Chapter 1. Nature of Auditing – Auditing: Principles and Techniques

Chapter 1

Nature of Auditing

CHAPTER OUTLINE
1.1 INTRODUCTION

The development of modern accountancy and the growth of auditing profession in India, and, indeed, in the world as a whole, must be seen in the context of the enormous expansion of industry and commerce, which has taken place since the Industrial Revolution. While business enterprises were comparatively small, and were managed by their proprietors, there was little need for the development of complex accounting procedures. When the scale of operations increased and capital was invested in joint stock companies by shareholders who took no part in the management of such companies, it became necessary for the managers to present accounts to the shareholders at regular intervals by means of annual accounts. However, the managers (or directors) of unsuccessful companies had an obvious vested interest in hiding the lack of success of their companies from the shareholders; this led to fraudulent accounting and resultant scandals. Governments therefore made provisions for the accounts of companies to be reported by persons other than the directors. In this way auditing was developed. The continuing increase in the size of enterprises and the greater complexity of their accounting procedures, have made increasing demands on the skill of auditors. Hence, it is required that accounts shall only be audited by qualified accountants, who are members of recognised professional bodies.

1.2 ORIGIN OF THE WORD ‘AUDIT’

The word ‘audit’ is derived from the Latin word ‘audire’, which means ‘to hear’. The origin of ‘audit’ can be traced back to olden times, but auditing as its existing form was established only in the middle of the 19th century.

In olden times, the methods of accounting were so crude and the number of transactions were so small that every individual was in a position to check all the transactions recorded by himself or by his employees. Whenever the owner of the business suspected frauds or misappropriation of funds, he appointed an official to check the accounts. Such a person would meet the concerned employees and hear whatever they had to say in connection with the accounts. The person appointed to examine the accounts came to be known as the ‘auditor’.

1.3 EARLY HISTORY OF AUDIT

Historical evidence reveals that soon after the ancient states and empires acquired a coherent organisation, systems of checks were applied to their public accounts as testified by ancient records. The ancient Egyptians, the Greeks and the Romans utilised systems of checks and counter checks among the various financial officials. The duties of the auditor in ancient times were thus limited.

The last decade of the 15th century, witnessed a great impetus in trade and commerce, inspired by the Renaissance in Italy. This led to the evolution of a system of accounts capable of recording completely all kinds of business transactions. The principles of double entry system were published in 1494, in Venice by Luca Pacioli, although the system had already been in existence in the preceding century. The author of the principles also defined and described, for the first time, the duties and responsibilities of ‘an auditor’ in detail. Since then, the duties and responsibilities of an auditor have increased enormously.

The Industrial Revolution was another landmark in the history of trade and commerce. It resulted in large scale production requiring huge amount of capital investment. Individuals were not in a position to provide adequate capital, because of their limited finances. It was at this time that the company as a form of business organisation came into existence, and this widened greatly, the possibilities of raising capital for industry from the general public by the issue of shares with a limited liability.

In this type of organisation, the shareholders delegated the management of the undertaking to a board of directors and periodically the board submitted the accounts of the company to the shareholders so that the shareholders were in a position to have a true and fair picture of the financial position and the profit and loss of the undertaking.

With the rapid growth in the number of companies, professional accountants came in the picture. In 1880, the Queen of United Kingdom granted a charter, which incorporated the various societies of accountants into a single body, the Institute of Chartered Accountants of England and Wales. By early 1990s, the concept of audit had developed to a stage where professional accountants became prominent as auditors. The objectives of audit were also changed during this time. Apart from detecting frauds and errors, the auditors also started verifying and reporting on the accuracy of the financial records and documents as well as the financial statements. The verification and attestation of financial statements became the primary objective of company audit. Detection of errors and frauds became incidental to the attainment of this objective. The Companies Act of 1948 in UK formalised this position.

Being under the British rule, the developments in the UK had a profound effect on the company legislation in India. The Joint Stock Companies Act of 1857 contained provisions for voluntary annual audit of company accounts. The Companies Act, 1913 made the audit of company accounts compulsory in India. The Act also prescribed, for the first time, the powers and duties of the auditors and the procedures of their appointment. In 1949, the Parliament of India passed the Chartered Accountants Act, under which a body of professional accountants, viz. The Institute of Chartered Accountants of India, was established. The Institute is an autonomous body, which regulates the profession of chartered accountants throughout India. In 1956, a new Companies Act replaced the Act of1913. The Act now contains elaborate provisions regarding qualifications and disqualifications of auditors, the method of appointment of auditors and their powers and duties.

1.4 AUDITING DEFINED

The word ‘Audit’ is derived from the Latin word audire, which means “to hear”. In olden times, whenever the owners of a business suspected fraud, they appointed certain persons to check the accounts. Such persons sent for the accountant and ‘heard’ what they had to say in connection with the accounts.

The dictionary meaning of audit is official examination of accounts. Obviously the person who examines the accounts must be a person who knows what to examine, how to examine and to whom his examination report and observations are to be submitted. In brief, it can be said that auditing is the process by which competent independent individuals collect and evaluate evidence to form an opinion and communicate their opinion to the person interested through their audit report.

From the above it is clear that the auditing process involves three components. These are as follows:

  • Books of accounts
  • Auditor
  • Techniques and procedures of audit

Montgomery, a leading American accountant, defines auditing as “a systematic examination of the books and records of a business or other organisations, in order to check or verify and to report upon results thereof”.

The ICAI has defined auditing in its Auditing and Assurance Standard –1 (AAS-1) 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 express an opinion thereon”.

From the above definitions, it is seen that an auditor has not only to see the arithmetical accuracy of the books of accounts but also has to go further and find out whether the transactions entered in the books of original entry are correct or not. It is possible to perform this function by inspecting, comparing, checking, reviewing, scrutinising the vouchers supporting the transactions in the books of accounts and examining the correspondence, minute books of the shareholders’ and directors’ meeting, Memorandum of Association and Articles of Associations etc.

1.5 ESSENTIAL FEATURES OF AUDITING

The following are the essential features of auditing:

1. Accounting control

Audit is an instrument of accounting control. The truth and fairness of the accounting information is controlled and checked by auditing activities.

2. Safeguard

Audit acts as a safeguard on behalf of the proprietor/s (whether an individual or a group of persons) against extravagance, carelessness or fraud on the part of the proprietors’ agents or servants in the realisation and utilisation of his/their money and other assets.

3. Assurance

Audit assures on the proprietors’ behalf that the accounts maintained truly represent facts and expenditure has been incurred with due regularity and propriety.

4. Assessment

Audit assesses the adequacy of the accounting system in order to ascertain its effectiveness in maintaining accounting records of an organisation.

5. Review

Audit carries out a review of the financial statements to know whether the accounting records are in agreement with those statements.

6. Reporting tool

Audit is a tool for reporting on the financial statements as required by the terms of the auditors’ appointment and in compliance with the relevant statutory obligations.

7. Practical subject

Auditing is a practical subject. It is something that people do. How it is done today is a result of long history of marginal changes and responses to new commercial and legal developments over the centuries with the most rapid progress in the last few years.

1.6 WHY IS THERE A NEED FOR AN AUDIT?

The problem that has always existed when the managers report to owners is the credibility of the report.

The report may

  • contain errors
  • not disclose frauds
  • be inadvertently misleading
  • be deliberately misleading
  • fail to disclose relevant information
  • fail to conform to regulations

The solution to this problem of credibility in reports and accounts lies in appointing an independent person called an auditor to investigate the report and submit his findings.

A further point is that modern companies can be very large with multi-national activities. The preparation of the accounts of such groups is a very complex operation involving the bringing together and summarising of accounts of subsidiaries with different conventions, legal systems and accounting and control systems. The examination of such accounts by independent experts trained in the assessment of financial information is of benefit to those who control and operate such organisations as well as to owners and outsiders.

Many financial statements must conform to statutory and other requirements. The most notable is that all company accounts have to conform to the requirements of the Companies Act. In addition, all accounts should conform to the requirements of accounting standards. It is essential that an audit should be carried out on financial statements to ensure that they conform to these requirements.

1.7 OBJECTIVE OF AN AUDIT

The original objective of an audit was principally to see whether the personnel involved in accounting had properly accounted for the receipts and payments of cash. In other words, the objective of audit was to find out whether cash had been embezzled and if so, who embezzled it and what amount was involved. Thus, it was only an audit of cash book. But, at present, the main aim of audit is to find out, after going through the books of accounts, whether the balance sheet and profit and loss account are drawn up accordingly and whether they represent a true and fair view of the state of the affairs of the concern. This is possible when the auditor verifies the accounts and the statements. While performing his duties, the auditor also has to discover errors and frauds.

The ICAI in its “statement on objective and scope of the audit of financial statements”AAS-2 enumerates the following as the objectives of auditing the financial statements:

  1. The objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements.
  2. The auditor’s opinion helps determination of the true and fair view of the financial position and operating results of an enterprise.

The auditor should be an independent person who is appointed to investigate the organisation, its records and financial statements prepared from them and thus form an opinion on the accuracy and correctness of the financial statements. The primary aim of an audit is to enable to confirm that the accounts show a true and fair view or, that they do not.

So, the primary aim of an audit is to promote efficiency and accuracy in accounting and to place before the shareholders and management accurate information of the financial condition of the business, which may serve as an aid to overall administration of the business entity. For the fulfillment of the primary objects of an audit, the following subsidiary objects are to be realised:

  • Detection of errors
  • Detection of frauds
  • Prevention of errors
  • Prevention of frauds

Again, errors, which arise out of innocence and carelessness, are of three types:

  • Clerical errors
  • Compensating errors
  • Errors of principles

Also, clerical errors may be of two types:

  • Errors of omission
  • Errors of commission

On the other hand, frauds which arise out of some intention to gain something through some manipulating devices are of three types:

  • Misappropriation or embezzlement of cash
  • Misappropriation of goods
  • Manipulation of accounts

The objectives of auditing can be presented in the following chart:

1.8 ERRORS AND FRAUDS IN ACCOUNTING

1.8.1 Errors

Generally errors are the result of carelessness on the part of the person preparing the accounts. During the course of auditing, errors may be detected, though auditing does not ensure detection of all errors. Errors can be described as unintentional mistakes. Errors can occur at any stage in business transaction processing i.e. transaction occurrence, documentation, record of prime entry, double entry record, summarising process or financial statement production. Errors can be of any of a multitude of kinds i.e. mathematical, clerical or in the application of accounting principles.

Accounting errors, which are possible to be detected through auditing, can be of the following types:

1. Errors of omission

When a transaction is omitted completely or partially from the books of accounts, it is known as an error of omission. This type of error is not reflected in the trial balance and hence are more difficult to detect.

 

Examples

  1. Omission of purchases from purchases day book.
  2. Ignoring depreciation on fixed assets completely.

2. Errors of commission

When entries made in the books of original entry or ledger are either wholly or partially incorrect, they are known as errors of commission. Some of these errors may not affect the trial balance.

 

Examples

  1. Wrong amount recorded in the books of original entry, e.g. sale of goods of Rs. 15,000 recorded as Rs. 1,500 in sales day book. This error will not affect trial balance.
  2. Posting to the wrong side of an account. In place of debiting, e.g. an amount of Rs. 150 is credited. This error will affect the trial balance.

3. Compensating errors

When an error offsets the effect of another error, it is known as a compensating error. These errors do not affect the agreement of the trial balance, hence cannot be located by it.

 

Examples

  1. A debit balance is undercast by Rs. 100 and credit balance is undercast by the same amount.
  2. Sales return of Rs. 500 is posted to the Return Inward A/c as Rs. 5,000 and similarly purchase return of Rs. 500 is posted to the Return Outward A/c as Rs. 5,000.

4. Errors of principles

When principles of book-keeping and accountancy are not followed, the error is known as error of principles. Such errors may be committed intentionally to understate asset and to overstate liability and to inflate and deflate profit as and when the circumstance dictates.

 

Examples

  1. Treatment of capital expenditure as revenue expenditure, e.g. purchase of machinery treated as purchase of goods.
  2. Valuation of stock on the basis of wrong principle.

1.8.2 Fraud

Fraud means false representation or entry made intentionally or without belief in its truth with a view to defraud somebody. Detection of fraud is considered to be one of the important duties of an auditor. The term ‘fraud’ is used for several sins including the following:

  1. Fraud, which involves the use of deception to obtain an unjust or illegal financial advantage
  2. Intentional mis-statements in, or omissions of, amounts or disclosures from an entity’s accounting records or financial statements
  3. Theft, whether or not accompanied by mis-statements of accounting records or financial statements

The following are the main ways in which fraud may be activated:

1. Embezzlement of cash

Defalcation of cash is possible irrespective of the size of the business small or large. The possibility of the misappropriation of cash is small in a small business organisation, where the proprietor has a direct control over the cash receipts and disbursement. The chances are greater in case of large business organisations. There are different methods of misappropriation of cash defalcation, out of which “Teeming and Lading” procedure in usually followed by the employees involved in the misappropriation of cash.

2. Misappropriation of goods

Misappropriation of goods is another type of fraud. It may happen that the valuable goods of an organisation may be stolen by the employees or workers. It may also happen that the storekeeper in collusion with the works manager may sell the goods illegally to some third party. Such frauds are very difficult to locate or identify.

3. Manipulation of accounts

Accounts are manipulated through falsification of accounts. These are fraudulent manipulations through accounts and arise generally through passing of false entries with the motive of misappropriating funds slowly and steadily. Unlike misappropriation of cash and goods, this type of fraud is done by the sophisticated personnel of an organisation.

1.9 ROLE OF AUDITORS IN DETECTING ERRORS AND FRAUDS

There is a difference of perception between the public and the auditing profession in relation to an auditor’s duty regarding errors and frauds.

The auditor sees his duty as:

“The independent examination of, and expression of opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.”

While certifying the final accounts of the concern, the auditor, has to face a specific problem. He has to certify in his report as to whether the profit and loss account reflects the true profit or loss for the financial year concerned and the balance sheet exhibits a true and fair view of the state of affairs at the end of the financial year. The emphasis is on financial statements. However, the public, including much of the business community, tends to see an auditor’s duties in terms of the detection and possibly prevention of error and fraud.

Accordingly, he has a duty to ascertain frauds and errors to justify the correctness of the accounts. This duty of detecting and preventing errors and frauds can be analysed in the following ways:

Detection of errors and frauds

It is desirable that the auditor should exercise reasonable care and skill, so that he may detect errors and frauds. If he carries routine checking and vouching more carefully and checks the books of accounts thoroughly, he may be successful in his duty. Whereas, in doing so, if he is not successful but he himself feels that he has not shown any negligence in his duty, then he cannot be held responsible for any error or fraud which remains undetected in accounts. Hence, an auditor is not an insurer.

Prevention of errors and frauds

The auditor has no authority to introduce remedial measures for the prevention of errors and frauds. All that he can do is to advise his client and suggest the ways and means to prevent them.

1.10 RELATION BETWEEN BOOK-KEEPING, ACCOUNTANCY AND AUDITING

1.10.1 Book-keeping

It is concerned with systematic recording of transactions in the books of original entry and their posting to the concerned ledger accounts. In fact, book-keeping involves the following activities:

  • Journalising the transactions
  • Posting them into respective ledger accounts
  • Casting the total of ledger accounts and
  • Finding the balances

1.10.2 Accountancy

Accountancy is concerned with the checking of arithmetical accuracy of ledger accounts as prepared by the book-keeper and preparing the trial balance from the balance available of different ledger accounts. Finally from the balances, profit and loss account and balance sheet are prepared to know the financial result and financial position of the concern. In short, accountancy involves the following activities:

  • Preparation of trial balance
  • Incorporation of adjustment entries and passing entries for rectification
  • Preparation of profit and loss account
  • Preparation of balance sheet

1.10.3 Auditing

When the accountancy work is completed, an auditor is invited to check the accounts prepared by the accountants. That is why, it is said that “Auditing begins where accountancy ends”. It is the duty of the auditor to critically examine and verify the accounts. In no case, it is the duty of the auditor to prepare accounts. After completing his work, the auditor has to submit a report of the fact whether or not the profit and loss account exhibits a true and fair financial result of the organisation and also whether the balance sheet reflects the true and fair financial picture of the organisation.

1.10.4 Accountancy vs auditing

The differences between accountancy and auditing are outlined in Table 1.1.

1.11 BASIC PRINCIPLES GOVERNING AN AUDIT

AAS-1 describes the basic principles which govern the auditor’s responsibilities and which should be complied with whenever an audit is carried out. They are as follows:

1. Integrity, objectivity and independence

The auditor should be straight forward, honest and sincere in his approach to his professional work and should maintain an impartial attitude.

2. Confidentiality

The auditor should respect the confidentiality of information acquired in the course of his audit work.

3. Skills and competence

The audit should be performed and the report should be prepared with due professional care by persons who have adequate training, experience and competence in auditing.

4. Documentation

The auditor should maintain documents which are important in providing evidence that the audit was carried out in accordance with the basic principles.

5. Planning

The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner.

 

TABLE 1.1 Accountancy vs auditing

Points of difference Accountancy Auditing

1. Scope

The scope of accountancy is limited to the preparation of financial statements.

In auditing, the auditor is concerned with the checking of accounts.

2. Objectives

The objective of accountancy is to know the financial result and financial position.

The objective of auditing is to verify the truth and fairness of the accounts.

3. Status

An accountant is an employee of the organisation.

An auditor is an independent outsider.

4. Qualification

Accounting work requires no formal qualification.

To be a company auditor, one should be a qualified chartered accountant.

5. Tenure of service

Accountant is usually a permanent employee of the organisation.

Auditor can be changed from year to year.

6. Knowledge in other subjects

An accountant is not expected to have knowledge in other subjects.

An auditor must have good knowledge not only in accountancy, but also in other related subjects.

7. Ranking of activities

Accountancy is not dependent on auditing work.

Auditing can be started only after the completion of accountancy work.

8. Time period of work

Accounting work is carried out throughout the year.

Auditing is usually carried out at the end of the year.

9. Professional control

There is no professional control over accountancy.

There are professional rules and regulations over the auditing work.

10. Nature of work

The nature of accountancy work is constructive.

Auditing work, on the other hand, is mostly analytical.

11. Submission of report

No report is required to be submitted at the end of the accounting work.

A report on the final accounts are required to be submitted by the auditor at the end of his work.

12. Accountability

The accountant is accountable to the management.

The auditor is accountable to the shareholders.

6. Audit evidence

The auditor should obtain sufficient appropriate audit evidence to enable him to draw reasonable conclusions therefrom on which he can base his opinion on the financial information.

7. Accounting system and internal control

The auditor should reasonably assure himself that the accounting system is adequate and that all the accounting information which should be recorded has been recorded intact.

8. Audit conclusions and reporting

The auditor should review and assess the conclusions drawn from the audit evidence and submit a report that contains a clear written opinion on the financial information of the organisation.

1.12 POSTULATES OF AUDITING

Auditing postulates are matters which are assumed to be true and are taken for granted. It is often considered that it is useful to examine a discipline and to see what, if any, are its postulates. This was done by Mautz and Sharaf in their book The Philosophy of Auditing in 1961. Their eight postulates are given below.

1. Financial statements and financial data are verifiable

This is an unspoken assumption by all auditors who otherwise would not attempt to verify the assertions in the accounts they are auditing. Sometimes facts are not strictly verifiable and auditors content themselves with statements of the circumstances, which can be verified.

2. There is no conflict of interest between the auditor and the management of the entity

If this was not so, auditors would not believe the answers given to their questions and, given the complexity of modern businesses, would find conducting an audit impossible. It is this basic assumption which leads auditors to consider whether they should accept a new client where the integrity of the client is suspected.

3. The financial statements are free from collusive and other unusual irregularities

Auditors are expected to uncover material mis-statements in financial statements caused by fraud or other irregularities but collusive fraud is often impossible to discover by auditing procedures. If there were a requirement to uncover such frauds the audit would become impossible or, at the least, require many more detailed and expensive procedures than are currently performed.

4. The existence of a satisfactory system of internal control eliminates the probability of irregularities

Auditors are entitled to rely on satisfactory internal controls as evidence of many assertions. If this postulate was not a fundamental principle of auditing they would not do so. Regardless of the assessed level of risk, auditors should perform some substantive procedures for financial statements assertions of material account balances and transaction classes.

5. Consistent application of generally accepted accounting principles results in fair presentation of the results and positions

Auditors need some criterion for their assessment of the fairness of the view given by financial statements and the GAAPs supply it. Otherwise there would be no standard by which fairness could be judged.

6. In the absence of clear evidence to the contrary, what has held true in the past for the entity will hold true in the future

If this were not so the auditor would be unable to accept the value of debts, the value of fixed assets, the saleability of stock, the effectiveness of internal controls, the integrity of management and many other matters.

7. When examining financial data, the auditor acts exclusively in the capacity of auditor

This is tied up with notions like independence, useful economic function and social responsibility to the public. This postulate is fundamental and yet the necessary independence of mind is still a difficult problem for many auditors.

8. The professional status of an independent auditor imposes commensurate professional obligations

This means that members of the professions have higher duties than economic self-interest. However, it is not always clear to whom professional duties are owed. Are they to the public at large, to the client company or the shareholders? However, it is certain that the professional accounting bodies impose very onerous duties on their members.

1.13 SCOPE AND PROCEDURES OF AUDIT

The scope and procedures of audit for a particular organisation will be determined by the auditor on the basis of the terms of engagement, the requirement of relevant legal formalities and the pronouncement of the Institute. The term of engagement cannot, however, in any way reduce the scope and procedures of audit which are prescribed by the legal provisions or by the pronouncement of the Institute.

To express an opinion on the financial statements of an organisation, the auditor should satisfy himself first whether the information contained in the given accounting records is authentic, reliable and adequate as a basis for the preparation of the financial statements. The audit procedure should be designed in such a manner to cover sufficiently all aspects of the organisation as far as they are relevant to the financial statements. In forming his opinion, the auditor should also decide whether the relevant information is properly disclosed in the financial statements on the basis of its statutory requirements.

The principal areas to be covered in an audit include the following:

1. Accounting and internal control

An examination of the system of accounting and internal control to ascertain whether it is adequate and appropriate for the concerned organisation or not.

2. Arithmetical accuracy

An overall checking of the arithmetical accuracy of the books of accounts by the method of posting, casting and balancing procedures.

3. Authenticity of transactions

A proper verification of the validity and authenticity of the transactions entered into by checking the entries with the supporting documents.

4. Distinction between capital and revenue items

An effective scrutiny over the distinction between the items of capital and of revenue nature of income and expenditure correspond to the accounting period.

5. Verification of assets

A detailed verification of the ownership, existence and value of the assets appearing in the balance sheet.

6. Verification of liabilities

A proper verification of the liabilities of the organisation as stated in the balance sheet.

7. Comparison of the financial statements

A comparison of the balance sheet and profit and loss account or other statements with the available records in order to see that they are in accordance therewith.

8. Truth and fairness of financial statements

An effective checking of the results as shown by the profit and loss account to see that the results shown are true and fair.

9. Statutory requirements

A concrete confirmation about the fulfilment of the statutory requirements and legal formalities in recording the financial transactions and in preparing the financial statements.

10. Appropriate reporting

An appropriate reporting to the concerned persons to explain whether the statements of accounts examined do reveal a true and fair view of the state of affairs and of the profit and loss of the organisation.

1.14 CHANGES IN THE CONCEPT OF AUDITING

The auditing profession has, at present, revised its method of work from the last century. In the early part of the 20th century, the emphasis in auditing was on the detection of error and fraud by massive checking of entries in the books of accounts. The growth in the size of the business entities, and the mechanisation and computerisation of accounting records, have made this approach increasingly realistic. The profession has responded by switching the emphasis of its auditing procedure from massive checking of individual items to establishing whether the organisations have a reliable system. The modern audit has increasingly concerned itself with establishing that the annual accounts have been prepared from a reliable accounting system on which a prudent auditor can reasonably place reliance and then with thoroughly testing and reviewing the final accounts themselves.

Moreover, the profession is now going beyond the duties prescribed on it by the Companies Act in that it is initiating its own accounting standards and auditing regulations and guidelines. At present, it has sought to standardise the accounting procedure by issuing mandatory accounting standards and also issuing standardised auditing guidelines for conducting audit work.

In addition to that, auditing in its modern form has adopted a multidimensional approach. At present, the scope of auditing is not only restricted to financial audit under the Companies Act. The purpose of auditing has been extended to cost accounts, managerial policies, operational efficiencies, system applications, social implications of business organisations and environmental aspects too. Even non-business organisations avail the services of qualified auditors and get their accounts audited. At present, the field of audit also covers the following:

  1. Checking cost accounting records and to verify whether costing principles are followed while preparing and presenting costing data.
  2. Comprehensive examination and review of managerial policies and operational efficiency.
  3. Checking the performance of the organisation and comparing it with the overall performance of the industry in which the organisation belongs.
  4. Critical examination and analysis of the contribution of the organisation for the benefit of the society.
  5. Evaluation and measurement of efficiency of human resources in the organisation and comparing it with the expected utilisation of the human resources as a whole.
1.15 SOCIAL OBJECTIVES OF AUDIT

An audit is a social science. So, audit has certain social objectives. It should make contributions towards the fulfilment of social purposes. Auditing work to be effectively performed has to function for the following purposes:

1. Protection of shareholders’ interest

Auditors are the representatives of the shareholders, naturally it is the duty of an auditor to see whether the interest of the shareholders are protected or not. The shareholders’ interest can be protected by ensuring stable solvency, profitability and efficiency position of the company form of organisation.

2. Protection of national interest

Another vital social object of an audit is to see that the national interest is protected. The national interest can be protected only when cases of evasions of taxes are prevented. So, tax evasion should be discouraged for national interest as there is no denying the fact that raising revenue through taxation is a must for the development of the country.

3. Safeguarding capital erosion

Mere examination of the books of accounts will not help to locate those factors which are responsible for capital erosion. In order to stop capital erosion of the business, different system of audit should be introduced. Capital erosion is very dangerous, because it tends to liquidate the business. So, the function of an audit from social point of view is to stress and scrutinise those aspects, which are responsible for capital erosion.

4. Measurement of fair wages

Measurement of fair wages does not come under the purview of general audit. It should be the social objective of an audit to see whether the wages for workers are fair and in conformity with the general price index.

5. Fair prices for consumers

As a part of the society, the business organisation should charge fair prices from the consumers. It not only creates goodwill of the organisation but also ensures its future growth. As an auditor of the organisation, everyone should take care of this social aspect of auditing.

6. Fair return for investors

If the capital of a company is not utilised efficiently, the company will not be able to earn fair profit. On the other hand, the growth of the business may be withheld. Both high and low turnover of capital stand on the way to fair return. This rate of turnover should be compared with turnover rate of other companies belonging to the same industry. Justice to the investors depends on the solvency and profitability position of the business, which becomes favourable through the earning of fair return.

1.16 ADVANTAGES OF AUDITING

The tasks of an auditor are of great importance to all concerned. The auditor must prepare his audit report impartially and effectively based on facts and actual figures. If this is done, the following advantages can be expected from auditing:

From Legal Point of View

1. Filing of income tax return

Income tax authorities generally accept the profit and loss account that has been prepared by a qualified auditor and they do not go into details of the accounts.

2. Borrowing of money from external sources

Money can be borrowed easily on the basis of audited balance sheet from external sources. Most of the financial institutions sanction loan on the basis of audited financial statements.

3. Settlement of insurance claim

In case of fire, flood and the like unexpected happenings the insurance company may settle the claim for loss or damages on the basis of audited accounts of the previous year.

4. Sales tax payments

The audited books of accounts may generally be accepted by the sales tax authorities.

5. Action against bankruptcy

The audited accounts serves as a basis to determine action in bankruptcy and insolvency cases.

From Internal Control Point of View

1. Quick discovery of errors and frauds

Errors and frauds are located at an early date, so that in future no attempt is made to commit such frauds as one is rather careful not to commit an error or a fraud as the accounts are subject to regular audit.

2. Moral check on the employees

The auditing of accounts keeps the accounts clerks regular and vigilant as they know that the auditor would complain against them if the accounts are not prepared upto date or if there is any irregularity.

3. Advice to the management

The management may consult the auditor and seek advice on certain technical points although it is not the duty of the auditor to give advice.

4. Uniformity in accounts

If the accounts have been prepared on a uniform basis, accounts of one year can be compared with other years and if there is any discrepency, the cause may be enquired into.

From External Affairs Point of View

1. Settlement of accounts

The audited accounts would facilitate the settlement of accounts of a deceased partner.

2. Valuation of assets and goodwill

If the business is to be sold as a going concern, there may not be much difficulty regarding the valuation of assets and goodwill as the accounts have already been audited by an independent person.

3. Future trend of the business

The future trend of the business can be assessed with certainty from the audited books of accounts.

1.17 LIMITATIONS OF AUDITING

Truly speaking, an audit should have no limitations of its own. It is designed to protect the interest of all parties who are interested in the affairs of the business. If there be any shortcoming arising therefrom, it may be due to its narrow scope of application in its related field of operation and unextended definition of the concept.

Auditing suffers from the following shortcomings:

1. Want of complete picture

The audit may not give complete picture. If the accounts are prepared with the intention to defraud others, auditor may not be able to detect them.

2. Problems of dependence

Sometimes the auditor has to depend on explanations, clarification and information from staff and the client. He may or may not get correct or complete information.

3. Post-mortem examination

Auditing is a post-mortem examination. There is no use of such examination when events have already been occurred.

4. Existence of errors in the audited accounts

It is not possible for the auditor in all cases, to check each and every transaction of an organisation. As a result, there may be error in the audited accounts even after the checking by the auditor.

5. Lack of expertise

Auditor has to seek opinion of experts on certain matters on which he may not have experts knowledge. The auditor has to depend upon such reports which may not always be correct.

6. Diversified situations

Auditing is considered to be a mechanical work. Auditors may not be in a position to frame audit programme, which can be followed in all situations.

7. Quality of the auditor

Success of audit depends on the sincerity with which the auditor has performed his duties. The same audit work can be done by two different auditors with difference in sincerity.

8. Existence of defective policies

The auditor can only report on the truth and fairness of the financial statements. But other defects, i.e. defects relating to management and control may not be possible to be covered by the auditor.

1.18 QUALITIES OF AN AUDITOR

Only a chartered accountant can be appointed as an auditor of a limited company. Besides the statutory requirement about the qualification of an auditor, he must possess the following qualities:

  • An auditor must possess the necessary technical ability and knowledge to audit accounts.
  • He must be conversant with the relevant provisions of the companies and other regulations and with both best current accounting practices and current auditing practices.
  • He must be objective both in formulating his opinions and in expressing them without bias.
  • He must have integrity. Once he has formed his opinion, he must be prepared to express it clearly without fear and favour.
  • He must be methodical in his work. An auditor who leaves loose ends will find himself open to allegations of negligence.
  • He should have an inquiring mind. An auditor must recognise suspicious circumstances, and once his suspicion has been aroused, he has a duty to probe matters to the bottom.
  • He also needs to be tactful and practical in his dealings with his clients.
  • An auditor must be independent and must be careful not to compromise his independence.

In the following chart, the qualities needed to become an effective auditor are shown:

1.19 AUDITING AND OTHER SERVICES

Auditing firms do not describe themselves as auditors. They describe themselves as Chartered Accountants or in some cases just as accountants. Auditing firms are composed of accountants who perform audit for their clients. They also perform other services. The small firms especially may spend more time on other services than on auditing.

Other services may include the following:

  • Writing up books
  • Balancing books
  • Preparing final accounts
  • Tax negotiations
  • Government form filling
  • Management and system advice
  • Financial advice
  • Liquidation and receivership work
  • Investigations
  • Risk management
  • Corporate governance

Case Study

Arun, Badal and Chavan are partners in a firm of constructions business. Since commencing in business in 15 months ago they have been fairly successful. Arun who has a Diploma in Business Management as well as in building constructions has kept the books and Arun has also prepared the first year’s accounts.

Three partners are discussing these accounts, which show a profit in excess of drawings. Badal and Chavan suggest that they could draw out the excess but Arun counsels caution, talking about working capital needs, which confuses the others.

Chavan questions Arun on his interpretation of the partnership agreement, which is a fairly complicated document and suggests that they should pay to have the accounts audited. Arun gets upset and says that it would be a waste of money and he is perfectly capable of maintaining the accounts and will not charge his partners for his work.

Discussion

  • What benefits would the partners get from employing an independent auditor?
  • Where would they find a suitable auditor?
POINTS TO PONDER
  • The word ‘audit’ is derived from the Latin word audire, which means, “to hear”. In olden times, whenever the owners of a business suspected fraud, they appointed persons to check the accounts. Such persons sent for the accountant and ‘heard’ what they to say in connection with the accounts.
  • The dictionary meaning of audit is official examination of accounts. In brief, auditing can be defined as a systematic examination of the books and records of a business or other organisations in order to check or verify and to report upon results thereof.
  • The essential features of auditing are accounting control, safeguard, assurance, assessment, review and reporting.
  • The primary object of an audit is to promote efficiency and accuracy in accounting. For the fulfilment of the primary objectives of auditing certain subsidiary objectives are to be realised, which include detection of errors and frauds and prevention of errors and frauds.
  • Errors are the result of carelessness on the part of the person preparing the accounts. Errors can be of different types—errors of omission, errors of commission, compensating errors and errors of principles.
  • Fraud means false representation or entry made intentionally or without belief in its truth with a view to defraud others. Fraud may be activated in different ways—embezzlement of cash, manipulation of accounts and misappropriation of goods.
  • It is expected that the auditor should exercise reasonable care and skill, so that he may detect errors and frauds. But the auditor has no authority to introduce remedial measures for the prevention of errors and frauds.
  • There exists a close relationship between accountancy and auditing. It is said that ‘auditing begins where accountancy ends’.
  • AAS-1 describes the basic principles governing an audit. These include integrity, objectivity and independence, confidentiality, skills and competence, documentation, planning, audit evidence, accounting system and internal control, audit conclusions and reporting.
  • Auditing postulates are matters, which are assumed to be true and are taken for granted. Mautz and Sharaf have referred eight different postulates of auditing.
  • The principal areas to be covered in an audit include accounting and internal control, arithmetical accuracy, authenticity of transactions, distinction between capital and revenue items, verification of assets and liabilities, comparison of the financial statements, truth and fairness of financial statements, statutory requirements and appropriate reporting.
  • Auditing in its modern form has adopted a multi-dimensional approach. At present, the scope of auditing is not only restricted to financial audit only, but also covers management audit, cost audit, efficiency audit, social audit and other areas of auditing.
  • Audit has certain social objectives. It should function for the protection of shareholder’s interest and national interest, for safeguarding capital erosion, for fair wages and prices and fair returns.
  • Auditing has a number of advantages, which include filing of income tax return, borrowing of money from external sources, settlement of insurance claim, sales tax payments, action against insolvency, quick discovery of errors and frauds, moral check on the employees, advice to the management, uniformity in accounts, settlement of accounts, valuation of assets and goodwill etc.
  • Auditing suffers from a number of shortcomings, which include want of complete picture, problems of dependence, post-mortem examination, existence of error in the audited accounts lack of expertise, diversified situations, quality of the auditor and existence of defective policies.
  • The auditor must possess a number of important qualities, which include professional, inherited, acquired and other general qualities.
REVIEW QUESTIONS

Short-answer Questions

  1. Offer your comment on the following statements:
    1. Auditing may be defined as an ‘accounting control’.
    2. Fraud does not necessarily involve misappropriation of cash or goods.
    3. Auditing is a dynamic social science.
    4. Accounting is a necessity to business organisation but auditing is a luxury.
    5. Accountancy begins where book-keeping ends, and where the work of an accountant ends, the work of an auditor begins.
    6. An auditor is not an insurer.
    7. The relationship of auditing to accounting is close, yet their natures are different. They are business associates, not parent and child.
    8. Auditing has its principal roots not in accounting which it reviews, but in logic on which it leans heavily for ideas and methods.
    9. Auditing does not mean ticking or checking totals.
  2. Define and explain the term ‘auditing’.
  3. What are the principles of auditing?
  4. Discuss the objectives of auditing.
  5. What are the differences between auditing and accountancy?
  6. Define and explain the terms ‘fraud’ and ‘error’.

Essay-type Questions

  1. Define ‘auditing’. Discuss the scope and procedure of audit.
  2. What are special and general qualifications that an auditor should possess and why?
  3. “Detection and prevention of errors and frauds are the main objectives of auditing”. Discuss its scope and explain the duties of the auditor in this regard.
  4. Discuss the advantages of audit (a) to the management, (b) to the government, (c) to the shareholders, and (d) to the society.
  5. Discuss the different aspects of social object of audit.
  6. Discuss various classes of error and state in each case the effect they might have on the trial balance being discovered.
  7. “It is nothing to the auditor whether the business is run prudently or imprudently, profitably or unprofitably”. Do you agree? Give reasons for your answer.
  8. Why are auditors generally required to express an opinion on the truth and fairness of the accounts and why they are not required to certify the accounts?
  9. “Audit of the accounts of the sole-proprietor is not compulsory. However, he may get his books of accounts audited for various reasons.” Discuss.
  10. Write a brief outline of the development of audit profession in India.