BFP601

Unit 1
Structure
Introduction
1.1 Introduction Objectives 1.2 Origin and Growth of Audit 1.3 Definition of Audit 1.4 Purpose of an Audit 1.5 Scope of an Audit 1.6 Difference between Bookkeeping, Accountancy and Audit 1.7 Advantages of an Audit 1.8 Different Types of Audit 1.9 Summary 1.10 Glossary 1.11 Terminal Questions 1.12 Answers 1.13 Further Reading
1.1 Introduction
A company makes various financial decisions that need to be based on correct financial information. Suppose you run a company that requires a loan from a bank. The bank will first require you to furnish the financial records of your company. These will consist of the balance sheet, which will detail the expenditure and income of the company. It will take into account the assets and liabilities of the company in order to reflect a true picture of the company in financial terms. A company needs to conduct a process called audit in order to evaluate its financial status and prepare a balance sheet. In this unit, we will get an overview of the process of auditing in terms of its origin, meaning, purpose and functions. We will also take a look at the growth of auditing, as well as its advantages and limitations. We will study the difference between book-keeping, accountancy and audit, objectives of auditing, the different types of audit and their main features.
Objectives
After studying this unit, you should be able to: Explain the origin and growth of audit Define audit and list its objects and scope
Principles and Practice of Auditing
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Differentiate between accountancy, book keeping and audit Explain the different types of audit and their relative advantages
1.2 Origin and Growth of Audit

The word audit has been derived from the word audire (Latin), meaning to hear or give credence to. In ancient times it was the practice to check the accounts of an estate, domain or manor by having such accounts called out by those who compiled them. Ever since control and accountability for money was entrusted to third parties, it became necessary to account for the transactions and subject them to some sort of an independent checking. The momentum of the independence was further accelerated with the emergence of the concept of limited liability and the growth of joint stock companies with limited liability. This made it all the more necessary for accounts to be subjected to an independent examination, and auditing, in the modern sense of the term, became an integral part of business. The creditors need for information on liquidity and long-run stability (because of the limited liability enjoyed by the proprietors) and of the shareholders for information on stewardship and profitability (because of the day-to-day control by the directors) necessitated the need for and as a justification for published audited information. The English Joint Stock Companies Act of 1844 contained provisions for the preparation of a full and fair balance sheet and presentation to every ordinary meeting of the shareholders. It also provided that the audited balance sheet should be filed with the Registrar of Joint Stock Companies. The joint Stock Banking Act of 1844 also required banking companies to provide the annual balance sheet and profit and loss account and for an annual audit. The first professional society of accountants and auditors was formed under a Royal Charter in Glasgow in 1854. The English Companies Act of 1862 formally recognized the auditors role for the first time. Towards the close of the 19thcentury, there was a spate of case laws relating to the responsibilities of the auditors vis--vis financial reporting. In India, the Companies Act of 1913 provided for an annual compulsory audit of every joint stock company. Qualifications for company auditors were also laid down. The Indian Accounts Board was established in 1932. With the enactment of the Chartered Accountants Act of 1949, autonomy was granted to the accountancy profession. Till the 1950s, the main objectives of auditing centred round detection and prevention of fraud and errors. Since that time, fundamental changes in the
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concept and objectives of an audit have taken place. The emphasis shifted from detection and prevention of fraud and errors to reporting on the true and fair view of the published financial statements. This change reflected not only the need for a broader approach to audit and the importance of an independent opinion on the financial statements but also the increasing importance of internal control procedures. By encouraging the development of sound internal control procedures, the auditors approach to auditing became less of detailed vouching and often somewhat mechanical checking of the transactions of the client, and turned more to employee procedures designed to test the operation of internal control mechanisms. The establishment of professional accounting bodies in a number of countries and the recommendations made by them from time to time have contributed towards setting new trends in auditing. Changing social attitudes have also gradually brought about a consensus that enterprises of significant size have wider obligations to such groups as employees, consumers and the general public to supply reliable information.
1.3 Definition of Audit

An Introduction to Indian Government Accounts and Audit, a book by the Comptroller and Auditor General of India, considers audit as an instrument of financial control. It states that:
It (audit) acts as a safeguard on behalf of the proprietor (whether an individual or a group of persons) against extravagance, carelessness or fraud on the part of the proprietors agents or servants in the realization and utilization of his money or other assets, and it ensures on the proprietors behalf that the accounts maintained truly represent facts and that expenditure has been incurred with due regularity and propriety.
The preface to International Auditing Guidelines of the International Federation of Accountants describes an audit as: The 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 Institute of Chartered Accountants in England and Wales in its Statement on Auditing has stated that the essential features of an audit are: (a) To make a critical review of the system of book keeping, accounting and internal control;
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(b) To make such tests and enquiries as the auditors consider necessary to form an opinion as to the reliability of the records as a basis for the preparation of accounts; (c) To compare the profit and loss account and the balance sheet with the underlying records in order to see whether they are in accordance therewith; (d) To make a critical review of the profit and loss account and the balance sheet in order that a report may be made to the members stating whether, in the opinion of the auditors, the accounts are presented and the items are described in such a way that they show not only a true but also a fair view and give in the prescribed manner the information required by the Act. The purpose of the work of the auditors is to enable them to express an opinion as to whether the accounts presented show a true and fair view. The purpose should govern their whole approach ... and if in any material they are unable to satisfy themselves, it will be their duty to include appropriate reservations in their report, to the extent, if necessary, of stating that they are not able to express the opinion that the accounts show a true and fair view.
1.4 Purpose of an Audit

The above definitions and observations throw light on the objectives and scope of an audit. The primary object of an audit is to enable the auditor to express an opinion on the financial statements that have been subject to such audit. This opinion is then embodied in what is known as audit report, addressed to those interested parties who commissioned the audit, or to whom the auditor is responsible under the relevant statute. It is true that there are certain inherent limitations present in any kind of examination where the person carrying out the examination will have to use his judgment. Also, much of the evidence available to auditors is persuasive rather than conclusive in nature. Hence there is an unavoidable risk that even some material misstatements may remain undiscovered, and absolute certainty in auditing is rarely attainable. However it is the sacred duty of an auditor to extend his procedures even at the slightest indication of the existence of fraud or error which may result in material misstatement so that he can confirm or dispel his suspicions. And wherever it is not possible to give an affirmative opinion whether or not the financial statements give a true and fair view, the auditor has to express a qualified opinion or
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disclaimer of opinion, as appropriate. Thus the opinion expressed by the auditor helps to establish the extent of credibility of the financial statements. Of course, such an opinion should not be construed as an assurance as to the future viability of the organization or as to the efficiency or effectiveness with which the management has conducted the affairs of that unit. There is often a mistaken impression that the primary object of an audit is to detect fraud and errors. This however, is not actually the case. It is true that the examination of books and records that the auditor undertakes to form an opinion often reveals material irregularities, including the presence of fraud and errors; but this is incidental to the primary objective of an audit mentioned above. Again, the regular conduct of an audit acts as a moral check on the persons responsible for proper management of the business which, in turn, facilitates prevention of fraud and errors. Thus, it may be emphasized that detection and prevention of fraud and errors, though of vital importance, are only subsidiary to the main objective of an audit. If circumstances indicate the possible existence of fraud or error, it is the duty of the auditor to consider its potential effect on the financial statements. Where the auditor has reason to believe that the suspected fraud or error could have a material effect on the financial statements, he should carry out such modified or additional procedures as he determines to be appropriate. In conclusion it may be pointed out that because of the inherent limitations of an audit together with the inherent limitations of any system of internal control, there is a possibility that even material misstatements of financial information resulting from fraud and/or error may remain undetected by the auditor.
Self-Assessment Questions
1. Fill in the blanks. (a) The first professional society of accountants and auditors was formed under a Royal Charter in __________ in 1854. (b) The emphasis of auditing has shifted from detection of fraud to reporting on the _________ view of financial statements. (c) Much of the evidence available to auditors is _________ rather than conclusive in nature. (d) Opinion expressed by an auditor helps to establish the credibility of the firms ______ __________.
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1.5 Scope of an Audit

The scope of an audit is dependent on the terms of agreement between the auditor and the client and on statutory requirements and the requirements of the relevant professional bodies. A properly conducted audit is organized to cover adequately all aspects of the organization as far as they are relevant to the financial statements subject to examination. The auditor has to ensure that information contained in the underlying accounting data and other source data is reliable and sufficient as the basis for the preparation of the financial statements. As to the point whether the relevant information is properly communicated, the auditor bases his opinion by: (a) Comparing the financial statements with the underlying accounting records and other source data to see whether they properly summarize the transactions and events recorded therein; and (b) Considering the judgments that management has made in preparing the financial statements; accordingly he assesses the selection and consistent application of accounting policies, the manner in which the information has been classified, and the adequacy of disclosure. It may be noted in this connection that the auditor is not responsible for preparation of the financial statements on which he has to form and express an opinion. This is the responsibility of the management of the particular organization concerned which, inter alia, also covers the maintenance of adequate accounting records and internal controls, the selection and application of appropriate accounting policies and the safeguarding of the assets of the organization.
1.5.1 Non-Auditing Services

It would not be out of place to mention certain non-auditing services performed by auditors for their clients. Apart from book keeping and accountancy work including the preparation of final accounts, these services are: (a) Taxation services such as agreement of tax computation, tax planning and tax negotiations (b) Secretarial services such as filing statistical and other returns (c) Financial advice such as advice on loan facilities, preparation of cash budgets, etc.
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(d) Management and systems advice such as the provision of advice on accounting systems (e) Liquidation and receivership services (f) Investigations including that relating to acquisitions (g) Negotiations on sale of business 1.5.2 Documents Used for Audit The broad, general documents used for audit are: Letter of engagement Summary of appropriate statutory provisions governing the accounts and audit of the client business Rules and regulations of the client business Copies of documents and minutes of relevance to the audit Address of registered office, factories, branches and all other premises with a short description of the business carried out at each place An organization chart or brief notes on the organization of the business The clients internal accounting instructions and internal audit instructions, including, where appropriate, stock taking instructions Notes of interviews and correspondence relating to internal control matters together with all past internal control letters Internal control questionnaires A list of the clients advisors such as bankers, stockbrokers, solicitors, insurance brokers, etc. Copies of letters where the client gives permanent instructions to supply the auditor with any information requested by him A list of the clients properties and investments, together with notes of verification A list of insurance effected by the client
1.6 Difference between Bookkeeping, Accountancy and Audit

It is important for the reader to know the difference between bookkeeping, accountancy and audit. Accountants sometimes act in the capacity of both accountants and auditors in that they prepare the accounts and subject them to
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an independent examination. This is all the more so in the case of clients other than limited companies. In such cases, the distinction between the work of accounting and the work of auditing is of vital significance. This is because some clients who do not realize the distinction between the terms book keeping, accounting and auditing use the terms indiscriminately. This may have far reaching consequences involving questions of negligence and misfeasance. Hence it is of utmost importance for a practising accountant to have the terms of his appointment clearly defined in writing. Of course, in the case of statutory audits this question does not arise since the auditors duties will be clearly defined in the relevant statutes, and any disputes as to the scope of his work will not normally arise, except where the statutory duties have been extended by an agreement. Apart from the question of negligence or misfeasance, there is another important reason why accounting and auditing work should be kept separate. One of the basic principles governing an audit is that an auditor should both be and appear to be free of any interest that might be regarded as being incompatible with integrity and objectivity. Where a firm of accountants acts in the capacity of both accountants and auditors for the same client, independence in mental attitude which is closely connected with integrity and objectivity is likely to be threatened in relation to the audit of financial statements for the preparation of which the same firm (or the same accountant) has been responsible. As a natural corollary to this, where the auditor is identified with the client as a result of his indirect participation in the management of the clients business through the supply of book keeping and accountancy services or any other non-audit services, then the value of the opinion expressed through the audit report and hence the credibility of the accounts might be impaired. Of course, sometimes this combination becomes unavoidable in which case it would be advisable to adopt the following steps: (a) Train the audit staff appropriately and make sure that they fully realize the importance of maintaining independence in mental attitude; (b) Divide the accounting and auditing work among entirely different sets of personnel. Wherever possible (especially in the case of larger accountancy firms) set up specialist departments; (c) Use different sets of standard working papers and working paper references for each type of work. Following are the differences between book-keeping, accountancy and audit.
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Book-keeping Recording business transactions in the primary books and posting in the ledger. May be considered the recording phase. Ledger totaling and extracting balances of different ledgers Person responsible is known as book-keeper. Does not give a complete picture of the financials.
Accountancy Examination of transactions in the primary books and posting in the ledger. May be considered the summarizing phase. Posting ledger account balances in the trial balance and preparation of financial statements. Person responsible is known as accountant. Gives a complete picture of the financials. Accountant analyses books of account to know the results of business activities and the financial position of the entity.
Auditing Examination of the work of accountants to ensure that financial statements adhere to accepted accounting standards and show a true and fair view. Ledger auditing does not involve writing of books of account or preparation of financial statements. Person responsible is known as auditor. Gives a critical examination.
Auditor conducts critical examination of books of account and evaluates financial statements of accountants.
Carried out throughout the Outsourced to specialists in year and performed by the field in order to obtain an fulltime employees. unbiased view. Accounting begins where book-keeping ends. An accountant need not have any pre-determined qualifications. Accountancy is creative. An accountant is not supposed to submit any report. Auditing begins where accountancy ends. An auditor should be a chartered accountant. Auditing is analytical. An auditor has to submit a report on the true and fair view of the financial statements.
1.7 Advantages of an Audit

A well-conducted and thorough audit offers several advantages to all companies, whether big or small, and that is why it is considered such a vital exercise. Let us discuss the important advantages of the auditing process.
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1. Detection and prevention of errors and frauds: It has already been mentioned that incidental to the primary objective, an audit facilitates the detection and prevention of fraud and errors. In this connection a brief mention of the various types of errors and frauds would be enlightening. Errors may be classified into: (i) Errors of omission (ii) Errors of commission (iii) Errors of principle (iv) Errors of duplication (v) Compensating errors 2. In the case of large organizations, the interests of many parties are protected. For example, in the case of limited companies, the interests of shareholders who do not take part in the day-to-day management of the companies and who thereby are divorced from management are protected. In addition, as mentioned earlier, audited accounts help to establish the credibility of annual accounts. As a result, even in cases where accounts have not been specifically prepared for use by third parties, it would be possible for them to make use of such accounts in order to take decisions based on them. It is with these objectives that statutory provisions are inforce for the compulsory audit of accounts by suitably qualified auditors in many cases. 3. Audited accounts will be more acceptable to banks and other financial institutions in extending financial accommodation. 4. Audited accounts will carry greater authority for tax assessment by tax authorities. 5. In the case of partnership organizations, audited accounts help in avoiding disputes between the partners especially where profit sharing arrangements are complex. So also, the admission of a new partner or the death, retirement, etc. of an existing partner or the sale of the business as a going concern may require revaluation of assets and liabilities and the computation of goodwill. In such cases, audited accounts will be a more suitable basis.
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2. State whether the following statements are true or false. (a) Auditor is responsible for preparation of financial statements on which he has to form an opinion. (b) The scope of an audit is dependent on the terms of agreement between the auditor and the client. (c) Auditing can be considered the recording phase of accounts. (d) An auditor is not required to submit a report. 3. Fill in the blanks. (a) __________ does not give a complete picture of the financials. b) ________ function is outsourced to specialized persons. (c) Investigations relating to acquisitions comprise __________ services provided by auditors. (d) _______ accounts are more acceptable to banks and other financial institutions.
1.8 Different Types of Audit

On the basis of nature of work undertaken, audit may be classified into: (i) Private audit (ii) Audit under statute (iii) Internal audit Private audit A private audit is one which is not a statutory requirement but is conducted primarily for the interest of the owners. Occasionally a private audit may become a requirement under tax laws, for example, audit of sole trading concerns and partnership firms. As indicated earlier, the accountant, in many cases, may be required to write up the accounts besides being required to carry out an audit. The client may not be fully aware of the distinction between the work of an accountant in doing the accounting work and in carrying out the work of audit and the full implications of each. These could have far reaching consequences that may involve issues of negligence and breach of trust on the part of the auditor.
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This indicates the necessity of getting the terms of appointment defined in writing whenever an auditor is taking up an appointment in respect of a private audit. The rights, duties and responsibilities of the auditor together with the nature and scope of work should be clearly specified. Even where the auditor is appointed to carry out work in accordance with the rules and regulations of an entity, as in the case of clubs, charitable organizations, etc, it would be advisable to obtain a letter of engagement. In case where a practising accountant is appointed only to prepare the accounts and not in the capacity of an auditor, the position should be made clear either by means of a note placed at the foot of the accounts or by means of a separate covering letter accompanying the accounts in which it should be stated: (i) The source or sources of information from which the accounts have been prepared; and (ii) That an audit or verification of assets and liabilities has not been carried out. Where the information is given in a covering letter accompanying the accounts, the accounts should include a specific statement referring to the covering letter. Audit under statute This is an audit prescribed by statute. In other words, a statutory audit is one required by the law of the incorporating Act. For example, in the case of a limited company, an audit is required under the Companies Act. The Companies Act prescribes the manner in which the audit should be conducted, its reporting and the manner of audit report. Although there are many audits prescribed by different statutes like the Income Tax Act, the VAT Act, etc., the term is used mainly to mean an audit under the Companies Act. In many cases, the relevant statutes will specify detailed provisions relating to the appointment, remuneration, removal, rights, duties, responsibilities, etc. of auditors for the independent audit of the financial statements of the undertakings covered by the respective statutes. For instance, the Companies Act contains such provisions relating to company audit. In such cases, the position of the auditor is clear and any restrictions on his work specified in the statues concerned will be ultra vires. Thus, the main difference between private audits and statutory audits arises from the fact that while in the former case the scope of the audit may be determined as narrowly or as broadly as the client wishes, according to his requirements, in the case of statutory audits their scope and
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depth are largely determined by the governing legislation, which neither the directors nor the members of the client organization or other persons have authority to restrict. Internal audit As the very name implies, this is an examination carried out by the employees specially appointed for the purpose by an organization. It is defined as an appraisal activity, independent of other activities, within an organization, for the review of operations, as a service to all levels of management. It differs from an independent audit, otherwise known as external audit, in scope, approach, responsibility and independence. On the basis of the methods of approach to work, audit may be classified into: (i) Final audit or completed audit (ii) Continuous audit (iii) Interim audit (iv) Partial audit (v) Procedural audit or systems audit (vi) Balance sheet audit (vii) Social audit (viii) Operational audit (ix) Management audit (x) Cost audit (xi) Special audit under the Companies Act. Final or completed audit A final audit, otherwise known as completed audit, is one that is carried through to completion in one continuous session. Normally it is commenced immediately after the end of the accounting period. In certain cases, it is commenced towards the end of the accounting period but completed after the end of such period. Continuous audit In the case of a continuous audit, work of audit is carried out throughout the accounting period by the audit staff engaged continuously on the audit. Interim audit This is an audit conducted in between two final audits. The object may be to complete detailed procedural or vouching tests with a view to assisting the
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speeding up of the final audit, or to make available interim results to the management to declare an interim dividend through the preparation of interim accounts. It is important to note in this connection that an interim audit does not take into account such matters as verification of assets and liabilities, provision for depreciation, bad debts, etc. Partial audit Partial audit is one which covers only a part of the accounts. For instance, a sole trader may require his cash book to be audited without involving any verification or valuation of assets or liabilities. As already indicated, partial audits should be undertaken only after getting the terms of such assignments clearly in writing as otherwise the auditor may be held liable for work which he/she was not supposed to do. Procedural or systems audit This is a part of the audit work as a whole. It is an examination, assessment and review of internal control procedures and records of an entity with a view to ensuring their reliability as a basis for the preparation of its final accounts. In other words, it consists of those audit steps that are designed to test whether the procedures laid down are in fact being followed, thus establishing independently the accuracy of the information supplied by the clients staff. The increased attention given by auditors to the internal control procedures existing in the clients organization has naturally resulted in the increased importance of procedural audit. Balance sheet audit Balance sheet audit operates in the opposite direction to audit procedures normally carried out. It commences with a detailed examination of the draft balance sheet and works back to the books of original entry and their documentary evidence. This type of audit need not necessarily be considered as strange in view of the fact that every single transaction has a direct effect on the balance sheet. Balance sheet audit is of more recent origin and is popular in the USA. It is appropriate under the following circumstances: 1. Where the client organization is a very large and complex economic unit employing qualified accounting staff and having an internal audit department. 2. Where the auditor has acted in that capacity for the client organization during the last few years.
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3. Where the internal control system in operation is efficient and effective in every material aspects, this having been proved to the entire satisfaction of the auditor. 4. Where an interim audit has already covered basic tests of routine procedures in each department of the client organization. Social audit or social responsibility audit Social audit takes into consideration the relationship of an entitys activities in relation to its employees, the community in general, and the customers in the context of social considerations. The concept of social audit arises from the modern conception that an entity owes certain duties, besides its duties to the shareholders who have put their capital in the entity, towards the employees who are putting their labour and their lives into the business, and towards its customers and the general public. In relation to employees, social audit will ascertain, assess and review whether the people who put their labour and lives into the company get fair wages, continuity of employment, and a recognition of their right to their jobs, as well as recreation and welfare facilities, retirement arrangements, etc. In relation to the general public, social audit will take into consideration the question of environment, pollution, ecology, and other factors of the entitys activities in the light of their immediate and long-term effects. Other considerations involving the welfare of the general public who are affected by the operations and actions of the entity will also be reviewed under social audit. In relation to the customers, social audit will take into consideration such factors as the entitys pricing policy, maintenance of quality control, methods of redressing the grievances of the customers, honesty in advertising, etc. Operational audit Operational audit is concerned with the operating propriety and efficiency of the functional areas of an organization. It takes into consideration (i) inefficient operations both from the time and cost angles; and (ii) wastage of resources through lack of propriety in expenses. It is aimed at improving the profitability of the organization and simultaneously at achieving the other organizational objectives. Management audit This is a total audit of every area of operation of an organization with a view to identifying the inefficiencies and/or ineffectiveness of the management and setting up criteria for efficiency.
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Management audit is an investigation to ascertain whether every level of management and staff is functioning at its optimum, and a set of recommendations is issued to the management after the review, keeping it alert against internal and external changes that may have a bearing on the growth plans of the organization. It may be noted that operational audit is used synonymously with management audit in certain quarters. Cost audit Cost audit involves an examination of the cost records and cost performance of an organization just as a financial audit is concerned with the financial records and performance. The Institute of Cost and Management Accountants, UK defines it as the verification of cost accounts and a check on adherence to cost accounting plan. Thus, cost audit is an examination of the cost accounting records to ensure that the cost statements are properly drawn up so as to show a true and fair view of the cost of production and marketing of various goods dealt with by the organization. Special audit under the Companies Act In terms of Section 233A of the Indian Companies Act, the Central Government is empowered to order a special audit of the accounts of a company for a specified period where it is of the opinion that: (a) The affairs of the company are not being managed in accordance with sound business principles or prudent commercial principles; or (b) Any company is being managed in a manner likely to cause serious injury or damage to the interests of the trade, industry or business to which it pertains; or (c) The financial position of any company is such as to endanger its solvency.
4. Fill in the blanks. (a) A ______ audit is carried through completion in one continuous session. (b) An __________ audit is conducted between two final audits. (c) A __________ audit covers only a part of the accounts. (d) A ____________ audit operates in the opposite direction to normal audit procedures.
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(e) A __________ audit is a total audit of every area of operation of an organization. 5. State whether the following statements are true or false. (a) Private audits can be conducted only under statutory provisions. (b) Scope of statutory audits is determined by government legislation. (c) Operational audit is concerned with inefficient operations only in terms of time. (d) Balance sheet audit is an examination of internal control procedures. (e) Social audit is a review of a firms activities vis--vis its employees and the community.
1.9 Summary
Let us recapitulate the important concepts discussed in this unit: There is evidence of the existence of auditing in some form since early civilizations. The English Companies Act of 1844 contained provisions for the preparation of a full and fair balance sheet and presentation to every ordinary meeting of the shareholders. The first professional society of accountants and auditors was formed under a Royal Charter in Glasgow in 1854. The English Companies Act of 1862 formally recognized the auditors role for the first time. In India, the Companies Act of 1913 provided for an annual compulsory audit of every joint stock company. Qualifications for company auditors were also laid down. In 1932 the Indian Accounts Board was established. With the enactment of the Chartered Accountants Act of 1949, autonomy was granted to the accountancy profession. Fundamental changes in the concept and objectives of an audit started occurring since the fifties of the last century. The emphasis shifted from the detection and prevention of fraud and errors towards reporting on the true and fair view of the published financial statements. The establishment of the International Federation of Accountants in 1977 and the establishment of the International Auditing Practices Committee (IAPC) are further landmarks in shaping contemporary auditing practices. IAPC is charged with the responsibility of developing and issuing guidelines
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on generally accepted auditing practices and on the form and contents of audit report which are intended for international acceptance with the object of improving uniformity of auditing practices globally. The primary object of an audit is to enable the auditor to express an opinion on the financial statements that have been subject to an audit. The opinion expressed helps to establish the credibility of the financial statements although this should not be construed as an assurance of the future viability of the organization concerned. There is often a mistaken impression that the primary object of an audit is to detect fraud and errors although the examination of books and records that the auditor undertakes to form an opinion often reveals irregularities, including the presence of fraud and errors. The scope of an audit is dependent on the terms of agreement between the auditor and the client and on statutory requirements and the requirements of the relevant professional bodies. There are differences between book keeping, accountancy and audit. An audit offers several advantages. There are different types of audit that may be classified on the basis of nature of work undertaken or on the basis of methods of approach to work. Each has its own relative advantages and disadvantages.
1.10 Glossary
Book-keeping: The systematic recording of a companys financial transactions. Auditing: Independent examination of financial records of a firm. Liquidation: Termination of a business operation by using its assets to discharge its liabilities. Defalcation: Misappropriation or misuse of company funds. Dividend: A sum of money paid periodically by a company to its shareholders out of its profits.
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1.11 Terminal Questions

1. What is an audit? Write a short note on its origin. 2. What are the differences between book keeping, accountancy and auditing? 3. Explain with appropriate examples fraud in relation to financial statements of an entity. 4. Write a short note on private audit. 5. Describe the various kinds of audit on the basis of method of work along with their advantages and disadvantages. 6. What are the purposes of an audit? 7. What are the advantages of an audit?
1.12 Answers Answers to Self-Assessment Questions

1. (a) Glasgow; (b) true and fair; (c) persuasive; (d) financial statements 2. (a) False; (b) True; (c) True; (d) False 3. (a) Book-keeping; (b) Auditing; (c) non-auditing; (d) Audited 4. (a) final; (b) interim; (c) partial; (d) balance sheet; (e) management 5. (a) False; (b) True; (c) False; (d) False; (e) True
Answers to Terminal Questions

1. Refer to Section 1.2 2. Refer to Section 1.6 3. Refer to Section 1.7 4. Refer to Section 1.8 5. Refer to Section 1.8 6. Refer to Section 1.4 7. Refer to Section 1.7
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1.13 Further Reading

1. Kumar, Ravinder and Virender Sharma. 2006. Auditing: Principles and Practice. New Delhi: PHI Learning Pvt. Ltd. 2. Shekhar, L and K C Shekhar. 2003. Auditing, 20th edition. Delhi: Vikas Publishing House.
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Unit 2
Structure
Audit: Preparation and Procedure
2.1 Introduction Objectives 2.2 Preparations before an Audit 2.3 Audit Planning 2.4 The Audit Programme 2.5 Summary 2.6 Glossary 2.7 Terminal Questions 2.8 Answers 2.9 Further Reading Appendix
2.1 Introduction
As you have studied in the last unit, an audit is the 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. An audit involves the systematic examination of the account books of a business; verification of the results shown by the profit and loss account and the state of affairs as shown by the balance sheet, as well as a critical review of the system of accounting and internal control. An audit is carried out by an independent person or body of persons who are duly qualified for the job. A number of documents are required during an audit vouchers, documents, as well as information and explanations received from the concerned authorities. In this unit we will study closely the preparations for an audit, including the preparation of audit files, audit note book and audit working papers. We will also take a look at the procedure of audit, including test checking, routine checking and adoption of distinctive ticks.
Objectives
After studying this unit, you should be able to: Describe the preparation required before audit including the preparation of audit files, audit note book and audit working papers Explain the procedure of audit, including test checking, routine checking and adoption of distinctive ticks
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2.2 Preparations before an Audit

Before an audit can be undertaken, a number of measures necessarily have to be taken. These include documentation such as audit working papers, audit files and audit notebook.
2.2.1 Documentation Audit Working Papers

It is important that an auditor should document matters which are important in providing sufficient evidence that the audit was carried out in accordance with the basic principles governing an audit. Documentation in this connection refers to the working papers prepared or obtained by the auditor and retained by him/ her in connection with the performance of a particular audit. Purpose of audit working papers: Audit working papers should be aimed at recording and demonstrating the steps taken by the auditor to enable him to form an opinion on the financial statements upon which he/she is required to report. In case the working papers are properly prepared or obtained, they: provide valuable assistance in the planning and performance of the audit; facilitate the review and supervision of the audit work; and provide evidence of the audit procedures performed to support the opinion expressed by the auditor through his report. In order to achieve the above aims, the working papers should provide: (a) a means of controlling the current years work and the basis on which to plan the following years audit; (b) evidence of the detailed work carried out by the auditor together with the conclusions drawn by the audit staff who performed the various sections of the work; (c) schedules and analyses in support of the accounts additional to, or summarising, the details in the books of accounts maintained by the client; (d) summary of significant points affecting the financial statements and the audit report, showing how these points were dealt with; (e) information concerning the legal and organizational structure of the business whose accounts have been audited, including its recent history. Form and contents of audit working papers: Working papers may be of any form devised by the auditor. The important point is that they should be so
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designed as to achieve the above objectives, according to the auditors own requirements and the particular circumstances of each audit, and should be comprehensible in themselves. They should be sufficiently complete and detailed for an experienced auditor, with no previous connection with the audit, to obtain an overall understanding of the audit. The extent of documentation is a matter of professional judgment since it is neither necessary nor practical for the auditor to document in his working papers every observation, consideration or conclusion made. In general, the form and contents of audit working papers are affected by such matters as: (a) the terms of engagement; (b) the nature and complexity of the business whose accounts are subjected to audit; (c) the nature and conditions of the records maintained by the business; (d) the nature and conditions of the internal controls in operation in the business; (e) the needs of the particular circumstances for supervision and review of the work performed by audit assistants. Sometimes, standardized working papers are used, e.g., specimen letters, internal control questionnaires and checklists concerning compliance with statutory disclosure provisions, etc. If used properly, standardized working papers help to instruct audit assistants and facilitate delegation of work while providing a means to control its quality. But it is important that they should be prepared properly and are subjected to periodical reviews. Sometimes, the auditor makes arrangements with the client to utilise working papers already prepared by the client staff. This would have the effect of increasing audit efficiency and reducing audit costs. In such cases, however, it is important that those working papers have been prepared with due care.
2.2.2 Audit Files

In case of recurring audits, it is usual to classify the working papers under permanent audit files and current audit files. Permanent audit files: Permanent audit files contain information of continuing importance to succeeding audits. They are usually be indexed. Such files usually contain the following papers and documents and are carried forward as long as the audit is carried out.
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(a) Summary of appropriate statutory provisions governing the accounts and audit of the client business. (b) Rules and regulations of the client business. For example, the Memorandum and Articles of Association in the case of limited companies, the Partnership Deed in the case of partnership firms, the Club Rules in the case of clubs, etc. (c) Copies of documents and minutes of continuing importance and relevance to the auditor. For example, letter of engagement and minutes of appointment of the auditor, trade license, lease deeds, debenture deeds, guarantees entered into, etc. (d) Addresses of registered office, factories, branches and all other premises, with a short description of the business carried on at each place. (e) An organizational chart or brief notes on the organization of the business showing (i) the principal departments and sub-divisions thereof, with a note of the number of people involved; and (ii) the titles and/or names of responsible officials, showing lines of responsibility. For the Accounting Department these details would be more elaborate than in the case of other departments. (f) List of books of account and other records and the places where they are maintained. The names of officials responsible for maintaining these books and authorising records together with their specimen signatures and initials would be included. Account codes and classification, wherever applicable, would also be held. (g) An outline history of the organization together with separate statements showing a note of any accounting matters of importance (h) The clients internal accounting instructions and internal audit instructions, including, where appropriate, stock taking instructions. (i) Notes of interviews and correspondence relating to internal control matters together with all past internal control letters. (j) Internal Control Questionnaires (k) A list of the clients advisors such as bankers, stockbrokers, solicitors, insurance brokers, etc. (l) Copies of letters where the client gives permanent instructions to those as in (k) above to supply the auditor with any information requested by him.
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(m) A list of the clients properties and investments, together with notes of verification. (n) A list of insurance effected by the client. In the case of non-statutory audits, the permanent file should contain the clients instructions as to the scope of the work to be performed. It is important that the permanent audit file is brought up to date at the appropriate times. Current audit files: Current audit files contain information relating primarily to the audit of the current period. Such files usually contain the following papers and documents: (a) Copies of the accounts and/or statements being audited, authenticated by directors signature or otherwise. (b) An index covering all working papers unless they are cross referenced to the relevant items in the accounts. (c) An Internal Control Questionnaire or other records describing the system of internal control; flow charts, where appropriate, and specimen documents. (d) An overall audit plan (e) A schedule for each item in the balance sheet, each schedule containing: (i) the item at the beginning of the year, changes during the year, and the balance at the end of the year; and (ii) details as to how the existence, ownership, value and appropriate disclosure have been verified. These schedules should be cross referenced to documents arising from external verification such as bank letters, the results of circularization of debtors and creditors, attendance at stocktaking, etc. (f) A schedule for each item in the profit and loss account, preferably including comparative figures, and such other items in the trading or subsidiary accounts as may be necessary. (g) A checklist showing compliance with statutory disclosure provisions. (h) A record showing full particulars of queries raised during the audit, coming forward from previous year, and their disposal together with notes, where appropriate, for attention during the following year. Queries which are not satisfactorily cleared should be entered on to another schedule for the attention of the person reviewing the audit and for reference to the client.
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Such queries may require a qualification in the audit report. Hence they should be fully documented and supported by a note of all discussions with the client and any explanation received. (i) Details of breakdowns or weaknesses in the internal control discovered during the course of the audit of day to day transactions, the conclusions reached as to their nature and the action which has been taken. (j) Copies of letters to the client setting out any material weaknesses or matters with which the auditor is dissatisfied in respect of the accounts or internal control procedures. (k) A schedule of important statistics or working ratios such as gross and net profit percentages, ratio of current assets to current liabilities, stock turnover ratios, liquidity ratios, debtors collection period, return on capital employed, etc. Where appropriate comparative figures for previous years should be included. Significant variations need to be investigated and explanations sought. (l) A record or abstracts from the minutes of the meetings of the company, the directors and any internal committees of the company whose deliberations are important to the auditor. These should be cross referenced, where relevant, to the auditors working schedules. (m) Letters of representation, i.e., letters written by the client to the auditor, being written confirmation of information given or opinion expressed in respect of matters such as the value of stock, amounts of current and contingent liabilities, etc. There may be matters which, while not of permanent importance, will require attention during the following years audit. Such matters should be listed, with reference to the relevant working papers, and they should be transferred to the current file of the subsequent year at the appropriate time. In some cases it is the practice to open a third file known as Internal Control File wherein all matters relating to internal control such as copies of internal control instructions, Internal Control Questionnaires, Internal Control Letters, etc will be filed. Before concluding this discussion on audit working papers, it would be pertinent to mention an important point. It is not necessary to include in audit working papers unnecessary detailed information relating to transactions or accounts shown i the books of the client business. It should be clearly understood that it is not the purpose of the audit working papers to make available a copy of
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the accounting records maintained by the client. In other words, audit working papers are not supposed to be a substitute for the clients accounting records. So also, it is not necessary to follow slavishly the form and contents of audit working papers prepared during the past. This, of course, does not mean that the previous years working papers will not act as broad guidelines for the auditor in connection with the current years documentation. Nevertheless, while the auditor is evaluating the contents of the past working papers the following points should receive his careful attention: (a) How far the particulars contained in the past working papers relevant to the current years audit? (b) Is it possible for the information contained in the past working papers to be presented in a more lucid manner? (c) Are there any points other than those included in the past working papers to be included in the current years working papers?
2.2.3 Letter of Engagement

In the interests of both the client and the auditor it would be advisable to define in writing the scope of the work which the auditor undertakes and other matters relevant to the audit through what is known as a Letter of Engagement. Such a letter is designed to document and confirm, before the commencement of the engagement, the auditors acceptance of the appointment, the scope of his/her work, the extent of his/her responsibilities and the form of any reports. The letter of engagement helps in avoiding misunderstandings with respect to the engagement. Where the auditor undertakes the private audit of accounts of individuals, sole traders, partnerships, unincorporated bodies, etc, a letter of engagement, clearly specifying the limits of his duties, is of paramount importance in order to avoid the possibility of any future litigation alleging negligence on the part of the auditor for not carrying out work which he was not supposed to do. It is true that in the case of statutory audits, the scope and limits of the auditors duties will be specified in the relevant statutes. Even then a letter of engagement will be found useful by the management of the entity subjected to audit and other related third parties. This is all the more important since the letter of engagement usually contains a description in summary of the work the auditor will need to carry out in order to form an opinion on the financial statements and the sort of assistance he will expect from the client. As such it gives the client an insight into the work of the auditor, including that relating to accounting and internal control systems and to accounting records and financial statements.
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Two important matters to be set out clearly in a letter of engagement are: (1) that the functions of an auditor are distinct from the provision of accounting and other services; and (2) that it is not the main purpose of an audit to discover defalcations and irregularities, and an audit should therefore not be relied on for the purpose.
1. Audit working papers should be aimed at _________and _______ the steps taken by the auditor to enable him to form an opinion on the financial statements upon which he/she is required to report. 2. Specimen letters, internal control questionnaires and checklists concerning compliance with statutory disclosure provisions, etc., are _____ standardized working papers. 3. In case of _____ audits, it is usual to classify the working papers under permanent audit files and current audit files. 4. _____ audit files contain information of continuing importance to succeeding audits and are usually indexed.
2.3 Audit Planning

Planning is a crucial step before an audit can take place. According to the International Auditing Guidelines, The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. Plans should be based on a knowledge of the clients business. Plans should be made to cover, among other things: (a) acquiring knowledge of the clients accounting system, policies and internal control procedures; (b) establishing the expected degree of reliance on internal control; (c) determining and programming the nature, timing and extent of the audit procedures to be performed; and (d) coordinating the work to be performed.
2.3.1 Importance and Benefits of Audit Planning

It has been correctly stated that audit planning is the key to an effective and efficient audit. Effectiveness results in the attainment of the main audit objectives
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without undue risk. Efficiency enables the auditor to achieve maximum practical utilization of not only of his own audit staff but also, wherever practicable, of the clients accounting and internal audit staff. In other words, effectiveness and efficiency are achieved because proper planning of an audit assignment: (i) identifies and establishes intended means of achieving audit objectives with reference to the specific audit; (ii) assists in a rational and judicious selection of audit staff and in co-ordination of work done by other auditors and experts; (iii) assists in the proper direction and control of work; (iv) helps to ensure that potential problems are promptly identified and critical aspects of the audit are given due attention; and (v) helps to ensure that the work is completed without undue delays and snags in the performance of audit procedures. More than ever, proper planning of audit work has become one of the most significant aspects of contemporary auditing. The introduction of generalized computer audit programmes and the increasing use of specific statistical sampling techniques, along with greater emphasis on quantitative techniques, have given a new look to the already complex problem of planning audit work under the present day conditions.
2.3.2 Factors to be Considered When Planning an Audit

An auditor needs to take into consideration the following important factors when planning an audit: (a) Audit objectives in connection with the particular audit: This will enable the auditor to determine the nature of audit procedures to be undertaken in order to form an opinion on the financial statements. Additionally, it will enable the auditor to determine the type of audit seniors and audit assistants suitable to supervise and carry out various procedures. (b) The preparatory matters requiring attention: By way of examples, matters raised in previous years audits, changes in statutory requirements and requirements of professional bodies, changes in clients business activities and accounting and internal control systems, etc are some of the preparatory matters which have an important bearing on the type of audit procedures to be undertaken. (c) The various locations where audit work will have to be carried out and the comparative importance of each location from the point of
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view of the audit: For example, special visits by audit teams will be necessary to all or some of the locations where the client organization carries out its business activities. Again, particular locations may have material quantities of stock in which case arrangements will have to be made to attend stocktaking at such locations. The extent of management control at each location is also likely to affect the extent of audit work to be carried out there. (d) The sequence of the various audit procedures to be undertaken: It is important to determine in advance, as far as practicable, the precise time when each audit procedure must be started and completed. This will enable the auditor to divide the work among the various audit staff, thus avoiding the possibility of wastage due to audit staff not being available to get on with their work because of the underlying records being not available as a result of their use by the employees of the client organization or by other members of the audit team. (e) The time by which the audit should be completed and report submitted: This will enable the auditor to plan interim audits and, where necessary, to work overtime to complete the audit in time. The auditor may wish to discuss elements of his overall plan and certain audit procedures with the clients management and staff to improve the efficiency of the audit in coordinating certain audit procedures with work carried out by the client staff, thereby avoiding unnecessary duplication of work. This is particularly relevant in connection with the point discussed in (d) above, where the auditor determines the sequence of audit procedures to be undertaken. Of course, the overall audit plan and the audit programme remain the auditors responsibility.
2.3.3 Stages in Audit Planning

Each audit will have to be tailored to the unique characteristics of the client. Hence, the extent of planning will vary according to the size and complexity of the specific audit, the auditors previous experience with the client, if any, and his knowledge of the clients business. This indicates that it may not be possible to lay down any hard and fast rules concerning the steps to be followed in planning an audit. Nevertheless the following stages of audit planning may act as a useful guide. Preliminary arrangements: In the case of a first audit, more elaborate preliminary arrangements will have to be made than in the case of a repeat audit. This is because in the case of a repeat audit, the previous years working papers including audit programme, time budget, staff requirements, etc., will
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act as a starting point, subject, of course, to the modifications necessary since the previous year. Knowledge of the client business: In the case of a first audit, the initial interview with the client is one of the most important aspects of planning the audit. At such an interview the auditor should try to obtain as much background information as possible before the commencement of detailed interim audit work. This interview should be arranged early in the client organizations financial year for the purpose of carrying out an initial study of the business. This will not involve detailed work but will concern itself with the following: (a) the environment of the client entity, including the industrial or commercial sector in which the organization is placed, its major customers, suppliers and competitors; (b) the nature of the entitys products or services; (c) the nature of the entitys organization, including its structure; (d) the nature of the entitys records, accounting policies and accounting procedures; (e) the significant trends within and outside the entity. In short, a background knowledge of the client is necessary to put the whole audit work into focus. It will enable the auditor to identify the events, transactions and practices that, in the auditors opinion, may have a significant effect on the financial statements. An audit is essentially a problem solving exercise; it is therefore essential that the nature and extent of the problems to be solved be known at a sufficiently early stage to allow the audit objectives to be attained within the time limits imposed by the client. This, of course, does not mean that every problem area will necessarily be uncovered during the initial study of the business; but this work should reveal where the auditor is to place the main emphasis of his work. A good background knowledge of the client organization will also assist the auditor in an understanding of the significant matters coming to his attention both at the transaction testing stage and at the analytical review stage of the audit. The initial interview and discussions with the clients management and staff should include such matters as: (i) recent changes in management, organizational structure and activities of the client; (ii) current Government regulations affecting the client; (iii) current business developments affecting the client;
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(iv) current or impending financial difficulties and/or accounting problems; (v) new or closed premises and plant facilities; (vi) recent or impending changes in technology types of products or services, and production and distribution methods; (vii) changes in the accounting system and in the system of internal control; (viii) known problem areas, including those arising this year, those unresolved from prior years and those satisfactorily resolved during prior years.
5. Proper planning of audit work has become one of the most significant aspects of contemporary auditing. (True/ False) 6. Matters raised in previous years audits are not important in the preparatory materials of an audit. (True/ False) 7. In the case of a first audit, less elaborate preliminary arrangements will have to be made than in the case of a repeat audit. (True/ False) 8. Each audit will have to be tailored to the unique characteristics of the client. (True/ False)
2.4 The Audit Programme

Closely related to the development of an audit plan is to draft an audit programme setting forth the procedures that are to be performed in order to implement the plan. As a matter of fact, a written audit programme is an important tool for the communication of audit directions to audit staff. It is advisable to include in the programme the audit objectives for each area. It should be so designed that it complies with generally accepted auditing standards and that the procedures contained therein are in accordance with the requirements and circumstances of the particular engagement. Before including a procedure in the audit programme, the auditor should ask himself whether it is useful and necessary under the circumstances of the particular case. In other words, each audit procedure must be justifiable as an efficient method of obtaining information necessary in the circumstances. The result of the programme should enable the auditor to conclude whether the accounting system and related internal controls of the client are reliable as a proper basis for the preparation of financial statements, whether the
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representations given by the clients management are supported by sufficient appropriate evidence and whether the information and representations contained in the financial statements are properly set forth in accordance with generally accepted accounting principles. Based on a review and evaluation of the clients system of accounting and related internal controls the auditor may be able to place reliance on certain internal controls in determining the nature, timing and extent of audit procedures to be included in the audit programme. It may be possible for the auditor to conclude that he could conduct his audit in an effective and efficient manner by relying on certain internal controls. On the contrary, the auditor may come to a conclusion not to rely on particular internal controls when there are other more efficient ways of obtaining sufficient appropriate audit evidence. The timing of audit procedures is as important as the procedures themselves. For instance, interim work to carry out detailed work on the clients accounting system and related internal controls and on the recording of the transactions will have to be timed for sufficiently early in the current financial year in the case of a first audit and at a time not too removed from the year end in the case of a repeat audit. At this stage, the procedures included in the programme should facilitate the auditor to understand the manner in which the accounting system and related internal controls operate, to determine whether they are in fact operating as understood by the auditor, to evaluate them, to point out any weaknesses in them to the client and to determine the nature, timing and extent of other audit procedures to be carried out. Similarly, the final audit work to carry pout analytical review of financial statements, verification of assets and liabilities and vouching of income and expenditure, agreement of final accounts to underlying records and to express an opinion on the financial statements will have to be timed for early in the next financial year. In deciding when to carry out the audit procedures the auditor can use his discretion since many of them need not be carried out within specific time limits. For instance, procedures carried out on transactions can be performed at any time after the transaction has been recorded. At the other extreme, in carrying out some of the procedures the auditor will find himself in no position to use his discretion. Observation at stocktaking is an example. This has to be done by the auditor at the year end when the client staff carry out physical stock count. It need hardly be emphasized that the audit programme should be reconsidered, and where necessary revised, as the audit progresses. Such reconsideration and revision should be based on the auditors review of the
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system of internal control, his preliminary evaluation thereof, and the results of his compliance and substantive procedures.
2.4.1 Advantages and Disadvantages of Audit Programmes

A planned audit programme generally serves as a guide for carrying out an organized audit procedure. But it is important that similar work viewed from two different angles is not repeated. For instance, it would be sheer waste of time if the verification of ledger postings against the sales day book is duplicated by including this work under the section of work regarding the sales day book postings to the sales ledger and under that regarding the sales ledger itself. Also, an audit programme should not be rigid; rather it should be flexible to suit developing circumstances as the audit progresses. Advantages: The following are the advantages of an audit programme: It provides a clear set of instructions to the audit staff concerning the work to be done. This would be of particular value to less experienced staff. It acts as a means to control the proper execution of audit work. Since definite instructions are laid down, junior audit staff may need less supervision. It places clear cut responsibility for each procedure. Since the person completing a particular task is required to sign or initial the programme for that part of the work done by him, it provides a clear record of the work carried out and by whom. It promotes the division of work among the audit staff in an organized manner. It results in proper routine and saves time. It emphasizes the essential procedures for each audit. Duplication of work is avoided. Omission of important work is avoided. It serves as a guide in succeeding years. Evidence of work done is available in the event of any subsequent action against the auditor. It facilitates the review by audit manager or senior auditor. It assures adherence to auditing standards and the application of generally accepted accounting principles.
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Preparation of an audit programme forces the audit staff to consider the reasons for performing various procedures. Disadvantages: The following are the disadvantages of an audit programme: The audit may become too mechanical. Thus there is the danger that variations in the working system of the client organization may be overlooked. Small parts may be executed without regard to the whole scheme, particularly where a number of audit staff are involved. The responsibility of the in-charge auditor is limited to the programme. Independent constructive thinking may be deterred and initiative may be stifled. There may be a tendency to hurry up work in order to complete a required schedule. Client staff may become aware of standard audit routines (e.g., counting of petty cash on arrival) and thus may facilitate fraud. In spite of the disadvantages listed above, an audit programme has now been recognized as a medium for having an organized audit. Of course, the audit programme should be flexible enough to suit developing circumstances during the course of the audit. No doubt, an audit programme loses much of its value if it is regarded as a rigid set of instructions incapable of improvements or corrections. Also, the programme chalked out for each client should be revised during each audit in accordance with changing conditions of the clients operations and developments in auditing standards and procedures. In other words, in the case of repeat audits, before commencing the audit in any year the clients system of internal control should first be reviewed and, if any changes in procedures or improvements in controls have taken place, it should be considered whether any change in the nature of work or levels of tests in the audit programme is appropriate.
9. It is advisable to include in the programme the audit ______for each area. 10. The ______of audit procedures is as important as the procedures themselves. 11. An audit ______sets forth the procedures that are to be performed in order to implement the plan.
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12. One of the disadvantages of an disadvantages of an audit programme is that the audit may become too______.
2.5 Summary
Let us recapitulate the main concepts discussed in the unit: Before an audit can be undertaken, a number of measures necessarily have to be taken. These include documentation such as audit working papers, audit files an audit notebook. The auditor should document matters which are important in providing sufficient evidence that the audit was carried out in accordance with the basic principles governing an audit. Documentation in this connection refers to the audit working papers. Audit working papers should be aimed at recording and demonstrating steps taken by the auditor to enable him to form an opinion on the financial statements upon which he/she is required to report. They should be sufficiently complete and detailed for an experienced auditor, with no previous connection with the audit, to obtain an overall understanding of the audit. In the case of recurring audits, it is usual to classify the working papers under permanent and current audit files. Permanent audit files contain information of continuing importance to succeeding audits. Current audit files contain information relating primarily to the audit of the current period. The auditor should plan his/her work to enable him/her to conduct an effective audit in an efficient and timely manner. There are certain important matters which the auditor should take into consideration when planning an audit. Closely related to the development of an audit plan is to draft an audit programme setting forth the procedures that are to be performed in order to implement the plan.
2.6 Glossary
Audit programme: A programme that sets forth the procedures that are to be performed in order to implement the plan. Current audit files: Files that contain information relating primarily to the audit of the current period.
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Documentation: The working papers prepared or obtained by the auditor and retained by him/her in connection with the performance of a particular audit. Permanent audit files: Files that contain information of continuing importance to succeeding audits. They are usually be indexed.

1. Explain the documentation required in auditing in terms of audit working papers. 2. What are audit files? Differentiate between permanent and current files. 3. Describe audit planning and its importance. List the factors to be considered when planning an audit. 4. Discuss the stages in an audit programme. 5. What is an audit programme? 6. What are the advantages and disadvantages of an audit programme?

1. Recording, demonstrating 2. Standardized 3. Recurring 4. Permanent 5. True 6. False 7. False 8. True 9. objectives 10. timing 11. programme 12. mechanical
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1. Audit working papers should be aimed at recording and demonstrating the steps taken by the auditor to enable him to form an opinion on the financial statements upon which he/she is required to report. Refer to Section 2.2.1 for further details. 2. In case of recurring audits, it is usual to classify the working papers under permanent audit files and current audit files. Refer to Section 2.2.2 for further details. 3. Audit planning is the key to an effective and efficient audit. Refer to Section 2.3.1 and 2.3.2 for further details. 4. Each audit will have to be tailored to the unique characteristics of the client. Refer to Section 2.3.3 for further details. 5. An audit programme sets forth the procedures that are to be performed in order to implement the audit plan. Refer to Section 2.4 for further details. 6. A planned audit programme generally serves as a guide for carrying out an organized audit procedure. Refer to Section 2.4.1 for further details.
2.9 Further Reading

1. Rittenberg, L E and Schwieger, B J, Auditing: Concepts for a Changing Environment, 5th edn, South-Western College, 2004. 2. Saeed K A, Auditing: Principles and Procedures, University of Virginia, 2009. 3. Shekhar L and Shekhar KC, Auditing, 20th edition. Delhi: Vikas Publishing House, 2003.
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APPENDIX
Audit Programme Following is a given specimen of a typical audit programme for bank and cash balances:
Working Paper Results Signature Reference of Tests and Date
Programme 1. Obtain or prepare a statement giving an analysis of balances held with bankers, distinguishing between debit and credit balances, and cash in hand. Note the figures for the previous year and indicate against each item the extent to which it has been verified Verification of Bank Balances: 2. Set out below the bank balances to be examined and the levels of tests to be carried out in accordance with paragraph 3 and 4 below, in the light of: (a) the purpose of the examination which is to confirm the validity of the balances shown by the cash books; (b) the evaluation and the procedural tests of the related control procedures; (c) the extent to which the items in reconciliation have been independently checked by the client and the extent of unexplained difference; 3. Obtain or prepare statements reconciling the balances as shown by the bank statements with the balances shown by the cash books. Check the reconciliations as follows: (a) compare cash books and bank statements in detail for the last few days of the year; (b) trace outstanding items to subsequent bank statements;
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(c) verify by reference to the bank paying-in slips that lodgments outstanding were actually lodged prior to the balance sheet date; (d) verify additions of reconciliations 4. In case where there is inadequate segregation between the cash recording and other accounting functions, give particular attention to: (a) transfers between bank accounts and other special items in cash books or bank statements (particularly those recorded near to the date of the checking); (b) unusual items in the reconciliation; (c) testing additions of cash books. 5. Arrange for certificate to be obtained direct from bankers at the year end. Mark off the certificates as follows: (a) in the case of bank balances, to the reconciliation statements in paragraph (3) above; (b) in the case of other matters, to the appropriate working papers. 6. Scrutinise bank statements for the first few days or weeks of the new period for dishonoured cheques and investigate any such items 7. Where securities have been deposited or a guarantee given, to cover an overdraft but there is no overdraft at the balance sheet date or, if there is, it is materially less than the amount secured or guaranteed, consider whether the position should be disclosed in the financial statements. Verification of Cash in Hand: 8. Arrange for cash to be counted and certified by a responsible official on the balance sheet date or, where substantial amounts are involved, to be counted by audit staff; alternatively arrange for cash to be paid into the bank at the year end.
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9. Verify, by examining the cash book for the few days immediately preceding and following the year end cash count, that all cheques drawn to replenish cash funds have been entered in the cash records. 10. Where appropriate, confirm that cash received in the last few days of the financial year was either banked on that date or produced during the cash count. Review of System of internal control 11. Did the foregoing examinations of bank and cash balances reveal: (a) any changes in the system of internal control; Yes/No (b) any weaknesses in the system of internal control; Yes/No (c) any instances where the system had not been followed in respect of specific transactions Yes/No 12. If the answer to any of these matters is Yes, prepare a schedule of the changes, weaknesses or instances of departure and bring the internal control questionnaire up to date. Information recorded on the working papers need not be repeated in detail on this schedule, but a cross-reference should be made to the appropriate working papers. File the schedule on the current audit file and bring to the attention of the audit manager/senior auditor. 13. The manager/senior auditor should ensure that the internal control questionnaire is brought up to date in respect of changes in the system of internal control
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Structure
Internal Controls, Internal Checks and Internal Audit
3.1 Introduction Objectives 3.2 Internal ControlMeaning and Significance 3.3 Elements of Internal Control 3.4 Evaluation of Internal Control System 3.5 Internal Check: Meaning, Definition and Fundamental Principles 3.6 Internal Auditing 3.7 Summary 3.8 Glossary 3.9 Terminal Questions 3.10 Answers 3.11 Further Reading/Reference
3.1 Introduction
One of the important responsibilities of an audit is the evaluation of internal controls. But what is internal control? Let us try and understand it. When you get out of your car, you always make sure that it is locked. This is a kind of internal control that you personally follow in your daily life. You keep your keys, cash and credit cards safely in your purse. It is an internal control to ensure that your valuable things. You also take the shortest or quickest route to the workplace an internal control that promotes operational efficiency. As with people, organizations also practise internal controls and checks to provide reasonable assurance and achieve objectives these are actions taken by the management of a company to manage risk and enhance the chances that established objectives and goals will be achieved. In the previous unit, you studied about the preparations, documentation and procedure of an audit. In this unit, we will study the internal controls and checks practiced by companies.
Objectives
After studying this unit, you should be able to: Explain internal controlmeaning and significance Explain the elements of internal control
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Describe the evaluation of Internal Control System Discuss the system of internal check Describe internal check as regards wages, cash sales and cash purchases Discuss internal audit meaning, importance, objectives and scope
3.2 Internal ControlMeaning and Significance

Internal control can be defined as a process, effected by an organization, board of directors, management and other personnel, which is designed to provide reasonable assurance regarding the achievement of objective in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations (Committee of Sponsoring Organizations COSO). With the growth in the size of business organizations and the increased realization of the fact that the primary responsibility of running an organization and preparing its accounts is that of the management, the importance of instituting proper systems of controls within the organization has received the attention of all concerned. By internal control is meant not only internal check and internal audit, but the whole system of controls, financial and otherwise, established by the management in order to carry on the business of an entity in an orderly manner, safeguard its assets and secure as far as possible the accuracy and reliability of its records. The auditor, in forming his opinion on the financial statements, needs reasonable assurance that the accounting system is adequate, that transactions are properly processed and recorded in the accounting records, and that significant transactions have not been omitted. Such assurance is usually drawn from a combination of reliance on certain internal controls and the performance of substantive procedures. As observed by the International Auditing Practices Committee:
The auditor should study and evaluate the accounting system and internal controls to identify those controls on which reliance may be placed and then determine the nature, extent and timing of other audit procedures to be used. This approach normally results in more effective auditing than can be accomplished through a large volume of detailed work.
Herein lies the importance of internal control under contemporary audit practices.
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3.3 Elements of Internal Control

Now that we have understood what internal control is and its significance, let us study it in detail. There are three divisions of the elements of internal control: 1. Organizational Structure: This involves the separation of an organizations operations into appropriate divisions and subdivisions, the appointment of persons to assume responsibility therefor, the establishment of clear lines of responsibility between each division and subdivision and the top management (e.g., Board of directors), and overall coordination of the organizations activities. It should be remembered in this connection that the organizational structure of an entity serves as a framework for the direction and control of its activities and that an effective structure provides for the communication of the delegation of authority and the scope of responsibilities. Equally important is the fact that proper functioning of any system depends on the competence and honesty of those operating it. It naturally follows that the qualifications, selection and training as well as the personal characteristics of the personnel involved are important features in a system of internal control. 2. Authorization, Recording and Custody Procedures: (with regard to the separation of duties which would, if combined, enable one individual to record and process a transaction from beginning to end). The objects of financial accounting control procedures are to ensure that the funds and the property of the organization are kept under proper custody and may not be improperly applied, either by error or intent; that expenditure may be incurred only after proper authorization, and is properly accounted for; and that all revenues are properly accounted for and received in due course. These objectives can be achieved through a suitable division of duties, the establishment of an appropriate accounting system and the institution of forms of internal check, segregating incompatible functions. Functions are considered to be incompatible which, if combined, would enable one individual to record and process one transaction from beginning to end and hence may permit the commitment and concealment of frauds and errors. In devising internal control measures for the establishment of an appropriate accounting system, the following objectives should be kept in mind: (i) Execution of transactions is carried out strictly in accordance with managements general or specific authorization; (ii) There is prompt recording of all transactions in their correct accounts and in the accounting period to which they relate;
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(iii) Access to assets is permitted only in accordance with managements authorization and approval; (iv) There is routine checking from the records to the relevant assets themselves at reasonable intervals and appropriate action is taken to resolve satisfactorily any discrepancies. Specific internal control procedures designed to achieve these objectives could include checking the arithmetical accuracy of the records; the maintenance and checking of totals, reconciliations, control accounts and trial balances; physically inspecting stocks, investments and cash balances and comparing them with accounts, records, etc; comparison of results with budgets; etc. 3. Managerial Supervision and Reviews (including internal audit): This involves the review by top management of an organizations financial operations and position at regular intervals by means of interim accounts, reports, operating summaries, and other appropriate financial and statistical information. Comparison with results for previous periods may indicate discrepancies which call for further examination and explanation. Budgetary control and standard costing systems will be additional tools of internal control. These will assist in revealing material variances which, in turn, could be investigated and satisfactorily resolved. Special reviews by top management of particular items such as stock in trade, or the operations of the wages department and other departments of importance constitute another tool of control.
3.3.1 Inherent Limitations of Internal Control

No internal control system, however elaborate, can by itself guarantee efficient administration and the completeness and accuracy of the records. In other words, any system of internal control could provide only reasonable assurance that management objectives are achieved. This is because of the following inherent limitations of internal control: (i) Management usually insists, and justifiably so, that controls should be cost effective, i.e., the cost of operating a control procedure should not be disproportionate to the potential loss due to fraud or error if the control procedure is removed. (ii) Most of the control procedures are devised in relation to anticipated types of transactions and hence may not be effective in relation to unusual or extraordinary transactions. (iii) Human errors due to errors of judgment or interpretation, misunderstanding, carelessness, fatigue or distraction may undermine the effective operation control procedures.
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(iv) There is the possibility of circumvention of controls through fraudulent collusion with parties outside the entity or with employees of the entity. (v) There is the possibility that the person responsible foe exercising a control could abuse that responsibility, e.g., authorization controls could be abused by the person in whom the authority is vested. Also, management is frequently in a position to override controls which it has itself set up. (vi) Although it is possible to ensure the competence and integrity of the personnel operating the controls by a proper system of selection and training, there is the possibility that these qualities may alter due to pressure both within and without the organization. (vii) There is the possibility that control procedures may become inadequate due to changes in conditions and compliance with procedures may deteriorate. It may be noted in this connection that the system of internal control to be adopted and the means by which it is to be communicated and implemented vary according to the nature and circumstances of each business. As a practical illustration, one large group of departmental stores, having considered the losses which could arise on stocks ceased to employ their internal auditors on routine stock checks as the expense involved in payment of salaries for such work considerably outweighed the possible stock losses which might arise. It is true that cash is the most readily convertible of all assets and thus vulnerable to misappropriation. But the fact should not be overlooked that this item forms only a part of an organizations total assets. Hence, equal attention should be given to custody and control procedures involving other forms of assets. Thus physical as well as documentary controls in all these areas are of vital importance.
1. Internal control is designed to provide reasonable assurance regarding the achievement of ________ in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. 2. By ________ is meant not only internal check and internal audit, but the whole system of controls, financial and otherwise.
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3. Checking the arithmetical accuracy of the records, maintenance and checking of totals, reconciliations, control accounts and trial balances are part of ________ controls. 4. ________ is the most readily convertible of all assets and thus vulnerable to misappropriation.
3.4 Evaluation of Internal Control System

As stated earlier, evaluating internal control systems is one of the major responsibilities of internal audit. This is carried out in the following stages: 1. Understanding the Accounting System and Related Internal Controls The auditor commences his evaluation of the system of internal control stated to be in operation in the client entity by reviewing the accounting system and related internal controls. The object at this stage is to gain an overall understanding of the flow of transactions and the specific control procedures to be able to make a preliminary evaluation, and identification of those internal controls on which it might be effective and efficient to rely in conducting his audit. He obtains an understanding of the accounting system to identify points in the processing of transactions and handling of assets where fraud or error might occur. It goes without saying that when an auditor intends to rely on the system of internal control in carrying out the audit, it is at these points that he must be satisfied that internal control procedures instituted by the client entity are fool proof. It naturally follows that it would be necessary for the auditor to acquire an uptodate record of the system of internal control in operation. For this he will have to familiarize himself with the following matters: (i) the nature of the clients business, place of its activities, methods of production, materials used, processes involved, methods of marketing, involving possibly an inspection of its physical assets and operations; (ii) the system of book keeping and accounting; (iii) the duties of the members of staff and the division of responsibilities; (iv) the internal check system in force; and (v) the internal audit arrangements. The review as above consists mainly of enquiries of personnel at various organizational levels within the client entity, together with reference to procedures
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manuals, job descriptions and flow charts. The object obviously is to gain knowledge about the controls which the auditor has identified as significant to his audit. At the time of the first audit the auditor will have to make extensive enquiries to ascertain the system. In a continuing engagement, he will be aware of internal controls through work carried out previously; but even then he will need to update his knowledge. It may be noted in this connection that a review of the kind mentioned above will give the auditor an awareness of the physical realities behind the book entries and records which he examines, and will enable him to consider their significance more intelligently. At this stage the auditor will be in a position to make a tentative decision as to whether he could probably rely on internal controls for the purpose of his audit. If he decides favourably, his next task will be to identify and document the various internal control measures. The auditor makes use of a number of techniques to document information concerning the control system. Common techniques used alone or in combination include narrative descriptions, internal control questionnaires and flow charts. It is important for the auditor to make enquiries in order to ensure that the internal controls were in use throughout the accounting period in an uninterrupted manner. If substantially different controls were used at different times during the period it would be necessary for the auditor to consider each separately. A breakdown of control measures for a specific portion of the period of intended reliance would necessitate separate consideration of the nature, timing and extent of the audit procedures to be applied to the transactions of that period. 2. Preliminary Evaluation A review as above will enable the auditor to identify tentatively the particular controls on which it is reasonable for him to rely for the purpose of his audit. It may be noted in this connection that on the basis of the review as above the auditor may conclude that it is not reasonable to rely on particular controls because they are either defective in design and/or operation or that the audit effort required to test compliance would exceed the reduction in effort that could be achieved by reliance on them. 3. Testing The next stage in the evaluation process is to carry out a series of compliance tests in order to gain evidence that those internal controls which the auditor has identified tentatively as reliable for the purpose of his audit operate generally as identified by him and that they function effectively throughout the accounting
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period in an uninterrupted manner. The concept of effective operation recognizes that some deviations from compliance may have occurred. For instance, changes in key members of staff, significant seasonal fluctuations in the volume of transactions, etc could cause deviations from prescribed controls. It is necessary for the auditor to make specific enquiries concerning such matters and to ensure that the compliance tests performed by him appropriately cover the transactions during such periods. Some aspects of the internal control system in operation may be tested by direct observation. For example, the adherence to prescribed stock taking procedures can be verified by direct observation by the auditor. In other cases, representative sections of the client entitys records are selected for examination in detail. These, in turn, can be subjected to testing in depth to ensure that transactions are properly authorized, evidenced and recorded. 4. Assessment On the basis of the results of the compliance tests, the auditor will be in a position to assess whether he could rely on the internal controls for the purpose of his audit. The reliance which is appropriate depends on the level of the auditors assurance as to the effective operation of the controls. It is possible that the results of compliance tests indicate that it is not appropriate to rely on a particular internal control to the degree previously contemplated. In that case the auditor should ascertain whether there is any other control which would satisfy his purpose and on which he might rely. In other words, in assessing weaknesses and inadequacies it is important to consider the system as a whole before a final view is formed. This is because an apparent weakness in an individual case may be unimportant when other aspects of the system are considered simultaneously, e.g., if all remittances received are by cheques which are crossed to the bank account of the client business on the opening of post by officials independent of the cashiers department and the sales ledger personnel, failure to maintain a rough cash book need not be considered as a point of weakness. Any conclusions in this regard, however, should strictly be based on the results of appropriate compliance tests. In performing compliance tests it is important to select transactions representing the whole accounting period under review. It is possible that the auditor selected a shorter period for performing initial compliance tests. In that case he should consider what is necessary to provide reasonable assurance as to the reliability of the accounting records for the whole period. It may be
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mentioned in this connection that in arriving at a judgment as to the nature, timing and extent of compliance or substantive tests to be performed to transactions occurring in the remaining period, the auditor should take into consideration the following factors: (a) the results of the tests already performed; (b) the response to enquiries as to whether the internal control system is still operating in the same manner as originally reviewed and evaluated; (c) the length of the remaining period; (d) the auditors evaluation of the internal control environment, especially supervisory controls; (e) the extent of substantive tests which the auditor intends to perform irrespective of the adequacy of internal controls.
3.4.1 Reporting Internal Control Weaknesses Letter of Weakness, Internal Control Letter, or Management Letter
Any weaknesses or defects in the system of internal control or areas where there is scope for improvement (discovered during the course of performing compliance tests) should be reported to the appropriate personnel and the facts placed on record. It is preferable for the auditor to arrange an interview with the appropriate personnel to discuss the weaknesses and the recommendations for improvement. Following this, a letter usually termed Internal Control Letter or Letter of Weakness or Management Letter should be sent. This letter should set out the weaknesses along with recommendations for improvement and any action agreed to be taken. It is important to point out in this letter that the weaknesses reported are only those which have come to the attention of the auditor during his examination of the system of internal control and that, consequently, they are not necessarily the only weaknesses that exist in the system. This will have the effect of making the management realize that the primary responsibility for establishing and maintaining an adequate system of internal control rests with them. The letter should be concluded with a direction to intimate the auditor of the steps taken by the management to remedy the weaknesses, or improvements made in the system. Internal Control Letters so sent to the management will not, however, absolve the auditor from discharging his responsibilities to state clearly the facts in his report. It may be repeated here that in exceptional cases the auditor may find that the records and the system of internal control are so seriously inadequate that no useful purpose could be served by embarking upon any extent of detailed
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checking because even the most detailed and exhaustive tests would not enable him to form an opinion on the financial statements. In that event the appropriate course will be to state the facts in his report and to inform the management of the respects in which the records and the system are deficient. Internal Control Questionnaires An internal control questionnaire (ICQ) contains questions designed to establish the strength of the system of internal control in operation in the various aspects of an organizations business and to highlight any defects, breakdowns or weaknesses. It also serves as a record of the review of the internal control system.
5. Evaluating internal control systems is one of the major responsibilities of internal audit. (True/ false) 6. While evaluating the internal control system, the concept of effective operation dictates that no deviations from compliance should have occurred. (True/ false) 7. The _______ sets out the weaknesses along with recommendations for improvement and any action agreed to be taken. 8. The _______ contains questions designed to establish the strength of the system of internal control in operation in the various aspects of an organizations business and to highlight any defects, breakdowns or weaknesses.
3.5 Internal Check: Meaning, Definition and Fundamental Principles

Internal check refers to the checks on the day-to-day transactions which operate continuously as part of the routine system whereby the work of one person is proved independently or is complementary to the work of another, the object being the prevention and early detection of errors or fraud. In other words, Thus it involves the allocation of book-keeping and other clerical duties in such a way as to ensure: (a) that no single task is carried out from its inception to its conclusion by the same person; and
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(b) that the work of each official engaged upon a particular task is subject to an independent and automatic check in the course of anothers duties. The clerical separation of the following functions will ensure the allocation of duties in such a way as to accomplish (a) and (b) above. (i) Maintenance internal check denotes those detailed administrative aspects of an organization which are designed with a view to preventing or detecting sufficiently early errors, frauds and other irregularities of history records for each employee, containing particulars of such matters as engagement, rates of pay, specimen signature, promotion, retirement, etc. (ii) Periodical checking of these records maintained by the wages department which are used in the preparation of wages sheets. (iii) Time attendance and job recording. (iv) Authorization of overtime and piece work. (v) Calculation of gross pay. (vi) Calculation of net pay taking into consideration deductions. (vii) Cast and cross cast of wages sheets. (viii) Checking of the wages sheet independently. (ix) Authorization of wages sheet. (x) Issue of wages cheque (xi) Collection of amount from the bank. (xii) Preparation of pay packets for each worker. (xiii) Payment of wages. (xiv) Treatment of unclaimed wages. It is important to note in this connection that internal checks should be made not only at each point where details are entered from documents or to subsequent records but also at any stage where significant action is based on the documents. For instance, at the time of signing cheques for payment, relevant supporting documents should be checked to confirm that they are valid, authentic and appropriate. Internal Check: Wages, Cash Sales and Cash Purchases: One of the primary duties of the auditor in relation to the audit of revenue and expenditure, whether it is wages or cash sales or cash purchases or any other item, is to ascertain the effectiveness of the internal controls, including internal check surrounding them. These are discussed in the following paragraphs.
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General Financial Controls: In addition to the basic principles governing internal control which have been highlighted earlier, the following points may be noted in connection with general financial controls. 1. An appropriate and properly integrated system of accounts and records should be instituted. 2. There should be adequate supervision with a clear, up-to-date and continuous supply of information to the management. This could be accomplished by using such means as budgetary control whereby variances from standards are revealed, regular interim accounts of suitable frequency and special reports. 3. Necessary precautions should be taken to safeguard, and if necessary to duplicate and maintain separately, important documents. 4. Proper procedures should be in operation in relation to (a) engagement, training and allocation to specific duties management and staff competent to fulfill their responsibilities; (b) arrangement of rotation of duties as necessary; (c) deputation of responsibilities during staff absences. Cash Receipts: Internal controls, including internal check relating to cash receipts, whether the item is cash sales or any other item connected to cash receipts, should be so devised as to ensure that all the cash to which the organization is entitled is collected, properly recorded and sufficiently safeguarded. The detailed procedures should cover the following main points: The cash department together with the cashier should be housed separately from the accounts department. The cashier or other members of staff of the cash department should not have access to books of account other than the cash book. Members of staff in the accounts department should not be allowed to handle cash. The cashier or other members of staff in the cash department should not be authorized to raise or approve any document which will result in cash collection. Similarly, the cashier or other members of staff of the cash department should not be authorized to write off bad debts or to raise or approve any document which will cancel the organizations right to receive cash (e.g., credit notes).
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Cash balance with the cashier should be physically verified frequently through surprise visits by responsible officials independent of the cash department. Having regard to the nature of the business, special insurance arrangements (e.g., fidelity insurance) should be effected. Sufficient arrangements should be made for safeguarding cash left on the premises outside business hours. Proper restrictions should be imposed as to access to cash department by people other than members of staff of that department. Cheques, postal orders, etc should be crossed immediately after opening of the mail. This work should preferably be done by an official independent of the cash department and the sales ledger personnel. In case of cash sales, only cashier should be authorized to receive cash and cash articles. Cash Payments: The following factors should be considered in devising controls with regard to cash payments, whether the item is wages or cash purchases. 1. Nomination of a responsible official to authorize expenditure, clearly specifying the means of indicating such authorization and the documentation to be presented and preserved as evidence. 2. Arrangements to ensure that the vouchers supporting payments cannot be presented for payment twice. 3. Procedures in respect of advances to employees, IOUs, etc. 4. The need to fix limits as regards amounts disbursed in respect of individual payments. Internal control and internal check as regards cash purchases: Internal control and internal check procedures as regards cash purchases should be devised on the following lines : (i) A responsible official should be nominated to authorize cash purchases, clearly specifying the means of indicating such authorization and the documentation to be presented. (ii) Arrangements should be there to make sure that the invoices supporting payments for cash purchases cannot be presented for payment more than once. (iii) Limits should be fixed in relation to the amounts disbursed in respect of individual cash purchases.
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Internal control and internal check as regards wages: Internal controls including internal check relating to wages should be so devised as to ensure that control procedures are in force in the following broad areas: (a) engagement, promotions, transfers and discharge of employees; (b) time records and piece work records; (c) preparation of wages sheets; (d) make up and payment of wages; (e) unclaimed wages.
9. ________refers to the checks on the day-to-day transactions which operate continuously as part of the routine system. 10. Internal check involves the allocation of book-keeping and other clerical duties such as to ensure that the work of each official engaged in a particular task is subject to ________ and ________check in the course of anothers duties. 11. The cash department together with the cashier should be housed separately from the ________department. 12. In case of cash sales, only the ________should be authorized to receive cash and cash articles.
3.6 Internal Auditing

Internal auditing is a tool of managerial control which is aimed at measuring, reviewing and evaluating the effectiveness of other controls.
3.6.1 Meaning, Significance and Importance

Internal auditing is defined as an appraisal activity, independent of other activities, within an organization, for the review of operations as a service to all levels of management. The basic goal of internal auditing is to measure the optimum use of all resources human, material and financial in the most efficient way to accomplish the organizations objectives. It strengthens the system of internal control and the way in which it operates.
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It may be noted in this connection that for the initial period of internal auditing, the internal audit function was mostly financial in nature concerned with verifying calculations and clerical operations, as opposed to verifying adherence to procedures and internal controls. Some internal audit functions verified hundred per cent of the transactions in this manner with staffing almost man to man with the clerical staff processing the documents. Over the years, however, the scope of internal auditing and the role of the internal auditor have been extended far beyond these traditional boundaries. The definition given by the Institute of Internal Auditors recognises the fact according to contemporary concept of internal auditing, an internal auditor has to go beyond the books of accounts and the underlying records and appraise the quality of performance of various personnel in the organization in carrying out assigned responsibilities. He is not to confine himself to the routine search for clerical errors in accounting documents and rigid adherence to policies and procedures but he has also to conduct an appraisal of the various operational functions on behalf of top management. In other words, of late, there has been a shift in the orientation of internal auditing to include what is sometimes referred to as operational auditing1.
3.6.2 Objectives and Scope of Internal Audit

What transpires from the above process of evolution is that under contemporary practices a wide range of activities is being done by the internal audit department. These activities may broadly be classified as financial and operational audits. Under the former may be included: (i) a continuous review of internal accounting controls; (ii) the scrutiny of reports and statements, financial or operating, as prepared for management purposes; (iii) the ascertainment to the extent to which the assets of the organization are accounted for and safeguarded from losses or damages; (iv) the examination of balance sheet items, tests of balances and transactions as to their authenticity through appropriate tests; etc. Under operational audit may be included: (i) the study and assessment of operating practices to promote increased efficiency and economy; (ii) the carrying out of audits to determine whether operating objectives, targets and associated control procedures are properly instituted and the degree to which the desired results are achieved;
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(iii) the examination and the ascertainment of the extent to which established policies, plans and procedures are complied with; (iv) the assessment of budgetary standard setting; (v) the assessment of the level of performance in successfully discharging duties and responsibilities assigned.
3.6.3 Scope of the Internal Audit Function

The independent auditor should evaluate the work performance of the internal audit personnel by examining and reviewing documentary evidence of their work. He should examine the actual contents of the assignments with which the internal audit personnel are being charged by management. He should then ensure that those assignments which have a bearing on his work have been performed with due professional care. He should: (a) Examine the audit programmes chalked out by the internal audit personnel to ensure that they are adequate enough to enable the assignments to be conducted in a timely and adequate manner. Such programmes should preferably be chalked out in cooperation with independent auditors. (b) Examine the relevant minutes, reports, Internal Control Letters, etc issued by the internal audit department so as to form an opinion as to the validity of the conclusions set out in such documents, wherever possible, comparing such conclusions with his own findings based upon his examination and evaluation of the same or similar transactions, balances or procedures. (c) Examine the extent to which and the promptness with which the recommendations issued by the internal audit department are considered and implemented by the management. In addition to the above, it is necessary for the independent auditor to test the work of the internal audit personnel by (i) examining some of the transactions or balances checked by the internal audit personnel; (ii) examining similar transactions and balances checked by the internal audit personnel and comparing the results of such tests with the conclusions reached; and (iii) reviewing the programme of work papers and reports of the internal audit personnel.
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Based on the outcome of the examination, review and assessment on the above lines, the independent auditor should decide on the nature and extent of his reliance on the work of the internal auditors. In some cases, it would be possible for him to reach a conclusion that audit work which he would normally expect to carry out himself may be carried out by the internal auditors.
13. ________auditing is a tool of managerial control which is aimed at measuring, reviewing and evaluating the effectiveness of other controls. 14. The basic goal of internal auditing is to measure the optimum use of________ in the most efficient way to accomplish the organizations objectives. 15. The study and assessment of operating practices to promote increased efficiency and economy comes under ________audit.
3.7 Summary
Let us recapitulate the main concepts discussed in this unit: By internal control is meant not only internal check and internal audit, but the whole system of controls, financial and otherwise, established by the business in order to carry on business of an organization in an orderly manner, safeguarding its assets and secure as far as possible the accuracy and reliability of its records. Three divisions of the elements of internal control are: (i) organizational structure, (ii) authorization, and (iii) managerial supervision and review (including internal audit). Evaluating internal control systems is one of the major responsibilities of internal audit. Stages in internal control evaluation consist of: (i) understanding the accounting system and related internal controls, (ii) preliminary evaluation, (iii) testing, and (iv) assessment. By internal check is meant the check on day to day transactions which operates continuously as part of routine system whereby the work of one person is proved independently or is complementary to the work of another, the object being the prevention or early detection of errors and fraud.
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One of the preliminary duties of the auditor in relation to the audit of revenue and expenditure, whether it is wages or cash sales or cash purchases or any other item, is to ascertain the effectiveness of the including internal check surrounding them. Internal auditing is a tool of managerial control which is aimed at measuring, reviewing and evaluating the effectiveness of other controls. The basic goal of internal auditing is to measure the optimum use of all resources human, material and financial in the most efficient way to accomplish the organizations objectives. It strengthens the system of internal control and the way in which it operates.
3.8 Glossary
Internal auditing: An appraisal activity, independent of other activities, within an organization, for the review of operations as a service to all levels of management. Internal check: Detailed administrative aspects of an organization which are designed with a view to preventing or detecting sufficiently early errors, frauds and other irregularities. Internal control letter: (letter of weakness or management letter) A letter that sets out the weaknesses along with recommendations for improvement and any action agreed to be taken. Internal control questionnaire (ICQ): A questionnaire that contains questions designed to establish the strength of the system of internal control in operation in the various aspects of an organizations business and to highlight any defects, breakdowns or weaknesses. It also serves as a record of the review of the internal control system. Internal control: A process, effected by an organization, board of directors, management and other personnel, which is designed to provide reasonable assurance regarding the achievement of objective in the effectiveness and efficiency of operations, reliability of financial reporting.

1. Define internal control and explain its meaning and significance. 2. Explain the elements of internal control.
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3. Explain briefly the steps in the evaluation of internal control systems. 4. Explain the mechanism for reporting internal control weaknesses. 5. What is meant by internal check? Explain the fundamental principles. 6. Explain the meaning, significance and scope of internal audit.

1. Objectives 2. internal control 3. internal 4. cash 5. True 6. False 7. Letter of weakness 8. internal control questionnaire 9. Internal check 10. Independent, automatic 11. Accounts 12. Cashier 13. Internal 14. Resources 15. operational

1. Internal control can be defined as a process, effected by an organization, board of directors, management and other personnel, which is designed to provide reasonable assurance regarding the achievement of objective in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. Refer to Section 3.2 for further details.
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2. There are three divisions of the elements of internal control organizational structure, authorization, recording and custody procedures, and managerial supervision and reviews. Refer to Section 3.3 for further details. 3. Evaluating internal control systems is one of the major responsibilities of internal audit. This is carried out in several stages. Refer to Section 3.4 for further details. 4. Any weaknesses or defects in the system of internal control should be reported to the appropriate personnel and the facts placed on record. Refer to Section 3.4.1 for further details. 5. Internal check denotes those detailed administrative aspects of an organization which are designed with a view to preventing or detecting sufficiently early errors, frauds and other irregularities. Refer to Section 3.5 for further details. 6. Internal auditing is a tool of managerial control which is aimed at measuring, reviewing and evaluating the effectiveness of other controls. Refer to Section 3.6 for further details.
3.11 Further Reading/Reference

1. Basu, SK, Auditing: Principles and Techniques, Pearson Education India, 2006. 2. Pickett, KHS, The Internal Auditing Handbook, 3rd edn, John Wiley & Sons, 2010. 3. Shekhar L and Shekhar KC, Auditing, 20th edition. Delhi: Vikas Publishing House, 2003. Reference 1. The scope of Operational Audit is defined by the Federal Financial Officers Institute of Canada as a systematic independent appraisal activity within an organisation for a review of the entire departmental operations as a service to management. The overall objective of operational auditing is to assist all levels of management in the effective discharge of their responsibilities by furnishing them objective analyses, appraisals, recommendations and pertinent comments concerning the activities reviewed.
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Structure 4.1 Introduction Objectives 4.2 Vouching: Meaning, Definition and Importance 4.3 Types of Vouchers 4.4 Summary 4.5 Glossary 4.6 Terminal Questions 4.7 Answers 4.8 Further Reading
Vouching
4.1 Introduction
In the previous unit, you studied the mechanism of internal controls, checks and internal audit. Another important part of audit is vouching. It is in fact, considered the backbone of the audit process. Vouching may appear to be similar to routine checking but they are two different functions. While routine checking is merely concerned with the verification of the arithmetical accuracy of the entries, vouching is more than the mere examination or comparison of the vouchers with the entries in the books of account. In this unit, we will study in detail about this very important tool of auditing. We will first understand the meaning and importance of vouching and look at the various types of vouching, that is, vouching for cash payments, cash receipts, purchases and sales.
Objectives
After studying this unit, you should be able to: Explain the meaning, definition and importance of vouching Describe the types of vouchers and vouching for these
4.2 Vouching: Meaning, Definition and Importance

Vouching refers to the examination of vouchers with a view to authenticating and supporting the transactions recorded in the books. Thus it involves comparing entries recorded in the books with the relevant and appropriate vouchers. According to F R M De Paula, vouching does not mean merely the inspection
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of receipts with the cash book, but includes the examination of the transactions of a business together with documentary and other evidence of sufficient validity to satisfy an auditor that such transactions are in order, have been properly authorized and are correctly recorded in the books. Again, Arthur W Holmes defines vouching thus: Vouching is the examination of the underlying evidence which is in support of the accuracy of the transaction. The process of vouching is intended to substantiate an entry by providing authority, ownership, existence and accuracy. It is of utmost importance that the auditor should exercise due professional care and skill in carrying out vouching tests. It should be clearly understood that such tests are performed to ensure the following: 1. Transactions are recorded in the correct amount. 2. Transactions are appropriately authorized appropriate to the levels of the relevant transactions. 3. Transactions have occurred in the accounting period under review. 4. Transactions represent items compatible with the needs of the client business, i.e., they fall within the purview of the normal activities of the client business. 5. Transactions represent items acquired for the purpose of the business and not for the personal benefit of any of the employees. 6. There is arithmetical accuracy in calculations, extensions, casts, etc. 7. There is appropriate allocation between capital and revenue. 8. There is evidence that vouchers comply with internal checking and control procedures. Such evidence may consist of initials, rubber stamp, signature, etc on vouchers concerned. Although vouching occupies a very important place in auditing, under the contemporary systems based audit it is not the usual practice to resort to extensive vouching tests except in the following cases: (a) In the case of organizations where the system of internal control is not satisfactory. (b) In the case of small organizations where it is not practicable to achieve a proper segregation of incompatible functions because of limited number of staff. (c) In the case of organizations which carry on specialized activities where although the number of transactions is limited most of them are of considerable value and material significance.
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(d) In the case of transactions which are specialized in nature and limited in number such as share capital, major items of capital expenditure, sales and purchases of investments, investment income, directors remuneration, commission paid to agents and salesmen, etc.
4.2.1 Importance of Vouching

Vouching is not the mere examination or comparison of the vouchers with the entries in the books of account. It is much more than that. It is such an examination of the entries in the books of account as will satisfy the auditor that the entries are not only supported by the vouchers but also they took place as stated, that they have been duly authorized by a competent official, that they properly related to the business and that they have been recorded in the books in conformity with accepted principles of accounting. Vouching is the essence or backbone of auditing and it is one of the most important tools in the hands of the auditor. It is the foundation upon which the very superstructure of auditing stands. An entry may appear to be innocent; but unless the auditor goes beyond the books and trace the very source it will not be possible to ascertain the truth and genuineness of the transaction. As observed earlier, the auditor has to go beyond establishing its arithmetical accuracy. He/she has to ensure that the entry is accurate, duly authorized by an appropriate official, relates to the period under review and properly relates to the business. For instance, a fictitious payment may have been entered in the books in order to misappropriate money, or the payment may be genuine but not on account of the business, or it may not relate to that accounting year. Herein lies the importance of vouching with professional care and skill. The observation of the learned judge in Armitage vs Brewer and Knott that it was clear that a good many documents were suspicious on their face and called for an enquiry brings out the importance of vouching with due And reasonable care by an auditor. In this case, the auditors were found guilty of negligence for their failure to display enough reasonable care and skill in vouching wages sheets and ending up in their failure to detect fraud in manipulation of the wages records and cash vouchers.
4.2.2 Routine Checking and Vouching

Routine checking consists of checking of casts, subcasts, carry forwards, extensions, calculations, etc in subsidiary books, checking of postings into the ledger, casting of ledger accounts, extraction of the balances, etc in the books of original entry, the checking of postings to the ledgers, the checking of ledger
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accounts in relation to their casts, balancing the carrying forward of balances and the transfer of balances to the trial balance. Normally this work is assigned to junior members of the audit staff. Routine checking is done with the principal objective of verification of the arithmetical accuracy of the entries with a view to ascertaining the accuracy of the postings to the ledgers, checking the ledger accounts and ascertaining the correct balancing and to make sure that there has been no alterations in the figures once the checking has been completed. As against this, the objects of vouching are much wider in scope. Besides the objects of routine checking mentioned above, vouching is done with the object of going behind the books and satisfying that the transactions recorded in the books of account are appropriately authorized and correctly entered into, thereby finding out facts behind the figures. Simple routine checking cannot establish the same accuracy which vouching can. The extent of vouching to be carried out by an auditor is dependent on the systems of accounting and related internal controls.
1. Vouching refers to the examination of vouchers with a view to ________and supporting the transactions recorded in the books. 2. Routine checking is done with the principal objective of verification of the ________of the entries 3. Under the contemporary systems based audit it is the usual practice to resort to extensive vouching tests. (True/ False) 4. Simple routine checking is capable of establishing the same accuracy which vouching can. (True/ False) 5. Vouching is not merely the examination or comparison of the vouchers with the entries in the books of account. (True/ False) 6. The extent of vouching to be carried out by an auditor the same in all organizations. (True/ False)
4.3 Types of Vouchers

A voucher is a documentary evidence in support of a transaction recorded in the books of account. There are different types of vouchers such as an invoice, a suppliers statement, correspondence, an insurance policy, a certificate from a third party, a statement from a debtor confirming the balance due, etc. Specific
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examples of types of vouchers in respect of the following items are given against each item: For cash payments: Receipts from payees, invoices, wages book, contracts, confirmation by creditors, etc. For cash receipts: Counterfoils of the receipts issued, correspondence with the relevant parties, etc. Purchases: Invoices, Goods Inward Book, copies of orders, correspondence with suppliers, etc. Sales: Copies of invoices, correspondence with purchasers, Goods Outward Book, etc. Let us study how the above types of vouchers and how they are vouched.
4.3.1 Vouching of Receipts

As you read in the last section, vouchers may of different types. Let us see how vouching is done for these: Vouching of receipts from cash sales: The procedure for recording receipts from cash sales is the most important factor in deciding the required evidence for vouching cash sales. The auditor should check carbon copies of the cash memos or cash sales invoices with reference to the entries in the books of account. Where automatic cash tills are used, summaries should be checked. Enquiries should be made on the basis of charging prices to the customers against each sale and documentary evidence in this connection should be examined. Based on the system of internal control in operation (the details of which are given in Unit 3), the extent of test check with the goods outward book should be decided and carried out accordingly. Usually, a junior member of the audit staff reads out the contents of the voucher such as number of the voucher, its amount, etc. The senior auditor compares every item stated in the vouchers with entries in the books. Various ticks or symbols, which are code words, are used to clear the items checked. Vouchers are stamped with cancelled stamp, or initial/signature is used to signify cancellation in order to avoid presentation of the same voucher in support of another entry. For missing vouchers/doubtful entries, the word Q is made against such missing vouchers/doubtful entries and the same is recorded in the audit working papers. Explanation is sought from relevant officials. Based on the explanation, the auditor will decide whether the same is satisfactory. Unsatisfactory replies are rejected and details of explanation and causes of
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rejection are noted down in the audit working papers. The auditor will try to make use of other available evidence to verify the truth and resolve the issue. Vouching of receipts from debtors: Examine the method of allowing discount to customers. Any unusual discount allowed should be noted and a satisfactory explanation from a responsible official should be obtained. Check the carbon copy of the receipt issued to the debtor/counterfoil of the receipt with reference to the cash book. Ensure that the custody and issue of the receipt books is in the hands of a responsible official. Ensure that the official responsible for handling remittances received from debtors has no responsibility in connection with the preparation and sending out of statements to debtors. Ascertain whether the bearer/order cheques are deposited in the bank. Vouching of bills receivable: Compare cash receipts from bills discounted or matured with reference to the Bills Receivable Book, Cash Book and bank pass book/statement, ensuring that all matured bills have been accounted for. Make enquiries concerning bills receivable which are due for receipts of cash but against which cash has not been received. A certificate should be obtained from an authorized person that payments on such bills have not been received. The matter should be further investigated to ensure that there is no misappropriation. Vouching of proceeds from sale of investments: The usual procedure for the sale of investments is through brokers. Entry in the books of account concerning the details of the amount received from the sale, commission paid to the broker, etc should be compared with the brokers sold note. In case there is any agreement or correspondence in relation to the sale, the same should also be examined. Sometimes, the investment has been sold cum-dividend in which case it should be ascertained that the relevant dividend has been received and apportioned between capital and revenue. Where the sale is ex-dividend, the relevant entry should be examined. Vouching of proceeds from the sale of buildings: Where the sale is through a broker, the proceeds of the sale should be vouched with reference to the note of the broker. Where a sale deed or contract is the medium, the relevant entry should be vouched with reference to the deed or contract.
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4.3.2 Vouching of Payments

Vouching of payments can be in different forms: Cash purchases: This can be done as follows: Vouch payments for cash purchases with reference to cash memos of the suppliers. Goods Received Notes and all available documentary evidence evidencing the receipt of goods should be checked to ensure that goods have actually been received. Verify allocation to the head of account debited. Vouching of payment to creditors: The following steps need to be taken: Ensure that invoices have been internally checked and initialed by authorized officials. Ensure that payments are authorized by appropriate officials. Check the cash book to ensure that the name of the payee is correctly stated in the cash book. Ensure that the amounts of payments and the head of account debited are correctly recorded in the cash book. Ascertain that the dates in the payees acknowledgements agree with the corresponding entries in the cash book. Scrutinize statements of the creditors. Vouching of bills payable: The following steps need to be taken: Check the bills paid during the period with reference to the cash book and bills returned. Check the total bills not matured and ensure that they agree with the credit balance on the bills payable account in the edger. Check the postings of the bills payable. Also, check the casts, cross casts and carry forwards. Vouching of purchase of building: The following steps need to be taken: Examine the documents of title to the property. Ascertain whether the building is purchased on freehold or leasehold basis. Where it is purchased on leasehold basis, ascertain the terms of the lease. Where it is purchased in an auction, examine the account submitted by the auctioneer.
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Where it is purchased through a broker, examine the brokers note. Where it is purchased direct from the seller, check the correspondence in relation thereto. Vouch auctioneers commission, brokerage, registration fees and legal charges, etc with reference to receipts obtained. Simultaneously ensure that the same have been capitalized. Vouching of purchase of plant and machinery: Where plant and machinery are purchased from a vendor, the invoice from the vendor and the receipt for payment towards the cost of the asset should be examined. Simultaneously proper enquiries should be made to ascertain that the items included under this head are bonafide capital charges including cost of carriage and erection. Where plant and machinery are bought in an auction, the auctioneers statement of account should be examined. Where they have been purchased under hirepurchase agreement, the agreement and the relevant vouchers should be examined and ascertain whether proper apportionment is made of the installments paid between capital and revenue. Ensure that repairs and expenses of maintenance are not capitalized. Also, ensure that loss on sale of any obsolete plant and machinery has been treated as revenue loss. Where plant and machinery are imported, customs duty will have been paid in which case the documents to be checked are: (a) accounts submitted by the clearing agent, (b) deposit account with customs authorities, (c) receipt issued by customs authorities for payments made, (d) statement of duty payable, and (e) other supporting papers and vouchers. It should be ensured that the customs duty paid is in connection with the import of plant and machinery only and that they are purchased for the use of the business concerned. The amount of customs duty should be verified with reference to the bill of entry duly stamped by customs authority. Where plant and machinery are imported through clearing agents, the accounts submitted by the clearing agents should be verified to make sure total charges including customs duty on account of import of the asset. The accounting aspect of customs duty paid against import of machinery should be looked into, viz., that the same has been capitalized by debiting plant and machinery account. Vouching of patent rights: The following steps need to be taken: Obtain a list of patents and examine it with reference to registration number, date, name of the seller, consideration paid, etc. Check the existence of patents, registration certificates, certificates of grant of patents, documents of assignment and receipts for the renewal fees.
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Where patents have been purchased through an agent, ascertain the agents fees and verify the amounts included in the books of account. Ensure that the patent renewal fee has not been charged to the patent account since it is a revenue expenditure. Ensure that lapsed patents have been written off from the books of account. Ensure that patents have been valued properly and that there is consistency in the method of valuation over the years.
4.3.3 Vouching of Deferred Revenue Expenditure

Deferred revenue expenditure is a non-recurring expenditure which is expected to be of financial benefit to several accounting periods. The accounting treatment of an item of deferred revenue expenditure is to allocate it over the financial years during which it is expected to yield benefits for the business. That portion of the deferred revenue expenditure which is not yet written off will be treated as a temporary asset. Research and development expenditure is a typical example of a deferred revenue expenditure. Other examples include plant rearrangement and removing costs; expenditure incurred in connection with the launching of a new product; cost of removal of the business to a more convenient locality; expenses incurred by way of exceptional repairs of nonrecurring nature; development expenditure; abnormal advertisement expenses in connection with a heavy sales campaign; etc. Following are given the procedures to be followed while vouching deferred revenue expenditure: 1. At the very outset, ascertain the nature of the work and it should be ensured that ordinary revenue expenditure is not treated as deferred revenue expenditure with a view to inflating profits. 2. Ascertain whether the concerned activity is authorized by the Board of Directors and has relevance to the objectives of the company. 3. In case the expenditure is for developing new products or for inventing a new product, see that such expenditure is written off over a period of three to five years, if successful. In case it is established that the effort is not going to succeed, see that the entire expenses incurred are written off to the profit and loss account. 4. Ensure that any machinery and equipment have been purchased for the purpose of the concerned activity, the cost thereof less the residual value is appropriately debited to the account of the concerned activity over the years of the activity.
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5. Ensure that no expenses unrelated to the activity are allowed to be debited to the account of the activity. 6. Verify various items of expenses incurred on the activity with reference to supporting documents and related agreements. For instance, the cost of materials consumed may be verified with reference to such documents as purchase invoices, goods received notes, records relating to issue of materials, agreements with third parties, etc. 7. Ensure that the deferral of the expenditure is in accordance with the recognized accounting policies and practices. 8. Check calculations and examine all related vouchers to ascertain the correct amount to be amortized. 9. See that the balance of expenditure not written off is shown on the asset side of the balance sheet until it is fully written off.
4.3.4 Vouching of Preliminary Expenses

Preliminary expenses are the expenses incurred in connection with the incorporation of the company. They include professional charges paid for consultation in incorporating the company; professional charges paid for drafting the Memorandum of Association and Articles of Association of the company; cost of printing Memorandum of Association, Articles of Association, Prospectus, Letters of Allotment, etc; stamp duty for the documents; registration fee paid to the Registrar of Companies for incorporation; cost of advertising the prospectus, etc; cost of companys seal and statutory books; cost of preparing, printing and stamping debenture trust deed, etc; incidental expenses such as stationary, conveyance, etc. Vouch the payments of such expenses by reference to receipts, invoices, bills, etc. Check the receipts issued by the Registrar of Stamps for stamps issued. In addition a photocopy of the relevant document duly attested by a director of the company should be examined. Preliminary expenses might have been incurred by more than one person. The promoter who incurred the expenditure has to present a statement of expenditure for reimbursement. The supporting documents such as relevant bills and receipts will be attached to such a statement. The auditor should check the expenditure concerned with reference to this statement and the supporting documents attached to it. The minutes of the Board of Directors which quantify the preliminary expenses should also be checked. Reimbursement of preliminary expenses should be checked with reference to the Memorandum of Association
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and Articles of Association to ascertain whether the relevant clause of reimbursement is contained therein.
4.3.5 Vouching of Underwriting Commission

Underwriting agreement is an agreement between a company and the underwriter, whereby the underwriter agrees to take up the whole or part of the shares/debentures of the company which may not be subscribed by the public. Underwriting commission is the commission payable to the underwriter for the underwriting agreement. The Companies Act contains provisions regarding the payment of underwriting commission subject to certain conditions. From the point of view of vouching underwriting commission, the more important provisions are: (i) that the payment should be authorized by the Articles of the company; (ii) that the rate of commission should not exceed five per cent of the price at which shares are issued or the rate authorized by the Articles of Association, whichever is less (two and a half per cent in the case of debentures); (iii) no commission should be paid by the company in respect of shares/debentures which are not offered to the public for subscription. In relation to vouching, the auditor should: check the terms of underwriting commission from the Articles of Association, prospectus and the underwriting agreement; examine the Articles of Association to ensure that the payment of underwriting commission is authorized; ensure that the rate of underwriting commission does not exceed five per cent in the case of shares and two and a half per cent in the case of debentures; check the calculations of commission paid and compare the amount with the underwriters receipt; verify the relevant entries where shares are allotted in the shape of commission; ensure that the underwriting commission is not included in the general heading preliminary expenses, but is shown separately in the balance sheet until written off; ensure that the amount not written off is shown distinctly in the balance sheet; ascertain whether the underwriting commission remains within the limits laid down by the Controller of Capital issues.
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7. An insurance policy can be considered as an example of a_________. 8. The procedure for recording _________ from cash sales is the most important factor in deciding the required evidence for vouching cash sales. 9. In vouching cash receipts, _________should be checked where automatic cash tills are used. 10. Vouchers are stamped with _________ stamp, or initial/signature is used to signify cancellation in order to avoid presentation of the same voucher in support of another entry. 11. Payments for cash purchases are vouched with reference to _________of the suppliers. 12. Deferred revenue expenditure is a _________expenditure which is expected to be of financial benefit to several accounting periods. 13. The expenses incurred in connection with the incorporation of the company are called _________expenses.
4.4 Summary
Let us recapitulate the important concepts discussed in this unit: Vouching refers to the examination of vouchers with a view to authenticating the transactions recorded in the books. It is important that the auditor should exercise due professional care and skill in carrying out vouching tests. Although vouching occupies a very important place in auditing, under the contemporary systems based audit, it is not the usual practice to resort to extensive vouching tests except in certain cases. Vouching is the essence or backbone of auditing. It is not the mere examination or comparison of the vouchers with the entries in the books of account. It is such an examination of the entries in the books of account as will satisfy the auditor that the entries are not only supported by the vouchers but also that they took placed as stated, that they have been duly authorized by a competent official, that they properly relate to the business and that they have been recorded in the books in conformity with accepted principles of accounting.
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The objects of vouching are much wider in scope as compared to routine checking. Simple routine checking cannot establish the same accuracy which vouching can. A voucher is documentary evidence in support of a transaction recorded in the books of account. There are different types of vouchers such as an invoice, a suppliers statement, correspondence, an insurance policy, a certificate from a third party, etc. The procedures for recording receipts from cash sales is the most important factor in deciding the required evidence for vouching cash sales. Vouching of receipts from debtors involves various steps. Bills Receivables should be vouched with reference to Bills Receivable Book, Cash Book and bank pass book/bank statement. In vouching proceeds from sale of investment, the auditor should pay particular attention to see whether the concerned investment has been sold cum-dividend or ex-dividend. Vouching of payment involves vouching of cash purchases, payments to creditors, bills payable and purchase of fixed assets. There are various procedures to be followed while vouching deferred revenue expenditure. Same is the case with the vouching of preliminary expenses and underwriting commission.
4.5 Glossary
Creditor: An entity (person or institution) that extends credit by giving another entity permission to borrow money if it is paid back at a later date. Deferred revenue expenditure: Non-recurring expenditure which is expected to be of financial benefit to several accounting periods. Invoice: a bill sent by a provider of a product or service to the purchaser. Ledger account: A separate page in a ledger that records increases and decreases in each balance sheet item Patent rights: The right to make or sell something that is given to a particular person or company through a patent. Routine checking: Checking done with the principal objective of verification of the arithmetical accuracy of the entries.
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Vouching: Examination of vouchers with a view to authenticating and supporting the transactions recorded in the books.

1. Define vouching and explain its meaning. 2. What is the importance of vouching? Distinguish vouching from routine checking. 3. What are the different types of vouchers? Explain the vouching of receipts. 4. Explain the vouching of payments of different types. 5. What is deferred revenue expenditure? Explain the vouching for this type of expenditure. 6. Write short notes on vouching for (a) preliminary expenses and (b) underwriting commission.

1. Authenticating 2. arithmetical accuracy 3. False 4. False 5. True 6. False 7. voucher 8. Receipts 9. Summaries 10. Cancelled 11. cash memos 12. non-recurring 13. Preliminary
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1. Vouching refers to the examination of vouchers with a view to authenticating and supporting the transactions recorded in the books. Refer to Section 4.2 for further details. 2. Vouching is the essence or backbone of auditing and it is one of the most important tools in the hands of the auditor. Refer to Section 4.2.1 and 4.2.2 for further details. 3. A voucher is a documentary evidence in support of a transaction recorded in the books of account. Refer to Section 4.3 and 4.3.1 for further details. 4. Vouching of payments can be in different forms- vouching of cash purchases, payment to creditors, for bills payable, etc. Refer to Section 4.3.2 for further details. 5. Deferred revenue expenditure is a non-recurring expenditure which is expected to be of financial benefit to several accounting periods. Refer to Section 4.3.3 for further details. 6. Preliminary expenses are the expenses incurred in connection with the incorporation of the company. Refer to Section 4.3.4 and 4.3.5 for further details.
4.8 Further Reading

1. Kumar R and Sharma V, Auditing: Principles and Practice, New Delhi: PHI Learning Pvt. Ltd., 2006 2. Shekhar L and Shekhar KC, Auditing, 20th edn, Delhi: Vikas Publishing House, 2003 3. Khan and Jain, Management Accounting, 4th edn, New Delhi: Tata McGrawHill, 2007
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Structure
Depreciation
5.1 Introduction Objectives 5.2 Depreciation: Meaning and Causes 5.3 Necessity of Providing Depreciation: Bases of Depreciation (Assessment of Depreciation) 5.4 Methods of Providing Depreciation 5.5 Auditors Duties as Regards Depreciation 5.6 Summary 5.7 Glossary 5.8 Terminal Questions 5.9 Answers 5.10 Further Reading/Reference
5.1 Introduction
You know from experience that a used item is not worth as much as a new item. Any product that you buy today will undergo wear and tear. An item like a computer or mobile phone also becomes obsolete over time and thus decreases in value. Let us take an example. Suppose you bought a camera for `5,000. You now own a camera worth `5,000 and `5,000 less in cash, so in principle, your net change in value is zero. Let us assume that the life of the camera is 5 years. So in the first year, `1000 of the asset is used, and the camera has now depreciated by `1000. After 5 years, the camera is fully depreciated, which means not that it has no more value, but you cannot take any more depreciation value. Similarly, businesses own a number of assets like machinery, buildings, vehicles, etc, which undergo depreciation. Depreciation is an important factor in accounting and audit. In this unit, we will study the concept of depreciation in detail, including its meaning, causes, necessity of depreciation, as well as methods of providing depreciation.
Objectives
After studying this unit, you should be able to: Explain the meaning and causes of depreciation Discuss the necessity of providing depreciation
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Describe the methods of providing depreciation Explain the auditors duties as regards depreciation
5.2 Depreciation: Meaning and Causes

The Institute of Chartered Accountants in England and Wales defines depreciation thus:
"Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned."
The Committee on Terminology of the American Institute of Accountants describes depreciation accounting thus:
"Depreciation accounting is a system of accounting which aims at distributing the cost or other basic value of tangible capital assets, less salvage (if any) over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is the portion of total charge under such a system that is allocated to the year. Although the allocation may properly take into account occurrences during the year, it is intended to be a measure of all such occurrences."
In terms of the Statement on Standard Accounting Practice:

"Depreciation is a measure of the wearing out, consumption or other loss of value of a fixed asset whether arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation should be allocated to accounting periods so as to charge a fair proportion to each accounting period during the expected useful life of the asset. Depreciation includes amortization of fixed assets whose useful life is predetermined (e.g., leases) and depletion of wasting assets (e.g., mines)."
Thus depreciation may be considered as the decrease in the utility value of a fixed asset over a period of time. This decrease in its value may arise from a variety of factors, some internal others external. Wear and tear in the case of such assets as plant and machinery or exhaustion in the case of wasting assets such as mines and quarries may be considered as examples of internal depreciation which arises from the operation of any cause natural to, or inherent in the asset itself. It may be noted in this connection that depletion is the term used to indicate the measure of exhaustion of a wasting asset, as its known or estimated resources are extracted.
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Obsolescence or effluxion of time are instances of external depreciation. Such depreciation arises as a result of forces outside the asset itself. Obsolescence indicates the loss of value of a fixed asset mainly due to changes in economic conditions, such as changes in consumption habits or methods and techniques of production. These developments nay render the asset out of date, in spite of the fact that the asset is comparatively new. For example, a new invention may lower the cost of production substantially which, in turn, will have the effect of rendering the existing machine obsolete. Unless the existing machine is replaced, the business may find it difficult to withstand the competition from its rivals who make use of the new invention. Businesses which make extensive use of the products of advanced technology are susceptible to this form of depreciation because of scientific developments taking place within a short period. Depreciation due to effluxion of time takes place in the case of fixed assets with a known life. They become exhausted simply by the passage of time. For example, leases, copyrights, patents, etc. Amortization is the term used to indicate depreciation provided on such assets. Thus the cost of a 15-year lease would be amortized over its known life of 15 years since its utility value to the lease holder will become nil at the end of this period.
1. The part of the cost of a fixed asset to its owner that is not recoverable when the asset is finally put out of use by him is called appreciation. (True/ False) 2. Provision against depreciation is an integral cost of conducting the business during the effective commercial life of the asset. (True/ False) 3. Depreciation accounting is a process of valuation, not of allocation. (True/ False) 4. Wear and tear in the case of assets such as plant and machinery or exhaustion in the case mines and quarries may be considered as examples of ________depreciation. 5. ________or _______of time are instances of external depreciation of assets. 6. The depreciation provided on such assets as lease and copyright is termed as ________.
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5.3 Necessity of Providing Depreciation: Bases of Depreciation (Assessment of Depreciation)

Depreciation is an important factor in accounting, as it helps to maximize profits with in house accounting control. Depreciation should be provided because of the following reasons: 1. The physical deterioration of an asset is an expense incurred during the current period. Depreciation is the recovery of the prepaid cost incurred by its acquisition. An annual charge which will do this is the minimum that must be charged against current operations during the useful life of the asset. This follows from the concept of matching costs against revenue. 2. In a continuing business where assets are depreciating, they will have to be replaced at some subsequent period. Hence if no provision is made for their replacement the business will face difficulties when the necessity for replacement arises. This follows from the going concern concept. 3. The concept of conservatism demands that in accounting matters figures which will understate rather than overstate the profits should be taken. Alternatively, this means that the figures which will cause the capital to be shown at a lower amount rather than at a higher one should be taken. If the loss to the effective life of a fixed asset is not quantified and proper provision for the same is not made, the effect will be to overvalue the asset concerned. Besides distorting the true and fair view presented through the accounts, this will be against the concept of conservatism. 4. It has been pointed out that the loss of value in the case of a fixed asset will have the effect of diminishing the capital in one sense. Hence payment of dividend without providing for this loss of capital may tantamount to payment of dividend out of capital which is in contravention of the provisions of the Companies Act. 5. The Indian Companies Act provides that a company must provide for depreciation before it declares a dividend. Section 205 of the Act is reproduced below for ready reference. (1) No dividend shall be declared or paid by any company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub section (2) or out of profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by
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the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government. Provided that (a) if the company has not provided for depreciation for any previous financial year or years which falls or fall after the commencement of the Companies (Amendment) Act, 1960, it shall, before declaring or paying dividend for any financial year provide for such depreciation out of the profits of that financial year or out of the profits of any other previous year or years; (b) if the company has incurred any loss in any previous year or years, which falls or fall after the commencement of the Companies (amendment) Act, 1960, then, the amount of loss or an amount which is equal to the amount provided for depreciation for that year or those years whichever is less, shall be set off against the profits of the company for any previous financial year or years, arrived at in both cases after providing for depreciation in accordance with sub section (2) or against both; (c) the Central Government may, if it thinks necessary so to do in the public interest, allow any company to declare or pay dividend for any financial year or any previous financial year or years for depreciation: Provided further that it shall not be necessary for a company to provide for depreciation as aforesaid where dividend for any financial year is declared or paid out of the profits of any previous financial year or years which falls or fall before the commencement of the Companies (Amendment) Act, 1960. (2) For the purpose of sub section (1), depreciation shall be provided either (a) the extent specified in section 350; or (b) in respect of each item of depreciable asset, for such an amount as is arrived at by dividing ninety five per cent of the original cost thereof to the company by the specified period1 in respect of such asset; or (c) any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period; or (d) as regards any other depreciable asset for which no rate of depreciation has been laid down by the Act or any rules made
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thereunder, on such basis as may be approved by the Central Government by any general order published in the Official Gazette or by any special order in any particular case: Provided that where depreciation is provided in the manner laid down in clause (b) or clause (c) then, in the event of the depreciable asset being sold, discarded, demolished or destroyed, shall be written off in accordance with the proviso to section 350. Section 349 of the Act lays down, inter alia, that in making the computation of net profit, depreciation to the extent specified in section 350 shall be deducted. In terms of section 350: The amount of depreciation to be deducted in pursuance of clause (k) of sub section (4) of section 349 shall be the amount calculated with reference to the written down value of the assets as shown by the books of the company at the end of the financial year expiring at the commencement of this Act or immediately thereafter and at the end of each subsequent financial year, at the rate specified in Schedule xiv. Provided that if any asset is sold, discarded, demolished or destroyed for any reason before depreciation of such asset has been provided for in full, the excess, if any, of the written down value of such asset over the sale proceeds or, as the case may be, its scrap value, shall be written off in the financial year in which the asset is sold, discarded, demolished or destroyed.
5.3.1 Assessment of Depreciation

The important factors in computing the rate of depreciation are as follows: The cost of the asset. Its effective life and the degree of use to which it will be put. The residual value which it will fetch at the end of its effective life. Foreseeable risk of obsolescence. Of these, the cost of the asset can be ascertained exactly. In this connection it is sometimes pointed out that depreciation of an asset should be based on the replacement value of the asset and not on the original cost. The reason advanced in support of this view is that as a result of the changes which have taken place in the purchasing power of money, the original cost of a fixed asset is far below its current replacement price and if depreciation is provided on the basis of the original cost the amounts accumulated out of profits for replacement of the asset will be quite inadequate. Although this argument contains an element
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of truth, it should be remembered that the main object of providing for depreciation is not to provide a fund for the replacement of the asset (this may be its incidental and useful result) but for accounting as an expense the cost of using it up. Depreciation is first and foremost the recovery, spread over the life of the asset, of the prepaid cost incurred by its acquisition. In the opinion of leading professional bodies, provision for depreciation should be on the basis of historical cost; but where it is anticipated that the cost of replacing an asset will be generally in excess of its original cost an additional amount should be set aside to provide the additional funds that will eventually be required for replacement. Such an additional amount should not be treated as a provision which must be made before profits for the year can be ascertained; but as a transfer to reserves which is an appropriation of profits rather than a charge against them. Thus the basic depreciation would continue to be deducted from the book value of the assets in the balance sheet and the supplementary depreciation brought to a special replacement reserve account. In many cases the second factor, viz., the effective life of the asset and the degree of use to which it will be put, is not susceptible of precise calculation. For example, the effective life of the asset is curtailed to a great extent on the necessity of shift working. On the other hand, its commercially useful life is prolonged as a result of exceptional maintenance expenditure. Assessment of such factors to arrive at an appropriate rate of depreciation will greatly be facilitated by the maintenance of a fixed assets register, the details of which are mentioned elsewhere. Of course, there are certain fixed assets like leases where the effective life of the asset can be ascertained exactly and hence the loss occasioned by effluxion of time can be calculated precisely. The residual value which the asset will fetch at the end of its effective life is also a matter of estimation. It is recommended that where the residual value is likely to be small in relation to cost it is convenient to regard it as nil and to deal with any proceeds on eventual disposal in the same way as depreciation over provided on disposal, viz., by showing this in the results of the year and disclosing it separately if material. Risk of obsolescence cannot be foreseen with any degree of accuracy. It may briefly be repeated here that in the case of businesses which make extensive use of the products of advanced technology, where considerable improvements take place within relatively short periods of time, the chances of obsolescence are high. To sum up, provisions for depreciation in most cases matters of estimation, based upon the available experience and knowledge, rather than of accurate
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determination. They require adjustments from time to time in the light of changes including prolongation of useful life due to exceptional maintenance expenditure, curtailment due to excessive use, or obsolescence not allowed for in the original estimate of the commercially useful life of the asset.
7. The ________deterioration of an asset is an expense incurred during the current period. 8. The concept of _________demands that in accounting matters figures which will understate rather than overstate the profits should be taken. 9. The loss of value in the case of a fixed asset will have the effect of _______the capital in one sense. 10. Depreciation is first and foremost the_______, spread over the life of the asset, of the prepaid cost incurred by its acquisition
5.4 Methods of Providing Depreciation

There are various methods for providing depreciation. These are discussed as follows: 1. Straight Line Method (also known as fixed installment method, original cost method or equal installment method) Under this method an equal amount is charged as depreciation for each year of expected use of the asset. In other words, depreciation is calculated on the basis of the amount of annual charge necessary to reduce the asset to its scrap value, or residual value, over the life of the asset. The formula is:
Depreciation per annum = Cost Price Estimated Residual Value Estimated Life in Years
For example, machinery is purchased for `7,500. It is estimated that it will need replacement in five years and then will fetch `2,500 on trade in. Using the above formula, depreciation per annum is `7,500 2,500 5,000/ 5 = `1,000. The asset will be depreciated by five equal installments of `1,000 and then will be reduced to a value of `2,500. As pointed out earlier, the residual value will be ignored where it would be a relatively small amount.
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This method is straightforward and easily understood. Besides, the asset is written down over a definite period to a predicted minimum value below which the business would not normally keep the asset. But the disadvantage of this method arises from the fact that in certain cases it would not be possible to ascertain the commercially useful life of the asset with any accuracy. Moreover, there may be a number of additions to the asset concerned during the course of the year. Necessary adjustments will have to be made in respect of such additions which, in turn, may require elaborate accounting arrangements. Again, this method will cause an increasing charge to the profit and loss account over the years because the repairs to an old asset increase. Since the depreciation charge is the same for every year, the total cost (depreciation plus repairs) will increase over the years. This is against the principle that the burden to the profit and loss account over the years from the use of the same asset should be the same. In spite of its limitations, this method has been recommended as being the most suitable for general application although other methods may be appropriate in the case of certain class of assets. It is recommended in the case of such fixed assets as freehold buildings, plant and machinery, ships, transport vehicles and similar other assets which are subject to depreciation by reason of their employment in the business. In the case of assets which become exhausted by the effluxion of time such as leaseholds, patents, etc also provision for amortization can be made on the basis of this method. 2. Reducing Balance Method (also known as Diminishing Balance Method, Written Down Value Method, Reducing Installment Method or Declining Balance Method) Under this method, the asset is depreciated by a fixed percentage on the diminishing balance of the account. In other words, the annual depreciation provision is calculated by applying a fixed percentage to the balance of costs not yet apportioned as an expense at the end of the previous accounting period. The balance of unapportioned costs will therefore decrease each year. And as a fixed percentage is being used, the depreciation provision will be less with each passing year. The balance of unapportioned costs at the end of the estimated effective life of the asset should equal the estimated residual value. Although this method will have the effect of resulting in relatively heavy charges for depreciation in the earlier years of the life of an asset and a relatively lighter charge in the later years, repair charges go on increasing when the asset grows older. Thus this method has the advantage of making the charge against the profits for the use of the asset more even over the years, since the
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diminishing charge for depreciation offsets the increasing charge for repairs. Another advantage of this method is that recalculations are not required when new assets are purchased or old assets are sold as depreciation is calculated only on the balance. Against these advantages may be pointed out that in order to provide depreciation under this method within any given period, the percentage applied needs to be much higher than that applied under the straight line method. This is a fact not generally realized, the consequence being that rates of depreciation on this basis may tend to be inadequate. The method is unsuitable especially in the case of assets with very short effective lives. For instance, to write off `10,000 completely over three years requires 90 per cent depreciation rate, i.e., `9,000 during the first year; `900 during the second year and `90 during the third year. This charge is so uneven as to be satisfactory. A further limitation of this method is that the asset is never completely written off. Again, the argument that the charge against the profits for the use of the asset is more or less even when coupled with the charges for depreciation and repairs will be true in actual practice only if the repairs and maintenance element is comparatively large. Reducing balance method is very popular as compared to the straight line method. It is true that it is being used by many small firms because of its application in the computation of depreciation for income tax purposes. But it is pointed out that from the accounting point of view, using a method in accounting purely because it is used for tax purposes can be very misleading since the aims of accounting and the aims of taxation often conflict with one another. 3. Revaluation Method In many cases especially in the case of assets of very short life such as loose tools it may not be possible to treat depreciation by the normal methods. For instance, a screw driver costing `2 and which is used frequently may not last for three years. If either of the methods described above is used then theoretically a calculation would have to be made of the over depreciation or under provision provided on the asset when it is put out of use, and an adjusting entry made to correct the accounts. With such an asset it is not worthwhile to keep such elaborate records. In such cases the asset is revalued which in no case will exceed the cost. In other words the asset is valued at the start of the period, the additions increase its value and then the asset is revalued at the end of the period. The amount in the decrease in value shows the amount by which the asset is considered to have depreciated.
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4. Sinking Fund Method (also known as Depreciation Fund Method or Redemption Fund method or Amortization Fund Method) This method is used mainly to arrange for funds to be readily available for the replacement of the asset at the end of its effective commercial life. A fixed amount is debited to the profit and loss account each year; and a corresponding amount of cash is invested every year in securities, the amount being sufficient to accumulate at compound interest to the sum equal to the cost of the asset less residual value, if any. The investment is usually made in fixed interest bearing securities with a redemption date as near as possible to the date on which the funds will be required to replace the asset. The amount to be invested each year is ascertained by reference to the compound interest tables. The asset is shown in the books at it original cost. The credit balance of the sinking fund represents the depreciation provided. At the end of the effective commercial life of the asset, the balance in the sinking fund will be transferred to the credit of the asset, leaving the balance of the latter at the figure computed for the residual value. The most important advantage of this method is that funds will be readily available when replacement of the asset becomes necessary. This is because funds are invested outside the business in securities. It also avoids strain on the working capital of the business which might occur if substantial amounts have to be withdrawn from the business for the replacement of particular assets. Nevertheless, the desired goal may not materialize owing to the following reasons: (a) Price at which the asset has to be replaced is much higher than the original cost of the asset on the basis of which investments were made. (b) Changes in legislation (e.g., taxation system) have affected the dividends or interest received and the amount realized on sale of the investments. (c) The market value of the investments has fallen considerably so that the realized value is much lower than that expected originally. In addition, since the funds are invested outside the business it may affect its working capital position. It may be that the funds could be more profitably used within the business itself. 5. Compound Interest Method (also known as Annuity Method) Under this method, the purchase of the asset is regarded as an investment of capital which, if employed for other purposes, would be earning a certain rate of
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interest. Interest at this fixed rate is, therefore, debited to the asset account each year and credited to an interest and depreciation account. The asset is then written down under the straight line method so that it eliminates the asset or brings it down to its residual value, if any, after charging it with interest on the value of the asset at the commencement of each year. The amount to be written off every year is calculated from the Annuity Tables. This method is usually applied to the writing off of leases. It is not suitable for assets like plant and machinery since fresh calculations will have to be made every time additions are made. Though pointed out as the most scientific system when investment is not desired out of the business, this method is criticized on the ground that it introduces an uncertain element, i.e., the rate of interest, which is bound to be arbitrarily arrived at, and also that it is not sufficiently conservative in the early years, so that if obsolescence supervenes the true depreciation will not have been made. 6. Insurance Policy Method Under this method an endowment policy is taken out for the amount required to replace the asset at the end of its effective life. The steps are similar to those under the Sinking Fund Method except that the investments take the form of annual payments to an insurance company, while no interest on investments is actually received. The advantage of this method is that, although the interest earned is often lower than that could be earned by investing the amount in securities, the risk of loss on realization, which could arise on the sale of securities, is eliminated. 7. Depletion Unit Method This method is generally used in the case of wasting assets like mines, quarries, oil fields, etc which are consumed in the form of basic raw materials or where the output is sold as such. Under this method, total contents of the asset is estimated and on the basis of this depreciation is worked out in proportion to the expired capital outlay according to the produce extracted. Sometimes a minimum annual charge is provided for depreciation even if the produce extracted has not reached the minimum. 8. Renewals Reserve Method This method is not used commonly. Under it round sums, not necessarily computed by reference to the useful lives of the assets, and sometimes determined largely by the result of the years trading, are provided and set
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aside as general provisions towards meeting the cost of future renewals. It does not accord with a strict view of depreciation and may distort the annual charges to revenue. 9. Machine Hour Method Also known as Efficiency Hours Method or Hours of Service Method or Unit of Production Method In the case of machines, the depreciation provision may be based on the number of hours that they were operated during the period compared with the total expected running hours during the machines commercially useful lives. For instance, if a machine costs `50,000 and has an expected commercially useful life of 10,000 hours with a residual value of `10,000, depreciation can be provided at the rate of `4 for every hour it has operated during a particular accounting period. The method can be applied only if it is possible to keep accurate records of the running hours of the machine concerned. It has the merit of burdening each accounting period with the exact amount of depreciation appropriate to the use of the machine. It is important to give due consideration to the fact that some depreciation normally takes place even when the machine is not in use. 10. Mileage Method This method is similar to the one explained above except that the commercially useful life of the asset is worked out in terms of miles or kilometres, e.g., in the case of vehicles. 11. Global Method This method does not accord with the strict view of depreciation. Under it, a flat rate is charged to all assets taken together. It does not make any distinction between various types of assets.
11. The straight line method of providing audit is also known as fixed installment method. (True/ False) 12. Under the diminishing balance method, an equal amount is charged as depreciation for each year of expected use of the asset. (True/ False) 13. In the reducing balance method, the balance of unapportioned costs will increase each year. (True/ False) 14. Revaluation method is especially used in the case of assets of very long life and high value. (True/ False)
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15. The ________ method is used mainly to arrange for funds to be readily available for the replacement of the asset at the end of its effective commercial life. 16. Under the________ method, the purchase of the asset is regarded as an investment of capital which, if employed for other purposes, would be earning a certain rate of interest.
5.5 Auditors Duties as Regards Depreciation

The auditor is generally not in a position to estimate the working life of most of the assets of a company. He needs to rely on the inputs provided by others, such as technical experts for machinery, etc. however, he is responsible for ensuring that the process of valuation is honest and transparent. 1. A method of depreciation appropriate in each particular case should be adopted. 2. The fixed assets register should be examined to ascertain the cost of each asset, the provision made for its depreciation, and the bases of provisions made. 3. It should be ensured that the amount of depreciation provided is neither too small nor too great. 4. In the case of a limited company, the relevant provisions in the Companies Act, explained earlier, should be adhered to. 5. The method adopted should be followed consistently. Otherwise the usefulness of periodic accounts for the purpose of comparison of one period with another will be vitiated. 6. Where the auditor is of the opinion that the provision made for depreciation is insufficient, and he is unable to induce his client to adopt his point of view, the matter should be dealt with in the audit report. Change in the method of computing depreciation As observed earlier, whatever method and rate of depreciation used, the provision for depreciation should be applied on a consistent basis from one period to another. Any change in the basis of providing depreciation from one year to another amounts to a change in the method of accounting, the result of which in terms of profits should be disclosed by way of a note to the profit and loss account. A switch over from the straight line method to the reducing balance method is an instance of such a change. Also, should the rates of depreciation
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be changed in a particular year, the effect on the profits should be explained in the note, if material. Where a company revalues its assets to a higher figure, the depreciation provided on the revalued figures would be higher than the depreciation figure computed on the asset figure before revaluation. According to the Research Committee of the Institute of Chartered Accountants of India, under such circumstances it would appear that a note would not be strictly necessary as the effect of revaluation would be apparent from the face of the accounts. However, in the Committees opinion, it would be desirable to insert an explanatory note.
17. The auditor himself can estimate the working life of most of the assets of a company. (True/False) 18. The fixed asset register should be examined to ascertain the cost of each asset, the provision made for its depreciation, and the bases of provisions made. (True/False) 19. In case the auditor is of the opinion that the provision made for depreciation is insufficient, and he is unable to induce his client to adopt his point of view, the matter should be ignored. (True/False) 20. A change in the basis of providing depreciation from one year to another amounts to a change in the method of accounting. (True/False)
5.6 Summary
Let us recapitulate the important concepts discussed in this unit: Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put out of use by him/ her. Depreciation may be considered as a decrease in the utility value of a fixed asset over a period of time. This decrease in its value may arise from a variety of factors, some internal others external. Wear and tear, exhaustion and depletion are examples of internal depreciation. Obsolescence or effluxion of time are instances of external depreciation. There are several reasons as to why depreciation should be provided.
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Depreciation is based or assessed and the rate of depreciation is computed taking into consideration certain factors. There are several methods of providing depreciation such as fixed installment method, diminishing balance method, annuity method, depreciation fund method, insurance policy method, revaluation method, compound interest method, depletion unit method, renewable reserve method, use or kilometer (mileage) method, efficiency hours method and global method. The auditor has certain duties as regards depreciation.
5.7 Glossary
Amortization: The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time. Depreciation: That part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put out of use by him. Effluxion of time: The conclusion or expiration of an agreed term of years specified in the deed or writing, such conclusion or expiration arising in the natural course of events, in contradistinction to the determination of the term by the acts of the parties or by some unexpected or unusual incident or other sudden event. Obsolescence: Being in the process of passing out of use or usefulness; becoming obsolete

1. Explain the meaning and causes of depreciation. 2. Give reasons why depreciation needs to be provided. 3. What are the important factors in assessing depreciation? 4. Explain the straight line or fixed installment method of providing depreciation. 5. Explain the reducing or diminishing balance method of providing depreciation. 6. Differentiate between revaluation method and sinking fund method of providing depreciation. 7. What are the auditors duties as regards depreciation?
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1. False 2. True 3. False 4. Internal 5. Obsolescence, effluxion 6. Amortization 7. Physical 8. Conservatism 9. Diminishing 10. Recovery 11. True 12. False 13. False 14. True 15. Sinking fund method 16. Compound interest or annuity method 17. False 18. True 19. False 20. True

1. Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put out of use by him. Refer to Section 5.2 for further details. 2. Depreciation is an important factor in accounting, as it helps to maximize profits with in house accounting control. Refer to Section 5.3 for further details.
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3. The important factors in computing the rate of depreciation are the cost of the asset, its effective life and the degree of use to which it will be put, residual value which it will fetch at the end of its effective life and foreseeable risk of obsolescence. Refer to Section 5.3.1 for further details. 4. Under this method an equal amount is charged as depreciation for each year of expected use of the asset. Refer to Section 5.4 for further details. 5. Under this method, the asset is depreciated by a fixed percentage on the diminishing balance of the account. Refer to Section 5.4 for further details. 6. Sinking fund method is used mainly to arrange for funds to be readily available for the replacement of the asset at the end of its effective commercial life, while revaluation method is used in case of assets of very short life such as loose tools. Refer to Section 5.4 and 5.4 for further details. 7. The auditor is responsible for ensuring that the process of valuation is honest and transparent. Refer to Section 5.5 for further details.

1. Kumar R and Sharma V, Auditing: Principles and Practice, New Delhi: PHI Learning Pvt. Ltd., 2006 2. Shekhar L and Shekhar KC, Auditing, 20th edn, Delhi: Vikas Publishing House, 2003 3. Khan and Jain, Management Accounting, 4th edn, New Delhi: Tata McGrawHill, 2007 Reference 1. Specified period in respect of any depreciable asset shall mean the number of years at the end of which at least ninety five per cent of the original cost of the asset to the company will have been provided for by way of depreciation if depreciation were to be calculated in accordance with the provisions of section 350.(sub section (5))
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Unit 6
Structure
Verification and Valuation of Assets and Liabilities
6.1 Introduction Objectives 6.2 Definition and General Principles 6.3 Verification and Valuation of Fixed Assets 6.4 Current Assets 6.5 Methods of Valuation of Stock in Trade 6.6 Verification of Liabilities 6.7 Summary 6.8 Glossary 6.9 Terminal Questions 6.10 Answers 6.11 Further Reading/Reference
6.1 Introduction
In the last unit, you studied about depreciation and its various aspects, including its causes, bases and methods of providing for depreciation. In this unit, you will study the verification and valuation of assets and liabilities. Assets and liabilities are important components of a companys balance sheet. Valuation and verification of these is essential to obtain an accurate picture of a companys financial status and health. The unit defines assets and liabilities and outlines the general principles related to these. It then differentiates between the verification and valuation of fixed assets. Current assets, verification of liabilities, etc., are also discussed.
Objectives
After studying this unit, you should be able to: Define assets and, their types Differentiate between verification and valuation of assets Explain the auditors position as regards valuation of assets Describe the verification and valuation of different classes of fixed assets
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Describe the verification and valuation of different classes of current assets Describe the verification and valuation of liabilities, including contingent liabilities
6.2 Definition and General Principles

Before we study the various aspects of assets and liabilities, let us understand the meaning of these terms. The term asset refers to a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Assets can be of two types fixed and current. Fixed assets: Fixed assets are those that are acquired by a business for the purpose of use in the business with the object of earning revenue and which are not intended for resale at a profit and conversion into cash in the ordinary course of business. They may broadly be classified into tangible and intangible assets. Tangible assets are those which have definite shape and which can be seen, e.g., plant and machinery, motor vehicles, land and buildings, furniture and fittings, investment property, etc. Intangible fixed assets are those that are not perceptible by touch; but nevertheless employed in the business for earning revenue, e.g., patents, copyrights, trademarks, goodwill, deferred expenditure such as development costs and franchises, etc. Current assets: Current assets refer to a balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash (investopedia.com).
6.2.1 Valuation and Verification of Assets

Valuation of assets: Valuation is a method of assessing the worth of a company, real property, security, antique or other item of worth. It is commonly performed prior to the sale of an asset or prior to purchasing insurance for an asset. Verification of assets: Verification refers to the process conducted by auditors to confirm that a company's assets actually exist. This may be performed by one to several auditors that will take a company's books and confirm that each asset listed is accounted for. Some of these auditors may be specialists on the auditing of a specific type of asset, which helps prevent an auditor from having
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to account for assets that he/she does not know exactly how to verify. An auditor may examine financial records, contracts, and other policies to verify any asset that is not physically at the company (investorwords.com).
6.2.2 Difference between Verification and Valuation

Verification is carried out in order to prove the existence, ownership and title to assets whereas in the case of valuation it certifies the value as at the date of the balance sheet. Verification is carried out for both assets and liabilities whereas in the case of valuation only the values of assets are certified. Auditor does the work of verification. Valuation is done by appropriate experts and responsible officials. Evidence is the basis of verification. Certificates issued by the officials form the basis of valuation.
6.2.3 Auditors Position as Regards Valuation of Assets

At the very outset, it may be noted that an auditor is not a valuer and he/she cannot be expected to act as such. Valuations are made by appropriate experts or responsible officials of the entity who have practical knowledge of the items concerned. The auditors duty is to test whether the valuation is fair and reasonable and that it is in accordance with accepted principles. As observed in the Kingston Cotton Mill company Case, an auditor is not guilty of negligence if he/she accepts the certificate of a responsible official in the absence of suspicious circumstances. According to the observations:
"...........It is the duty of the auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with a 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 in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite his suspicion he should probe it to the bottom, but in the absence of anything of that kind, he is only bound to be reasonably cautious and careful............."
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1. The term _______refers to a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. 2. Fixed assets may broadly be classified into ________and _____assets. 3. The duty of the _______is to test whether the valuation is fair and reasonable and that it is in accordance with accepted principles. 4. Cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash come under current assets. (True/ False) 5. Verification a method of assessing the worth of a company, real property, security, antique or other item of worth. (True/ False)
6.3 Verification and Valuation of Fixed Assets

As fixed assets are acquired by a business with the object of earning profits and are not held for resale in the ordinary course of business, they are valued on the going concern basis. In other words, fixed assets are valued at cost less provision for depreciation or amortization arising from wear and tear, obsolescence, etc. Where there has been a permanent increase in the values of certain fixed assets such as freehold land, the valuation of an expert may be taken into the books of account in place of cost, subject to the provision that any profit arising therefrom is an unrealized profit which is not normally available for distribution. Fixed asset register: For the verification of fixed assets, it is essential to maintain an accurate and up-to-date fixed asset register. Large manufacturing companies should invariably maintain a register of their fixed assets in order to control and identify the assets that have been acquired for permanent use in the business. A fixed asset register should contain the following information in respect of each fixed asset. date of purchase, with reference to the authority given name and address of supplier and cost location, brief description and identifying number rate of depreciation to be applied
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date of sale, scrapping or transfer, with reference to the authority given and details of amounts received dates on which the asset has been physically verified in order to ensure that it is still in use at its specified location where any investment grants have been received, details of the same Fixed asset registers should be maintained for the following reasons: It enables the enterprise to have a record of all the fixed assets that it owns. It facilitates periodical verification of fixed assets. It facilitates the correct computation of depreciation, particularly in case of disposal of assets. It assists in ensuring that additions and disposals of fixed assets are properly accounted for in the books of the enterprise. It assists in ensuring that there is proper control over fixed assets. It enables a check to be made periodically that the rates of depreciation are appropriate. In the case of a limited company there is also the matter of compliance with presentation provisions under the Companies Act. It assists in arriving at insurance valuations and insurance claims. Audit approach in relation to fixed assets: The general audit objectives in connection with fixed assets are: Completeness: to ensure that all fixed assets owned by the entity at the end of the accounting period have been recorded. Existence: to ensure that the recorded fixed assets were in existence at the end of the accounting period and remain in use by the entity. Ownership: to ensure that the recorded fixed assets were properly owned by the entity at the end of the accounting period and that all liens and other encumbrances on them have been properly identified. Valuation: to ensure that the recorded fixed assets were properly valued at the end of the accounting period in accordance with statutory provisions and generally accepted accounting principles. Disclosure: to ensure that the disclosure of fixed assets is in accordance with statutory provisions and generally accepted accounting principles.
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6.3.1 Goodwill
Goodwill may be defined as the excess of the value of a business as a whole over the fair value of its accountable net identifiable assets, including identifiable intangibles such as trademarks, patents, etc. Where a business is purchased as a going concern, the difference between the purchase price and the net assets acquired indicates the price paid for goodwill. The usual accounting treatment of goodwill is to write off the same over a number of years. The amount so far not written off is shown in the balance sheet. The auditor should review this item for its reasonableness and consistency of amounts between years.
6.3.2 Land and Buildings

In the case of freehold properties, the original title deeds should be examined. It should be ensured that they are free from any mortgage. Strictly speaking, verification of title deeds has to be done by a solicitor. Where the title deeds are deposited with bankers for safe custody, a certificate should be obtained from the bankers that they are held for safe custody and that they are free from any lien, mortgage or other charges. Where land has been purchased along with building/s, the vendors sale deed needs to be verified. It must be ensured that the allocation of purchase price as between land and building/s has been made by an appropriate expert unless there is some other sufficient appropriate evidence showing their costs separately. This is important since depreciation is provided on buildings while no depreciation is normally provided on land. Where the building has been constructed by the client entity, the architects certificate has to be obtained on the cost and the extent of completion of the building. Where the building has been constructed by a contractor, the agreement with the contractor regarding the terms of agreement needs to be checked. In the case of leasehold property, the item needs t be verified by inspecting the original lease. Where the client is not the original lessee, verify the item by inspecting the original lease together with the assignment thereof. If the property is held in the name of a nominee for the client, a letter of acknowledgment therefrom should be obtained. If the lease is acquired during the current accounting period, the cost of the property should be vouched. Where the lease was acquired previously and additions have been made to the property during
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the current accounting period, the cost of such additions should be vouched by reference to correspondence with solicitors, contractors accounts, architects certificate, etc. Provision for depreciation should be on such a basis that the total cost of the lease together with the cost of building/s that may have been erected on the land subsequently is extinguished on the date when the lease is due to expire.
6.3.3 Plant and Machinery

Check whether the expenses for the erection of plant and machinery are properly capitalized. Where the items are purchased on hire purchase or instalment system, examine the relevant agreements. Make sure that the amounts outstanding along with interest and other charges are shown as liability. Check the computation of hire purchase interest and see that the allocation to revenue is correct. In the case of motor vehicles, check the registration books and ensure that the client is the registered owner. In the case of new vehicles examine the invoices. Examine the insurance policies. Make sure that the premia are up to date. 6.3.4 Patents and Trademarks
Where the client is the owner of a number of trademarks and/or patents, obtain a schedule showing their particulars and verify them with the relevant certificates. Where a trademark/patent is acquired by assignment, vouch the amount paid by reference to the assignment. Make sure that the same is treated as capital expenditure. Where a trademark/patent is registered by the client, vouch the amounts treated as capital expenditure (e.g., registration fees) and ensure that the amounts capitalised in respect of staff salaries, overheads, etc (for the time utilised to the design of the trade mark/patent) are easonable. See that the amounts paid for the renewal of the trade mark/patent are charged to revenue. Examine the last renewal receipt to ensure that the trade mark/patent has not been allowed to lapse.
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See that the trade mark/patent is shown in the balance sheet at cost less depreciation to date.
6.3.5 Investments
Audit of investments has to be carried out very carefully since they represent assets with high inherent audit risk. It may be repeated here that inherent audit risk is derived from the characteristics of the client and the expectation of errors prior to the consideration of the effects of internal controls. It varies according to the accounts item being examined and verified. Investments are one such item and they carry high inherent audit risk as a result of the factors mentioned below. 1. Investments which are in the nature of fixed assets are valued at cost less any permanent fall in value. On the other hand, investments which are in the nature of current assets are valued at cost price or net realizable value whichever is lower. This, in turn, causes the auditor to refer to some measure of current market value of the investments. The ascertainment of current market value is often complicated and involves the subjective assessment of the clients management (e.g., directors of a company). For instance, valuation of unlisted securities is difficult since there is no established market price. In the case of listed securities, the market value at the date of the financial statements may be ascertained from the Official Lists of recognised stock exchanges. Here also it should be remembered that stock exchanges are often very volatile and that there is a risk that valuation has to be supplemented by post balance sheet events in relation to the movements in the prices of securities concerned. 2. Many investments are readily marketable and thud they could be converted into cash without much difficulty. The point involved in this is that chances of fraud and defalcation are more in the case of such investments. Also, forged investment certificates and investments in fictitious companies are to be guarded against. In short, the auditor is faced with an inherent risk in the audit of investments as a result of greater possibilities of fraudulent activities in relation to this asset. 3. Chances of fraud are more as regards income from investments since they are received at irregular intervals and in irregular amounts. There is a greater possibility that such income may not be posted to the accounting records.
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6. Fixed assets are valued on the _______basis. 7. Companies should maintain a ________of their fixed assets in order to control and identify the assets that have been acquired for permanent use in the business. 8. Where a business is purchased as a going concern, the difference between the purchase price and the net assets acquired indicates the price paid for_________. 9. If the client is the owner of a number of trademarks and/or patents, a schedule should be obtained showing their particulars and these should be verified against the relevant certificates. (True/ False) 10. Investments that are in the nature of fixed assets are valued at cost price or net realizable value whichever is lower. (True/ False)
6.4 Current Assets

Current assets, which otherwise are known as floating assets, are cash and other assets acquired by a business for subsequent conversion into cash, e.g., stock in trade, book debts, bills receivable, etc. The basic principle of valuation of such assets is cost price or market price whichever is lower. Audit approach in relation to current assets The general audit objectives in connection with current assets are more or less on the same lines as with fixed assets. In more specific terms, they are as follows: Completeness: to ensure that all current assets owned by the entity at the end of the accounting period have been recorded. Existence: to ensure that the recorded current assets were in existence at the end of the accounting period. Ownership: to ensure that the recorded current assets were properly owned by the entity at the end of the accounting period and all liens, security interests and other encumbrances have been properly identified. Valuation: to ensure that the recorded current assets were accurately valued at the end of the accounting period in accordance with the entitys
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accounting policies applied on a consistent basis and generally accepted accounting principles. Disclosure: to ensure that the disclosure of current assets is in accordance with generally accepted accounting principles.
6.4.1 Cash in Hand

The internal controls relating to cash should cover the following points: Definite rules should be in force as to the size of cash floats to meet expenses and their method of reimbursement. Similarly, rules should be in force as to cash floats at cash desks and cash registers. Cash floats should be regularly verified by independent officials. Procedures should be laid down for the control of funds held in trust for employees, e.g., unclaimed wages. Only properly authorized persons should be allowed to have access to cash department and cash registers.
6.4.2 Cash at Bank

The internal control procedures in operation should ensure that there is a proper division of responsibilities between the following: officials approving vouchers for payment officials having custody of unused cheque books officials preparing cheques and recording payments officials signing cheques
6.4.3 Sundry Debtors1

Internal controls relating to trade debtors are closely associated with internal controls relating to sales. As such they are discussed together in the following paragraphs. Internal controls relating to sales and trade debtors should be so devised as to ensure that there is proper division of responsibilities between: accepting customers orders control of credit
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control and dispatch of goods processing and recording of invoices collection of cash Proper controls should be in force in the following areas: recording and processing of orders granting of credit facilities goods dispatched preparation of invoices preparation of credit notes recording of invoices and credit notes
11. Current assets are also known as ________assets. 12. The basic principle of valuation of current assets is cost price or market price whichever is lower. (True/False)
6.5 Methods of Valuation of Stock in Trade

Stock in trade (inventories) are generally the second largest item in the financial statements of an enterprise, especially in the case of manufacturing organizations. As such, this item needs extremely careful treatment in that both verification and valuation of inventories assume importance. Inventories are normally classified in the financial statements under the following heads: Raw materials and components Work-in-process Finished goods Stores and spares
6.5.1 Internal Controls Relating to Stock in Trade

It is not possible to lay down any hard and fast rules as to the detailed procedures to be adopted in connection with inventory control or stock control. Such
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procedures depend on the size of the organization, the quantity and variety of inventories, etc. In general, the following points need attention: Proper arrangements should be made for receiving, checking and recording goods inwards. A responsible official should undertake the duty of safeguarding inventories. Proper precautions should be taken against theft, misuse and deterioration. Arrangements should be made for controlling inventories through maximum and minimum stock limits so that materials are readily available whenever required, at the same time ensuring that inventories are not unnecessarily large. Proper procedures should be laid down for recording inventories through stock ledgers, independent control accounts and continuous stock records such as bin cards. Proper procedures should be laid down for physically checking inventories at periodical intervals and comparing the same with inventory records. Arrangements should be made for the periodical review of the condition of inventories and writing off damaged and obsolete items under proper authority. Movements of inventories out of store or from one process to another should be properly authorised, evidenced and recorded. The arrangements for the issue of inventories should ensure that lots received earlier are automatically issued first. Proper arrangements should exist for dealing with and maintaining control over inventories of the business held by others. Procedures should be laid down to control and account for waste, and receipts from the disposal of such items. Proper cut off procedures should be in operation. Custody of inventories should be segregated from control over the records. Detailed, clear and foolproof instructions should be issued in connection with annual stocktaking. Proper basis should exist for computing the amount at which inventories are to be stated in the accounts. The concept of consistency should be followed in such computation.
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6.5.2 Valuation of Inventories, or Stock in Trade

The item inventories is a current asset. The items included in inventories are held for subsequent conversion into cash in the ordinary course of business through sale or for use in the process of production of finished goods or services or for consumption in the production of such finished goods or services. The valuation of inventories is of utmost significance since the value attached to inventories can materially affect the operating results and financial position of an entity. The basic principle of valuation of inventories as pointed out by the Institute of Chartered Accountants of India is cost or net realizable value, whichever is lower. The Accounting Standard AS2 issued by the Institute of Chartered Accountants of India states that this basic principle should be followed in all cases subject to the following exceptions. Inventory of consumable stores and maintenance supplies should ordinarily be valued at cost although they may be valued at below cost in appropriate circumstances. Inventory of by-products should be valued at cost or net realizable value, whichever is lower. In case it is not possible to ascertain the cost of the by-product, the same should be valued at net realizable value. Inventory of reusable waste should be valued at raw material costs less reprocessing cost in case facilities for reprocessing exist. Net realizable value should be the basis of valuation in the case of inventory of non-reusable waste or inventory of usable rewaste where facilities for reprocessing do not exist. The statement further clarifies that special considerations apply in the case of inventories associated with the following: plantations, forestry, agricultural commodities and livestock; extractive industries such as mining, quarrying, etc; work in progress under long term contracts, such as engineering, real estate development and construction projects; securities such as shares, debentures, etc held as stock in trade; immovable properties; loose tools. Having stated that the basic principle of valuation of inventories should be cost or net realizable value whichever is lower, it is necessary to explain the meaning of cost and net realizable value.
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6.5.3 Methods of Computing Costs

Different methods are used for computing costs. The important among them are as follows: Unit cost method: Under this method, the total cost is ascertained by aggregating the individual cost of each article, batch, parcel or other unit. The disadvantage of this method is that it is not always applicable, either because the individual units lose their identity (e.g., where inventories are bulked or pass through a number of processes) or because it would involve undue expenses or complexity to keep individual records of cost particularly where these necessitate allocation of expense. First in, first out (FIFO) method: Under this method, cost is ascertained on the assumption that goods sold or consumed are those which have been longest on hand and those remaining in stock represent the latest purchases or production. The main advantage of this method is that the stock in hand tends to represent a fairly up to date cost. Average cost method: Under this method, cost is ascertained by averaging the amount at which stock is brought forward at the beginning of a period with the cost of stock acquired during the period, consumption in the period is then deducted at the average cost thus ascertained. The periodical rests for calculating the average will be as frequent as the circumstances and nature of the business require and permit. This method tends to give a lower amount than the cost of unsold stock computed under the first in, first out method during periods of rising price levels. On the other hand, during periods of falling price levels it tends to give a higher amount compared to first in, first out method. Standard cost method: Under this method, a predetermined or budgeted cost per unit is used. It is particularly useful where items pass through a number of processes or are manufactured on mass production lines; but it will not result in a fair approximation to actual cost unless there is a regular review of the standards with appropriate adjustments and revisions wherever necessary. Adjusted selling price method (also known as retail inventory method): Under this method, the items are first valued at normal selling prices and then a reduction is made at normal gross profit margins. This method is employed in the retail trade where the margins may be largely standardised for large groups of items. The calculation of the estimated gross profit margins may be made for individual items or group of items or by departments, as may be appropriate in the circumstances of each particular case. This method is also employed by some manufacturing organisations for ascertaining the value of finished items
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held against forward sale contracts. When making use of this method it is important to remember that reductions in selling prices should be reflected while determining stock values as otherwise the items in question will be valued below cost. Last in, first out (LIFO) method: Under this method, cost is computed on the assumption that stocks consumed or sold are from the latest production or purchases and those remaining in stock represent the earliest production or purchase. This method is criticised mainly on two grounds, viz., (i) it rarely accords with business reality from a Balance Sheet point of view, and (ii) during periods of inflation it tends to state inventories at lower than actual cost. The main advantage of this method is that it provides management with profits information based on comparing sales with current production costs. Specific identification method: Under this method, specific costs are attributed to identified goods that have been produced or purchased and are segregated for a specific purpose. Base stock method: Under this method, it is assumed that a minimum quantity of inventory known as base stock is necessary at all times to carry on business. Inventories up to this level are valued at the cost at which base stock was acquired. Inventories beyond this level are valued by using any one of the above methods. This method has only a limited application since it requires a clear existence of the circumstances that a minimum level of inventory is required at all times to carry on business.
6.5.4 Net Realizable Value

Net realizable value (NRV) is the amount estimated to be realized from the disposal of stocks in the ordinary course of business, either in their existing condition or as incorporated in the products normally sold, after deducting all costs of completion and disposal. For this purpose, selling prices should be net of trade discounts. The costs which have to be incurred for the purpose of bringing the inventories to the state in which they are normally sold to customers are the costs of completion. As observed at the very outset, in accordance with the principle of conservatism, inventories should not be shown in the financial statements in excess of amounts expected to be realized in the ordinary course of business. In other words, the basic principle of valuation of inventories should be historical cost or net realizable value, whichever is lower. This is because historical cost of inventories may not be realized under certain circumstances. For example,
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there could be a permanent fall in selling prices, or the items may have become wholly or partially obsolete, or the quantity of inventories may be so large that it is unlikely that they will be sold or utilized within the normal turnover period. In all such cases, it is necessary to write down inventories to net realizable value so that the loss in profit earning capacity is recognized in the period in which it becomes apparent. Historical cost and net realisable value can be compared in respect of each item of inventory, or for groups of similar interchangeable articles separately. But the total of all dissimilar and non interchangeable items or all the inventories on an overall basis should not be compared since it may result in setting off loss against unrealized profit. Normal quantities of materials and other supplies held for use in production are not written down below historical cost where the finished products are expected to be sold at or above historical cost. Similarly inventories of maintenance supplies and consumable stores are ordinarily valued at cost although they are valued at less than cost in appropriate cases.
13. _________are generally the second largest item in the financial statements of an enterprise, especially in the case of manufacturing organizations. 14. The item inventories is a ________asset. 15. The basic principle of valuation of inventories should be _____or _________whichever is lower. 16. The amount estimated to be realized from the disposal of stocks in the ordinary course of business, either in their existing condition or as incorporated in the products normally sold, after deducting all costs of completion and disposal is referred to as ___________.
6.6 Verification of Liabilities

Liabilities refer to a company's legal debts or obligations that arise during the course of business operations. They include loans and borrowings, trade creditors and other current liabilities, deferred payments, intalments to be paid, etc. These are settled over time through the transfer of economic benefits including money, goods or services.
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Verification of liabilities is an extremely important part of auditing, as without this, the balance sheet of a company will not reflect an accurate picture of the companys financial status. Verification of liabilities is carried out by the following steps: Analysis of records Direct confirmation procedure Examination of disclosure Analytical review procedures Obtaining management representations
6.6.1 Sundry Creditors

Internal controls relating to trade creditors are closely associated with internal controls relating to purchases. As such they are discussed together in the following paragraphs. Internal controls relating to purchases and trade creditors should be so devised as to ensure that proper controls are in operation in the areas of authorization, custody and recording procedures. In particular, it should be ensured that (a) the goods ordered for are those the organization requires, the right quantity and the right quality and they are obtained on the most advantageous terms; (b) the goods received are in accordance with those ordered for; (c) the goods received and accepted are properly recorded in the books during the period to which they relate; (d) the payments are made in respect of goods accepted; (e) credit is obtained in respect of goods returned.
6.6.2 Outstanding Expenses

Outstanding expenses include prepayments, accrued income, unearned income and unpaid expenses. It may be recalled that one of the fundamental accounting concepts which underlies the preparation of periodic financial statements of a business enterprise is the accruals concept which states that revenue and costs are accrued, i.e., they are recognized as they are earned or incurred, not as money received or paid. Hence, it is important that all items of prepayments, accrued income, unearned income and unpaid expenses should be brought
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into account in the preparation of financial statements. It is equally important that accrued income is brought into account only if there is reasonable certainty that such income will be received in due course. Expenses incurred during the current financial year but a part of which relates to subsequent periods should be appropriately be apportioned as between the periods during which the benefit will be received. Insurance prepaid, rent and rates prepaid, advertising charges prepaid, commission prepaid, office stationery bought in advance, spare parts for motor vehicles and machinery bought in advance, etc., are examples of such prepayments. The apportionment of such expenses may be made on a time basis or on a revenue basis or on an inventory basis. For example, insurance prepaid could be apportioned on a time basis; advertising charges prepaid could be apportioned on the basis of the revenue produced by the same; office stationery bought in advance could be apportioned on the basis of the actual physical consumption of the stationery. It may be noted that for balance sheet purposes prepayments and accrued income should be treated as outstanding assets. Outstanding liabilities: As in the case of outstanding assets mentioned in the above paragraph, there could be outstanding liabilities in respect of unearned income (e.g., rent received in advance) and/or unpaid expenses (e.g., rent for that part of the period coinciding with the date of the financial statements, but before the regular date on which rent is paid; wages and salaries due as at the date of the financial statements, but before the regular pay date; interest payable till the date of the financial statements; etc.). Necessary adjustments should be made in the financial statements in respect of such outstanding liabilities. Audit procedures in relation to prepayments, accrued income, unearned income and unpaid expenses Arrange for a listing of the items of prepayments, accrued income, unearned income and unpaid expenses for the current financial period and compare this list with a similar list for the previous period and investigate into any material variations. Review the lists of expenses for material items where a prepayment or unpaid expense could be expected. Examples of such expenses include rent, rates, insurance, office stationery, interest, etc. Carry out further investigations wherever necessary. Make sure that the necessary adjusting entries are made in the impersonal ledger.
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Ensure that the necessary adjustments are made in the profit and loss account and balance sheet. Scrutinize the cash book records for the period immediately following the date of the financial statements in order to identify any items which relate to the period under review.
6.6.3 Contingent Liabilities

According to the Accounting Statement AS4 issued by the Institute of Chartered Accountants of India, a contingency is a condition or situation, the ultimate outcome of which, gain or loss, will be known or determined on the occurrence or non-occurrence of one or more uncertain future events. Contingent gains are not generally accounted for in the financial statements in the light of the prudence concept. But contingent liabilities are accounted for in the financial statements. Contingent liabilities are possible liabilities of presently determinable amounts or indeterminable amounts that have arisen from past dealings or actions which may not become legal obligations in future. The uncertainty as to whether any legal obligation will arise is the distinguishing feature of contingent liabilities. This uncertainty distinguishes them from actual liabilities for which provisions are required in the financial statements. Contingent liabilities may arise from a number of sources such as: pending law suits against the client in respect of faulty goods, infringement of patent rights and other alleged breaches of contracts; bills discounted; debts sold to factors, with recourse; product warranties or guarantees; guarantees given on behalf of directors or officers of the client entity or on behalf of subsidiary companies; contracts signed but which have yet to be carried out either fully or partly. It may be noted that contingent liabilities will not be recorded in the books of account. The auditor should first seek information from the management of the client entity concerning the estimates of contingent liabilities and should obtain a written assurance from the appropriate official or director concerned that he/she is not aware of any contingent liability other than those disclosed. Normally, this is included in the letter of representation obtained from the management. During the course of the audit, the auditor should be alive to the
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possibility of contingent liabilities being in existence. In addition, the following audit procedures may be undertaken to identify the existence of contingent liabilities, especially in relation to pending legal claims against the client: Evaluate the system in operation in the client entity for recording claims and the procedures followed for bringing them to the attention of the management. Examine correspondence with third parties/solicitors for any evidence of legal claims. Examine the minutes of the Board of directors or other appropriate committee for any evidence of legal claims. Obtain a list of matters referred to solicitors from the management of the client entity concerning legal claims with estimates of potential liability. In those cases where matters have been referred to solicitors for advice or action, the auditor should request the client to advice the solicitors to furnish the auditor with details of the claims together with an estimate of the likely outcome of each claim. The reply from the solicitor should be sent direct to the auditor. In appropriate cases, it would be advisable for the auditor and the client to arrange a meeting with the solicitors to discuss the position. On the basis of enquiries on the above lines, if the auditor is satisfied, absence of corroboration of the completeness of a list of legal claims need not be considered as a sufficient reason to qualify the audit report. On the other hand, where the auditor discovers matters not previously identified as a result of his enquiries or where material claims are outstanding and the auditor is unable to obtain sufficient appropriate evidence to enable him to a conclusion, then a qualification to the audit report is inevitable and the reasons for the qualification should be explained. Disclosure of contingent liabilities: In the case of limited companies, the Companies Act stipulates that the following should be disclosed by way of notes to the financial statements: Claims against the company which are not acknowledged as debts. Where partly paid shares are held, the amount of liability in respect of uncalled capital. Arrears of fixed cumulative dividend. Estimates of contracts remaining to be executed on capital account and not provided for.
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Guarantees executed by the company on behalf of directors and other officers of the company together with the general nature of each such contingent liability, if material. All other contingent liabilities. Where a contingent liability is disclosed, the following information should be given in the financial statements: the nature of the contingency; the uncertainties which affect the future outcome; an estimate of the financial effect made at the date on which the financial statements are approved by the directors or a statement that such an estimate cannot be made.
17. A company's legal debts or obligations that arise during the course of business operations are known as ________. 18. Prepayments, accrued income, unearned income and unpaid expenses come under ________.
6.7 Summary
Let us recapitulate the main points discussed in this unit: The term asset refers to a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Assets can be of two types fixed and current. Fixed assets are those assets acquired by a busi9ness for the purpose of use in the business with the object of earning revenue and which are not intended for resale at a profit or conversion into cash in the ordinary course of business. They may be tangible assets or intangible assets. They are valued on the going concern basis. Before carrying out detailed audit tests on fixed assets, the auditor should examine the internal control procedures relating to them. Large manufacturing companies should maintain a fixed asset register. There are certain reasons for maintaining such a register.
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The general audit objectives in connection with fixed assets are (i) completeness, (ii) existence, (iii) ownership, (iv) valuation, and (v) disclosure. There are some differences between verification and valuation. Auditors position as regards valuation of assets is that an auditor is not a valuer and he/she cannot be expected to act as such. In relation to specified categories of fixed assets such as goodwill, land and buildings, plant and machinery, patents and trademarks and investments, there are certain points to be noted in addition to the audit approach applicable to fixed assets in general. Current assets are cash and those assets acquired by a business for subsequent conversion into cash. The basic principle of their valuation is cost price or market price whichever is lower. In relation to the verification and valuation of current assets such as cash in hand, cash at bank, sundry debtors, stock in trade, the auditor has certain duties. In relation to verification and valuation of liabilities such as sundry creditors, outstanding expenses and contingent liabilities, the auditor has certain duties to perform.
6.8 Glossary
Asset: A resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Current assets: Current assets refer to a balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Fixed assets: Fixed assets are those that are acquired by a business for the purpose of use in the business with the object of earning revenue and which are not intended for resale at a profit and conversion into cash in the ordinary course of business. Goodwill: The excess of the value of a business as a whole over the fair value of its accountable net identifiable assets, including identifiable intangibles such as trademarks, patents, etc. Liabilities: A company's legal debts or obligations that arise during the course of business operations. They include loans and borrowings, trade
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creditors and other current liabilities, deferred payments, intalments to be paid, etc. Net realizable value (NRV): The amount estimated to be realized from the disposal of stocks in the ordinary course of business, either in their existing condition or as incorporated in the products normally sold, after deducting all costs of completion and disposal. Valuation of assets: A method of assessing the worth of a company, real property, security, antique or other item of worth. It is commonly performed prior to the sale of an asset or prior to purchasing insurance for an asset. Verification of assets: A process conducted by auditors to confirm that a company's assets actually exist.

1. Define the term asset and explain the types of assets with examples. 2. Differentiate between valuation and verification of assets. Explain the auditors position as regards valuation of assets. 3. Explain the process of verification and valuation of fixed assets. 4. What are current assets? Explain the internal controls relating to the different types of current assets. 5. Explain the verification and valuation of stock in trade (inventories). 6. Explain the different methods of computing costs. 7. What are liabilities? Explain the internal controls relating to sundry trade creditors, outstanding expenses and contingent liabilities.

1. asset 2. Tangible, intangible 3. auditor 4. True 5. False
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6. going concern 7. register 8. goodwill 9. True 10. False 11. Floating 12. True 13. Stock in trade (inventories) 14. Current 15. Cost, net realizable value 16. Net realizable value (NRV) 17. Liabilities 18. outstanding assets

1. The term asset refers to a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Refer to Section 6.2 for further details. 2. Valuation is a method of assessing the worth of a company, real property, security, antique or other item of worth. It is commonly performed prior to the sale of an asset or prior to purchasing insurance for an asset. Refer to Section 6.2.1, 6.2.2 and 6.2.3 for further details. 3. As fixed assets are acquired by a business with the object of earning profits and are not held for resale in the ordinary course of business, they are valued on the going concern basis. Refer to Section 6.3 for further details. 4. Current assets, which otherwise are known as floating assets, are cash and other assets acquired by a business for subsequent conversion into cash, e.g., stock in trade, book debts, bills receivable, etc. Refer to Section 6.4 for further details. 5. Verification and valuation of inventories is very important, as stock in trade (inventories) are generally the second largest item in the financial
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statements of an enterprise, especially in the case of manufacturing organizations. Refer to Section 6.5 for further details. 6. Different methods are used for computing costs. Refer to Section 6.5.3 for further details. 7. Liabilities refer to a company's legal debts or obligations that arise during the course of business operations. Refer to Section 6.6 for further details.

1. Shekhar L and Shekhar KC, Auditing, 20th edn, Delhi: Vikas Publishing House, 2003 2. Khan and Jain, Management Accounting, 4th edn, New Delhi: Tata McGrawHill, 2007 Reference 1. The amounts to be shown under sundry debtors shall include the amounts due in respect of goods sold or services rendered or in respect of other contractual obligations but shall not include the amounts in the nature of loans or advances.
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Structure
Companys Auditor
7.1 Introduction Objectives 7.2 Appointment, Removal and Remuneration of Auditors 7.3 Qualifications and Disqualifications of Auditors 7.4 Powers, Rights and Duties of Auditors 7.5 Liabilities of Auditors - Civil and Criminal 7.6 Summary 7.7 Glossary 7.8 Terminal Questions 7.9 Answers 7.10 Further Reading/References
7.1 Introduction
In the last unit, we studied about the assets and liabilities of a company and understood how important they were in obtaining a clear picture of a companys financial health. This is possible only with the help of auditors, who play a vital role in a company. Auditors examine several aspects of the business, including employees, apart from checking the financial records. They keep track of the companys assets and liabilities, as well as ensure the efficient use of resources in order to serve an organization best. Based on their analysis of these aspects, they put forward solutions for rectifying financial imbalance and other unprofitable areas in a company. In this unit, we will take a close look at the role of auditors, including their appointment, qualifications, powers, duties and liabilities.
Objectives
After studying this unit, you should be able to: Discuss the appointment, removal and remuneration of company auditors Describe the qualifications and disqualifications of company auditors Explain the powers, rights and duties of company auditors Discuss the liabilities of company auditors civil and criminal
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7.2 Appointment, Removal and Remuneration of Auditors

Auditors of limited companies are appointed in terms of the provisions of the Indian Companies Act, 1956. As such it is imperative that they should be fully conversant with the provisions of the Companies Act relating to their appointment, reappointment, removal, rights, duties, etc. Section 224 of the Indian Companies Act, 1956 (the Act) deals with the appointment and remuneration of auditors. In terms of that section: 1. At each annual general meeting (AGM), every company has to appoint an auditor to hold office until the next AGM. 2. The auditor appointed as above has to inform the Registrar whether the appointment has been accepted or not. 3. At any AGM, a retiring auditor shall be reappointed subject to certain conditions. 4. In case auditors are not appointed or reappointed at an AGM, the Central Government may appoint an auditor. 5. The first auditor of a company shall be appointed by the Board of Directors within one month of the date of the registration of the company, who holds office till the first AGM. Such an auditor may be removed by the company at a general meeting subject to a notice of at least 14 days before the date of the meeting being given. 6. Where the Board fails to appoint the first auditor, the company in general meeting may appoint the first auditor. 7. Any casual vacancy in the office of an auditor may be filled by the Board unless such a vacancy has been due to the resignation of the auditor in which case the vacancy has to be filled in a general meeting. 8. An auditor can be removed before the expiry of the term only in general meeting after obtaining the previous approval of the Central Government. 9. Remuneration of the auditor is fixed by the Board/general meeting/central government. Provisions as to Resolutions for Appointing or Removing Auditors Section 225 of the Act contains provisions relating to resolutions for appointing or removing auditors. The relevant provisions are as follows:
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1. Special notice shall be required for a resolution at an annual general meeting appointing as auditor a person other than the retiring auditor, or providing expressly that a retiring auditor shall not be reappointed. 2. On receipt of notice of such a resolution, the company shall forthwith send a copy thereof to the retiring auditor. 3. Where notice is given of such a resolution and the retiring auditor makes with respect thereto representations in writing to the company (not exceeding a reasonable length) and requests their notification to members of the company, the company shall, unless the representations are received too late for it to do so, (a) in any notice of the resolution given to members of the company, state the fact of the representations having been made; and (b) send a copy of the representations to every member of the company to whom notice of the meeting is sent, whether before or after the receipt of the representations by the company; and if a copy of the representations is not sent as aforesaid because they were received too late or because of the companys default the auditor may (without prejudice to his right to be heard orally) require that the representations shall be read out at the meeting: Provided that copies of the representations need not be sent out and the representations need not be read out at the meeting if, on the application either of the company or any other person who claims to be aggrieved, the Company Law Board is satisfied that the rights conferred by this sub section are being abused to secure needless publicity for defamatory matter; and the Company Law Board may order the companys costs on such an application to be paid in whole or in part by the auditor, notwithstanding that he is not a party to the application. 4. Sub sections 2 and 3 shall apply to a resolution to remove the first auditors or any of them under sub section 5 of section 224 or to the removal of any auditor or auditors under sub section 7 of that section, as they apply in relation to a resolution that a retiring auditor shall not be reappointed. 5. The auditor of a government company is appointed or reappointed by the Comptroller and Auditor General of India.
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1. Auditors should be fully conversant with the provisions of the _______relating to their appointment, reappointment, removal, rights, duties, etc. 2. The auditor of a government company is appointed or reappointed by the _______of India.
7.3 Qualifications and Disqualifications of Auditors

Section 226 of the Companies Act deals with the qualifications and disqualifications of auditors. In terms of that section: Only a chartered accountant can be appointed as a company auditor. None of the following persons shall be qualified for appointment as auditor of a company: (a) a body corporate; (b) an officer or employee of the company; (c) a person who is a partner, or who is in the employment, of an officer or employee of the company; (d) a person who is indebted to the company for an amount exceeding one thousand rupees, or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the company for an amount exceeding one thousand rupees; (e) a person holding any security of that company after a period of one year from the date of commencement of the Companies (Amendment) Act, 2000. Elaborate requirements concerning the appointment, reappointment, removal, qualifications and disqualifications of auditors are incorporated in the legislation with a view to ensuring that audit of limited companies is carried out by persons possessing the necessary expertise. In addition, independence is guaranteed to the auditor through the relevant provisions concerning his/her reappointment and removal. For instance, the provision stipulating that notice shall be sent to the auditor whose displacement is sought and to all members of the company and the provision stipulating that in the case of representations made by such an auditor copies of the representations shall be sent to all
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members of the company are aimed at preventing the removal of an auditor without the knowledge of all members of the company. In short, the ultimate authority to appoint auditors of a company rests with the members of the company except in the case of appointment of auditors before the first annual general meeting or in the case of a casual vacancy. Even in such cases, the Act contains suitable provisions to safeguard the interests of the members of the company. Thus the auditor of a company is responsible to the members of the company and has to act on their behalf, and not on behalf of the directors. Of course, the auditor will be coming into personal contact with the directors in their dealings with the accounts of the company; but it should be appreciated that here the directors are acting in the capacity of agents for the members in carrying out the day-to-day activities of the company. It is not unusual for the auditors to disagree with the directors in their opinion on the financial statements. This in itself does not justify the removal of auditors unless the members of the company do not have confidence in the judgment, competence or conduct of the auditors as their representatives. In addition to the requirements specified in the Companies Act, as indicated earlier, an auditor proposed to be appointed in the place of an existing auditor has a duty to communicate with the retiring auditor to find out whether there is any professional reason why the proposed auditor should not accept the appointment. Failure to do this will be considered as professional misconduct with the resultant disciplinary proceedings. The primary object of this provision is to ensure the independence of auditors in carrying out their examination of accountants and the expression of their opinion without fear or favour.
7.3.1 Professional Competence and Technical Standards

An audit should be carried out and the audit report should be prepared only by persons who have adequate training, experience and competence in auditing. And the auditor should be careful to exercise due skill and professional care throughout his work. What is due skill and professional care will depend on the circumstances of each particular case. So also the extent of training, experience and competence required of audit assistants will depend on the gradations and functions of work carried out by them. It need hardly be emphasized that specialized skills and competence are required of an auditor. These are acquired through a combination of general education, technical knowledge obtained through study and formal courses concluded by a qualifying examination, and practical experience under proper guidance and adequate supervision. It is of
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utmost importance that an auditor should refrain from undertaking or continuing any audit assignment which he is not competent to carry out unless he obtains such advice and guidance as will enable him to carry out his assignment successfully. It is equally important that an auditor should have a continuing awareness of developments including relevant national and international pronouncements in the fields of accounting and auditing, and relevant regulations and statutory requirements. This is to ensure that his client receives the advantage of competent professional advice based on up to date developments in practice, legislation and techniques. Integrity and objectivity: Integrity and objectivity are preeminent qualities expected in all auditors. An auditor should be straightforward, honest and sincere in his approach to professional work. He must be fair and should not allow prejudice or bias to override his objectivity. Independence: An auditor must approach his work with an independent attitude. He should not do anything which would adversely affect that independence. As a matter of fact, independence is an essential concomitant to integrity and objectivity. It is the quality which permits the auditor to apply unbiased judgment and objective consideration to established facts in arriving at an opinion. In considering the situations which may come into conflict with an auditors independence, the following matters are important and they should be given due consideration: Financial involvement, direct or indirect, in a clients affairs, e.g., in the case of a limited company being in the position of a shareholder, loans to or from clients, etc. Cases where an auditor or a firm of auditors earn the major part of the professional income from one client or a group of connected clients. Personal and family relations. For instance where the same partner or member of staff is in charge of the audit of a particular client for a number of years; where the auditor has a mutual business interest with an officer or employee of a client; where the auditor has an interest in a joint venture; close friendship or relationship by blood or marriage; etc. Acceptance of audit assignments on a contingent fee basis. Confidentiality: An auditor should respect confidentiality of information acquired in the course of performing his work and should not disclose any such information unless there is a specific authority from the client or unless there is a legal or
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professional reason for disclosure. It is equally important that he should ensure that the principle of confidentiality is observed by the members of staff under his control and others from whom he obtains advice and assistance. Ethical behaviour: It is the duty of the auditor to refrain from any conduct which might bring discredit to the profession. The code of conduct laid down by the relevant professional body in this regard should be strictly observed. Such a code, inter alia, covers such aspects as the responsibilities to the clients, to the members of the same professional body, to fellow auditors, to the third parties, and the general public. Reliance on work performed by others: Where an auditor relies on work performed by other auditors (e.g., branch auditors appointed under the Companies Act) or experts or his own assistants, he should ensure that such persons have adequate skills and competence to carry out their work and should carefully direct, review and supervise their work. Documentation: It is important that an auditor should document matters which are important in providing sufficient evidence that the audit was carried out in accordance with the basic principles governing an audit. Such documentation should be aimed at recording and demonstrating the steps taken by the auditor to enable him to form an opinion on the financial statements under his examination. Audit planning: Proper planning of the audit work is a necessary pre requisite for the effective and efficient conduct of an audit. Planning should be continuous throughout the engagement and plans should be revised to suit the developing circumstances.
3. Only a chartered accountant can be appointed as a company auditor. (True/ False) 4. An officer or employee of the company may be appointed the auditor in case he is qualified. (True/ false) 5. The auditor of a company is responsible to the members of the company and has to act on behalf of the directors. (True/ false) 6. Integrity and objectivity are preeminent qualities expected in all auditors. (True/ false)
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7.4 Powers, Rights and Duties of Auditors

As stated earlier, auditors play a vital role in a company. Their powers, rights and duties are discussed below. Right of access to books, accounts and vouchers and right to require information: Every auditor of a company has a right of access to the books and accounts and vouchers of the company and is entitled to require from the officers of the company such information and explanations as the auditor may think necessary for the performance of his/her duties as auditor. The right entitling the auditor to require from the officers of the company such information and explanations as he thinks necessary for the performance of his duties as an auditor is a very significant one. The point to be noted here is that it is up to the auditor to decide what information and explanations are necessary. The directors or officers of the company are not entitled to argue that a specific piece of information or explanation is not necessary for the performance of the duties of the auditor. In case this happens and in case a particular piece of information or explanation is refused on this ground, the auditor will have no alternative other than to report that he has not obtained all the information and explanations he required. 2. Right to attend general meetings of the company 3. Right of lien over the books and documents in the auditors possession 4. Right of working papers With regard to working prepared by an accountant in connection with accounting work and/or auditing work, they belong to the accountant and he is entitled to retain them where the relationship between the client and the accountant is that of a client and a professional person.
7.4.1 Duties of Company Auditors

Section 227 of the Indian Companies Act, as amended in 1960, 1965, 1999 and 2000, deals with the duties of company auditors. In terms of Section 227 (2) of the Act, company auditors are required to make a report on the accounts of a company audited by them and on every balance sheet and profit and loss account and on every document declared by the Act to be part of or annexed to the balance sheet and profit and loss account, which are laid before the company in general meeting during their tenure of office.
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Under the Companies Act, it is the duty of the auditor to state in his/her report whether in the opinion of the auditor and to the best of his/her information and according to the explanations given to him/her, the said accounts give the information required by the Act in the manner so required and give a true and fair view: (i) in the case of the balance sheet of the state of the companys affairs as at the end of the financial year; and (ii) in the case of the profit and loss account, of the profit or loss for the financial year. It is further provided that the duty of the company auditor to state in the report: (a) whether he/she has obtained all the information and explanations to the best of his/her knowledge and belief which were necessary for the purpose of his/her audit; (b) whether in his/her opinion, proper books of account as required by law have been kept by the company so far as appears from his/her examination of those books, and proper returns adequate for the purpose of his/her audit have been received from the branches not visited by him/her; (c) whether the report on the account of any branch office audit under Section 228 by any person other than the companys auditor has been forwarded to him/her as required by that section and how he/ she has dealt with the same in preparing the auditors report; (d) whether the companys balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and returns; (e) whether in his/her opinion the profit and loss account and balance sheet comply with the accounting standards referred to in sub section 3C of Section 211;1 (f) in thick type or in italics the observations or comments of the auditor which have any adverse effect on the functioning of the company;2 (g) whether any director is disqualified from being appointed as director as director under clause (g) of sub section (1) of Section 274.3 Where any of the matters referred to in (i) and (ii) or in (a), (b), (c), (d) and (e) above is answered in the negative or with a qualification, it shall be the duty of the auditor to state in his/her report the reason for the answer.
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Further, the Central Government may, by general or special order, direct that, in the case of such class or description of companies as may be specified in the order, it shall be the duty of the auditor to include in his/her report on such matters as may be specified therein. The Act also imposes a duty on the part of the auditor to make an enquiry regarding the following matters (Section 227 (1A) : (a) whether loans and advances made by the company on the basis of security have been properly secured and whether the terms on which they have been made are not prejudicial to the interests of the company; (b) whether transactions of the company which are represented by mere book entries are not prejudicial to the interests of the company; (c) where the company is not an investment company within the meaning of Section 372 or a banking company, whether so much assets of the company bas consist of shares, debentures and other securities sold at a price less than at which they were purchased by the company; (d) whether loans and advances made by the company have been shown as deposits; (e) whether personal expenses have been charged to revenue account; (f) where it is stated in the books and papers of the company that any shares have been allotted for cash, whether cash has actually been received, whether the position as stated in the account books and balance sheet is correct, regular and not misleading. It may be noted in this connection that according to the Research Committee of the Institute of Chartered Accountants of India, the auditor is not required to report on the matters specified above, unless he/she has any special comments to make on any of these. If he/she is satisfied as a result of the enquiries, he has no further duty to report that he/she is so satisfied. The absence of any comments, therefore, equivalent to a positive statement by the auditor that he/she has investigated and satisfied himself/herself on all these matters.
7. Every auditor of a company has a right of access to the ______and vouchers of the company.
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8. The auditor has the right to attend the _______of the company. 9. It is the duty of the company auditor to state in the report whether he/she has obtained all the information and explanations to the best of his/her knowledge and belief which were necessary for the purpose of his/her audit. (True/ false) 10. The auditor does not have the right to check on the loans and advances made by the company. (True/ false)
7.5 Liabilities of Auditors - Civil and Criminal

Liabilities of auditors, in their professional capacity, arise mainly from the following sources, namely: (a) Liabilities under the Contract Act (b) Liabilities under the relevant statute, e.g., the Companies Act and/or the Penal Code, the Income Tax Act, the Chartered Accountants Act, etc Liabilities under the Companies Act may again be sub divided into civil liability and criminal liability. In the case of a private audit, the liabilities of an auditor are mainly dependent on the terms of his engagement Liability for Professional Negligence Liability for professional negligence arises irrespective of whether it is a private audit or a company/statutory audit. It is a common rule of law that a person who owes a duty to another is expected to act without negligence when the former discharges his duty to the latter. In the case of an accountant, he is expected to act with reasonable care and skill while discharging his duties. What is reasonable care and skill depends on the particular circumstances of each case. Nevertheless, this phrase certainly implies that the accountant/auditor has to carry out his work in accordance with the generally accepted accounting/ auditing standards issued by the professional bodies from time to time and that it should be in step with contemporary accounting/auditing practices. While considering any charge of dereliction of duty or negligence, the courts of law is almost certain to judge the merits of the case by reference to the criteria of reasonable care and skill. In this connection it should be remembered that what exactly constitutes reasonable care and skill is subject to change, in step with changes in legislation and standards of professional work in general. In these times of litigation consciousness, accountants/auditors in general are well aware of the liability that they may have to face in case a charge of negligence
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is levelled against them. The best way to counter these charges is for the accountant/auditor to satisfy himself concerning the scope and quality of the work they have carried out and that the work is in conformity with the requirements of best practice. Penalty for Non-Compliance by Auditor with Sections 227 and 229 So far the discussion was around the civil liabilities of an auditor in relation to professional negligence. Section 233 of the Indian Companies Act as amended in 2000stipulates that:
"If any auditors report is made, or any document of the company is signed or authenticated, otherwise than in conformity with the requirements of sections 227 and 229, the auditor concerned, and the person, if any, other than the auditor who signs the report or signs or authenticates the document, shall, if the default is willful, be punishable with fine which may extend to ten thousand rupees."
Criminal Liability In considering the criminal liability of an accountant/auditor, the relevant provision in the Income Tax Act is of relevance. In terms of the Income Tax Act, an authorized representative (which includes an accountant/auditor) who is found guilty of abetting or inducing an assessee in filing a false account, statement or declaration which he knows to be false or does not believe to be true is criminally liable. According to the relevant provision
"If a person abets or induces in any manner another person to make and deliver an account or a statement or a declaration relating to any income chargeable to tax which is false and which he either knows to be false or does not believe to be true or to commit an offence under sub section (i) of section 276 C, he shall be punishable: (i) in a case where the amount of tax, penalty or interest, which would have been evaded, if the declaration, account or statement had been accepted as true, or which is willfully attempted to be evaded, exceeds one hundred thousand rupees with rigorous imprisonment for a term which shall not be less than six months but which may extend to seven years and with fine; (ii) in any other case, with rigorous imprisonment for a term which shall not be less than three months but which may extend to three years and with fine."
The Indian Penal Code also contains a provision relating to the issue of false certificates which is of relevance to accountants/auditors. According to the relevant provision:
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"Whoever issues or signs any certificate required by law to be given or signed or relating to any fact which such certificate is by law admissible in evidence, knowing or believing that such certificate is false in any material point, shall be punishable in the same manner as if he gives a false evidence."
With particular reference to limited companies, sections 68, 539, 545 and 628 of the Indian Companies Act are of relevance.
11. Liabilities of auditors, in their professional capacity, arise mainly from two sourcesliabilities under the ________and liabilities under the relevant statute. 12. Liability for_________arises irrespective of whether it is a private audit or a company/statutory audit.
7.6 Summary
Let us recapitulate the main points discussed in the unit: Auditors of limited companies are appointed in terms of the provisions of the Indian Companies Act, 1956. At each annual general meeting (AGM), every company has to appoint an auditor to hold office until the next AGM. Section 226 of the Companies Act deals with the qualifications and disqualifications of auditors. In terms of that section, only a chartered accountant can be appointed as a company auditor. An audit should be carried out and the audit report should be prepared only by persons who have adequate training, experience and competence in auditing. An auditor needs to have integrity and objectivity, independence, confidentiality, and ethical behaviour. An auditor has the following rights and powers -- right of access to books, accounts and vouchers and right to require information, right to attend general meetings of the company, right of lien over the books and documents in the auditors possession and right of working papers. Section 227 of the Indian Companies Act, as amended in 1960, 1965, 1999 and 2000, deals with the duties of company auditors.
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Liabilities of auditors, in their professional capacity, arise mainly from the following sources, namely: (a) Liabilities under the Contract Act and (b) Liabilities under the relevant statute, e.g., the Companies Act and/or the Penal Code, the Income Tax Act, the Chartered Accountants Act, etc. Liabilities under the Companies Act may again be sub divided into civil liability and criminal liability. Liability for professional negligence arises irrespective of whether it is a private audit or a company/statutory audit.
7.7 Glossary
Civil liability: Potential responsibility for payment of damages or other court-enforcement in a lawsuit, as distinguished from criminal liability, which means open to punishment for a crime. Criminal Liability: The liability that arises out of breaking a law or committing a criminal act. Liability: an obligation, responsibility, or debt; a company's legal debts or obligations that arise during the course of business operations Lien: A legal claim against an asset which is used to secure a loan and which must be paid when the property is sold.

1. Discuss the appointment, removal and remuneration of auditors. 2. Explain the qualifications and disqualifications of auditors. 3. Discuss the professional competence and technical standards required of auditors. 4. What are the powers, rights and duties of auditors? 5. Explain the duties of company auditors. 6. What are the liabilities of auditors? Explain both civil and criminal liabilities.
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1. Companies Act 2. Comptroller and Auditor General 3. True 4. False 5. False 6. True 7. books and accounts 8. general meetings 9. True 10. False 11. Contract Act 12. professional negligence

1. Auditors of limited companies are appointed in terms of the provisions of the Indian Companies Act, 1956. Refer to Section 7.2 for further details. 2. Section 226 of the Companies Act deals with the qualifications and disqualifications of auditors. Refer to Section 7.3 for further details. 3. An audit should be carried out and the audit report should be prepared only by persons who have adequate training, experience and competence in auditing. Refer to Section 7.3.1 for further details. 4. The powers, rights and duties include right of access to books, accounts and vouchers and right to require information. Refer to Section 7.4 for further details. 5. Section 227 of the Indian Companies Act, as amended in 1960, 1965, 1999 and 2000, deals with the duties of company auditors. Refer to Section 7.4.1 for further details.
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6. Liabilities of auditors, in their professional capacity, arise mainly from the following sources: (a) Liabilities under the Contract Act and (b) Liabilities under the relevant statute. Refer to Section 7.5 for further details.
7.10 Further Reading/References

1. Shekhar L and Shekhar KC, Auditing, 20th edn, Delhi: Vikas Publishing House, 2003 2. Khan and Jain, Management Accounting, 4th edn, New Delhi: Tata McGrawHill, 2007 3. Pandey, I M, Management Accounting, 3rd edn, New Delhi: Vikas Publishing House, 1994 References 1. Inserted by the Companies (Amendment) Act, 1999 2. Inserted by the Companies (Amendment) Act, 2000 3. Inserted by the Companies (Amendment) Act, 2000
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Unit 8
Structure
Share Capital, Dividends and Divisible Profits
8.1 Introduction Objectives 8.2 Audit of Share Capital 8.3 Profits, Divisible Profits and Dividends 8.4 Principles of Accountancy in Relation to Dividends 8.5 Memorandum of Association and Articles of Association 8.6 Reserves and Provisions 8.7 Summary 8.8 Glossary 8.9 Terminal Questions 8.10 Answers 8.11 Further Reading
8.1 Introduction
In the previous unit, you learnt about the qualifications required in an auditor and the process of appointment of an auditor. You also understood the structure of remuneration paid to an auditor and the process of his removal. The previous unit further delineated the powers, rights, duties and liabilities of company auditors. In this unit, you will become familiar with the concepts of share capital, dividends and divisible profits and their auditing ramifications. Provisions of the memorandum of association and articles of association will be focused upon. You will learn about the different kinds of reserves created by companies and the various provisions regarding payment of dividend.
Objectives
After studying this unit, you should be able to: Elaborate on the salient aspects of audit of share capital and transfer of shares Examine profits vis--vis divisible profits Explain the memorandum of understanding and articles of association along with their legal aspects
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Differentiate between provisions and reserves Analyse the duties of an auditor
8.2 Audit of Share Capital

The audit objectives concerning the verification of share capital in financial statements are to ascertain whether: (i) Share capital at the end of the year is properly recorded; (ii) Changes in share capital during the year are included in the accounts properly; (iii) Changes in the authorized or issued capital have been carried out under proper authorization such as properly authorized resolution of the members and/or board of directors; (iv) The relevant provisions relating to share capital contained in the articles and memorandum of association of the company as well as the relevant statutory provisions (i.e., the Companies Act requirements) have been complied with; (v) The record of shareholders maintained by the company is proper and accurate; and all issues, transfers, etc. relating to shares during the current period have been appropriately entered in the records. It would be advisable for the auditor to obtain a schedule from the client showing in summarized form the authorized and issued share capital as at the end of the year, classifying the same by class of shares and containing such relevant particulars as (a) Changes effected in the authorized and issued share capital together with are conciliation showing the figures at the end of the financial period with the figures as at the end of the previous financial period; (b) Calls in arrear and calls received in advance; (c) The amounts and dates of redemption of any redeemable preference shares; (d) Where cumulative preference dividends are in arrears, the amounts concerned and the period for which they have remained in arrears. In case the schedule as above is not forthcoming from the client, the auditor will have to prepare it himself. Even when the schedule is received from the client, the auditor is expected to ensure that the calculations on the schedule
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are correct. He should also check the reconciliation of the figures of authorized and issued share capital as at the beginning and close of the financial period and should compare them with the relevant figures in the financial statements. The auditor should tally the description and the amount of authorized capital in the schedule with those in the articles and memorandum of association of the company. Any changes in the authorized or issued share capital should be verified by reference to the prospectus (or, equivalent document), the allotment book/sheets and the board minutes and the minutes of the general meeting.
8.2.1 Audit Procedures in Relation to Issue of Shares

During the first year after the incorporation of the company, the auditor will have to carry out detailed audit procedures in connection with the issue of shares. Given below is a list of audit procedures to be performed in this connection: 1. Make sure that the provisions contained in the articles and memorandum of association of the company coupled with the prospectus or equivalent document (e.g., statement in lieu of prospectus) have been complied with. 2. Make sure that the allotment was made only after the amount of minimum subscription as stated in the prospectus (or, equivalent document) has been subscribed, and the sum payable on application for the amount so stated has been paid to and received by the company in cash or by cheque or other instrument. Also, see that the amounts received from the applicants for shares are deposited in a scheduled bank until the certificate to commence business is obtained or where such certificate has already been obtained, until the entire amount of minimum subscription has been received. 3. See that the amount payable on application on each share is not less than five per cent of the nominal value of the share. 4. Ensure that, before offering shares for public subscription, the company had made an application to one or more recognized stock exchanges for permission for the shares to be dealt in on such stock exchange or exchanges. Also, ensure that all amounts received from applicants were kept in a separate bank account maintained with a scheduled bank until the permission as above had been granted or until the disposal of an appeal against the refusal to grant such permission. Further, ensure that the amount standing to the credit of such bank account was utilized only for adjustment against allotment of shares (Refer to Section 73 of the Act).
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5. Ascertain whether permission has been obtained from the Controller of Capital Issues for the allotment of shares, wherever such permission is necessary. 6. In case the company has paid any brokerage or underwriting commission, see that this is in conformity with the provisions contained in Section 76 of the Act, that the articles of the company authorize such payment and that it is disclosed in the prospectus. Underwriting commission paid should be verified by reference to the underwriting contracts and receipts given by the underwriters. Ensure that the rate of commission paid does not exceed that authorized by the articles of the company or, five per cent of the price at which the shares are issued, whichever is less and that it agrees with the amount disclosed in the prospectus. Brokerage paid should be verified by reference to the stamps of brokers on application forms. 7. In case the company has entered into preliminary contracts, see that they are in accordance with the terms contained in the prospectus. 8. Ensure that the nominal value of the shares allotted is within the limits of the authorized and issued share capital and that allotments are in accordance with the provisions contained in the prospectus. 9. Verify the amounts received on application of shares by checking the entries in the Application and Allotment Book with the original applications together with the entries in the cash book and bank records and make sure that the money so received was deposited in a scheduled bank to comply with the requirements of Section 69 of the Act. Amount refunded to unsuccessful applicants should be vouched by reference to the copies of letters of regret, cash book and bank records (e.g., bank passbook/ bank statements). Check the journal entry debiting Share Application Account and crediting Share Capital Account and ensure the accuracy of the amount by reference to the Application and Allotment Book. 10. Check board minutes to see that the allotment of shares has been properly approved. Check entries in the Application and Allotment Book by reference to copies of letters of allotment. Verify the amount received on allotment of shares by checking the entries in the cash book. Ascertain the total amount payable on allotment. Check the journal entry debiting Share Allotment Account and crediting Share Capital Account and ensure the accuracy of the amount by reference to the Application and Allotment Book. Make sure that the return of allotment was filed with the Registrar of Joint Stock Companies within thirty days of the allotment (Refer to Section 75).
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11. In case calls have been made on shares, check the board minutes to see that such calls have been made on the basis of a properly approved resolution. Verify the amounts received in respect of the calls by reference to the counterfoils of the receipts. Check the Calls Book for calls due and the cash book for cash received and verify the entries in the Share Register. Check the journal entry debiting the Call Account and crediting Share Capital Account. Ascertain the total amount payable on calls and see whether calls in arrears have been arrived at correctly. Calls in arrears should be shown separately in the financial statements. See whether the company has received any calls in advance and, if so, whether the articles of the company allow such a procedure. Make sure that such calls in advance are also shown separately and that they are not shown as part of capital. Verify calls in advance by reference to the cash book, bank passbook/bank statements and counterfoils of receipts issued. 12. Where shares have been issued for consideration other than cash, examine the underlying contract in respect of which such shares have been issued and the board minutes to see that the issue has been authorized through a proper resolution. Also, ensure that the relevant contracts were produced to the Registrar of Joint Stock Companies for inspection and examination, and copies of such contracts and a return stating the number and nominal amount of shares so allotted, the extent to which they are to be treated as paid up and the consideration for which they have been allotted have been filed with the Registrar (Refer to Section 75). Further, make sure that such shares are shown separately in the financial statements.
1. Fill in the blanks: (a) Auditors should verify the brokerage paid in issue of shares by reference to the _______ of brokers on application forms. (b) The amount payable on application for issue of shares should not be less than ______ per cent of the nominal value of the share. (c) The transfer of shares and debentures is governed by the _____________ Act.
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8.3 Profits, Divisible Profits and Dividends

It is not an easy task to define the term profits. The Companies Act fails to give a clear definition of this term. Roughly it may be stated that profits mean the excess of current income over current expenditure. Although this definition has the advantage of brevity, it does not bring out clearly the nature or meaning of profits. The remarks made by Fletcher Moulton, LJ in the case of Spanish Prospecting Company Limited (1911) are highly pertinent in this connection. According to him:
...................Profits imply a comparison between the state of business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at two dates. If the total assets of the business at the two dates be compared, the increase which they show at the later date as compared with the earlier date (due allowance, of course, being made for any capital introduced or taken out of the business in the meanwhile) represents in strictness the profits of the business during the period in question.
These remarks imply that the term profits means the change in the net assets of an entity between any two accounting periods.
8.3.1 Effect of Wrong Calculation of Profit

Users of financial statements depend upon accurate financial statements to base their decisions. Hence it is necessary to ensure that calculation of profits of an entity is correct. For instance, if the value of stock in trade is wrongly arrived at, it causes an error in the cost of goods sold and consequently an error in arriving at gross profit and net income. This, in turn, causes the reported value of assets and owners equity on the balance sheet to be wrong. An understatement of stock in trade results in an understatement of owners equity and an overstatement results in overstatement of owners equity. In short, wrong calculation of profits will affect profits legally available for dividend, for distribution to investors in hybrid instruments like income bonds, for incentive payments to members of staff, for calculation of borrowing capacity, etc. It may be noted in this connection that there are different ways of arriving at profits which lead to widely different figures.
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8.3.2 Divisible Profits

The terms profits and divisible profits are sometimes used synonymously. In the case of a sole trader or a partnership firm, this is largely true since the proprietors are entitled, by and large, to distribute among themselves entire profits as shown by their profit and loss accounts. But as far as limited companies are concerned, the treatment is different. Profits as disclosed by financial statements of limited companies do not necessarily mean divisible profits. Divisible profits in the context of a limited company mean that part of the total profits earned by it which can legally be distributed among the shareholders in the form of dividends. This divergence arises because in the case of limited companies, it becomes a matter of great importance to protect the rights of various parties including shareholders, creditors and other third parties when considering how much of the profits as arrived at by the profit and loss accounts of the respective companies could be allowed to be distributed. Briefly the considerations are: (a) Provisions of the Companies Act (b) Provisions in the Memorandum and Articles of Association (c) Decided case laws having a bearing on distributable profits (d) Accounting principles Determination of Distributable Profits under the Companies Act The Indian Companies Act, 1956 does not define the term divisible profits. The dictionary meaning of the term is the share of the sum divided that falls to each individual by way of interest or otherwise. A better definition is that given in Halsburys Laws of England where the term is defined as the share of profits, whether at a fixed rate or otherwise, allocated to the holders of shares in a company. In the case of Kantilal Manilal (1961), the Supreme Court of India explained the ordinary meaning of the term dividend as the distributive share of profits or income of a company given to its shareholders. Although the Companies Act does not define the term divisible profits explicitly, it lays down the manner in which such profits should be arrived at in terms of sub-section (1) of Section 205.
8.4 Principles of Accountancy in Relation to Dividends

Check the authority of dividend declaration against the minutes of the meetings of the board of directors and the shareholders.
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1. Check the legality of dividend declaration against the relevant provisions in the articles of association of the company, the Companies Act and any relevant rules. In particular pay attention to the following: (a) Ascertainment of distributable profits as per Section 205 and provision for depreciation under Section 350 of the Companies Act; (b) Compliance with the Companies (Declaration of Dividends out of Reserves) Rules, 1975 where dividends are declared taking advantage of Section 205 A (3) of the Companies Act; (c) Compliance with the recommendations of the Research Committee of the Institute of Chartered Accountants of India where capital profits are included in distributable profits; (d) Transfer to reserves under Companies (Transfer of Profits to Reserves) Rules, 1975; (e) Transfer to reserves in terms of appropriate resolutions of the board of directors. 2. Check the amount of dividends declared for each class of shares by multiplying the number of outstanding shares by the dividend rate. Ensure that this amount agrees with the total of the dividend list. 3. In relation to separate bank account maintained for the payment of dividends, see that this bank account is reconciled by persons independent of duties connected with dividend lists and/or dividend warrants. 4. Ensure that the relevant provisions of Sections 205 A, 205 B, 205 C, 206 and 206 A are complied with. 5. Check an appropriate portion of paid dividend warrants to see that the names of the payees are correct and that the warrants appear to have been paid by the bank. 6. Check an appropriate portion of dividends paid to nominees with the authorities received from the shareholders. 7. Test check amounts paid to individual shareholders and trace them to the related accounts in the register of members. 8. Ensure that any restrictions on dividend payments are strictly observed. Satisfy that no dividends are declared or paid in violation of any legal or contractual restrictions or in excess of limitations voluntarily imposed by the board of directors. Companies (Temporary Restriction on Dividends) Act, 1974, the provisions of which have ceased to be operative with effect
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from July 1976, is an example of such restrictions. Relevant contracts and minutes of the meetings of board of directors/shareholders are other sources to check any restrictions on dividend payments. 9. In the case of interim dividends, ensure that the provisions contained in the Companies (Amendment) Act, 2000 are complied with. 10. Make sure that any arrears of dividends on cumulative preference shares are disclosed as a contingent liability.
8.5 Memorandum of Association and Articles of Association

Memorandum of Association This important document should be examined by the auditor to ascertain the provisions concerning the accounts of the company and to ensure that the issued share capital is within the authorized share capital as specified in the memorandum. The Objects Clause is also of special relevance to the auditor since any transaction in relation to activities outside the Objects Clause will be ultra vires the company and the auditor has a duty to point out this in his report. Failure to report the same will make him liable for negligence. Articles of Association Articles of association contain the internal regulations of the company and as such the auditor should be well acquainted with the provisions contained therein. It should be noted that where a company has not registered separate articles, the regulations contained in Table A of the Act shall apply. Failure on the part of the auditor to get familiarized with the provisions of the articles of association and to make sure that these provisions have been complied with by the management in carrying out its duties will make the auditor liable for negligence. Following are a few examples of important matters which are found in the Articles of Association and which would be of interest and significance to the auditor: Provisions concerning: 1. Issue of share capital, rights attached to different classes of shares, variation of rights, minimum subscription, etc. 2. Payment of underwriting commission 3. Lien on shares
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4. Calls on shares, calls in arrears and calls paid in advance 5. Forfeiture of shares 6. Transfer and transmission of shares 7. Conversion of shares into stock 8. Share warrants 9. Reorganization of share capital 10. Dividend 11. Reserves and capitalization of profits 12. General meetings and proceedings at general meetings 13. Voting rights 14. Directors, their remuneration, qualifications, disqualifications, removal, etc. 15. Meetings of the board of directors and the proceedings thereat 16. Borrowing powers of the company and the directors 17. Appointment of managing director, manager, secretary, etc. 18. Common seal of the company 19. Payment of interest out of capital 20. Accounts and audit
2. Fill in the blanks: (a) ________ _________ are that part of the total profits which can legally be distributed among shareholders in the form of dividend. (b) Wrong calculation of profits affects the profits legally available for distribution as ________. (c) Articles of association contain the __________ regulations of a company.
8.6 Reserves and Provisions

Reserves are amounts that are earmarked by an entity from its retained earnings for future use, e.g., for meeting likely-to-be incurred bad debts. They are
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appropriations of profits. A provision is a liability of uncertain timing or amount. A present obligation of an entity arising from past events, the settlement of which will result in an outflow of resources is a liability. A provision is recognized if (i) an entity has a present obligation resulting from a past event, (ii) an outflow of resources will be necessary, and (iii) it is possible to make a reliable estimate of the amount of the obligation. Provision for legal claims is an example. Provision for bad debt is another example. In terms of generally accepted accounting principles and international financial reporting standards, a company has to report the allowances for doubtful items in the balance sheet and bad debts in the profit and loss account.
8.6.1 Kinds of Reserves

There are different kinds of reserves created and maintained by companies. The differences arise on account of the purpose for their creation and the source of their creation. Specific Reserve Auditors Duties A specific reserve is a reserve created by appropriation of profits in order to meet a definite purpose or to comply with the provisions in the Articles of Association or in terms of a decision by the board of directors. In addition, certain types of specific reserves may be required to be created in terms of contractual obligations or legal compulsion. Debenture Redemption Reserve is an example of the former and Development Rebate Reserve is an example of the latter. Generally speaking, specific reserves are available for dividend payments on the recommendation of the board of directors, subject to the approval of the shareholders. At the same time, certain kinds of specific reserves cannot be used for dividend payments. Examples of specific reserves include: (i) debenture redemption reserve created with a view to redeem the debentures by transferring a part of the profit every year; (ii) capital redemption reserve created where preference shares are to be redeemed out of profit in terms of Section 80 of the Companies Act; (iii) dividend equalization reserve created with the object of making payment of dividends at stable rates in different years irrespective of the profit earned; (iv) foreign project reserve created out of profits earned from foreign projects (the amount credited to the reserve has to be utilized within a period of 5 years for the purpose of the business itself and it is eligible for availing deduction under Section 80 III B; and (v) staff welfare reserve created for carrying on welfare activities of the members of staff of the entity.
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Although creation of specific reserves does not alter the true and fair view of the financial statements, the auditor has certain duties in relation to specific reserves, especially in the case of specific reserves which are to be created in terms of contractual obligations or legal compulsions. Their adequacy has to be verified and the auditor should ensure that they are not used for any purpose other than that for which they are created. Failure to do so will make the auditor guilty of negligence. The steps which the auditor should follow in connection with specific reserves are: 1. Peruse the Articles of Association to see whether there is any provision to create specific reserves. 2. Examine the directors minute book to see whether any decision has been taken for the creation of any specific reserve in which case whether the decision has been given effect to by the creation of the reserve concerned. 3. Examine the balance sheet to ensure that the specific reserves created have been shown in the balance sheet according to the requirement of Part I of schedule VI of the Companies Act. 4. Examine the related documents such as debenture trust deed to ensure that sufficient provision has been made in terms of the legal requirements and the utilization of the reserve, if any, has been done according to legal provisions. General Reserve By transferring a certain amount of profit from the account of retained earnings to the general reserve account, a general reserve is created. This is done to meet potential future unknown liabilities. American Institute of Accountants states that the use of the term reserve is limited to indicate that an undivided portion of the asset is being held or retained for general or specific purposes. Capital Reserve A capital reserve is a reserve created out of capital profits. A capital profit is one which does not arise in the normal course of business. Capital reserves are created out of the profits earned on the sale of fixed assets at prices above the cost, profits earned on revaluation of assets, profits earned prior to incorporation of the company, profits on reissue of forfeited shares, etc. Capital reserve is defined in Part III of schedule VI to the Companies Act according to which it is a reserve which does not include any amount regarded as free for distribution through profit and loss account.
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Normally, a capital reserve can be used for two purposes, viz., (i) for the issue of bonus shares subject to an appropriate provision in the Articles of Association, and (ii) for writing off intangible and fictitious assets. Companies Act does not specifically indicate whether capital reserves can be made available for dividend payments. In this connection cases such as Lubbock Vs The British Bank of South America and Foster Vs The New Trinidad Lake Asphalte Co Ltd throw light on the issue. In the former case: It was held that profit made on the sale of a part of the undertaking could be distributed as dividends, subject to the relevant permission in the articles of association. In the latter case, it was held that a realized appreciation in the value of one of the items of capital assets could not be deemed to be profits divisible among the shareholders, unless such surplus remains after a revaluation of the whole of the assets. Secret Reserves Secret reserves are reserves which are not disclosed in the balance sheet. They are also known as hidden reserves or internal reserves or inner reserves. They represent the surplus of assets over liabilities and capital. They do not appear in the ledger. Secret reserves are created by adopting such measures as charging capital expenditure to revenue, providing excessive depreciation/ excessive provision for bad and doubtful debts/ excessive discounts on sundry debtors, writing down goodwill to nominal value, undervaluing stock in trade, omitting some assets altogether from the books, showing contingent liabilities as actual liabilities, overvaluing liabilities, suppressing sales figures, etc. Secret Reserves Their Usefulness and Effects Secret reserves are created for different objectives. These objectives may be summarized as: meeting an extraordinary loss in future without disclosing the fact to the shareholders, strengthening the financial position of the entity, misleading trade competitors about the financial position of the company, manipulating prices of shares in the stock market, evading income tax and wealth tax, equalizing dividends (thus maintaining the financial stability of the company, etc. Objections to creation of secret reserves Creation of secret reserves is objected to on the following grounds: (i) Balance sheet will not show a true and fair view of the state of affairs of the company as required by the Companies Act. So also, the profit and
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loss account will not give a true and fair view of the profit/loss of the company because of the provision of excessive depreciation/excessive provision for bad and doubtful debts, etc. In short, secret reserves make the information disclosed by the financial statements false and incorrect. (ii) Directors of the company may make use of the secret reserves to conceal their weakness in terms of mismanagement. In other words, secret reserves may cover up the inefficiency and fraud committed by the directors. (iii) Where secret reserves are created by undervaluation of assets and an accident like fire occurs in the premises, the company will not be able to claim the full value of the assets since the insurance company will pay according to the book value of the assets. (iv) Secret reserves may enable members of the management of the company to indulge in speculation in the shares of the company for their own benefit. (v) Value of the shares will be affected adversely in the share market.
8.6.2 Duties of an Auditor

Auditors duty is to report whether the financial statements show a true and fair view as at the date of such statements. Creation of secret reserves will go against the true and fair view. As such, the duty of the auditor is obvious and he/she will not be justified in reporting that the financial statements show a true and fair view in case secret reserves exist. Even when such reserves have been created with honest intentions such as to strengthen the financial position of the company, the auditors position is not altered. He/she will have to qualify the report by stating that the financial statements do not show a true and fair view. Certain types of companies are permitted to create secret reserves. Even in their case, the auditor should ascertain the magnitude and the necessity of the creation of such reserves. Where he/she is satisfied that they have been created in the best interests of the company and that they are reasonable, the auditor is justified in not qualifying the report. It may be noted in this connection that a provision in the Articles of Association of the company forbidding the auditor from disclosing the fact concerning secret reserves is ultra vires the statutory duty of the auditor.
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3. Fill in the blanks: (a) __________ are amounts that are earmarked by a company from its retailed earnings for future use. (b) Capital reserves can be used for issue of __________ shares. (c) ___________ reserves are not declared in the balance sheet. (d) A __________ reserve is created by transferring a certain amount of profit from the account of retained earnings.
8.7 Summary
Let us recapitulate the important concepts discussed in this unit. There are specific audit objectives concerning the verification of share capital. It would be advisable for the auditor to obtain a schedule showing in summarized form the authorized and issued share capital as at the end of the year, classifying the same by classes of shares and containing the relevant particulars. This should be checked by the auditor and should be compared with the relevant figures in the financial statements. During the first year after the incorporation of the company, the auditor will have to carry out detailed audit procedures in connection with the audit of share capital. Companies Act contains detailed provisions concerning transfer/ transmission of shares/debentures. The Companies Act fails to give a clear definition of the term profits. Roughly, profit means the excess of current income over current expenditure. Users of financial statements depend upon accurate financial statements to base their decisions. Hence it is necessary to ensure that calculation of profits of an entity is correct. The terms profits and divisible profits are sometimes used synonymously. In the case of a sole trader or a partnership firm, this is largely true. But in
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case of limited companies, profits as disclosed by the financial statements need not necessarily mean divisible profits. Divisible profits is that part of the total profits which can legally be distributed in the form of dividends. When a dividend has been declared, it becomes a debt due by the company to the shareholders concerned. In the case of companies that have listed their shares in any recognized stock exchange, they should comply with the terms of standard listing agreement in relation to dividends. There are certain case laws that have a bearing on the payment of dividends. Memorandum of association and articles of association are two important documents that should be examined by the auditor to ascertain various provisions concerning the accounts of the company. There are certain differences between reserves and provisions. Reserves may be classified into specific reserves, general reserves, capital reserves and secret reserves. The auditor should follow appropriate procedures in relation to specific reserves. A capital reserve is a reserve created out of capital profits. Secret reserves are reserves that are not disclosed in the balance sheet. They are also known as hidden reserves or internal reserves or inner reserves. An auditor has certain duties in relation to various kinds of reserves.
8.8 Glossary
Divisible profits: That part of the total profits earned by a company that can be legally distributed among the shareholders as dividend. Current profits: Profits after tax, after statutory transfer to development rebate reserve and after providing for depreciation. Capital profits: Profits arising from activities other than normal trading activities; for example sale of a fixed asset. Interim dividend: Dividend declared in between two final dividends.
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1. Write a short note on the audit objectives concerning the verification of share capital in the financial statements of a limited company. 2. Describe the distinction between profits and divisible profits. 3. List the matters found in the Articles of Association of a company that would be of significance to the auditor. 4. What are the differences between provisions and reserves? 5. Describe the various kinds of reserves.

1. (a) stamps; (b) five; (c) Companies 2. (a) Divisible profits; (b) dividend; (c) internal 3. (a) Reserves; (b) bonus; (c) Secret; (d) general

1. Refer to Section 8.2 2. Refer to Section 8.3.2 3. Refer to Section 8.4 4. Refer to Section 8.5 5. Refer to Section 8.6.1

1. Kumar, Ravinder and Virender Sharma.2006. Auditing: Principles and Practice. New Delhi: PHI Learning Pvt. Ltd. 2. Shekhar, L and Shekhar KC. 2003. Auditing. 20th edition, Delhi: Vikas Publishing House.
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Structure
Audit of Different Types of Undertakings
9.1 Introduction Objectives 9.2 Audit of Co-operative Societies 9.3 Audit of Educational Institutions 9.4 Audit of Social Clubs 9.5 Audit of Hotels 9.6 Audit of Hospitals and Nursing Homes 9.7 Audit of Hire Purchase Companies 9.8 Audit of Leasing Companies 9.9 Summary 9.10 Glossary 9.11 Terminal Questions 9.12 Answers 9.13 Further Reading
9.1 Introduction
The previous eight units have familiarized you with the basic concept and processes of auditing along with the ancillary exercises that it entails. These include vouching, factoring in of depreciation, verification and valuation of assets and liabilities, audit of share capital, transfer of shares and creation and maintenance of reserves among others. You are now ready to learn about the conduct of audit in different kinds of undertakings and institutions that vary in terms of their constitution, their purpose and the service that they offer. We will begin with the complex system of auditing of accounts of co-operative institutions and go on to study the same in educational institutions, social clubs, hotels, hospitals and nursing homes, hire purchase companies and leasing companies.
Objectives
After studying this unit, you should be able to: Outline the audit process of co-operative societies Describe the audit process for educational institutions Delineate the audit procedures for other entities like social clubs, hotels, hospitals and nursing homes
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9.2 Audit of Co-operative Societies

Audit of a co-operative institution is not merely a financial audit. The auditor of a co-operative institution is not merely expected to satisfy himself by examining the books of accounts. In addition, he has to ensure that the institution is working in accordance with the co-operatives principles, the relevant Act and rules, and the directions issued by the appropriate authority. Hence, an audit of a cooperative institution may be regarded as an administrative audit also. Co-operative audit may also be described as a critical examination of the documentary and other evidence with the help of which the profit and loss account and the balance sheet of a co-operative institution have been prepared in order to report that they exhibit a true and fair view of the summary of transactions for the period under audit. The audit of a co-operative institution is the statutory responsibility of the Registrar of Co-operative Societies. He delegates his powers in this regard to his subordinates who conduct the audit and submit the audit report to him.
9.2.1 Appointment of Auditor

The auditor of a co-operative institution is appointed by the Registrar of Cooperative Societies. The accounts of every co-operative institution are required to be audited once in each year. For efficient and timely audit of these institutions, the Registrar delegates his powers in this respect to his subordinates through a special or general order. Rights, Duties and Powers of a Co-operative Auditor The duties and responsibilities of a co-operative auditor are laid down in the Act. Following are the duties: 1. The primary duty of an auditor visiting the institution is verification of the cash balance. The result of the verification shall be recorded in the books. 2. Before the commencement of the audit, the auditor shall go through the byelaws of the institution and ascertain the manner in which the institution is working. 3. It is the duty of the auditor to verify whether all the relevant books and registers, as prescribed by the Act, are maintained by the institution. 4. While verifying the loans granted by the institution, he should ascertain that the security offered by the loanee is adequate and genuine.
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5. He should make a detailed study of loans granted and classify them as good, doubtful and bad. The action taken by the managing committee in recovering the overdue loans should also be verified. 6. He should state in his report whether any of the provisions in the Act have been violated. 7. The auditor should verify the liabilities of the institution towards the Government, the Central Co-operative Bank and the general public. He should ensure the correctness of the outstanding amounts through obtaining confirmation from the creditors concerned. 8. He should verify the budgeted limit in respect of expenditure and ascertain whether the limit has been exceeded. It is also his duty to see that the items of expenditure are reasonable. 9. He should ensure that frauds are not committed in any of the transactions. 10. After verifying the accounts, documents and securities, he should report whether, in his opinion, the accounts show a true and fair view.
9.2.2 Commencement of Audit

Every auditor, except those who are working as concurrent auditors, will have a number of institutions under his charge for audit. In order to complete the audit of all institutions efficiently and effectively, the auditor should chalk out a definite programme which has to be approved by his senior officer. Prior notice should be sent to the institutions concerned intimating them the date of commencement of audit so that they prepare relevant schedules and statements required for the audit well in advance. Audit Note Book and Working Sheets An audit note book is maintained by the auditor in order to record all important points that come to his attention during the audit. The working sheets maintained by the auditor contain the following particulars: 1. Queries raised during the audit 2. Explanations received 3. Errors and/or frauds detected 4. Details of missing vouchers 5. Matters that require further elucidation
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Audit Fees Every co-operative institution, except the exempted category, whose accounts are audited by the Registrar or his nominee is required to pay to the Government audit fees according to the norms laid down under the provisions of the Cooperative Societies Act concerned. Statutory Funds Statutory funds are created out of the net profits of the institution in terms of the relevant provisions in the statute and bye laws of the institution. Summary of Defects The auditor of a co-operative institution should furnish the summary of defects noticed during the audit. It contains general observations concerning the affairs of the institution together with suggestions for improvement. This summary is prepared in two parts. Part A contains details of irregularities of a serious nature which call for immediate action. Part B contains defects of a routine nature. The summary should be submitted along with the audit report. The auditor is not expected to record his opinion in any of the books kept by the institution. Special Report Where the auditor, during the course of his audit, has detected any defect of a very serious nature that calls for immediate attention, he should submit a special report. Following are given some of the circumstances that will necessitate a special report: 1. Non-production of cash balance for verification 2. Destruction of records 3. Misappropriation of funds and/or other properties 4. Loans granted against insufficient securities 5. Instances where the provisions of the Act, rules and/or bye laws on the institution are violated 6. Instances where the involvement of the members of staff of the institution have resulted in losses to the institution
9.2.3 Preparation of Financial Statements

Contrary to the practice prevailing in ordinary commercial establishments, the financial statements of a co-operative society are prepared by the auditor himself.
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The preparation of financial statements of a co-operative society is divided into three stages: (a) Preparation of the Receipts and Disbursement Statement (b) Preparation of Trading and Profit and Loss Account (c) Preparation of Balance Sheet Audit Report Soon after finalization of the audit, the auditor has to prepare the audit memorandum and the audit certificate in the format prescribed by the Registrar of Co-operative societies. The audit memorandum is in the form of questions. The auditor has to answer the questions with reference to the checking done by him. On completion of the memorandum, it has to be submitted to the authority competent to approve the same. The following statements have also to be submitted along with the memorandum: 1. Details about transactions that appear to be contrary to the provisions of the Act, rules and bye laws 2. All sums that ought to have been brought into account but have not been 3. Material irregularities, if any, in the expenditure and/or receipt of money 4. Bad or doubtful debts and/or assets 5. Audit classification statement 6. Any other statement required by the Registrar 7. Summary of defects Audit Certificate As mentioned above, the auditor has to submit the audit memorandum in the prescribed format. On the balance sheet and trading and profit and loss account for the period up to which the accounts have been audited by the auditor, he has to state whether in his opinion and to the best of his knowledge and information and according to the explanations given to him, whether the accounts as above give all the information required by the Act and give a true and fair view in the case of the balance sheet the affairs of the institution as at the end of the year up to which the accounts are made up and examined by him and in the case of the profit and loss account the profit/loss for the year up to which the audit has been completed. In addition, the auditor has to furnish a certificate in the form of a report. The certificate contains the following information:
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1. Whether he has examined the overdue debts, verified the cash balance and securities, and valued the assets and liabilities of the institution as required by the Act. 2. Whether, in his opinion, the balance sheet is a full and fair one containing all the necessary particulars and is properly drawn up so as to exhibit a true and correct view of the affairs of the institution according to the best of his knowledge and explanations given to him and as shown by the books. 3. Whether he has called for any explanation or information, whether such explanation or information has been given to him and has been found satisfactory. 4. Whether the transactions of the institution that have come to his notice have been within the competence of the institution. 5. Whether the returns received from the branches of the institution have been adequate for the purposes of his audit. 6. Whether the profit and loss account shows a true balance of profit/ loss for the year covered by such account. 7. Whether, in his opinion, the balance sheet and profit and loss account are drawn up in conformity with the law. 8. Whether, in his opinion, books of account have been kept by the institution as required by law.
1. Fill in the blanks. (a) Audit of a co-operative society may be regarded as an _____________ audit also. (b) Audit of a co-operative institution is the statutory responsibility of the _______. (c) The auditor of a co-operative society is required to furnish the summary of ________ noticed during the audit. (d) After finalization of audit, the auditor has to prepare the audit ___________ and the audit ______________.
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2. State whether the following statements are true or false. (a) The primary duty of the auditor of a co-operative society is verification of the cash balance. (b) Co-operative societies are not required to pay any audit fees. (c) Destruction of records constitutes a serious defect that calls for a special report. (d) Financial statements of co-operative societies are prepared by their accountants and audited by auditors.
9.3 Audit of Educational Institutions

Educational institutions differ from other business organizations and as such the audit process of these institutions differs very much from other organizations. Following are given the audit steps that are important for performing the audit of educational institutions. 1. Examine the rules and regulations of the institution or the relevant legislation and rules framed thereunder (e.g., in the case of universities), the relevant statutes, etc., as the case may be, and carefully note the provisions concerning accounts and audit. 2. Examine the relevant minutes of the committee concerned so far as they relate to the accounts and ensure that they are properly followed. 3. Vouch cash received in respect of admission fees and tuition fees by reference to the admission register and register of students, counterfoils of receipts issued and other documentary evidences and ensure that the total cash received is properly accounted for. Also, make sure that fees received in advance and fees in arrears are adjusted properly. 4. Ascertain whether miscellaneous receipts of cash on account of library, laboratory, sports, magazine, fines, etc. are properly accounted for. 5. Check whether free studentships and other concessions are duly authorized by a competent authority and whether, wherever applicable, reimbursements in respect of them are received and accounted for. 6. Ensure that caution deposits received but not refunded are shown as a liability in the balance sheet.
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7. Ascertain whether grants received from the Government and/or other sources are properly accounted for. Check the relevant correspondence relating thereto. 8. Review and examine the data underlying gifts, grants, donations and bequests, including documentation, correspondence, acknowledgments and notifications of grant awards; governing board minutes; and compare by type and nature with amounts from previous periods. 9. Test records and revenues relating to sporting events and other activities of the students union including ticket sales, ticket numbers, free tickets and contracts, if any, with other institutions. 10. Check the treatment of any provident fund contributions and ensure that they are properly dealt with. 11. Vouch in the usual way any income from landed property, investments, etc. 12. Ascertain whether all reimbursements in respect of tax paid on exempted items have been duly received and properly accounted for. 13. Make sure that all expenses have been incurred in accordance with the relevant rules and budgeted provisions. 14. Vouch the payment of salaries to the members of staff in the usual manner. Make sure that the increments allowed to them are according to the rules. 15. Vouch the establishment expenses. A comparison with the previous year will reveal any unusual items in which case further enquiries should be made to ascertain the reasons therefor. 16. Verify all the fixed assets in the usual way and make sure that proper provision has been made for depreciation. 17. Verify in the usual way cash in hand and balance with the bank. The auditor should make sure that the institution concerned has instituted a proper system of internal control covering revenues and expenses. Major internal controls in respect of revenues and expenses are given below: (i) Budgetary control should be exercised over all recorded revenues. This should include regular comparisons with budget estimates and independently carried out analysis of significant variations. (ii) Revenues should be controlled by recording them on a consistently adopted accruals basis. These should be compared with previous year, and adjusted.
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(iii) Issues of credits, allowances, scholarships, and any other adjustments to normal revenue flows should be controlled independently. (iv) Procedures for receiving and acknowledging gifts, donations, grants, etc. should be strictly followed. (v) Proper procedures should be laid down covering various types of expenses and they should be strictly followed.
9.4 Audit of Social Clubs

When auditing social clubs, the auditor is faced with certain problems. Clubs are managed largely by volunteers who lack professionalism. The small size of managerial staff and its voluntary nature make the division of duties difficult. The sources of cash are numerous and varied. Of course, it is comparatively easy to control subscription and joining fees. But cash may be forthcoming from other sources also such as social functions, hire of the facilities of the club, canteens and bars, local authority subsidies and grants, etc. Further, unusual and non-recurring receipts of cash are likely to be there. The club authorities should be advised to make use of an analytical cash book so that each source of income could be identified. Banking cash and regular counts of cash will also enhance the control over cash. Items of expenditure, particularly those expenses that are paid in cash from receipts, also pose problems. Where payments are made for such items as casual labour, it is extremely difficult to verify them unless the receipts are properly controlled. It would be advisable to ensure that all invoices or all items of cash expenditure are authorized by the head of the relevant committees or by someone other than the person handling cash. In addition, control over expenditure could be enhanced if there are two signatories for all cheques and by insisting that cheques are signed only with supporting documentation. Stocks is another area that gives rise to difficulties. The extent of these difficulties depends on the stock lines and the accuracy of the analysis of cash and purchases. As far as possible, it should be ensured that stocks are controlled by regular stocktaking. The following general procedures may be followed in carrying out an audit of a social club. 1. Examine the bye-laws of the club in order to ascertain its legal status, the power of its executive committee, and the rules and regulations
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concerning its accounts in general and the opening and operation of bank account in particular. 2. Examine the relevant minutes with particular reference to matters affecting the accounts. 3. Vouch the joining fees and annual subscription together with the counterfoils of the receipt books. The total should be verified with the annual list of members. Amounts shown as arrears should be enquired into. 4. Make sure that proper appropriation is made of life membership fees, subscription in arrears and subscription received in advance. 5. Vouch cash received from social functions, hire of the facilities of the club, canteens, bars, etc. and make sure that there is proper control over such cash receipts. 6. Unusual and non-recurring receipts of cash should receive the attention of the auditor. Ensure that they are properly apportioned. 7. Make sure that expenditure is incurred only on proper authorization according to the rules and regulations of the club. Examine the supporting documentation and ascertain the accuracy of apportionment between capital and revenue. 8. Verify in the usual manner the assets and liabilities of the club as at the date of the balance sheet, giving due consideration to stock in hand. In order to give a clean opinion, the auditor must be satisfied with the clubs internal control system. Otherwise, the auditor will be forced to express in his report his dissatisfaction with material inadequacies. Usually while auditing clubs, the auditor places emphasis on substantive testing and analytical review procedures rather than compliance testing.
3. Fill in the blanks. (a) Auditor of an educational institution should ensure that ________ deposits received but not refunded are shown as a liability in the balance sheet. (b) ___________ of an educational institution should be controlled by recording them of a consistently adopted accruals basis.
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(c) Auditing of social clubs poses certain problems because they are largely managed by _________.
9.5 Audit of Hotels

Audit objectives in the case of hotels are: (i) to ensure that all billable services are correctly reported and properly reflected in the financial statements, (ii) to ascertain that adjustments to revenue are appropriate and approved, (iii) to ensure that procedures and policies of the entity concerning revenue recording and reporting are carried out in accordance with current requirements, and (iv) to ascertain that controls and procedures are efficient, effective and economical. 1. Examine the constitution of the hotel with particular reference to its legal status, the rules and regulations concerning the maintenance of accounts in general and operation of bank account in particular. 2. See whether the hotel is affiliated to any chain of hotels. The terms of affiliation should be examined and it should be ensured that they are complied with. 3. Examine the internal control system in operations as regards (a) purchases (including edibles, stores, kitchen, guest toiletries), (b) occupancy of rooms, etc, (c) procedures for taking orders, serving food and collection of bills, (d) recording sales, (e) salaries of staff, (f) registration of guests, recording of check in time, number of persons differentiating between adults and children etc., (g) serving food inside the rooms, (h) booking of conference hall, (i) discarding (or, otherwise disposing) furniture, cutlery, etc. (j) facilities such as foreign exchange conversion, travel desk, shopping area, etc. 4. Evaluate ICQs (internal control questionnaire) for weaknesses. 5. Study significant accounting and other policies of the hotel with reference to check-in and check-out time of the guests, discount structure, concessions to corporate clientele, allocation of overheads to various departments or profit centres, etc. 6. Get an understanding of the various profit centres identified by the management of the hotel. 7. Arrive at the gross profit for each profit centre and make use of analytical review procedures in order to make comparisons with industry averages and previous years figures which will give an insight into the reliability of the figure for the current year.
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8. Examine the allocation of overheads such as depreciation on furniture, kitchen equipments to the profit centre concerned. 9. Understand the procedures for collection through credit cards and see that they are followed. 10. Vouch receipts (such as room revenue, food and beverages, banquets, etc.) and payments (such as administrative expenditure, purchases, etc.) and ensure that there is proper control over them. 11. Vouchers should be obtained for all revenue adjustment transactions for a couple of test days selected during pre-audit. Total voucher amount should be traced to final revenue detail report to ascertain whether all adjustments are supported by proper vouchers. Review vouchers for propriety, proper completion and approval. 12. Vacant room inspection procedures should be documented, showing (i) whether all rooms not reporting revenue are inspected daily, (ii) what report is used for the inspection, (iii) who performs the inspection, (iv) how is the inspection documented, etc. 13. Review lease/rental agreements for hotel space to ascertain whether recorded revenues agree to the terms specified. 14. In the case of entity managed gift shops: (i) discuss with the management procedures to verify that all gift shop revenues are correctly recorded and ensure whether an inventory count is performed periodically by management, and (ii) on the basis of profit and loss review, evaluate gift shop profit margin for reasonableness as compared to budget. 15. See whether a separate account is maintained for special events like food festivals and that the surplus is transferred to general profit and loss account. 16. Ensure that depreciation, interest on loans, auditors fee, etc. are charged to the general revenue account to arrive at the profit or loss. 17. In case interest is paid out of capital (hotels are considered to be long gestation projects), ensure that the requirements of the Companies Act are complied with. 18. The Companies Act requires the auditor to state whether there is a periodic verification of fixed assets and the treatment of material variations observed during the course of such verifications. 19. Obtain a management letter of representation for the verification of miscellaneous assets like crockery and cutlery.
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20. Check all bills raised on licencees with reference to agreements including charge of electricity wherever applicable. 21. Review various insurance covers taken for their adequacy. 22. Review insurance claims lodged with the insurance companies and follow up action. 23. Review position of maintenance of books of accounts and make suggestions, if any, for updating. 24. Review bank reconciliation statements. 25. Review advances and their adjustments. 26. Review outstanding liabilities for adjustments. 27. Scrutinize general ledger for required adjustments.
9.6 Audit of Hospitals and Nursing Homes

Auditing of hospitals and nursing homes requires following of strict procedures and guidelines as these are community welfare institutions. Following are some of the salient features of hospital audits. 1. Examine the relevant provisions binding the formation and organization of the entity with particular reference to the maintenance of accounts. 2. Check cash received in respect of various services recorded in the relevant registers along with the counterfoils of receipt books and any other documentary evidence. 3. Check the receipts on account of subscriptions, donations, etc. in the cash book with reference to all documentary evidences such as counterfoils of the receipt books, correspondence, etc. If they are made for a specific purpose, ensure that it is complied with. 4. Vouch any grants received from the Government or local authorities along with the relevant correspondence and ensure that such grants are utilized properly. 5. Follow the usual procedures in vouching miscellaneous receipts such as rent, interest, dividends, etc. Ensure that tax paid, if any, on the same is reclaimed in case of exemptions. 6. Ensure that expenses are incurred on proper authorization and in accordance with budget sanctions.
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7. Ensure that a proper system of internal checks exists concerning the receipt and issue of medicines, equipments, linen, etc. 8. Ensure that the items included in stock at the balance sheet date are valued properly, comparing the total value with the relevant ledger balances. 9. Verify in the usual way the fixed assets of the entity and ensure that adequate depreciation has been provided on them.
9.7 Audit of Hire Purchase Companies

Following are the important guidelines when auditing hire purchase companies. 1. Ensure that there is an adequate system for extending hire purchase finance. 2. Examine the higher purchase agreement to make sure that the agreement is in writing and signed by all the parties concerned. 3. Matters such as hire purchase price, cash price, amount and number of installments, the date on which the agreement shall be deemed to have commenced, place, mode and due date of payment, etc. should be noted. 4. Where higher value items are involved, ascertain whether the valuation and installation reports are called for. Also, physically verify the asset in possession of hirers, especially in case the auditor has any doubts regarding the genuineness of the transaction. 5. Check whether the registration certificates in respect of vehicles contain endorsements in favour of the hire purchase company. 6. Verify whether the hire purchase company has a proper system in place to verify hire purchase assets periodically to make sure that the hirers have not sold them or otherwise encumbered them. 7. Ensure that the assets given on hire purchase have adequate insurance cover. 8. Make sure that the installments are being received regularly. In case old installments are outstanding, ensure that appropriate provisions have been made in respect of overdue installments. 9. Where assets are repossessed by vendor as a result of default made by the hirer, make sure that such repossessed assets are valued on a realistic and consistent basis.
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9.8 Audit of Leasing Companies

When auditing leasing companies, again great caution is to be observed. Following are the important considerations. 1. Object clause of the leasing company should be examined to see the types of activities that the company can undertake. 2. See whether there exists an appropriate credit appraisal system to appraise the creditworthiness of the lessee, e.g., debt repayment history, capital strength, gross/net income per annum, etc. 3. Examine the lease agreement with particular reference to matters such as description of lesser, lessee and equipment, the location where the equipment is to be installed, period of lease, amount of lease, rent, due date of payment, whether the agreement contains any provision granting right to lessee to sublet the equipment, etc. 4. Examine the lease proposal form received from the lessee requesting the lesser to provide the equipment on lease. 5. Ensure that the invoice is being safely retained. 6. Examine the acceptance letter received from the lessee indicating that the equipment has been received and acceptable to the lessee. 7. Ensure that a resolution has been passed by the board of directors of the lessee company (where the lessee is a limited company) authorizing a particular director to execute lease agreement on behalf of the company. 8. Ensure that copies of insurance policies have been obtained for the records of the lesser.
4. State whether the following statements are true or false. (a) Affiliation of a hotel to a chain of hotels has no impact on its auditing. (b) Vouching of receipts and payments is an important component of a hotels audit. (c) Grants by the government to hospitals and nursing homes are not open to audit.
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(d) A hire purchase company is not required to insure the assets it gives for hire and purchase. (e) Examination of the lease proposal form is critical when auditing a leasing company.
9.9 Summary
Let us recapitulate the important concepts discussed in this unit: Audit of a cooperative institution is not only a financial audit, but also a statutory audit and a state controlled audit. The auditor of a cooperative institution is appointed by the Registrar of Cooperative Societies. The duties and responsibilities of a cooperative auditor are laid down in the Cooperative Societies Act. A cooperative auditor should have a definite programme of work to facilitate the completion of audit in time. A summary of defects noticed during the audit is furnished by a cooperative auditor in a special report. A cooperative auditor prepares the Receipts and Disbursement Statement with the help of the general ledger. On finalization of Audit, the auditor prepares the audit memorandum and audit certificate in the prescribed format. In addition, a certificate is furnished in the form of a report. In the case of educational institutions, social clubs, hotels, hospitals and nursing homes, hire purchase companies and leasing companies, the auditor follows detailed checking of various matters connected with the accounts.
9.10 Glossary
Caution deposit: A sum of money deposited as security for good conduct, against possible debts, etc. Volunteer: A person who offers to take part in an enterprise or undertakes a task without promise of payment.
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Hire purchase: A system by which a buyer pays for a thing in regular installments while enjoying the use of it. Leasing company: A company from which property or equipment is taken on lease.

1. Discuss the important components of the audit of a co-operative society. What are the duties of the auditor in this case? 2. What are the salient features of the audit of an educational institution? 3. Give the salient features of the audit of a social club. 4. What are the points to keep in mind when auditing a hospital or a nursing home? 5. Discuss the auditing of hire purchase and leasing companies.

1. (a) administrative; (b) Registrar of Co-operative Societies; (c) defects; (d) memorandum, certificate 2. (a) True; (b) False; (c) True; (d) False 3. (a) caution; (b) Revenues; (c) volunteers 4. (a) False; (b) True; (c) False; (d) False; (e) True

1. Refer to Section 9.2 2. Refer to Section 9.3 3. Refer to Section 9.4 4. Refer to Section 9.6 5. Refer to Sections 9.7 and 9.8
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1. Kumar, Ravinder and Virender Sharma. 2006. Auditing: Principles and Practice. New Delhi: PHI Learning Pvt. Ltd. 2. Shekhar, L and K C Shekhar. 2003. Auditing. 20th edition, Delhi: Vikas Publishing House.
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Unit 10
Structure
Audit of Limited Companies, Government and NGOs
10.1 Introduction Objectives 10.2 Audit of a Limited Company 10.3 Features and Basic Principles of Government Audit 10.4 Features and Basic Principles of Audit of Local Bodies 10.5 Features and Basic Principles of Audit of Non-Governmental Organizations (NGOs) 10.6 The Comptroller and Auditor General (CAG) 10.7 Summary 10.8 Glossary 10.9 Terminal Questions 10.10 Answers 10.11 Further Reading
10.1 Introduction
In the previous unit, you learnt about the principles and process of auditing for different kinds of undertakings; primarily co-operative societies, educational institutions, social clubs, hotels, hospitals and nursing homes, hire purchase companies and leasing companies. This unit will broaden your knowledge of the practice of auditing by discussing the modalities of auditing in limited companies, the government, local bodies and non-governmental organizations. The role, responsibilities and duties of the Comptroller and Auditor General of India who is the government auditor will also be discussed.
Objectives
After studying this unit, you should be able to: Define a limited company and discuss the main aspects of its auditing Describe the features and basic principles of government audit Examine the main considerations in audit of local bodies and nongovernmental organizations Delineate the constitutional role of the Comptroller and Auditor General and his duties
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10.2 Audit of a Limited Company

A limited company is a type of company that offers limited liability, or legal protection for its shareholders and places certain restrictions on its ownership. These restrictions are defined in the companys by laws or regulations and are meant to prevent any hostile takeover attempt. The major ownership restrictions are: (a) shareholders cannot sell or transfer their shares without first offering them to other shareholders for purchase, (b) shareholders cannot offer their shares to the general public over a stock exchange, and (c) the number of shareholders cannot exceed a fixed figure. It has an independent legal existence. The Indian Companies Act, 1956 contains provisions regarding the legal formalities for setting up of a private limited company. Registrars of Companies (ROC) appointed under the Companies Act covering the various states and union territories are vested with the duty of registering companies floated in the respective states and the union territories. It is relatively less cumbersome to organize and operate a limited company it as it is exempted from many regulations and restrictions to which a public limited company is subjected. Some of them are: It need not file a prospectus with the Registrar. It need not obtain the Certificate for Commencement of business. It need not hold the statutory general meeting nor need it file the statutory report. Restrictions placed on the directors of the public limited company do not apply to its directors. Every company is required to get its book of accounts audited under the Companies Act, 1956 irrespective of quantum of revenue, losses, profits or capital expenditure. Income tax rules make a tax audit mandatory under the Income Tax Act, 1961, if the turnover of the company exceeds `60 lakh in the previous year. Proper audit is extremely important for limited as well as other companies because: Audit authenticates the account books and ensures that they are maintained in accordance with law. Audit ensures that internal operations of the company are in accordance with the norms of the management.
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Audit helps to improve company efficiency. It helps management to better understand their own working and financial systems. An audit gives assurance to shareholders that accounts of the company are being maintained properly and disclose true and fair view of the company. Detection of fraud and error within the company is enabled. Only a practicing member of ICAI can be appointed as auditor of a company registered under the Companies Act, 1956. The Act also prescribes strict penal provisions for failure to get an audit conducted on the books of accounts within the due date. On commencing the audit, the following matters should receive the primary attention of the auditor. 1. Books of account of the company: Obtain a list of all books of account statutory, statistical and memoranda maintained by the company and ensure that they comply with the relevant statutory requirements. 2. Officials of the company and books maintained by them: Obtain a list of the officials of the company along with their specimen signature and names of the books and registers maintained by them. This will facilitate the clearance of queries that the auditor may have to make in the course of performing various audit procedures. 3. Examination of basic documents: Documents such as certificate of incorporation, certificate to commence business, memorandum of association, articles of association, prospectus, previous years balance sheet and profit and loss account, directors report and other related documents, letter of engagement, accounting system and related internal controls, Companies Act requirements concerning matters related to issue of shares/debentures, etc. have to be duly examined by the auditor.
10.3 Features and Basic Principles of Government Audit

The basic aim of government auditing is to achieve public accountability. The idea of public accountability can be classified into six kinds of focus, viz., (i) highlighting the public sector, (ii) highlighting public authority and power along with national and local governments themselves, (iii) highlighting the function of governmental services, (iv) highlighting expenditure of the public sector,
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(v) highlighting the interest in, and concern for, and degree of trust in public organizations, and (vi) highlighting the management of public funds and resources. The scope of accountability in contemporary government auditing is wide and it includes not only financial accountability but also management accountability and programme accountability. The focus of government auditing has changed from financial auditing to performance auditing in order to respond to the demands of taxpayers for performance-related information and as a result, necessitating performance evaluation. Thus, expansion in the scope of government auditing has taken place. Government auditing has certain areas that are different from auditing of profit-oriented organizations. In government auditing, the scope of financial auditing includes areas other than the audit of accounts and it includes the evaluation of economy, efficiency and effectiveness (sometimes referred to as the 3 Es). Of course, the role of government auditing is not to criticize the government but to monitor and instruct the government, based on the evaluation of its programmes. In government audit conducted by the office of the Comptroller and Auditor General, audit of government expenditure is one of the major components. The basic standards set for this component are to make sure that there is provision of funds authorized by competent authority by laying down the limits within which expenditure can be incurred. These standards consist of : (i) it is the duty of the auditor to ensure that the expenditure incurred conforms to the relevant provisions of the statute and is in accordance with the financial rules and regulations; (ii) it is the duty of the auditor to see that each item of expenditure is covered by a sanction accorded by the competent authority - such sanction may be either general or special; (iii) it is the duty of the auditor to ensure that there is a provision of funds out of which expenditure is incurred and the amount of expenditure is not more than the appropriations made; (iv) it is the duty of the auditor to ensure that various programmes, schemes and projects where large expenditure has been incurred are being done economically and are yielding results expected of them (i.e., performance audit); (v) it is the duty of the auditor to ensure that the expenditure is incurred with due regard to broad and general principles of financial propriety (i.e., propriety audit).
10.4 Features and Basic Principles of Audit of Local Bodies

State governments exercise control over the expenditure of local bodies. This is done through the appointment of external auditors. Certain local bodies like the
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municipal corporations of Delhi, Mumbai, etc. are empowered to appoint their own external auditors. Audit is used as a method to exercise financial control over local bodies. This provision is coupled with the privilege of ultra vires. Where an action of a local body is beyond legal authority, it results in a qualified audit report. Besides external audit, internal audit is also performed by local bodies. Internal audit is carried out on a continuous basis with the help of a well-defined programme by the staff of the institution concerned. Detailed checking becomes necessary in the case of comparatively small or inadequately staffed local bodies where internal audit does not exist or where it is not effective. Contemporary trends indicate that value for money audit is being given increasing attention. Value for money audit emphasizes assessment of whether the institution concerned is fulfilling its responsibilities with what is known as the three Es, viz., efficiency, economy and effectiveness. The basic objectives of audit of local bodies may be summarized as reporting on: (i) the fairness of the content and presentation of financial statements, (ii) the strengths and weaknesses of financial controls, (iii) compliance with legal and/or administrative requirements, and (iv) whether value is being fully received on the money spent. Detection and prevention of fraud and errors and check on misuse of resources are also important objectives.
10.5 Features and Basic Principles of Audit of Non-Governmental Organizations (NGOs)

Non- governmental organizations are entities whose intention is not to make profit but to work for a larger cause. They raise funds from members and contributors. In addition, they receive donations of time, energy and skills for achieving their social objectives. They are either incorporated as societies in terms of the Societies Registration Act or as trusts in terms of the Trust Act. They are also incorporated as companies in terms of the Companies Act. In planning the audit of an NGO, the auditor has to pay attention to such matters as (i) work carried on by the NGO, its mission, area of operation and environment in which it operates; (ii) the legal form of the NGO, its memorandum of association, articles of association, rules and regulations; (iii) NGOs organization chart, financial and administrative manuals, project and programme guidelines, funding agencies requirements and formats and budgetary policies; (iv) minutes of board/managing committee/governing body in order to ascertain
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the impact of any decisions on the financial records; and (v) the accounting system and related internal controls including internal control procedures and internal checks. Basic approach in auditing an NGO takes the following broad pattern: == Vouch: (a) grants received towards corpus fund with reference to correspondence with the contributors; (b) interest and dividends received and receivable withy reference to Investment Register and investments held; (c) disbursements and expenditures with reference to agreements with the contributors for each of the balances; (d) loans with reference to loan agreements and receipts/repayments with reference to counterfoils issued; (e) fees received with reference to Membership Register to make sure that proper classification has been made between entrance and annual fees and life membership fees. == Verify: (a) stock in hand and letter of representation from the management for the quantities and valuation placed; (b) agreement with contributors supporting particular programmes or projects in order to ascertain the conditions with respect to undertaking the programmes or projects concerned; (c) the internal control system in relation to fund-raising programmes in order to ascertain the persons responsible for collection of funds and mode of receipt, ensuring that collections from such programmes are deposited in the bank. == Check: (a) ear-marked funds with reference to requirements of contributors, resolutions of the appropriate authority such as the board/managing committee/governing body of the NGO, rules and resolutions of the schemes of the ear-marked funds; (b) investments register and investments held in order to ensure that investments are in the name of the NGO; (c) approval of the appropriate authority where investments and disinvestments are made;
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(d) whether physically verified cash balance is in agreement with the books of accounts; (e) bank reconciliation statements for bank balance (f) agreements with contributors and grants letters in order to make sure that amounts received have been accounted for; (g) foreign contributions bank accounts to make sure that all foreign contributions are deposited in that account to comply with Foreign Contribution (Regulation) Act. (h) subscription register and counterfoils of receipts issued to make sure that subscriptions are properly accounted for.
Self-Assessement Questions
1. Fill in the blanks. (a) A limited company places certain ________ on its ownership. (b) Income Tax Act, 1961 makes a tax audit mandatory if the turnover of the company exceeds ________. (c) The aim of government auditing is to achieve public ________. (d) The focus of government auditing has changed from financial auditing to ________ auditing. (e) State governments exercise control over the expenditure of local bodies through the appointment of ________. 2. State whether the following statements are true or false. (a) Shareholders of a limited company cannot sell their shares on the stock exchange. (b) Government auditing is similar to auditing of profit-oriented organizations. (c) Conduct of an audit has no bearing on its efficiency. (d) The role of government auditing is to criticize the government. (e) Audit is used as a method to exercise financial control over local bodies. (f) Grants received by non-governmental organizations should be minutely audited.
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10.6 The Comptroller and Auditor General (CAG)

The CAG is an official mandated by the Constitution of India to act as a watchdog over government finances and its functioning. The CAG plays a crucial role in making the government more transparent and accountable to the legislature and civil society. The CAG is appointed by the President of India on the recommendation of the Prime Minister.
10.6.1 Constitutional Role of the Comptroller and Auditor General

The constitutional role that the CAG plays may be summarized as safeguarding public money through observation and examination of the government accounting system and a strict vigil over government receipts and expenditure a strict watch over where public money goes and for what it is spent. In other words, the CAG is the watchdog of the nation against executive extravaganza and inefficiency. As observed by a bench of the Supreme Court of India, while dismissing a petition challenging CAG reports on 2G Spectrum, Coalgate, etc.: CAG is not a munimji or an accountant or something like that... He is a constitutional authority who can examine the revenue allocation and matters relating to the economy. CAG is the principal auditor whose function is to go into the economy, effectiveness and efficiency of the use of resources by the government. If the CAG will not do, then who else will? Again, Dr Rajendra Prasad, the first President of India, had observed: CAG should have the power to call to account any officer however highly placed, so far as the state money is concerned and it is essential that every rupee that we spend is properly accounted for. Jurisdiction of the CAG covers the central and state government departments and offices including the Indian Railways and Posts and Telecommunications, commercial enterprises owned/controlled by the central and state governments, non-commercial autonomous bodies owned/controlled by the central or state governments and authorities and bodies substantially financed from the central or state revenues. The CAG is entrusted with the audit of government accounts of the central and state governments and is empowered to audit all expenditure from the revenues of the central or state governments, whether incurred within India or outside. Besides, the CAG executes performance and compliance audits of various functions and departments of the government.
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The CAG has a key role in the functioning of the financial committees of the Parliament and the state legislatures. These committees work generally on the basis of the CAGs reports, although they may also examine issues not included in such reports. The notes that are submitted by the various ministries are scrutinized by the CAG and help the committees to check the correctness of facts and figures in their draft reports.
10.6.2 Audits Performed by the CAG

Broadly, there are two classifications of audit by the CAG, viz., 1) Regularity Audit (Compliance) and Regularity Audit (Financial); and 2) Performance Audit. Regularity Audit (Compliance) This audit consists of the following: Audit against provision of funds This is done with a view to ascertaining whether the amounts shown as expenditure in the accounts were authorized for the purpose for which they were spent. Audit against rules and regulations This is done with a view to ascertaining that the expenditure incurred was in accordance with the laws, rules and regulations framed to regulate the procedure for spending public money. Audit of sanctions to expenditure This is done with a view to ascertaining that each item of expenditure was done with the approval of the appropriate authority in the government. Propriety audit This is done with a view to bringing to light cases of improper expenditure or waste of public money. It extends beyond scrutinizing the mere formality of expenditure to its wisdom and economy. Audit of the receipts of the central and state governments This is done for the CAG to satisfy himself that the rules and procedures ensure that assessment, collection and allocation to revenue are done in conformity with the laws and that there is no leakage of revenue. Regularity Audit (Financial) In this audit, it is the duty of the auditor to analyse the financial statements to establish whether acceptable accounting standards for financial reporting and disclosure are complied with. Analysis of financial statements is done to such a degree that a rational basis is obtained to express an opinion on the financial statements.
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Performance Audit The aim of performance audit is to ensure that government programmes have achieved the desired objectives at the lowest cost and have given the intended benefits.
10.6.3 Duties of the CAG

Duties of the CAG as contained in Chapter III of the Comptroller and Auditor Generals (Duties, Powers and Conditions of Service) Act, 1971, as amended from time to time, are: (i) Compilation of the accounts of the Union and each state from the initial and subsidiary accounts rendered to the audit and accounts office; (ii) Submission of accounts to the President, Governors of states and Administrators of union territories; (iii) Giving information and rendering assistance to the Union and the states in the preparation of their annual financial statements; (iv) Auditing of all expenditure for the Consolidated Fund of India and of each state and ascertaining whether the amounts shown in the accounts as having been disbursed were legally available for and applicable to the service or purpose to which they have been applied or charged and whether the expenditure conforms to the authority which governs it and reporting on the expenditure audited; (v) Auditing all transactions of the Union and of the states relating to contingency funds and public accounts and reporting on the same; (vi) Auditing all trading, manufacturing, profit and loss accounts and balance sheets and other subsidiary accounts kept in any department of the Union or of a state and reporting on the same; (vii) Auditing receipts and expenditure of bodies or authorities substantially financed from Union or state revenues; (viii) Scrutinizing the procedures by which the sanctioning authority satisfies as to the fulfillment of the conditions subject to which any grants or loans are given for any specific purpose from the Consolidated Fund of India or of any state/union territory to any authority or body; (ix) Auditing all receipts that are payable to the Consolidated Fund of India and of each state/union territory and satisfying that the rules and
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procedures in that behalf are designed to secure an effective check on the assessment/collection and proper allocation of revenue and are being duly observed, and reporting on the same; (x) Auditing and reporting on the accounts of stores and stock kept in any office or department of the Union or of a state; (xi) Auditing the accounts of government companies in accordance with the provisions of the Companies Act and submitting the report on the same to the government or governments concerned.
Self-Assessement Questions
3. Fill in the blanks. (a) The Comptroller and Auditor General is an official mandated by the _______ to act as a watchdog on government finances and its functioning. (b) The Comptroller and Auditor General is appointed by the _______ on the recommendation of _______. (c) The Comptroller and Auditor General is the watchdog of the nation against _______ extravaganza and inefficiency. (d) In _______ audit, it is the duty of the auditor to analyze the financial statements to establish whether acceptable accounting standards for financial reporting and disclosure are complied with. (e) The aim of _______ audit is to ensure that government programmes have achieved the desired objectives at the lowest cost. 4. State whether the following statements are true or false. (a) The Comptroller has a key role in the functioning of the financial committees of the Parliament and state legislatures. (b) Audit of sanctions to expenditure is a part of performance audit. (c) Expenditure from the Consolidated Fund of India is not under the purview of the Comptroller and Auditor General. (d) Auditing of contingency funds is a duty of the Comptroller and Auditor General.
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10.7 Summary
Let us recapitulate the important concepts discussed in this unit. A limited company is a type of company that offers limited liability, or legal protection for its shareholders and places certain restrictions on its ownership. Every company is required to get its book of accounts audited under the Companies Act, 1956 irrespective of quantum of revenue, losses, profits or capital expenditure. Income tax rules make a tax audit mandatory under the Income Tax Act, 1961, if the turnover of the company exceeds `60 lakh in the previous year. On commencing the audit of a limited company, the primary attention of the auditor should be in relation to (i) books of account of the company, (ii) officials of the company and books maintained by them, and (iii) examination of the basic documents of the company. The aim of government auditing is to achieve public accountability. The idea of public accountability can be classified into six areas of focus. The scope of accountability in contemporary government auditing is wide and it includes not only financial accountability but also management accountability and programme accountability. The role of government auditing is not to criticize the government but to monitor and instruct the government, based on the evaluation of its performance. In government audit conducted by the office of the Comptroller and Auditor General, audit of government expenditure is one of the major components. The basic standards set for this component are to make sure that there is provision of funds authorized by competent authority by laying down the limits within which expenditure can be incurred. State governments exercise control over the expenditure of local bodies through the appointment of external auditors although certain local bodies are empowered to appoint their own external auditors. In addition to external audit, local bodies perform internal audit. Contemporary trends indicate value for money audit is being given increasing attention. Non-governmental organizations are non-profit making entities. In planning the audit of an NGO, the auditor has to pay attention to certain matters.
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Basic approach in auditing an NGO consists of vouching, verifying and checking. The Comptroller and Auditor General (CAG) is an official mandated by the Constitution of India to act as a watchdog on government finances and functioning. The CAG is appointed by the President of India on the recommendation of the Prime Minister. The CAG plays a key role in the functioning of the financial committees of the Parliament and the state legislatures. Broadly, there are two classifications of audit by the CAG, viz., (i) regularity audit (both compliance and financial) and (ii) performance audit. In regularity audit (financial), it is the duty of the auditor to analyse the financial statements to establish whether acceptable accounting standards for financial reporting and disclosure have been complied with. The aim of performance audit is to ensure that government programmes have achieved the desired objectives at the lowest cost and have given the intended benefits. Duties of the CAG are contained in the Comptroller and Auditor Generals (Duties, Powers and Conditions of Service) Act, 1971, as amended from time to time.
10.8 Glossary
Liability: A thing for which someone is responsible, especially a debt or financial obligation. Turnover: The amount of money made by a business in a given period of time. Consolidated Fund of India: All revenues received by the Indian Government by way of taxes like income tax, central excise, customs and other receipts flowing to the government in connection with the conduct of government business are credited into the Consolidated Fund constituted under Article 266 (1) of the Constitution of India.

1. What is a limited company? Why is auditing an important exercise for a limited company?
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2. Discuss the basic principles of government auditing. 3. Explain the salient features of audit of local bodies. 4. Outline the basic approach in auditing of non-governmental organizations. 5. Explain the constitutional role of the Comptroller and Auditor General. 6. What are the two different kinds of audit performed by the Comptroller and Auditor General? 7. What are the duties of the Comptroller and Auditor General?

1. (a) restrictions; (b) `60 lakh; (c) accountability; (d) performance; (e) independent auditors 2. (a) True; (b) False; (c) False; (d) False; (e) True; (f) True 3. (a) Constitution of India; (b) President of India, Prime Minister; (c) executive; (d) regularity (financial); (e) performance 4. (a) True; (b) False; (c) False; (d) True

1. Refer to Section 10.2 2. Refer to Section 10.3 3. Refer to Section 10.4 4. Refer to Section 10.5 5. Refer to Section 10.6.1 6. Refer to Section 10.6.2 7. Refer to Section 10.6.3

1. Davies, Marlene and John Aston. 2010. Auditing Fundamentals. Pearson Education. 2. Millichamp, A H. 2002. Auditing. UK: Thompson.
Unit 11
Structure 11.1 Introduction Objectives 11.2 Investigation 11.3 Difference between Investigation and Auditing 11.4 Types of Investigation 11.5 Summary 11.6 Glossary 11.7 Terminal Questions 11.8 Answers 11.9 Further Reading
Investigation
11.1 Introduction
In the previous two units, you learnt about the auditing needs and procedures in various types of undertakings including the government and limited companies. But it is important for you to note that besides conducting the important exercise of auditing, companies are also often required to carry out investigations into their account books and financial dealings for a variety of reasons. This unit will familiarize you with this important aspect of financial accounting. It will also clarify the differences between auditing and investigation and will go on to explain the investigation procedures in some scenarios that are commonly faced by business organizations.
Objectives
After studying this unit, you should be able to: Define investigation Explain why investigations are conducted and who conducts them Differentiate between auditing and investigation Analyse the common situations in companies that require investigation
11.2 Investigation
11.2.1 Meaning of Investigation
Investigation in the context of accounting implies an examination of the accounts and records of a business with a definite object in view. Taylor and Perry define
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investigation thus: Investigation involves enquiry into facts behind the books of accounts into the technical, financial and economic position of the business or organization. According to L R Howard, investigation is an examination of the accounts and balance sheet of an organization and the supporting documents for the specific purposes of obtaining information to be submitted to an interested party. Investigation is required to be carried out in companies for a variety of reasons. Some of these are: To judge the viability of acquiring a business or shares of a company To ascertain the credentials of an incoming partner To assess the financial health of an entity before granting loans To detect misappropriation of money and embezzlement To learn the truth about a suspected fraud Such investigations into account books are normally carried out by qualified accountants who are well-versed in the techniques and modalities of account keeping. However, unlike for auditing, it is not mandatory that an investigation may be carried out only by a qualified accountant.
11.2.2 Investigators Report

It is important for the investigating accountant to get clear instructions in writing as to the purpose for which his/her services are sought. This will avoid the possibilities of any misunderstandings or future disputes. Also, this will enable the accountant to decide on the extent of detailed work to be carried out and the manner in which his report has to be drafted. While drafting the report, the accountant should bear in mind the general reporting rules which may be summarized as under: 1. The main heading and subsequent sub-headings should be so worded as to make clear the subject of the report. 2. The exact period covered by the investigation should be stated. 3. The conclusions arrived at by the investigator should be given in the body of the report in a clear, concise and unambiguous manner. 4. References may be made to the detailed calculations and statistical data in the body of the report. But in order to make the report concise and to the point, these may be given separately by way of appendices to the report. All items of special importance and relevance to the client should be referred to specifically.
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5. The report should not be so worded as to make it highly technical and sophisticated. The level of accounting knowledge and technical matters of the client should be kept in mind while drafting the report. In other words, the client should be able to understand clearly the exact position revealed by the report. 6. Where the accountant has placed reliance on audited accounts, the exact extent of reliance on the work of the auditors should be mentioned. In summary, it may be observed that all detailed workings and notes should be preserved by the accountant. It may be necessary for him to produce these later in the course of any litigation proceedings or otherwise.
11.3 Difference between Investigation and Auditing

It is true that the detailed procedures adopted to carry out an investigation resemble, in many ways, those of an audit. Nevertheless there are certain essential differences between investigation and audit. These differences must to be understood as both can be carried out by the same auditors at different periods. These may be summarized as follows: 1. Object: The object of an audit remains the same in all cases. More specifically, the object of an audit is to enable the auditor to report whether the balance sheet shows a true and fair view of the state of affairs of the business at the end of the accounting period and whether the profit and loss account shows a true and fair view of the profit or loss of the business for the accounting period under review. In the case of investigation, the object of each investigation may be different. The specific requirement of the party concerned is the object of a particular investigation. For instance, a proposed purchaser of a business may appoint an accountant to find out whether the purchase is likely to be beneficial to him. In another case, the proprietors of a business may suspect fraud in which case, the object of investigation will be the detection of fraud. In a third case, an incoming partner may require the accountant to assess the feasibility of joining the partnership. 2. Period: The period covered by an audit is normally one accounting year while in the case of an investigation, the period covered will vary depending on the nature and complexity of the issue involved and will usually extend beyond one accounting year.
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3. Who conducts it: Audit of a joint stock company is to be conducted only by qualified accountants as specified in the relevant statutes. An investigator, in most cases, need not necessarily be a qualified accountant although qualified accountants are best suited to carry out an investigation. 4. Mandatory: Annual audit is a compulsory requirement in the case of joint stock companies and other corporate bodies. Investigation is not a compulsory annual requirement. It is carried out only when a specific requirement arises. 5. Nature and scope: An audit is an examination of books, accounts and vouchers of a business to report whether the annual accounts show a true and fair view according to the books, as shown by the accounts and as per the explanations given to the auditor. The auditor has to make sure that proper accounting policies are adopted and the accounts strictly adhere to the disclosure requirements. On the other hand, an investigator is not usually bound by accounting policies, disclosure requirements, etc. In most cases, the investigator will find it necessary to go beyond the facts contained in the books of accounts and make an assessment of many outside factors to arrive at conclusions. For example, in the case of an investigation on behalf of an intending purchaser of a business, the investigator has to take into consideration, among other factors, the impact of intending legislations and impending local developments on the future earning capacity of the business. Also, in most cases the investigator makes certain adjustments to the net profit as shown by the audited profit and loss account. 6. Magnitude of work: An audit report is brief and follows the same pattern except for the qualifications which may be necessary. An investigators report, on the other hand, is usually lengthy. It contains the instructions given by the client, the method of approach, the detailed work conducted by the investigator, the adjustments he finds necessary and any recommendations made by him.
1. Fill in the blanks. (a) Investigation into account books are normally carried out by _______. (b) It is important for the investigating accountant to ________ all detailed workings and notes.
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(c) The object of each investigating may be __________. (d) An investigating is carried out only when a __________ arises. 2. State whether the following statements are true or false. (a) The detailed procedures adopted by an accountant to carry out an investigation resemble those of an audit. (b) The objects of an investigation remain the same in all cases. (c) The objects of an audit remain the same in all cases. (d) In the case of an investigation regarding business purchase the period covered is usually one year. (e) An investigator need not be a qualified accountant. (f) An investigator is bound by accounting policies, disclosure requirements, etc. (g) In the case of joint stock companies, investigation is a compulsory annual requirement.
11.4 Types of Investigation

As mentioned earlier, there are various reasons for conducting investigations. Let us explore the modalities of this exercise in situations that commonly require investigation.
11.4.1 Investigation Regarding Business Purchase and Investments

(a) Preliminary Matters 1. Ascertain the reasons for selling the business. 2. Obtain an outline history of the business together with a description of the accounting system and related internal controls. Assess how far the accounting system and related internal controls are reliable. 3. Ascertain whether the accounts are audited by a qualified auditor. If so, examine the auditors report and see whether there are any material qualifications in them. 4. Obtain a rough idea about the earning capacity of the business proposed to be taken over and see whether it compares favourably with the minimum rate of return required by the intending purchaser.
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5. Ascertain how far the successful continuation of the business depends on the ability, influence and/or connections of the present owner/s. 6. Ascertain whether the seller will undertake not to compete with the business after the sale. 7. Establish the validity of any crucial assumptions made by the intending purchaser. A preliminary review as above will give an idea to the investigating accountant whether the proposed purchase of the business is prima facie feasible and whether it is worth carrying out a detailed investigation. (b) Examination of the Accounts and Adjustments thereof Prepare a statement of assets and liabilities as at the date of the last balance sheet, showing in particular: Itemized description of fixed assets showing the method of valuation, basis of providing depreciation, accumulated depreciation to date, any revaluation effected, etc; The amount of goodwill, if any, specifying the manner in which the same has been arrived at; The amount of stock in trade with its analysis into raw materials, work in progress and finished stock, showing the basis of valuation and any change effected in the basis in the recent past, and provision made in respect of damaged, defective, obsolete and slow-moving stock; Amount of debtors classifying them into those falling within the agreed period of credit, those due from directors/partners/employees, etc; and those which are not trading debtors together with provisions made for bad and doubtful debts; Amount of creditors, classifying them into those which are not yet due and those which are overdue and giving particulars of the extent to which the business is taking advantage of discount terms; Itemized description of other liabilities, classifying them into secured and unsecured liabilities and showing the amounts outstanding, due dates of repayment and details of the assets charged in respect of secured liabilities; Separate details of bank overdrafts, indicating the limits and the dates when the position is to be reviewed next; Schedules of investments, showing the title, nominal value, book value and market value of each investment and attaching copies of the latest
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audited financial statements of relevant companies in respect of unquoted investments; List of contingent liabilities, showing the details in respect of which each such liability exists. The details of the trading and profit and loss account should be obtained for an appropriate number of years, preferably for a period ranging between three to five years. A shorter period may not be enough to disclose significant trends and too long a period may be irrelevant to shed light on the existing trends. The details should be redrafted in columnar form on a uniform basis for the purpose of easy comparison and ascertainment of significant trends. Wherever applicable, percentages to turnover should be given. This will highlight unreasonable fluctuations which, in turn, need further detailed examination. In particular, the investigating accountant should: (a) Examine the trend of sales; (b) Carry out appropriate tests to ensure that the accounts are not manipulated to show higher profits; (c) Ascertain the method of stock taking, basis of stock valuation and consistency in applying the basis of valuation; (d) Ensure that proper provision has been made in respect of damaged, obsolete, defective and slow-moving stocks; (e) Carry out appropriate tests on purchase records; (f) Carry out appropriate tests on sales records especially for the inclusion of fictitious sales, goods out on sale or return basis, etc; (g) Carry out appropriate tests to ascertain the authenticity of cut-off; (h) Ensure that all outstandings are brought in at the date of the balance sheet; (i) Ensure that provisions for bad debts are adequate; (j) Ensure that depreciation charges to date are adequate having regard to any agreed sale value of fixed assets; (k) Carry out appropriate tests on material items charged to asset accounts to ensure proper capitalization; (l) Ascertain whether the business has been starved in recent periods of necessary expenditure on maintenance, repairs and renewals, etc;
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(m) Ensure that proper allocation has been made between capital and revenue; (n) Ensure that the goodwill has been properly arrived at; (o) Ascertain the adequacy or otherwise of the reserves. 11.4.2 Investigation on Behalf of a Proposed Investment in Shares In addition to the relevant points mentioned above, the following additional work will have to be carried out by an accountant investigating on behalf of a proposed purchaser of a limited companys shares: 1. In the case of a private limited company, ascertain whether the company is dominated by one individual or a small group of individuals in which case acquisition of minority holding of shares will not be advisable. 2. Examine the articles of association and memorandum of association carefully to ascertain the rights attaching to the particular class of shares proposed to be acquired. In the case of a private limited company, consider carefully any special provisions relating to the transfer of shares and other restrictive provisions. 3. Adjust the net profits by taking into consideration any amount required for the payment of dividends on shares with preferential rights and any amount of future profits that will have to be transferred to reserves to facilitate future expansion. 4. Adjusted profits as in (3) above should be considered in the light of the asset cover for the shares proposed to be purchased and of the current yield obtainable on quoted shares of companies engaged in the same industry. 5. Consider the strength of the companys management, together with the terms of any service agreements. 6. Check the particulars with the Registrar of Joint Stock Companies to find out whether there are any charges on the companys assets that are not apparent. 7. Prepare a statement of capital employed in order to make an assessment as to how far the liquid position of the company is satisfactory. In preparing such a statement, current values should be used and intangible assets should be ignored. It may be mentioned in this connection that the investigating accountant need not necessarily, unless specifically requested, endeavour to place a value
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on the shares. All the same, it is advisable to give a fair indication of average maintainable profits that could be used as a measurement of the companys worth. In arriving at the average maintainable profits and return on capital, it would be desirable to study and evaluate any profit and cash flow forecasts, wherever available. Of course, it is true that forecasts would need to be treated with caution since they are, by their very nature, uncertain. Hence, while evaluating the validity of such forecasts, the assumptions on which they are based and the procedures followed by the company in preparing them should be closely examined. Comparison of earlier forecasts with subsequent results will provide valuable insight into their validity. Where a company proposes to make an investment by acquiring the whole of the shares of another company, the investigating accountant should also consider the potential for improved profitability as a result of such factors as: Elimination of the competition previously offered by the company proposed to be taken over; Employment of some of the assets of the company proposed to be taken over for other development purposes; Introduction of greater managerial efficiency; Employment of the existing distribution outlets of the company proposed to be taken over for distributing product lines additionally manufactured/traded. Simultaneously, the investigating accountant should consider alterations that will need to be made in the articles of association and memorandum of association, with particular reference to the Objects Clause, where any major changes in the nature of the business are contemplated. It is also important to establish whether the proposed investment through acquisition falls within the range of those covered by appropriate regulations. 11.4.3 Investigation on Behalf of an Incoming Partner Many of the points referred to under Investigation in connection with the acquisition of a business are pertinent in this connection also. Various steps discussed therein are appropriate when an investigation is undertaken on behalf of an incoming partner. The additional points which should receive the attention of the investigating accountant are as follows: 1. Ascertain the reasons as to why it is proposed to admit a partner. It may be that one or more of the existing partners are personally involved in financial difficulties. The investigating accountant should watch for any
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such indication. In case he comes across such financial difficulties of the existing partners, the fact should be brought to the attention of the prospective partner. 2. Obtain a copy of the partnership deed together with changes that are proposed on the admission of the new partner. Make sure that the terms of agreement are reasonable from the point of view of the new partner. In particular, see that the agreement clearly lays down the manner in which a retiring or deceased partners share of the business is to be determined. Also, the agreement should lay down clearly the manner of determining the amount of profit available for distribution among partners. 3. See whether the assets are properly valued for inclusion in the new partnership books since any overvaluation of the assets will result in inflation of the capitals of the existing partners. This, in turn, will affect adversely the position of the incoming partner in the event of any subsequent dissolution of the partnership. 4. Assuming that the new partnership is taking over the debts of the old firm, make sure that sufficient provision has been made for bad and doubtful debts. Alternatively, the existing partners should be made personally responsible for debts already in existence. 5. In case the accounts and books have been audited in the past, an attempt should be made to contact the previous auditors in order to examine their working papers. For this, the prior permission of the existing partners will be required. Any qualifications in previous audit reports should receive the careful attention of the investigating accountant. The effect of such qualifications on the validity of the view presented by previous accounts should be assessed. 6. It should be ensured that subtle manipulations have not been effected, for example, by the omission of outstanding liabilities, starving the business of necessary expenditure, paying liabilities out of the personal funds of the existing partners with a view to inflating the profits, etc. 7. The following additional matters should require the attention of the investigating accountant, wherever relevant: Whether one or more partners are contemplating retirement in the near future and, if so, whether this is likely to affect the successful running of the business. The terms of the business premises; the remaining life of the existing leases and the possibility of any substantial increase in rent.
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The effect of any redevelopment plans around the location of the business. The nature of any contracts with present employees and the possibilities of introducing greater employee efficiency. 11.4.4 Investigation on Behalf of a Financial Institution for Purposes of Granting Loans Where an application is received from a prospective borrower, it is not uncommon for the lender (say, a bank) to commission the services of a professional accountant to carry out an investigation into the affairs of the applicant. This is all the more so where the amount involved is a large one. The lender will need detailed information on such matters as the purpose of the loan, prospects of payment of interest and repayment of the loan, the security for the loan, etc. An accountant undertaking such an investigation should proceed on the following lines: 1. Ascertain the reasons for the loan required. 2. Where the loan is to be utilized for financing a business proposition, examine the business background and the general standing of the promoters, including a record of their past successes and/or failures. Also, examine the ability of the promoters to provide satisfactory reference as to their business integrity, honesty and fairness in business dealings. 3. Examine the viability of the business proposition in the light of current and future conditions in the particular field of operation. 4. Find out the period that would be required for the proposed proposition to commence commercial operations. Make sure that this period is not considerable and that the promoters will not face financial difficulties owing to the long gestation period of the project. 5. Assess the quality of the products/services which the promoters are proposing to offer in relation to those presently available as also a comparison of the prices. 6. Obtain detailed information as to the researches on marketing the products/ services conducted by the promoters as also the technical feasibility of such matters as manufacture, deliveries, etc. Examine the conclusions of such researches. 7. Examine the extent to which the promoters are able to match the requested finance with their own resources (roughly one-third of the total requirement is to be raised out of the promoters own resources.).
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8. Examine the financial strength of the promoters and their ability to provide personal guarantees for the requested finance. 9. Determine the working capital requirements. 10. Prepare cash flow forecasts of the project for at least the first two years. 11. Prepare estimates, month by month, of incomes from sales/services. This should be shown as net of variable expenditure incurred in earning those incomes. 12. Also, prepare detailed estimates, month by month, the fixed and set-up costs likely to be incurred from the beginning of the project. 13. Wherever possible, prepare another set of cash flow forecasts and estimates as in (9) (10) and (11) above on the assumption that the worst position emerges as the project progresses. This will enable the lending institution to assess the extent to which the requested finance may be utilized until the project is fully operational as viable and self-financing and also to assess whether the available security would be sufficient enough in case the worst position materializes. Where the applicant for the loan is an existing business, the following additional points will also be of considerable interest to the investigating accountant. Obtain copies of audited accounts of the business for the last three to five years and consider any qualifications or reservations in the audit reports. Make necessary adjustments to the accounts for these years considering the likely future conditions of the business. Examine the trends and ratios after making the necessary adjustments. Assess the soundness of the trade debts and bills receivable. Ascertain the level of maintainable profits after making the necessary adjustments.
11.4.5 Investigation for Suspected Fraud

The term fraud in this context is used to mean intentional misrepresentation of financial information by one or more individuals among management, employees or third parties. Fraud involves: (i) Manipulation, falsification or alteration of records or documents; (ii) Misappropriation or embezzlement of assets;
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(iii) Suppression or omission of the effects of transactions from records or documents; (iv) Recording of transactions without substance; and (v) Misapplication of accounting policies. In general, inadequate and inefficient internal control system and noncompliance with identified control procedures are the main factors that facilitate the commitment and concealment of fraud. It has already been explained that weaknesses and/or breakdowns in the following control aspects could result in the commitment and concealment of fraud: (a) Segregation of duties; (b) Authorization (particularly of expense items and new ledger accounts); (c) Completeness and accuracy of accounting data; (d) Safeguard procedures (e.g., control and custody of cheque books, receipt books, etc.) (e) Internal check arrangements; (f) Comprehensiveness of controls; and (g) Internal audit arrangements. In addition, there are certain conditions or events that indicate the possible existence of fraud. They include: 1. Questions with respect to the integrity or competence of management, examples are: (a) Dominance of management by one person or a small group; (b) Existence of a complex corporate structure where such complexity does not seem to be warranted in the circumstances of the particular case; (c) Obvious failure to remedy major weaknesses in internal control in spite of reasonable possibilities to do it (d) High turnover rate or frequent changes of key accounting and financial personnel; (e) Prolonged understaffing of the accounting department; (f) Frequent changes of legal advisors, auditors, etc.
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2. Unusual pressures within the entity, examples are: (a) Declining trend shown by the industry; (b) Frequent failures of other units operating within the same industry; (c) Deteriorating quality of earnings such as increased risk taking with respect to credit sales, changes in business practices, selection of accounting policy alternatives, etc with a view to showing improved income; (d) Necessity to support the market price of shares by showing a rising trend in profit; (e) Significant investment in an industry or product line noted for rapid technological change; (f) Heavy dependence on one or a very limited range of products or customers; (g) Pressure on accounting personnel to complete financial statements in an unusually short period of time. 3. Unusual transactions, for example: (a) Unusual or non-recurring transactions, especially towards the year end, that have a material impact on earnings; (b) Related-party transactions; (c) Exceptionally large payments to individuals or firms providing professional services to the entity, such as legal advisors, agents, consultants, etc; 4. Problems in obtaining sufficient appropriate evidence in support of entries in the records, for example: (a) Inadequate records, such as incomplete records, failure to record transactions in accordance with accepted procedures, unbalanced control accounts, etc.; (b) Inadequate documentation of transactions, such as lack of proper authorization, non-availability of original vouchers, alteration to documents, etc.; (c) Differences or conflicts disclosed by audit procedures, such as an unreasonably large number of differences between the accounting records and confirmation with third parties, unexplainable fluctuations in key accounting ratios, etc.;
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(d) Evasive or unreasonable responses by management in relation to queries concerning accounting and related matters. It may be made clear at the very outset that techniques employed in committing fraud vary widely, and hence it would be difficult to list every one of them. It is common knowledge that cash is the most readily convertible of all assets and hence most vulnerable to misappropriation. Items of stock and fixed assets are also vulnerable to misappropriation. Frauds involving misappropriation of these items are usually committed by employees either in isolation or in collusion with others within the entity or third parties outside the entity. There is another kind of fraud that does not involve any misappropriation or embezzlement of cash or other assets. This is usually committed by people at the top. The object is to show the financial statements in a different light other than a true and fair view by distorting the figures included therein effected through falsification of records. An accountant investigating any kind of fraud should be careful to look for the indications outlined above. He will need to consider information available from prior experience, if any, and knowledge of the clients business in general and the accounting system and related internal controls in particular. More specifically, the plan of action chalked out by the investigating accountant will depend, to a large extent, on his judgment as to: The types of fraud that are likely to occur (or have occurred previously) The relative risk of their occurrence While carrying out his procedures, the investigating accountant should bear in mind the fact that he may come across indications of the possibilities of fraud. Examples of such indications include: Missing vouchers or documents Altered vouchers or documents Evidence of falsified documents Unsatisfactory explanations Figures, trends or results that are inconsistent with expectations Unexplained items on reconciliations, control accounts or suspense accounts Evidence of disputes Evidence of unduly lavish lifestyles by members of staff Unusual investment of funds held in a fiduciary capacity
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It is important that the investigating accountant should keep his programme of work sufficiently flexible to follow up any such indications coming to his attention. Equally important is the point that unless circumstances clearly indicate otherwise, he should not assume that an instance of fraud is an isolated occurrence.
3. Fill in the blanks. (a) In the case of an investigation regarding ________ of a business, the accountant should obtain an outline history of the business. (b) Before making an investment in shares, the investigator should check the particulars with the __________ of Joint Stock Companies. (c) Before purchasing a business, the investigator should obtain the trading and profit loss accounts for a period ranging between _____ to ________ years. (d) Fraud means intentional _______ of financial information. 4. State whether the following statements are true or false. (a) While redrafting the accounts of a proposed business purchase, the investigating accountant should make adjustments to the figure contained therein by excluding from profits all exceptional, non-trading and extraordinary profits. (b) It is important for the investigating accountant to establish whether a proposed investment through acquisition of shares, etc. falls within the range of those covered by appropriate regulations. (c) Partnership deed should be studied for investigation on behalf of an incoming partner. (d) Before granting a loan, it is not important to know the reasons for the requirement. (e) Misapplication of accounting policies does not constitute fraud.
11.5 Summary
Let us recapitulate the important concepts discussed in this unit: Investigation implies an examination of the accounts and records with a definite object in view.
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Investigation is required to be carried out in companies for a variety of reasons. Some of these are to judge the viability of acquiring a business or shares of a company, ascertain the credentials of an incoming partner, assess the financial health of an entity before granting loans, detect misappropriation of money and embezzlement or learn the truth about a suspected fraud. Investigations into account books are normally carried out by qualified accountants who are well-versed in the techniques and modalities of account keeping. However, unlike for auditing, it is not mandatory that an investigation can be carried out only by a qualified accountant. It is important for the investigating accountant to get clear instructions in writing. This will avoid the possibilities of any future disputes and will enable the accountant to decide on the extent of the detailed work. While drafting the report, the investigating accountant should bear in mind the general principles of reporting. Although the detailed procedures adopted to carry out an investigation resemble those of an audit in many ways, there are certain essential differences between investigation and audit. In the case of an investigation regarding business purchase, the stages involved are: (i) preliminary matters, (ii) examination of the accounts and adjustments thereof, (iii) obtaining the details of the trading and profit and loss accounts for an appropriate number of years and redrafting in columnar form on a uniform basis for easy comparison and ascertainment of significant trends, (iv) making proper adjustment to the figures while redrafting by excluding profits in the case of certain items and adding back to profits in the case of certain other items, (v) establishing the trend of the business by working out key accounting ratios and making detailed enquiries concerning marked fluctuations in these ratios, and (vi) making enquiries beyond the details contained in the books and accounts. In addition to the broad pattern of stages involved in the case of an investigation regarding business purchase, certain additional work will have to be carried out by the accountant investigating on behalf of a proposed investment in a limited companys shares. Where a company proposes to make an investment by acquiring the whole of the shares of another company, the investigating accountant should also consider the potential for improved profitability. It is equally important
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to establish whether the proposed investment through acquisition falls within the range of those covered by appropriate regulations.
11.6 Glossary
Embezzlement: To take (money, for example) for ones own use in violation of a trust. Litigation: A legal proceeding in a court; a judicial contest to determine and enforce legal rights. Overdraft: A deficit in a bank account caused by drawing more money than the account holds. Bad debt: Loans given, the recovery of which is unlikely or uncertain.

1. What is an investigation? Under what situations is it conducted? 2. Distinguish between investigation and auditing. 3. Explain the matters to be considered by an investigating accountant regarding purchase of a business. 4. Explain the matters to be considered by an investigating accountant in relation to investment in the shares of a limited company. 5. What is a fraud? What are the important points to be kept in mind when investigating a suspected fraud?

1. (a) qualified accountant; (b) preserve; (c) different; (d) requirement 2. (a) True; (b) False; (c) True; (d) False; (e) True; (f) False; (g) False 3. (a) purchase; (b) Registrar; (c) three, five; (d) misrepresentation 4. (a) True;(b) True; (c) True; (d) False; (e) False
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1. Refer to Section 11.2.1 2. Refer to Section 11.3 3. Refer to Section 11.4.1 4. Refer to Section 11.4.2 5. Refer to Section 11.4.5

1 Rawat, D S. 2013. Students Guide to Auditing Standards. 18th Revised Edition, India: Taxmann. 2 Shekhar, L and Shekhar KC. 2003. Auditing. 20th edition, Delhi: Vikas Publishing House.
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Structure
Auditing Standards and Procedures
12.1 Introduction Objectives 12.2 Auditing Standards and Procedures 12.3 Auditing Standards and Procedures: An Overview 12.4 Generally Accepted Accounting Practices and Auditing Procedures 12.5 Statements on Standard Auditing Practices and Guidance Notes 12.6 Summary 12.7 Glossary 12.8 Terminal Questions 12.9 Answers 12.10 Further Reading
12.1 Introduction
In the previous unit, you learnt the meaning of investigation as also the difference between general investigation and auditing investigation with reference to business purchases and investments. To make your understanding of the concept of auditing comprehensive, this unit will explain the auditing standards and procedures that are mandatory in India. It will also delineate the professional behaviour expected of an auditor and will give you an overview of the generally accepted accounting practices and auditing procedures in the country.
Objectives
After studying this unit, you should be able to: Describe the mandatory accounting standards issued by Institute of Chartered Accountants of India Delineate the professional ethics of an auditor Explain the auditing standards and procedures Analyse the generally accepted accounting practices and auditing procedures Elucidate on statements on standard accounting practices and guidance notes
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12.2
Auditing Standards and Procedures
Lack of standardization and absence of standards in auditing will lead to various firms adopting diverse procedures as per their needs and suitability. Some basic uniformity is essential to ensure that accounting exercises do not result in reams of numbers and figures that make sense to only those who arrived at them. Let us examine the need for preparing accounting and auditing standards.
12.2.1 Need for Auditing Standards

At the very outset, it may be noted that the aim of accounting standards is to harmonize different accounting policies and practices in India. In other words, the objective of accounting standards is to reduce the accounting alternatives in the preparation of financial statements, thereby ensuring comparability of financial statements of different entities in order to provide meaningful information to the users of such statements with a view to enabling them to make informed decisions. The accounting standards not only prescribe appropriate accounting treatment of complex business transactions but also ensure greater transparency and market discipline. They also serve the purpose of helping the regulatory agencies in benchmarking accounting accuracy.
12.2.2 Mandatory Accounting Standards Issued by the Institute of Chartered Accountants of India
Accounting Standards Body (ASB) constituted by the Institute of Chartered Accountants of India (ICAI) in 1977 formulated the accounting standards on the basis of the International Financial Reporting Standards/Standards Board. These international accounting standards are issued under the authority of the Council of the ICAI. Interpretations and guidance on issues arising from accounting standards are provided by the ASB. The ASB undertakes review of these standards from time to time and, if necessary, revises the same. In issuing accounting standards, efforts are made to conform to the provisions of applicable laws, customs, usages and business environment in India. In case a particular standard is not in conformity with the law, the provisions of the law will prevail. Accounting standards are intended to apply only to items that are material. The standard becomes mandatory from the date mentioned in the accounting standard. It means that it will be the duty of chartered accountants to examine whether the standard is complied with in the presentation of relevant
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financial statements. In case there is any deviation from the standard, it is the duty of the accountant to make adequate disclosure in the audit report so that the users of financial statements are aware of such deviation. It is the responsibility of the management to ensure compliance with the mandatory accounting standards while preparing financial statements. It may be noted in this connection that the Companies Act gives legal recognition to the accounting standards issued by the ICAI. In terms of the Companies Act, statutory auditors of every company are required to report whether the accounting standards have been complied with or not. In addition, the Insurance Regulatory and Development Authority, the Securities and Exchange Board of India and the Reserve Bank of India require compliance with accounting standards.
12.2.3 What are the Mandatory Standards

Mandatory accounting standards issued by the Institute of Chartered Accountants of India as on 1 July 2012 are: (i) disclosure of accounting policies, (ii) valuation of inventories, (iii) cash flow statements, (iv) contingencies and events occurring after the balance sheet date, (v) net profit or loss for the period, prior period items and changes in accounting policies, (vi) depreciation accounting, (vii) construction contracts, (viii) revenue recognition, (ix) accounting for fixed assets, (x) effects of changes in foreign exchange rates, (xi) accounting for government grants, (xii) accounting for investments, (xiii) accounting for amalgamations, (xiv) employee benefits, (xv) borrowing costs, (xvi) segment reporting, (xvii) related party disclosures, (xviii) accounting for leases, (xix) earnings per share (xx) consolidated financial statement, (xxi) accounting for taxes on income, (xxii) accounting for investment associates in consolidated financial statement, (xxiii) discontinuing operation, (xxiv) interim financial reporting, (xxv) intangible assets, (xxvi) financial reporting on interest in joint ventures, (xxvii) impairment of assets, (xxviii) provisions, contingent liabilities and contingent assets, (xxix) financial instrument, (xxx) financial instrument presentation, and (xxxi) financial instruments disclosures and limited revision to accounting standards.
12.2.4 Professional Ethics of an Auditor

A code of professional ethics is a necessary pre-requisite for the success of the accountancy profession. Chartered accountants who attest the financial statements of organizations have certain responsibilities and obligations towards those who rely on their work. According to the International Federation of Accountants, Persons who pursue a vocation in which they offer their knowledge
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and skills in the service of the affairs of others have responsibilities and obligations to those who rely on their work. An essential pre-requisite for any group of such persons is the acceptance and observance of professional ethical standards regulating their relationship with clients, employers, employees, fellow members of the group and the public. The Code of Ethics requires that the objectives of accountancy profession are to set the highest standards of professionalism, to attain the highest level of performance, and generally to meet the public interest requirements. Four basic needs are involved in these objectives, viz., credibility, professionalism, quality of service and confidence. With a view to achieving these objectives, chartered accountants in service have to display the following qualities: Professional competence: An audit should be carried out and the audit report should be prepared only by persons who have adequate training, experience and competence in auditing. And the auditor should be careful to exercise due skill and professional care throughout his work. What is due skill and professional care will depend on the circumstances of each particular case. So also the extent of training, experience and competence required of audit assistants will depend on the gradations and functions of work carried out by them. It need hardly be emphasized that specialized skills and competence are required of an auditor. These are acquired through a combination of general education, technical knowledge obtained through study and formal courses concluded by a qualifying examination, and practical experience under proper guidance and adequate supervision. It is of utmost importance that an auditor should refrain from undertaking or continuing any audit assignment which he is not competent to carry out unless he obtains such advice and guidance as will enable him to carry out his assignment successfully. Knowledge of current developments: It is equally important that an auditor should have a continuing awareness of developments including relevant national and international pronouncements in the fields of accounting and auditing, and relevant regulations and statutory requirements. This will ensure that his client receives the advantage of competent professional advice based on up-to-date developments in practice, legislation and techniques. Integrity and objectivity: Integrity and objectivity are pre-eminent qualities expected in all auditors. An auditor should be straightforward, honest and sincere in his approach to professional work. Fairness: An auditor must be fair and should not allow prejudice or bias to override his objectivity. He should ensure that he maintains an impartial attitude
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while he is reporting on the financial statements subjected to his examination. He should both be and appear to be independent of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity and objectivity. In other words, an auditor should be, and seen to be, independent in each professional assignment he undertakes of any interest which might detract him from objectivity. Non-biased and independent: An auditor must approach his work with an independent attitude. He should not do anything that would adversely affect that independence. As a matter of fact, independence is an essential concomitant to integrity and objectivity in an auditor. It is the quality which permits the auditor to apply unbiased judgment and objective consideration to established facts in arriving at an opinion. In considering situations that may come into conflict with an auditors independence, the following matters are important. (i) Financial involvement, direct or indirect, in a clients affairs, e.g., in the case of a limited company being in the position of a shareholder, loans to or from clients, etc. (ii) Cases where an auditor or a firm of auditors earn the major part of their professional income from one client or a group of connected clients. (iii) Personal and family relations. For instance where the same partner or member of staff is in charge of the audit of a particular client for a number of years; where the auditor has a mutual business interest with an officer or employee of a client; where the auditor has an interest in a joint venture; close friendship or relationship by blood or marriage; etc. (iv) Acceptance of audit assignments on a contingent fee basis. Confidentiality: An auditor should respect confidentiality of information acquired in the course of performing his work and should not disclose any such information unless there is specific authority from the client or there is a legal or professional reason for disclosure. It is equally important that he should ensure that the principle of confidentiality is observed by the members of staff under his control and others from whom he obtains advice and assistance. Ethical behaviour: It is the duty of the auditor to refrain from any conduct that might bring discredit to the profession. The code of conduct laid down by the relevant professional body in this regard should be strictly observed. Such a code covers aspects such as responsibilities to the clients, to the members of the same professional body, to fellow auditors, to third parties and the general public. Reliance on work performed by others: Where an auditor relies on work performed by other auditors (e.g., branch auditors appointed under the Companies Act) or experts or his own assistants, he should ensure that such
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persons have adequate skills and competence to carry out their work and should carefully direct, review and supervise their work. He should not forget the fact that when he delegates work to assistants, or makes use of work performed by others, he continues to be responsible for forming and expressing his own opinion on the financial statements. Thorough documentation: It is important that an auditor should document matters that are important in providing sufficient evidence that the audit was carried out in accordance with the principles governing an audit. Such documentation should be aimed at recording and demonstrating the steps taken by the auditor to enable him to form an opinion on financial statements under his examination. Proper planning: Proper planning of the audit work is a necessary prerequisite for effective and efficient conduct of an audit. Planning should be continuous throughout the engagement and plans should be revised to suit the developing circumstances. The auditor should study and evaluate the accounting system and the related internal controls instituted by the clients management in order to identify those controls on which audit reliance may be placed and then determine the nature, extent and timing of audit procedures to be carried out. Valid audit evidence: An auditor should obtain and retain relevant and valid audit evidence through the performance of compliance procedures and substantive procedures to enable him to draw reasonable conclusions therefrom on which to base his opinion on financial statements. Adequate review of financial statements: An auditor should carry out a review of the financial statements in conjunction with the conclusions drawn from the audit evidence obtained during the course of the examination to form conclusions concerning the financial statements, with due consideration to the following points: (i) whether the financial statements have been prepared using acceptable accounting policies that have been consistently applied and are appropriate to the particular case; (ii) whether the financial statements comply with all relevant statutory requirements and other relevant regulations; (iii) whether the individual items appearing in the financial statements are consistent with each other, with known trends and with the auditors knowledge of the business; (iv) whether the view presented by the financial statements as a whole is consistent with the auditors knowledge of the business concerned; (v) whether there is sufficient disclosure of all material matters relevant to the proper presentation of financial statements and individual items contained therein are classified and presented in a proper manner; (vi) whether the conclusions drawn from the audit procedures carried out together with those drawn from the auditors overall assessment of
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the financial statements enable him to draw enough conclusions for the expression of his opinion. Clear preparation of audit report: The report through which the auditor is expressing his opinion on the financial statements subjected to his examination should be worded in an unambiguous manner. The absence of any comment in the report is equivalent to a positive statement by the auditor that he has investigated and satisfied himself on the points referred to in the preceding paragraph. Where an opinion other than unqualified is given, it should be direct and informative. It should be so phrased as to leave the reader in no doubt as to its meaning or the view formed by the auditor. In conclusion, it may be stated that pride of service in preference to personal gain is the sum total of the professional ethics of an auditor. A code of professional ethics of an auditor has the force of law as well as the result of discipline and conventions voluntarily established by members of the professional body. Any breach of the code would result in the person being disentitled to continue as a member of the professional body. This could rightly be considered as an assurance to the public that in case a member strays away from the path of duty, he would suitably be dealt with by the professional body. It may not be out of place to mention in this connection that the Council of the ICAI has been empowered to inquire into the conduct of any member of the Institute which may in the opinion of the Council be not desirable and/or expected of a chartered accountant and take appropriate disciplinary action.
1. State whether the following statements are true or false. (a) The aim of accounting standards is to harmonize different accounting policies and practice in India (b) It is not the responsibility of the management of an enterprise to ensure compliance with mandatory accounting standards while preparing financial statements. (c) Independence of an auditor has nothing to do with integrity and objectivity. (d) When an auditor relies on work performed by other auditors or his own assistants, he should ensure that such persons have adequate skills and competence.
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2. Fill in the blanks: (a) The objective of accounting standards is to reduce the _______in the preparation of financial statements. (b) Accounting standards are issued under the authority of the __________. (c) The _________ Act gives legal recognition to the accounting standards issued by the ICAI. (d) A ________ is a necessary pre-requisite for the success of the accountancy profession.
12.3 Auditing Standards and Procedures: An Overview

By the term standard we mean the degree of excellence required to achieve a particular objective. It may be defined as a measure accepted by an authority or by general consent, to which one is expected to conform and in relation to which a performance can be judged. Viewed in this light, an auditing standard is a measure of the degree of excellence that an auditor is expected to conform and which measure is laid down by professional bodies with the consent of the independent auditing community in general. For example, the statement that due professional care is to be exercised in the performance of the examination and the preparation of the audit report is an auditing standard. Again, sufficient competent evidential matter is to be obtained through inspection, observation, enquiries and confirmations to afford a reasonable basis for an opinion regarding financial statements under consideration is another auditing standard. By the term techniques of auditing we mean the basic methods to be adopted or the acts to be performed by an auditor for collecting and evaluating audit evidence. C A Moyer has distinguished auditing standards and auditing techniques thus:
Auditing standards are criteria or measures of performance. Auditing techniques are the devices or methods available to the auditor for obtaining competent evidential matter. They are the working tools of the auditor.
Thus while techniques of auditing refer to the acts to be performed by an auditor, standards in auditing refer to the degree of excellence of these acts and of the objectives to be achieved by the use of these techniques. In short, standards in auditing provide the basis for acceptance of various audit techniques as Standard Auditing Practice.
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In selecting a particular auditing technique, special attention will have to be paid to two important points, viz., (i) the peculiar characteristics of the assertion in the books of account, documents, statements, etc. to be reviewed, and (ii) the nature of evidence available in support of that assertion. With development in the scope of auditing, the changes in the methods of maintaining the books of account and the growth in the complexities of circumstances in which business enterprises operate, there is a need to update auditing techniques on an ongoing basis. Examples of more important auditing techniques may be summarized as under: (a) Physical verification. (b) Observation. (c) Enquiry and confirmation (d) Examination of documents and their comparison with records (e) Computation (f) Analytical review
12.3.1 Audit Procedures

Audit procedures may broadly be defined as the acts performed by the auditor in the course of attaining the objectives of his examination. Audit procedures and audit techniques are closely related. Audit procedures are ways of applying audit techniques to particular phases of a particular audit assignment. In more clear terms, audit procedures are the specific means to carry out a particular audit technique. For instance, enquiry and confirmation is an auditing technique. In support of verification of debtor balances, this technique is often employed by auditors. But an auditor may use either the positive method or negative method of circularization. The specific method adopted by the auditor to carry out the audit technique of enquiry and confirmation in this case becomes the audit procedure. Thus, audit procedures may be designed to incorporate the use of various audit techniques to achieve a specific objective. The design and modification of different audit procedures to fit different audit objectives and situations is largely dependent on various circumstances of each audit engagement and the individual judgment of the auditor. It has been correctly stated that through controlled planning and execution of audit procedures, an auditor achieves compliance with auditing standards and thereby develops a professionally defensible audit opinion. The audit procedures selected for a particular audit engagement or examination are generally combined in a written plan styled audit programme.
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12.4 Generally Accepted Accounting Practices and Auditing Procedures

12.4.1 Generally Accepted Accounting Practices
Generally accepted accounting practices are the rules to which accountants adhere while preparing the financial statements. They exist in order to ensure that accountants use them or almost the same practices so as to achieve easy comparison of different financial statements in addition to promoting transparency in accounting. Uniformity can be achieved only if accounting transactions are recorded on the basis of certain definite practices or principles which implies that there is a need to follow uniform accounting practices from the stage of recording business transactions to the stage of preparation of financial statements. Thus, generally accepted accounting practices are the rules based on assumptions, customs, usages and traditions for recording business transactions and preparing financial statements. Accounting has developed its own concepts and conventions and they have now become acceptable accounting practices. Accounting practices may be divided into two categories, viz., (a) accounting concepts and (b) accounting conventions. Primarily, they are dependent on how they meet such criteria as objectivity, application, reliability, feasibility and understandability. Accounting concepts refer to assumptions and conditions on which accounting is based. Accounting conventions refer to usages and customs of accounting. Since conventions are useful for better understanding, they are used for the preparation of accounting statements. Conservatism, consistency, materiality and full disclosure are types of accounting conventions. Fundamental Accounting Concepts The Accounting Standards Committee (UK) defines fundamental accounting concepts as broad basic assumptions which underlie the periodic financial accounts of business enterprises. Though a number of accounting concepts have been developed, the following four fundamental concepts are regarded as having such general acceptance that they call for no explanation in published accounts unless stated otherwise. Of course, the relative significance of each will vary according to the circumstances of the particular case. It may be mentioned in this connection that these are practical rules rather than theoretical
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ideals and are capable of variation and evolution as accounting thought and practice develop, but their present generally accepted meanings are as follows: (i) The Going Concern Concept: It is assumed that the enterprise will continue in operational existence for the foreseeable future. This means in particular that the Profit and Loss Account and the Balance Sheet assume no intention or necessity to liquidate or curtail significantly the scale of operation. The importance of this concept stems from the fact that if the enterprise decides to liquidate or becomes bankrupt, a different basis will have to be adopted in the valuations used for the preparation of accounts. More about this point is considered in the unit dealing with Audit Reports. (ii) The Accruals Concept: Revenue and costs are accrued (that is, recognized as they are earned or incurred, not as money is received or paid), matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period in which they relate; provided that where the accruals concept is inconsistent with the prudence concept, the latter prevails. The accruals concept implies that the profit and loss account reflects changes in the amount of net assets that arise out of the transactions of the relevant period other than distributions or subscriptions of capital and unrealized surpluses arising on revaluation of assets). Revenue and profits dealt with in the profit and loss account are matched with ascertained costs and expenses by including in the same account the costs incurred in earning them (so far these are material and identifiable). (iii) The Consistency Concept: In accounting treatment certain alternatives are considered equally applicable. But according to the consistency concept, it is assumed that, once an alternative is adopted; there is consistency of accounting treatment of like items within each accounting period and from one period to the next. (iv) The Concept of Prudence: (Otherwise known as the concept of conservatism) Revenue and profits are not anticipated, but are considered as earned only when realized in the form either of cash or of other assets, the ultimate realization of which can be assessed with reasonable certainty. Provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate in the light of information available. In the application of the fundamental accounting concepts, some problems are likely to arise. One such problem arises from the fact that many business
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transactions have financial effects spreading over a number of years. Decisions have to be made on the extent to which expenditure incurred in one year can reasonably be expected to produce benefits in the form of revenue in other years and should therefore be carried forward, in whole or in part: that is, should be dealt with as an expense of the current year in the profit and loss account because the benefit has been exhausted in that year. There are also cases where revenue is received for goods or services the production or supply of which will involve some later expenditure. In such cases, a decision will have to be made as to how much of the revenue should be carried forward, to be dealt with in subsequent profit and loss accounts when the relevant costs are incurred. In all these cases, consideration will have to be given to future events of uncertain financial effects, and to this extent, an element of commercial judgment is unavoidable in the assessment. Examples of matters that give rise to particular difficulty are: future benefits to be derived from stock in trade and work in progress at the end of the year; future benefits to be derived from fixed assets, and the period of years over which these will be fruitful; the extent to which expenditure on research and development can be expected to produce future benefits. Accounting Bases Accounting bases are defined as the methods that have been developed for expressing or applying fundamental accounting concepts to financial transactions and items. In the course of practice, diverse and numerous accounting bases have been developed to provide consistent, fair and objective solutions to these problems in particular circumstances, e.g., bases for calculating such items as depreciation, the amounts at which stock in trade and work in progress are to be stated, etc. Though accounting bases provide an orderly and consistent framework for periodic reporting of an entitys results and financial position, they should not be considered as substitutes for the exercise of commercial judgment in the preparation of financial statements. Where there are a number of accounting bases to choose from, judgment will have to be exercised to select those which are best suited to present fairly the results and financial position of the business. The bases thus adopted then become the accounting policies of the particular business concerned. The significance of accounting bases is that they provide limits to the area subject to the exercise of judgment, and a check against
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arbitrary, excessive or unjustifiable adjustments where no other objective yardstick is available. By definition it is not possible to develop generalized rules for the exercise of judgment, though practical working rules may be evolved for limited use in particular circumstances. The longer a concerns normal business cycle the period between initiation of business transactions and their completion the greater the area subject to judgment and its effect on periodic financial accounts, and the less its susceptibility to close regulation by accounting bases. Following are examples of significant matters for which different accounting bases are recognized and which may have a material effect on profits or losses and financial position as disclosed through the balance sheet. The examples should not be considered as exhaustive. They may vary according to the nature of the operations conducted. (a) Depreciation on fixed assets (b) Treatment and amortization of intangibles such as research and development expenditure, patents and trade marks (c) Stock in trade and work in progress (d) Long-term contracts (e) Repairs and renewals (f) Hire purchase and instalment transactions (g) Conversion of foreign currencies Accounting Policies Accounting policies may be defined as the specific accounting bases selected and consistently followed by a business enterprise as being, in the opinion of the management, appropriate to its circumstances and best suited to fairly present its results and financial position. It may be noted here that disclosure of accounting policies is significant. This is in view of the fact that in those cases where more than one accounting basis is acceptable in principle, the accounting policy followed by a business can significantly affect its profits or losses and financial position as disclosed through the balance sheet. It naturally follows that the view thus presented can be properly appreciated only if the policies followed in dealing with material items are disclosed and explained. A few examples of significant matters that require a clear explanation of accounting policies for dealing with them have already been mentioned. The
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management should identify those items of the type mentioned that are judged material or critical for the purpose of determining and fully appreciating the organizations profits or losses and its financial position and should make clear the accounting policies followed for dealing with them. The following Standard Accounting Practice is recommended in this connection: 1. If accounts are prepared on the basis of assumptions that differ in material respects from any of the generally accepted fundamental concepts mentioned above, the facts should be explained. In the absence of a clear statement to the contrary, there is a presumption that the four fundamental concepts have been observed. 2. The accounting policies followed for dealing with items that are judged material or critical in determining profit or loss for the year and in stating the financial position should be disclosed by way of notes to the accounts. The explanations should be clear, fair and as brief as possible. Auditors Duties It is the duty of the auditor to ensure that the principles explained above are followed by his client. Sometimes the auditor may find that one of the fundamental accounting concepts is inconsistent with another. Here, he will have to exercise his judgment according to the circumstances prevailing in the particular instance. By way of an example, it may be repeated here that where the accruals basis is inconsistent with the prudence basis, the latter should prevail. The overall object should be to ensure that a true and fair view is disclosed. It need hardly be pointed out that if the accounts are prepared on assumptions that differ in material respects from any of the generally accepted fundamental accounting concepts, the facts should be explained. As a general rule, the auditor should first consult with the management to ensure that the accounts give a true and fair view. In case he finds that the management is not financially in agreement with him, he would have to make a mention of the fact in his report. The auditor should mention in his report any material departures from accounting standards made by the management in preparing the financial statements. This is in spite of the fact that such departures are disclosed in the notes to the financial statements. In addition to this, the auditor should give a qualified opinion if, in his opinion, the departure is not justified and hence the financial statements fail to give a true and fair view. If possible, he should also state the financial effects of the departure.
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The auditor may sometimes agree with the departure as a means of ensuring true and fair view of the financial statements. Even in such cases, the matter should be referred to in his report stating that he agrees with the departure. If the notes forming part of the financial statements fully explain the facts relating to the departure, it is enough for the auditor to make a reference to the circumstances in his report, provided that the financial statements together with the notes show a true and fair view.
12.4.2 Generally Accepted Auditing Procedures

Inspection, observation, enquiry and confirmation, computation and analytical review are the generally accepted auditing procedures. A detailed discussion on these procedures is given in Unit 2 under the sub-heading Methods of Obtaining Audit Evidence. In order to avoid needless repetition, the readers attention is invited to this part in Unit 2. This may be read in conjunction with Audit Procedures explained earlier in this unit.
12.5 Statements on Standard Auditing Practices and Guidance Notes

Statement on Standard Auditing Practices Statements on standard auditing practices are mandatory since they have been issued by the Institute of Chartered Accountants of India in order to secure compliance by members of the Institute on matters, which, in the opinion of the Council of the Institute, are critical for proper discharge of their functions. As such, it will be the duty of the chartered accountants to (i) examine whether statements relating to accounting matters are complied with in the presentation of financial statements covered by their audit and to make adequate disclosure in the audit reports concerning any deviation from the statements, and (ii) ensure that the statements relating to auditing matters are followed and to draw attention in the audit reports to any material departures. The Institute has so far issued four statements, viz., (i) Statement on Auditing Practices that was withdrawn subsequent to the issue of a number of AAS and Guidance Notes on the topics covered by the statement, (ii) Statement on Payments to Auditor for Other Services, (iii) Statement on Qualification in Auditors Report, and (iv) Statement on the Companies (Auditors Report) Order, 2003.
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Guidance Notes The primary object of Guidance Notes is to provide guidance to the members of the ICAI concerning matters that may arise in the course of their professional work on which they may desire assistance in resolving issues that pose difficulty. These notes are recommendatory. Ordinarily, a chartered accountant should follow recommendations contained in a guidance note concerning an auditing matter. The exception to this is where he is satisfied that in the particular circumstance of the case, it may not be necessary to do so. When a chartered accountant is discharging his attest function, he should examine whether the recommendations in a guidance note concerning an accounting matter have been followed or not.
3. State whether the following statements are true or false. (a) Standards in auditing provide the basis for acceptance of various audit techniques as Standard Auditing Practice. (b) Examination of documents and their comparison with records is an audit procedure. (c) Accounting concepts refer to assumptions and conditions on which accounting is based. (d) In terms of going concern concept, business would continue to run indefinitely beyond the foreseeable future. (e) Cost concept is applicable to fixed assets and current assets. (f) Accounting conventions refer to usages and customs of accounting that are used for the preparation of accounting statements. (g) The concept of prudence is otherwise known as the concept of conservatism. 4. Fill in the blanks: (a) ________ are criteria or measures of performance. (b) Audit ________ are the specific means to carry out a particular audit technique. (c) The audit procedure selected for a particular audit assignment or examination is generally combined in a written plan styled ________.
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(d) Accounting practices may be divided into two categories, viz., ________ and ________. (e) Inspection, observation, enquiry and confirmation, computation and ________ are the generally accepted procedures. (f) Statements on Standard Audit Practices are ________.
12.6 Summary
Let us recapitulate the important concepts discussed in this unit: The objective of accounting standards is to reduce the accounting alternatives in the preparation of financial statements, thereby ensuring comparability of financial statements of different entities in order to provide meaningful information to the users of such statements with a view to enabling them to make informed decisions. Accounting Standards Body formulates accounting standards. These standards are issued under the authority of the Council of the Institute of Chartered Accountants of India (ICAI). Companies Act gives legal recognition to these standards. There are 31 mandatory accounting standards issued by the ICAI. A code of ethics is a necessary pre-requisite for the success of accountancy profession. Such a code requires that the objectives of accountancy profession are to be the highest standards of professionalism, to attain the highest level of performance, and generally to meet the public interest requirements. In order to meet these objectives, chartered accountants in practice have to observe certain fundamental principles. Pride of service in preference to personal gain is the sum total of the professional ethics of an auditor. An auditing standard is a measure of the degree of excellence that an auditor is expected to conform and which measure is laid down by professional bodies with the consensus of the auditing community in general. Auditing standards are criteria or measures of performance. Auditing techniques are the devices or methods available to auditors for obtaining competent evidential matter. Important auditing techniques are physical verification, observation, enquiry and confirmation, examination of documents and their comparison with records, computation and analytical review.
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Audit procedures are ways of applying audit techniques to particular phases of a particular audit assignment. Generally accepted accounting practices are rules to which accountants adhere while preparing financial statements. Accounting practices may broadly be divided into two categories, viz., accounting concepts and accounting conventions. Accounting concepts refer to assumptions and conditions on which accounting is based. Fundamental accounting concepts are: the going concern concept, the accruals concept, the consistency concept and the concept of prudence. Accounting bases are methods that have been developed for expressing or applying fundamental accounting concepts to financial transactions and items. Accounting policies are specific accounting bases selected and consistently followed by a business enterprise as being appropriate to its circumstances and best suited to fairly present its results and financial position. Inspection, observation, enquiry and confirmation, computation and analytical review are the generally accepted audit procedures. Statements on standard auditing practice are mandatory since they have been issued by ICAI. The primary objective of Guidance Notes is to provide guidance to chartered accountants concerning matters that may arise in the course of their professional work on which they desire assistance in resolving difficult issues. These notes are recommendatory.
12.7 Glossary
Deviation: The action of departing from an established course or accepted standard. Audit evidence: Evidence obtained during a financial audit and recorded in the audit working papers. Auditing techniques: Devices or methods available to the auditor for obtaining competent evidential matter. Circularization: The act of circulating printed documents or notices for information.
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Fundamental accounting concepts: Broad basic assumptions that underlie the periodic financial accounts of business enterprises.

1. Describe the professional competence and technical standards required of an auditor. 2. What are the salient features of generally accepted accounting practices? 3. Give an explanation of the going concern concept and the accruals concept in relation to accounting concepts. 4. Explain the concept and significance of accounting bases. 5. What are accounting policies? Why are they important? 6. Write a short note on Statement of Standard Auditing Practices. 7. Outline the meaning and significance of Guidance Notes. 8. What are the mandatory accounting standards issued by the Institute of Chartered Accountants of India? 9. Give an overview of auditing standards and procedures.

1. (a) True; (b) False; (c) False; (d) True 2. (a) accounting alternatives; (b) Council of ICAI; (c) Companies; (d) code of professional ethics 3. (a) True;(b) False; (c) True; (d) False; (e) False; (f) True; (g) True 4. (a) Auditing standards; (b) procedures; (c) audit programme; (d) accounting concepts, accounting conventions; (e) analytical review; (f) mandatory

1. Refer to Section 12.2.4 2. Refer to Section 12.4.1 3. Refer to Section 12.4.1
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4. Refer to Section 12.4.1 5. Refer to Section 12.4.1 6. Refer to Section 12.5 7. Refer to Section 12.5 8. Refer to Section 12.2.2 and 12.2.3 9. Refer to Section 12.3

1. Rawat, D S. 2013. Students Guide to Auditing Standards. 18th Revised Edition, India: Taxmann. 2. Shekhar, L and Shekhar KC. 2003. Auditing. 20th edition, Delhi: Vikas Publishing House.
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Unit 1

Principles and Practice of Auditing

1.2 Origin and Growth of Audit

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Principles and Practice of Auditing

1.3 Definition of Audit

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Principles and Practice of Auditing

1.4 Purpose of an Audit

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Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

1.5 Scope of an Audit

1.5.1 Non-Auditing Services

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Principles and Practice of Auditing

1.6 Difference between Bookkeeping, Accountancy and Audit

Principles and Practice of Auditing

Principles and Practice of Auditing

1.7 Advantages of an Audit

Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

1.8 Different Types of Audit

Principles and Practice of Auditing

Principles and Practice of Auditing

Principles and Practice of Auditing

Principles and Practice of Auditing

Principles and Practice of Auditing

Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

1.11 Terminal Questions

1.12 Answers Answers to Self-Assessment Questions

Answers to Terminal Questions

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Principles and Practice of Auditing

1.13 Further Reading

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Audit: Preparation and Procedure

Principles and Practice of Auditing

2.2 Preparations before an Audit

2.2.1 Documentation Audit Working Papers

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Principles and Practice of Auditing

2.2.2 Audit Files

Sikkim Manipal University

Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

Principles and Practice of Auditing

Sikkim Manipal University

Principles and Practice of Auditing

2.2.3 Letter of Engagement

Sikkim Manipal University

Principles and Practice of Auditing

2.3 Audit Planning

2.3.1 Importance and Benefits of Audit Planning

Principles and Practice of Auditing

2.3.2 Factors to be Considered When Planning an Audit

Principles and Practice of Auditing