Chapter 6. Verification and Valuation of Assets and Liabilities – Auditing: Principles and Techniques

Chapter 6

Verification and Valuation of Assets and Liabilities

CHAPTER OUTLINE
6.1 INTRODUCTION

One of the most important duties of an auditor in connection with the audit of the accounts of a concern is to verify the assets and liabilities appearing in the balance sheet. He has not only to examine the arithmetical accuracy of the transactions in the books of accounts by vouching, but also to see that the assets as recorded in the balance sheet actually exist.

If the auditor fails to verify the assets, he will be held liable as was decided in the case of “London Oil Storage Co. Ltd. vs Seear Hasluck & Co. (1904)”. It was held in that case that “the auditor should verify the existence of the assets stated in the balance sheet, otherwise he will be liable for any damage suffered by the client”.

6.2 MEANING OF VERIFICATION OF ASSETS

Verification means the proof of existence or confirmation of assets and liabilities on the date of balance sheet.

Verification usually indicates verification of assets of any concern, which can be done by the examination of value, ownership, existence and possession of any asset. According to Spicer and Pegler, “verification of assets implies an enquiry into the value, ownership and title, existence and possession and the presence of any charge on the assets”.

So, verification is a process, which includes

  • valuation of assets at its proper value
  • ownership and title of the assets
  • confirmation about the existence of the assets
  • satisfaction about the condition that they are free from any charge or mortgage.
6.3 MEANING OF VALUATION OF ASSETS

Valuation of assets means examination of the accuracy and propriety of the valuation of those assets, which are shown in the balance sheet of any concern at the end of the financial year.

So, valuation is an operation, which includes

  • obtaining all the necessary information regarding valuation
  • analysing all the figures available
  • confirming the fact that the valuation is being determined on the basis of generally accepted conventions and accounting principles
  • ensuring that consistency of methods are followed for the valuation from year to year
  • obtaining an opinion regarding the accuracy of valuation.
6.4 DIFFERENCE BETWEEN VERIFICATION AND VALUATION

Valuation of assets is a part and parcel of verification. Without proper valuation of assets, verification is not possible.

Verification includes, apart from valuation, the examination of ownership right, the existence of the asset in the business and its freeness from any sort of charge or mortgage.

6.5 IMPORTANCE OF VERIFICATION OF ASSETS

The auditor’s duty is not complete only when he has vouched the entries appearing in the books. The substantiation of an entry under the date on which it is made does not prove the existence of the related asset at the date of the balance sheet, nor is the value of such asset necessary to be the same as on the date of the original entry. The auditor has the further duty of substantiating the existence and value of such items as on the date of the balance sheet. This work can be performed through proper verification of assets.

If the balance sheet contains an asset, which, in fact, does not exist or which is stated at a value different from what is considered reasonable, both the balance sheet and the profit and loss account would be incorrect. For instance, when the balance of sundry debtors include debts amounting to Rs. 5,000, that are irrecoverable and no provision has been created against such bad debts, then the amount of profit, the value of assets and the value of proprietor’s fund would be shown in excess by that amount.

Auditors’ duty under the Companies Act has been extended by the promulgation of the Other Companies (Auditors Report) Order ‘2003, issued under Section 227(4A) of the Companies Act. This order requires the auditor to state in his report some additional matters, which include matters like verification of fixed assets and stock. On these accounts, it is essential that assets should be verified with utmost care.

6.6 IMPORTANCE OF VALUATION OF ASSETS

Principally, the auditor is required to verify the original cost of asset and confirm, as far as practicable, that such a valuation is fair and reasonable. As regards the manner in which the original cost should be ascertained, there are well-defined modes of valuation, which are expected to follow.

Assets are valued either on a ‘going concern’ or a ‘break-up value’ basis. Under ‘going concern’ method, it is necessary to find out and calculate the cost of acquisition of the concerned assets and the rate of depreciation required to be provided. ‘Break-up value’ basis is considered when the company is being wound up. In this method, assets are valued at their realisable value. So, value of an asset is being determined differently in different ways.

It is thus evident that the auditor is expected to apply his knowledge and skill assessing the value of each asset with a view to confirm that it is true and fair, having regard to the principles on which assets are generally valued. In the words of Lancaster, ‘’ an auditor is not a valuer and cannot be expected to act as such. All that he can do is to verify the original cost and to ascertain as far as possible that the current values are fair and reasonable and are in accordance with the accepted commercial principles”.

So, valuation forms an important part of every audit. This is because the fairness of the balance sheet depends much upon how correctly the valuation of various assets and liabilities has been made. The auditor has to see that the assets and liabilities appearing in the balance sheet have been exhibiting their proper value.

6.7 GENERAL PRINCIPLES FOR VERIFICATION AND VALUATION OF ASSETS

The following are the general principles which are required to be considered by the auditor in conducting verification and valuation of assets in an organisation:

  1. Acquisition of individual asset   The cost of asset acquired should be verified with their purchase agreements or ownership rights and the receipts of the seller in respect of the price paid. It should be verified that expenditure on assets newly acquired and the renewal and replacement of old assets have been correctly recorded in consistent with the method that has been generally followed in the past.

     

  2. Acquisition of group of assets   Where a concern has taken over the assets of a going concern, the agreement of purchase should be inspected and that the amount paid for them should also be ascertained.

     

  3. Sale of assets   When an asset is sold, its sale proceeds should be vouched for reference to the agreement, containing the terms and conditions of sale, counterfoil of the receipt issued to the purchaser or any other evidence which may be available.

    If the sale of a fixed asset has resulted in capital profit, it should be transferred to capital reserve. However, the profit limited to the original cost or a loss should be transferred to the profit and loss account.

     

  4. Depreciation   It is now obligatory for a company to provide for depreciation out of profits in accordance with the provisions under Sub-section (1) of Section 205, before any profit can be distributed as dividend.

    The law requires that depreciation should be provided in any one of the ways specified in Section 205(2) of the Companies Act.

    The value of certain assets (viz. plant and machinery) is also affected by an accident or by obsolescence. Any asset which has been discarded after such a happening should be shown in the balance sheet only at realisable value.

     

  5. Physical verification of fixed assets   The existence of fixed assets, where practicable, should be verified by physical inspection or by comparing the particulars of assets as entered in the schedule attached to the balance sheet, with the asset register and also reconciling their total value with the general ledger balances.

     

  6. Inspection of current assets and investments   Wherever possible, all the securities and documents of title, cash, negotiable instruments etc. representing the assets should be inspected at the close of the last day of the accounting period. If this is not practicable and the examination is undertaken at a latter date, a careful scrutiny of transactions subsequent to the date of the balance sheet must be made to ensure that the changes in their balances that have subsequently taken place are bonafide and are supported by adequate evidence.

     

  7. Charges on assets   It should be ascertained that no unauthorised charge has been created against an asset and all the charges are duly registered and disclosed.

    Where shares or securities are lodged with a bank to secure a loan or an overdraft, a certificate should be obtained from the bank showing the nature of the charges, if any.

     

  8. Assets with third parties   Where assets, e.g. government securities, shares and debentures, stock sent on consignment, goods sent on sale or approval basis etc. are in the custody of a third party other than a bank, these must be inspected.
6.8 PROBLEMS IN VERIFICATION

Without proper verification of assets and liabilities, it is not possible for the auditor to certify the balance sheet as it exhibits a true and fair view of the state of affairs of the business. It will never be possible on the part of the auditor to perform the function in his own responsibility and in accordance with his own knowledge and expertise.

 

Example

If the auditor is required to verify the stock-in-trade at the end of the accounting period, it will take weeks and months to complete this work. Not only that, the auditor will have to take help of experts in this line. In addition to that, there are certain assets, which have no physical existence in appearance, namely goodwill, patent, copyright, trademarks etc. In these cases, the auditor has to conduct verification on the basis of available documents.

In Kingston Cotton Mills Ltd. Case (1896), it was held that “it is no part of an auditor’s duty to take stock. No one contends that it is. He must rely on others for the details of stock-in-trade”. So there was no breach of duty on the part of the auditor. An auditor is not supposed to take stock himself and in the absence of suspicious circumstances he can accept a stock certificate by a trusted official of the company.

6.9 PROBLEMS IN VALUATION

The various problems which an auditor faces while conducting valuation of assets and liabilities are stated below:

  1. Character of the assets   In some cases, it is not possible to identify the character of the asset for the purpose of valuation as whether it is fixed asset or current asset. The mode of valuation process of fixed asset is different from the mode of valuation process of current assets, e.g. investments.

     

  2. Use ofassets   In some situations, the same asset is available for sale and is again used in the organisation. The valuation process also depends on the nature of use of the concerned assets, e.g. stock of furniture.

     

  3. Estimated life   The life of the fixed assets are not certain. The valuation of these assets is made on the basis of estimated life of the assets. However, the determination of estimated life is not an easy task.

     

  4. Eventual problems   It is not possible for the auditor to take into consideration the events that have occurred after balance sheet date, which have the effect on valuation of assets.

     

  5. Lack of information   The auditor may not be in possession of all the relevant information, which are required to be considered by the auditor in the determination of the value of assets.

     

6.10 WINDOW DRESSING—A CHALLENGE TO VERIFICATION

Window dressing may be defined as an artificial practice to show the current ratio position favourable. When window dressing technique is adopted in accounting statement presentations, the financial position is shown in such a way that it seems to be better than what it is. It is more of a misrepresentation than fraud.

Window dressing may be practiced in any one of the following ways:

  1. Deferring purchases, i.e. purchase of a year may be shown as of next year
  2. Making extensive drive for the collection of book debts to show the book balance favourable
  3. Recording incomes for the next year in advance in the accounts of the current year
  4. Showing borrowed capital as long-term debt capital
  5. Making provision for inadequate amount of depreciation and bad debts
  6. Charging revenue expenditure as capital expenditure
  7. Making over-and/or under-valuation of assets and liabilities
  8. Inflating the profits by entering non-existent items of purchase returns and sales return
  9. Utilising secret reserves during the depression period without making the fact known to the shareholders

The auditor should carefully verify the existence of the assets and liabilities. He should see that no attempts have been made by the client to adopt window dressing. It may sometimes happen that the client may show a particular asset in paper only, which, in fact, does not exist physically. Window dressing is a challenge to the work of verification, which should be faced by the auditor through conducting of effective verification work.

6.11 VERIFICATION AND VALUATION OF ASSETS

Verification of asset is an important audit technique. Conventionally, the scope of this technique is limited to inspection of assets and collection of information about the assets.

Through verification, the auditor should confirm the following:

  • The assets are in existence on the date of the balance sheet.
  • The concerned assets have been acquired for use in the business.
  • The assets have been purchased under a proper authority.
  • The concern has the right of ownership of the assets.
  • The assets are free from any charge not disclosed in the balance sheet.
  • The assets are correctly valued.
  • The assets are correctly presented in the balance sheet.

Verification of assets is primarily the responsibility of the management. They are expected to have a much greater knowledge of the assets of the business as regards their condition, location etc. than that which an outsider might be able to acquire on their inspection. They are competent to determine the values of the assets at which they should be included in the balance sheet. The auditor is only expected to apply his skill and expertise estimating the value of each asset with a view to confirm that they are truly and fairly disclosed in the balance sheet.

For the purpose of applying verification techniques, we may divide the assets into the following four categories:

  1. Intangible assets, viz. goodwill, patent, trademark, copyright, etc.
  2. Fixed assets, viz. land and building, plant & machinery, furniture and fixtures, motor vehicles etc.
  3. Current assets viz. stock-in-trade, sundry debtors, prepaid expenses and accrued incomes, cash and bank balances etc.
  4. Fictitious assets viz. preliminary expenses, discount on issue of shares or debentures etc.
6.12 VERIFICATION AND VALUATION OF INTANGIBLE ASSETS

6.12.1 Goodwill

Goodwill is considered as an intangible fixed asset. The value, which is shown in the balance sheet, does not appear to be its present value, because the present value of goodwill depends upon a number of factors like financial position of the business, earning capacity at present and its future trend etc. But in actual practice, it is not valued at cost.

Valuation of goodwill

There are several methods of valuation of goodwill. However, goodwill should not be recognised in the accounts unless it is purchased. Regarding valuation of goodwill, an appropriate method is to be adopted to write the cost down out of the available profits and in this way, it should be ensured that the capital of the business is represented by tangible assets only.

Auditor’s duty regarding valuation

  1. The auditor should confirm that goodwill appearing in the balance sheet has not been shown in excess of its cost price.
  2. The auditor should see that the goodwill is never appreciated in the books of a company.

Verification of goodwill

Goodwill is the excess price paid for a business as a whole over the book value or the computed value or the agreed value of all tangible assets purchased. It is not possible to be verified physically; hence verification of goodwill means proper checking of accounting entries passed for goodwill.

Auditor’s duty regarding verification

  1. The goodwill as recorded in the books of accounts should be properly examined and the same is to be verified with the balance sheet.
  2. If goodwill is created on account of purchasing a running business, the auditor should verify it with the contract made between the client and the vendor.
  3. Sometimes, management intends to capitalise the current expenditure by raising goodwill, which is usually high. The auditor should raise objection to this practice.
  4. In case of goodwill once written off, but later on brought back in order to write off the debit balance of profit and loss account or any capital loss, the auditor should investigate the reasons for this and may refer to the resolutions adopted at the directors meeting and the approval of the shareholders.
  5. The auditor should ensure that as required by Accounting Standard-10 for fixed assets, goodwill has been recorded in the books only when some consideration in money or moneys has been paid for.

6.12.2 Patent

A patent is an official document which secures to an investor the exclusive right to make, use and sell his invention.

Valuation of patent

The patent is valued at cost less depreciation. Cost is the acquisition cost, which may be purchase cost or invention cost. Also the cost of registration of patent should be included in the valuation, while the renewal fees should be charged off to revenue. Since patent suffers depreciation through effluxion of time, it is preferable to adopt fixed instalment method of charging depreciation based on its legal life.

Auditor’s duty regarding valuation

  1. The patent should be examined to see that the company concerned is registered as the owner of the patent.
  2. It should be seen that the patent is valued at cost less depreciation. If it is found that the commercial life of the patent is shorter than its legal life, the depreciation should be spread over its commercial life only.

Verification of patent

Actual patent should be physically verified by the auditor and it should be seen that it has been duly registered. In case of joint registration of the patent with an individual, who might have developed the patented article, it should be seen that a registered assignment by the individual in favour of the company has been made.

Auditor’s duty regarding verification

  1. The auditor should check the patent register in order to verify that it has been properly included therein.
  2. The auditor should also ensure that the legal life of the patent has not yet been expired.
  3. The latest renewal certificate of the patent should also be verified by the auditor.
  4. The patent may also be subject to litigation about its title. A certificate from the solicitors of the company should be obtained to ensure that it is free from encumbrances.

6.12.3 Copyright

A copyright is the exclusive legal right to produce or reproduce some kind of literary work. It is the legal protection provided to an author by which the publication of his work by others is restricted.

Valuation of copyright

Generally the value of the copyright is not fixed, as a copyright loses its value with the passage of time. In the balance sheet, it is shown at cost less amounts written off from time to time.

Auditor’s duty regarding valuation

  1. The auditor should see that the value of copyright is determined on proper basis including the period of copyrights.
  2. It should be ensured that if any copyright does not command sale of any books, the same should be written off in that year.
  3. It should be confirmed that the legal life of the copyright has not been expired.
  4. The auditor should see that the copyright having no commercial value has been completely written off.

Verification of copyright

In verifying copyright, the auditor should inspect the agreement between the author and the publisher. If there are many copyrights with the business of the client, the auditor should ask for a schedule thereof from the client and verify them from the schedules.

6.12.4 Trademarks

A trademark is a distinctive mark attached to the goods offered for sale in the market so as to distinguish the same from similar goods available in the market and also to identify them with a particular trader.

Valuation of trademarks

The trademark is a symbol of the organisation’s prestige. The value of trademark may be justified by reference to its renewal fees. If the trademark is purchased, the price paid for it is to be considered as the value of the trademark.

Auditor’s duty regarding valuation

  1. The auditor should see that trade marks are properly valued and shown in the balance sheet.
  2. If the trademark has been purchased, the auditor should verify the payment made to the seller against the acquisition of trademark.
  3. The auditor should ensure that all expenses incurred in the acquisition of the trade mark have been treated as capital expenditure, any renewal fees paid has been treated as revenue expenditure.

Verification of trademarks

Trademarks can be verified by examining the assignment deed duly endorsed by the office of the register of trademark. If trademarks are purchased, the assignment of interest or the assignment deed should be inspected.

Auditor’s duty regarding verification

  1. The auditor should see that they are registered in the name of the client and are the property of the client.
  2. He should also see that proper distinction between capital and revenue expenditure is maintained. All research expense in this connection should also be capitalised.
  3. In case the trademarks have been purchased from others, the auditor should check the expenditure incurred in connection with their acquisition, e.g. registration fees, payments made to vendor etc.
6.13 VERIFICATION AND VALUATION OF FIXED ASSETS

6.13.1 Land and Buildings

Almost all the business or commercial undertakings have land and buildings of their own. For the purposes of verification and valuation of land and buildings, they can be classified into two types, which are freehold and lease hold property.

1. Freehold property

Verification

  1. The auditor should inspect the title deed and see that they appear to be in order. He should obtain a certificate from the legal advisor of the client confirming the validity of the title to the property.
  2. He should also verify that the conveyance deed has been duly registered as required by the Indian Registration Act and the particulars to be endorsed thereon have been duly endorsed.
  3. If the property is mortgaged, the title deed would be in the possession of the mortgage. A certificate to this effect should be obtained.
  4. In the case of property built or created by the client himself, the auditor should ensure that proper capitalisation of materials, labour and overhead is done.

Valuation

  1. The original cost and any improvement thereon should be checked with original deed and receipt. It is also seen that all expenses incurred on registration, brokerage or other legal fees have been duly capitalised.
  2. The cost of buildings should be depreciated at appropriate value, depending upon the quality of their structure and the use, which is being made of them.
  3. The auditor should check the expenditure on repairs so as to exclude such expenditure from capital cost.
  4. In respect of property built by the client, contractors bill and other relevant accounts should be referred.

2. Leasehold property

Verification

  1. The auditor should inspect the lease or assignment thereof to ascertain the amount of premium, if any, paid for securing the lease and its terms and conditions.
  2. The auditor should also see whether the lease has been duly registered.
  3. He should also verify that all conditions prescribed by the lease are being duly complied with.
  4. He should confirm the writing off of any legal expenses incurred to acquire the lease.

Valuation

  1. The value of the leasehold property should be checked from the lease deed. Any addition or expansion thereon should be examined by reference to the contractor’s bills and other supporting papers.
  2. The auditor should ensure that the provision for any claim that may arise under the dilapidation clause on the expiry of the lease has been made.
  3. He should see that the cost as well as legal expenses incurred to acquire the lease is being written off at an appropriate rate over the unexpected term of the lease.
  4. He should also check the accounting of leasehold property to ensure that it is maintained separately.

6.13.2 Building

Verification

  1. The auditor should examine the title deed of buildings to see whether the client holds the title on the balance sheet date. If the building has been mortgaged, the title deed will be in the possession of the mortgagee from whom a certificate should be obtained.
  2. He should see the appropriate lease deed, if the building is leasehold, to ascertain the cost, amortisation etc.
  3. He should also ensure that all conditions in the lease deed have been fulfilled by the client.
  4. The auditor should ensure that the relevant particulars of buildings have been entered in the fixed assets register maintained by the client.

Valuation

  1. The auditor should verify the original cost of the building by reference to the deed of conveyance. If the building is constructed by the client, he should verify the original cost by reference to the contractor’s bill.
  2. He should also verify that appropriate depreciation has been provided against the building. In case no depreciation is provided on the building, a note to this effect should be given in the profit and loss account.
  3. He should see that the buildings have been valued at cost less depreciation. In case of a company, the requirements of Schedule VI have to be complied with.
  4. If any revaluation has taken place, the auditor should look into the basis of revaluation and ensure that the disclosure of the same has been made.

6.13.3 Plant and Machinery

Verification

  1. The auditor should call for the plant register or detailed break up schedule of plant and machinery. For the balance appearing in the balance sheet, he should identify the specific items and check the details thereof.
  2. In the case of a company, the management is duly bound to physically verify the plant and machinery and the auditor should ask for the related working papers for his examination.
  3. The additions and disposals during the year should be verified with reference to the purchase invoices and other appropriate documents.
  4. The auditor should verify some of the important items of plant and machinery on test check basis.

Valuation

  1. The cost price of any plant or machinery plus any cost of installation will be vouched with supplier’s invoices and other supporting documents.
  2. The auditor should see that proper depreciation has been provided during the year.
  3. He should check as to whether any of the items has been disposed off or sold during the year. If so, he should satisfy that it was properly authorised and the sale proceeds credited to plant and machinery account. Any capital profit made should be transferred to capital reserve.
  4. The auditor should also verify that the plant and machinery have been properly shown under fixed assets in the balance sheet.

6.13.4 Furnitures and Fixtures

Verification

  1. The auditor should ascertain whether a register is maintained for furniture and fixtures detailing the nature of the item, its acquisition cost, location, code number etc.
  2. He should also verify whether the furniture and fixtures bear on them the code numbers allotted.
  3. He should inquire whether physical verification of the furniture and fixtures has been carried out by the management and if so, he should examine the working papers.
  4. The auditor should verify physically some of the important items of furniture and fixtures on test check basis.

Valuation

  1. The auditor should satisfy that the furniture and fixtures have been properly depreciated and value written off for damaged or unserviceable items,
  2. He should see that the cost of furniture and fixture has been properly ascertained and recorded in the books of accounts.
  3. He should enquire whether any of the items have been disposed off or sold during the year. If so, he should check that it was properly authorised and the sale proceeds credited to furniture and fixture account. Any capital profit made therein should be transferred to capital reserve.
  4. The auditor should also verify that furniture and fixtures have been properly shown under fixed assets in the balance sheet.

6.13.5 Motor Vehicles

Verification

  1. The auditor may call for a schedule of motor vehicles and compare it with the motor vehicles register maintained.
  2. He should also examine the registration document for each vehicle. He should compare the registration number and description given in the registration document with the particulars shown in the ledger account or motor vehicle register.
  3. If the vehicle is registered in the name of a person other than the client, the auditor should inspect the letter confirming the arrangement and ascertain that there is no charge on the vehicle in favour of such person.
  4. The auditor should also check the insurance premium receipts to ensure that the vehicles are fully insured against accidents, theft etc.

Valuation

  1. The motor vehicles are to be valued at cost less depreciation.
  2. The cost price of any motor vehicle will be vouched with supplier’s invoices and other supporting documents. However, he should see that expenditures on repair have been charged to profit and loss account and not added to its cost.
  3. The auditor should verify the adequacy of the depreciation. It is a common practice for the motor vehicles to be written off over the mileage they are expected to run.
  4. He should also verify that the motor vehicles have been properly shown under fixed assets in the balance sheet.

6.13.6 Assets Acquired Under Hire Purchase System

Verification

  1. The existence of the assets acquired can be confirmed by physical verification of the assets by the auditor or by reviewing the working papers of physical verification of fixed assets done by the management.
  2. The company is not the owner of the asset till the last instalment under hire purchase agreement has been paid. However, the possession right of the asset can be verified by reference to the hire purchase agreement.
  3. A default in payment of the hire purchase instalment entitles the hire vendor to take back the possession of the asset. So, the hire purchase agreement has to be examined to ascertain the nature of encumbrances.
  4. The auditor should also see that the asset purchased is included in the fixed asset register.

Valuation

  1. Fixed assets are generally valued at cost less depreciation. So, the auditor will have to examine the hire purchase agreement and the price list to ascertain the cash cost of the asset.
  2. Depreciation should be deducted and the auditor should ensure that the rate normally charged by the company on same or similar assets has been applied on a consistent basis.
  3. The auditor should confirm the proper recording of assets acquired under hire purchase agreement. The interest element in the instalments should be charged off to revenue.
  4. The assets purchased on hire purchase agreement may also be shown at the capital value of instalments paid to date. In that case also, the depreciation at the normal rate for the full period on the cash value will have to be charged.
6.14 VERIFICATION AND VALUATION OF INVESTMENTS

In carrying out an audit of investments, the auditor should aim at collecting sufficient audit evidence in order to assure himself about the existence, ownership, valuation and possession of investment in favour of the client.

The following aspects are important in this respect:

  1. Existence: The auditor should verify that investments shown in the balance sheet really exist on the date of the balance sheet.
  2. Ownership: The auditor should assure himself that investments shown in the balance sheet are owned by the enterprise.
  3. Accounting records: He should check the transactions of acquisitions, disposal etc. of the investments during the accounting period in order to verify as to whether they are properly recorded in the books of accounts.
  4. Valuation: He should confirm that investments are stated in the balance sheet at appropriate amount in accordance with the recognised accounting principles.
  5. Disclosure: He should also confirm that investments are properly classified and disclosed in the financial statements in accordance with the recognised accounting principles and relevant statutory requirements.
  6. Internal control: The auditor should evaluate the internal control procedures relating to investments in order to determine the nature, timing and extent of the procedural aspects.

Almost all the business and commercial undertakings have investments of different types. In case of finance and investment companies, the amount of investment constitutes a major part of the total assets of the concern. For the purpose of verification and valuation of investments, it can be broadly classified into quoted and unquoted investments.

6.14.1 Quoted Investments

Verification

  1. The auditor should physically inspect the investments. It should be physically verified on the last date of the accounting year. If the investments are not in the possession of the entity, a certificate should be obtained from the party concerned.
  2. The auditor should assure himself that the title of the investments are in the name of the client itself.
  3. The purchase and sale of investments should be verified with reference to the broker’s contract note, bills of cost etc.
  4. If the amount of purchase or sale of investments are substantial, the auditor should check the price with reference to stock exchange quotations.
  5. The auditor should also examine the relevant provisions of Section 227(1 A) and see that a company not being an investment or banking company, whether so much of the assets of the company as represented by shares and debentures have been sold at a price less than that at which they were purchased by the company.
  6. He should also confirm that the relevant provisions of the CARO, 2003 have been duly complied with in this regard.

Valuation

  1. The auditor should satisfy himself that the investments have been valued and disclosed in the financial statements in accordance with the recognised accounting policies and practices and relevant statutory requirements.
  2. He should examine whether in computing the cost of investments, expenditure incurred on account of transfer fees, stamp duty etc. is included in the cost of investment.

The auditor may ascertain that the market value of investments are in accordance with the authentic market reports or stock exchange quotations. To judge the overall reasonableness of the amount invested, the auditor may relate the amount with the preceeding year’s figure and calculate relevant ratios.

6.14.2 Unquoted Investments

Verification

  1. The auditor should ascertain the power of the enterprise to make investments by examining the memorandum of association in case of investment by a company, to ensure that the investments are not ultra-vires the company.
  2. He should also ascertain that all the legal formalities relating to purchase of investments have been duly complied with.
  3. Where investments are in large numbers, the auditor should obtain the schedule of securities certified by a senior officer of the company. The statement must include the name of the investment, the book value, the market price, date of purchase etc.
  4. The auditor must verify the whole of the investment at one time. Investments are of a negotiable character and their verification at the same time removes the danger of their substitution for others.

Valuation

  1. The unquoted shares held as investments should ordinarily be valued at cost. However, if on study of the latest annual accounts of the companies, the shares of which are held as investment and the dividend records of such companies, it appears that there has occurred a permanent and material fall in the value of investments, a proper provision against such fall in values should be made. The auditor should confirm this compliance.
  2. Unquoted shares and debentures should be shown in the balance sheet under the main head “Investments” on the asset side, indicating the mode of valuation and the aggregate amount of the unquoted shares and debentures should also be stated.
  3. The auditor should confirm that equity and preference shares are shown separately as also fully paid up and partly paid shares being distinguished.
  4. If the shares or debentures are held in the subsidiary of the company, the auditor should assure that the above should be shown under the sub-heading “Investment in subsidiaries”.
6.15 VERIFICATION AND VALUATION OF CURRENT ASSETS

6.15.1 Stock-in-trade

Introduction

The valuation of stock is frequently the main factor in determining the results shown by the accounts. Apart from the effect on the balance sheet, incorrect stock would affect the profit of the year that has closed as well as that of next year.

Auditor’s duty

The valuation of the closing stock, therefore, is an important step essential for the determination of the profits of the year, also for truly disclosing the financial position of the entity at the end of the year. An auditor being intimately connected with these aspects of financial statements, it is his duty to verify the existence of the stock-in-trade possessed by the concern at the end of the year and to ascertain that the same has been valued correctly on a consistent basis.

The precise duties in regard to verification of stock-in-trade are nowhere defined. Under the circumstances, these have to be deduced from an interpretation of the general responsibilities of auditors in regard to the statements of accounts verified by them, especially in regard to stock-in-trade.

Case Decisions

Justice Lindley, while delivering his famous judgment in the case of Kingston Cotton Mills Ltd. (1896) observed: “It is no part of the auditor’s duty to take stock. No one contends that it is so. He must rely on other people for details of the stock-in-trade in hand.” In the case of a cotton mill, he must rely on some skilled person for the material necessary to enable him to enter the stock-in-trade at its proper value in the balance sheet.

In the same case, Justice Lopes observed: “An auditor is not bound to be a detective or as was said to approach his work with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest to rely upon their representations, provided he takes reasonable care”.

In a more recent judgment in the case of Westminster Road Construction & Engineering Co. Ltd. (1932), it was held that “an auditor must make the fullest use of all materials available to him and although he is not a stock-taker and not a valuer of work-in-progress, he will be guilty of negligence, if he fails to take notice of all available evidence from which it could be reasonably deduced that the work-in-progress was over-valued”.

The decisions thus appear to have settled the following three principles for the general guidance of the auditor:

  1. That it is no part of the auditor’s duty to take stock.
  2. That for the purpose he can rely upon statements and reports made available to him in regard to the valuation of stock so long as there is no circumstance, which may arouse his suspicion, and he is satisfied.
  3. That an auditor would be failing in his duty if he does not take reasonable care in verifying the statement of stock according to the information in his possession and the expert knowledge is expected of him in regard to methods of verification and stock control.

Provisions of the Companies Act

The recent changes in the Companies Act have also considerably advanced the responsibilities of auditors in this regard. Section 209 of the Act requires a company to maintain proper books of accounts. Such books of accounts must include books kept to record transactions in stock-in-trade.

The Companies (Amendment) Act of 1956 empowers the central government under Section 227 (4A) to require companies engaged in production, processing, manufacturing or mining activities to maintain books as would furnish particulars in relation to utilisation of material or labour or other items of cost as may be prescribed.

Furthermore, by Section 541 (2), proper books of accounts have been defined to include statement of annual stock-taking and of all the goods purchased and sold.

Accounting presentation

Part II of Schedule VI to the Companies Act prescribes that the figures of opening and closing balances of stock and work in progress be disclosed in the profit and loss account. Part I of the same schedule requires that the mode of valuation of stock be shown in the balance sheet. The recent amendment to Schedule VI requiring particulars of materials purchased, opening and closing stock-in-trade and also of turnover made during a particular accounting period.

Steps for verification

Verification of year end stock includes the following steps:

  1. Review the procedure and arrangements for the maintenance of stock records.
  2. Secure the original rough stock sheet, if available.
  3. Check all additions and test fair proportions of extensions.
  4. Ascertain the basis and method of valuation adopted and confirm that the same has been followed consistently.
  5. Verify the cost of raw materials and stores by reference to purchase invoices.
  6. Confirm that stock has been valued at ‘lower of cost or market price’ principle.
  7. Ascertain that the goods not belonging to the client have not been included in stock-in-trade.
  8. Examine the stock sheets to ascertain that they only contain goods normally dealt in by the business.
  9. Find out whether there has been a complete physical stock-taking.
  10. See that the stock sheets have been signed by the responsible person.

6.15.2 Work-in-Progress

As per the “Guidance Note on Audit of Inventories” (Guidance Note-2) issued by the Institute of Chartered Accountants of India in general, the audit procedures regarding verification of work-in-progress are similar to those used for stock-in-trade, i.e. stock of raw-materials as well as of finished goods. However, the auditor should pay attention to the following matters due to the difference in nature of work-in-progress as compared to the stock of finished goods and stock of raw materials:

  1. The auditor has to carefully assess the degree of completion of the work-in-progress for assessing the appropriateness of its valuation.
  2. He should examine the cost records and obtain expert opinion where necessary.
  3. He should also obtain a certificate from the production engineer to confirm the accuracy of the cost records.
  4. The elements of cost and the method of pricing of the various elements may be compared with that of the previous year and if there is a material deviation, the reasons for the same may be investigated.
  5. In certain cases, physical verification of work-in-progress may not be possible due to the nature of the product and the manufacturing process involved. In such cases, the auditor should give greater emphasis on ascertaining the reliability of the system of control of work-in-progress.
  6. It may also be useful for the auditor to examine the subsequent records of production.

6.15.3 Sundry Debtors

Verification

  1. Existence of book debts can be verified by examining the books of account and satisfying that the entries therein are supported by proper sales documents.
  2. Balance of book debts should be sent to the debtors for their confirmation, which will also establish the existence of the book debts.
  3. The examination of debtor’s ledgers with related sales documents and correspondence with debtors will confirm the ownership of book debts.
  4. The auditor should also enquire whether there is any dispute on any of the balances included in sundry debtors. In this case, the documents regarding dispute should be examined.

Valuation

  1. Usually the balances shown in the debtor’s ledger supported by sales documents represent the value of book debts.
  2. The auditor should call for the lists of book debts and debts written off and arrive at the conclusion about adequacy of write off and provision for doubtful debts.
  3. The confirmation of balances by debtors will help establish the valuation of book debts.
  4. It should be ensured by the auditor that sundry debtors are valued only at realisable value.

6.15.4 Bills Receivables

Verification

  1. The auditor should examine the bills receivable book and prepare a schedule of all those bills receivable, which have not yet matured before the date of the preparation of the balance sheet.
  2. Where the number of bills is large and are kept with the bankers for collection, the auditor should obtain a detailed certificate from the bank to ascertain the clear position about the bills.
  3. Any contingent liability in respect of the bills that are discounted or endorsed but remain outstanding at the time of audit should be maintained as a footnote of the balance sheet.
  4. The bills which have been dishonoured before the due date of the balance sheet should not be included in the balance sheet as “bills receivable in hand” as they are no longer assets.

Valuation

  1. The auditor should see that the bills are properly drawn, stamped and duly accepted and are not overdue. In case of renewal of any bills, the auditor should compare the new bill with the old bill.
  2. Sometimes, the bills might have matured and honoured subsequent to the date of the balance sheet, but prior to the date of the audit. The auditor should check the cash received as shown in the cash book of the next year.
  3. If the bills have been retired before the date of the balance sheet, the proceeds thereof should be checked by reference to the cash book.
  4. For the bills discounted prior to the date of maturity when the date of maturity is to fall after the date of balance sheet, the discount on such bills must be properly apportioned between periods covered by two separate financial years.

6.15.5 Cash at Bank

Verification

  1. The auditor should compare the balances as shown in the passbook with the balances as shown in the cash book.
  2. The auditor should prepare a bank reconciliation statement or should check the statement prepared by the client in order to ascertain the correct bank balance.
  3. He should obtain a balance confirmation certificate from the bank at the close of the year.
  4. He should also obtain separate certificate for fixed deposit account, current account and savings bank account from different banks to confirm total deposits in different banks.

Valuation

  1. In order to ascertain the current position with regard to cheques issued but not yet presented or cheques deposited but not collected, the auditor should confirm through cash book and passbook figures.
  2. Where amounts are deposited in foreign banks under exchange control regulations, the fact is to be disclosed.
  3. Where amounts are kept in different reserve accounts in the banks in order to avail deductions under Indian Income Tax Act, the fact should also be disclosed.
  4. The auditor should also ensure that the bank balances are properly disclosed in the balance sheet according to Schedule VI of the Companies Act.

6.15.6 Cash-in-hand

Verification

  1. The most common practice in verifying cash balance is to obtain a certificate from the accountant about the actual cash balance in hand at the date of the balance sheet.
  2. The auditor should verify the cash in hand by actually counting it on the close of the business on the date of the balance sheet.
  3. In certain cases, if the client is maintaining an unduly large balance of cash in hand consistently, the auditor should make a surprise check to ascertain whether the actual cash in hand agrees with the balances as shown by the books.
  4. As far as cash in transit is concerned, the auditor should verify this balance with the help of proper documentary evidences and correspondence.

Valuation

  1. If the cash-in-hand is not in agreement with the balance as shown in the books, it should be the duty of the auditor to call for an explanation.
  2. Often postage and other stamps are taken with the cash in the balance sheet. The auditor should confirm the balance of postage and stamps by physical counting only.
  3. He should also check the system of making payments and safety arrangements provided for the protection of cash balance.
  4. In case cash is maintained at the local branches and the auditor is unable to pay visit to the branch, he may ask the branch manager to deposit the balance of cash in the bank on the balance sheet date.

6.15.7 Prepaid Expenses

Verification

  1. The auditor should verify the receipts for pre-payments, i.e. expenses paid during the period for future financial periods.
  2. The amount of prepaid expenses should be shown in the asset side of the balance sheet under current assets. The auditor should assure that it has been shown properly in the balance sheet.
  3. Prepaid expenses for the last accounting period should be properly adjusted. The auditor should see the expenses paid in the last year pertaining to the current accounting year have been properly adjusted.
  4. The auditor should also check the adjustments made in the next year, if possible, against the prepaid expenses made during the year.

Valuation

  1. The auditor should check the calculations for ascertaining the portion of expenses belonging to the next period by reference to the contract or other documents.
  2. In respect of rent, rates and taxes, the auditor should check the payment vouchers and satisfy that allocation to carry forward has been made on time basis.
  3. In respect of insurance premium, the auditor should also confirm that the carry forward allocation has been made on the basis of the terms of policy and the premium paid.
  4. In case of prepaid sales commission, where salesmen are allowed to take payments out of future earnings, the auditor should examine the statement of sales to determine the commission earned.
6.16 VERIFICATION AND VALUATION OF FICTITIOUS ASSETS

6.16.1 Preliminary Expenses

The expenses incurred for the formation and commencement of a company is usually grouped under the heading “preliminary expenses”. These include stamp duties, registration fees, legal costs, cost of printing etc.

In order to verify preliminary expenses, the auditor should take into consideration the following matters:

  1. It should be seen by the auditor that no expenses other than those related to the formation of a company are included under this head.
  2. The auditor should examine the contracts relating to preliminary expenses. If preliminary expenses that were incurred by the promoters have been reimbursed to them by the company, the resolution of the board and the power in the articles to make such payment should be considered.
  3. The auditor can cross check the amount of preliminary expenses with that disclosed in the prospectus, statutory report and the balance sheet.
  4. Being a fictitious asset, it should be written off as early as possible and the auditor should verify that the balance of preliminary expenses which has not been written off is shown in the balance sheet under the heading “miscellaneous expenditure”.
  5. Underwriting commission and brokerage in shares and debentures should not be included under the head “preliminary expenses”. The auditor should also confirm this aspect.
  6. The bills and statements supporting each item of preliminary expenses should be checked.
  7. The auditor should also ensure that proper deduction has been availed against taxable income under the Income Tax Act, 1961.

6.16.2 Discount on Issue of Shares or Debentures

This refers to the expenditure or losses essentially of a revenue nature, which instead of being charged off as and when incurred, is accumulated in an account and the balance in the account is written off over a period of years during which its benefit is expected to accrue to the business.

In order to verify the discount on issue of shares or debentures, the auditor should pay attention to the following matters:

  1. The auditor should confirm that it continues to appear as an asset on the right side of the balance sheet as long as the discount is not written off.
  2. If during the year, any amount has been added thereto, the auditor should ask for the justification of the same.
  3. Being a fictitious asset, it should be written off as early as possible. The auditor should also confirm this aspect.
  4. The auditor should see that the discount on issue of shares or debentures has been shown separately under the heading ‘Discount on Issue of Shares or Debentures’.
  5. In issuing shares or debentures at a discount, whether the governing provisions relating to issue of shares and debentures have been duly complied with or not, should also be checked by the auditor.
6.17 VERIFICATION AND VALUATION OF CONTINGENT ASSETS

The contingent assets are those which may arise on the happening of an uncertain event. As a general practice, contingent assets are not recorded in the balance sheet because that would imply taking credit for revenue which has not accrued. But it is logical as the contingent liabilities are shown in the balance sheet the contingent assets should also be shown. The Companies Act does not require disclosure of contingent asset in the balance sheet. However, if contingent assets have a significant value, it may be advisable to disclose such assets in a note to the balance sheet.

As regards valuation of contingent assets, it may be noted that ordinarily no valuation would be required. However, if such assets were disclosed by way of a note, a proper valuation based on the related contract would be made. Where full realisation of such assets is doubtful even on the face of contingency occurring, it would be safer to value the assets on a realisable basis.

6.18 VERIFICATION AND VALUATION OF LIABILITIES

The verification of liabilities is of equal importance as that of an asset. The auditor has to satisfy himself that all liabilities whether existing or contingent have been properly determined and disclosed in the balance sheet. In case liabilities are overstated or understated, the balance sheet will not represent a fair view of the state of affairs of the company. Therefore, the auditor should ensure the following:

  • That liabilities shown in the balance sheet are actually payable
  • That all liabilities are properly recorded in the books
  • That the recorded liabilities are payable for the legitimate operations of the business, and
  • That the nature and extent of contingent liabilities has been disclosed in the balance sheet by way of a footnote.

For the purpose of applying verification technique, we may divide the liabilities into the following three categories:

  • Fixed or long term liabilities, viz. share capital, debentures, long term loan from bank and other financial institutions etc.
  • Current liabilities, viz. sundry creditors, bills payable, bank overdraft etc.
  • Contingent liabilities viz. disputed liability of income tax suits pending for damages etc.
6.19 VERIFICATION AND VALUATION OF FIXED OR LONG TERM LIABILITIES

6.19.1 Debentures

Verification

  1. The auditor should go through the memorandum and articles of the company in order to determine the extent of borrowing power of the company and also to ascertain the limitation upon the borrowing power, if any.
  2. A prospectus must have been issued and filed with the registrar of companies. The auditor should verify the prospectus to ensure that the terms of the prospectus have been complied with.
  3. Balances from the register of debenture holders will have to be extracted and the total amount received from debenture holders be tallied with the total of debenture account in the general ledger.
  4. The auditor should also examine a copy of the debenture bond to ascertain the terms and conditions on which the debentures have been issued, the particulars of assets charged as security and the method of redemption.
  5. If the debentures are mortgaged the debentures trust deed should be studied by the auditor and it should be seen that the terms and conditions of the trust deed have been fully observed by the company.

Presentation

  1. Debentures have to be shown under the head ‘secured loans’.
  2. The debentures subscribed by the directors and managers should be shown separately.
  3. Interest accrued and due on debentures but not paid should be included along with debentures, but interest accrued but not due has to be shown under ‘current liabilities’.
  4. The nature of security provided should also be disclosed.
  5. The terms and conditions of the redemption or conversion of the debentures should be stated with the earliest date of redemption or conversion.

6.19.2 Secured Long Term Loans

A company can obtain loans from banks and other financial institutions on the basis of security provided. For the purpose of verification of long-term loans, they can be classified under two broad categories:

  1. Loans against security of fixed assets
  2. Loans against security of stock

1. Loans against security of fixed assets

  1. The auditor should examine the memorandum and the Articles of Association to see whether the company is empowered to borrow money against fixed assets.
  2. He should scrutinise the loan account in the ledger and the documents relating to the fixed assets.
  3. He should also examine the mortgage deed and find out whether the mortgage is properly executed.
  4. He should enquire whether the lender has a right to lend money against such security.
  5. The auditor should also obtain confirmation from the lender for the amount of loan.
  6. He should see whether principal is being repaid as stipulated and whether interest on loan is paid regularly as per the terms of loans as prescribed in CARO.

2. Loans against security of stock

  1. The auditor should inspect the receipts of the godown keeper if the loan has been taken against the godown keeper’s receipts.
  2. If the stocks are at dock or in bonded warehouse, the dock warrant or the warehouse certificate duly endorsed in favour of the lender should also be examined.
  3. The auditor should see that the rent for the warehouse has been paid by the client regularly. If it has not been paid, adequate provision should have to be made for the purpose.
  4. He should also obtain a certificate from the lender showing particulars of securities deposited and confirm that the same has been correctly disclosed and duly registered with registrar of companies and recorded in the register of charges.
  5. The auditor should verify the authority under which the loan has been raised. In the case of a company, only the Board of Directors is empowered to raise a loan or borrow from a bank.
  6. He should also confirm that the restraint as contained in Section 293 of the Companies Act as regards the maximum amount of loan that a company can raise has not been contravened.
6.20 VERIFICATION AND VALUATION OF CURRENT LIABILITIES

6.20.1 Sundry Creditors

  1. The auditor will verify creditors more or less on similar lines as in the case of sundry debtors. He should take a statement of balance of the trade creditors duly signed by the authorised official and these balances should be verified with the purchase ledger balances.
  2. He may also obtain confirmatory statements from the creditors.
  3. He should also examine the invoices as sent by the suppliers. He should carry out test checking of purchases made during the year, particularly those made at the close of the year.
  4. If debts have not been paid for a long time, he should enquire into the situation in detail. Sometimes it is noticed that instead of paying the creditors, the amount might have been misappropriated by the officials.
  5. If the client maintains provision in respect of discount on creditors, he should check the same with reference to the creditors account.
  6. The purchase ledger should also be checked by the auditor with the books of original entry, invoices, credit notes etc.
  7. For any purchase returns, he should examine the ‘return outward book’ and verify them with the help of credit notes as sent by the suppliers.
  8. The auditor should pay special attention to the entries made either in the beginning or at the end of the year to check the fictitious entries in this respect.

6.20.2 Bills Payable

  1. The auditor should get a statement of bills payable and compare it with the bills payable book and bills payable account.
  2. For the bills which have been met after the date of the balance sheet but before the date of audit, he should examine the cash book and bank passbook.
  3. The bills payable already paid should be checked from the cash book and the auditor should examine the returned bills payable.
  4. He should also ensure that the bills which have been paid are not recorded as outstanding.
  5. He should get confirmation in respect of amounts due on the bills accepted by the client that are held by them.
  6. He should reconcile the total of the bills payable outstanding at the end of the year with the balance in the bills payable account.

6.20.3 Bank Overdraft

  1. The auditor should examine the overdraft agreement with the bank in order to ascertain the terms and conditions of overdraft and the maximum limit thereon.
  2. The Memorandum of Association in case of a company should be examined to ascertain the borrowing powers of the company and any limitations thereon.
  3. The auditor should verify the minutes of the Board meeting to assure that the bank overdraft borrowing is being authorised by the Board.
  4. If the client is a company and if the overdraft is against any security, the auditor should see whether the charge created was registered with the registrar of companies, if required.
  5. The auditor should also obtain the confirmation certificate from the bank in respect of amount of overdraft at the close of the year.
  6. The auditor should also check whether interest on overdraft has been duly accounted for.
  7. The auditor should also confirm that the amount overdrawn is within the maximum limit sanctioned by the bank.
  8. It is to be seen whether any security was offered for the overdraft in terms of agreement, depending on which the overdraft is to be classified as secured or unsecured.

6.20.4 Provision for Taxation

  1. The auditor should ascertain the tax liability and check the computation of the assessable profit and loss account. Thus, adjustments affecting taxable profit must be carefully scrutinised.
  2. He should also go through earlier completed assessment in order to know what sort of adjustments were actually made in the past.
  3. He should also check the amount of advance tax paid and the calculations thereof. Advance tax is required to be verified in order to provide the liability of future taxation.
  4. If income tax return has already been filed before the date of audit, the auditor should also check the copy of the income tax return.
  5. The auditor should ensure the amount of overall provision on the date of the balance sheet having adequate regard to the figure of provision of the year, the advance tax paid, past provision made and assessment orders in respect thereof received up to the date of audit, pending appeals and refunds, if any.
  6. He should also obtain a certificate from the tax practitioner regarding the amount of tax payable.

6.20.5 Outstanding Liabilities for Expenses

  1. The auditor should ask for the list of outstanding expenses from the client classified on the basis of nature of expenses.
  2. He should verify the supporting documents evidencing the outstanding expenses.
  3. He should also verify the basis of estimation of outstanding expenses, if they are provided on an estimated basis.
  4. He should check the cash book of the previous year in order to see that the usual outstanding expenses have been paid off by the time of audit.
  5. He should also ensure that no outstanding expenses have been paid which have not been provided in the account. If paid, he should check the adjustment entries passed for this purpose.
  6. He should compare the list of outstanding expenses of the current year with that of the previous year to identify any major deviations.
  7. The auditor should also ensure that no usual outstanding expenses have been left out to be provided.
  8. He should also confirm that outstanding expenses have been shown under current liabilities in the balance sheet.
6.21 VERIFICATION AND VALUATION OF CONTINGENT LIABILITIES

A contingent liability is not an actual liability but which will become a liability on the happening of an event in future. It may be converted into actual liability on an uncertain event in the future.

W. B. Meigs defines contingent liability as “the potential obligations, which may in future develop into actual liability or may dissolve without necessitating any outlay”.

Accounting Standard 29 issued by the ICAI deals with the ‘provisions, contingent liabilities and contingent assets’. According to it a contingent liability is

  1. a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or
  2. a present obligation that arises from past events but is not recognised because
    1. it is not probable that an outflow of resource embodying economic benefits will be required to settle the obligation; or
    2. a reliable estimate of the amount of the obligation cannot be made.

Simply stated, contingent liability is not an actual liability but will become a liability on the happening of an event in the future. The examples of contingent liabilities are as follows:

  • Discounting of bills receivables
  • Pending suits for damages or compensation
  • Disputed liability on account of income tax
  • Guarantee given by the bank on behalf of the company.

As per Part I of Schedule VI of the Companies Act, 1956, a footnote may be added to the balance sheet to indicate the amount of contingent liability.

While going through the books of accounts, correspondence, minute books, bank statements and other relevant documents, the auditor may identify the existence of contingent liabilities of the concern.

From the auditing point of view, the auditor should verify that a proper disclosure about contingent liabilities is made in financial statement as required by AS-29. As per para 68 of AS-29 an enterprise should disclose for each class of contingent liability at the balance sheet date. The auditor’s duty in this respect would be as follows

  1. Inspect the minute book of the company to identify all contingent liabilities existing at the end of the year.
  2. Scrutinise the lawyer’s bill to ascertain unreported contingent liabilities.
  3. Examine correspondence with the bank in respect of bill discounted but not yet matured.
  4. Examine bank letters to ascertain guarantees given on behalf of other companies or individuals.
  5. Scrutinise correspondence with suppliers, customers, and lawyers etc. to ascertain the existence of contingent liabilities.
  6. Check the investments in the shares made by the client to identify the liabilities on partly paid up shares.
  7. Find out the arrears of preference dividend on cumulative preference shares.
  8. Obtain a certificate from the management that known contingent liabilities have been included in the accounts and that they have been properly disclosed.
6.22 EVENTS OCCURRING AFTER THE BALANCE SHEET DATE

Accounting Standard-4 on ‘contingencies and events occurring after the balance sheet date’ deals with the treatment of contingencies and events occurring after the balance sheet date in financial statements. According to this statement, events occurring after the balance sheet date are those significant events, both favourable and unfavourable, that occur between the balance sheet date and the date on which the financial statements are approved by the Board of Directors in the case of a company and in the case of any other entity by the corresponding approving authority.

Some of such events may require adjustments to assets and liabilities as at the balance sheet date or may require disclosure. These include the following:

6.22.1 Adjusting Events

Adjusting events are those significant events occurring after the balance sheet date that provide additional information materially affecting the determination of the amounts relating to conditions existing at the balance sheet date.

 

Example

An adjustment may be made for bad debt, which is confirmed by the insolvency of the customer, which occurs after the balance sheet date.

6.22.2 Non-adjusting Events

Non-adjusting events are those events which do not relate to conditions existing at the balance sheet date. However, disclosure of such events is generally made in case these represent unusual changes affecting the existence of the enterprise at the balance sheet date.

 

Example

The destruction of a major part of the factory building by a fire after the balance sheet date will not require any adjustment in the balance sheet as no conditions existed on the date of the balance sheet.

6.22.3 Other Events

There is another category which although takes place after the balance sheet date is required to be reflected in the financial statements because of statutory requirements or because of their special nature.

 

Example

Dividend proposed or declared after the balance sheet date in respect of the period covered by the financial statements.

6.23 PRIOR PERIOD AND EXTRAORDINARY ITEMS AND CHANGES IN ACCOUNTING POLICIES

Accounting Standard-5 on ‘prior period and extraordinary items and changes in accounting policies’ deals with the treatment of prior period and extraordinary items. The objective of this statement is to prescribe the classification and disclosure of certain items in the statement of profit and loss so that all enterprises prepare and present such a statement on a uniform basis. It also specifies the accounting treatment for changes in accounting estimates and the disclosure to be made in the financial statements regarding changes in accounting policies.

The net profit or loss for the period comprises the following components, each of which should be disclosed on the face of the statement of profit or loss:

  1. Profit or loss from ordinary activities
  2. Extraordinary items

Prior period items

Prior period items are income or expenses which arise in the current period as a result of errors or commissions in the preparation of the financial statements of one or more prior periods.

Extraordinary items

Extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore are not expected to recur frequently or regularly.

Any change in an accounting policy which has a material effect should be disclosed. The impact of and adjustments resulting from such change, if material, should be shown in the financial statements of the period in which such change is made, to reflect the effect of such change.

 

POINTS TO PONDER
  • Verification means the proof of existence or confirmation of assets and liabilities on the date of balance sheet. It is a process which includes valuation of asset and liabilities, checking of ownership and title of the asset, confirmation about their existence and satisfaction about the condition that they are free from any charge.
  • Valuation of assets means examination of the accuracy and propriety of the valuation of those assets, which are shown in the balance sheet of any concern at the end of the financial year.
  • Valuation of assets is a part and parcel of verification. Without proper valuation of assets, verification is not possible. Verification includes, apart from valuation, the examination of ownership right, the existence of the asset in the business and its freeness from any sort of charge or mortgage.
  • The auditor has the duty of substantiating the existence and value of the assets and liabilities as on the date of the balance sheet. If the balance sheet contains as asset, which, in fact, does not exist or which is stated at a value different from what is considered reasonable, both the balance sheet and the profit and loss account would be incorrect.
  • Valuation forms an important part of every audit. The fairness of the balance sheet depends much upon how correctly the valuation of various assets and liabilities has been made. The auditor has to see that the assets and liabilities appearing in the balance sheet have been exhibiting their proper value.
  • Basic principles to be followed for verification and valuation of assets include acquisition of assets, sale of assets, depreciation, physical verification and charges on assets.
  • Without proper verification of assets and liabilities, it is not possible for the auditor to certify the balance sheet as it exhibits a true and fair view of the state of affairs of the business. But it will never be possible on the part of the auditor to perform the function in his own responsibility and in accordance with his own knowledge and expertise.
  • Problems of valuation include the nature of the assets, use of the assets, estimated life of the assets, eventual problems and lack of information.
  • Window dressing is an artificial practice to show the current ratio position favourable. Through window dressing the financial position is shown in such a way that it seems to be better than what it is.
  • Events occurring after the balance sheet date are those significant events, both favourable and unfavourable, which that occur between the balance sheet date and the date on which the financial statements are approved by the authority.
  • Prior period items are income or expenses, which arise in the current as a result of errors or commissions in the preparation of financial statements of one or more prior periods.
  • Extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and therefore are not expected to recur frequently or regularly.
REVIEW QUESTIONS

Short-answer Questions

  1. What is verification of assets and liabilities?
  2. Distinguish between verification and valuation.
  3. Discuss the importance of verification and valuation of assets.
  4. What is intangible asset? Give five examples of intangible assets.
  5. What do you mean by fictitious assets? Give example.
  6. What is meant by contingent liability? Discuss the auditor’s duty in this regard.
  7. What is goodwill? As an auditor, how would you ascertain that an amount paid for goodwill is justified?
  8. Do you think that verification of assets and liabilities is necessary when vouching has been done properly?
  9. “Verification forms an important part of the whole system of audit.” Explain.
  10. “Intangible assets are not always fictitious assets.” Illustrate.
  11. Discuss the problems in the valuation and verification of assets.
  12. “Verification includes valuation.” Comment.
  13. How and in what way does verification of assets and liabilities differ from vouching?
  14. What do you mean by “window-dressing of balance sheet”? State the duties of an auditor in this respect.
  15. “Information and means of information are by no means equivalent terms.” Comment.
  16. State which of the following statements are true:
    1. If capital expenditure is treated as revenue expenditure the profit for the year is understated, but in the long run, because of depreciation, there is no effect on profit.
    2. Revenue expenditure includes loss arising from an event beyond one’s control.
    3. An expenditure which is not capital is revenue.
    4. The rate of depreciation is not important since sooner or later the full cost of the asset is bound to be written off.
    5. Under the two different methods of depreciation, the straight line method and the diminishing balance method, the life assumed is different.
    6. Distinction between capital and revenue expenditure is relevant for short duration business.
    7. Expenditure resulting from the acquisition of tangible asset is capital even if there is no income from that asset.
    8. Interest included in hire-purchase price is also capital expenditure.
    9. Verification of assets means establishing their physical existence and ownership, but not their valuation.
    10. Trade investments are fixed assets.
    11. It is necessary to indicate the fact if an asset is acquired on hire purchase basis.
    12. Property let out on rent need not be depreciated.

Essay-type Questions

  1. “An auditor is not a valuer though he is intimately connected with values.” Discuss referring to the relevant case decisions.
  2. “It has been stated that the valuation of investment for the balance sheet purpose depends largely upon the object for which investments are held.” Discuss the statement.
  3. How do you verify the following items?
    1. Raw material stock
    2. Land
    3. Preliminary expenses
    4. Investment
    5. Work-in-progress
    6. Copyright
    7. Machine purchased on H. P. system
    8. Patterns and designs
    9. Freehold properties
    10. Loans and advances
    11. Debtors
    12. Secured loan
  4. How will you as an auditor deal with the following?
    1. Cash
    2. Provision for taxation
    3. Leasehold properties
    4. Unpaid dividends
    5. Goods in transit
    6. Disposal of plant
  5. What are the special points to which an auditor should direct his attention for ascertaining the adequacy of provision for bad and doubtful debts in the context of proper valuation of sundry debtors?
  6. “Physical presence of the auditor at the time of year end verification of stock is though not always possible, it is recommended that he should at least be present as an observer.” Signify the importance of this statement and list out the important aspects which the auditor should look into to ensure an effective physical verification programme.
  7. (a) What are the general considerations for valuation and verification of assets? (b) State your views on the following:
    1. Events occurring after the balance sheet date
    2. Prior period and extra ordinary items