Chapter 2. Classification of Auditing – Auditing: Principles and Techniques

Chapter 2

Classification of Auditing

CHAPTER OUTLINE
2.1 INTRODUCTION

Auditing is a multidimensional and comprehensive subject. An effective insight into the nature of auditing can be obtained by understanding the various types of audit, which together constitute the auditing discipline. Auditing can be classified from various viewpoints. In this chapter, classification of audit will be discussed in detail.

2.2 CLASSIFICATION OF AUDIT

An audit can be classified under different groups on different bases.

2.2.1 Classification on the Basis of Organisation

Under this category, the audit is classified on the basis of nature of the organisation for which the audit work is undertaken. It includes the following types:

Audit required under law

  • Companies governed by the Companies Act, 1956
  • Banking companies governed by the Banking Regulation Act, 1949
  • Electricity supply companies governed by the Electricity Supply Act, 1948
  • Co-operative societies registered under the Co-operative Societies Act, 1912
  • Public and charitable trusts registered under various Religious and Endowment Acts
  • Corporations set up under an Act of Parliament or State Legislative (e.g. Life Insurance Corporation of India)
  • Specified entities under various sections of the Income Tax Act, 1961
  • Government departments/Public utilities
  • Registered clubs, societies etc. registered under Societies Registration Act, 1960

Audit under voluntary category

  • Proprietary concern
  • Partnership firm
  • Hindu undivided family
  • Association of persons
  • Non-profit seeking organisations

2.2.2 Classification on the Basis of Function

Under this category, the audit is classified on the basis of functional activities of the auditor. In fact, in this group audit is classified on the basis of the auditor involved in the work of audit. It includes the following types:

  1. External audit/Independent financial audit
  2. Internal audit

2.2.3 Classification on the Basis of Practical Approach

The classification of audit under this group involves a practical approach to the work. It includes the following types:

  • Continuous audit
  • Periodical audit
  • Interim audit
  • Partial audit
  • Occasional audit
  • Standard audit
  • Balance sheet audit
  • Complete audit

2.2.4 Classification on the Basis of Audit Dimension

Under this category, the audit is classified on the basis of dimension of audit activities. It includes the following types:

  • Management audit
  • Cost audit
  • Tax audit
  • Human resource audit
  • System audit
  • Propriety audit
  • Performance or efficiency audit
  • Environment audit
  • Social audit
  • Cash transactions audit
  • Government audit
  • Secretarial audit
  • Energy audit
  • Other types of audit including special purpose audit (e.g. ABC audit, audit of bonus computation etc.).

A detailed classification of audit is presented in the following chart:

2.3 CLASSIFICATION ON THE BASIS OF ORGANISATION

Audit is not legally obligatory for all types of business organisations. On the basis of organisational structure, audits may be of two broad categories:

2.3.1 Audit Required under Law

This type of audit is also known as statutory audit. The organisations which require audit under law are as follows:

1. Company audit

Audit of accounts of companies registered under the Companies Act is compulsory. As the control of the company is vested with the directors of the company, the need for protection of the interest of the shareholders arises. The introduction of Companies Act, 1956, which outlines the procedure of audit work, the different books of accounts to be maintained, rights, duties and liabilities of the auditor was definitely a right step towards the protection of shareholders’ interest over the company.

2. Bank audit

Audit of banking companies is made compulsory under the statute, since it is governed by the Banking Regulation Act, 1949. The objective of bank audit is not only to check the financial result and financial position, so far as its truth and fairness are concerned, but also to review whether the banks are engaging themselves in those businesses which are given in the Act only and follow the regulations to operate the banking business as per the regulations given in the Act.

3. Electricity company audit

The electricity companies are governed by the Electricity Supply Act, 1948. The books of accounts that are to be maintained by electricity companies are given in the provisions of the said Act. The auditor will examine the details of the books of accounts and check the reliability of the internal check system of the organisation. The prescribed forms for the presentation of accounts should be used as per the requirements of the Act.

4. Co-operative society audit

Audit of co-operative societies is conducted by the co-operative department of the state government or by the Registrar of co-operative societies, as the case may be. The co-operative societies are governed by the Co-operative Societies Act, 1912, which gives the detailed procedures of audit for a co-operative society. These types of societies have a good number of financial transactions. So, this type of organisation has the statutory obligation to introduce audit for its better performance.

5. Trusts audit

The income of the trusted properties is distributed by the trustees among the beneficiaries as per the trust deed. As the beneficiaries of the trust in most of the cases do not know the techniques of reading the books of accounts, the chances of being defrauded by the trustees cannot be avoided. So, this type of audit protects the beneficiaries of the trusted properties against the possible losses by unscrupulous trustees.

6. Insurance audit

The insurance companies that are governed by Insurance Act, 1938, include fire, marine and other miscellaneous insurance businesses. The books of accounts that are to be maintained by the insurance companies are governed in accordance with the provisions of the said Act. The auditor will examine the details of the books of accounts and check the reliability of the internal check systems. The audit of insurance companies, in fact, enhances the confidence of the policy holders.

7. Specified entities as per Income Tax Act

According to the various provisions of the Income Tax Act, certain entities are required to get their accounts audited to fulfill the requirement of the income tax regulations. These entities are required to appoint a qualified auditor to conduct audit of their financial statements in order to get exemptions and deduction from the income of the entity.

8. Audit of government departments and government public utilities

Different government departments and public utilities are also subject to independent financial audit. The requirement for such audit is contained in the constitution of India. In addition to that, government departments and public utilities also have the internal audit system of their own.

9. Audit of registered clubs, societies etc.

Though it is not compulsory in all cases, the audit of societies, clubs etc., which are registered under the Societies Registration Act, 1960, conduct audit of their activities to continue registration. In addition to that, different government grants and loans are given to these societies, clubs etc. on the basis of their application along with the audited income and expenditure account and the balance sheet. It is the responsibility of the secretary of the society or club to submit the audited financial statements to the members in the annual meeting of the society or club.

2.3.2 Audit of Other Organisations Not Covered by Any Law

There is no basic legal requirement of audit in respect of certain organisations. These organisations may require audit as a matter of internal rules. Some may be required to get their accounts audited on the directives of government for various purposes like sanction of loan, grants etc. These organisations include:

1. Sole proprietors

The sole proprietors are not required to have their accounts audited under any specific statute. But the sole proprietary businesses, in which the number of transactions are large and a huge amount is involved in the business, get their accounts audited. The proprietor himself takes decision about the scope of audit and the appointment of auditor. In fact, under this type of audit, the auditing work will depend upon the agreement of audit and the specific instructions given by the proprietor.

2. Partnership firm

There is no legal compulsion to get partnership accounts audited. But in partnership, there are possibilities of mistrust and dissatisfactions among the partners. As such, an independent external auditor’s view regarding the correctness of accounts is desirable in case of this type of organisation. Usually, the partnership deed includes the provision of audit of their accounts. In conducting partnership business audit, the auditor has to refer to the partnership deed. But in the absence of partnership deed or any aspect which is not included in the deed, the auditor may refer to the Partnership Act, 1932.

3. Hindu undivided family

In respect of accounts of Hindu undivided family, there is no basic legal requirement of audit. But the important motive for getting the accounts of this type of family business audited lies in the inherent advantages that follow from an independent professional audit. If there will be any dispute or mistrust among the members of the Hindu undivided family regarding accounts, that can be settled through the audited accounts.

4. Association of persons

Though it is not legally required to get accounts of such associations audited, some associations of persons, e.g the Bengal Chamber of Commerce, are interested to appoint qualified auditors and get their accounts audited for different reasons. For availing exemption from income tax liability, such associations are required to submit their audited accounts to the income tax authority. In conducting this type of audit, the auditor has to refer the constitution of the association.

5. Non-profit seeking organisations

Certain non-profit seeking organisations, e.g. colleges, libraries, hospitals, clubs charitable institutions etc. get their accounts audited. The basic purpose of audit of these types of organisations is to locate error or fraud committed by the staff members. The governing body of these organisations usually appoints the auditor. These organisations usually depend upon government grants and other aids from different bodies. Audited accounts are helpful in getting grants and aids.

2.4 CLASSIFICATION ON THE BASIS OF FUNCTION

The function of the auditor depends on the role of the auditor, i.e. in which capacity he is conducting the audit work. So, on the basis of function, auditing can be of the following types:

2.4.1 External Audit

External audit is conducted by an independent external auditor. This type of audit is usually conducted to fulfil the requirement of the provisions of law. Qualified chartered accountants who are not connected with the preparation of accounts or management of the organisation can be appointed as external auditors.

The auditor who conducts such an audit is ‘independent’ of the enterprise under audit, i. e. he is an independent professional who does not have any such relationship with the enterprise as might adversely affect his ability to form an objective judgment about the financial statements. The various matters relating to the procedures of audit, rights, duties and liabilities of the auditor, their appointment procedures and presentation of reports are provided in the concerned statute.

Features of external audit

  1. External audit is usually conducted by an independent qualified auditor.
  2. In the normal course, this type of audit is conducted periodically.
  3. The purpose of external audit is to see whether financial statements give a true and fair view of the financial position and result of the concern.
  4. The external auditor can work independently, and enjoys better status.
  5. The Indian Companies Act, 1956 and other statutes provide the area of responsibilities and functions of the external auditors.
  6. In cases where external audit is being conducted due to legal compulsion the auditor must have a professional qualification.
  7. This type of audit is conducted mainly for safeguarding the interest of owners, shareholders and other parties who do not have knowledge of day-to-day operation of the organisations.
  8. The Act always provides for the norms regarding the appointment of auditor. The auditor must not be disqualified as per the provision of the law.

Independent financial audit is undoubtedly the most common type of audit. It is generally conducted to ascertain whether the balance sheet and the profit and loss account give a true and fair view of the financial position and financial performance respectively of the enterprise under audit.

2.4.2 Internal Audit

Internal audit is conducted by specially assigned staff within the organisation. It is an audit through which a thorough examination of the accounting transactions as well as the system according to which these transactions have been recorded is conducted. Internal audit is undertaken to verify the accuracy and authenticity of the financial accounting and statistical records presented to the management. As per AAS-7, the scope and objectives of internal audit vary widely and are dependent upon the size and structure of the entity and the requirements of its management.

Features of internal audit

  1. The internal audit system is considered to be a part of the management control system and not merely an assistant thereto.
  2. Internal audit often differs in its scope and emphasis. It is more managerial than accounting.
  3. The nature and extent of checking also depends on the size and type of the business organisation.
  4. It embraces not only the operational audit of various operational activities in the organisation but also includes the audit of management itself.
  5. The function of internal audit can be considered as an integral part of the internal control system.
  6. Internal audit is continuous in nature. The work of internal auditor starts after the transactions are completed.
  7. Generally the internal audit is conducted by the permanent staff of the organisation. Sometimes outside agencies may be asked to conduct internal audit.
  8. The existence of internal audit is a help to the external auditor.

2.4.3 External Audit and Internal Audit Compared and Contrasted

Internal audit involves an examination and evaluation of various activities of an enterprise. The scope of internal audit in a particular situation is determined by the management in the context of its specific requirements. The internal auditor, thus, engages himself primarily in the task of reviewing the various activities of an enterprise and reporting on the same to its management.

Internal audit is different from independent financial audit in two important aspects. Firstly, independent financial audit is often required under law and the auditors are not usually appointed by the management and the auditors are also not required to report to the management. On the other hand, the internal auditors are appointed by the management and they are required to submit the report to the management. Secondly, the objective of independent financial audit is to ascertain whether the financial statements are reliable, i. e. whether they give a true and fair view of the financial result and financial position of the enterprise.

Similarities between internal and external audit

  • An effective system of internal control
  • Continuous effective operation of such system
  • Adequate management information flow
  • Assets safeguarding
  • Adequate accounting system
  • Ensuring compliance with statutory and regulatory requirements

Areas of differences between internal and external audit

  • The extent of work undertaken
  • Approach
  • Responsibility

Areas of work overlap between internal and external audit

  • Examination of the system of internal control
  • Examination of the accounting records and supporting documents
  • Verification of assets and liabilities
  • Observation, enquiry and the ratio measurement

2.4.4 Distinction between External and Internal Audit

The difference between external audit and internal audit can be outlined as shown in Table 2.1.

2.5 CLASSIFICATION ON THE BASIS OF PRACTICAL APPROACH

On the basis of requirements of audit, the approach to auditing may differ. So, on the basis of practical approach for conducting the audit work, the audit can be classified under the following types:

 

TABLE 2.1 Differences between external audit and internal audit

Area of difference External audit Internal audit

1. Nature

It is conducted for reporting on the reliability and fairness of the financial statements.

It is conducted with a view to check adherence to norms and established procedures and protect the assets of the organisation.

2. Qualifications

The auditor must possess specific qualification as prescribed by the respective statute.

No specific qualification is required to be possessed by the internal auditor.

3. Scope of work

This type of audit must be complete in all respects. Its scope can not be curtailed in any way by the management.

The scope of work of the internal audit is determined by the management.

4. Purpose

The object of this type of audit is to protect the interest of the owners and other parties related to the enterprise.

The basic objective of internal audit is to improve performance, efficiency and profitability of the enterprise.

5. Appointment of auditor

The external auditors are usually appointed by the owners and in some cases by the government.

The internal auditor is appointed by the management.

6. Status

The auditor is an outsider and independent person. He is not under any rules and regulations of the organisation.

The internal auditor is an employee of the organisation. He is bound by the rules and regulations of the organisation.

7. Continuity

External audit may be periodical or continuous in nature.

Internal audit is continuous in nature. It is carried out throughout the year.

2.5.1 Continuous Audit

A continuous audit or a detailed audit is an audit which involves a detailed examination of the books of accounts at regular intervals of, say, one month or three months. The auditor visits his clients at regular or irregular intervals of time during the financial year and checks each and every transaction. At the end of the year, he checks the profit and loss account and the balance sheet.

According to R. C. Williams, “A continuous audit is one where the auditor or his staff is constantly engaged in checking the accounts during the whole period or where the auditor or his staff attends at regular or irregular intervals during the period.”

Applicability

  1. Where it is desired to present the accounts just after the close of the financial year.
  2. Where the volume of transactions is very large.
  3. Where periodical statements are required to be presented to the management.

Advantages

  1. Easy and quick discovery of errors   As the auditor starts checking just after the completion of the transaction, it becomes easier for the auditor to detect fraud and errors quickly.

     

  2. Moral check on the client’s staff   As the auditor visits frequently and checks the accounts at regular or irregular intervals, this method of auditing provides moral check on the employees of the organisation.

     

  3. Preparation of interim accounts   Under continuous audit system, interim accounts can be prepared without much delay in time. It will help the Board of Directors to declare interim dividend.

     

  4. Up-to-date accounts   Due to continuous pressure from the auditors, the efficiency of accounts department’s staff will increase and their work will be up-to-date and accurate.

     

  5. More knowledge of technical details   Continuous audit will help auditor to understand the technicalities of the business. This will help the auditor to make valuable suggestions for the improvement of the business.

     

  6. Audit staff can be kept busy throughout the year   The auditor can make his audit plan in a systematic manner. He can evenly spread his work to the audit staff throughout the year. It will help the auditor to keep his staff busy throughout the year.

     

  7. Quick presentation of accounts   Audited accounts can be presented just after the end of the financial year as the auditor has already completed most of his routine audit work.

     

  8. Efficient audit due to more time   Since the audit is carried out throughout the year, sufficient time is available for detailed checking. It will result in efficient audit.

Disadvantages

  1. Expensive system of audit   As the auditing work is required to be carried out throughout the year, it becomes an expensive system. Small organisations cannot afford to adopt this expensive system of audit.

     

  2. Alteration of figures already checked   After the accounts have been checked, the staff of the client may fraudulently alter the figures.

     

  3. Dislocation of client’s work   Frequent visits by the auditor for checking the books of accounts and related documents may dislocate the work flow of the organisation.

     

  4. Queries may remain outstanding   As the work is not completed at a time, the auditor may lose continuity and certain questions and inquiries may remain unanswered.

     

  5. Unhealthy relationship   Frequent visits and disturbances in the daily work may provide scope for unhealthy relationships between the audit staff and the client’s staff.

     

  6. Reviewing of work already done   Before starting the audit work, a review of findings of previous audit work should be made to establish link with the past work done.

Ways and means of removing the drawbacks of continuous audit

In a large enterprise, continuous audit is a must for proper and timely completion of audit. So some special measures have to be taken for avoiding the limitations of continuous audit as far as possible. The following measures can be taken to overcome the shortcomings of continuous audit:

  1. Use of audit note book   The auditor must record in his notebook the work completed by him and his assistants from time to time, material errors detected and rectified, queries raised by him and his staff and explanations given by the client. Before starting the work each time, the auditor should have a look over the notebook and books of accounts to know the extent of work completed up to last visit or whether any query remains unanswered or whether any alteration is made.

     

  2. Use of special ticks in checking   The auditor may use a different tick for checking the figures altered before the audit. Such variation in tick mark should be slight and unnoticeable. This will enable the auditor to identify whether any unauthorised alteration has been made subsequent to audit.

     

  3. No change in audit staff   The duties of audit staff should not be changed in order to maintain the flow of work undisturbed and to ensure follow up of unresolved points. However, to avoid monotony in work, the nature of duty of the audit staff may be changed after completion of annual audit.

     

  4. No change in audited figures   Clear instructions must be given to the client for not changing any audited figure. If any extra ordinary situation requires such change, it should be done with prior intimation to the auditor and with the help of rectification entry only.

     

  5. Casting in ink   The casting of periodical total of the various books of accounts should be written in ink as and when they are checked.

     

  6. Incomplete work   Checking each part of work, whenever undertaken, should be completed in one visit and should not be left incomplete to be completed for the next visit.

     

  7. Sound audit programme   There should be well-framed audit programme indicating the extent of work to be completed, allocation of work and time schedule of various works. This will make the continuous audit very effective.

2.5.2 Periodical or Final or Complete Audit

Periodical audit is one which is taken up at the close of the financial period, when all the accounts have been balanced and final accounts have already been prepared. It may also commence before the final accounts are prepared and continue till the audit is completed even after the close of financial period.

According to Spicer and Pegler, “A final or complete audit is commonly understood to be an audit which is not commenced until after the end of the financial period and is then carried on until completed.”

In case of this type of audit, the auditor visits his client only once a year and goes on checking the accounts until the audit work for the whole of the period is completed.

Applicability

  1. Where the volume of transactions of the organisation is small
  2. Where there is no urgency to present the audited accounts within a certain period of time
  3. Where internal control system is very effective.
  4. Where interim statements of accounts are not required by the management for review or for some other purposes

Advantages

  1. Inexpensive   It is a less expensive system as compared to continuous audit system. Hence, the method of auditing is suitable for small business organisations.

     

  2. Quick completion of audit   Periodical audit can be finished quickly, within a reasonable time.

     

  3. Minimum chances of alteration   There is minimum chance of alteration of figures after they have been checked as the auditor completes his work on a continuous basis.

     

  4. Less disturbance in client’s work   Client’s daily office work is not unnecessarily disturbed because auditors visit only once a year.

     

  5. Preparation of audit schedule   The auditor will not face any problem in preparing his audit schedule.

     

  6. Requirement of small establishment   The auditor is not required to maintain a big establishment for this purpose.

Disadvantages

  1. Delay in presentation of accounts   This type of audit can be satisfactorily applied in case of small concerns. But in case of large concerns, it takes more time to complete the audit work and hence presentation of accounts to the shareholders is delayed.

     

  2. Preparation of interim accounts   Under periodical auditing system, it is not possible to prepare interim accounts. As a result, no interim dividend can be paid without the availability of audited interim accounts.

     

  3. Possibility of undetected errors and frauds   The auditor may not be able to check and verify all the transactions. As such, there is every chance that some of the errors and frauds may remain undetected.

     

  4. Fixation of audit programme   If the auditor has several clients whose financial year ends on the same date, it may be difficult for the auditor to complete the work of all the clients within the scheduled time.

2.5.3 Interim Audit

Interim audit is an audit, which is conducted in between the two annual audits with a view to find out interim profit of the business to enable it to declare an interim dividend. It is a kind of audit, which is conducted between the two periodical or balance sheet audits.

Advantages

  1. This type of audit is helpful to those concerns where the publication of interim accounts is required.
  2. The final audit can be completed within the scheduled time, if interim audit has already been conducted by the organisation.
  3. Errors and frauds can be found more quickly and detected during the course of the interim audit.
  4. There is a moral check on the staff of the client as the accounts are checked after three or six months.

TABLE 2.2 Distinction between continuous audit and periodical audit

Points of difference Continuous audit Periodical audit

Presentation of annual report

It ensures early publication of annual report.

Publication of annual report may be delayed.

Period of audit work

Audit is carried out throughout the year.

Audit is carried out only once at the close of the accounting period.

Work-coverage

Detailed checking of the books of accounts is possible because of the existence of sufficient time at the disposal of the auditor.

Detailed checking is usually not possible. In most of the cases, the checking of the books of accounts is limited to test checking.

Alteration of figures

Alteration of audited figures is possible due to the long gap between the two consecutive visits of the auditor to his client.

Alteration of figures is not possible as there is no break in the process of auditing work.

Cost involvement

It is very expensive to operate this system.

It is economical.

Applicability

It is applicable to large business organisations.

It is applicable in case of small business organisations.

Audit process

The audit staff visits and checks the accounts frequently.

The audit staff visits the client’s business only once in a year after the accounts are closed.

Detection of errors and frauds

It is very effective for early detection of errors and frauds.

Errors and frauds are left in the books till audit is conducted at the close of the year.

Disadvantages

  1. Figures may be altered in the accounts which have already been audited.
  2. It will mean that the audit staff will have to prepare notes when they finish the audit work.
  3. This audit implies additional work.
  4. In case of interim audit, the interim trial balance has to be prepared and for this purpose, balancing of all existing accounts is required to be made at the middle of the year.

2.5.4 Partial Audit

It is a kind of audit where the work of the auditor is curtailed. The auditor is asked to check a few books. For example, he may be asked to check the payment side of the cash book.

Partial audit is not permitted in case of limited companies (private or public) as, according to the Companies Act, the duties of an auditor of a company cannot be curtailed. Again, in case of a very big proprietary concern, it may not be possible for the proprietor himself to disburse all payments and if he suspects misappropriation of cash, he may appoint an auditor to check only the cash book.

When an auditor is appointed to conduct partial audit, he must make it clear in his report that he has performed partial audit as per the instructions of the client.

Advantages

  1. It serves the specific interest of the client.
  2. There is much scope to render quick service, as the auditor has to deal with only one or two aspects of business transactions.
  3. Critical analysis of the books of account relating to a particular item or group of items is made possible.
  4. It may act as a moral check on the part of persons who intend to falsify accounts.

Disadvantages

  1. The conduct of this type of audit is strictly restricted under the Companies Act.
  2. The audit report does not reflect the financial position of the business as a whole.
  3. It cannot be widely used.
  4. This type of audit is conducted only for a particular purpose.

2.5.5 Occasional Audit

As the name indicates, this type of audit is conducted once in a while, whenever the need arises and the client desires it to be carried out.

This is possible only in case of proprietary concerns but in case of joint stock companies, banking and insurance companies etc. the audit has to be carried out once or twice a year according to the Companies Act.

Advantages

  1. The client can know its actual financial position on the date when the books of accounts are audited.
  2. It brings some sort of satisfaction in the mind of the client that the audited accounts are accepted by all.
  3. Impartial view can be expressed through the procedure of audit.
  4. It can be profitably used in small concerns.

Disadvantages

  1. The conduct of this audit brings some confusion about the authenticity of final audit in a big concern.
  2. It is expensive to operate.
  3. The auditor faces a lot of problems in conducting his audit work, as the client’s staff is not accustomed to the procedures of auditing.
  4. The books of accounts may not be available according to the requirement of audit procedures.

2.5.6 Standard Audit

Standard audit can be defined as a “complete check and analysis of certain items and contingent upon effective internal check, appropriate test checks on remaining items, the whole of work being in accordance with general auditing standards.”

From the above, it is clear that under this type of audit, certain items in the accounts are thoroughly checked and analysed and appropriate test checks are applied to other items, provided there is a good and effective internal check in operation.

Advantages

  1. Development of new auditing standards in view of changing socio-economic condition can be made possible through scrutiny of auditing standards so far established.
  2. It controls the nature and extent of documents and evidences which are obtained through the procedure of an audit.
  3. It influences the audit programme.
  4. The destructive criticism often made by the general public that the management, in collusion with auditor, distorts the financial statements may be rooted out through the application of standard audit procedures.

Disadvantages

  1. It is very difficult to bring all organisations under the same accounting practices for the uniform application of standard audit.
  2. The application of a particular standard procedure to different organisations having different standards may invite chaos instead of development.
  3. Standards are always subject to change of circumstances, nature and environment of business.
  4. Finally, setting up a standard narrows the development of standard.

2.5.7 Balance Sheet Audit

Balance sheet audit means limited audit in which all the balance sheet accounts are verified and tests imposed only on those profit and loss items which are directly related to the assets and liabilities such as repairs and maintenance, provision for depreciation, bad debts etc. Accounts such as these are analysed, but otherwise no detailed audit is conducted.

Under this type of audit, the audit is commenced from the balance sheet working back to the books of original entry and the related documents etc.

This type of audit is more popular in USA than in England and other European countries. However, this type of audit is more widely used.

Advantages

  1. It records the changing events of the period. The change in working capital can be reflected through Balance sheet audit.
  2. This type of audit furnishes different information relating to over-capitalisation, under-capitalisation, over-trading and under-trading of the business.
  3. It establishes proper relationship between assets and liabilities of the business.
  4. It guides different parties interested in the affairs of the business in taking business decisions.

Disadvantages

  1. It lacks in disclosing certain material information needed to evaluate different measuring bases.
  2. Balance sheet reflects the financial position of the business only at a given point of time. Events occurring after balance sheet date may affect materially the process of decision.
  3. Comparison between the two periods may be drawn, but the causes for the change of figures between the two periods are not stated.
  4. Information regarding the generation of profit or loss of the business is not stated in the balance sheet. This is required to make the balance sheet more informative and balance sheet audit more dynamic.
2.6 CLASSIFICATION ON THE BASIS OF AUDIT DIMENSION

The scope of an audit varies widely and depends on the purpose of the audit, the dimension of auditing work and the conditions of the audit requirement. On the basis of this dimensional aspect, auditing can be classified under the following types:

2.6.1 Management Audit

Management audit is a comprehensive critical review of all aspects of the management process. In fact, it is a tool of management control. It covers all areas of management like planning, organising, co-ordination, control etc. It assists at all levels of the management in the effective discharge of managerial functions.

A management audit is forward-looking and independent. It is a systematic evaluation of the activities of the management at all levels for the improvement of the organisational profitability and attainment of other objectives of the organisation through improvements in the performance of the management function. In short, management audit is a guide which helps in improving the efficiency of the management.

2.6.2 Cost Audit

Cost audit is an effective means of control in the hands of the management to have an idea about the working of the costing department of the organisation and to suggest ways and means for its smooth running. It is the detailed checking as well as the verification of the correctness of the costing techniques, systems and cost accounts.

Cost audit was introduced in India for the first time in the year 1965 with the introduction of clause (d) to Section 209 and 233B of Section 233 of the Companies Act. The need for such provision in the Act arose as the maintenance and proper use of scientific cost records is essential for those companies, which are engaged in the manufacturing and related activities.

2.6.3 Tax Audit

Tax audit refers to audit of incomes or expenses or specific claims of deductions or exemptions for the purpose of assessment of income tax. Tax audit is required in addition to financial audit, which does not fulfill the specific requirement of the tax authority.

Since the assessment year 1985–86, certain provisions under Section 44AB of the Income Tax Act was inserted to provide that certain persons have to get compulsory tax audit of their accounts. These persons shall get their accounts of the previous year audited by an accountant before the ‘specific date’ and obtain before that date the report of such audit in the prescribed form duly signed and verified by such accountant.

2.6.4 Human Resource Audit

One of the defects of financial accounting is its failure to show the human resources in the balance sheet. However, it is a fact that external users may wish to know the degree of employee morale, customer satisfaction, product quality and the reputation of an entity. So, disclosure of information regarding human resources in the annual report of the company may help a lot to the investors in framing an opinion whether to invest or not.

The auditor for the purpose of making audit of human resources, if it is included in the annual accounts, should carefully examine the basis of valuation of human resources. His examination should not relate to the tightness of the process of valuation of the human resources but he should see that information upon which the calculations are based are reliable and authentic. So, human resource audit is concerned about the human asset figure that appears in the balance sheet through checking, inspecting and appraising the various facts and figures, which are based on the estimated value of human resources.

2.6.5 System Audit

The purpose of the system audit is to design appropriate system of accounts suitable to the business and to obtain information, through the process of investigation for improving the accounting method. In fact accounting systems are required to be revised in order to ensure that it may provide the information desired by the executives as an aid to management decision.

So, system audit is concerned with that method of checking, which is directed to ascertain whether the accounting practices are up-to-date and economical and whether the existing practices are required to be changed so as to do the work better, quicker and at less cost under the present conditions.

2.6.6 Propriety Audit

Propriety audit is concerned with scrutiny of executive decisions bearing on the financial and profit and loss aspect of the concern with special reference to public interest and commonly accepted customs and standards of conduct. While performing a propriety audit, the auditor would judge whether the standards of propriety have been maintained in making payments, incurring expenditure or entering into transactions.

Propriety audit ensures that the public money has not been utilised for the benefit of a particular person or section of the community and all transactions have been activated for the best interest of the concern itself. Section 227 (1A) and CARO, 2003 issued under section 227(4A) of the Companies Act, 1956 also contain clauses dealing with the examination of transactions from the view point of propriety.

2.6.7 Performance or Efficiency Audit

Efficiency audit provides the means to appraise the performance of the enterprise and to diagnose the weakness of the enterprise. It aims to determine whether the resources of the business flow into remunerative or paying channels. It is concerned with the review of the organisational environment, measuring return on investment, cash flow performance etc. and comparing these with the standard.

The efficiency audit is based on the basic economic principles. The objective of this type of audit is to evaluate and compare the optimum return with the amount of capital invested in the business and to ensure that investment techniques aim at giving optimum results. In short, efficiency audit is introduced to ensure the improvement of organisational efficiency.

2.6.8 Environmental Audit

Environmental audit is an excellent management tool for relating productivity to pollution. Environmental audit is the examination of the correctness of environmental accounts. In broader sense, environmental auditing is the examination of accounts of revenues and costs of environmental and natural resources, their estimate, depreciation and values recorded in the books of accounts.

In India, recognising the importance of environmental audit and its procedure was first notified under the Environment (Protection) Act, 1986 by the Ministry of Environment and Forests. Under this Act, every person running an industry, operation or process requiring consent under Section 25 of the Water (Prevention & Control of Pollution) Act, 1974 or under Section 21 of the Air (Prevention & Control of Pollution) Act, 1981 or both or authorisation under the Hazardous Wastes (Management and Handling) Rule of 1989 issued under the Hazardous (Protection) Act, 1986 is required to submit an environmental audit report.

2.6.9 Social Audit

Business organisations are now regarded as a great social force. They are not expected to be only engaged in profit earning activity and paying dividend to the shareholders. They have an important role to play in the social well being. They have some responsibility to the society.

Social audit is aimed at an assessment of the performance of an entity towards the fulfilment of social obligations. The objective of social audit is to bring to light for public knowledge how far an organisation has discharged its responsibility to the society and to make an assessment of the social performance of an organisation. But audit of social accounts is not yet in practice and the term ‘social audit’ is still in a conceptual stage in our country.

2.6.10 Cash Transaction Audit

Cash transaction audit is the oldest concept in auditing system. In the olden times, a person was appointed to check cash transactions only, i.e. whether the person responsible for recording cash receipts and payments on behalf of the business owner has done his job properly or not. Hence it was merely a cash audit.

So, when an audit of all items of cash book, is conducted it is known as cash audit. The auditor will check the receipt and payments made by cash with the vouchers and documents. It is useful in an organisation in which most of the transactions are made through cash. It is only a partial audit and at present the concept of this auditing has a wider meaning.

2.6.11 Energy Audit

It is a relatively new branch of auditing. It is emerging as a consequence of heavily depleting physical energy resources in the world. Need for conservation of energy is the most important parameter of modern day world. Energy audit is focussed to see whether right amount of energy, both organic and inorganic, is used by the enterprises and there occurs no avoidable loss or waste of energy due to human indifference. Conducting energy audit inevitably calls for technical input and an audit team with audit professionals and technical personnel is needed for the purpose.

2.6.12 Secretarial Audit

This is also a relatively new concept and is coming to be recognised with growing complexities in the corporate laws. Compliance with the provisions of various corporate laws is as important as to be in the business. Any failure to comply may invite heavy penalty and/or even imprisonment. It is therefore imperative for corporate entities to ensure compliance with the applicable legal requirements, which are numerous. A secretarial audit assures the corporate body that the legal requirements have been duly complied with and in time. If non-compliances are noticed by the audit, management will have time to rectify the situation with much lesser problems and costs.

POINTS TO PONDER
  • Auditing is a multidimensional and comprehensive subject. An effective insight into the nature of auditing can be obtained by understanding the various types of audit.
  • Auditing can be classified from the following viewpoints: organisation, functions, practical approach and audit dimension.
  • Company audit, bank audit, electricity company audit, co-operative society audit, trusts audit, insurance audit etc. are required under law, whereas audit of sole-proprietors, partnership firms, association of persons, non-profit seeking organisations etc. are not required under law.
  • On the basis of functions, audit can be of two types: external audit and internal audit. External audit is conducted by an independent external auditor, whereas internal audit is conducted by specially assigned staff within the organisation.
  • On the basis of practical approach for conducting audit, the audit can be classified under the following types: continuous audit, periodical audit and interim audit on the basis of time complete and partial audit on the basis of scope and balance sheet; and occasional and standard audit on the basis of objectives.
  • On the basis of dimension of audit work, audit can be classified under the following types: management audit, cost audit, human resource audit, system audit, propriety audit, efficiency audit, environment audit, social audit, cash transaction audit, energy audit, secretarial audit etc.
REVIEW QUESTIONS

Short-answer Questions

  1. What is management audit?
  2. Distinguish between internal audit and statutory audit.
  3. Write a short-note on the various classes of audits.
  4. ‘Continuous audit is a double edged weapon’. Discuss.
  5. What is interim audit? Why is it required?
  6. Write short notes on:
    1. Standard audit
    2. System audit
    3. Efficiency audit
    4. Social audit

Essay-type Questions

  1. What is statutory audit? Describe the points of differences between statutory audit and non-statutory audit.
  2. What is periodical audit? What are the advantages and disadvantages of periodical audit? Distinguish between continuous audit and periodical audit.
  3. What is continuous audit? In which case is this audit applicable? State the advantages and disadvantages of continuous audit.
  4. Discuss the advantages and disadvantages of balance sheet audit. Also state the auditor’s position in relation to balance sheet audit.