Auditing Chapter 1 PDF

FYBAF/BFMA Chapter 1: Introduction to Auditing Financial Statements Financial Statements are ordinarily prepared and presented annually. The financial statements aim to meet the need fo...

FYBAF/BFMA Chapter 1: Introduction to Auditing Financial Statements Financial Statements are ordinarily prepared and presented annually. The financial statements aim to meet the need for information of different types of users. In view of this, financial statements need to prepare in accordance with: Companies Act, 2013, Accounting Standards (AS) issued by ICAI and Guidance notes issued by ICAI.  Items Includes in Financial Statements: 1. Balance Sheet- It shows Financial Position of the Company as on particular date. 2. Statement of Profit and Loss- It shows Profit earned or Loss incurred during the year. 3. Cash Flow Statement- It shows movement of cash during the year. Notes to Accounts- Notes are explanatory information.  Users of Financial Statements: 1. Owners: Owner, Who supply Capital, need to know how much income is earned by using their funds. 2. Employees: Employees need to know whether their employer is profitable as well as stable. A profitable concern will pay a good salary and a big bonus. A stable concern will employ the staff for a long time and pay them pension etc. even after retirement. 3. Lenders: Lenders, such as banks which give loan to the business concern, need to know whether their loans and interest will be paid in time. 4. Creditors: Creditors, who supply goods to the business concern on credit, need to know whether their outstanding will be paid in time. 5. Customers: Customers, who purchase goods, need to know whether they can depend upon the business concern for supply of the goods over a long period of time. 6. Government: Government needs to know how much taxes should be paid by the concern. Definition of Auditing: Auditing means systematic examination of books of accounts by an independent person to satisfy whether books of accounts reflects true and fair view of state of affairs of business. i.e. whether profit and loss accounts reflects true and fair view of profit earned or loss suffered during particular period and whether balance sheet reflects true and fair view of assets and liabilities of business as on balance sheet date. The person who conducts audit is known as auditor and auditor has to be qualified chartered accountant (CA). As auditing implies an examination of the accounts, it is said that auditing begins where accounting ends. Objectives of Auditing: Objectives Primary Objective Secondary Objective Specific Objective 1. Primary Objective: The primary objective of auditing is Reporting (to give an opinion), whether books of accounts reflects true and fair view of state of affairs of business. i.e. whether profit and loss accounts reflects true and fair view of profit earned or loss suffered during particular period and whether balance sheet reflects true and fair view of assets and liabilities of business as on balance sheet date. 2. Specific Objective: Specific Objective is not for routine checking but it is for specific purpose, like Cost audit & Efficiency audit. Compiled By Pratik surve  FYBAF/BFMA A. Cost Audit: It is an attempt to control the cost of any product. E.g. X & Co. produce one pen, the cost of production of that pen is Rs. 10. Whereas Y & Co. produce the same pen at the cost of Rs. 9. The auditor checks the cost statement of both the companies and find out the difference to control the cost of X & Co. B. Efficiency Audit: Efficiency audit is generally done for Labour Rate Efficiency, Machine Hour Efficiency, etc. E.g. 1. The Efficiency of Labour of Y & Co. more as compare to Labour of X & Co. because they are paid more and they are working in a good working environment as compare to X & Co. 2. In Y & Co. the Efficiency of Machine is very high as compare to X & Co. because they use New Technologies. 3. Secondary Objective: Secondary Objective Detection & Prevention of Errors Detection & Prevention of Frauds A. Detection & Prevention of Errors: Error is an innocent or unintentional mistake in the books and records. One of the incidental objective of auditing is detection of accounting errors. Auditor should carefully check the transactions so that if there is any accounting error it can be detected. There are different types of errors which may be committed at various stages of accounting. The types of errors are as follows: Detection & Prevention of Errors Clerical Error Error of Principal 1. Error of Omission 1. Capital V/S Revenue 2. Error of Commission (Posting Error) 2. Depreciation 3. Compensating Error 3. Stock Valuation 4. Error of Duplication 1) Clerical Error: These are human errors arising in the course of recording the accounting transactions. These errors normally occur due to carelessness, negligence, pressure of work or lack of knowledge. This type of error is further divided into four categories: Error of Omission, Error of Commission, Compensating Error and Error of Duplication.  Error of Omission: When by mistake a transaction is either wholly or partly omitted from recording in the books of accounts, this type of error occurs. When a transaction is wholly omitted, such error does not disturb the trial balance, hence such errors are difficult to detect. When transaction is partly omitted, it disturbs the trial balance, hence such error are easy to detect.  Error of Commission: When by mistake transaction is wrongly recorded in the books of account, such type of error occurs. These errors are further classified as mathematical errors, casting errors, and posting errors. Mathematical errors are errors of calculation. Casting errors are errors in totalling. Posting errors are errors in posting.  Compensating Errors: When the effect of one error is nullified by the effect of another error, them such errors are called as compensating errors. Whenever one error exist and another error takes place, such errors are also called as compensating error.  Error of Duplication: When by mistake a transaction is recorded twice, error of duplication takes place. The transaction may be recorded twice or the posting may be done twice. Compiled By Pratik surve  FYBAF/BFMA e.g. Purchase of goods recorded twice or posting to supplier’s A/c may be done twice. 2) Error of Principle: These errors occur when transaction are not recorded according to the basic principles of accounting. These errors do not disturb the trial balance. Auditor has to check the accounts carefully to detect such errors. Examples of Such errors are:  Over Valuation or Under Valuation of Stock.  Inadequate provision for depreciation.  Treatment of Capital expenditure as revenue expenditure and vice versa.  Inadequate provision for RDD. B. Detection & Prevention of Frauds: Frauds means intentional mistakes in presentation of financial information to make someone believe something which is not true. It is deliberate mistake committed in the accounts with a view to get personal gain. Frauds may be either Misappropriation of Assets that may be called as Employee Fraud or Manipulation of Accounts that is referred to as Management Fraud. Detection & Prevention of Frauds Misappropriation of Cash/Goods Manipulation of Accounts 1. Goods Stolen/Theft Over Statement of Profit Under Statement of Profit 2. Cash Sales Misappropriated 1. To Earn more 1. To Avoid TAX commission 3. Teeming and Lading 2. To Distribute more 2. To Avoid / Decrease Dividend Competition 4. Showing Personal Expenses as 3. To Avail more Loan Business Expenses. 1) Misappropriation of Cash/Goods:  Goods Stolen/Theft: It means that the goods have been removed from the business without informing the owner of the business. E.g. Goods Actually Stolen, Goods Received, Goods sold.  Cash Sales Misappropriated: Cash sales are either wholly or partly misappropriated means payment received but the cash is not handed over to the owner. In case of wholly misappropriation of cash sales the entire amount of sales is not handed over to owner. In case of partly misappropriation of cash sales only some part of cash sales is handed over to owner and balance is misappropriated.  Teeming and Lading: It means allocation of one customer’s payment to another in order to make the balance. In this kind of fraud when cash is received from one party it is not recorded in the books but misappropriated and when cash is received from second party it is recorded as received from the first party. When cash is received from a third party it is recorded as received from second party. This way it is continued till the end of the year.  Showing personal expenses as business expenses it is also one of the example of Misappropriation of Cash/Goods. 2) Manipulation of Books of Accounts (Window Dressing): It implies for presentation of accounts more favourable than what they actually are. Window dressing means showing wrong picture. The fraud through manipulation of accounts is also known as window dressing because accounts are manipulated to show wrong picture of profit or loss of the business. Generally this type of error is Compiled By Pratik surve  FYBAF/BFMA committed by people of Top level management. It doesn’t involve any misappropriation of Cash/Goods but it involves Overstatement of Profit or Understatement of Profit. Such frauds are relatively difficult to detect.  Overstatement of Profit is shown for following reason: I. To earn more Commission. II. To distribute more dividend to keep shareholders happy. III. To avail more loan.  Understatement of Profit is shown for following reason: I. To avoid Tax II. To avoid/decrease Competition. Secret Reserve The term secret reserve refers to a reserve the existence of which is not disclosed in the Balance Sheet. Secret reserves are also called Hidden Reserve or Internal Reserve. Such a reserve is not disclosed on the Balance Sheet. It can be said that there is a surplus of assets over liabilities and that surplus is not disclosed or shown by the Balance Sheet. Method of Creation of Secret Reserves Secret reserves may be created in the following ways: 1. Providing excess depreciation on fixed assets such as plant, machinery, land & building, furniture and fixtures, etc. 2. Writing down intangible asset or deferred revenue expenses completely. 3. Undervaluing assets such as stock, investments, etc. and showing them much below their cost or market value. 4. Non-recording of permanent rise or appreciation in value of a fixed asset, e.g., buildings. 5. Providing excessively for bad and doubtful debts. 6. Overvaluing liabilities or Including of fictitious liabilities. 7. Recording Purchase of subsequent year in current year. 8. Recording Sales of current year in subsequent year. 9. Showing contingent liabilities as real liabilities. 10. Recording accrued income and prepaid expenses at a lower amount. 11. Making excess provision for expenses. Objects of Creating Secret Reserve The inherent ideas of creating secret reserve are as follows: 1. Maintaining a strong financial position. 2. Meeting sudden future financial losses. 3. Facing competitions. 4. Confusing the competitor regarding profitability. 5. Providing additional working capital. 6. Maintaining a stable dividend payment. Secret Reserve is created by the management to show a bad financial position to the employees for rejecting their demands for higher bonus, increase in pay scale, etc. or to pay less income tax, sales tax, etc. or to mislead the competitors. It involves manipulation or misrepresentation of accounts and hence it affects the true and fair position. Auditors Duty Regarding Errors and Frauds: Following are the duties of the auditor regarding errors & frauds: Compiled By Pratik surve  FYBAF/BFMA 1. Auditor should check each and every transaction in detail: It is the responsibility of the auditor to check each and every transactions amount, date, with whom the transaction has been done, etc. everything has to be checked in detail. 2. Auditor should check all the opening & closing balances and verifies all the posting & casting: All the opening balances are matching with last year’s closing balances or not have to be checked by the auditor. He should also check whether all the posting & totals are correctly done or not. 3. Auditor should ensure that depreciation is charged at proper rate: Depreciation is always charged on the fixed assets. The rate of depreciation is also fixed so the auditor must see to it that the depreciation is properly charged. There is no increase or decrease in the rate of depreciation every year. 4. Auditor should ensure that proper distinction is made between capital & revenue items: Capital transactions are not wrongly recorded as revenue transaction and vice versa, it should be checked by the auditor properly. If such error takes place it comes under error of principle. 5. Auditor should ensure that closing stock is valued properly: Valuation of closing stock should be properly done. There should not be an overvaluation or undervaluation of stock it has to be properly examined. 6. Auditor should ensure that proper internal control system exists within the organisation and implemented properly: There should be a proper internal control system in each & every organisation for rechecking of transaction recorded in books of accounts, in order to avoid errors & frauds. Auditor should see to it that this system is exist and implemented properly in the organisation. Distinction between Accounting & Auditing: Accounting Auditing 1. Meaning Accounting is maintenance of books of account Auditing is systematic examination of books of and preparation of final accounts. accounts. 2. Purpose Accounting purpose is to show the financial Auditing verifies the true and fair view of position of the business. financial statement. 3. Commencement and End It starts when book-keeping ends. It ends with It starts when accounting ends. It ends with the the preparation of final accounts. submission of audit report. 4. Qualification Legally accountant does not require any Auditor must be a practising chartered qualifications. accountant. 5. Submission Report An accountant is not required to submit any An auditor has to submit report in the report. prescribed form. 6. Status An accountant is an employee of the An auditor is an independent professional organisation. person. 7. Appointment Accountant is appointed by management. Auditor is appointed by shareholders. 8. Responsibility Accountant’s responsibility is fixed by the Auditor’s responsibility is fixed by law. management. Advantages of Auditing: Advantages of Auditing Compiled By Pratik surve  FYBAF/BFMA Businessman’s Point of View Investors Point of View Other Advantages 1. Detection of errors & frauds 1. Protect Interest of Investors 1. Settlement of Claim 2. Loan from Banks 2. Moral Check 2. Evidence in Court 3. Government Acceptance 3. Proper Valuation of 3. Settlement of Accounts Investment 4. Proper valuation of Assets 4. Facilitates Calculation of PC  Businessman’s Point of View: 1. Detection of errors and frauds: It helps in detection and prevention of errors and frauds. 2. Loan from Banks: Loan from Banks can be easily obtained because banks can rely on the audited books of accounts. 3. Government Acceptance: Government authorities can rely on the audited accounts as a true & fair for the purpose of taxation. 4. Proper Valuation of Assets: Audited accounts enable the company to know the proper valuation of assets for the purpose of purchase and sale of assets.  Investors Point of View: 1. Protect Interest of Investors: Auditor is considered to be the representative of shareholder and trustees. This helps the investors to save their interest. 2. Moral check: Audit helps to keep moral check on all the directors and managers so that they work honestly. Auditor checks the books in order to protect the happening of frauds by any manager or director. 3. Proper Valuation of Investment: Valuation of investment is done properly by the auditor. Books are audited so that investors can rely and receive proper rate of interest.  Other Advantages: 1. Settlement of Claim: Insurance companies can rely the audited statements. Audited accounts play vital role in settlement of insurance claim. 2. Evidence in Court: Audited accounts can be produce as evidence in the court of law in case of disputes. 3. Settlement of Accounts: Parties can settle their accounts if books are audited. Audited statement helps to settle account of Debtors, Creditors, etc. 4. Facilitates Calculation of PC: Audited books of accounts help the purchaser to calculate the amount of Purchase consideration of business. Limitations of Auditing: 1. Rely on Explanation Given by Client’s Staff: Auditors have no other option rather than relying on explanation given by the client’s staff because auditor has knowledge regarding accounts and not about the client’s day to day activity. 2. 100% checking not possible: Auditors cannot check each and every transaction of the large business as they might be doing so many transactions in a day. Due to this true & fair view of statement is not possible. So it is one of the disadvantage of auditing. 3. Corrupt practice to influence auditor: If the auditor is not honest than the books of accounts are not properly audited. For examination of books of accounts the auditor should be an honest person. 4. Auditor’s work involves exercise of judgement: The work of the auditor involves exercise of judgement in deciding the extent of audit work, provision for RDD, etc. The judgement may go wrong. Compiled By Pratik surve  FYBAF/BFMA 5. Dependence on other Experts: Auditor has to rely on the opinion given by different experts such as engineers, architects, lawyers, etc. If these experts give wrong opinion, audit report will be adversely affected. Concept of True & Fair View: Books of accounts show True & Fair view if and only if the following 5 points are satisfied: 1. Adherence to Accounting Principles: The books of accounts must be kept according to the accepted accounting principles. Auditor should follow all the accounting principles given by ICAI. 2. No window dressing: The accounts must be prepared honestly. There should not be any window dressing i.e. overstatement & understatement of profit. The accounts must disclose true position. 3. Disclosure of Material Facts: The books of accounts must disclose all the material facts regarding Revenue, Expenses, Assets & Liabilities. Material facts mean important facts. There should not be any misappropriation in the financial statements. 4. Confirming to Financial reporting framework: Financial statement must be prepared according to the provision of Revised Schedule VI of companies Act. The Final account must prepare in the format prescribed by the companies act. 5. Guideline of ICAI: The accounts must be in accordance with the various guidelines prescribed by the ICAI. These guidance notes are issued by ICAI. Principles of Auditing: The word principle is defined as a fundamental truth or a primary or basic law or a settled rule of action. A principle of auditing means the fundamental truth necessary for the accomplishment of auditing objectives. Following are the auditing principle laid down by ICAI: 1. Principle of Integrity and Independence: The auditor should be honest, straightforward and sincere in his professional work. The decision of auditor should be true & fair and not in the favour of client. 2. Principle of Objectivity: Audit should be conducted objectively. The auditor should be free from personal bias and emotions while conducting audit. 3. Principle of Full Disclosure: It means that the client should not hide any single information from auditor. Client must provide all the evidence, records and explanation. And the auditor must disclose all the things in his report and should not hide anything. E.g. If the company has paid penalty then the auditor should not adjust the penalty amount anywhere else. 4. Principle of Materiality: According to this principle the auditor should pay more attention to the item which are more significant. Whether the items are material or not should be decided according to the situation. 5. Principle of Confidentiality: Auditor should keep the information acquired in the course of his work, confidential and should not disclose any such information to a third party without specific authority. 6. Skill and Competence: The auditor requires specialised skill and competence. He should have adequate qualification and practical experience. He should aware of recent developments in the field of auditing such a statements issued by the ICAI on accounting and auditing matters, changes in company law and recent judgement given by court which have bearings on audit work. 7. Work performed by others: The auditor should direct, supervise and review the work done by his assistants. He should carefully delegate work to his assistants and see that the work done by them is upto satisfaction. Compiled By Pratik surve  FYBAF/BFMA 8. Working Papers (SA 230): The auditor should maintain working papers as evidence that the audit work was carried out in accordance with the basic principles. At the end of the audit work the working papers are always with the auditor. 9. Planning (SA 300): The auditor should plan his audit work. He should prepare a detailed audit programme to complete audit efficiently and in time. Plan should be further developed and revised as necessary during the course of the audit. Auditor should first plan his work and then work his plan. 10. Audit Evidence (SA 500): The audit report of the auditor should be based on evidence obtained in the course of audit. Evidence may be obtained through vouching, verification, ratio analysis, trend analysis, etc. 11. Evaluation of Accounting System and Internal Control: The auditor should ensure that the accounting system is adequate. He should also evaluate the internal control system of client. 12. Opinion and Report: The auditor should form his opinion about the accounts on the basis of audit evidence. He should submit his report to the shareholders. The report should clearly express his opinion. The content and form of report should be as required by law. MATERIALITY CONCEPT (SA 320) Concepts and conventions in accountancy mean basic assumptions while recording transactions in the books of accounts. Auditor should have knowledge of different concepts and conventions in accountancy such as Entity, Materiality, Going Concern Historical Cost, Accrual, Matching cost and revenue. Accounting period, Conservatism etc. In accountancy, materiality concept means it is assumed that all material items of expenses and incomes, assets and liabilities are shown separately in the Mal accounts and not grouped or clubbed or hidden in some other item. E.g. Directors' Remuneration is shown separately and not hidden in salaries; Audit Fees is shown separately and not clubbed in sundry expenses etc. According to Standard of Auditing 320 (AAS - 13) issued by The Institute of Chartered Accountants of India, concept of materiality recognises that some matters, either individually or in aggregate, are relatively important for true and fair presentation of financial information in conformity with recognised accounting policies and practices. Auditor must consider materiality while conducting audit. Any information is material if its misstatement (i.e. omission or wrong statement) could influence the economic decisions of users. Materiality depends on the size and nature of item. Auditor should consider materiality at both the levels, overall financial information level and in relation to individual account balances and classes of transactions. Materiality is also influenced by legal and regularity requirements and considerations relating to individual account balances. Legal and regularity requirement implies that auditor should see that financial statements disclose all material items, extraordinary items, prior period items, change in accounting policies and their effect on current profits. Financial statements holds comply with all legal and regularity requirements. In individual account balances, if auditor has come to a conclusion that the aggregate of uncorrected misstatements is causing financial information to be materially misstated, then he should request the management to rectify those misstatements and adjust financial information. Auditor may set acceptable cutoff level for verifying individual transactions. Whether a particular item is material or to, not is a matter of professional judgement. In short, auditor should ensure that all material misstatements in the financial information audited by him are rectified and if not then reported by him in his audit report. GOING CONCERN CONCEPT (SA 570) Going concern Concept in accountancy means it is assumed that the as going concern for a long time and that there is no lift down in the near future. An entity's continuance as a going concern for foreseeable future i.e. generally a period of one year after balance sheet date, is while preparing Compiled By Pratik surve  FYBAF/BFMA financial statements. This is why in case of fixed asset, valuation is made at written down values and not at current market values or prices. Auditor should consider the risk that going concern assumption may no longer be appropriate. In that case, showing assets and liabilities at book values will not show a true and fair view. According to (AAS - 16), Standard of Auditing 570 issued by the ICAI, there may be financial indicators, operating indicators or other indicators indicating that the organisation is not a going concern. Indicators of Absence of Going Concern assumption - 1. Financial Indicators - Negative Net Worth, Negative Working Capital, Adverse, key financial ratios, Recurring operating and net loss, negative cash flow position, increasing unsalable stock, rising unrealisable debtors etc. 2. Operating Indicators - Loss of key personnel, Labour problems, Loss of major customer or supplier, Loss of infrastructure facilities like power, water, roads etc. 3. Other Indicators - New legislation. Change in Government Policy, pending legal case, ban on products, change in technology etc. When such indicators are present, auditor should gather sufficient audit evidence to resolve the question regarding entity's ability to continue in operation for foreseeable future. After considering management's plan and other mitigating factors such as alternative sales market, restructuring of loans etc. auditor should decide whether the company is going concern or not. If adequate disclosure is made in the financial statement about this going concern assumption, then auditor should express unqualified opinion. However, if adequate disclosure is not made in the financial statements, then auditor should express a qualified or adverse opinion, as he feels appropriate. Qualities of Auditor According to Prof. L.R. Dicksee, qualities required by an auditor are tact, caution, firmness, good temper, integrity, discretion, industry, judgement, patience, clear headedness and reliability. In short all those personal qualities that make a good businessman, contribute to the making of a good auditor. An auditor should possess the following qualities- 1. Chartered Accountant - A company’s auditor must be a practicing charted accountant. This is a qualification rather than a quality. 2. Skill and competence - An auditor must have thorough knowledge of accounting, auditing and general principles of law which govern matters of his intimate contact. He should have knowledge of the Companies Act, 1956, Partnership Act, 1932, different mercantile laws end where an undertaking is governed by a special statute, provisions of that statute. He should be aware of the latest developments matters. He must have obtained professional training and must be possessing required professional qualification i.e. he should be a practicing chartered accountant. 3. Honest - An auditor must be honest. In the words of Lord Justice Lindley “an auditor must not certify what he does not believe to be true and he must exercise reasonable care and skill before he believes that what he certifies is true.” 4. Trustworthy - An auditor holds a position of trust and hence he should be trustworthy. He should not disclose the information obtained by him during the course of his audit to outsiders. He should keep such information confidential. An auditor should keep his eyes and ears open, but keep his mouth shut. An auditor should have the highest degree of integrity. 5. Independent - An auditor must be independent. He should be impartial as well as fearless in the discharge of his duties. He should not have any vested interest that would affect his independence as an auditor. 6. Judgement - An auditor must have the ability to judge persons correctly. He has to make judgement about the internal control system, internal check system and the internal audit existing in the company. On this basis he decides the extent of checking to be carried out. He Compiled By Pratik surve  FYBAF/BFMA has to judge the validity and sufficiency of the supporting and documentary evidences in support of the transactions. 7. Systematic and methodical - An auditor must be systematic and methodical in his approach to work. He must be able to plan his work and work his plan. He should prepare an audit programme, obtain evidences, keep his working papers, supervise work done by others and complete audit in time. 8. Drafting ability - An auditor must possess drafting ability as he has to write the audit report. He should have the ability to convey what he wants to convey in proper words. Audit report should be written in unambiguous terms, in simple and straightforward language and it should not be confusing. 9. Personal Qualities - An auditor must be constantly watchful and alert. He must have the knowledge of client's business. He should be endowed with common sense. He should be like a friend, philosopher and guide for his clients. Compiled By Pratik surve