Commerce for IAS – Auditing Basics (Q & A)
Question. “Auditing is as old as accounting.” Explain the meaning & objectives of Auditing.
Auditing is as old as accounting. It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing. Arthasashthra by Kautilya detailed rules for accounting and auditing of public finances.
Auditing evolved and grew rapidly after the industrial revolution in the 18th century With the growth of the joint stock companies the ownership and management became separate. The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors.
The main point of distinction between accounting & auditing is that accountancy is concerned with the preparation of financial statements whereas auditing is concerned with checking of these financial statements and reporting on the financial position and result of operation of the organisation.
According to 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.
Institute of Chartered Accountants of India (ICAI) defines Auditing as – “Auditing is defined as a systematic and independent examination of data, statements, records, operations and performance of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collect evidences, evaluates the same and on this basis formulates his judgement which is communicated through his audit report”.
The meaning of an Audit contains:
(i) An intelligent and critical examination of the books of accounts of business.
(ii) It is done by an independent qualified person.
(iii) It is done with the help of vouchers, documents, information and explanations received from the clients.
(iv) The auditor satisfies himself with the authenticity of the financial accounts prepared for a particular period.
Objectives of Auditing
The objectives of auditing may be classified into two parts:
1. The primary objective
2. The secondary or incidental objective.
Primary objective – As per Section 143 of the Companies Act 2013, the primary duty (objective) of the auditor is to report to the owners that the accounts, financial statements give a true and fair view of the state of the company’s affairs as at the end of its financial year and profit or loss and cash flow for the year and such other matters as may be prescribed.
Secondary objective –It is also called the incidental objective as it is incidental to the satisfaction of the main objective. The incidental objectives 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.
Question. The task of Auditing is no futile one and it brings with it various advantages. Explain any 5 advantages of Auditing?
(i) Satisfaction of Owner: It is because of audit that the owner will be satisfied about the business operations and working of its various departments.
(ii) Detection and Prevention of Errors and Frauds: The errors whether committed innocently or deliberately are discovered by the process of audit and its presence prevents their occurrence in the future. No one will try to commit an error or fraud as the accounts are subject to audit and hence they will have a fear of being detected. Just like errors, frauds are discovered by audit and its presence minimizes future possibility if not eliminated totally.
(iii) Verification of Books: Another advantage of audit is the verification of the books of accounts, this helps in maintaining the records up to date at all times.
(iv) Independent Opinion: Auditing is very useful in obtaining the independent opinion of the auditor about business condition. If the accounts are audited by an independent auditor, the report of the auditor will be true and fair in all respects and it will be of extreme importance for the management of the company.
(v) Moral Check: The process of audit will establish a check on the minds of the staff working in the business and they will not be able to commit any irregularity, as they will have a fear and will also be aware that the accounts will be examined in the near future and that action would be taken against them if any irregularity is discovered. Thus the audit prevents the happening of any irregularity before it starts and the staff hence becomes more active and responsible. The fear of their getting caught act as a moral check on the staff of the company.
(vi) Protection of the Rights and Interests of Shareholders: Audit helps in protecting the interests of shareholders in case of joint stock company. Audit gives assurance to the shareholders that the accounts of the company are being maintained properly and their interest will not suffer under any circumstances.
(vii) Reliance by Outsiders: Outsiders like creditors, debenture holders and banks etc. will rely on the books of accounts and financial statements of the business if they are audited by an independent authority (external auditor).
(viii) Ensures Compliance with Legal Requirements: Audited statements are necessary to fulfill certain legal requirements e.g. listing requirements of stock exchange etc.
(ix) Reinforce and Strengthen Internal Control: Since auditing exercise involves the review of internal control system, an auditor will identify the gaps in internal control system and can suggest the necessary changes in the internal control system.
(x) Loan Facility: Money can be borrowed easily on the basis of audited balance sheet from financial institutions. If accounts are audited the true picture will be visible to banks and it will be easy for them to issue loans as early as possible.
Question. Auditing is not full proof due to its inherent limitations. Discuss the inherent limitations of Auditing.
“The evidences obtained by the auditor are persuasive rather than conclusive”. Explain.
Besides having various benefits, there are some inherent limitations of auditing. These are as follows :
(i) Higher Cost Burden: Due to Higher Cost Burden, the auditor limits his scope of work to selective testing or sampling thus in depth checking of books of accounts is not possible.
(ii) Based on test checks. Generally an auditing exercise is based on test checking. Inferring a result on the basis of test check always need not to be true.
(iii) Insufficient Time: Generally an auditor needs to release the report up to a specified timeline. Sometime this timeline become a constraint for an auditor in carrying out the auditing exercise effectively. This time constraint may affect the amount of evidence that can be obtained concerning events and transactions after the balance sheet date that may have an effect on the financial statements. Moreover, there is a relatively short time period available for resolving uncertainties existing at the financial statement date
(iv) Inconclusiveness of Evidences: The evidences obtained by an auditor are persuasive rather than conclusive. For example, an architect’s certificate of valuation for a newly constructed building of a client may not be conclusive evidence of the correct value of building.
(v) Based on Estimates: Estimates are an inherent part of the accounting process, and no one, including auditors, can foresee the outcome of uncertainties. Estimate range from the allowance for doubtful accounts and an inventory obsolescence reserve to impairment tests of fixed assets and goodwill. An audit cannot add exactness and certainty to financial statements when these factors do not exist.
(vi) Based on the Information provided by the Management: The audit opinion is based on the information provided by the management. Hence, outsiders cannot fully rely on the auditor’s report.
Question. What do you mean by investigation. How does it differ from auditing?
The investigation is related to critical checking of particular records. Investigation is done when a lapse already exists to pin point the reason and person involved in it so that responsibility for such lapse could be fixed whereas audit is a process to check whether the accounts are properly maintained as per required norms following all the procedures etc. and to point out any lapses in this line. The purpose of auditing and investigation is different.
Comparison between Audit and Investigation:
|Description||Audit means the inspection, examination or verification of a person, organization, system, process, enterprise, project or product.||Investigation means an inquiry, or is the act of detail examination of activities so as to achieve certain objectives.|
|Owners||Audit is conducted on behalf of owners only and they make the appointment.||Investigation may be conducted either by owner of the undertaking or by an outsider.|
|Purpose||To determine the true and fair view.||Varies from business to business|
|Process||Routine process||Investigation is not a regular process|
|Scope||It includes only an examination of the accounts of a business||It covers an examination of the accounts bur also covers an inquiry into other matter that are connected with the purpose for which it is undertaken|
|Period||Year or six months||May cover several years|
|Employees||Does not examine personally||May examine personally|
|Sequence||Usually conducted before investigation of accounts||Usually conducted after the audit of accounts|
|Person performing work||Audit is to be conducted by a chartered accountant||Investigation may be take on even by a non-chartered accountant|
|Legal Obligations||Audit is mandatory under law||There is no such legal obligations with regard to investigation|
Question. What are the various aspects to be covered by an auditor in an audit of Financial Statements?
The following aspects are required to be covered by an auditor while doing audit of any organization. The principal aspects can also be called the functions of audit:
(i) Review of System and Procedures: Review of system and procedure is the primary function of auditing exercise. First an auditor needs to understand the system and procedures adopted by the entity to go further in the auditing exercise.
(ii) Review of Internal Control System: Review of internal control system is very important for the auditor as the effectives of internal control system will determine the extent of checking to be done by the auditor. The compliance test and substantive procedures performed by the auditor will determine the effectiveness of internal control system. If internal control system is effective, less checking is required and vice-versa. Moreover As per Company Audit report Order, 2003 also an auditor need to comment on the effectiveness of Internal control system in the organization so the review of internal control is necessary for carrying out the Auditing exercise.
(iii) Routine Checking/ Arithmetical Accuracy: It is the duty of the auditor to check the arithmetical accuracy of the books of account by checking the proper posting and balances of the books of accounts.
(iv) Accounting Principles: Auditor has to ascertain whether proper distinction has been made between the item of capital and revenue nature and also whether the item of income and expenditure of a particular period has been adjusted in the books of accounts of that accounting period.
(v) Books and Statements: Auditor has to compare the balance sheet and profit and loss account or other statement with the books of accounts and supporting vouchers to ascertain that the final accounts have been made in accordance with the underlying records.
(vi) Verification of Assets: It is the duty of the auditor to physically inspect the assets and their recording in the books of accounts and verify the legal and official documents to ascertain the existence, ownership, possession, classification and valuation of assets of an entity.
(vii) Verification of Liabilities: It is the duty of the auditor to inspect the books of accounts and verify the legal and official documents to ascertain the existence, obligation, completeness, valuation and disclosure of liabilities of an entity.
(viii) True and Fair View: The auditor has to give its opinion whether the financial statements depicts the true and fair view of the state of affairs of the organization.
(ix) Statutory Compliance: Auditor has to ensure that all the statutory requirements has been complied by the entity like provisions of Income Tax Act, Companies Act and other acts if any applicable has been complied by the organization.
(x) Reporting: The auditor has to report to the authority appointing him for conducting audit whether the financial statements of accounts examined actually reveals true and fair view of the state of affairs and of the profit or loss earned during the period by the organization.
Question. Detection of errors of frauds is not the primary aim of audit; the primary aim is the establishment of a degree of reliability of the annual statements of account. Examine the statement relating it to the leading case “Re-Kingston Cotton Mills Co.”
Detection of errors of frauds is not the primary aim of audit; the primary aim is the establishment of a degree of reliability of the annual statements of account. If there remains a deep laid fraud in the accounts, which in the normal course of examination of accounts may not come to light, it will not be construed as failure of audit, provided the auditor was not negligent in the carrying out his normal work.
This principle was established as early as in 1896 in the leading case in Re-Kingston Cotton Mills Co.
Question. Differentiate between fraud and Error in an audit of Financial Statements.
Primary objective of audit is to substantiate the accuracy of the financial statements prepared by the accountant while the secondary objective is to detect and prevent errors and frauds
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. In accounting, fraud means two things. a. Defalcation involving misappropriation of either cash or goods; and b. Fraudulent manipulation of accounts not involving defalcation.
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.