Techniques and Procedures of Auditing
An auditor must ensure that he fully understands the enterprise with which he is dealing before he determines his basic approach to an audit. He must familiarise himself with its organisation and visit the location at which it operates. He should have a detailed knowledge of its products or services. He must ensure that he has fully grasped any technicalities peculiar to the business. Only then he will be in a position to fully comprehend and identify the transactions which are being recorded in the accounting records, in relation to which the internal controls will be operating.
The auditor should follow the appropriate audit procedure and adopt different techniques of auditing. He should maintain the principles of auditing in conducting audit of an organisation in order to meet the following requirement:
- Ascertain and record the accounting system and internal controls, assess the adequacy of the accounting system and evaluate the controls on which the auditor wishes to place reliance
- Test the accounting records and perform compliance tests on the operation of those internal controls on which the auditor wishes to place reliance
- Compare the financial statements with the accounting records and perform substantive tests to see that they are in agreement
- Carry out a review of the financial statements
- Report on the financial statements as required by the terms of auditor’s appointment, and in compliance with any relevant statutory obligation.
On the basis of his assessment of the accounting system and evaluation of the internal controls, the auditor will draw up an audit programme specifically designed for that particular audit.
3.2 PREPARATORY STEPS BEFORE COMMENCEMENT OF AUDIT
Effective execution of any audit work requires appropriate planning and a well-designed audit programme. For effective audit planning and for desiging appropriate audit programme, the auditor should prepare himself before the commencement of his audit work. For this purpose, the auditor should take the following steps:
1. Receiving appointment letter
The auditor is usually appointed by the shareholders in the annual general meeting and shall hold office till the conclusion of the next annual general meeting. The auditor should receive the appointment letter before starting his audit work as he has to conduct his audit work on the basis of terms of references as given in the appointment letter. This appointment letter is formally called Audit Engagement Letter. Auditing and Assurance Standard (AAS-26) describes the purposes, applicability and contents of Audit Engagement Letter.
2. Communication with the existing auditor
Before accepting the work of a new audit, in the case of a continuing business, it is established professional etiquette for the proposed auditor to communicate with the previous auditor to see whether he has any objections to raise. This is also an official requirement as per the Institute of Chartered Accountants Act, 1949 and has to be adhered to by the practicing chartered accountants.
If the auditor is satisfied with the reasons for not appointing the previous auditor, he can then accept the appointment. The auditor should confirm his acceptance to the concerned organisation through a letter of acceptance.
4. Ascertaining the scope of audit
After accepting his appointment, he should ascertain the precise nature and scope of his audit work. In case of statutory audit, the scope and the nature of audit work can be ascertained by referring to the statute. In case of other types of audit, the auditor should discuss with the client about his area of auditing work.
5. Knowledge about the organisation
Before the auditor can determine his basic approach to an audit, he must ensure that he fully understands the enterprise. He must comprehend the nature of the business and have a detailed knowledge of its activities. He must familiarise himself with the organisation and visit the location at which it operates. This will enable him to understand the nature of transactions, which are recorded in the books of accounts. AAS-20 describes how the knowledge of business is relevant to the auditors and how the auditors will obtain and use the knowledge of the business in their audit work.
6. Knowledge of the accounting system
The auditor should obtain a list of all books maintained by the organisation for recording its accounting transactions along with the information relating to the existing accounting system. He should also acquire complete information about the internal control system of the organisation. In fact, the extent of his work is greatly influenced by the reliability of internal control system and appropriateness of accounting system adopted.
7. Complete list of principal officers
The auditor should also obtain a list of the principal officers of the organisation. He should also acquire knowledge about the area and extent of authority of each one of them. This will help the auditor to have appropriate clarification from the concerned officer.
8. Knowledge of technical details
The auditor must ensure that he has fully grasped the technicalities peculiar to the business. Only then, he will be in a position to identify the transactions of the accounting records and relate the accounting system with the internal control system adopted.
9. Observation of the previous auditor’s report
The auditor should go through the previous auditor’s report as well as the final accounts of the previous year. This will help him to understand the nature of accounts, important areas for which detailed checkings are required and the techniques to be used to conduct his audit work effectively.
After completing the above-mentioned steps, the auditor should issue clear instructions to his client that the accounts should be finalised and kept ready for audit and the necessary schedules required to support the final accounts be prepared and made available to him.
3.3 PREPARATION BY THE AUDITOR
Modern techniques require a new approach to the practical aspects of the auditor’s work. Detailed checking and vouching no longer constitute the main aspect of the operations involved; the ascertainment of the internal control system, the investigation of its working and the verification of assets and liabilities in order to ensure the presentation of the true and fair view of the financial statements, now prevail. The attitude that an audit is mainly useful for the discovery or prevention of fraud is no longer accepted. It is now more generally appreciated that an audit not only ensures the true and fair presentation of the affairs of the organisation, but also that it can be of real benefit in bringing about the establishment and maintenance of efficient business methods.
So, in order to conduct the work of audit smoothly and efficiently, at present, the auditor should prepare himself for the following aspects of audit.
3.3.1 Audit Planning
Audit planning is the process of deciding in advance what is to be done, who is to do it, how it is to be done and when it is to be done by the auditor in order to have an effective and efficient completion of audit.
According to AAS-8, “Audit planning refers to planning by the auditor made to enable him to conduct an effective audit in an efficient and timely manner, and includes planning about area, scope, depth of transactions to be audited, time to be devoted, persons to be deployed for audit etc.”
Audit planning is necessary for efficient and effective conduct of an audit. It should be continuously followed throughout the course of audit assignment. As per AAS-8, audit planning facilitates the following:
- Appropriate attention devoted to important areas of the audit
- Prompt identification of potential problems
- Timely completion of work
- Proper utilisation of assistants
- Coordination of work done by other auditors and experts
The main objectives of audit planning are to ensure the following:
- That the auditing work is conducted efficiently and profitably
- That high standards of audit works are maintained, so that the risk of litigation against the practice for negligence is minimised
It is important that audit should be carefully planned to ensure that correct number of staff of the appropriate level of seniority are available when they are required. In addition to that, in case of large audits, the work must be planned so that maximum work is done on an interim basis during the year. This has the double advantage of employing staff effectively throughout the year and ensuring that the only audit work that is remaining at the year end is the work that could not be performed earlier. To enable this planning to be carried out efficiently, the auditor will need to liaison with the chief financial officer/accountant of the organisation and ensure that the audit firm is fully aware of the exact proposed timing of the client’s own accounting procedures.
- Statutory requirement under the assignment
- Terms and conditions of engagement
- Nature and timings of reporting
- Significant audit areas
- Applicable legal provisions
- Reliability of accounting and internal control system
- Existing accounting practices followed
- Areas requiring special attentions
3.3.2 Audit Programme
Before starting an audit, a programme of work is usually drawn up. This is known as the ‘audit programme’. It is a detailed plan of work, prepared by the auditor, for carrying out an audit. It comprises a set of techniques and procedures, which the auditor plans to apply to the given audit for forming an opinion about the statement of account of an organisation.
Prof. Meigs defined audit programme as “a detailed plan of the auditing work to be performed, specifying the procedure to be followed in verification of each item in the financial statements and giving the estimated time required.”
So, audit programme may be defined as a careful flexibly written layout of the work to be done by the auditor and his staff in the conduct of an audit. The preparation of audit programme involves the following considerations:
- Area or extent of work
- Allocation of work
- Time duration for the completion of the work
- Responsibility of the persons, who have been assigned the work for its’ timely completion
The specimen of an audit programme is given here.
Purposes of audit programme
There is no denying the fact that audit programme not only serves as the plan of action to be taken for the completion of assigned audit work efficiently and effectively, but the progress of the audit work may also be ascertained by it. However, different purposes of audit programme are given as follows:
- Co-ordinating the procedures of audit
- Ascertaining the progress of audit-work
- Recording the work done during the process of auditing. Such records can act as an evidence of work done.
- Assigning responsibilities to the audit staff for the completion of audit work within the time limit.
TABLE 3.1 Specimen of an audit programme Name of the organisation : M/s ZYX Ltd. for the year ended on 31.3.20xx
Types of audit programme
An audit programme can be of the following two types:
- Predetermined audit programme In this audit programme, all the procedures of audit must be outlined in general, even though all procedures may not be relevant in a particular type of audit. The purpose of this type of audit programme is to offer either procedural guideline or to serve as a ‘check off list’. For this reason, this predetermined audit programme is also known as. tailor-made audit programme.
- Progressive audit programme The progressive form of audit programme is known as ‘skeleton’ form of audit programme. It sets forth briefly general scope, character and limitations of audit work. This type of programme is suitable in those cases where the condition of the business changes year after year.
Advantages of audit programme
Whatever may be the nature of audit programme, usually the following benefits are derived from an audit programme:
- Assurance of completion of work It ensures that all necessary work has been done and nothing has been omitted.
- Information about work-progress The auditor is in a position to know about the progress of the work done by his assistants.
- Uniformity of work A uniformity of the work can be attained as the same programme will be followed at subsequent audits.
- Simplification of work allocation It simplifies the allocation of work to various grades of articled and audit clerks.
- Guidance to the staff It is a kind of guidance to the audit clerk for the work he has to perform.
- Defence against charge of negligence The auditor can defend himself in case of a charge of negligence on the basis of the audit programme.
- Division of responsibility Work of the audit can be divided amongst the different juniors who will be held responsible for their work.
- Final review of work An audit programme facilitates the final review of work before the report is signed.
- Helpful to the new employees For a new employee, the audit programme is a guide to his duty.
- Basis of future programmes It is a useful basis for preparing the programme for the subsequent years.
Disadvantages of audit programme
- Loss of initiative An efficient clerk loses his initiative because he has to follow the programme which has been fixed in advance.
- Want of flexibility Even if the audit programme is well drawn up, it may not cover everything that might come up during the course of audit.
- Rigidity in programme Each business may have a separate problem of its own and hence a rigid programme cannot be laid down for each type of business.
- Unsuitable for small concerns Drawing up of an audit programme may be unnecessary for a small concern.
- No scope of changes The audit programme may be followed mechanically year after year though some changes might have been introduced by the client.
- Concealment of incapacity of staff Inefficient audit assistants may also take shelters behind the programme.
Steps to be taken to overcome the disadvantages of written audit programme
Obtaining up-to-date information and encouraging audit assistants to inform the deviations from the standard and the audit programme can avoid the aforesaid shortcomings and accordingly the principal may modify the programme.
In fact the disadvantages of written audit programme arise due to misunderstanding of its purpose. It should be taken as only a guide to audit and should not be treated as rigid and inflexible document. For this purpose, the auditor should take the following steps:
- Educating the audit staff The audit staff should be made known about the purpose of audit programme. They must be clearly stated that they may go beyond the audit programme if the situation so warrants. The opinion of the audit staff may also be taken while drafting the audit programmes.
- Revision of audit programme It should be the responsibility of the audit manager to constantly review the existing audit programme and modify it in the light of experience of the previous year’s audit and according to the changing circumstances. The audit staff should also be encouraged to give their suggestions in this regard.
- Rotation of work The duty of audit staff should be rotated so that no staff does the same job year after year. This will help in reducing the monotony of work.
- Overall supervision Proper supervision and review of work is also useful for overcoming the disadvantages of predetermined audit programme.
3.3.2 Audit Notebook
An audit notebook is usually a bound book in which a large variety of matters observed during the course of audit are recorded. It is thus a part of the record of the auditor available for reference later on, if required. The matters may be observed during the course of audit for which no satisfactory answer have been given by the client or those which require to be incorporated in the audit report. It is a kind of permanent record available to the auditor.
The audit notebook may be in two parts:
- For keeping a record of general information as regards the audit as a whole
- For recording special points which have been observed during the course of audit of the accounts of different years
Objectives of audit notebook
The audit notebook is an important document of audit. It serves the following purposes:
- Facilitates future audit The audit notebook of current year helps the auditor while he starts audit in the next year. He can easily understand which areas of the organisation should deserve his special attention.
- Documentary evidence The audit notebook provides an evidence about the extent of work done and degree of skill and care exercised by the auditor in conducting audit. By producing audit notebook in the court he can defend himself against charge of negligence.
- Helps in preparing audit report It is not possible for the auditor to keep in memory all important matters and audit findings that are required to be considered in preparing the audit report. So, maintenance of audit notebook recording all such important matters provides him a lot of assistance in preparation of audit report.
- Settlement of audit queries The accounting staff of the client may feel disturbed if the auditor puts audit queries before them every now and then in the course of audit. So, for the sake of convenience of the client’s staff, audit queries should be recorded in the notebook as and when they crop up and placed at a time before the staff of the client for their explanations.
- Evaluation of work The auditor, by going through the audit notebook, can understand the progress of audit work and the level of efficiency of his staff in audit work.
The audit notebook is of great value to an auditor at the time of preparing the report to be submitted to the shoreholders. In case a charge of negligence is filed against the auditor, a notebook may prove to be a good evidence.
From this notebook, an auditor may know the exact volume of work performed by his assistants. It also helps for future reference and guidance. This can serve as a guide also in framing the audit programme in future, so far as the points recorded in the notebook indicate the weaknesses in the system of the accounting of the client, which requires to be looked into.
Contents of audit note book
Some of the important points which are noted down in an audit notebook are given below:
- A list of books of accounts maintained by the clients
- The names of the principal officers, their powers, duties and responsibilities
- The technical terms used in the business
- The points which require further explanations
- The particulars of missing vouchers, the duplicate of which have to be obtained
- The mistakes and errors discovered
- Total or balances of certain books of accounts, bank reconciliation statement etc.
- Notes and queries which might be required at a subsequent audit
- The points which have to be incorporated in the audit report
- Any matter which requires discussions with the senior officials or with the auditor
- Accounting method followed in the business
- Date of commencement and completion of audit
- Provisions in the Articles and Memorandum of Association affecting the accounts and audit
- Abstracts from minutes, contracts etc. having a bearing upon accounts
- Particulars of accounting and financial policies followed
Advantages of audit notebook
- From the audit note book, an auditor may know the exact volume of work performed by his assistants.
- It helps for future reference and guidance. This can serve as a guide in framing the audit programme in future.
- It facilitates the preparation of the audit report.
- In case of change of audit assistants, no difficulty is faced by the new assistant in continuing the incomplete work.
- It ensures that the audit programme has been sincerely followed.
- It is a reliable evidence in the eye of law, if an auditor has to defend himself.
- The responsibility of errors undetected can be fixed on the assistant concerned.
- The important matters relating to the audit work may be easily recalled.
Audit working papers are written records kept by the auditor of the evidence accumulated during the course of the audit, the methods and procedures followed and the conclusions reached. They should include all the information that the auditor considers necessary to adequately conduct his examination and provide support for his audit report.
In short audit working papers are those papers which contain essential facts about accounts that are under audit.
Purpose of working papers
Working papers are actually the compilation of all evidences which are collected by the auditor in the course of his audit. They serve the following purposes:
- They show the extent of adherence to accounting principles and auditing standards.
- They are useful as evidence against the charge of negligence.
- They assist the auditor in co-ordinating and organising the work of audit assistants.
- They ensure the possibility of quick preparation of audit report.
- Through the working papers, the auditor can know the distribution and accomplishment of work.
- Measurement of the efficiency of the assistants can be done with the help of working papers.
- They can be used as permanent record for future references.
- They can act as a means to give training to the audit clerk.
- They provide a means to control the ongoing audit work.
- Working papers assist the auditor in forming an opinion on the financial statements.
Contents of working papers
Audit working papers should include a summary of all significant matters identified which may require the exercise of judgment, together with the auditor’s conclusion thereon. If difficult questions of principle or of judgment arise during the course of the audit, the auditor should record the relevant information received and summarise both the management viewpoints and his conclusions.
AAS-3 issued by the Institute of Chartered Accountants of India makes the following suggestions regarding the form and contents of working papers.
- The working papers should record the audit plan, the nature, timing and extent of auditing procedures performed and the conclusions drawn from the evidence obtained.
- The exact form and content of working papers are affected by various matters such as given below:
- The nature of the engagement
- The form of the audit report
- The nature and complexity of client’s business
- The nature and conditions of the client’s records and degree of reliance on internal controls
- The need in particular circumstances for direction, supervision and review of work performed by assistants
- Working papers should be designed and properly organised to meet the circumstances of each audit and the auditor’s need in respect thereof.
- Working papers should be sufficiently complete and detailed for an auditor to obtain an overall understanding of the audit.
- All significant matters which require the judgement, together with the auditor’s conclusion thereon, should be included in the auditor’s working papers.
- To improve audit efficiency, the auditor normally obtains and utilises schedules, analysis and other working papers prepared by the client such as analysis of important revenue accounts receivables etc.
- In case of recurring audits, some working papers may be classified as permanent audit files as distinct from current audit files relating primarily to the audit of a single period.
Responsibility on protection and preservation of working papers
Whosoever is in the possesion of working papers should be responsible for their safe custody. These should in no case be shown to a third party except with the permission of the client. As the working papers are prepared in respect of the client’s business, they should be treated as top secret and should be preserved in all circumstances and at all times.
After the audit report has been prepared and delivered to the client, these papers may be filed and preserved for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirements of record retention.
Ownership of working papers
An important and pertinent question arises as to the ownership of these working papers. The claim of the auditor is that it is he who has collected the information for the purpose of discharging his duties. Therefore, he is entitled to the possession of these papers. On the other hand, it is the claim of the client that the auditor is his agent and hence he should surrender these papers to the client.
In fact, this question of ownership in respect to the working papers arose in the case of Sockockingky vs Bright Graham & Co. (1938) in England. The question was whether the auditor had a right to retain the working papers as if it were his own property even after the payment of the audit fees. The court gave judgement in favour of the auditors on the ground that they were independent contractors and not agents of the client.
According to the views of the Institute of Chartered Accountants of India (AAS-3), working papers are the property of the auditor. The auditor may, at his discretion, make portions of or extracts from his working papers available to his clients. Further, according to this standard of auditing practices, an auditor should adopt reasonable procedures for custody and confidentiality of his working papers and should retain them for a period of time sufficient to meet the needs of his practice and satisfy any pertitent legal and professional requirements of record retention.
3.3.5 Audit Files
The file which is used by the auditor for preserving the written statements of necessary matters relating to audit is called the audit file. It maintains different audit documents, viz. audit notes, audit programme, audit working papers etc. The efficient audit filing system strengthens the integrity of the audit work.
- Permanent audit file
- Temporary audit file
Permanent audit file
In the case of recurring audits, some working paper files may be classified as permanent audit files which are updated currently with information of continuing importance to succeeding audit.
A permanent audit file normally includes the following:
- Information regarding the legal and organisational structure of the organisation. In case of company form of organisation, this includes the Memorandum and Articles of Association
- Extracts or copies of important legal documents, agreements and minutes relevant to the audit
- A record of the study and evaluation of the internal controls relating to the accounting system
- Copies of audited financial statements for previous years
- Analysis of significant ratios and trends
- Copies of management letters issued by the auditor, if any
- Record of communication with the retiring auditor, if any, before acceptence of the appointment as auditor
- Notes regarding significant accounting policies
- Significant audit observations of earlier years
Temporary audit file
In the case of single period audit, some working paper files may be classified as temporary audit file, which contain information relating primarily to the audit of a single period.
A temporary audit file usually includes the following:
- Draft financial statements being audited
- Schedules supporting the financial statements
- Extracts from relevant minutes
- Audit programme and time budget
- Internal control questionnaire and, where applicable, flow charts and notes on the system of internal control
- Confirmations obtained from banks and other relevant organisations regarding items in the financial statements
- Details of queries raised during the audit, and the answers obtained to them
- Copy of letter of representation
3.3.6 Audit Manual
Audit manual may be defined as a “written internal auditing document”. It provides different information regarding detailed auditing procedures, objects of auditing, standard of performance, time recording procedure, preparation of audit report etc. The audit manual is prepared for the general guidance of the auditors with the object of planning the procedure of audit.
- Different information regarding policies of the concern and procedure of audit is available in the manual.
- Information relating to required steps to be followed for conducting different auditing work can be collected from the manual.
- Audit manual provides answers to routine questions by the audit staff.
- Efficient distribution of work among the audit staff can be made possible.
- Audit manual provides useful information to the new entrants to the profession.
- Different audit procedures as contained in the manual become very mechanical.
- Creative thinking on the part of the audit staff is discouraged.
- If the manuals are not kept up to date, it may, instead of providing useful guidance, misguide the working staff.
- It discourages the individual initiative.
- The procedure of audit as given in the audit manual may sometime fail to co-ordinate the activities of the audit staff during the course of audit.
3.3.7 Audit Memorandum
An audit memorandum is a statement containing all useful information regarding the business of the client. It indicates the method of operation, policies of different aspects of the business as well as all the conditions in respect of audit.
Audit memorandum is very useful in case of first time audit by the concerned auditor in an organisation. While conducting his auditing work, the auditor requires certain information which may be directly related with the method of operation of the business. If the auditor is not informed about the method of operation as well as the operational activities of the organisation, he will not be in a position to conduct his audit effectively. Hence audit memorandum is useful to the auditor while the auditor wants to relate the financial transactions with the business activities, with the condition of the business in which the transactions are being activated.
Contents of audit memorandum
- About the business—its early history and growth
- Nature of ownership of the organisation
- Location of its principal offices and factories
- Sources of factors of production—materials, labour etc
- Details about its manufacturing operations
- Principal products produced by the concern
- Market condition and nature of competition in the market
- Organisational structure and heirarchy
- Method of accounting and nature of books of accounts
- List of persons involved in management
Principles of auditing refer to fundamental consideration that sustain the function of auditing and direct its activities. Auditing has evolved in the satisfaction of a social need to see that the accounting statements on which people rely are reliable. To achieve this broad functional objective, certain techniques and procedures have been developed over the years on the basis of certain concepts and principles that are considered to be the governing forces. AAS-1 on “Basic Principles Governing an Audit” describes the basic principles which govern the auditor’s professional responsibilities and which should be complied with whenever an audit is carried out. It also states that compliance with the basic principles requires the application of auditing procedures and reporting practices appropriate to the particular circumstances.
Auditing techniques refer to the methods and means adopted by an auditor for collection and evaluation of audit evidence in different auditing situations. When the audit objective is to see that debtors’ balances are correctly stated in the balance sheets, the auditor would introduce confirmation and scrutiny of subsequent years’ accounts as the appropriate audit technique. The method of collection of evidence to verify accounts maintained under manual system will be different from that, when accounts are computerised. In the former case, audit trial will be available and usual techniques like posting verification and casting verification would be appropriate. However, in the latter case, because of loss of audit trial and accuracy of the computer, these techniques are replaced by more intensive and extensive examination of the internal control. Also, the technique may vary according to the nature of proposition to be tested.
Thus auditing principles are fundamental in nature which underlie the conduct of the audit. These principles are not liable to change frequently while audit techniques may vary according to the nature of propositions to be tested. For instance, audit technique to test the existence of cash in hand will be different from the method to verify recoverability of sundry debtors. Further, audit techniques may vary from organisation to organisation depending upon the nature of the business but the principles of auditing will remain the same irrespective of the nature of the organisation.
3.4.1 Important Audit Techniques
The techniques or strategies, which are followed in order to collect proper evidence in support of the transactions recorded in the books of accounts, are termed as ‘Techniques of Auditing’.
Important techniques usually adopted by the auditors include the following.
- Vouching (of expenses)
- Physical verification (of fixed and current assets)
- Reconciliation (of stock statement)
- Confirmation (of customers or bank balance)
- Re-computation (of depreciation and other calculations)
- Scanning (of legal formalities)
- Scrutiny (of ledger balances)
- Inquiry (of propriety aspect)
There is no fixed rule regarding the procedures the auditor would follow in the course of audit. He would fix up the procedures after reviewing the situations on the basis of auditor’s own knowledge, intelligence, efficiency and experience. But the generally accepted procedures followed by an auditor include the following:
3.5.1 Audit Evidence
It is the auditor’s duty to express a professional opinion on financial statements and it must always be a matter of judgement whether the auditor has sufficient evidence on which to base such an opinion. The auditor can never be absolutely certain that the financial statements show a true and fair view; the question is, whether as an honest and careful auditor, he has adequate evidence on which to base a reasonable opinion?
The term evidence includes “all influences on the mind of an auditor which affect his judgement about the truthfulness of the propositions submitted to him for review.”
Types of audit evidence
Professor R. K. Mautz in his work Fundamentals of Auditing has rightly observed that ”the nature of financial statement assertions leads to the conclusion that the nature of the following kinds of evidences are indicative of the validity of financial statement assertions in varying degrees depending on the circumstances of the examination.”
Thus professor Mautz cited nine types of audit evidences, which are as follows.
- Physical examination by the auditor of the article represented in the accounts
- Statement by independent third parties:
- oral evidence
- written evidence
- Authoritative documents:
- prepared outside the enterprise under examination
- prepared inside the enterprise under examination
- Statements by officers and employees of the concern under examination:
- formal statement
- informal statement
- Calculations performed by the auditors
- Satisfactory internal control procedures
- Subsequent actions by the concern under examination and by others
- Subsidiary or detail records with no significant indications of irregularity
- Interrelationship within the data examined
Methods of obtaining audit evidence
AAS-5 on “audit evidence” describes the method of obtaining audit evidences. According to this statement, the auditor obtains evidence in performing compliance and substantive procedures by one or more of the following methods:
- Inspection Inspection consists of examining records, documents or tangible assets. Inspection of records and documents provides evidence of varying degree of reliability depending on their nature and source and the effectiveness of internal controls over their processing. Four major categories of documentary evidences, which provide different degrees of reliability to the auditor, are as follows:
- Documentary evidence originating from and held by third parties
- Documentary evidence originating from third parties and held by the entity
- Documentary evidence originating from the entity and held by third parties
- Documentary evidence originating from and held by the entity
Inspection of tangible assets is one of the methods to obtain reliable evidence with respect to their existence but not necessarily as to their ownership or value.
- Observation Observation consists of witnessing a process or procedure being performed by others. For example, the auditor may observe the counting of inventories by client personnel or the performance of internal control procedures that leave no audit trial.
- Inquiry and confirmation Inquiry consists of seeking appropriate information from knowledgeable persons inside and outside the entity. Inquiries may range from formal written inquiries addressed to third parties to informal oral inquiries addressed to persons inside the entity. Responses to inquiries may provide the auditor with information which he did not previously possess or may provide him with corroborative evidence.
Confirmation consists of the response to an inquiry to corroborate information contained in the accounting records. For example, the auditor requests confirmation of receivables by direct communication with the debtors.
- Re-computation Re-computation consists of checking the arithmetical accuracy of source documents and accounting records or performing independent calculations.
- Analytical review Analytical review consists of studying significant ratios and trends and investigating unusual fluctuations and items.
3.5.2 Routine Checking
Routine checking is a total process of accounting control, which includes the following:
- Examination of the totalling and balancing of the books of prime entry
- Examination of the posting from the primary books to the ledger accounts
- Examination of totalling and balancing of the ledger accounts and of the trial balance prepared with those balances
- Overall examination of writing up the transactions properly
In short, the routine checking is concerned with ascertaining the arithmetical accuracy of casting, posting and carry forwards. For the purpose of confirming the arithmetical accuracy and detecting frauds and errors of very simple nature, this method is adopted as basic to all types of audit work. The scope of application of routine checking depends upon the nature and size of the organisation as well as the effectiveness of the internal check and control system.
Objectives of routine checking can be described as follows:
- To ensure the arithmetical accuracy of the books of accounts
- To form the basis of vouching
- To prevent alteration of figures
- To increase reliability of financial statements
- To detect errors and frauds
- It is the simplest form of audit work.
- Errors and frauds of simple nature can be detected very easily.
- The books of accounts can be thoroughly checked.
- It is the basis of checking the final account as it helps in checking castings and postings.
- Arithmetical accuracy of all the transactions can be confirmed by this method.
- It offers an opportunity to train the new entrants to the profession.
- It is not generally considered as an important part of audit work where self-balancing system is maintained.
- As the audit staff are engaged in same type of work the possibility of becoming monotonous may grow in this system.
- Negligence of work, taking the advantage of internal check system, are frequent.
- It fails to detect errors and frauds arising from the fraudulent manipulation in accounting principles.
Auditor’s duty regarding routine checking
Although routine checking is a monotonous and time consuming process and is not very effective in detecting planned fraud, the auditor cannot skip it. It is an important part of audit. It should deserve equal emphasis from auditor as other techniques of audit. His duties in connection with routine checking are as follows:
- The auditor will first evaluate the internal control and internal check system existing in the organisation. Based upon his evaluation, he will determine the extent of routine checking to be adopted.
- In a small firm it is possible for the auditor to undertake thorough routine checking. So, it is advisable that he should undertake thorough routine checking in such cases.
- In case of audit of large organisations, it is not possible for him to undertake thorough routine checking. So, in such cases, he will apply his judgment, experience and knowledge in determining the extent of routine checking.
- The auditor should frequently supervise the work of routine checking being done by his subordinates and ensure the adherence to his instructions in this regard.
- Computerisation of accounting system obviates the necessity of casting carry forward, posting from journal to ledger etc. So, the auditor will determine his duty after examining the degree of computerisation.
3.5.3 Test Checking
The term ‘test checking’ stands for the method of auditing, where instead of a complete examination of all the transactions recorded in the books of accounts only some of the transactions are selected and verified. The underlying intention is to test some of the transactions to form an opinion for the whole. According to Prof. Meig “test checking means to select and examine a representative sample from a large number of similar items”.
The justification of test checking lies on the theory of probability which states in effect that a sample selected from a series of items will tend to show the same characteristics present in the full series of items, which is commonly referred to as “population” or “universe”.
Objectives of test checking
Accounts of large organisations usually include an enormous number of transactions. But the auditor is not in a position to check each and every transaction within the limited time and due to the constraint of resources available to him. So, he has to depend on selective verification of the transactions. The selection of transactions will be made in such a way that the auditor will verify a small but representative number of transactions and he can draw conclusions about the transactions as a whole. So, the basic objective of test checking is to draw a valid conclusion by undertaking examination of some transactions from the large number of transactions and thereby save time and cost.
Factors to be considered before resorting to test checking
The auditor should consider the following factors before starting test checking.
- Nature of transactions The nature of transactions should be carefully considered for determining the extent of test checking. If the transactions of a particular category are of repetitive nature, the size of sample may be small. However, if the transactions of a particular category are of divergent nature, sample size of test checking should be large.
- Effectiveness of internal control The internal control system existing in the organisation should be evaluated. If the internal control system is found to be sound, the auditor may adopt test checking determining the suitable sample size. But if the internal control system is found ineffective, the reliance on test checking should be minimum.
- Materiality of items An item becomes material when any mis-statement regarding it is likely to influence the decisions of the users of financial statements. The extent of checking to be adopted should depend upon the materiality of the items.
- Previous experience Previous experience should also be considered while determining the extent of test checking. For example, the auditor might have noticed in the last audit that the management had the tendency to inflate the value of work-in-progress, but the cashier had honestly and sincerely recorded all the cash transactions. Based on this experience, the auditor may undertake exhaustive checking of the details of valuation of work-in-progress while restricting his checking to few transactions in the cashbook.
- It is one of the best techniques of auditing through which cost of audit can be reduced.
- It can ensure the speed of audit work.
- It can easily locate the deficient areas and thus help to come to the conclusion as to the acceptability of financial records.
- It is a labour saving device.
- It acts as a guide to the auditor to arrive at a conclusion regarding the true and fair view of the state of affairs of the business.
- It will prove inefficient where internal check and control system are not operating or found ineffective.
- It is not suitable for small concerns.
- It will show incorrect results if the samples are not proper representatives of the population.
- It does not offer any consistency in selecting the percentage of check that will be adopted by all concerns.
- It is not applicable in case of diversified transactions.
Precautions to be taken before taking test-checking technique
In order to apply test checking technique effectively in the audit work of an organisation, an auditor has to take certain precautionary measures. These measures include the following:
- The auditor should review the existing internal control in order to ascertain its effectiveness.
- The transactions to be selected for test checking must be homogenous.
- The transactions to be test checked must form an adequate sample.
- As far as possible the transactions to be selected for test checking should be on the basis of random number tables.
- The results of the test checks themselves should be examined, particularly the nature of errors.
Transactions not suitable for the adoption of test checking
If the number of transactions in any area is sufficiently large, the auditors usually adopt test-check technique. However, as a practical measure, usually the following types of transactions and records are kept outside the purview of test checking :
- In those industries, where the activities are based on seasonal fluctuations, test checking cannot be adopted on an annual basis.
- Exceptional transactions or the transactions of a non-recurring nature are also not suitable for adoption of test checking.
- Some transactions have legal implication, i.e. they have to be recorded on the basis of legal provisions. Such transactions cannot be test checked.
- Areas involving computation and calculations should not be subjected to test checking.
- There should not be test checking for opening as well as closing entries.
- Bank reconciliation statement cannot be checked by adopting this technique.
- Presentation and disclosure of information in the balance sheet and the profit and loss account should not be subjected to test checking.
Auditor’s duty regarding test checking
Test checking is a short-cut method of audit. It curtails costs and time of audit. But it involves risk on the part of the auditor. If some errors or frauds which escaped the notice of the auditor because of sample checking are detected subsequently, the auditor may be held liable for negligence. So, enough care and caution should be taken by the auditor while resorting to test checking. He must evaluate the internal control system existing in the organisation beforehand. He must carefully consider the circumstances for determining the sample size. Materiality of item must not escape his notice while he selects the sample. The items selected should be verified in depth from its origin to the conclusion. Test checking will then be effective. There will be minimum possibility of errors and frauds remaining undetected if the auditor exercises reasonable care according to circumstances in conducting test checking.
He must bear in mind that test checking is just like a double-edged sword. If it is used properly and with reasonable care and caution, it will not hurt the auditor, i.e. the auditor will not be held responsible for any error or fraud left undetected. However, if the tool is applied indiscriminately and negligently, he will not be spared for errors and frauds detected subsequently.
3.5.4 Auditing in Depth
Auditing in depth is a technique, which assists the auditor in conducting test checking and adoption of such a system becomes essential in large organisations, where detailed examination of all the records is not possible. It is a method of auditing under which a few selective transactions are subjected to a thorough scrutiny for arriving at the accuracy of the data.
This technique involves the selection of a sample of transactions from one area of accounting and tracing them from the beginning to the conclusion. This method is undertaken to examine the effectiveness of the internal control and internal check system. In order to conduct the work of auditing in depth of a specific transaction, the auditor has to examine thoroughly the different stages of the transaction.
Practical application of the technique
In respect of goods purchased, the auditing in depth technique will be applied through the following stages.
- Examining the requisition note from the stores, ensuring that it has been signed by the appropriate official
- Examining the copy of the order placed by the purchasing department, ensuring that it was properly executed on the official form, complied with all the client’s regulations and was authorised by the appropriate official
- Examining the delivery note from the supplier and comparing it with the copy of the order
- Examining the goods inward note made out when the goods were received, noting if it has been properly signed, if it indicates that the correct goods have been received and if their quantity and condition have been checked
- Checking the entries in the store records
- Checking in the accounts department that the invoice received from the supplier has been matched with the copy of the order and the copy of the goods received note before being processed and that the calculations have been checked
- Checking the appropriate entries in the accounting records
- Comparing the cheque with the invoice and supplier’s statement, if any
From the above example, it can be seen that the auditor would trace the transaction right through the system. He would not merely satisfy himself that the entries in the records were correct, but would ensure that the appropriate internal controls relating to authorisation of transactions, the checking of one document against another and physical inspection of goods has been properly operated at the appropriate times. He would also ensure that a proper system was in force to claim credits in respect of short deliveries or deliveries of defective goods.
Where the examination of successive stages in the depth test produces satisfactory results, it is an accepted practice that the auditor may progressively reduce the number of items to be examined at subsequent stages. However, if the tests reveal an unacceptable number of errors, it will be necessary for the auditor to increase the number of items examined in order to discover whether the original sample was representative.
- Precision in course of audit work can be achieved.
- It guards against the fraudulent manipulation of accounts.
- It does not offer any monotony in work to the auditor. Because the auditor will have to deal all the time with new ideas and techniques.
- It saves the cost of audit.
- The experience in auditing in depth can be widely used in preparing audit plan.
- As the concept is linked with selective verification, its application may be fruitless if the selection of item is wrong.
- Instead of saving cost and time, this technique entails loss of time and extra cost because of unskilled handling of audit affairs.
- Proper selection of transactions for conducting auditing in depth is too much risky. If the items are not properly selected, it will not at all serve the purpose of auditing.
- This technique can not be applied to small concerns.
- It has been observed that the auditor relies too heavily upon intuition. Here, he uses no objective method of measuring the adequacy of samples.
3.5.5 Cut-off Examination
Cut-off examinations are the procedures designed to ensure that at the year end trading transactions are entered in the period to which they relate. In other words, the term “cutoff” refers to the procedure adopted to ensure the separation of transactions as at the end of one accounting year from those at the commencement of the next following year, specially for items which may overlap, e.g. sales, purchase, stock etc.
Significance of cut-off in auditing
The cut-off procedure is very significant in auditing to ensure that the revenue and expenditure of one year is not recorded in the following year, as that will distort the true and fair view of the accounts. The auditor must either establish that there are satisfactory internal controls in respect of cut-off and carry out compliance tests to ensure that these controls are functioning properly or carry out appropriate substantive tests. An obvious way in which accounts can be manipulated is for purchase invoices in respect of goods purchased shortly before the year end to be held over and entered in the following accounting period. The goods will be included in stock, but the purchases will not be included in the accounts as either a liability or a charge. Similarly, the profits and assets can be inflated by including goods that have been sold, but not yet despatched, in both stock and sales. Tests should be carried out between the purchase invoices, goods inward records and store records on the one hand, and the sales invoices, goods outward records and store records on the other, to ensure that there is consistency in treatment.
Cut-off manipulation was an important feature in which the auditors of Thomas Gerrard & Son Ltd. (1967) were held to have been negligent. The auditors’ negligence arose primarily from their failure to follow up the alterations of the purchase invoices.
3.5.6 Statistical Sampling
Auditors have long considered it sufficient in given circumstances not to check all the items within any section of the work, but to test them to satisfy themselves whether they may consider the whole group as being satisfactory for their purposes. This is based upon the assumption that, subject to special circumstances such as beginning or end of period test, the number of samples tested are sufficiently indicative of the accuracy or otherwise of the whole group.
The use of this method in practice does not require a detailed mathematical or statistical knowledge of the formulae on which the actual tests are based. Sets of tables are available which, on having decided the degree of confidence, the auditor wishes to place in the result and the accuracy he desires he can consult, and the amount of the tests to be carried out is specified.
Procedures for application of statistical sampling
When statistical sampling is to be applied to a certain section of the audit, the procedure to be undertaken is as follows:
- The nature of the unit and the field of population should be carefully defined, as any indefinite items wrongly included will vitiate the usefulness of the test.
- The precise nature of the attributes to be tested should be defined, such as errors or authentication signatures, or if the sample is in respect of variables the data must be examined to determine the basic figures to be applied.
- The population should be broadly examined to ascertain whether any stratification will be necessary.
- The level of confidence and precision limits should be fixed in accordance with the auditor’s judgement.
- In accordance with the auditor’s judgement as mentioned earlier, the sampling tables should be consulted giving the sample size in the case of attributes; where variables are concerned, a preliminary sample may be necessary.
- Random digit tables should be consulted showing the items to be selected for examination.
- The test should be evaluated comparing the result obtained with the predetermined acceptance or rejection levels.
- Where the sample is accepted, the auditor must ensure that the results are properly recorded so that if he is called upon to prove that he has applied due care, skill and diligence to the work, he may be able to show his confidence to have been rightly placed.
3.5.7 Surprise Checking
‘Surprise checking’ means audit verification on a non-routine and surprise basis. Usually the routine checking plan of the auditor as well as its timing is known to the client. As a result, the client’s staff try to cover up incompleteness in the books and records before the visit by the auditor. However, surprise check, as a part of normal audit procedure, significantly enhances the effectiveness of an audit. For carrying out surprise check, the auditor visits the client’s office without prior intimation and verifies certain specific matters, the regularity of which is vital for audit. For example, the correctness of cash balance in hand is immensely important because of the nature of this asset. It is the general experience that irregularities and fraud are facilitated when books and records are not maintained systematically and regularly. Many important frauds and errors that are not detected from continuous check may be detected through the process of surprise checking.
Purposes of surprise checking
In any area of audit verification, the process of surprise checking is applicable. However, following are the specific areas, where the process of surprise checking can be effectively applied :
- For the verification of books of accounts and records, which are maintained in the branch offices
- For the verification of cash, stock and similar type of assets, which are kept at other places
- For checking of cash balance on a non-routine basis
- For checking of investments on a non-routine basis
- For the verification of the regularity of the maintenance of books of accounts, statutory registers and other important documents
- For the physical verification of stock and stores on a non-routine basis
- For verification of the operation of any specific internal control procedures
3.5.8 Audit Flow Chart
A graphical presentation of different stages of a document, flow of goods or cash, with the aid of various symbolic marks, for the purpose of operation and control of audit organisation may be termed as ‘audit flow chart’. In other words, it can be described as a map of inter-related operations.
It is arranged specially for indicating the sequence and also the types of operation as a part of total unit. Narrative description is replaced by the use of different symbols. The symbols are standardised in a greater way and the different interconnecting lines indicate the flow direction which is either horizontal or vertical. The reason for the adoption of this chart is due to its advantages of making easy to visualise the relationship between different parts of the integrated system of the organisation. The need for proper study and evaluation of internal control system has long been felt. The efficient preparation and introduction of the flow chart on a wide basis may fulfil the necessity.
- It acts as an effective tool to study internal control system of the organisation. Thus the weaknesses in the internal controls may be revealed by the examination of the flow chart.
- Identification and location of various responsibility areas of the organisation can be made possible from this chart.
- It gives a bird’s eye view on the happenings of the business operations and areas where more control needs to be emphasised.
- It can depict a situation relating to accounting and auditing system in a concise and simple way.
- It is an important tool through which the training of audit staffs can be facilitated.
- This chart can be introduced by the audit managers as a control device for their audit operation.
- It consumes time in preparing this chart.
- It is not possible to have same pattern of flow chart that will be suitable to all types of organisations.
- It is not possible to accumulate in a flow chart all the activities or operations of an organisation in all cases.
- It is very difficult to form a judgement in selecting the level of sub-division that may give proper reflection of actual position.
3.5.9 Internal Control Questionnaires
Internal control questionnaires now form an important part of any efficiently conducted audit. By their use, any system of internal control may be investigated and its weaknesses revealed. It is usual to have sets of standardised questionnaires which may be applied, subject to modification on any type of audit.
The procedure employed is to use the standard questionnaire relevant to the various sections of a concern on the first occasion. These are completed by staff on the job and are thereafter examined by the manager in charge. Points of lesser importance may be dealt with and questions inapplicable to the job eliminated. In conjunction with the questionnaire an audit programme for the job may be prepared. This does not signify that the audit cannot be commenced until the questionnaire has been dealt with or a standard form of programme will have been already in use.
Such questionnaires have already been proved to save much time in audit planning and do much to ensure that no aspect of the work is overlooked from the point of view of the audit. On the first occasion a greater amount of work will be involved than on subsequent audits, as it is necessary to investigate the whole system of control; thereafter checks may be made to ensure that the system is being adhered to. Where changes in the system are deemed necessary, the auditor should request modification, but in any case he should be able to discover any such alterations, and no doubt the questionnaire should be updated from time to time.
Audit tests are of two types:
- Compliance test
- Substantive test
A compliance test is a test which seeks to provide audit evidence that internal control procedures are being applied as prescribed.
- Checking for authorisation on a credit note. This should confirm that all credit notes are suitably authorised before being issued.
- Checking for the casting stamp on a purchase invoice. This should confirm that all invoices are cast before being paid.
A substantive test is a test of a transaction or balance which seeks to provide audit evidence as to the completeness, accuracy and validity of the information contained in the accounting records or financial statements.
- Circularisation of letters to debtors to confirm the accuracy of the balance on the sales ledger.
- Matching a purchase invoice with the original order and goods received note to confirm that the purchase is bonafide.
POINTS TO PONDER
- The auditor should follow the appropriate audit procedure and adopt different techniques of auditing. On the basis of his assessment of the accounting system and evaluation of the internal controls, the auditor will draw up an audit programme specially designed for that particular audit.
- For effective audit planning and for designing appropriate audit programme, the auditor should prepare himself before the commencement of his audit work. For this purpose, he should take a number of preparatory steps.
- Audit planning is the process of deciding in advance what is to be done, who should do it, how it should be done and when it should be done by the auditor in order to have effective and efficient completion of audit.
- Audit programme is a detailed plan of work, prepared by the auditor for carrying out an audit. It comprises a set of techniques and procedures, which the auditor plans to apply to the given audit for forming an opinion about the statement of accounts of an organisation. Audit programme can be of two types: predetermined audit programmne and progressive audit programme.
- Audit note book is a bound book in which a large variety of matters observed during the course of audit are recorded. It is of great value to the auditor at the time of preparing the audit report. In case a charge of negligence is filed against the auditor, a note book may prove to be good evidence.
- Audit working papers kept by the auditor are the written records of the evidence accumulated during the course of audit. As the working papers are prepared in respect of the client’s business, they should be treated as top secret and should be preserved carefully.
- Audit file maintains different audit documents. Audit file is generally of two types: permanent audit file and temporary audit file.
- Audit manual is a written internal document, which provides different information regarding detailed auditing procedure. It is prepared for the general guidance of the auditors with the object of planning the procedure of audit.
- An audit memorandum is a statement containing all useful information regarding the business of the client. It indicates the method of operation, policies of different aspects of the business as well as the conditions in respect of audit.
- Principles of auditing refer to fundamental consideration that sustain the function of auditing and direct its activities. On the other hand, auditing techniques refer to the methods and means adopted by an auditor for collection and evaluation of audit evidence in different auditing situations. Audit techniques may vary from organisation to organisation depending upon the nature of the business, but the principles of auditing will remain the same irrespective of the nature of the organisation.
- The techniques, which are followed in order to collect proper evidence in support of the transactions recorded in the books of accounts, are termed as the techniques of auditing.
- Important techniques usually adopted by the auditors include vouching, physical verification, reconciliation, confirmation, re-computation, scanning, scrutiny and inquiry.
- The term ‘evidence’ includes all influences on the mind of an auditor, which affect his judgement about the truthfulness of the propositions submitted to him for review. Methods of obtaining audit evidence include inspection, observation, inquiry and confirmation, re-computation and analytical review.
- Routine checking is concerned with ascertaining the arithmetical accuracy of casting, posting and carry forwards. It is an important part of audit and deserves equal emphasis from the auditor as do other techniques of audit.
- Test checking is a method of auditing, where instead of examination of all the transactions recorded in the books only some of the transactions are selected and verified. Its basic objective is to draw a valid conclusion by undertaking examination of some transactions from the large number of transactions and thereby save both time and cost.
- Auditing in depth is a technique, which assists the auditor in conducting test checking. In this technique, a few selective transactions are subjected to a thorough scrutiny for arriving at the accuracy of the data.
- Cut-off examination refers to the procedure adopted to ensure the separation of transactions as at the end of one accounting year from those at the commencement of the following year, especially for those items which may overlap.
- Surprise checking means audit verification on a non-routine and surprise basis. Many important frauds and errors that are not detected from continuous check may be detected through the process of surprise checking.
- Audit flow chart can be described as a map of inter-related operations. It makes easier to visualise the relationship between different parts of the integrated system of an organisation.
- Internal control questionnaires form an important part of an efficiently conducted audit. Such questionnaires save much time in audit planning and do much to ensure that no aspect of the work is overlooked from the viewpoint of audit.
- Audit tests are of two types: compliance test and substantive test. A compliance test is a test which seeks to provide audit evidence that internal control procedures are being applied as prescribed. On the other hand, a substantive test is a test of a transaction or balance which seeks to provide audit evidence as to the completeness, accuracy and validity of the information contained in the accounting records or financial statements.
- Test checking is based on presumption. What is that presumption?
- What is audit memorandum?
- What is audit manual?
- Discuss the importance of surprise check.
- Distinguish between principles of auditing and techniques of auditing.
- What are the considerations to be kept in mind by an auditor before commencement of an audit?
- What is audit programme? Discuss the advantages and disadvantages of conducting an audit according to a predetermined audit programme. How can these disadvantages be overcome?
- How is an audit programme prepared? State the objectives of audit programme. What are the steps to be followed in drawing an audit programme?
- What are audit files? What are the contents of audit files? What are the advantages of audit files?
- What is an audit note book? What purpose does it serve ? What are the contents of an audit note book?
- What are audit working papers? What are its objectives? Discuss the essential characteristics of a good working paper. Who can claim the ownership of those papers?
- What is routine checking? What types of work are included in routine checking? What are the objectives of routine checking? Describe the advantages and disadvantages of routine checking. Discuss the duties of an auditor in this regard.
- What is test checking? In what circumstances test checking factors are to be considered before resorting to test checking? What are the advantages and disadvantages of test checking? Discuss the duty of an auditor in this regard.
- What is auditing in depth? Discuss the advantages and disadvantages of this audit technique.
- Discuss briefly the methods of obtaining audit evidence. In this context, state what do you mean by ‘compliance test’ and ‘substantive test’.
- What do you mean by techniques of auditing? Discuss the various techniques adopted by an auditor in the course of his audit work.