme importance are often widows and minors,

who cannot criticize the accounts in any effect

ive manner. Though audit of trusts, except for

public trusts, is not compulsory most of the trust deeds contain a clause for audit of accounts.

Private trustees also recognise the advantages

of audit in their own interest, since any

erroneous treatment in the accounts for which t

hey might be personally

liable will be pointed

out by the auditor.

1.11 Advantages of an

Independent Audit

The fact that audit is compulsory by law, in cert

ain cases by itself should show that there must

be some positive utility in it. The chief utility

of audit lies in reliable financial statements on the

basis of which the state of affairs may be easy

to understand. Apart from this obvious utility,

there are other advantages of audit. Some or all of these are of considerable value even to

those enterprises and organisations where audit

is not compulsory, these advantages are

given below :

(a) It safeguards the financial interest of persons who are not associated with the

management of the entity, whether they are partners or shareholders.

(b) It acts as a moral check on the employees from committing defalcations or

embezzlement.

settling liability for

taxes, negotiating loans

and for determining the purchase consideration for a business.

(d) These are also useful for settling trade

disputes for higher wages or bonus as well as

claims in respect of damage suffered by pr

operty, by fire or some other calamity.

Nature of Auditing 1.39

(e) An audit can also help in the detection of

wastages and losses to show the different ways

by which these might be checked, especially those that occur due to the absence or

inadequacy of internal checks or

internal control measures.

(g) Audit ascertains whether the necessary boo

ks of account and allied records have been

properly kept and helps the client in making good deficiencies or inadequacies in this

respect.

(h) As an appraisal function, audit reviews the existence and operations of various controls

in the organisations and reports weaknesses, inadequacies, etc., in them.

(i) Audited accounts are of great help in the

settlement of accounts at the time of admission

or death of partner.

(j) Government may require audited and certifie

d statement before it gives assistance or

issues a license for a particular trade.

1.12 Relationship of Auditi

ng With Other Disciplines

The field of auditing as a discipline in simple wo

rds involves review of various assertions; both

in financial as well as in non-financial terms,

with a view to prove the veracity of such

assertions and expression of opinion by audito

r on the same. Thus, it is quite logical and

natural that the function of audit can be perfor

med if and only if the person also possesses a

good knowledge about the fields in respect of which he is conducting such a review.

1.12.1 Auditing and Accounting

It has been pointed out earlier that both accounting

and auditing are closely related with each other

as auditing reviews the financial statements

which are nothing but a result of the overall accounting process. It naturally calls on the part of

the auditor to have a thorough and sound knowledge of generally accepted principles of

accounting before he can review the financial st

atements. In fact, auditi

ng as a discipline is

also closely related with various other disciplines

as there is lot of linkages in the work which

is done by an auditor in his day-to

-day activities. To begin with,

it may be noted that the disci-

pline of auditing itself is a logical construct

and everything done in auditing must be bound by

the rules of logic. Ethical precepts are the foundations on which the foundation of the entire

accounting profession rests. The knowledge of language is also considered essential in the

field of auditing as the auditor s

hall be required to communicate,

both in writing as well as

orally, in day-to-day work.

1.12.2 Auditing and Law

The relationship between auditing and law is very close one.

Auditing involves examination of various transac

tions from the view point of whether or not

these have been properly entered into. It

necessitates that an auditor should have a good

knowledge of business laws affecting the entity. He should be familiar with the law of

contracts, negotiable instruments, etc. The know

ledge of taxation laws is also inevitable as

entity is required to prepare thei

r financial statements taking into account various provisions

affected by various tax laws. In analysing the im

pact of various transactions particularly from

the accounting aspect, an auditor ought to have

a good knowledge about the direct as well as

indirect tax laws.

1.40 Auditing and Assurance

1.12.3 Auditing and Economics:

As, it is well known, accounting is concerned with the

accumulation and presentation of data relati

ng to economic activity

. Though the concept of

income as put forward by economis

ts is different as compared to the accountants concept of

income, still, there are lot of similar grounds on

which the accounting has flourished. From the

auditing view point, the auditors are more concer

ned with Micro economics rather than with

the Macro economics. The knowledge of Macro economics should include the nature of

economic force that affect the firm, relations

hip of price, productivity and the role of

Government and Government regulations. Auditor

is expected to be familiar with the overall

economic environment in which his client is operating.

1.12.4 Auditing and Behavioural Science:

The field of auditing as a discipline involves

review of various assertions; both in financial as

well as in non-financial

terms, with a view to

prove the veracity of such assertions and expr

ession of opinion by auditor on the same. Thus,

it is quite logical and natural that the function of audit can be performed if and only if the

person also possesses a good knowledge about the fields in respect of which he is conducting

such a review.

The discipline of behavioural science is closely lin

ked with the subject of

auditing. While it may

be said that an auditor, particularly the finan

cial auditor, deals basic

ally with the figures

contained in the financial statements but he shall be required to interact with a lot of people in

the organisation. As against the financial audito

r, the internal audito

r or a management auditor

is expected to deal with human beings rather than financial figures. One of the basic elements

in designing the internal control system is pe

rsonnel. Howsoever, if a sound internal control

structure is designed, it cannot work until and unless the people who are working in the

organisation are competent and honest. The knowledge of human behaviour is indeed very

essential for an auditor so as to

effectively discharge his duties.

1.12.5 Auditing and Statistics & Mathematics:

With the passage of time, test check

procedures in auditing have become part of

generally accepted auditing procedures. With the

emergence of test check procedure, discipline of

statistics has co

me quite close to auditing as

the auditor is also expected to have the knowledge

of statistical sampling so as to arrive at

meaningful conclusions. The knowledge of mathemat

ics is also required on the part of auditor

particularly at the time of verification of inventories.

1.12.6 Auditing an

d Data Processing:

Today, organisations are witnessing revolution

in the field of data processing of accounts. M

any organisations are carrying out their financial

accounting activities with the help of computers which can document, record, collate, allocate

and value accounting data and information in very large quantity at very high speed. The

dependence on the accuracy of the programmed instructions given today, the computer is able

to carry out each of these activities with co

mplete accuracy. With

such a phenomenal growth

in the field of computer sciences, the auditor should have good knowledge of the components,

general capability of the system and the relate

d terms. In fact, EDP auditing in itself is

developing as a discipline in itself.

Nature of Auditing 1.41

1.12.7 Auditing and Financial Management:

Auditing is also clos

ely related with other

functional fields of business such as finance, production, marketing, personnel and other

general areas of business management. With the overgrowing field of auditing, the financial

services sector occupies a dominant place in

our system. While in general terms, the auditor

is expected to have knowledge about various

financial techniques such as working capital

management, funds flow, ratio analysis, capital budg

eting etc. The auditor

is also expected to

have a fair knowledge of the institutions that

comprise the market place. The knowledge of

various institutions and Government activities

that influence the operations of the financial

market are also required to be

understood by an auditor.

1.12.8 Auditing and Production:

Regarding production function, it may be stated that a

good auditor is one who understands the client a

nd his business. While carrying out the audit

activity, the auditor is required to evaluate transactions from the accounting aspect in relation

to the process through which it has passed through as accounting for by-products; joint-

products may also require to be done. The knowledge of production process shall become

more essential in case of an internal auditor.

The auditor shall also require understanding the

cost system in operation in the factory and assessing whether the same is adequate for the

particular company. The understanding of the

terminology of the production shall enable an

auditor to communicate with production em

ployees in connection with his work.

On the similar pattern the auditor is also

expected to have good understanding about the

marketing, personnel and other

general business management areas.

Case study

Mr. Veeru of Delhi has starte

d a new business of selling

of Handloom items He

purchases these items from a factory situated

in Ludhiana and sells to local customers

at a price which gives him reasonable amount of

profit. All gets well

in the first year

and he earns some inco

me from the business.

However, he feels that he could expand this

business if he was

able to bring more

items to the place

where he sells them and al

so he is aware of th

e fact that there are

several other locations as well

where he could sell these it

ems . He could achieve this

by buying a van and by employing other peop

le who will assist him in his business on

the other locations.

He needs more money to achieve this expa

nsion of his business.

He decides to ask

his friend Raju to inve

st in the business.

Having seen the potential of

Veeru’s business, Ra

ju wants to inve

st, but neither he

wants to manage nor wants to

have ultimate liability for

the debts of th

e business in

case business fails. He ther

efore suggested that they should set up a proprietary firm.

He will be the owner of the firm

and will be entitled to prof

its. On the other hand, Veeru

would be the Manager

and be paid a salary.

1.42 Auditing and Assurance

At the end of the first year of trading when Ra

ju receives copy of the financial statements,he

finds that Profits are much lower than what

was expected. Raju knows that Veeru is paid

salary so he may not care for low profits. Raju is concerned by the level of profits and feels

that he wants further assurance on the accounts. He does not know whether the accounts give

a true and fair view of the last year’s trading

because the profits do not seem as high as those

Veeru had predicted when he agreed to invest.

Raju seeks solution for his problem.

The solution is that the assurance Raju is seeking may be given by an Independent Audit of

accounts.

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