Chapter 18. Audit of Soleproprietorship and Partnership Firm – Auditing: Principles and Techniques

Chapter 18

Audit of Sole-proprietorship and Partnership Firm

CHAPTER OUTLINE
18.1 INTRODUCTION

There are different types of business organisations from the point of view of their formation and legal aspects. Amongst the different types of business organisations the important types are the sole-proprietorship business and partnership business forms of organisation. Unlike company form of organisation, there is no compulsion in conducting audit for these two types of organisations as a matter of legal requirement, because under these two types of organisations, the owners have direct control over the day-to-day management and accounts are being prepared under the direct control and supervision of the owners. But it does not indicate that there is no requirement of audit to be conducted in these types of organisations. These organisations appoint auditors and get their accounts audited due to the various advantages they can derive by conducting an audit.

18.2 AUDIT OF SOLE-PROPRIETORSHIP BUSINESS

There is no legal requirement that a qualified auditor should audit the books of accounts of the sole-proprietorship business. It is up to the choice of the sole proprietor to get his accounts audited by a qualified auditor. But the sole-proprietors having large business houses are found to get their accounts audited due to the inherent advantages of audit.

Usually following are the reasons behind the audit of the proprietorship business.

1. To know about the adequacy of books of accounts

The sole proprietor is confirmed about the adequacy of the books of accounts maintained by him through the conduct of an audit.

2. To know the true and fair view of the accounts

The sole proprietor can assure himself by conducting audit that the books of accounts maintained by him exhibit a true and fair view of the state of affairs of the business.

3. To detect and prevent errors and frauds

In order to detect and prevent errors and frauds committed by the staff members, auditing can be undertaken. If there is an audit, errors and frauds can be detected and located at any early date.

4. To implement moral check on employees

The auditing of accounts keeps the employees regular and careful in their work, as they know that their auditor will complain against them if there is any error or fraud or if the accounts are not prepared up to date.

5. To settle insurance claim

In case of fire, theft or other hazards, the insurance company may settle the claim on the basis of the audited accounts of the client.

6. To borrow money from banks etc.

Money can be borrowed easily from bank and other financial institutions on the basis of audited balance sheet. Usually, in most of the cases, the banks and other financial institutions grant loans on the basis of previous audit report.

7. To file income tax return

In order to present reliable accounts to the income tax authority, auditing is undertaken. Generally the income tax authorities accept the profit and loss account that has been prepared and audited by a qualified auditor and they do not go into the details of the accounts.

8. To value 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, if the accounts have already been audited by a qualified auditor.

9. To bring uniformity in accounts

If the accounts have been prepared on a uniform basis for the purpose of auditor’s satisfaction, accounts of one year can be compared with other years and if there is any discrepancy, the cause may be enquired.

10. To get advice from the auditor

The proprietor may consult the auditor and seek his advice for efficient keeping of his accounts.

18.2.1 Appointment of Auditor for Sole-proprietorship Business

The audit of accounts of the sole-proprietorship business is not governed by any specific statute. Hence, the appointment of auditor in this type of organisation depends upon the contract entered into by the proprietor with the auditor. Normally it is expected that the contract for appointment should be in writing and it should include the details of work to be undertaken by the auditor in conducting his audit because an auditor is required in some cases to prepare the accounts also, in addition to his audit work. All these assignments and other terms and conditions of the appointment should be clearly stated in the contract. In this context, it is important to note that the newly appointed auditor should correspond with the previous auditor intimating him about the acceptance of audit assignment. The remuneration of the auditor of this type of organisation usually depends upon the nature and volume of work and should also be included in the contract.

18.2.2 Steps to be Taken Before Commencement of New Audit in a Sole-proprietorship Business

In order to conduct audit in a sole-proprietorship business, the auditor should take the following steps before the commencement of new audit:

1. Ascertain the scope of work

First of all, the auditor should ascertain the precise nature and scope of his audit work. In case of sole-proprietorship business, in fact, the scope and area of work depends on the contract between the owner and the auditor.

2. Knowledge about the business

In order to conduct audit efficiently, the auditor should clearly understand the nature of the business and activities undertaken by the business organisation. The nature and activities of the business will help the auditor to get a clear idea about the different types of transactions in the organisation.

3. Knowledge about the accounting system

The auditor should collect from the proprietor a list of all books of accounts maintained in order to record the transactions of the organisation and assure himself that those books of accounts are maintained in actual practice.

4. List of principal officers

The auditor should also obtain list of the principal officers of the organisation. He should also acquire knowledge about the extent and scope of authority of each of them.

5. Knowledge of technical details

He should also acquire some knowledge about the technical details, if any, of the business. This will enable him to grasp the nature of transactions, which will be the subject matter of audit.

6. Communication with the previous auditor

If the auditor is being appointed in place of another auditor, it becomes his professional duty to communicate with the auditor, in whose place he is appointed.

7. Instruction to the proprietor

After completing the aspects as stated above, the auditor should issue clear instructions to the proprietor of the business to keep the accounts ready for audit and to prepare necessary schedules and annexure for the finalisation of audit work.

8. Preparation of audit programme

Finally, the auditor will prepare an audit programme, which will outline the procedures to be followed in conducting his audit work effectively.

18.3 AUDIT OF PARTNERSHIP FIRM

Like the audit of sole-proprietorship business, there is no legal obligation in case of partnership firm of business organisation that the books of accounts are to be audited by a qualified auditor. Even in the Indian Partnership Act, 1932 there are no specific provisions containing any instructions to get the accounts audited by a qualified auditor. But there are certain situations which usually occur in case of partnership business, which demand that the books of accounts of the firm should be audited by a duly qualified auditor. In this type of business, there may be the possibility of friction or dissatisfaction among the partners of the firm regarding the accounts maintained. In order to avoid this situation, many firms generally contain in their partnership deed a clause to the effect that the books of accounts should be audited by a qualified auditor.

Usually following are the reasons behind the audit of a partnership firm.

1. Settlement of dispute

The audit of accounts by an independent auditor may minimise or settle the misunderstandings and disputes among the partners. If there is no understanding among the partners, the growth and expansion of the business will not be activated. So, auditing of accounts may bring a peaceful atmosphere in the organisation, which is the key to the future development of the business.

2. Protection of sleeping partners

The audit of accounts of the partnership firm may protect the interest of the sleeping partners of the business. As the sleeping partners do not take active part in the day-to-day management of the business, they can depend on the audited accounts about the truth and fair view of the business.

3. Borrowing facilities

The audited accounts are very helpful in securing loan from bank and other financial institutions. In most cases, normally banks and other financial institutions grant loans on the basis of audited accounts of the applicants.

4. Assessment of tax

The income tax department seldom feels discontent on the certified accounts presented for the assessment of tax. As a result, in order to present reliable accounts to the income tax authority, auditing is undertaken.

5. Settlement of accounts

The audited accounts are very helpful in the settlement of disputes arising from retirement and death of partners and dissolution of the partnership firm. So, the audited accounts facilitate the settlement of the accounts of the retired or deceased partner.

6. Presentation as evidence

The audited accounts may be considered as reliable evidence in the court of law. So, in deciding the judgment against any case, the audited accounts can play an important role.

7. Valuation of goodwill of the firm

Valuation of goodwill in case of partnership firm arises as a result of changes in the constitution of the partnership firm. For the purpose of valuation of goodwill, the most important factor is the profit of the business. Therefore, the audited profit figure may be of great benefit in this regard.

8. Improvement of business

The firm may be greatly benefited as regards its improvement in managerial operation and keeping up-to-date records if the suggestions of the auditor are taken into consideration.

18.3.1 Appointment of Auditor for Partnership Firm

Like sole-proprietorship business, the audit of accounts of the partnership firm is not governed by any specific statute. Even in the Partnership Act, 1932 there are no specific provisions regarding the appointment of auditor in a partnership firm. In these types of organisations, the auditor is appointed as per agreement among the partners or as per the provision of the partnership deed. Normally it is expected that the contract for appointment of an auditor should be in writing and it should include the details of work to be undertaken by the auditor in conducting the audit. Under this type of audit the auditor has to check merely the compliance of the provisions of the partnership deed, those provisions of the Partnership Act, which have a bearing on the financial transactions and accounts. All these assignments and other terms and conditions of the appointment should be clearly indicated in the contract. The remuneration of the auditor of this type of organisation usually depends upon the nature and volume of transactions and should also be included in the contract.

18.3.2 Steps to be Taken Before Commencement of New Audit in a Partnership Firm

Before the conduct of an audit of the accounts of the partnership firm, the auditor should first of all obtain from his client a clear-cut instruction as to his scope of work and nature of assignment. For this purpose, he should confirm that his contract for appointment is in writing and in order. In the absence of any such clear-cut instruction, the auditor is required to perform complete audit, otherwise he may be held liable for the damages caused to the business for his failure to conduct complete audit.

However, the following steps may be suggested as a part of the conduct of an audit of partnership firm:

1. Knowledge about partnership deed

The auditor should carefully go through the partnership deed for knowing the different aspects of the partnership business viz. amount of capital contributed by the partners, profit sharing ratio, valuation of goodwill etc.

2. Observation of internal check system

He should observe the operation of the system of internal check and check whether the system is effectively implemented or not.

3. Knowledge about sleeping partners

He should collect the names of the sleeping partners and verify whether their interest is justified by the working partners.

4. List of books of accounts

The books of accounts maintained by the firm should be collected and the auditor should observe the nature of usual transactions that are recorded in the books of accounts.

5. Provisions of the partnership deed

The auditor should carefully note the provisions of the partnership deed regarding the maintenance of accounts of the firm and for taxation purpose whether the partnership firm will be treated as such or as an association of persons.

6. Contracts with the third parties

He should verify the contracts that are entered into with the third parties by reference to agreement deed and other documentary evidences.

7. Knowledge about the business

In order to conduct audit effectively, the auditor should clearly understand the nature of the business and activities undertaken by the firm. This will help him to get clear idea about the different types of transactions in the organisation.

8. Ascertain the scope of work

The auditor should ascertain the precise nature and scope of his audit work. In case of partnership firm audit, the scope and area of work depends upon the terms of contract entered in between the firm and the auditor.

9. Knowledge about the accounting system

The auditor should know the accounting system adopted by the organisation to ensure that all the transactions not agreed by the partners are incorporated in the books of accounts according to the provisions of the Partnership Act, 1932.

10. Knowledge of technical details

He should also acquire some knowledge about the technical details, if any, of the business. This will enable him to set the idea about the nature of transactions of the business.

11. Communication with the previous auditor

In case of fresh appointment, professional ethics requires that the newly appointed auditor should communicate with the previous auditor.

12. Preparation of audit programme

Finally, the auditor will prepare an audit programme, which will outline the procedures to be followed for conducting his audit work effectively.

18.4 SALIENT FEATURES OF AUDIT OF ACCOUNTS OF SOLE-PROPRIETORSHIP AND PARTNERSHIP FIRM

The audit of sole-proprietorship business and partnership firm is not legally compulsory. Sole-proprietorship business is not governed by any specific Act. So, there is no question of any legal provision of audit of sole-proprietorship business. Although the Partnership Act, 1932 governs the partnership business, it does not contain any legal provision for compulsory audit of partnership business.

The important features of the audit of accounts of sole-proprietorship or partnership businesses are as follows:

1. Legal compulsion of audit

Audit of sole-proprietorship or partnership business is not compulsory. It is basically voluntary in nature and conducting audit of these types of businesses depends on the wish of the proprietor or the partners. However, in case of partnership firm, the partnership deed may contain provision for regular audit of accounts.

2. Scope of audit

As there is legal provision regarding the scope or area of audit under these types of businesses, it depends on the terms of appointment of the auditor. As a result, an auditor of such a business is required to get clearly in writing from his client as to what area he has to cover exactly.

3. Application of legal provision

In case of audit of sole-proprietorship or partnership business, there is no statutory provision relating to recognition of income or expenditure, valuation of assets and liabilities, presentation of financial statements etc. Therefore, in those matters only basic accounting and commercial principles are required to be applied. However, in case of partnership business the partnership deed may contain certain provisions on accounting and financial matters in addition to matters of mutual interests of partners. In the absence of agreement amongst the partners on certain matters of mutual interest, the provisions of the Partnership Act will apply.

4. Qualification of an auditor

There is no statutory provision regarding the qualification of an auditor of a sole-proprietorship or partnership business. Therefore, the auditor of such organisations need not be a chartered accountant. But a chartered accountant usually conducts audit of these types of organisations, because audit by a chartered accountant is advantageous to the organisation. However, the partnership deed may provide for audit by a chartered accountant.

18.5 RIGHTS, DUTIES AND LIABILITIES OF THE AUDITOR OF A SOLE-PROPRIETORSHIP OR PARTNERSHIP FIRM

There is no specific provision in any statute, which contains the rights or duties or liabilities of an auditor of a sole-proprietorship or partnership business. In fact, the rights, duties and liabilities of an auditor of these types of organisations are the results of the agreement between the auditor and the firm itself.

Auditor’s right

The auditor enjoys no statutory right, in case of audit of accounts of sole-proprietorship or partnership firm. However, for audit of accounts of these types of organisations the auditor has the right to get all the books of accounts, vouchers, supporting documents, relevant records and necessary information and explanations from the management, i.e. he must be provided all the facilities, which are required for the effective discharge of his duties. In addition to that, the auditor has the right to take expert advice on any technical point and give advice for the proper maintenance of books of accounts and of course he should have the right to receive the agreed remuneration after successful completion of his work.

Auditor’s duties

An auditor of a sole-proprietorship or partnership organisation has no statutory duties to perform in conducting audit. But there is a contractual relationship between the auditor and his client. The auditor is also an agent of his client. Therefore, it is his duty under common law to exercise reasonable skill, care and caution in the performance of his work. It is his ethical duty to maintain confidentiality of all such information relating to the client’s business as he acquires this information in the course of his work. Moreover, his work is not complete, unless he gives a report to his client informing the outcome of audit or audit findings. Such a report should include the following points:

  • Whether he could get all such books, records, vouchers and other documents, and obtain all such information and explanations from the management, as are necessary for the purpose of his audit.
  • Whether the balance sheet and the profit and loss account of the organisation are in complete agreement with the books of accounts as maintained by the firm.
  • Whether the books of accounts are adequate according to the nature and size of the business and whether these have been written correctly and properly.
  • Whether the balance sheet and the profit and loss account give a true and correct view of the state of affairs and of the profit or loss of the business respectively.

The auditor should not hide any material information when he gives his report. In his report he should mention all frauds and material errors discovered by him in clear and unambiguous language. These are his duties relating to audit report. If the auditor has worked as an accountant, he should indicate the fact and the nature of his work in his report.

Auditor’s liabilities

An auditor of a sole-proprietorship or partnership organisation has no specific statutory liability. However, as per common law an auditor is liable to his client for damages if he is negligent in the performance of his duties and by such negligence his client suffers loss. But, the nature of his work is an important determinant of the extent of his liability. If he is appointed for maintaining the books of accounts and records, he will not be held liable for the errors and fraud activated through the books of accounts and records in his individual capacity. In that case, he will be considered as servant of the company.

18.6 POSITION OF AUDITOR OF A SOLE-PROPRIETORSHIP OR PARTNERSHIP FIRM

The position of an auditor of a firm or individual is totally different from that of a company. In the case of a company, audit is compulsory under the Companies Act. The Act lays down how the statutory auditor can be appointed and what are his specific duties and responsibilities, which cannot be curbed in any manner by the Directors, the shareholders or by the Articles of Association.

The position of an auditor of an individual or firm is, on the other hand, completely different. Here, the auditor is mostly guided by the agreement between him and the individual or the partners, as the case may be, and by any expressed provision in the partnership deed. There is no specific statute, which lays down the duties and liabilities of the auditor of an individual or firm. Hence, it is said that the auditor of an individual or a firm has no statutory obligation to comply with.

But whatever be the difference between the auditor of a company and the auditor of an individual or firm, the statement quoted above is not correct. It is true that the auditor of an individual or firm is outside the purview of the Companies Act, but it is equally true that even he has certain statutory obligations as the following points reveal:

1. Law of Agency

There is an agent-principal relationship between the auditor and his client and hence an auditor is required to protect the interest of his client and performs his duties with utmost care and skill as required by the law of agency.

2. Contract Act

Once an auditor is given an offer to work as an auditor for an individual or firm in consideration for a fee and the auditor accepts the offer, there is a binding contract under the Contract Act, and the auditor is under statutory obligation to fulfil the terms of the contract.

3. Chartered Accountants Act

The Chartered Accountants Act, 1949 requires a chartered accountant in practice not to be negligent in his professional duty. Negligence in duty attracts disciplinary proceedings under the said Act.

4. Indian Penal Code

For giving false information or evidence etc. an auditor is liable for fraud under the Indian Penal Code.

5. Income Tax Act

Where an auditor of an individual or firm by the terms of appointment acts like an accountant on matters of income tax, he must guard against certain liabilities, which may arise under the Income Tax Act.

From the above, it is clear that the auditor of an individual or firm is also not free from statutory obligation.

18.7 REPORTS ON ACCOUNTS OF INDIVIDUAL OR PARTNERSHIP FIRM

There is no statutory form of auditor’s report in the case of sole-proprietor and partnership firm. Often the auditors of sole-proprietors and partnership firms have nothing to say on the audited accounts except “Examined and found correct” or “Audited and found correct”. This form of reporting is not recommended, as it gives no indication of the extent of the examination of accounts that has been undertaken by the auditor.

Having realised the need of a clear and appropriate report by the professional accountants on the accounts of sole-proprietor and partnership firm, the Institute of Chartered Accountants in England and Wales issued a statement on the subject.

According to the statement of the Institute, the audit report of a sole-proprietorship firm or a partnership firm should highlight the following aspects:

  1. Undertaking of accounting and auditing work for sole-proprietor and partnership firm is a matter of instruction of each particular client. Responsibility of the professional accountant is governed by the scope of work assigned to be done and by the nature and extent of the records to be made available.
  2. The accountants should make it clear to the client at the engagement stage the responsibility he is accepting in relation to the accounts. This could be done by the issue of an ‘engagement letter’ or by maintaining a proper record of the client’s instructions.
  3. The report should bear a specific mention of the extent of responsibilities accepted by them, opinion on accounts to truth and fairness should be expressed in the report only if such accounts have been audited.
  4. Where accountants have been instructed to prepare accounts but not to audit, the report on the accounts prepared should be titled as “Accountant’s Report” and should be so carefully worded as to exclude the possibility of misunderstanding about the nature of the job.
  5. Where an audit has not been carried out, care should be taken that any reference to the accountant’s fees in the accounts or in footnotes or in correspondence with the client does not indicate them as audit fees.
  6. Accountants should not allow their names to be associated with the accounts, even though unaudited, which they believe give a misleading view.
  7. Accountants, when instructed to prepare accounts, should see that the accounts conform to accepted accounting principles.
  8. Reports on accounts prepared without audit should not be extended to include expression of opinion or to disclaim responsibility for any particular item.
  9. Where the instruction is to conduct audit, the same should be carried out on the principles of auditing. The accountant should see that he has audited the accounts and also should state whether such accounts present a true and fair view.
  10. Accounts prepared with or without audit should be approved by the client before the report is signed.
18.8 COMPARISON OF COMPANY AUDIT WITH THE AUDIT OF SOLE-PROPRIETORSHIP AND PARTNERSHIP FIRM

The distinction between audit of company with the audit of sole-proprietorship and partnership firm is given in Table 18.1.

 

TABLE 18.1 Distinction in the audit of different kinds of companies

18.9 LEGAL VIEWS AS REGARDS AUDIT OF INDIVIDUAL AND FIRM

Case Study

  1. Case: Leech vs Stokes Bros. & Prim (1937)

    Fact of the case: The defendants had prepared accounts for a number of years for a firm of solicitors for the purpose of submission to the inspector of taxes. No balance sheet was ever prepared. The instructions were given by one of the partners, Dublin, and on his death, a new partner employed another accountant to audit the accounts, as a result of which defalcations by the cashier of client’s money were discovered. Action for damages on the ground of negligence was brought against the defendants.

    Legal view: The negligence alleged were as follows:

    • Failure to prepare a balance sheet
    • Failure to vouch or test certain fees brought into the accounts
    • Failure to reconcile the bank account and cash

    The defendants were able to prove that they were not employed to audit the accounts but only to prepare a profit and loss account for income tax.

    The courts found that there was no negligence in not preparing a balance sheet or in not refusing to prepare a profit and loss account until the books were written up to enable them to prepare a balance sheet.

  2. Case: Smith vs Sheard (1906)

    Fact of the case: The plaintiff had incurred losses owing to the defalcations of an employee. The actual contract with the accountant was in question. The defendant denied that he had ever agreed to audit the books; he was only instructed to check the postings in order to make out a balance. But in sending the bill of charges, his clerk had inadvertently used the word “audit”, instead of “auditing of postings”. The accounts and balance sheet sent in did not contain any signature or certificate.

    Legal view: It was held that the accountant was liable for damages. The jury found that there was a contract to audit, though the decision was very much against the opinion of the judge.

  3. Case: Trustee of Apfel vs Annan, Dexter and Co. (1926)

    Fact of the case: The trustee in bankruptcy of Apfel sought to recover damages from the defendants in that they had failed to discover that large sums had been converted to their own use by the sons of the bankrupt. The plaintiff alleged that the defendants were employed as auditors. The defendants replied that they were employed only as accountants to prepare such accounts as were necessary for the purpose of income tax returns. The form of certificate used was “prepared from the books of Mrs. Adele Apfel, and in accordance therewith” but the account of charges and the covering letter referred to “the audit of your accounts” and “auditing”.

    Legal view: It was held that the work the defendants were instructed to do and the work they actually did, was accountancy for a specific purpose, and that they were not liable for the loss. It was suggested in this case that the accountants should have discovered the frauds if they had examined into the books for the months following the date to which the accounts were made up. But the learned judge pointed out that they had no right to examine the books for the year following that for which they were engaged, and ought not to be prejudiced by what might have come to light if they had examined the later records.

POINTS TO PONDER
  • Unlike company form of organisation, there is no compulsion in conducting audit for sole-proprietorship and partnership firms. As the owners of these types of organisations have direct control over the day-to-day management and accounts, legally it is not required to conduct audit.
  • The sole-proprietorship and partnership firms having large business houses are found to get their accounts audited due to the inherent advantages of audit.
  • The audit of accounts of the sole-proprietorship and partnership firms is not governed by any specific statute. Hence the appointment of auditor in these types of organisations depends upon the contract entered into between the owner/s with the auditor.
  • In order to conduct audit in a sole-proprietorship and partnership firm, the auditor should take a number of preparatory steps, which includes ascertainment of the scope of audit, knowledge about the business and accounting system, list of principal officers, knowledge of technical details, communication with the previous auditor, instruction to the proprietor and preparation of audit programme.
  • Before the conduct of an audit of the accounts of the sole-proprietorship firm or partnership firm, the auditor should first of all obtain from his client a clear-cut instruction as to his scope of work and nature of assignment. In the absence of any such clear-cut instruction, the auditor is required to perform complete audit, otherwise he may be held liable for the damages caused to the business for his failure to conduct complete audit.
  • Audit of sole-proprietorship and partnership firm is not compulsory. As a result, auditor of such a business is required to get clearly in writing from his client as to what area he has to cover exactly. Usually the auditor of such organisations need not be a chartered accountant.
  • There is no specific provision in any statute, which contains the rights and duties or liabilities of an auditor of a sole-proprietorship or partnership business. In fact, the rights, duties and liabilities of an auditor of these types of organisations are the results of the agreements between the auditor and the firm. In the absence of agreement his rights, duties and liabilities are governed by the common law.
  • The position of an auditor of a firm or individual is totally different from that of a company. Though there is no specific rule that governs the activities of an auditor of a firm or individual, he is not free from statutory obligations.
  • There is no statutory form of auditor’s report in the case of sole-proprietorship and partnership firm.
REVIEW QUESTIONS

Short-answer Questions

  1. Is the audit of sole-proprietorship business compulsory?
  2. Is the audit of partnership business compulsory?
  3. “The auditor of an individual or a firm has no statutory obligation to comply with.” Comment.
  4. Can an auditor be appointed by a partner or his legal representative to audit the accounts of a firm?

Essay-type Questions

  1. Discuss the appointment, scope of work, rights and duties of an auditor of a sole-proprietorship business.
  2. What are the advantages of the audit of a partnership firm? What special points should be included in the audit report in respect of such an audit?
  3. Describe the steps to be taken by the auditor before commencement of a new audit of a partnership firm.
  4. State the special points to be considered while conducting audit on behalf of the following perons:
    • A sleeping partner
    • A retiring partner
    • The legal representatives of a deceased partner
  5. Does the audit of accounts of a partnership firm differ from that of a company? If so, in what respect?