Principles and Practice of Auditing VI Semester B.Com PDF

COURSE MANUAL FOR UNDE UNDERGRADUATE COURSES (For Internall Circu Circulation only) PRINCIPLES AND PRAC RACTICE OF AUDITING VI SEMESTE ESTER B.Com (As per Bangalore Univers...

COURSE MANUAL FOR UNDE UNDERGRADUATE COURSES (For Internall Circu Circulation only) PRINCIPLES AND PRAC RACTICE OF AUDITING VI SEMESTE ESTER B.Com (As per Bangalore Univers niversity CBCS Syllabus) SUMATH ATHI C. HOD, Department ment oof Commerce SeshadripuramComm Commerce College BANUMAT MATHI R. Senior Lecturer, Departm epartment of Commerce SeshadripuramComm Commerce College THERESE SE FR FRANCIS Senior Lecturer, Departm epartment of Commerce SeshadripuramComm Commerce College Dr.PRADEEP EP KU KUMAR S.V. Lecturer, Departmen rtment of Commerce SeshadripuramComm Commerce College SWATHI ATHI N. Lecturer, Departmen rtment of Commerce SeshadripuramComm Commerce College SESHADRIPURAM EDU EDUCATIONAL TRUST BENGALURU, MYSORE, RE, T TUMKUR, MANDYA Published : 2019 Printed : KRIYA PRAKASHANA # 40/5, 2nd 'B' Main, 16th Cross, SR Nagar, Bengaluru - 27 Ph.:080 22234369 e-mail : [email protected] ii  ACKNOWLEDGEMENT It has given us great pleasure to prepare the Course manual for the subject Principles and Practices of Auditing as per the syllabus prescribed for VI Semester B.Com. Bangalore University under the Choice Based Credit Scheme. There is no claim of originally and the manual is a compilation of material from different sources including the internet. It is solely for internal circulation among students of degree colleges belonging to the Seshadripuram Group of Institutions in Bangalore. We have attempted to present the material in a manner which will help our students to understand concepts clearly. We would like to emphasize that this manual attempts to lay the foundation for understanding and learning the subject and cannot be taken as a substitute for a standard textbook or reference book. We also hope that the material provided will motivate students to explore the subject beyond examination requirements. We are grateful to the Management for giving us the unique opportunity to prepare the course manual which we hope will be of great use for our students. We would like to thank our Principal Dr.Manjunath. R. We would also like to thank our students who have been our constant motivation in preparing this manual. We look forward to their feedback which will help us to improve the material in subsequent years. C. Sumathi. R. Banumathi. Therese Francis Dr.Pradeepkumar S. V. Swathi N. iii  PREFACE Audit has become in dispensable for a business. It is through audit that one can see the soundness of commercial and non-commercial concerns. The success, prosperity and even the failure of the business depends upon efficiency of audit system. It is an important tool of management control. Audit procedure involves vouching, verification, valuation and reporting. These aspects have been analyzed in a simple way to meet the students understand the subject matter without any difficulty. Rights, duties and liabilities of company auditor have been incorporated as per new companies Act 2013. The latest provisions of companies Act 201, standard of audit and other related Acts have been taken into consideration while writing this manual. iv  6.2 PRINCIPLES AND PRACTICE OF AUDITING Syllabus OBJECTIVE: This subject aims at imparting knowledge about the principles and methods of auditing and their applications. Unit 1: INTRODUCTION TO AUDITING 12 Hrs Introduction – Meaning - Definition – Objectives – Differences between Accountancy and Auditing – Types of Audit - Advantages of Auditing – Preparation before commencement of new Audit – Audit Notebook – Audit Working Papers – Audit Program, Recent Trends in Auditing: Nature & Significance of Tax Audit – Cost Audit - Management Audit. Unit 2: INTERNAL CONTROL 10 Hrs Internal Control: Meaning and objectives. Internal Check: Meaning, objectives and fundamental principles. Internal Check as regards: Wage Payments, Cash Sales, Cash Purchases. Internal Audit: Meaning - Advantages and Disadvantages of Internal Audit – Differences between Internal Check and Internal Audit. Unit 3: VOUCHING 12 Hrs Meaning - Definition – Importance – Routine Checking and Vouching – Voucher -Types of Vouchers – Vouching of Receipts: Cash Sales, Receipts from debtors, Proceeds of the sale of Investments. Vouching of Payments: Cash Purchases, Payment to Creditors, Deferred Revenue Expenditure. Unit 4: VERIFICATION AND VALUATION OF ASSETS AND LIABILITIES 12 Hrs Meaning and Objectives of verification and valuation– Position of an Auditor as regards the Valuation of Assets – Verification and Valuation of different Items: Assets: Land & Building, Plant & Machinery, Goodwill – Investments - Stock in Trade. Liabilities: Bills Payable - Sundry Creditors – Contingent Liabilities. v Unit 5: AUDIT OF LIMITED COMPANIES AND OTHERS 10 Hrs Company Auditor – Appointment – Qualification - Powers - Duties and Liabilities – Professional Ethics of an Auditor. Audit of Educational Institutions – Audit of Insurance Companies- Audit of Co-operative societies. SKILL DEVELOPMENT: Collect the information about types of audit conducted in any one Organization Visit an audit firm, write about the procedure followed by them in Auditing the books of accounts of a firm. Draft an investigation report on behalf of a Public Limited Company Record the verification procedure with respect to any one fixed asset. Draft an audit program. vi  CONTENTS Sl. Page Units No. No. 1 INTRODUCTION TO AUDITING 1 – 30 2 INTERNAL CONTROL 31 – 56 3 VOUCHING 57 – 82 VERIFICATION AND VALUATION OF ASSETS AND 4 83 – 96 LIABILITIES 5 AUDIT OF LIMITED COMPANIES AND OTHERS 97 – 118 BOOKS FOR REFERENCE 118 PREVIOUS EXAM QUESTION PAPERS 119-120 vii viii  UNIT – 1 INTRODUCTION TO AUDITING Introduction – Meaning - Definition – Objectives – Differences between Accountancy and Auditing – Types of Audit - Advantages of Auditing – Preparation before commencement of new Audit – Audit Notebook – Audit Working Papers – Audit Program, Recent Trends in Auditing: Nature & Significance of Tax Audit – Cost Audit - Management Audit. Introduction Auditing is an important task, carrying heavy responsibility and demanding skill combined with proper judgment. In the past, the method of maintenance of accounts was not proper because the size of the business was generally small, involving small amount of capital. Auditing was introduced in the 18th century when the practice of large scale production was developed as an effect of the industrial revolution. Origin of auditing Auditing is as old as Accounting. The practice of auditing existed even in the Vedic period. A historical record reveals that Egyptians, Greeks, Mesopotamians and Romans used to get this public accounts examined by an independent official. In India auditing exists in ancient period. Kautilya had mentioned in his book 'Arthashastra’. The detailed rules for accounting and auditing of public finances, but auditing as a system at evolved and grew rapidly only after the industrial revolution in the 18th century. Meaning of auditing: The word Audit has been derived from Latin word 'Audire' which means 'to hear'. In middle ages, an auditor used to listen to the accounts read over by an accountant in order to check them. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 1 Auditing simply means verification and examination of accounts. It is done to ascertain the reliability and validity of information. The auditing process can be started only when accounting ends. In other words, an audit is an attempt to find out whether the financial statements reflect the true and fair result and financial position of the company or institution. Definition of auditing: In the words of R.B.Bose,"Audit may be said to the verification of the accuracy and correctness of the books of accounts by an independent person qualified for the job and not in any way connected with the preparation of such accounts". According to A.W.Hanson, "An audit is an examination of such records to establish their reliability and the reliability of the statement drawn from them". According to R. K. Moutz, "Auditing is concerned with the verification of accounting data with determining the accuracy and reliability of accounting statement and record." According to Montgomery, " Auditing is a systematic examination of the books and records of a business or the organization in order to ascertain or verify and to report upon the facts regarding the financial operation and the result thereof." Meaning of auditor An auditor is a trained professional who is responsible to review and verify the accounting data of any business undertaking pertaining to its business activities. Objectives of Auditing I. Primary Objectives: The primary objectives of an audit are as follows: To express an appropriate opinion as to whether the financial statements present fairly, in all material respects, the financial position, the results of operations and the cash flows of the company's business. To verify how far the accounting system is successful in correctly recording transactions, checking whether the accounts are prepared in accordance with recognized accounting policies and practices and as per statutory requirements. 2 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM II. Secondary Objectives: An auditor may come across some errors and frauds examining the books of accounts in order to report the true financial condition of the business. This detection and prevention of frauds and errors are the secondary objectives of auditing. These objectives are classified into following types: A. Detection and Prevention of Errors. B. Detection and Prevention of Frauds. A. Detection of and Prevention of Errors: Errors refers to the mistakes which are committed unintentionally because of carelessness, ignorance etc. Errors are of different types: 1. Clerical Errors 2. Compensating Errors 3. Error of Principle 1. Clerical Errors: Clerical errors refer to those errors which arise due to wrong posting, ignorance, carelessness etc. If these errors are discovered in the process of audit, the auditor should get them rectified. Clerical errors are of two types: Errors of Omission: These are the types of errors which arise on account of transaction omitted to be recorded in books of accounts wholly or partially. This omission of transaction does not affect the agreement of trial balance; hence it is more difficult to find out. Example: Furniture purchased for Cash Rs.5000 not recorded in the books of accounts. Errors of Commission: These are the types of errors which arise due to wrong posting to ledger account, wrong totalling, wrong calculations or balancing in the books of accounts wholly or partially. These errors affect the agreement of trial balance. Example: Cash Sales Rs.10, 000 recorded as Rs.1,000. 2. Compensating Errors: When an error is counter balanced with another error, such an error is known as compensating errors. These errors will not disturb the agreement of trial balance. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 3  Example: Geetha's account which was to be debited for Rs.6,000 was credited for Rs. 6,000 and similarly, Seetha’s account which was to be credited for Rs.6,000 was debited for Rs.6,000 These two errors will nullify the effect of each other. 3. Error of Principle: When transactions are not recorded in accordance with the fundamental principles of accounting, such errors are known as Errors of Principle. Example: Furniture purchased for Rs. 5,000 debited to Purchases A/C. This is an error of principle. A. Location of errors: Auditors are appointed to audit the boots not to identify the errors but in many cases they are called to find out the difference in the books of accounts. The auditor should follow the following procedure in this regard: 1. Trial balance must be checked. 2. He should compare the list of debtors and creditors with the trial balance. 3. He should compare the names of account appearing in the ledger with the names of accounting in the trial balance. 4. He must check the totals and balances of all accounts and see that they have been properly shown in the trial balance. 5. He should also check the posting of entries from various books into ledger. B. Detection and Prevention of Frauds: Fraud refers to the intentional and deliberate misrepresentation of accounting records for a financial gain. These frauds are intended to deceive, to mislead or to conceal the truth or the material facts. They are more serious than errors. Frauds are of three types: a. Embezzlement or misappropriation of cash. b. Misappropriation of goods. c. Manipulation of accounts. a) Misappropriation of Cash: These types of errors take place by omission of receipt regarding to the payment, receipts of cash vouchers. It means mis utilization of cash by without showing the cash book. This 4 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  type of fraud may be done by an employee or cashier of the business concern. This method is called "Teeming and lading or lapping". Teeming and Lading is a method of committing fraud by an employee or cashier of the business concern. Teeming and lading may be adopted in which money received from one customer is pocketed and when later on money received from another customer may be shown as received from former customer. b) Misappropriation of Goods: The misappropriation of goods is easy in case of a business which produces or deals in goods of high value and less bulky. Usually businessman does not bother much for defalcation of goods as compared to misappropriation of money. Defalcation of goods can be done as follows: Issuing false credit notes to customers for sales returns and such goods are misappropriated. Goods may be stolen by employees from the godowns. c) Manipulation of Accounts: This type of fraud is committed by upper level of management with the different objectives to mislead certain parties within or outside the business. This is also known as "WINDOW DRESSING. The objective of Window Dressing may be to evade tax, to borrow money from bank, to increase the share price etc. Two types of motives are principally behind such manipulations: a) Showing lower profits than the actual ones: To give a wrong impression about success of the business to competitors. To reduce or avoid payment of income tax. To purchase shares at lower price in the market. b) Showing more profits than what actually they are: The manager may get more commission if such commission is calculated on the basis of Profit earned. To sell the shares at a high price by declaring higher dividends, this is done when such persons hold shares of the company. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 5  Difference between Auditing & Accounting SL. BASIS ACCOUNTING AUDITING NO. 1 Meaning It means the maintaining It means examining the books of accounts the books of accounts & reporting about their accuracy 2 Performance Accounting job is Auditing job is of work performed by the performed by the accountant auditor 3 Appointment Is appointed by manager Is appointed by shareholders 4 Nature of Job Accountant job is Auditing job is not so mechanical nature mechanical 5 Qualification For the accountant no For auditing specific specific qualification is qualification is required (PUC or any required i.e. An Degree) auditor must be a qualified Charted Accountant 6 Status Accountant is an An auditor is an employee of the independent auditor organization who does not belong to the organization 7 Scope Is limited to the Auditing is concerned preparation of financial with checking of statements accounts 8 Benefit Accountant gets the salary Auditor gets the fees for his work for his work known as audit fee 9 Period of Accounting work is It is done usually at work carried throughout the the end of the year year 10 Dependence Accounting is not Auditing can be dependent on auditing started only after accounting ends & it is dependent on accounting 6 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  11 Nature of Accountancycy is a Auditing is an work constructivee work analytical work 12 Accountability The accountant tant is Auditor is accountable accountable to to the shareholders management 13 Rules Accountantt is gov governed Auditing is governed by code of condu conduct laid by the charted down by thee insti institute accountant code of conduct 14 Record/Data Accounting is rel related with Auditing verifies the the present record true picture of the financial statement 15 Removal Accountantt can bbe Auditor cannot be removed from om his job at removed till he any time completes his period of appointment Types of Audit PRINCIPLES AND PRACTIC ACTICE OF AUDITING VI SEMESTER B.COM | 7  The different classifications of audit are explained below: I. Classification on the basis of the organization: The audits under this classification are further divided into two types: a. Statutory Audits. b. Voluntary or Non-statutory Audits. a. Statutory Audit: Statutory audit refers to the audit of an organization performed under a statute. For certain business organization or institutions audits are mandatory; such organisations come under this category. In this type of audit, the rights, powers, duties and responsibilities of auditors are laid down by the statute which cannot be altered or curtailed by the client or auditor himself. The following are some of the organisation which requires statutory audits: Companies- According to Companies Act 1956 Banking Companies- According to the Banking Regulations Act, 1949 Co-operative Societies-The Co-operative Societies Act, 1912 Insurance Companies-The Insurance Act, 1938 Public and Charitable Trusts - Various Religious and Other Endowment Acts b. Voluntary or Non-statutory Audits: Voluntary audit refers to the audit performed by the auditors because the proprietors or the Government bodies of the organisation wants their accounts to be audited as it provides the assurance on the reliability of accounts and the financial results of the organisations. These audits are also known as 'Private Audits'. In this type of audit, the duties, powers and responsibilities are decided as per the agreement between the auditor and the client. The following are some of the organisations which go for voluntary audits: Proprietary Concerns. Partnership firms. Unregistered clubs and societies. II. Classification on the basis of the Functions: The function of the auditor depends upon the capacity of conducting the work by the auditor. Based on this, the audit is classified into two types 8 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  Internal Audit. External Audit. a) Internal Audit: Internal audit is a type of audit conducted by the own staff of the organization specially assigned for that purpose. In this type of audit, thorough examinations of the accounting transaction as well as the system according to which transactions are recorded or conducted. It is done to verify the reliability and authenticity of the financial accounting and other records presented to the management. The scope and objectives of this type of audit vary widely and are dependent on the size and nature of the business. b) External Audit: It is a type of audit performed by the auditors outside the business organisation. They are no way related with the preparation of accounts or management of the organisation. Qualified Charted Accountants are appointed as external auditors of the organisation. This audit is conducted in order to fulfil the legal requirement of the business. The various procedures relating to this type of audit is laid down in the concerned statute. III. Classification on the basis of Audit Approach: On the basis of practical approach of audit work, audit can be classified into 1. Time basis. a. Continuous Audit b. Interim Audit. c. Periodical or Final Audit. 2. Scope basis: a. Complete Audit. b. Partial Audit. 3. Objective basis; a. Balance sheet Audit. b. Occasional Audit. 1. Time Basis: Further audit can be divided on the time basis which is as follows: PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 9  i. Continuous Audit. ii. Interim Audit. iii. Final or Complete Audit. Continuous Audit: Continuous audit is also known as Detailed Audit. Under this type of audit, detailed examination of books of accounts are conducted at regular intervals say weekly, monthly or once in three months. The auditor checks and verifies each and every transaction by visiting clients place regularly during the financial year. This type of audit is carried in large organizations where bulk and variety of transactions are involved. Advantages of Continuous Audit: Quick preparation of final accounts: Since, the routine audit is done continuously; the Final Accounts can be prepared immediately after the year end. Early dividends to shareholders: The shareholders would be happy as they receive dividends soon after the end of financial year. The company can prepare interim accounts and pay even interim dividends to the Shareholders. Up-to-date accounts for banks/investors: The up-to-date final accounts are useful to banks and investors for taking decisions regarding loans and investment Check on employees: Since the auditors visit regularly throughout the year, it acts as check on the employees to keep the accounts ready and up-to-date. Prevents errors and frauds: Constant checking by the auditors helps to detect and even prevent errors and Frauds. Increases familiarity with client’s business: Since the auditor spends more time at the clients place, he becomes familiar with all the aspects of client's business. Thorough audit: The auditor has more time at his disposal to do a thorough checking of all transactions. This reduces the risk of missing any material items. Utilization of audit staff: Audit Staff can be kept busy throughout the year. Audit work can be evenly distributed to avoid overwork after year end. 10 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM Disadvantages of Continuous Audit: Expensive: Since the auditor spends more time on the audit work, the audit fees are much more. Continuous Audit is thus expensive. However, only a large organization should opt for a Continuous Audit Audit in instalments: Since the audit work is done at intervals and not at one go, audit may be inefficient, the queries during the last visit may remain unsolved. It is difficult at each visit to take up the work precisely at the stage of last visit. To overcome this disadvantage, audit should be well-planned. All queries should be noted in the Audit Note Book and Cleared before taking up fresh work. The work done up to end of each visit, relevant voucher numbers, totals etc. should be carefully noted in the Audit Note Book. Dislocation of client's work: If a proper audit programme is not adopted, continuous audit may disrupt the routine accounting work of the client. Either the audit staff may have to sit Idle or the accounts staff of the client may waste time for want of books of accounts. Employees have to attend the auditor for explanation. They have to keep aside their usual work to attend the auditors for explanation. Errors and frauds in books already checked: If an employee changes some figures in the books already checked by the auditor during his earlier visits, it would be difficult to detect such errors and frauds subsequently. Monotonous/tiresome/tedious: Continuous visits to the clients place may make the work tedious and the audit staffs lose interest from work consequently. The quality of audit suffers. Absence of link: In the absence of well-planned audit work, an auditor may miss the thread of audit work. Further, some important queries may be over looked if no proper audit notes and queries are recorded by the audit staff during the course of the audit. Conflict between audit and accounts staff: The members of audit and accounts staff come in Close contact and sometimes it may result in spoiling the healthy relations between them and thereby the quality of audit may suffer. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 11  Dependence of the accounts staff on the auditor: The accounts staff may depend on the audit staff. They may require the help of auditor for even small errors which they can discover or avoid by taking proper care. Interim Audit: It is a type of audit which is conducted in between two annual audits with a view to find out the interim profits. It is done for the purpose of declaring interim dividend to the shareholders. In simple words, it is an audit which is conducted between two balance sheet audits. Advantages of Interim Audit Interim audit is similar to Continuous Audit and enjoys similar advantages Quarterly Results: A public limited company listed on the stock exchange can comply with the statutory provision of declaring quarterly results. Interim Dividends to Shareholders: The shareholders would be happy as the Company can pay interim dividends to the shareholders. Quick Preparation of Final Accounts. Since the Interim audit is already done, the final accounts can be prepared immediately after the year end. Up-to-date Accounts for Banks investors: The up-to-date interim accounts are useful to banks and investors for taking decisions regarding loans and investment. Check on employees: Interim audit acts as check on the employees to keep the accounts ready and up-to date. Prevents errors and frauds: Checking by the auditors for the purpose of interim audit helps to detect and even prevent errors and frauds. Enables thorough Final audit: The auditor has more time at his disposal at the time of final audit, which reduces the risk of missing any material items. Utilization of audit staff: Audit staff can be utilized in a better manner. Interim audit is done when the audit staff is relatively free. 12 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM Disadvantages of Interim Audit Expensive:Since the auditor does two audits in one year, the audit fees are more to that extent. Interim Audit is thus expensive. Audit in instalments: Since the audit work is done at two stages (interim and final) and not at one go, audit may be inefficient. It is difficult at the time of final audit to take up the work precisely at the stage where it was left at the time of interim audit. To overcome this, audit should be well-planned. The work done up to end of the interim audit, relevant voucher numbers, totals, etc. should be carefully noted in the Audit Note book. Disrupts Accounts work: Interim audit disrupts the work of accounts staff. To avoid this disadvantage the audit program should be co- ordinated with the client to avoid disruption in routine auditors’ work the client should appoint an employee especially to co-ordinate with and attend to the auditors. Periodical or final or Complete Audit: It is a type of audit where the checking and verification of books of accounts are conducted only at the end of the accounting period. It is taken up by the auditor when all transactions for the year are completely recorded; balanced and final accounts have already been prepared. In this case, the auditor visits the clients place once in a year and takes up his work until it is completed for the whole period. It is also known as 'Complete Audit'. 2. Scope basis: The types of audit on the basis of its scope are as follows: Complete audit: It is a type of audit where an auditor is asked to check and verify all the books of accounts. This type of audit is permitted in limited companies. Partial Audit: It is a type of audit where an auditor is asked to check and verify only few books of accounts for a particular work. This type of audit curtails the work of auditor. According to Companies Act, the duties of an auditor of a company cannot be curtailed. Hence this type of audit is not permitted in limited companies. The auditor should mention that he has done partial audit as per the instructions of the clients in his reports in order to avoid dispute. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 13 3. Objective basis: On the basis of the objective of audit, it can be classified into two types: Balance Sheet Audit: This type of audit is of recent origin. Under this type of audit, the checking and verification of books of accounts starts from the balance sheet and working back to the original books of entry and other related documents. In this audit, all the balance sheet accounts and the related items are verified. This is more widely used type of audit. Occasional Audit: It refers to a type of audit which is carried out whenever the clients desire it and whenever there is need. This type of audit cannot be carried out in case of joint Stock companies, Banking, Insurance companies. Only proprietary concerns can opt for this type of audit. On the basis of audit dimension The following are the different types of audit which are classified on the basis of audit dimension: 1. Tax Audit: A tax audit refers to examining of an organizations or individuals incomes or expenses and claims of deductions or exemptions for the purpose of assessment of tax. It is compulsory in addition to financial audit. It has to be done by the qualified Chartered Accountant. 2. Management Audit: Management audit is one of the techniques of management control it refers to the systematic examination of the activities of management at all levels of management. Covers all the areas of management such as Planning, Organizing, Directing, Controlling etc. This type of audit helps in improving the efficiency of management. 3. Cost Audit: Cost audit simply means audit of cost records. In other words, it refers to detailed checking and verification of correctness of cost accounts, costing techniques and system. It acts as an effective managerial tool for detection of frauds, errors and inconsistencies of cost records. 4. System Audit: System audit refers to an audit concerned with evaluation of accounting practices which is directed to ascertain whether they are up-to- date and economical. It also involves ascertainment of whether the existing accounting practices are required to be modified so as to carry on the work quicker, better and at less cost. 14 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM 5. Cash Audit: Cash audit involves the evaluation of the entire cash transactions all the organization for a given period of time. In this type of audit, the auditor will check all the cash receipts and payments with the vouchers and documents. It is the oldest concept of auditing. 6. Social Audit: This type of audit is concerned with examination of performance of an organisation or an entity towards the fulfillment of social obligation. The purpose of this audit is to present the organisational image among the public as to how an organisation has discharged its responsibility to the Society, but this is not much in practice in India. 7. Energy Audit: It is of recent origin. It is an important factor for the present day world to conserve the energy resources. This type of audit aims at evaluating whether the right type of energy is used in the organization and also confirming that there is no waste of energy due to human difference. 8. Proprietary Audit: Proprietary audit aims at examining the allocations of resources and also ascertaining whether there is any violation of legal, economic or financial aspects of the organisation. This audit ensures the public money has not been utilized for the benefit of a particular person or a community. 9. Performance Audit: In this type of audit, the auditor examines the growth of the organisation in terms of production, sales and profitability of the organisation. The purpose of this audit is to evaluate and compare the optimum return with the amount of capital invested. 10. Secretarial Audit: This is also a new concept of auditing. It is an audit which ensures that the corporate body's legal requirements have been duly complied with and in time. If there is any noncompliance noticed by the auditor, the management will have time to rectify the situation with less problem and cost. Advantages of Auditing It is compulsory for all the organizations registered under the companies act must be audited. There are advantages in auditing the accounts even when there is no legal obligation for doing so. Some of the advantages of auditing are as follows: 1. Verification of Books and Statement: The main object of audit is the verification of the books and the financial statements of the company concerned. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 15 2. Detection and Prevention of errors and frauds: The main advantage of auditing is to detect errors and frauds. It is the duty of auditors, while examining the books, they should find out various kinds of errors and frauds. Therefore, audit is very useful in preventing and detecting the errors and frauds. 3. Moral Check: When each employee of the company knows that this financial transactions will be examined by the auditor then he fears to do the fraud. The fear of their detection acts as a moral check on the employees of the company. 4. Independent Opinion: Auditing is very useful in obtaining the independent opinion of the auditor about the business condition. If the accounts are audited by the independent auditor, the report, of the auditor will be a true picture and it will be very important for the management. Keeping view the report, owner of the business will be able to prevent frauds and errors in future. 5. Protects the interest of shareholder: Audit protects the interest of shareholders in the case of Joint Stock Company. Through audit shareholders are assured that the accounts of the company are maintained properly and their interest will not suffer. 6. Check on Directors: Audit acts a check upon the directors and precaution against fraud on the part of the management. 7. Valuable advice: The auditor has expert knowledge about the accounts and finance problems, so he will be the right person to consult these problems. 8. Advantage for general public: Audited financial statements present the real position of the company before the general public. The general public can make investments keeping in view the position of the Company.. 9. Useful for Tax Department: Assessment of tax becomes easy for the tax department. Taxes are imposed keeping in view the audited accounts. 10. Information about Financial condition: Financial conditions of various companies can be judged through their audited accounts. If these companies are improving their financial condition, it means it is a good sign for the economy. 16 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM Disadvantages/ Limitations of Auditing It is true that auditing as many advantages, but it has some limitations as such:- 1. Non-detection of errors/frauds:-Auditor may not be able to detect certain frauds which are committed with malafide intentions. 2. Dependence on explanation by others:-Auditor has to depend on the explanation and information given by the responsible officers of the company. Audit report is affected adversely if the explanation and information prove to be false. 3. Dependence on opinions of others:-Auditor has to rely on the views or opinions given by different experts’ viz. Lawyers, Solicitors, Engineers, and Architects etc. He cannot be an expert in all the fields. 4. Conflict with others:-Auditor may have differences of opinion with the accountants, management, engineers etc. In such case personal judgment plays an important role. It differs from person to person. 5. Effect of inflation:-Financial statements may not disclose the true picture even after audit due to inflationary trends. 6. Corrupt practices to influence the auditors:-The management may use corrupt practices to influence the auditors and get a favourable report about the state of affairs of the organization. 7. No assurance about the company future:-Auditor cannot give any assurance about future profitability and prospects of the company. 8. Inherent limitations of financial statements:-Financial statements do not reflect current values of the assets and liabilities. Many items are based on personal judgment of the owners. Certain non-monetary Facts cannot be measured. Audited statements due to these limitations cannot exhibit true position. 9. Post-mortem examination: Auditing work begins where accounting ends then the auditor fully depends upon the accounting transaction provided by the accountant. So auditing work is not suitable for the current position of the business. But it is useful to the future business situation. 10. Detailed checking not possible:-Auditor cannot check each and every transaction. He may be required to do test checking. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 17 Preparation before Commencement of New Audit The processing of audits is a multi-step process and fairly complex. For effective execution of the audit work, proper planning is needed. Hence, an auditor should pay proper attention to the following before taking up a new audit: 1. Receiving appointment letter: Generally, the auditors of the companies are appointed by the shareholders in the annual general meeting. Therefore, an auditor should get and examine. The copy of resolution passed by the shareholders in the general meeting to confirm and should receive the appointment letter before starting up a new audit. 2. Communication with the existing auditor: In case of an audit proposal is for an existing business, the proposed auditor must communicate with the previous auditor to know whether he has any objections to be raised. It is also an official requirement as per the Institute of Chartered Accountants Act 1949, and has to adhere by the Chartered Accountants. 3. Acceptance of appointment: If the auditor is satisfied with the communication with the previous auditor, the auditor should confirm his acceptance through a letter of acceptance. 4. Ascertaining the scope of audit: An auditor should know the nature of audit of his client before starting the work. If the nature of audit is a statutory audit, the scope of audit work should be in accordance with the statute. In other types of audit, an auditor should discuss with his clients regarding the nature of audit work. 5. Knowledge about the organization: Before determining a basic approach to audit, an auditor must have knowledge about the organisation. He must familiarize himself with detailed knowledge of business, its activities and visit the location at which he operates. This helps him to know the nature of transactions which are recorded in the books of accounts. 6. Knowledge about accounting system: The system of accounting employed by the client should be examined by the auditor before taking up the audit. He should obtain list of all books maintained by the organisation for recording its accounting transactions. He must also acquire complete information about the internal control system of the organisation. 18 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM 7. Knowledge of technical details: The auditor must ensure that he has grasped the entire technicalities particular to the business. Then only he will be in a position to identify the transactions of the accounting records. 8. Complete list of Principal Officers: The auditor should take the complete list of all the principal officers with their names, duties and powers. He should also get their specimen signatures. 9. Observations in the previous auditor's report: If the company is not a new one, the auditor should also inspect the report of previous auditor. This will help him in understanding the nature of accounts, important areas to which detailed checking is required and the techniques to be used to conduct the audit work efficiently. 10. Instructions to the client: After completing all the above steps, the auditor should issue clear instructions to the client that the accounts should be finalized & kept ready for audit. Audit Notebook An Audit note book is a book which is maintained by the audit staff in which large variety of matters observed during the course of audit is recorded. It contains that information which requires further clarification and explanation. It is a kind of permanent book available to the auditor. The objectives of Audit Notebook The following are the important objectives of audit note book. 1. The audit notebook of current year will help the auditor for starting audit for the next year. 2. It provides evidence about the extent of work done by the auditor. 3. It helps in preparation of audit report. 4. It helps the auditor to know about the progress of audit work and the efficiency of his staff in audit work. 5. It also helps the auditor for the settlement of audit queries. Contents of Audit Notebook The important points that should be noted down in the audit note book is as follows: PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 19  1. List of books maintained by the clients. 2. The names of the Principal Officers, their powers, duties and responsibilities. 3. The technical terms used in the business. 4. The points which require further clarifications. 5. The particulars of missing vouchers. 6. The mistakes and errors discovered. 7. The points to be incorporated in the audit report. 8. Accounting method followed in the business. 9. Date of commencement and completion of audit 10. Particulars of accounting and financial policies followed. Audit Working Papers Audit working papers refers to the audit papers which records the audit evidence resulting from the audit work performed to provide support for the auditor's opinion including the representation. They are the direct aid in the planning, performance and supervision of the audit. Purpose of Audit working Papers The following are the important objectives of audit working papers : They show the extent of adherence to accounting principles and accounting standards. They are useful as evidence against the charge of negligence. They assist the auditor in Co-ordinating and organising the work of audit assistants. They ensure the possibility of quick preparation of audit report. They can be used as a permanent record for future references. They help in controlling the ongoing audit work Contents of working papers Audit programme Audit note book 20 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  Audit appointment letter. Correspondence done in relation to audit programme. List of debtors and creditors. Opening and closing trial balance. A copy of audit report. Rules of the organisation, memorandum of association, articles of association, prospectus etc. List of costs vouchers. Documents relating to depreciation. Audit Program An auditor prepares a plan after the selection of senior and junior staffs allocating the jobs to them, mentioning when to start, how to do the work etc, this plan is known as audit program. An auditor could include all the procedures in written form. Objectives of each sector and all the directions which are to be given to the staffs which helps to control their works and helps to implement such programs into action. Definition of Audit Program In the words of Howard Settler "An audit program is an outline of all procedures to be followed in order to arrive at option concerning the client's financial statements." Types of Audit Programs Audit program can be classified into following two groups: 1. Fixed Audit Program: Generally, auditor prepares audit program on the suggestions and recommendation of assistant staff but such program cannot be changed during the course of audit which is known as fixed audit program. Such program, due to pace of time or change in the situation and size of the client needs to change even though it cannot be changed. Fixed Audit Program can be used in all organizations. 2. Flexible Audit Program: An audit program which can be changed as per the need, time, nature of business and auditing standard is known as flexible audit program. Such programs should be reviewed on the recommendations and suggestions of assistants. Such change can be made PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 21  due to change in number of work, nature of business, change in management and their feelings. It is considered just as an assistance but provides scope for the assistant staff who prepare the program to use their knowledge, calibre and intelligence. Objectives of Audit Program The following are the objectives of audit program: a. Audit program helps to check systematically the books of accounts which help to conduct fair audit. b. Audit program specifies the time period clearly, which helps to complete the work of audit in less time. c. Assistant should sign after the completion of work which specifies the responsibility and accountability of staffs. It also helps to prove the completion of task. d. Audit program shows the way to the new staffs to perform work of audit. Recent Trends in Auditing: 1. Tax audit: Tax audit involves verification and Confirmation of certain facts, figures and information that are generally required by the tax authorities in the course of assessment proceedings. Definition of Tax Audit Tax audit can be defined as "an examination of financial records to assess correctness of calculation of taxable profits, to ensure compliance with the provisions of the Income Tax Act and also to ensure fulfilment of conditions for claiming deductions under the tax act." The Income Tax Act 1961 contains several provisions which require audit for tax purposes i.e., sections 12A, 33AB, 350, 35E, 44AB, 80IB, 80IA and 142 (2A). Compulsory tax audit U/5 44AB Section 44AB provides for the compulsory audit of accounts of certain persons carrying on business and profession stated as below:: 1. In case the total sales, (turnover) or gross receipts exceeds Rs. 40 lakhs of a business in the previous year. 22 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  2. If gross professional receipts exceeds Rs.10 lakhs in the previous year in the case of profession, 3. In case of business. if the profits and gains from the business are deemed to be the profits and gains of a person under section 44AD (business of civil construction) or Section 44AE (business of plying, hiring or leasing of goods and carriage) and Section 44AF (business of retail trade) and sections 44BB or 44BBB and that person has claimed his income in each case to be lower than the presumptive income. It is obligatory on the part of such person to get the accounts audited by a specified date and submit the prescribed details and report of such audit in the prescribed form duly signed and verified by an accountant. It should be noted that if such a person is required to get his accounts audited under any other law, he will then be required to get accounts of such business or profession audited under that law before the specified date and obtain a report of the auditor and also audit report under sec 44AB before the specified date in the prescribed manner. Appointment of Tax Auditor A chartered accountant within the meaning of the Chartered Accountants Act 1949 and includes a person who, under section 226 (2) of the companies act is entitled to be appointed as an auditor of the company. Under section 7 of the act only a practicing chartered accountant can perform tax audit of all the above mentioned provisions of the Income Tax Act. 1961. Disqualification of Tax audit 1. An employee of the assesse of a concern under the same management. 2. A charted accountant, who has prepared the books of accounts of assesse removal of tax auditor: Under the normal circumstances an auditor is not removed but if there are valid grounds then the tax auditor can be removed. However a chartered account should not accept the audit assignment if the removal of the previous auditor was not on justified grounds. Tax audit broadly relates to the following: 1. Books of accounts examined. 2. Methods of accounting employed and their consistency. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 23  3. Methods of valuation and quantitative reconciliation of inventories. 4. Borrowing and repayment of certain types of loans. 5. Prior-period adjustments. 6. Deductions of tax at source and deposit thereof with appropriate authorities. Cost Audit Meaning and definition of Cost Audit The term 'cost audit' refers to the audit of cost records. The cost auditor is appointed to check the cost. The term 'Cost audit' refers to ascertain their accuracy and also to ensure that cost accounting plan as laid down by the company is carried out. Cost audit is an audit of actual performances. Cost audit acts as an effective managerial tool for the detection of errors, frauds, inconsistencies and irregularities in cost accounting records. Cost audit is different from financial audit as the latter is an examination of financial books and records in order to see whether or not statements represent a true and fair view of the state of affairs of the organization while the former is the verification of cost accounts and a check on adherence to the cost accounting plans. Objectives The following are some of the objectives for which cost audit is under taken: 1. To establish the accuracy of costing data. This is done by verifying the arithmetical accuracy of cost accounting entries in the books of accounts 2. To ensure that cost accounting principles are governed by the management objectives and these are strictly adhered in preparing cost accounts 3. To ensure that cost accounts are correct and also to detect errors, frauds and wrong practice in the existing system. 4. To check the general working of the costing department of the organization and to make suggestions for improvement. 5. To help the management in taking correct decisions on certain important matters i.e., to determine the actual cost of production when the goods are ready. 6. To reduce the amount of detailed checking by the external auditor if effective internal cost audit system is in operation. 24 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM Advantages of Cost Audit The important advantages of cost audit are briefly discussed as follows: A. Advantages of Cost Audit to the Management 1. Cost audit provides reliable cost data for managerial decisions. 2. Cost audit helps management to regulate production. 3. Cost audit acts as an effective managerial tool for the detection of errors, frauds and irregularities so that reliable and smooth functions of the system are continued. 4. Cost audit reduces the cost production through plugging labour relating to wastage of material, labour and overheads. 5. Cost audit can fix the responsibility of an individual wherever irregularities or wastage are found. 6. Cost audit improves efficiency of the organization as a whole and Costing System in particular by constant review, revision and checking or routine procedures and methods. Advantages of Cost Audit to the Shareholders 1. Cost audit ensures that proper records are maintained as to purchases, utilization of materials and expenses incurred on various items i.e. wages and overheads etc. also makes sure that the industrial unit has been working efficiently and economically. 2. The cost audit enables shareholders to determine whether or not they are getting a fair return on their investments. It reflects managerial efficiency or inefficiency. 3. Cost audit ensures a true picture of company's state of affairs. It reveals whether the resources like plant and machinery are being properly utilized or not. Advantages of Cost Audit to Society 1. Cost audit tells the true cost of production. From this the consumer may know whether the market price of the article is fair or not. The consumer is saved from the exploitation. 2. Cost audit improves the efficiency of industrial units and thereby assists in economic progress of the nation. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 25  3. Since price increase by the industry is not allowed without justification as to increase in cost of production, consumers can maintain their standard of living. Advantages of Cost Audit to the Government 1. Cost audit assists the 'Tariff Board. in deciding whether tariff protection should be extended to a particular industry or not. 2. Cost audit helps to ascertain whether any particular industry should be given any subsidy in order to the development of that industry. 3. Cost audit provides reliable data to the government for fixing up the setting prices of the various commodities. 4. Cost audit helps the government to take necessary measures to improve the efficiency of sick industrial units. 5. Cost audit can reveal the fraudulent intentions of the management. Management Audit Meaning Management audit is a comprehensive structure of a company, institution or branch of a government or any component thereof such as division or department and its plans and objectives its means of operation and its use of human and physical facilities It is a critical examination, security and appraisal of the plans, policies, objectives and means operations and the use of physical facilities. Differences between Management Audit and Cost audit 1. Cost audit is the verification cost accounting records to measures the internal efficiency of a business. But management audit is the investigation into the objectives and actions of the management to measure the performance of the management. 2. Cost audit is generally a program of one year, management audit may cover more than one year. 3. Cost audit has to be conducted only by qualified cost accounts or chartered accountant whereas management audit can be conducted by an independent person having a good knowledge of principles and practice. 26 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  4. Cost audit is made compulsory for companies engaged in production, processing, manufacturing or mining activities. On the other hand management audit is not made compulsory for any company. 5. There is a time limit fixed by the statute for the submission of cost audit report. But there is no time limit fixed by any statute for submission of management audit report. Objectives 1. To identify the overall objectives of the organization 2. To streamline the managerial services according to the requirements of the business and achieve efficiency in management. 3. To pinpoint the deficiencies and defects in functional areas and suggest improvements for better performance. 4. To review the methods used in managerial services and suggest remedies for improvement to attain efficiency in managerial services. 5. To assist various levels of management to discharge their duties effectively and efficiently. 6. To help the management in achieving co-ordination among the various departments 7. To ensure that management objectives are achieved. 8. To evaluate performance by relating inputs (both human and physical) with outputs. Significance and Advantages of Management Audit 1. It defines the overall objectives of the organization 2. It assesses the organizational structure in regard to its suitability to achieve the goals of the organization. 3. It reviews plans, policies, procedures and controls. 4. It ascertains the motivational system in operation in the business and its effect on the performance, 5. It evaluates the system of control in force in the organization and its suitability to the business. 6. It assesses the performance in each functional area and compares it with the predetermined standards or targets 7. It suggests ways and means for the attainment of management goals. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 27 Auditor is a Watch Dog, not A Blood Hound “An auditor is not bound to be a detective or to approach to his work with suspicion, or with the foregone conclusion that there is something wrong. He is a watch dog but not a bloodhound. He is justified in believing tried servants of the company and is entitled to relay upon their representation provided he takes reasonable care.” 1. An auditor is a watchdog: The auditor must take care of interest of the owners of the business. The watch dog is kept by its owners to remain alert and inform the owners whenever any suspicion arises. Same is the position of an auditor; he should make every effort to detect errors and frauds so that he can protect the interest of his client. All this should be conducted by the auditor honestly and tactfully. 2. Auditor is not a blood hound: Duty of the auditor is not that of bloodhound. He is fully justify in believing the tried and tested servants of the company and he is entitled to relay upon their representation provided he takes reasonable care. It is not the part of his duty to harm those who have been found guilty or are found responsible for negligence or misappropriation. He shall not harm the persons whose work he is to certify. The auditor must be systematic, sincere and honest while conducting his work. The detection of errors and frauds is an important part of auditor’s duty. Not only the detection of such errors and frauds but also their prevention should be ensured in future such job is really difficult for him, because such errors or frauds are committed by officers who are presumed to be honest, responsible and sincere. 28 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  Review Questions SECTION-A (2 Marks ) 1. What is auditing? 2. Stare two main objectives of auditing. 3. What is error of omission? 4. What is error of commission? 5. What is compensating error? 6. What is error of duplication? 7. What is error of principle? 8. Give the meaning of "Fraud" in auditing. 9. What is "Teaming and Lading"? 10. What is Cost Audit? 11. What do you mean by Tax Audit? 12. What do you mean by Management Audit? 13. Name the accounts subjected to cost audit? 14. What is statutory audit? 15. What is Continuous audit? 16. What is Periodical audit? 17. What is Interim audit? 18. What is Partial audit? 19. What is Balance Sheet audit? 20. What is Cash audit? 21. What is Performance audit? 22. What is an audit Programme? 23. What is an audit working paper? 24. What is an audit note book? 25. What do you mean by audit tick? 26. What do you mean by routine checking? SECTION-B (6 Marks ) 1. Write a note on origin of auditing. 2. Analyze the nature of auditing. 3. Give a note on scope of auditing. 4. Distinguish between Accountancy and Auditing. 5. Distinguish between Auditing and Investigation. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 29  6. Brieryanalyzes the twin objectives of auditing. 7. Analyze the various aspects of errors of principle. 8. Analyze the different types of frauds committed in accounting. 9. Give a note on qualities of auditor. 10. Analyze the functions of cost audit of a manufacturing unit. 11. Briefly give a note on objectives of cost audit. 12. Distinguish between cost audit and financial audit 13. Write a note on management audit. 14. Give a note on Tax audit. 15. Give a note on significance of management audit. 16. Write a note on the nature of cost audit. 17. State the advantages and disadvantages of continuous audit. 18. Distinguish between Final audit and Continuous audit. 19. Distinguish between cost audit, financial audit and management audit. 20. Give a note on Cost audit. 21. Write a note on Management audit. 22. State advantages and disadvantages of preparing an audit programme? 23. Analyze the merits and demerits of routine checking. 24. State the preparation to be made prior to the commencement of new audit. SECTION-C ( 14 Marks) 1. Briefly explain the various objectives of auditing. 2. Briefly explain the advantages and limitations of audit. 3. Briefly explain the objectives and advantages of cost audit. 4. Briefly explain the type of audit on the basis of organizational structure. 5. Briefly explain the types of audits under statutes. 6. Explain the importance of ‘Routine Checking' in the audit work. 30 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  UNIT – 2 INTERNAL CONTROL Internal Control: Meaning – Objectives of Internal Check: Meaning -- objectives -- Fundamental Principles of Internal Check as regards: Wage Payments, Cash Sales, Cash purchases. Internal Audit: Meaning - Advantages -- Disadvantages of Internal Audit – Differences between Internal Check and Internal Audit. Internal Control Internal control is a process for assuring achievement of an organization's objectives in operational effectiveness and efficiency, reliable financial reporting and compliance with laws, regulations and policies. Meaning Internal control refers to the various methods and procedures adopted for the control of production, distribution and the whole system (financial and non- financial) of the enterprise. Internal control is a broad term which is normally used to control financial and non-financial activities. It involves a number of checks and controls exercised in a business to ensure efficient and economic working. In other words, internal control system - the whole system of controls financial or otherwise, established by the management in order to carry on the business of the enterprise in an orderly and efficient manner- ensures adherence to management policies, safeguards the assets and secures as far as possible the completeness and accuracy of the records. Definition of Internal Control According to W.W.Bigg “Internal control is best regarded as indicating the whole system of controls, financial and otherwise, established by the management in the conduct of a business, including internal check, internal audit and other forms of Control". PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 31 American Institute of Certified Public Accountants defines "Internal control comprises the plan of organization and all the co-ordinated methods and measures adopted with in a business to safeguard its assets. Check the accuracy and reliability of its accounting data, promote operational efficiency and encourage adherence to prescribed managerial policies". Basic/ Fundamental / Essential Elements of Internal Control A system of internal control will have the following features or characteristics. 1. Plan of organization. 2. Authorization, recording and control procedures. 3. Sound practice in performance of functions. 4. Competency of personnel. 1. Plan of organization: It should establish clear line of duties, responsibilities, segregation of operations, and subordination of each member of the staff. Organization structure must provide for adequate independence for various functions performed at different levels. The division of duties should be such that activities of a department are controlled by records maintained outside it. 2. Authorization, recording and control procedures: They should ensure that (a) Every item of expenditure has been properly authorized and accounted for. (b) Every item of receipt has in fact been received and accounted for. (c) There is proper custody of the funds and assets. (d) There is no misapplication or misuse of any property of the enterprise. 3. Sound practice in performance of functions: An effective system of internal check should lie down that no single person should alone handle any transaction completely from beginning to end. The system should provide that the work of one person will be checked by another, the management shall be able to detect errors and frauds. 4. Competency of personnel: It means the competency of departmental heads, key personnel and all persons performing routine tasks at different levels. This will require proper selection, training, effective direction, supervision and control, quick corrective action to avoid violation of prescribed procedures. 32 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  Duties of Auditors regarding Internal Control The auditor's duties regarding internal control are as follows: 1. To assess the adequacy of the accounting system as a basis for preparing the financial statement. 2. To identify the types of potential misstatement that could occur in the financial statement. 3. To consider the factors that affects the risks of misstatements. 4. To design appropriate audit procedure. The auditor should rely on internal controls only after ascertaining and evaluating these controls. If the auditor has reasons to believe that a client has set up a strong system of internal control, the reliance on that system will help the auditor to reduce the detailed checking which would otherwise be undertaken. Objectives of Internal Control 1. Proper authorization: Transactions are executed with management's general and specific authorization. 2. Prompt recording of transactions: All the transactions are promptly recorded in the correct amount in the appropriate accounts and in the accounting period in which they are executed so as to permit preparation of financial information within a framework of recognized accounting policies and to maintain accountability of assets. 3. Restricted access to assets: Access to assets is permitted only in accordance with management's authorization. 4. Actions against deviations: The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with regard to any differences. To minimize, if not completely eliminate, wastage and inefficiencies in business operations and to safeguard the assets of the business. To ensure high degree of accuracy and reliability of accounting data and promote operational efficiency. To measure how far the policies of the management are being implemented. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 33  To evaluate the efficiency of performance in all aspects of business activities and to highlight the weaknesses. Principles of Internal Control An effective internal control system should have the following factors: 1. Competent and trust worthy staff: People in charge of internal control system must be reliable and highly competent about the work. Lack of knowledge and dishonesty will spoil the efficiency of the system. 2. Records of financial and other organizational plans: A good internal control system must have good documentation system. Filing, recording, classifying etc. will help in this regard. 3. Segregation of duties: Normally, there should be a separate department for internal control this reduces frauds, bias etc. Normally a clerk in charge of accounting function should not be in charge of assets also. 4. Supervision: Proper reviewing of the operations of the company regularly makes the control system effective. 5. Authorization: All transactions must be properly authorized. In other words, the authority of each person should be well defined. 6. Sound practices: The Company should have well established procedures, policies, delegations, organizational manuals etc. 7. Internal Audit: It’s a part of internal control and it should be independent of internal check. 8. Accounting Controls: Proper accounting information systems should be established so that the information relating to accounts is properly collected, recorded and accounts prepared. Advantages of Internal Control The various advantages that may be derived from internal control system are summarized as follows: 1. Identification of defects: Under internal control system, the total activities are segregated in such a way that the work performed by one employee is automatically checked by another employee. So, if there is any defect in the system, it is easily detected. 34 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM 2. Flexibility: In this system, year-wise comparative analysis is done, so, if there is any change in the mode of operation, the changes in the system can easily be accommodated. Therefore, the opportunity for flexibility is available. 3. Time savings: If the internal control system is in operation in an organisation, there is no need for the preparation of separate audit programmes for each and every audit engagement. Thus, it saves time to a great extent. 4. Lesser risk of omission: Under this system, the total work is sub-divided into a number of activities and each employee is assigned with a particular type of activity. So, there is least chance of oversight or omission of any matter. 5. Provision for training facility: Due to lack of adequate experience, the auditor may face difficulty in establishing a close relationship between audit programme and the internal control system. This system itself provides training facilities to auditors to overcome this difficulty. Limitations of internal control 1. Cost: The management thinks that the cost of a control procedure must not be in excess of potential loss due to error or frauds. 2. Transactions: The internal control tends to be directed an anticipated types of transactions and not at unusual transactions. 3. Possibility of error: There is possibility of human error due to carelessness, distraction, mistake of judgment or the misunderstanding of instructions. 4. Circumstances: There may be collusion with parties outside the entity, employees of the entity. Due to such collusion there is possibility of circumvention of control. 5. Responsibility: There is a chance that a person responsible for exercising control could abuse that responsibility, for example, a member of management over riding a control. 6. Conditions: There is a possibility that procedure may become inadequate due to changes in conditions and compliance with procedure may deteriorate. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 35 Internal Check Meaning Internal check is an arrangement of the duties of the staff members of the accounting functions in such a way that the work performed by a person is automatically checked by another. Internal check is a part of the whole system of internal control and is best regarded as the checks on the day to day transaction. It is an arrangement of routine book keeping, where the work of one person is automatically checked by another so that errors and frauds are prevented or discovered without delay and without any additional financial burden for the firm. Definition According to Spicer and Pegler "A system of internal check is an arrangement of staff duties whereby no one person is allowed to carry through and to record every aspect of a transaction so that, without collusion between two or more persons, fraud is prevented and at the same time the possibilities of errors are reduced to a minimum." According to De Pallia "An internal check means practically a continuous internal audit carried on by the staff itself, by means of which the work of each individual is checked by the members of the staff." Prof. L. R. Dicksee defines internal check as, “An arrangement of the accounting routine that errors and frauds are automatically prevented or discovered by the very operation of the book-keeping itself.” According to D. R. Davar,"Internal check is a system or method introduced with defined instructions given to staff as to their place of work with a view to control and verification of their work and also maintenance of accurate records as the ultimate aim." Principles of Internal Check 1. Sufficient staff: The principle of internal check is sufficient staff. The employees can be appointed according to the workload. The management can determine the amount of work, which is distributed among the departments. The persons are hired to perform their duties. The overloading can create trouble for management. 36 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM 2. Division of Work: Division of work is a principle of internal check. The management can determine the total amount of work. The whole work is divided among the departments. The heads of such departments are responsible for completion of work according to timetable. 3. Co-ordination: Coordination is a principle of internal check. All departmental managers are bound to coordinate with others in order to achieve organization objectives. When there is fault in one department, the work of other department suffers. The objectives cannot be achieved. Internal check determines the degree of coordination among the managers. 4. Rotation of duties: Rotation of duties is a principle of internal check. The workers feel bore by doing the same work from year to year. There is a need of rotation of duties. It is in the interest of concern as well as employees. The efficiency is improved due to changes is duties. 5. Responsibility: Responsibility of each individual must be properly defined and fixed. The work of the business should be allocated amongst various clerks in such a manner that their duties and responsibilities are clearly and judiciously divided. 6. Automatic Machines: According to the principles, machines must be used to do accounting work if permissible. The machines can do a lot work without delay. The changes of fraud and error are reduced to a minimum. The working of machines improves efficiency of accounting staff. 7. Checking: The principle of internal check is to check the work of other employees. Many persons perform the work. The officers can put his signatures to verify the work done by his subordinate. In this way one work passes many hands. The chances of error and fraud are minimized due to checking and counter checking. 8. Simplicity: The principle of internal check is that it is simple in working. The employees can understand the working of internal check system. A person can work under the supervision of other employees. The line of authority moves from top to bottom level. All workers can understand their duties in the organization. 9. Documents classification: The classification of documents is the principle of internal check. The business documents are prepared, collected, recorded and placed in proper files. The index is prepared to PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 37  compile the data. The hiring system is useful to place the latter, in case if needed documents are traced at once. 10. Dependent work: Dependent work is a principle of internal check. The work of one employee is dependent upon others. One work passes in the hands of two or three persons till it is complete. Objectives of Internal Check The objectives of internal check system are: To allocate duties and responsibilities of every clerk in such a way that he may be held responsible for a particular error or fraud. To minimize the possibilities of errors, frauds or irregularities. To detect errors or frauds easily if it is committed, as there is a provision for independent checking in internal check. To enhance the efficiency of clerks through assignment of duties based on the principle of division of labour. To distribute the work in such a way that no transaction is left unrecorded. To prepare final accounts with easy and efficiency, as an efficient system can make accounts more reliable. To exercise moral pressure over staff. To prevent misappropriation of goods or cash by any clerk etc. Why to have internal check? / Purposes of Internal Check / Advantages of Internal Check Advantages from business point of view: (1) Proper allocation of work: Rational allocation of work among the different staff members of the organisation brings precision in work. (2) Control device: The distribution of work under this system is such that it acts as a control device against unscrupulous employees. The chances of fraudulent manipulation are thus minimized due to the existence of this check. (3) Speedy work: As the individual staff is engaged in the same type of jobs for a considerable period of time, it results in the efficient performance of the activities and high speed of work. 38 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  (4) Increase in efficiency and skill: A good system of internal check increases the efficiency of work among the staff due to its proper planning for assigning the right job to the right person. (5) Easy preparation of final accounts: Since no individual worker is allowed to handle a job completely and the work is divided among the employees in a proper manner, the books of accounts can be kept up to date, as a result, the final accounts can be prepared easily. (6) Creation of moral check: Knowledge of subsequent checking of each employee's work by another act as a great check to commission of errors and frauds. From the owner's point of view: (1) Reliability on accounts: If there is a good system of internal check, the owner of the concern may rely upon the genuineness and accuracy of the accounts. (2) Orientation of accounting: As the responsibility of each staff is clearly defined and fixed, it develops a system of accounting which is known as responsibility accounting. (3) Economical operation: Although it seems that the introduction of well- integrated system of internal check is costly in actual practice, it is observed that the staff patterns are so arranged that the existing staff be properly filled in different operating areas involving no extra cost. From the auditor's point of view: (1) Facilitation of audit work: Sound and efficient internal check system may facilitate to a greater extent, the work of the auditor by relying on “test check”. (2) Attention to other important matters: As the auditor gains confidence on the internal check system, he can avoid the basic routine checking work to some extent and can give attention to other important matters. Other advantages are: a) It is very easy and convenient to assign duties to staff in a precise way. b) It is quite easy to detect and prevent errors and frauds in accounting records. c) It acts as a scientific tool to increase the efficiency in operation by alerting the staff at all times. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 39  d) Accounting records can be kept intact and it will be helping the organization to finalize the accounts quickly. e) By imposing moral check on the staff, it leads to economy in operation. f) An effective internal check system eases the work of an auditor. g) If it is operated efficiently in all parts of the concern, it automatically results in increase of profitability and economy. Disadvantages Internal check suffers from certain limitations, which are listed as under: a) It is an expensive system for a small scale concern, and hence it cannot afford in all divisions of the organization. b) It may develop complexity among staff particularly with the top management, which may damage the entire organization if anything goes wrong. c) It may create unhealthy environment in the organization, if it is not properly designed and adopted. d) The auditor's work may become very difficult, if the system is defective and unorganized. Internal check as regards Cash Sales 1) Counter Sales Book: The salesmen can sell products over the counter. The sales book can be prepared on the basis of cash memos issued by the staff. The sales staff should not handle cash. All cash receipts must be handed over to the cashier. Accountant can make entries in the books of accounts. Another person can deposit cash. 2) Cash Register: Cash register is maintained in large retail shop. There is a need of secrecy for its working. The main equipment and attachments must work without any interference from employees. 3) Checking Copies: The auditor can check carbon copies of cash sales. The copies can be used as a basis of determining total sales for a particular period. 4) Receipt of Goods: The goods are handed over to the customer along with cash memo. The officer sales must check and sign the cash memo at the time of delivery of goods. One copy is kept for determining total sales. 40 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  5) Sales Summary: The sales summary must be prepared and sent to sales manager. The sales summary must tally with the cash received from the customers. 6) Cash Verification: The sales officer can check the cash memo for the day. The sales summary should be examined. The cash collected must tally with the cash memo as well as total sales summary for the day. 7) Cash Deposits: The cashier should not deposit the cash into the bank account. The total cash must be handed over to the accountant who should make arrangement for deposit of cash. 8) Sales Discount: The sales discount rate can be examined from the price list. The discount must not be in excess of the rates stated in the list. The discount allowed should be posted to the sales discount accounts. The sales manager must approve the discount. Internal check with regard to counter sales The following is the internal check system regarding sales over the counter. Each counter should have a separate salesman. Each salesman should be given a separate sales memo book. Usually different colour is used for different counters. Sales memo should be prepared by the salesman in 4 copies. The sales memo is checked by another clerk before being handed it over to customer. A copy is retained by the clerk. Payment is made at the cash counter. One copy of cash memo is returned to the customer duly stamped as cash paid. 2 copies are retained with the cashier. The cashier records days total sales in cash sales register. Every salesman should prepare total sales summary of the respective counters. At the end of the day total sales as recorded by salesman, total cash received and total sales as per register must agree with each other. Internal check as regards credit sales: The whole system of credit sales should be kept under proper control and supervision. There should be a separate sales department for the purpose. The PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 41 sales department should have charge of receiving orders, supplying goods to customers, preparing invoices and maintaining accounts of goods supplied. The sales department should function as a composite of some sub-departments. The procedure of its working may be like this: (1) All orders received should be entered in the orders received book and properly numbered. The original order or its copy should then be sent to the dispatch department. (2) The dispatch department should take steps to pack the goods as per the order. It should prepare a statement showing the goods packed. (3) The statement so prepared by the Dispatch Department should be sent to the Counting House where the list of goods should be checked and rates, etc. entered in it. The invoice will then be prepared in triplicate by means of carbon papers. (4) Two copies may be sent to the customers who will then return one of them after signing it in token of having received the goods. Thus, it will serve the purpose of delivery note. The third copy will be retained for further reference. (5) The Accounts Department should prepare documents like Railway Receipt, Bill of Lading, etc. (6) All goods supplied on order should be entered in the Goods Outward Book which should be checked at frequent intervals with the Orders Received Book. (7) The Invoice Book should also be compared with the Goods Outward Book and the Orders Received Book (8) The Sales Book should be written up with the help of the copies of invoices. The following type of fraud may be committed in connection with sales: (1) Sales may be omitted from recording in the Sales Book. (2) Inflation of sales in the Sales Book in any of the following ways: Recording fictitious sales: Treating goods as sales sent on approval or by V. P. P. but not yet accepted or sent on consignment but not yet sold by the consignee ; 42 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  Treating sales of fixed assets as sales of goods; Entering sales of the next year as sales of the current year; Treating sales of consignment inward as own sales. Internal check as regards sales return All goods returned by customers should be recorded in the Goods Inward Book. The statement of goods so returned when received should be sent to the Dispatch Department which should check it and then send it to the Accounts Department. A credit note should then be prepared and signed by a responsible official before it is sent to the customer. The Sales Return Book should be written up with the help of the copies of credit notes issued. The number and date of credit notes should also be entered in this book. The aim of such a system is to prevent an improper credit being passed in the books for fictitious returns and to avoid fraud involved in misappropriating equivalent cash. Internal check as regards purchases Following suggestions are given for a proper control over the purchases: 1. Supply of Requisition: Whenever goods are needed in any department of the company, the head of the department should send the purchase requisition to the purchase department. He should mention the quality, quantity of the item and the time by which the goods must be supplied. 2. Purchase Order: PO should be given in writing. It should be given on printed and numbered forms. It should be recorded in the purchase book. 3. Copies of Purchase Order: There should be three copies of each purchase order. One copy should be sent to the supplies. One copy to the store clerk and one should remain with purchase department. 4. Writing Note: When goods will be received the store department will make an actual inspection. After Counting or weighing receiving person will write the particulars on the good received note in duplicate. 5. Comparisons: One copy of the received good note will be sent to the purchase department. Purchase department will compare the quality and quantity with the invoice. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 43 6. Invoice checking: Each invoice on receipt should be checked by responsible officer with the Purchase order that price and quantity is correct. 7. Inspection: Before storing the goods, these should be inspected and quality should be tested. 8. Purchase Returns: In case of any defect it should be immediately reported the purchase department. Purchase department may take up the case. All returns out wards should be duly authenticated. 9. Invoice Recording: Each invoice should be consecutively numbered and properly filed. 10. Payment: A responsible officer should pass on the payment of invoices. Before signing the cheque he should assure himself about the correctness of the account 11. Proper record: Proper record of purchase should be maintained in writing. All the officials and officers who are involved in the purchase their initials must be taken. Internal check as regards credit purchases A separate department for credit purchases is usually maintained in business houses. The efficiency of such a department depends upon its policy of purchasing best goods at the cheapest Price. The Purchases Department should function separately and its work should be sub-divided between small departments, each of which should be headed by a responsible officer. To facilitate its operation, the whole work Connected with purchases may be divided into five heads: (1) Assessment of Requirements (2) Enquiry (3) Placing Orders (4) Receipt of Goods, and (5) Recording and Making Payments. 1. Assessment of requirements: This is the first important job to assess requirements of goods. Requisition Books should be issued to the various departments of a concern. The head of the department which is in need of 44 | PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM  goods should fill in a requisition slip duly signed and then send it to the Purchases Department. The details about the quantity, quality, the price (if it can be quoted) and the time by which goods must be supplied, should be entered in the requisition slip, On receipt of similar requisition slips from the various departments, the Purchases Department can know exactly the volume of different goods to be purchased. 2. Enquiry: Then, the Purchases Department makes an enquiry about the terms and conditions of purchases from different suppliers. For this, tenders or quotations are invited from them. The lowest tender should be accepted, and accordingly, a decision can be taken by an officer or by a sub- committee of the Purchase Department in it. His amount of purchase is heavy and involves a huge expenditure. 3. Placing orders: The Purchases Department places orders which should be recorded in the purchases Order Book. Three copies of such orders should be prepared. One each for the supplier, the store and the purchases department itself. A responsible officer should sign the order. After putting the number of the order on the requisition slip concerned and vice versa, such requisition slip should be filled in the purchases department. 4. Receipt of goods: On receipt of goods, the gate-keeper should enter the particulars of all goods received in the Goods Inward Book after having checked them properly. The goods then should be sent to the Store where they should be carefully preserved. The stores Department should prepare a 'Goods Received Note’ and send a copy thereof to the purchase Department, the Accounts Department and the Production Control Department The goods received note should be prepared with the following details: The date when the goods were received. The name of the supplier. The advice note number The description and code number of goods. The quantity advised The quantity received. The quantity rejected. PRINCIPLES AND PRACTICE OF AUDITING VI SEMESTER B.COM | 45  The rejection note number. The quantity accepted into store. Signatures of employees concerned with having entered