Introduction to Auditing

DEFINITIONS:

The term auditing has been defined by different authorities.

Spicer and Pegler: “Auditing is such an examination of books of accounts and vouchers of business, as will enable the auditors to satisfy himself that the balance sheet is properly drawn up, so as to give a true and fair view of the state of affairs of the business and that the profit and loss account gives true and fair view of the profit/loss for the financial period, according to the best of information and explanation given to him and as shown by the books; and if not, in what respect he is not satisfied.”

Prof. L.R.Dicksee. “auditing is an examination of accounting records undertaken with a view to establish whether they correctly and completely reflect the transactions to which they relate”.

FEATURES OF AUDITING
a. Audit is a systematic and scientific examination of the books of accounts of a business;
b. Audit is undertaken by an independent person or body of persons who are duly qualified for the job.
c Audit is a verification of the results shown by the profit and loss account and the state of affairs as shown by the balance sheet.
d. Audit is a critical review of the system of accounting and internal control.
e. Audit is done with the help of vouchers, documents, information and explanations received from the authorities.
f. The auditor has to satisfy himself with the authenticity of the financial statements and report that they exhibit a true and fair view of the state of affairs of the concern.
g. The auditor has to inspect, compare, check, review, scrutinize the vouchers supporting the transactions and examine correspondence, minute books of share holders, directors, Memorandum of
Association and Articles of association etc., in order to establish correctness of the books of accounts.

OBJECTIVES OF AUDITING
There are two main objectives of auditing. The primary objective and the secondary or incidental objective.
a. Primary objective – as per Section 227 of the Companies Act 1956, the primary duty (objective) of the auditor is to report to the owners whether the balance sheet gives a true and fair view of the Company’s state of affairs and the profit and loss A/c gives a correct figure of profit of loss for the financial year.

b. Secondary objective – it is also called the incidental objective as it is incidental to the satisfaction of the main objective. The incidental objective of auditing are:
 i. Detection and prevention of Frauds, and
                                   ii. Detection and prevention of Errors.
Detection of material frauds and errors as an incidental objective of independent financial auditing flows from the main objective of determining whether or not the financial statements give a true and fair view. As the Statement on auditing Practices issued by the Institute of Chartered Accountants of India states, an auditor should bear in mind the possibility of the existence of frauds or errors in the accounts under audit since they may cause the financial position to be mis-stated.

Fraud refers to intentional misrepresentation of financial information with the intention to deceive. Frauds can take place in the form of manipulation of accounts, misappropriation of cash and misappropriation of goods. It is of great importance for the auditor to detect any frauds, and prevent their recurrence. Errors refer to unintentional mistake in the financial information arising on account
of ignorance of accounting principles i.e. principle errors, or error arising out of negligence of accounting staff i.e. Clerical errors.

DETECTION OF FRAUD & ERRORS

The term fraud means the willful misrepresentation made with an intention of deceiving others. It is a deliberate mistake committed in the accounts with a view to get personal gain. In accounting, fraud means two things.
a. Defalcation involving misappropriation of either cash or goods; and
                       b. Fraudulent manipulation of accounts not involving defalcation.

    FRAUD THROUGH DEFALCATION.
Following are the methods of defalcation involving misappropriation of cash or goods:
1. By misappropriating the receipt by not recording the same in the cashbook
2. By destroying the carbon copy or counter foil of the receipt and misappropriating the cash received
3. By entering lesser amount on the counterfoil and misappropriating the difference between money actually-received and the amount entered on the counterfoil of the receipt book
4. By not recording the receipt of sale of a casual nature for example sale of scrap, sale of old newspapers etc.
5. By omitting to record cash donations received by non-profit making charitable institutions
6. By misappropriating the cash received on discounting the bills receivable and showing them as bills outstanding on hand.
7. By misappropriating cash received from debtors and concealing the same by giving artificial credit to the debtors in the form of bad debts, discount or sales return etc.
8. By adopting the method of “teeming and lading” or “lapping process”. Under this method cash received from one debtor is misappropriated and deficiency in that debtors account is made good when another payment is received from second debtor by crediting the second debtors account less by that amount. This process is carried out round the year.
9. By suppressing the cash sales by not recording them or by treating the cash sales as credit sales.
10. By misappropriating the sale proceeds of VPP sales or sales of goods on approval basis by treating the transaction as goods received or not approved.
11. By under casting receipt side total of the cashbook
12. By recording fictitious or bogus payments
13. By recording more payments than actual amounts paid by altering the figures on the vouchers.
14. By showing the same payment twice.
15. By showing credit purchases as cash purchases and misappropriating the amount
16. Recording personal expenses as business expenses
17. By not recording discounts and allowances given by the creditors and misappropriating the amounts
18. By overcasting the payment side total of the cashbook
19. Recording fictitious and inflated purchases and misappropriating that amount.
20. By suppressing the credit notes for returns and showing the full payment to creditors.
21. By including the names of dummy workers or the workers who have left the job in the wage sheets and misappropriating the amount.
22. By over casting the total of wages sheets and drawing that amount for misappropriation.
23. By misappropriating the un-disbursed wages.

FRAUD THROUGH MANIPULATION OF ACCOUNTS
It implies presentation of accounts more favorably than what they actually are. Window dressing means showing a wrong picture. The fraud through manipulation of accounts is also known as window dressing
because accounts are manipulated to show a wrong picture of the profit or loss of the business and its financial state of affairs. Generally this type of fraud is committed by the people at the top management level. This does not involve any misappropriation of cash or goods but it is either over statement of profit or understatement of the same. Such fraud is committed with certain objective and is relatively difficult to detect.

THE AUDITOR CAN SUSPECT FRAUD UNDER THE FOLLOWING CIRCUMSTANCES:
1. When vouchers, invoices, cheques, contracts are missing etc.
2. When control account does not agree with subsidiary books.
3. When the difference in trial balance is difficult to locate.
4. When there are greater fluctuation in G.P. and N.P. ratios.
5. When there is difference between the balance and the confirmation of the balance by the parties.
6. When there is difference between the stock as per records and the stock physically counted.
7. When the explanation given by the client is not satisfactory.
8. When there is a overwriting of some figures.
9. When there is a contradiction in the explanation given by different parties.

PROCEDURE TO BE FOLLOWED TO DETECT ERRORS:
Following procedures may be adopted by the auditor to detect the errors:
1. Check the opening balances from the balance sheet of the last year.
2. Check the posting into respective ledger accounts
3. Check the total of the subsidiary books.
4. Verify all the castings and the carry forwards.
5. Ensure that the list of debtors and creditors tally with the ledger accounts.
6. Make sure that all accounts from the ledger are taken into accounts.
7. Verify the total of the trial balance.
8. Compare the various items from the trial balance with that of the previous year.
9. Find out the amount of difference and see whether an item of half or such amount is entered wrongly.
10. Check differences involving round figures as Rs. 1,000; Rs. 100 etc .
11. See where there is misplacement or transposition of figures that is 72 for 27; or 31 for 13 etc.
12. Ultimately careful scrutiny is the only remedy for detection of errors.
13. See that no entry of the original book has remained unposted.

THE AUDITOR SHOULD PERFORM THE FOLLOWING DUTIES IN RESPECT OF FRAUD:
1. Examine all aspects of the finance.
2. Vouch all the receipts from the counterfoils or carbon copies or cash memos, sales mart reports etc.
3. Check thoroughly the salary and wages register.
4. Verify the methods of valuation of stocks.
5. Check up stock register, goods inwards notes, goods out wards books and delivery challans etc
6. Calculate various ratios in order to detect fraudulent manipulation of accounts
7. Go through the details of unusual items.
8. Probe into the details of the problems when there is a suspicion.
9. Exercise reasonable skill and care while performing the duty.
10. Make surprise visit to check the accounts.

 LIMITATIONS OF AUDITING

1. Non-detection of errors/frauds:- Auditor may not be able to detect certain frauds which are committed with malafide intentions.
2. Dependence on explanation by others:– Auditor has to depend on the explanation and information given by the responsible officers of the company. Audit report is affected adversely if the explanation
and information prove to be false.
3. Dependence on opinions of others:– Auditor has to rely on the views or opinions given by different experts viz Lawyers, Solicitors, Engineers, Architects etc. he can not be an expert in all the fields.
4. Conflict with others: – Auditor may have differences of opinion with the accountants, management, engineers etc. In such a case personal judgement plays an important role. It differs from person to
person.
5. Effect of inflation : – Financial statements may not disclose true picture even after audit due to inflationary trends.
6. Corrupt practices to influence the auditors :- The management may use corrupt practices to influence the auditors and get a favorable report about the state of affairs of the organisation.
7. No assurance :- Auditor cannot give any assurance about future profitability and prospects of the company.
8. Inherent limitations of the financial statements :– Financial statements do not reflect current values of the assets and liabilities. Many items are based on personal judgement of the owners. Certain non-monetary facts can not be measured. Audited statements due to these limitations can not exhibit true position.
9.Detailed checking not possible :- Auditor cannot check each and every transaction. He may be required to do test checking.

TRUE AND FAIR VIEW.
An audit of accounts by an independent expert assures the outside users that the accounts are proper and reliable. The outsiders can rely on the accounts if the auditor reports that the accounts are true and
fair. The accounts are said to be true and fair:
1.When the profit and loss shown in the profit and loss account is true and fair, and

2. Also when the value of assets and liabilities shown in the balance sheet is true and fair.

What constitutes true and fair is not defined under any law. However the following general guidelines maybe laid down in connection with true and fair.
a) Conform to accounting principles: The books of accounts must be kept according to the normally accepted accounting principles such as the concept of entity, continuity, periodical matching of costs and revenue, accrual and double entry system etc.
b) No window dressing or secret reserves: The accounts must show the financial position and the profit or loss as they are i.e.there is neither an overstatement nor an understatement. There should be in other words neither window dressing nor secret reserves. In window dressing the accounts are made in such a
way as to show a much better condition than the actual condition. The profit and the net worth are overstated.
The accounts are said to show true and fair view when the accounts show only the actual conditions as it is i.e. the profit and the net worth are shown as they are.
In order to show a true and fair view the auditor should ensure that:
1. The final accounts agree with the books of accounts.
2. The provision for depreciation is proper.
3. The closing stock is physically verified and valued properly.
4. Intangible assets like goodwill, patents, preliminary expenses or other deferred revenue expenses are written off properly.
5. Proper provision is made for bad and doubtful debts.
6. Capital expenses is not treated as revenue expenses and vice versa.
7. Capital receipts are not treated as revenue receipts.
8. Effect of changes in rate of foreign exchange on value of assets and liabilities is recorded in the books properly.
9. Contingent liabilities are not treated as actual liabilities and vice versa.
10. Provision is made for all known losses and liabilities
11. A reserve is not shown as a provision and vice versa
12. Cut off transactions are recorded properly, so that all sales invoices are matched with goods delivered and all purchase invoices are matched with goods received.
13. Transactions are recorded on accrual basis, i.e. outstanding expenses, prepaid expenses, income accrued and advance income are recorded properly.
14. Expected or anticipated gains are not credited to the profit and loss account.
15. Effect of events after the balance sheet date on the value of an asset and liability is disclosed in the accounts properly
16. The exceptional or non-recurring transactions are disclosed separately in the accounts.

3.Disclose all material facts: The books of accounts must disclose all material facts regarding revenue, expenses, assets and liabilities. Material means important and essential. The disclosure of important matters in the accounts helps the users in taking business decisions. There should be neither suppression of vital facts nor mis-statements.

4.Legal requirements: In case of limited company the account must disclose the matters required to be disclosed under the Companies Act. The final accounts must be in the format prescribed under Schedule VI of the Companies Act, 1956. Special companies such as banks, insurance, electricity supply companies prepare accounts as prescribed under special laws. A co-operative society, a trust etc. must also prepare the accounts as required under relevant laws.

5.Requirements of Institute of Chartered Accountants of India:The accounts must also be in accordance with the various guidelines prescribed by the ICAI. These guidelines are contained in the statements,
standard and guidance notes issued by the institute from time to time.

KEYWORDS
Auditing: Auditing is a systematic and scientific examination of the books of accounts and records of business to enable the auditor to satisfy himself that the profit and loss account and the balance sheet are properly drawn up so as to exhibit a true and fair view of the financial state of affairs of the business and profit or loss for the financial period.

Continuous audit: An audit which involves a detailed and exhaustive examination of the books of accounts at regular intervals throughout the year along with the accounting work.

Errors: Mistakes committed innocently and unknowingly while making entries in the books of accounts.

Frauds: Fictitious entries made in the books of accounts with certain motives.

Interim audit: An audit which is conducted for a part of the accounting period for some specific purpose.

Investigation: Examination of accounts for special purpose.

Qualified auditor: A person who is a Chartered Accountant withinthe meaning of the Chartered Accountants Act,1949.

Statutory audit: An audit undertaken under any specific statute orAct.

True and fair view: A phrase which means that the financial statements must not contain anything which is untrue, unfair, unlawful, immoral and unethical i.e. the financial statements must not contain errors and fraud.