Auditing and Assurance PDF Study Material

PROFESSIONAL COMPETENCE COURSE STUDY MATERIAL AUDITING AND ASSURANCE PAPER 2 Auditing And Assurance BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject. Students should also supplement their study by reference to the recommended text books. In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein, they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material. © The Institute of Chartered Accountants of India All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission, in writing, from the publisher. Website : www.icai.org. E-mail : [email protected] ISBN No. : 978-81-8441-045-7 Published by : The Publication Department on behalf of CA. R. Devarajan, Additional Director of Studies (SG), The Institute of Chartered Accountants of India, A-94/4, Sector-58, NOIDA – 201 301, India. Printed by : Sahitya Bhawan Publications, Hospital Road, Agra 282 003. May/2008/25,000 Copies (Reprint) PREFACE Auditing is, perhaps, one of the most practical-oriented subjects in the C.A. curriculum. The inclusion of this subject at the Professional Competence Course (PCC) Level, aims to provide working knowledge of generally accepted auditing procedures and of techniques and skills needed to apply them in audit and attestation engagements. A good knowledge of the subject would provide a strong foundation to students while pursuing the chartered accountancy course. A good understanding of the theoretical concepts, particularly, in the context of auditing standards would make practical training an enriching and enjoying experience. While studying this paper, students are advised to integrate the knowledge acquired in other subjects, specifically, accounting and corporate laws in a meaningful manner. Such a learning would only help a student to become a better professional. In nutshell, it is a subject which involves application of theoretical knowledge of other subjects included in the course curriculum. It is this practical aspect of the subject which allows the individual students to exhibit their intelligence and ability upon which the scoring of the marks depends. A systematic study of the subject will not only help in securing good marks and passing the examination but also enable one to become a good chartered accountant. A list of steps to be followed is given below: Familiarise yourself with the syllabus: You must know the exact scope of the syllabus. Divide the entire syllabus into broad topics. At the PCC level, the broad topics are – Nature and Objectives of Auditing. Audit Planning, Internal Control, Vouching, Verification of assets and liabilities, Company Audit, Special Audits, etc. Such a division of syllabus would always provide a bench-mark to assess the extent of preparation and, thus, infuse confidence. Read each topic thoroughly: One may read each topic thoroughly, understand and grasp the same. This is not a subject where the student can exploit his intellect and commonsense without having the requisite knowledge of the subject. A thorough preparation is pre-requisite for success in this subject. If necessary, supplement the same with a standard text book. While reading through each topic, take special note of Auditing and Assurance Standards (AASs), Accounting Standards (AS), relevant case laws, provisions of the Companies Act, 1956 or other special legislations, etc. As stated earlier, auditing should not be studied in isolation since it is related to other subjects. In particular, the knowledge of Accounting Standards; laws affecting business organisation, such a Partnership Act, 1932, Companies Act, 1956, etc. is pre-requisite for understanding of the subject and to write a good answer. One must read the monthly publications of the Institute, viz., The Chartered Accountant and the Students’ Newsletter regularly to keep abreast of the latest developments in the field. Prepare Notes: You will appreciate that normally mere reading a page from the book does not lead you anywhere. It is very essential to comprehend the subject. Therefore, effective reading is essential to absorb the same. After reading each chapter, prepare comprehensive notes since the actual writing down of the matter helps not only in understanding but facilitates quick revision as well. You may make use of mnemonic while preparing notes. For example, assertions in respect of an item appearing in the balance sheet to be verified may be remembered as VCREP in the mnemonic form wherein V stands for Valuation, C stands for completeness, R stands for Rights/obligation, E stands for existence and P stands for presentation and disclosure requirements. Check Your Progress: Perhaps, the best way to check your progress is to go through question papers of previous examinations. An element of introspection is necessary at this stage. In case a student feels that he is not able to answer the requisite number of questions, he must ask himself and ascertain reasons for the same. You must write answers under mock examination conditions to assess your writing capability and compare the same with suggested answers provided by the Board of Studies. Having regard to the extent of changes, students may note that suggested answers to the questions set at the previous Intermediate Examinations would still be beneficial from the academic preparation view point. A word of caution. While going through “Suggested Answers” for previous examinations, no attempt should be made to memorise the answers as such. Rather a student may read them thoroughly to gain knowledge and improve understanding and specifically as to how an answer should be written in the examination. Examination Approach: Having prepared thoroughly on the aforesaid lines, a student should not rush to write the answers the examination. Read the question carefully, understand its exact scope, plan the main headings and points to be covered and then write your answer. Answer should be to the point and this can only be so if the question is understood by the students in proper perspective. Question should be read carefully to know its exact requirements. For instance, a question relating to vouching may pertain to any entity or with specific reference to a company. The students should discuss the questions as exhaustively as it could be made remembering at the same time that no insignificant and irrelevant matters are included in the answers. The students should cultivate the habit of remembering all the important and relevant points relating to the question prepared by them. The suggested answers published by the Board stand as the best guide in this rect. Merely stating one or two points is not enough where the question calls for a number of points. All the important and relevant points should either be discussed or at least stated depending upon the marks assigned to the question. Reference to relevant AASs, AS, provisions of the Companies Act, 1956, decided case laws, etc. enriches the quality of an answer. Command over standard English is absolutely essential. You may divide or sub-divide descriptive questions with distinct paragraph headings. In a professional examination a candidate must attempt all the required number of questions. For instance in Auditing, a candidate must attempt all questions (say, six) in a balanced manner. Proper time management is thus, essential. It may so happen that a candidate is not in a position to write all six answers and may be decided to write five answers in an excellent manner and skip the sixth one. This approach is not advisable since in such a case a candidate would have attempt questions of about 80 marks only. Keep in mind the golden principle that six average answers shall fetch more marks than five best answers. Read on and Best of Luck ! SYLLABUS Paper 2: Auditing and Assurance (One Paper- Three hours -100 Marks) Level of knowledge: Working Knowledge Objective: To understand objective and concept of auditing and gain working knowledge of generally accepted auditing procedures and of techniques and skills needed to apply them in audit and attestation engagements. Contents: 1. Auditing Concepts ─ Nature and limitations of Auditing, Basic Principles governing an audit, Ethical principles and concept of Auditor’s Independence, Relationship of auditing with other disciplines. 2. Auditing and Assurance Standards and Guidance Notes ─ Overview, Standard-setting process, Role of International Auditing and Assurance Standards Board, Auditing and Assurance Standards issued by the ICAI AAS 1 – AAS 30 and AAS 34; Guidance Note(s) on ─ Audit of Fixed Assets, Audit of Inventories, Audit of Investments, Audit of Debtors, Loans and Advances, Audit of Cash and Bank Balances, Audit of Miscellaneous Expenditure, Audit of Liabilities, Audit of Revenue, Audit of Expenses. 3. Auditing engagement ─ Audit planning, Audit programme, Control of quality of audit work ─ Delegation and supervision of audit work. 4. Documentation ─ Audit working papers, Audit files: Permanent and current audit files, Ownership and custody of working papers. 5. Audit evidence ─ Audit procedures for obtaining evidence, Sources of evidence, Reliability of audit evidence, Methods of obtaining audit evidence ─ Physical verification, Documentation, Direct confirmation, Re-computation, Analytical review techniques, Representation by management, Obtaining certificate. 6. Internal Control ─ Elements of internal control, Review and documentation, Evaluation of internal control system, Internal control questionnaire, Internal control check list, Tests of control, Application of concept of materiality and audit risk, Concept of internal audit. 7. Internal Control and Computerized Environment, Approaches to Auditing in Computerised Environment. 8. Auditing Sampling ─ Types of sampling, Test checking, Techniques of test checks. 9. Analytical review procedures. 10. Audit of payments ─ General considerations, Wages, Capital expenditure, Other payments and expenses, Petty cash payments, Bank payments, Bank reconciliation. 11. Audit of receipts ─ General considerations, Cash sales, Receipts from debtors, Other Receipts. 12. Audit of Purchases ─ Vouching cash and credit purchases, Forward purchases, Purchase returns, Allowance received from suppliers. 13. Audit of Sales ─ Vouching of cash and credit sales, Goods on consignment, Sale on approval basis, Sale under hire-purchase agreement, Returnable containers, Various types of allowances given to customers, Sale returns. 14. Audit of suppliers' ledger and the debtors' ledger ─ Self-balancing and the sectional balancing system, Total or control accounts, Confirmatory statements from credit customers and suppliers, Provision for bad and doubtful debts, Writing off of bad debts. 15. Audit of impersonal ledger ─ Capital expenditure, deferred revenue expenditure and revenue expenditure, Outstanding expenses and income, Repairs and renewals, Distinction between reserves and provisions, Implications of change in the basis of accounting. 16. Audit of assets and liabilities. 17. Company Audit ─ Audit of Shares, Qualifications and Disqualifications of Auditors, Appointment of auditors, Removal of auditors, Powers and duties of auditors, Branch audit , Joint audit , Special audit, Reporting requirements under the Companies Act, 1956. 18. Audit Report ─ Qualifications, Disclaimers, Adverse opinion, Disclosures, Reports and certificates. 19. Special points in audit of different types of undertakings, i.e., Educational institutions, Hotels, Clubs, Hospitals, Hire-purchase and leasing companies (excluding banks, electricity companies, cooperative societies, and insurance companies). 20. Features and basic principles of government audit, Local bodies and not-for-profit organizations, Comptroller and Auditor General and its constitutional role. CONTENTS Preface Syllabus Chapter 1 - Nature of Auditing 1.1 Introduction............................................................................................................................... 1.1 1.2 Nature and Purpose of Financial Statements........................................................................... 1.2 1.3 Auditing and Assurance Standards.......................................................................................... 1.3 1.3.1 International Auditing and Assurance Standards Board................................................ 1.3 1.3.2 Auditing and Assurance Standards Board.................................................................... 1.4 1.4 Definition of Auditing................................................................................................................. 1.7 1.5 The Auditor............................................................................................................................... 1.7 1.5.1 Functional Classification of Auditors : Internal Audit vs. External Audit........................... 1.9 1.5.2 Qualities of an Auditor..................................................................................................... 1.9 1.6 Objectives of Audit.................................................................................................................. 1.10 1.6.1 Expression of opinion.................................................................................................... 1.10 1.6.2 Errors and Frauds.......................................................................................................... 1.12 1.6.3 Detection of Fraud and Error : Duty of an Auditor......................................................... 1.19 1.7 Aspects to be covered in Audit............................................................................................... 1.25 1.8 Basic principles governing an Audit........................................................................................ 1.26 1.9 Scope of Audit........................................................................................................................ 1.29 1.10 Inherent Limitations of Audit................................................................................................... 1.26 1.11 Auditing and Investigation...................................................................................................... 1.27 1.12 Types of Audit........................................................................................................................ 1.27 1.13 Advantages of an Independent Audit..................................................................................... 1.28 1.1 Relationship of Auditing with other Disciplines....................................................................... 1.29 1.14.1 Auditing and Accounting............................................................................................. 1.29 1.14.2 Auditing and Law........................................................................................................ 1.34 1.14.3 Auditing and Economics.............................................................................................. 1.34 1.14.4 Auditing and Behavioural Science.............................................................................. 1.35 1.14.5 Auditing and Statistics & Mathematics........................................................................ 1.35 1.14.6 Auditing and Data Processing..................................................................................... 1.35 1.14.7 Auditing and Financial Management........................................................................... 1.35 1.14.8 Auditing and Production.............................................................................................. 1.36 Self-Examination Questions............................................................................................................... 1.36 Chapter 2 - Basic Concepts in Auditing 2.1 Concept of Auditor’s Independence......................................................................................... 2.1 2.2 Audit Evidence......................................................................................................................... 2.4 2.2.1 Introduction...................................................................................................................... 2.4 2.2.2 Audit Procedures to Obtain Audit Evidence..................................................................... 2.5 2.2.3 Types of Audit Evidence.................................................................................................. 2.8 2.2.4 Reliability of Audit Evidence............................................................................................ 2.8 2.2.5 Methods to Obtain Audit Evidence.................................................................................. 2.8 2.3 Concept of Materiality............................................................................................................. 2.10 2.4 Concept of True and Fair........................................................................................................ 2.12 2.5 Disclosure of Accounting Policies........................................................................................... 2.13 2.5.1 Nature of Accounting Policies........................................................................................ 2.13 2.5.2 Areas in which Different Accounting Policies are Encountered..................................... 2.13 2.5.3 Disclosure of Accounting Policies.................................................................................. 2.14 2.5.4 Fundamental Accounting Assumptions......................................................................... 2.14 Self-Examination Questions............................................................................................................... 2.15 Chapter 3 - Preparation for an Audit 3.1 Auditor’s Engagement.............................................................................................................. 3.1 3.2 Audit process............................................................................................................................ 3.3 3.3 Audit techniques....................................................................................................................... 3.4 3.4 Audit Procedure........................................................................................................................ 3.5 3.5 Audit Planning.......................................................................................................................... 3.6 3.5.1 Knowledge of the Client's Business................................................................................. 3.7 3.5.2 Development of an Overall Plan...................................................................................... 3.8 3.5.3 Developing the Audit Programme.................................................................................... 3.9 3.6 Audit Programme.................................................................................................................... 3.10 3.6.1 Advantages and Disadvantages of the use of an Audit Programme............................. 3.13 ii 3.7 Methods of work....................................................................................................................... 3.1 3.8 Continuous and final audit...................................................................................................... 3.14 3.9 Audit Planning and Materiality................................................................................................ 3.16 3.10 The overall audit approach..................................................................................................... 3.17 3.11 udit Working Papers............................................................................................................... 3.18 3.111 Form and Content of Working Papers.......................................................................... 3.19 3.112 Audit Note Book............................................................................................................ 3.20 3.113 Ownership and Custody of Working Papers................................................................. 3.22 3.114 Importance of Working Papers..................................................................................... 3.22 3.12Quality Control for Audit Work.................................................................................................... 3.23 3.121 Firm Level..................................................................................................................... 3.24 3.12.2 Individual Audit Level................................................................................................. 3.24 3.13 Elements of Statistical Sampling............................................................................................ 3.25 3.13.1 Test Checking.............................................................................................................. 3.26 3.13.2 Precautions to be taken in Adopting Test Checking Techniques................................. 3.27 3.13.3 Methods of Statistical Sampling.................................................................................. 3.29 3.13.4 Selection of the Sample............................................................................................... 3.30 3.13.5 Advantages of Statistical Sampling in Auditing............................................................ 3.31 3.14 Audit Risk............................................................................................................................... 3.32 3.14.1 Concept of audit risk.................................................................................................... 3.32 3.14.2 Materiality and Audit Risk............................................................................................ 3.34 3.15 Surprise Checks..................................................................................................................... 3.35 3.16 Obtaining Certificate from Management................................................................................. 3.37 Self-examination Questions............................................................................................................... 3.38 Chapter 4 - Internal Control 4.1 Concept of Internal Control....................................................................................................... 4.2 4.2 Environment of Internal Control................................................................................................ 4.2 4.3 Inherent limitations of Internal Control...................................................................................... 4.3 4.4 Accounting and financial control............................................................................................... 4.4 4.5 Internal Control and management............................................................................................ 4.5 4.6 Internal Control and the Auditor................................................................................................ 4.5 4.7 Review of internal control by the auditor.................................................................................. 4.7 4.7.1 The Narrative Record...................................................................................................... 4.9 4.7.2 A Check List.................................................................................................................... 4.9 iii 4.7.3 Internal Control Questionnaire....................................................................................... 4.10 4.7.4 A Flow Chart.................................................................................................................. 4.10 4.8 Testing of Internal Control...................................................................................................... 4.11 4.9 Examination in depth.............................................................................................................. 4.13 4.10 Relationship Between the Assessments of Inherent and Control Risks................................. 4.13 4.11 Communication of weaknesses in Internal Control................................................................. 4.15 4.12 Internal Control in the Small Business.................................................................................... 4.15 4.13 Internal Control and the Computerised Information System (CIS) Environment.................... 4.15 4.13.1 Organizational Structure in an EDP Environment........................................................ 4.17 4.13.2 Internal Controls in an EDP Environment.................................................................... 4.19 4.13.3 Review of Internal Controls......................................................................................... 4.21 4.13.4 Approaches to Audit in CIS Environment.................................................................... 4.22 4.14 Internal Check........................................................................................................................ 4.25 4.14.1 General Considerations in Framing a System of Internal Check................................. 4.26 4.15 Internal Audit.......................................................................................................................... 4.27 4.16 Relationship between the Statutory and the Internal Auditors................................................ 4.30 4.16.1 General Evaluation of Internal Audit Function............................................................. 4.31 4.16.2 Coordination................................................................................................................ 4.31 4.16.3 Requirements of CARO, 2003..................................................................................... 4.32 Self-Examination Questions............................................................................................................... 4.39 Chapter 5 - Vouching 5.1 Audit of cash transactions........................................................................................................ 5.1 5.1.1 General Considerations................................................................................................... 5.1 5.1.2 Casting or Totalling.......................................................................................................... 5.5 5.1.3 Bank Reconciliation Statement........................................................................................ 5.6 5.2 Audit of Payments.................................................................................................................... 5.6 5.2.1 Purchase of Goods.......................................................................................................... 5.7 5.2.2 Transactions with Directors............................................................................................. 5.7 5.2.3 Remuneration paid to Directors....................................................................................... 5.8 5.2.4 Payment for Acquisition of Assets................................................................................... 5.8 5.2.5 Payments controlled by the Companies Act, 1956.......................................................... 5.9 5.2.6 Assets acquired on Hire Purchase Basis....................................................................... 5.10 5.2.7 Assets Acquired on Lease............................................................................................. 5.10 5.2.8 Payment of Expenses.................................................................................................... 5.10 iv 5.2.9 Payment of Taxes.......................................................................................................... 5.11 5.2.10 Customs and Excise Duties......................................................................................... 5.11 5.2.11 Travelling Expenses.................................................................................................... 5.12 5.2.12 Repairs to Assets........................................................................................................ 5.12 5.2.13 Preliminary Expenses.................................................................................................. 5.13 5.2.14 Salaries and Wages.................................................................................................... 5.13 5.2.15 Petty Cash................................................................................................................... 5.15 5.2.16 Advertisement Expenses............................................................................................. 5.16 5.2.17 Payment of Dividends.................................................................................................. 5.16 5.2.18 Retirement Gratuity to Employees............................................................................... 5.17 5.3 Cash Receipts........................................................................................................................ 5.17 5.3.1 Cash Sales.................................................................................................................... 5.19 5.3.2 Receipts from Customers.............................................................................................. 5.19 5.3.3 Income from Investments.............................................................................................. 5.20 5.3.4 Rental Receipts............................................................................................................. 5.20 5.3.5 Bankruptcy Dividends.................................................................................................... 5.20 5.3.6 Sale of Investments....................................................................................................... 5.20 5.3.7 Loans............................................................................................................................. 5.21 5.3.8 Bills Receivable............................................................................................................. 5.21 5.3.9 Sale of Assets................................................................................................................ 5.21 5.3.10 Royalties received....................................................................................................... 5.22 5.3.11 Interest and Dividends received.................................................................................. 5.22 5.3.12 Insurance Claims......................................................................................................... 5.22 5.3.13 Sale Proceeds of Junk Materials................................................................................. 5.22 5.3.14 Recovery of Bad Debts written off............................................................................... 5.23 5.3.15 Refund of General Insurance Premium paid............................................................... 5.26 5.3.16 Discounted Bills Receivable Dishonoured................................................................... 5.23 5.4 Verification of bank balance and cash-in-hand....................................................................... 5.24 5.4.1 Verification of bank balance.......................................................................................... 5.24 5.4.2 Verification of Cash-in-hand.......................................................................................... 5.25 5.5 Audit of trading transactions................................................................................................... 5.26 5.5.1 General Considerations................................................................................................. 5.26 5.5.2 Internal Control in Respect of Trading Transactions..................................................... 5.29 5.5.3 Internal Control in Respect of Services......................................................................... 5.31 v 5.6 Audit of Purchases................................................................................................................. 5.31 5.6.1 Special Precautions in Verification of Purchase Invoices.............................................. 5.32 5.6.2 Failure to Check Stock.................................................................................................. 5.33 5.6.3 Gross Profit.................................................................................................................... 5.34 5.6.4 Purchases Returns........................................................................................................ 5.36 5.7 Sales.................................................................................................................................... 5.37 5.7.1 Goods Sent Out on Sale or Return Basis...................................................................... 5.38 5.7.2 Sales Returns and Allowances...................................................................................... 5.38 5.7.3 Empties......................................................................................................................... 5.39 5.7.4 Consignment Sale......................................................................................................... 5.39 5.8 Cut-off arrangement............................................................................................................... 5.39 5.9 Audit of Ledgers..................................................................................................................... 5.40 5.9.1 General Considerations................................................................................................. 5.40 5.9.2 Ledger Keeper and Frauds............................................................................................ 5.41 5.9.3 Scrutiny of Ledgers........................................................................................................ 5.43 5.10 Outstanding Liabilities............................................................................................................ 5.48 5.11 Outstanding Assets................................................................................................................ 5.49 5.12 General scrutiny of expense accounts................................................................................... 5.50 5.13 Income accounts.................................................................................................................... 5.51 5.14 Asset Accounts....................................................................................................................... 5.52 5.15 Liabilities................................................................................................................................. 5.53 5.16 Analytical Procedures............................................................................................................. 5.53 5.17 Balance Sheet Audit............................................................................................................... 5.55 5.18 Direct confirmation of balances.............................................................................................. 5.58 Self-examination Questions............................................................................................................... 5.62 Chapter 6 - Verification of Assets and Liabilities 6.1 Capital and Revenue Expenditure............................................................................................ 6.1 6.1.1 Capital Expenditure......................................................................................................... 6.1 6.1.2 Revenue Expenditure...................................................................................................... 6.1 6.2 Depreciation............................................................................................................................. 6.2 6.2.1 Definition of Depreciation................................................................................................ 6.2 6.2.2 Purposes of Providing Depreciation................................................................................ 6.2 6.2.3 Depreciation on Wasting Assets...................................................................................... 6.3 6.2.4 Methods of Depreciation.................................................................................................. 6.4 vi 6.2.5 Determining the Amount of Depreciation......................................................................... 6.5 6.2.6 Depreciation on Low Value Items.................................................................................... 6.6 6.2.7 Disclosure in the Profit and Loss Account and Balance Sheet of a Company................. 6.6 6.2.8 Legal Necessity of Provision for Depreciation................................................................. 6.7 6.2.9 Provision of Depreciation for Past Years......................................................................... 6.8 6.2.10 Auditor's Duty as Regards Depreciation........................................................................ 6.8 6.2.11 Revaluation of Fixed Assets.......................................................................................... 6.9 6.2.12 Impairment of Assets.................................................................................................. 6.10 6.3 Reserves................................................................................................................................ 6.10 6.3.1 Reserves v. Provision.................................................................................................... 6.10 6.3.2 Specific Reserves.......................................................................................................... 6.12 6.4 Verification of assets.............................................................................................................. 6.13 6.4.1 General Principles......................................................................................................... 6.13 6.4.2 Valuation of Assets........................................................................................................ 6.14 6.4.3 General Principles Regarding Verification of Assets..................................................... 6.19 6.4.4 Audit of Fixed Assets..................................................................................................... 6.20 6.4.5 Fixed Assets and Requirements of CARO, 2003........................................................ 6.21 6.5 Verification of specific Assets................................................................................................. 6.24 6.5.1 Land and Buildings........................................................................................................ 6.24 6.5.2 Leasehold Property....................................................................................................... 6.26 6.5.3 Building.......................................................................................................................... 6.27 6.5.4 Intangible Asset............................................................................................................. 6.27 6.5.5 Plant and Machinery...................................................................................................... 6.28 6.5.6 Patterns, Dies, Loose Tools, etc.................................................................................... 6.28 6.5.7 Furniture, Fittings and Fixtures...................................................................................... 6.29 6.5.8 Motor Lorries, Vans, etc................................................................................................ 6.29 6.5.9 Livestock....................................................................................................................... 6.29 6.5.10 Ships........................................................................................................................... 6.29 6.5.11 Investments................................................................................................................. 6.30 6.5.12 Investment in the Capital of a Partnership Firm........................................................... 6.32 6.5.13 Patent Rights............................................................................................................... 6.32 6.5.14 Trademarks and Copyright.......................................................................................... 6.32 6.5.15 Endowment Policies.................................................................................................... 6.33 6.5.16 Assets Abroad............................................................................................................. 6.33 vii 6.5.17 Development of Property............................................................................................. 6.33 6.5.18 Railway Siding............................................................................................................. 6.33 6.6 Current Assets........................................................................................................................ 6.33 6.6.1 Stock-in-Trade............................................................................................................... 6.33 6.6.2 Verification of Inventories.............................................................................................. 6.35 6.6.3 Attendance at Stock-taking............................................................................................ 6.36 6.6.4 Confirmations from Third Parties................................................................................... 6.37 6.6.5 Examination of Valuation and Disclosure...................................................................... 6.37 6.6.6 Analytical Review Procedures....................................................................................... 6.38 6.6.7 Work-in-progress........................................................................................................... 6.38 6.6.8 CARO, 2033 and Inventory Requirements.................................................................. 6.39 6.6.9 Goods on Consignment................................................................................................. 6.43 6.6.10 Goods on Approval...................................................................................................... 6.43 6.6.11 Goods in Bond............................................................................................................. 6.43 6.6.12 Contracts in Course of Completion.............................................................................. 6.43 6.7 Book-debts............................................................................................................................. 6.44 6.7.1 Examination of Records................................................................................................ 6.44 6.7.2 Direct Confirmation Procedure...................................................................................... 6.46 6.7.3 Analytical Review Procedures....................................................................................... 6.47 6.7.4 Disclosure...................................................................................................................... 6.48 6.7.5 Debts Requiring Special Consideration......................................................................... 6.48 6.7.6 Debt Due from Subsidiary Companies.......................................................................... 6.49 6.7.7 Bills Receivable............................................................................................................. 6.49 6.7.8 Advances....................................................................................................................... 6.49 6.7.9 Loans............................................................................................................................. 6.49 6.8 Bank Balances....................................................................................................................... 6.52 6.9 Cash in hand.......................................................................................................................... 6.53 6.10 Miscellaneous Expenditure..................................................................................................... 6.54 6.11 Verification of Liabilities.......................................................................................................... 6.55 6.11.1 General Considerations............................................................................................... 6.55 6.11.2 Loans and Borrowings................................................................................................. 6.56 6.11.3 Provisions.................................................................................................................... 6.58 6.11.4 Contingent Liabilities................................................................................................... 6.59 6.11.5 Examination of Disclosure........................................................................................... 6.60 viii 6.11.6 Analytical Review Procedures..................................................................................... 6.60 6.11.7 Special Considerations in the Case of a Company..................................................... 6.61 6.11.8 Debentures.................................................................................................................. 6.65 6.12 Contingent Liabilities.............................................................................................................. 6.68 6.13 Events occurring after the Balance Sheet Date...................................................................... 6.69 6.14 Prior Period and Extraordinary Items and Changes in Accounting Policies............................................................................................. 6.70 Self-examination Questions............................................................................................................... 6.72 Chapter 7 - The Company Audit-I 7.1 Qualifications and Disqualifications of an Auditor..................................................................... 7.1 7.2 Appointment of auditor............................................................................................................. 7.3 7.2.1 Appointment by shareholders.......................................................................................... 7.3 7.2.2 Appointment of the First Auditor...................................................................................... 7.4 7.2.3 Reappointment of auditor................................................................................................ 7.5 7.2.4 Filling of a Casual Vacancy............................................................................................. 7.5 7.2.5 Appointment by the Central Government........................................................................ 7.6 7.2.6 Appointment of Auditor by Special Resolution................................................................. 7.6 7.2.7 Appointment of Auditor of a Government company......................................................... 7.6 7.2.8 Auditor Appointed at an Annual General Meeting Failing to Accept the Appointment..... 7.7 7.2.9 When Appointment is Made to Fill Up a Vacancy of Resignation of the Previous Auditor.............................................................................. 7.8 7.3 Ceiling on number of audits...................................................................................................... 7.9 7.4 Auditor's Remuneration.......................................................................................................... 7.12 7.5 Removal of Auditors............................................................................................................... 7.12 7.5.1 Removal of Auditor before Expiry of Term..................................................................... 7.12 7.5.2 After Expiry of Term....................................................................................................... 7.12 7.6 Powers of Auditors................................................................................................................. 7.13 7.7 Duties of Auditors................................................................................................................... 7.15 7.7.1 Scope of Audit Report Under Section 227..................................................................... 7.16 7.7.2 General considerations.................................................................................................. 7.20 7.8 Audit Report........................................................................................................................... 7.21 7.8.1 Basic Elements of the Auditor’s Report....................................................................... 7.21 7.8.2 Format of Audit Report................................................................................................ 7.24 7.8.3 Companies (Auditor’s Report) Order, 2003................................................................. 7.24 ix 7.9 Unqualified Report.................................................................................................................. 7.31 7.9.1 Modified Reports......................................................................................................... 7.31 7.10 Disclosure in the Auditor's Report......................................................................................... 7.33 7.11 Specimen Report.................................................................................................................... 7.35 7.12 Signing of the Audit Report..................................................................................................... 7.40 7.13 The Auditor's Lien................................................................................................................... 7.41 7.14 Audit of branch office accounts.............................................................................................. 7.41 7.15 Joint Audit............................................................................................................................... 7.44 7.16 Special Audit.......................................................................................................................... 7.45 7.17 Cost Audit............................................................................................................................... 7.46 7.18 Statutory Report..................................................................................................................... 7.48 Self-examination questions................................................................................................................ 7.49 Chapter 8 - The Company Audit-II 8.1 General Considerations in a Company Audit............................................................................ 8.1 8.2 Specific Provisions as regards Accounts in the Companies Act, 1956..................................... 8.3 8.3 Payment of Interest out of capital during construction............................................................ 8.10 8.4 Special requirements of company audit................................................................................. 8.11 8.5 Audit of share capital.............................................................................................................. 8.15 8.5.1 General Programme for Verification of Share Capital................................................... 8.15 8.5.2 Verification of Shares Issued for Cash.......................................................................... 8.16 8.5.3 Shares Issued for Consideration other than Cash......................................................... 8.17 8.5.4 Shares Issued at a Premium......................................................................................... 8.18 8.5.5 Shares Issued at a Discount.......................................................................................... 8.18 8.5.6 Issue of Sweat Equity Shares........................................................................................ 8.18 8.5.7 Power of Company to Purchase its Own Securities...................................................... 8.19 8.5.8 Calls Paid in Advance.................................................................................................... 8.21 8.5.9 Calls in Arrears.............................................................................................................. 8.21 8.5.10 Issue and Redemption of Preference Shares.............................................................. 8.21 8.5.11 Alteration of Share Capital........................................................................................... 8.22 8.5.12 Reduction of Capital (Section 100).............................................................................. 8.23 8.5.13 Verification of Forfeiture of Shares.............................................................................. 8.23 8.6 Option on share capital........................................................................................................... 8.24 8.7 Shares transfer audit.............................................................................................................. 8.24 8.8 Verification of Issue of Bonus Shares..................................................................................... 8.28 x 8.9 Audit of Debentures................................................................................................................ 8.28 8.9.1 Allotment of Debentures................................................................................................ 8.28 8.9.2 Issue of Debentures...................................................................................................... 8.29 8.9.3 Redemption of Debentures at a Premium..................................................................... 8.30 8.9.4 Interest on Debentures.................................................................................................. 8.30 8.9.5 Re-issue of Redeemed Debentures.............................................................................. 8.30 8.9.6 Re-issue as Collateral Security..................................................................................... 8.30 8.10 Audit of dividends................................................................................................................... 8.31 8.10.1 Verification of Dividends.............................................................................................. 8.31 8.10.2 Interim Dividends......................................................................................................... 8.32 8.11 Presentation of Financial Statements.................................................................................... 8.33 Part I : Form of Balance Sheet............................................................................................... 8.33 Part II : Requirements as to profit and loss account............................................................... 8.44 Part III: Interpretation.............................................................................................................. 8.44 Self-Examination Questions............................................................................................................... 8.54 Chapter 9 - Special Audits 9.1 Government Audit..................................................................................................................... 9.1 9.1.1 Background..................................................................................................................... 9.1 9.1.2 Legal Framework and Comptroller & Auditor General..................................................... 9.2 9.1.3 Comptroller and Auditor General's - Duties and Powers................................................. 9.3 9.1.4 Expenditure Audit............................................................................................................ 9.5 9.1.5 Audit of Receipts............................................................................................................. 9.8 9.1.6 Audit of Stores and Stocks.............................................................................................. 9.8 9.1.7 Audit of Commercial Accounts........................................................................................ 9.9 9.1.8 Reporting Procedures.................................................................................................... 9.10 9.2 Audit of Local Bodies.............................................................................................................. 9.12 9.2.1 Background................................................................................................................... 9.12 9.2.2 Financial Administration................................................................................................ 9.13 9.2.3 Audit of Local Bodies..................................................................................................... 9.13 9.3 Audit of Non-Governmental Organisations (NGO's)............................................................... 9.14 9.3.1 Background................................................................................................................... 9.14 9.3.2 Sources and applications of funds................................................................................. 9.15 9.3.3 Provisions Relating to Audit........................................................................................... 9.15 9.4 Miscellaneous Audits.............................................................................................................. 9.18 xi 9.4.1 Audit of a Sole Trader.................................................................................................... 9.18 9.4.2 Audit of a Firm............................................................................................................... 9.18 9.4.3 Audit of Small Companies............................................................................................... 9.2 9.4.4 Audit of Charitable Institutions....................................................................................... 9.25 9.4.5 Audit of Educational Institutions : (School, College or University)................................. 9.27 9.4.6 Audit of Hospital............................................................................................................ 9.29 9.4.7 Audit of Club.................................................................................................................. 9.30 9.4.8 Audit of Cinema............................................................................................................. 9.31 9.4.9 Audit of Hotels............................................................................................................... 9.32 9.4.10 Audit of Hire Purchase and Leasing Companies......................................................... 9.34 Self-examination Questions............................................................................................................... 9.36 APPENDICES Appendix-I : A Summary of the Significant Legal Decisions The Leeds Estate Building and Investment Company v. Shepherd (1887)........................................... I.1 Lee v. Neuchatel Asphalte Company Limited (1889)............................................................................ I.1 Bolton v. The Natal Land and Colonisation Company Limited (1891)................................................... I.2 Lubbock v. The British Bank of South America Limited (1892)............................................................. I.3 Verner v. The General and Commercial Investment Trust Limited (1894)............................................ I.3 Wilmer v. M'Namara & Company Limited (1895).................................................................................. I.4 In re the London and General Bank Ltd. (1895).................................................................................... I.5 In re The Kingston Cotton Mill Co. Ltd. (1896)...................................................................................... I.6 In re City Equitable Fire Insurance Co. Ltd. (1926)............................................................................... I.8 In re Westminster Road Construction and Engineering Co. Ltd. (1932)............................................... I.9 In re Allen Craig & Co. (London) Ltd. (1934)....................................................................................... I.10 In re S.P. Catterson and Sons, Ltd. (1937)......................................................................................... I.11 Newton v. Birmingham Small Arms Co. Ltd. (1906)............................................................................ I.12 Spackman v. Evans............................................................................................................................ I.13 London Oil Storage Company Limited v. Seear Hasluck and Company............................................. I.14 Armitage v. Brewer and Knott (1932).................................................................................................. I.15 Rex v. Kylsant and Morland (1931)..................................................................................................... I.16 Appendix II : Question Bank xii 1 NATURE OF AUDITING In this Chapter, the background of auditing has been discussed at length. The nature of auditing, its definition and objectives have been highlighted. 1.1 INTRODUCTION Auditing along with other disciplines such as accounting and law, equips you with all the knowledge that is required to enter into auditing as a profession. No business or institution can effectively carry on its activities 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 have 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 statements 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 loss, the proprietor may take the decision to sell the business at a loss. Thus from the point of view of the management itself, authenticity of financial statements is essential. It is more 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 which ensures that the accounting statements are authentic. In today’s economic environment, information and accountability have assumed a larger role than ever before. As a result, the independent audit of an entity’s financial statements is a vital service to investors, creditors, and other participants in economic exchange. Historically, the word ‘auditing’ has been derived from Latin word “audire” which means “to 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 has undergone revolutionary change. According to Dicksee, traditionally auditing can be understood as an examination of accounting records undertaken with a view to establishing 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 1.2 Auditing and Assurance the character of the statements of accounts prepared from the accounting records so examined as to whether they portray a true and fair picture. 1.2 NATURE AND PURPOSE OF FINANCIAL STATEMENTS For correctly realising the role of auditing, you must understand the nature and purpose of the financial statements. ‘Financial 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 description 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 reporting for these entities is directed toward the common interest of various users. Financial statements provide owners with information about the stewardship of management. They also provide a basis for investors’ decisions about whether to buy or sell securities; for credit rating services’ decisions about the credit worthiness of entities; for bankers’ decisions about whether to lend money, and for decisions of other creditors, regulators and others outside the entity. Information contained in the statement of accounts of a business are primarily intended for the owners. However, many others make use of the information for different purposes. Management of the business uses it for decision-making purposes, lenders and creditors examine it to establish the degree of safety of their money. Government levies tax putting a prima facie reliance on the statements and regulates the socio-economic state of affairs on a summary view of the information contained in various accounting statement made available to it. Investors review the information for making investment decisions and the financial analysts can use the information to assess the performance of an entity. Financial statements are of great significance to workers as well; they want to be assured that reasonable and legitimate share of the revenue earned by the organisation has been paid to them as bonus and the distribution pattern has not violated the norms of social justice. You will realise, from the above the importance and utility of statements of account and the need for their reliability. To ensure the acceptable degree of reliability and accuracy of the financial statements, examination and appraisal of accounts and the financial picture by an independent expert is necessary. This is what has led to the evolution of the auditing profession. 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 the other interests. 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 Nature of Auditing 1.3 of the present 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 because 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 results of operations. Management is responsible for selecting accounting principles that appropriately reflect events that occur and for making other accounting estimates and judgments. This responsibility is not lessened by an independent audit. 1.3 AUDITING AND ASSURANCE STANDARDS 1.3.1 International Auditing and Assurance Standards Board In 1977, the International Federation of Accountants (IFAC) was 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 Auditing and Assurance Standards Board (IAASB) to develop and issue, in the public interest and under its own authority, high quality auditing and assurance standards for use around the world. The IFAC Board has determined that designation of the IAASB as the responsible body, under its own authority 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 and assurance 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 auditing standards and guidance for financial statement audits that are generally accepted and recognized by investors, auditors, governments, banking regulators, securities regulators and other key stakeholders across the world; Establishing high quality standards and guidance 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 quality control covering the scope of services addressed by the IAASB; and 1.4 Auditing and Assurance Publishing other pronouncements on auditing and assurance matters, thereby advancing public understanding of the roles and responsibility of professional auditors and assurance service providers. The IAASB’s Pronouncements: The IAASB’s pronouncements govern audit, review, other assurance and related services engagements that are conducted in accordance with International Standards. They do not override the local laws or regulations that govern the audit of historical financial statements or assurance engagements on other information in a particular country required to be followed in accordance with that country’s national standards. In the event that local laws or regulations differ from, or conflict with, the IAASB’s Standards on a particular subject, an engagement conducted in accordance with local laws or regulations 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 Assurance Standards Board The Institute of Chartered Accountants of India is a member of the IFAC and is committed to work towards the implementation of the guidelines issued by the IFAC. The Institute of Chartered Accountants of India constituted the Auditing Practices Committee (APC) in 1982. The main function of the APC is to review the existing auditing practices in India and to develop Statements on Standard Auditing Practices (SAPs) so that these may be issued by the Council of the Institute. While formulating the SAPs in India, the APC gives due consideration to the international auditing guidelines issued by the IAPC and then tries to integrate 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 laws, customs, usages and business environment in India. In July, 2002, the Auditing Practices 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 segments of the society and interest groups, such as, regulators, industry and academics. The nomenclature of SAPs have also been changed to Auditing and Assurance Standards (AASs). The AASs will apply whenever an independent audit is carried out; that is, in the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size, or legal form (unless specified otherwise) when such an examination is conducted with a view to expressing an opinion thereon. While discharging their attest function, it will be the duty of members of the Institute to ensure that the AASs are followed in the audit of financial information covered by their audit reports. If for any reason a member has not been able to perform an audit in accordance with the AASs, his report should draw attention to the material departures therefrom, auditors will be expected to follow AASs in the audits commencing on or after the date specified in the statement. Remember all AASs are mandatory from the date mentioned herein and it is obligatory upon members of Institute to Nature of Auditing 1.5 adhere to these whenever an audit is carried out. The Council of the ICAI has issued following AASs so far. The title of each statement and the date from which it comes into force is given below : AAS - 1 : Basic Principles Governing an Audit (April 1, 1985) AAS - 2 : Objective and Scope of the Audit of Financial Statements (April 1, 1985) AAS - 3 : Documentation (July 1, 1985) AAS – 4 (Revised) : Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements (April 1, 2003) AAS - 5 : Audit Evidence (January 1, 1989) AAS – 6 (Revised) : Risk Assessments and Internal Control (April 1, 2002) AAS - 7 : Relying upon the Work of an Internal Auditor (April 1, 1989) AAS - 8 : Audit Planning (April 1, 1989) AAS - 9 : Using the Work of an Expert (April 1, 1991) AAS – 10 (Revised) : Using the Work of Another Auditor (April 1, 2002) AAS - 11 : Representations by Management (April 1, 1995) AAS - 12 : Responsibility of Joint Auditors (April 1, 1996) AAS - 13 : Audit Materiality (April 1, 1996) AAS - 14 : Analytical Procedures (April 1, 1997) AAS - 15 : Audit Sampling (April 1, 1998) AAS - 16 : Going Concern (April 1, 1999) AAS - 17 : Quality Control for Audit work (April 1, 1999) AAS - 18 : Audit of Accounting Estimates (April 1, 2000) AAS - 19 : Subsequent Events (April 1, 2000) AAS – 20 : Knowledge of the Business (April 1, 2000) AAS - 21 : Consideration of Laws and Regulations in an Audit of Financial Statements (July 1, 2001) AAS - 22 : Initial Engagements – Opening Balances (July 1, 2001) AAS - 23 : Related Parties (April 1, 2001) 1.6 Auditing and Assurance AAS – 24 : Audit Considerations Relating to Entities Using Service Organisations (April 1, 2003) AAS - 25 : Comparatives (April 1, 2003) AAS - 26 : Terms of Audit Engagements (April 1, 2003) AAS - 27 : Communications of Audit Matters to those charged with Governance (April 1, 2003) AAS - 28 : The Auditor’s Report on Financial Statements (April 1, 2003) AAS - 29 : Auditing in a Computer Information Systems Environment (April 1, 2003) AAS 30 : External Confirmations (April 1, 2003) AAS 31 : Engagements to Compile Financial Information (April 1, 2004) AAS 32 : Engagements to Perform Agreed-upon Procedures Regarding Financial Information (April 1, 2004) AAS 33 : Engagements to Review Financial Statements (April 1, 2005) AAS 34 : Audit Evidence – Additional Consideration for Specific Items (April 1, 2005) All relevant AASs which are important from students’ view point have been covered as an integral part of the text. Procedure for Issuing the Statements on Standard Auditing Practices Broadly, the following procedure is adopted for the formulation of Auditing and Assurance Standards. (i) The Auditing and Assurance Standards Board (AASB) determines the broad areas in which the Auditing and Assurance Standards (AASs) need to be formulated and the priority in regard to the selection therefor. (ii) In the preparation of AASs, the AASB is assisted by study groups constituted to consider specific subjects. In the formation of study groups, provision is made for participation of a cross-section of members of the Institute. (iii) On the basis of the work of the study groups, an exposure draft of the proposed AAS is prepared by the Board and issued for comments by members of the Institute. (iv) After taking into consideration the comments received, the draft of the proposed AAS is finalised by the AASB and submitted to the Council of the Institute. (v) The Council of the Institute will consider the final draft of the proposed AAS, and if necessary, modify the same in consultation with the AASB. The AAS is issued under the authority of the Council. Nature of Auditing 1.7 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 discharge of their functions. ‘Statements’ therefore are mandatory. Accordingly, while discharging their 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 will 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 reports. 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 thereform. ‘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 arise in the course of their professional work and on which they may desire assistance in resolving issues which may pose difficulty. Guidance Notes are recommendatory 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 function, 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 disclosure in his report is necessary. 1.4 DEFINITION OF AUDITING According to General Guidelines on Internal Auditing issued 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 this basis formulates his judgement 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 enterprise 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 the transactions of an enterprise have been executed within the framework of certain standards 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 1.8 Auditing and Assurance thereon may have to be suitably modified. According to AAS-1 on “Basic Principles Governing an Audit”, “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 opinion 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 account 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 properly classified, described and disclosed in conformity with accounting 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 definition given in AAS-1 is restrictive since it covers financial information aspect only. However, the scope of auditing is not restricted to financial information only but, today, it extends to variety of non-financial areas as well. That is how various expressions like marketing audit, personnel audit, efficiency audit, production audit, etc. came into existence. Students may note that study material deals with various aspects of financial audit only unless otherwise specified. 1.5 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 reflect 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 India, under the authority of the Companies Act, 1956, only Chartered Accountants, are professionally 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 aspect, unlike cost accountants whose sphere has been restricted to audit of the cost accounting records and statements. By and large, it is Nature of Auditing 1.9 chartered accountants or a firm whose all partners are chartered accountants who act as auditors in India. 1.5.1 Functional Classification of Auditors : Internal Audit vs. External Audit On the basis of functional division, auditors can 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 internal auditors, on the other hand, may also be professionally 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 the scope of work is also specified by it. They may be appointed either on a contract basis 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. Another significant distinction between the internal and external auditor is that the former is not considered independent vis-a-vis the 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 extend 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, envisages 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. 1.5.2 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, AAS-1 mentions integrity, objectivity and independence as one of the basic principles. He must have a thorough knowledge of the general principles of law which govern matters with which he is likely to be in intimate contact. 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. 1.10 Auditing and Assurance 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 theoretical 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 accounts are under audit. AAS-8 on ‘Audit Planning’ emphasises that an auditor should have adequate knowledge of the client’s business. The auditor, who holds a position of trust, must have the basic human qualities 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 knowledge 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. Auditing is a profession calling for wide variety of knowledge to which no one has yet set a limit; the most useful part of the knowledge is probably that which cannot be learnt from books because its acquisition depends on the alertness of the mind in applying to ever varying circumstances, the fruits of his own observation and reflection; only he who is endowed with common sense in adequate measure can achieve it. Lord Justice Lindley in the course of the judgment in the famous London & General Bank case 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”. 1.6 OBJECTIVES OF AUDIT 1.6.1 Expression of opinion When we speak of the objective, we rationalise the thinking process to formulate a set of attainable goals, with 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 audit, 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 the 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 Nature of Auditing 1.11 statements in such a way as to enable the reader of the accounting statement to form a correct view of the state of affairs. Quite a few managements took advantage of the situation and manipulated profit or loss and assets and liabilities 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 the substitution of “true and correct” by “true and fair” need 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 tho

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