AUDITING BASICS I This study note includes ! Evolution of Auditing ! Definitions ! Major Influences of Auditing ! Nature of Auditing !

! Scope of Auditing ! Role of Evidence in Auditing ! Auditing Techniques and Practices ! Generally Accepted Auditing Standards ! Concept of Materiality in Auditing 1.1 EVOLUTION OF AUDITING In the early days of commerce and business there was no existence of the concept of auditing. This was, may be due to the small nature of business and day to day personal control of the proprietor .Audit can be traced back in the period 3600-3200 B.C. Initially, the audit was mainly done that of public accounts only. From historical records it appears that the ancient Egyptians, Greeks and Romans were used to the government accounts audit. The accounts of the corporation of the city of London were audited in 12th Century. Later in Shakespeares Timon of Athens the steward Flavins makes the remark If you suspect my husbandry or falsehood, call me before the exactest auditor, and set me on the proof which indicates the existence of an audit in the 14th century also. In 1314, auditors were officially appointed to check the public accounts in England. In 1494, Luca Pacioli, a French celebrated mathematician, brought the concept of Double Entry book-keeping and auditing in practice. Gradually and especially after the Industrial Revolution in the 18th century, the nature, type and size of business organizations changed. The large scale business came into existence causing dilution or strength in the regular and direct control of the proprietor or property owner. This made it necessary to get the transactions made by the staff and representatives of owners, checked and verified by an independent person and this has given rise to concept of auditing. In 1866, the Englands Exchequer and Audit Department was created by Act of Parliament. In 1870, The Institute of Accountants in the form of a society was formed in England. It got a Royal Charter in 1880 and was turned into The Institute of Chartered Accountants in England and Wales, but before that in 1854, with a Royal Charter, The Institute of Accountants and Actuaries in Glasgow. In Tanzania, before the Arusha declaration the statutory audits of limited companies were carried out by private audit firms like coopers and Lybrand. with the establishment of Tanzania Audit corporation in 1968 it became mandatory that the audit of all parastatal companies should be carried out by Tanzania Audit corporation (TAC)the appointment of TAC as auditors of such organization was considered the best approach to safeguard the interest of the nation according to the existing policy of socialism and self reliance on those days .the corporative sector entities were audited by the cooperative audit and supervision corporation (COASCO).the government were audited by the controller and auditor general (CAG)the rest of the economy the private businesses were audited by the private audit firms. Due to staffing problems the TAC and COASCO did not perform to the expectations .Mean while the economy was

expanding and the Government withdrew from active control of economy so in late eighties the monopoly of TAC and COASCO ended when the private audit firms were allowed to audit the parastatal organisations and cooperative sector entities. The government accounts are still to be audited by the controller auditor General except the donor funded projects which are audited by the CAG and the commissioned private audit firms practices. In 1972the national; board of Accountants and Auditors (NBAA) was formed and Changed with the responsibility of overseeing the development of accounting profession and conducting professional examinations among other duties .it conducts the examinations twice in a year since 1975 also issued several accounting and auditing standards but in July 2004 we shifted to International standards .The board also conducted continuous programme Education for its Members. This programme requires the registered auditors to compulsorily attend 4hours seminar per annum while accountants should attend 30hours per annum. Recently an Association of qualified accountants known as Tanzania Association of Accountants has also been formed whose objectives and aims are geared at encouraging the exchange of ideas among accountants and promoting the image and development of the profession in the country. A number of technological, economic changes, social events, globalization, liberalization, privatization etc. have influenced auditing to a great extent in the course of development of auditing and caused considerable changes and improvements in the techniques, principles, standards, reporting, professional ethics and responsibilities of auditor. 1.2 DEFINITIONS The term audit has been derived from the Latin words audire which means to listen. In those ancient days, the person appointed to check the accounts, used to hear the explanations required from responsible officers and thats why, the person who heard the explanations was called as an auditor. However, now days, due to drastic changes in business, accounting systems, size and the provisions of different laws, this hearing concept of auditing is considerably changed and become more exhaustive and therefore, different authors have defined auditing differently, few of the important definitions are as under: (a) Taylor and Perry Audit is defined as an investigation of some statements of figures involving examination of certain evidence, so as to enable an auditor to make a report on the statement. (b) F.R.M De Paula An audit denotes the examination of Balance Sheet and Profit and Loss Account prepared by others together with the books of accounts and vouchers relating thereto in such a manner that the auditor may be able to satisfy himself and honestly report that, in his opinion, such Balance Sheet is properly drawn up so as to exhibit a true and correct view of the state of affairs of the particular concern according to the information and explanations given to him and as shown by the books

(c) Prof. Montgomerly Auditing is a systematic examination of the books and records of business or other organization, in order to ascertain or verify and to report upon the facts regarding its financial operations and the result there of. (d) M.L.Shandilya Auditing may be defined as inspecting, comparing, checking, reviewing, vouching, ascertaining, scrutinizing, examining and verifying the books of accounts of a business concern with a view to have a correct and true idea of its financial state of affairs. (e) Spicer & Pegler- Audit such an examination of the books of accounts and vouchers of a business, as will enable the auditor to satisfy himself that the Balance Sheet is properly drawn up, so as to give a true and fair view of the state affairs of the business, and whether the profit and loss account gives a true and fair view of the profit or loss for the financial period according to the best of his information and explanations given to him and as shown by the books, and if not, in what respect he is not satisfied. In the close scrutiny of the different definitions we found that there are different ways of expressing the concept auditing but having lot of similarity therein. 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. (v) The auditor reports that(a) The Balance Sheet exhibits a true and fair view of the state of affairs of the concern. (b) The profit and loss account reveals the true and fair view of the profit or loss for the financial period. (c) The accounts have been prepared in conformity with the concerned law. (d) If he is not satisfied then reports in what respect he is not satisfied. 313 1.3 MAJOR INFLUENCES OF AUDITING Now a days the techniques & process of audit ethical & professional responsibilities of an auditor, reporting method & standard, legal & statutory status of an auditor have been drastically changed compared to that of ancient days, due to the influence of different things like events, laws, revolutions etc.Some of them are (a) Industrial Revolution (b) Ownership (c) Professional Management (d) Statutory Provisions (e) Case Laws (f) Information Technology 5.4 NATURE OF AUDITING

An audit is a dynamic concept where accountancy ends and auditing begins. An auditor has to verify the entries passed by the accountant and the final accounts prepared by him. Auditing is, therefore, the scrutiny of the accounts of business with the help of the vouchers, documents and the information given to him. In the olden days audit was voluntary act of few businessmen having very limited scope, however the change in the form of organizations after industrial revolution had increased the scope of audit considerably. Auditor acts according to the instructions of his client and in case of statutory audits to a certain extent regulated by the concerned law, the words certain extent are meant as the actual method of performing an audit is not prescribed, and never can be prescribed, and although professional auditors act on certain well defined lines can be indicated only in a general way. A very eminent English Judge once described an auditor as a watchdog and not a blood hound which expression has been frequently quoted by others equally well informed as to the nature of an auditors work and of the very short period occupied by him, in the performance of his duties. An erroneous description could not be applied to an auditor, as a watchdog is a dog kept on premises for the purpose of guarding them from the damages from theft. An auditor on the other hand only appears on the scene after the damage or theft, if any, has been perpetrated, and the most he can do is to find out the amount of theft or extent of damages and also, if possible, the proprietor. The nature of auditing is such that, the auditor will later on appear in his capacity as a critic of a book-keepers work, may have a great morale effect and thus prevent a cashier or book keeper from embezzling money. This morale effect has prevented theft in many more cases and is a more powerful point in favor of auditing. 5.5 SCOPE OF AUDITING Development in the last two decades have extended the scope of auditing. Therefore, a more comprehensive definition of auditing given by Schlosser may also be considered. According to him, auditing is a systematic examination of financial statements, records and related operation to determine adherence to generally accepted accounting principles, management policies of stated requirements. The earlier definition of auditing by Mautz emphasizes the verification of accounting statements. While retaining that emphasis, Scholssers definition extends the scope of auditing by including in it an examination of allied operations. Similarly the purpose of auditing has been extended to examination of allied operations to management policies or stated requirements. This, whereas

the previous definition mainly covers Mautz independent professional audit, Schlossers definition also covers cost audit, internal audit, Government audit, management audit, operational audit and the like. The auditor is not supposed to perform the duties which are beyond the scope of his competence. Accounting is concerned with the recording of the transaction and preparation of statements of account but auditing involves a detailed and critical examination of accounts prepared by others. In fact, auditing begins where accounting ends. Constraints on the scope of the audit of financial statements that impair the auditors ability to express an unqualified opinion on such financial statement should be set out in the report. Qualified opinion or disclaimer of opinion should be expressed as appropriate. 314 AUDITING AUDITING BASICS I According to Schlosser, audit now also covers cost audit, management audit, internal audit, energy audit, excise audit, VAT audit and government audit too. Today audit is not confined to the business houses only, but also to nonbusiness organizations. Auditor is in the nature of a watch-dog and a trustee of the nations finances. The scope of an audit of financial statements will be determined by the auditor having regard to the terms of the engagement, the requirements of relevant legislations. Of course the terms of engagement cannot restrict the scope of an audit in relation to matters which are prescribed by legislation or by the pronouncement of the institute. The auditors work involves exercise of judgment for example, in deciding the extent of audit procedures and in assessing the reasonableness of the judgments and estimates made by the management in preparing the financial statements. Further more, much of the evidence available to the auditor can enable him to draw only reasonable conclusion therefrom. Because of these factors, absolute certainty in auditing is rarely attainable. Hence, it becomes quite clear that the scope of audit is widening and there is a change in emphasis in audit objectives too. 5.6 ROLE OF EVIDENCE IN AUDITING Meaning and Importance The concept of evidence is fundamental to auditing. All auditing techniques and procedures are derived from it. It helps the auditor in perceiving the types of evidence available in an audit situation, collecting it through the various audit techniques and evaluating its sufficiency and competency to support accounting data. Development of this

concept is therefore, basic to the understanding of the audit process. Mautz and Sharaf list the following five steps in the process of Judgment formation in auditing. 1. Recognition of the propositions to be proved. 2. Evaluation of the proposition in terms of materiality or significance. 3. Collection of evidence with in given limits of time and costs. 4. Evaluation of evidence obtained as valid or not valid. 5. Formation of judgment as to the propositions at issue. Indian Accounting Standards (AS) and their interpretations (ASI) The auditor is required to obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions there from on which his opinion on financial statements be based. Types of Audit Evidence The audit evidence influences the judgment of an auditor. The evidence need not be only documentary. Arons and Luobecke have given types of audit evidence- Physical examination, confirmation, documentation, observation, inquiries of the client, mechanical accounting, and analytical tests. While Prof.Mautz gives nine types of audit evidence 1) physical examination by the auditor of the thing represented in the accounts. 2) Written or oral statement by independent third parties. 3) Authoritative documents- prepared inside or outside the enterprise 4) Formal or informal statement by officers and employees of the enterprise. 5) Calculations performed by the auditor. 6) Satisfactory internal control procedure. 7) Subsequent actions by the enterprise and by others. 8) Subsidiary or detailed records with no significant indications of irregularities. 9) Interrelationship within the data examined. The types of audit evidence can be grouped under the following two heads (a) Analytical evidence These evidences consist of journals, subsidiary books, allocation sheets, reconciliation statements, or any other records which supports the data appearing in the books of accounts. (b) Corroborative Evidence This evidence consists of invoices, confirmations, cancelled cheques or similar documents. Obtaining Audit Evidence: Before obtaining audit evidence the auditor should give consideration to what types of evidence available and how to obtain them. What amount of evidence to be collected depends upon the nature and circumstances & the types of evidence to be collected depends upon the transaction and relevance of the evidence. AUDITING 315

Auditor obtains evidence in performing compliance and substantive procedures by any one or more of the following methods(a) Inspection (b) Observation (c) Inquiry and Confirmation (d) Computation (e) Analytical Review 5.7 AUDIT TECHNIQUES AND PRACTICES Effective auditing is the outcome of systematic audit procedures applied to trade and examine audit evidence with the help of audit techniques. According to Moyer, audit techniques are the devices or methods available to the auditor for obtaining competent evidential matter. While according to statement on audit standards, audit procedure is the act to be performed, such as reviewing, inspecting and confirming. Practice refers to the application of principles and techniques in various situations to get the expected results, on the same line auditing practice means the use of auditing principles, as were already established and notified by professional pronouncements from time to time, in different auditing situations. Audit Techniques: As explained above, audit techniques are the tools used to get reliable evidence while conducting an audit. According to Prof. Mautz, basically there are following ten techniques available (i) Physical Examination (ii) Confirmation (iii) Comparing Documents With The Records (Vouching) (iv) Computation (v) Re-tracking Book-keeping (vi) Scanning (vii) Inquiry (viii) Examining Subsidiary Records (ix) Co-relation With The Related Information (x) Observation of Pertinent Activities Professional Pronouncements Professional pronouncements issued by professional bodies like ICAI, ICWAI, in various countries on generally accepted auditing standards regulate the auditing practice. These standards are not related only to financial and cost audit but also to other items like compilation of financial statements. Compilation with the auditing standards is a must in normal situation, and hence an auditor is expected to observe it while expressing his opinion in audit report and so he has to mention in his report whether the audit is carried out in accordance with the GAAS (Generally

Accepted Auditing Standards) or not, if not the reasons thereof. As per the provisions of the Chartered Accountants Act, 1949, auditor is charged for professional misconduct if he fails to mention any material departure from the Generally Accepted Audit Procedure. The Institute of Chartered Accountants of India has issued number of pronouncements from time to time, which contain (i) Auditing, Reveiw & Other Standards (formerly known as AAS) (ii) Accounting standards and accounting standards interpretation. (iii) Other statements on accounting and auditing. (iv) Guidance notes (v) Opinions (vi) Research studies/ monographs. The Institute of Cost and Works Accountants of India has also issued number of pronouncements from time to time, which includes- (i) Cost Accounting Record Rules and Cost Audit (Report) Rule- uptil now 47 Record Rules and Report Rules have been issued. (ii) Guidance Notes- uptil now about 26 such guidance notes have been issued. (iii) Research Publicationsuptil now 20 such research publications are issued. (iv) Research Bulletin- Bi-annual. (v) Cost Accounting Standards uptil now 12 such standards have been pronounced. The International Federation of Accountants pronounced (i) International Standards on Auditing. (ii) International Accounting Standards- uptil now about 41 such standards have been issued. (iii) International Financial Reporting Standards. 316 AUDITING AUDITING BASICS I Accounting Standards and Accounting Standards Interpretation The ICAIs Accounting Standard Board has uptil now issued following 32 accounting standards. These standards are based on the International Accounting Standards. These standards are mandatory and, according to Sec 227(3) of the Companies Act, the auditor is required to state whether accounting standards have been complied with or not; also in case of Tax Audit u/s 44 AB, of I. Tax Act, 1961, these standards are mandatory. The SEBI also requires the listed companies to comply with these Accounting Standards. If any company does not follow these standards, it should be disclosed in financial statements along with (i) The deviation from accounting standards. (ii) The reasons of such deviation and (iii) The financial effect, if any, arising from such deviation. These standards are applicable to all types of organizations whether business oriented or not except activities like collecting donations and expending on earth quake relief etc. Some enterprises whose turnover in the immediately preceding financial year exceeds `40 lakhs but does not exceed `50 crores or whose borrowings include public

deposits exceeds `1 crore but do not exceed `10 crores and those enterprises whose turnover does not exceed `40 lakhs and borrowings do not exceed ` 1 crore are exempted from the applicability of accounting standards nos. 3, 17, 18, 21, 23, 24, 25 and 27. AS 1- Disclosure of Accounting Policies AS 2- Valuation of Inventories AS 3- Cash Flow Statements AS 4- Contingencies and events occurring after the balance sheet date AS 5- Net profit or loss for the period, prior period items and changes in accounting policies AS 6- Depreciation Accounting AS 7- Construction Contracts AS 8- Accounting for research and development (withdrawn) AS 9- Revenue recognition AS 10- Accounting for fixed assets AS 11- The effects of changes in foreign exchange rates AS 12- Accounting for government grants AS 13- Accounting for investments AS 14- Accounting for amalgamations AS 15- Accounting for retirement benefits in the financial statements of employees AS 16- Borrowing costs AS 17- Segment reporting AS 18- Related party disclosures AS 19- Leases AS 20- Earning per share AS 21- Consolidated financial statements AS 22- Accounting for taxes on income AS 23- Accounting for investments in associates in consolidated financial statements AS 24- Discontinuing operations AS 25- Interim financial reporting AS 26- Intangible assets AS 27- Financial reporting of interest in joint venture AS 28- Impairment of assets AS 29- Provisions, contingent liabilities and contingent assets. AS 30- Financial Instruments : Recognition & Measurement. AS 31- Financial Instruments : Presentation. AS 32- Financial Instruments : Disclosures. AUDITING 317 Cost Accounting Record Rules and Cost Audit Report Rules The ICWAI had issued following 47 Cost Accounting Record Rules and Cost Audit Report Rules and these rules are mandatory as were made by the Central Government and came into force from the date of publication. (1) Cost Accounting Record Rules and Cost Audit Report Rules (cement) of 1997 (2) Cost Accounting Record Rules and Cost Audit Report Rules (cycles) of 1967 (3) Cost Accounting Record Rules and Cost Audit Report Rules (tyres and tubes) of 1967

(4) Cost Accounting Record Rules and Cost Audit Report Rules (caustic soda) of 1967 (5) Cost Accounting Record Rules and Cost Audit Report Rules (air conditioners) of 1967 (6) Cost Accounting Record Rules and Cost Audit Report Rules (refrigerators) of 1967 (7) Cost Accounting Record Rules and Cost Audit Report Rules (batteries) of 1967 (8) Cost Accounting Record Rules and Cost Audit Report Rules (Electric lamps) of 1967 (9) Cost Accounting Record Rules and Cost Audit Report Rules (Electric fans) of 1969 (10) Cost Accounting Record Rules and Cost Audit Report Rules (motor vehicles) of 1997 (11) Cost Accounting Record Rules and Cost Audit Report Rules (electric motors) of 1969 (12) Cost Accounting Record Rules and Cost Audit Report Rules (aluminium) of 1972 (13) Cost Accounting Record Rules and Cost Audit Report Rules (vanaspati) of 1972 (14) Cost Accounting Record Rules and Cost Audit Report Rules (bulk drugs) of 1974 (15) Cost Accounting Record Rules and Cost Audit Report Rules (sugar) of 1974 (16) Cost Accounting Record Rules and Cost Audit Report Rules (milk food) of 2001 (17) Cost Accounting Record Rules and Cost Audit Report Rules (jute goods) of 1975 (18) Cost Accounting Record Rules and Cost Audit Report Rules (industrial alcohol) of 1975 (19) Cost Accounting Record Rules and Cost Audit Report Rules (paper) of 1975 (20) Cost Accounting Record Rules and Cost Audit Report Rules (rayon) of 1976 (21) Cost Accounting Record Rules and Cost Audit Report Rules (dyes) of 1976 (22) Cost Accounting Record Rules and Cost Audit Report Rules (soda ash) of 1976 (23) Cost Accounting Record Rules and Cost Audit Report Rules (polyester) of 1977 (24) Cost Accounting Record Rules and Cost Audit Report Rules (nylon) of 1977 (25) Cost Accounting Record Rules and Cost Audit Report Rules (textiles) of 1977 (26) Cost Accounting Record Rules and Cost Audit Report Rules (Dry battery cell) of 1979 (27) Cost Accounting Record Rules and Cost Audit Report Rules (sulphuric acid) of 1980 (28) Cost Accounting Record Rules and Cost Audit Report Rules (steel tubes and pipes) of 1984 (29) Cost Accounting Record Rules and Cost Audit Report Rules (engineering industries) of 1984 (30) Cost Accounting Record Rules and Cost Audit Report Rules (electric cables and conductors) of 1984 (31) Cost Accounting Record Rules and Cost Audit Report Rules (bearings) of 1985 (32) Cost Accounting Record Rules and Cost Audit Report Rules (chemical industries) of 1987 (33) Cost Accounting Record Rules and Cost Audit Report Rules (formulations) of 1985 (34) Cost Accounting Record Rules and Cost Audit Report Rules (steel plant) of 1990 (35) Cost Accounting Record Rules and Cost Audit Report Rules (insecticides) of 1993 (36) Cost Accounting Record Rules and Cost Audit Report Rules (fertilizers) of 1993 (37) Cost Accounting Record Rules and Cost Audit Report Rules (scraps and detergents) of 1993 (38) Cost Accounting Record Rules and Cost Audit Report Rules (cosmetics and toiletries) of 1993 (39) Cost Accounting Record Rules and Cost Audit Report Rules (footwear) of 1996 (40) Cost Accounting Record Rules and Cost Audit Report Rules (shaving systems) of 1996

(41) Cost Accounting Record Rules and Cost Audit Report Rules (industrial gases) of 1996 318 AUDITING AUDITING BASICS I (42) Cost Accounting Record Rules and Cost Audit Report Rules (mining and metallurgy) of 2001 (43) Cost Accounting Record Rules and Cost Audit Report Rules (electronic products) of 2001 (44) Cost Accounting Record Rules and Cost Audit Report Rules (electricity) of 2001 (45) Cost Accounting Record Rules and Cost Audit Report Rules (plantation products) of 2002 (46) Cost Accounting Record Rules and Cost Audit Report Rules (petroleum industries) of 2002 (47) Cost Accounting Record Rules and Cost Audit Report Rules (telecommunications) of 2002 These cost accounting record rules are not applicable to a company though it falls under any of the above (i) if the aggregate value of the machinery and plant installed where in, as on the last date of the preceding financial year, does not exceed the limits as specified for a small scale industrial undertaking under the provisions of the Industries (Development and Regulation Act), 1951 and (ii) the aggregate value of the turnover made by the company from sale or supply of all of its products during the preceding year does not exceed ten crore rupees. The auditor has to make mention in his report about whether the enterprise has maintained proper cost accounting records as prescribed u/s 209(1)(d). Cost Accounting Standards (CAS) The ICWAI had pronounced following five cost accounting standards, which the cost accountants are required to consider in order to make a standard approach towards maintenance of cost accounting record and undertaking cost audit u/s 209(1)d and sec.233(B) of the Companies Act, 1956. These standards equip the cost accountants with better guidelines on standard cost audit practice. CAS 1- Classification of costs CAS 2- Capacity determination CAS 3- Overheads CAS 4- Cost of production for captive consumption CAS 5- Determination of average (equalized) transportation cost. CAS6- Material Cost CAS 7- Employee Cost CAS 8- Cost of Utilities CAS 9- Packing Material Cost CAS 10- Direct Expenses. CAS 11- Administrative Overland.

CAS 12- Repairs & Maintenance Cost. International Accounting Standards (IAS) The International Federation of Accountants had issued the following 41 accounting standards, though these standards are not mandatory, these provide a basis for development of accounting standards in individual country. IAS 1- Presentation of financial statements IAS 2- Inventories IAS 3- Consolidated financial statements (superceded by IAS 27 & IAS 28 in 1989) IAS 4- Depreciation accounting (replaced by IAS 16, 22 & 38 in 1998) IAS 5- Information to be disclosed in financial statements (superceded by IAS 1 in 1997) IAS 6- Accounting responses to changing prices (superceded by IAS 15, which was withdrawn in 2003) IAS 7- Cash flow statements IAS 8- Accounting policies, changes in accounting estimates and errors IAS 9- Accounting for research and development activities (superceded by IAS 38 in 1999) IAS 10- Events after the balance sheet date IAS 11- Construction contracts AUDITING 319 IAS 12- Income taxes IAS 13- Presentation of current assets and current liabilities (superceded by IAS 1) IAS 14- Segment reporting IAS 15- Information reflecting the effects of changing prices (withdrawn in 2003) IAS 16- Property, plant and equipments IAS 17- Lease IAS 18- Revenue IAS 19- Employee Benefits IAS 20- Accounting for government grants and disclosure of government assistance IAS 21- The effects of changes in foreign exchange rates IAS 22- Business combinations (superceded by IFRS 3 in 2004) IAS 23- Borrowing cost IAS 24- Related party disclosure IAS 25- Accounting for investments (superceded by IAS 39 & 40 in 2001) IAS 26- Accounting and reporting of retirement benefit plans IAS 27- Consolidated and separated financial statements IAS 28- Investments in associates IAS 29- Financial reporting in hyper inflationary economics IAS 30- Disclosures in the financial statements of banks and similar financial institutions (superceded by IFRS 7 in 2007) IAS 31- Interest in joint ventures IAS 32- Financial instruments presentation disclosure provision (superceded by IFRS 7 in 2007) IAS 33- Earning per share IAS 34- Interim financial reporting IAS 35- Discontinuing operations (superceded by IFRS 5 in 2005)

IAS 36- Impairment of assets IAS 37- Provisions, contingent liabilities and contingent assets IAS 38- Intangible assets IAS 39- Financial instruments IAS 40- Investment property IAS 41- Agriculture International Financial Reporting Standards (IFRS) The International Federation of Accountants had issued following International Financial Reporting Standards. Actually these standards are pronounced by the International Accounting Standard Board (IASB) constituted in place of old International Accounting Standards Committee (IASC) in 2001, this pronunciation has amended certain IAS by IFRS. These IFRS apply to the general purpose of financial statements and other financial reporting by profit oriented entities. These IFRS apply to individual company and consolidated financial statements. The ICA of India has decided to fully converge with IFRS from the accounting period commencing on or after 1st April 2011 IFRS 1- First time adoption of International Financial Reporting Standard IFRS 2- Share based payments IFRS 3- Business combinations IFRS 4- Insurance contracts IFRS 5- Non current assets held for sale and discontinued operations IFRS 6- Exploration for and evaluation of mineral assets 320 AUDITING AUDITING BASICS I IFRS 7- Financial instruments disclosures IFRS 8- Operating segments IFRS 9- Financial Instruments Guidance Notes : The ICWAI issued no. of guidance notes as for the benefit of cost accounts, which includes (i) guidance note on valuation audit under central excise law (ii) guidelines on central excise MODVAT audit (iii) guidelines on cost audit (iv) guidelines on inventory valuation (v) total cost management in the manufacturing process (vi) guidelines on transfer pricing (vii) guidelines on CenVAT audit under central excise (viii) Environmental audit. ICAI has also issued a number of guidence notes on different auditing aspects. 5.8 GENERALLY ACCEPTED AUDITING STANDARDS PRINCIPLES (GAAS/GAAP) GAAS/GAAP means the norms of auditing as per the provisions of law, accounting standards, auditing and assurance standard, pronunciations, guidance notes, research monograms etc. to be followed by the auditor while conducting

an audit and reporting the findings. The expression was first coined by the American Institute of Certified Public Accountants (AICPA) in 1963. The generally accepted auditing standards for comprehensive audit performance approved by AICPA are really like a light house. According to AICPA the auditor along with his training, knowledge and experience must be aware of and understand new authoritative pronouncements on accounting and auditing: He/she should be intellectually honest, free from any obligation to be recognized as independent. He should observe the standards in field work and reporting. (I) General Standards(i) Independence- The auditor, in all matters relating to the assignments, should follow an independent attitude. (ii) Due Care- In exercising the work of audit, the auditor should exercise due care. (II) Field Work Standards(iii) Planning and Supervision- Before the beginning of an audit, the audit work should be properly planned and the work assigned to assistants be carefully supervised. (iv) Internal Control- The internal controls existing in the enterprise be studied and evaluated before hand. (v) Evidential Matter- While auditing, auditor should collect the evidential documents to afford a reasonable basis for forming an opinion on the financial statements. (III) Reporting Standards(vi) Financial Statements- Auditor should make a mention whether the financial statements are prepared according to the Generally Accepted Auditing Standards/Principles or not. (vii) Consistency- He should make a mention whether these Principles/Standards are consistently followed including current year. (viii) Disclosure- If auditor does not make any adverse comment in his report; the financial statements are taken as reasonably adequate. (ix) Obligation- Auditor should submit his report, when the work is finished, stating clearly his opinion or if not possible make a mention there in that opinion cannot be expressed and in such a case support it with reasons. These formal standards/principles are framed in the context of statutory auditing but the AICPA suggest that while following these GAAP/GAAS, due consideration be given to materiality and audit risk. AUDITING 321 The International Federation of Accountants had issued following nine broad GAAP i.e. Basic Principles governing

an audit : 1. Integrity, Objective and Independence 2. Confidentiality 3. Skills and Competence 4. Work Performed by Others 5. Documentation 6. Planning 7. Audit Evidence 8. Accounting System and Internal Control 9. Audit Conclusions and Reporting A COMPARISON IGAAP US GAAP IFRS The features of US-GAAP and Indian Accounting Standards are clear from their differences. They are as follows :INDIAS GAAP VERSUS THE US GAAP Balance Sheet Basis of IFRS USGAAP IGAAP Difference Format IFRS does not prescribe any format, but stipulates minimum line items like PPE, Investment property, Intangible assets, Financial assets, Biological assets, inventory, receivables, etc. US GAAP also does not prescribe any format, but Rule S-X of SEC stipulates for listed companies minimum line items to be disclosed either on face of Balance Sheet or Notes to Accounts. IGAAP provides two format to Balance Sheet Horizontal and Vertical format (Part I of Schedule VI to the Companies Act, 1956). Order Under IFRS, line items are presented in increasing order of liquidity. Under US GAAP, items in assets and liabilities are presented in decreasing order of liquidity. In IGAAP, line items are presented in increasing

order of liquidity. Consolidation Consolidation of Financial statements of subsidiaries is not compulsory until it is required under some other law or regulation Under US GAAP consolidation of results of Subsidiaries and Variable interest entity (FIN 46R) is compuslory It is not mandatory for companies to prepare CFS under AS 21. However, listed enterprises are mandatorily required by listing agreement of SEBI to prepare and present CFS. Current/NonCurrent An organisation has an option to adopt Current or Non current classification of assets and liabilities Bifurcation into current & non-current items is compulsorily required. No such requirement 322 AUDITING AUDITING BASICS I Income Statement Basis of IFRS USGAAP IGAAP Difference Format IFRS does not prescribe any standard format for income statement but prescibes minimum disclosure includes revenue, finance costs, share of post tax results of JV and associates using equity method. There is no prescribed format, SEC guidelines Rule S-X prescribe minimum line items to be shown on the face of income statement & suggest 2 alternatives

(a) a single step format where expenses are classifed by function and (b) a Multiple step format where Cost of sales is deducted from sales Under Indian GAAP no format is prescribed, but minimum line items have been specified in Part II of Schedule VI to Companies Act, 1956 including Aggregate Turnover, Gross Service revenue for Commission paid to Sole selling agent, Brokerage and discount on sales etc. Prior Period Items A prior period item/error should be corrected by retrospective effect by restatement of opening balance of assets, liabilities or equities Mandates retrospective application of error and requires restatement of comparative opening balance with suitable footnote disclosure. Requires separate disclosure of prior period in the current financial statement & no restatement of retained earnings are required. Discounting IFRS provides that where the inflow of cash is significantly deferred without interest, discounting is needed. US GAAP also permits discounting in certain case fo instance discounting is done in case of loans, debentures, bonds and upfront fees There is no concept of discounting under IGAAP. Change in

accounting policy IFRS requires retroactive application for the earliest period practical and adjustment of opening retained earning. Requires prospective application of change in accounting policy and proforma disclosure of effect on income before extraordinary items on the face of income statement as separate section. Only in specific case retrospective is applicable. Under IGAAP, effect for change in accounting policy is given with prospective effect, if the same is material. Bifurcation of Cost There is no specific provision in this regard. Total cost is required to be shown separately under : (a) Cost of Sales (b) Selling and Administration (c) R & D There is no specific provision in this regard. There are certain disclosure requirements under varied AS which should be complied. Extra ordinary Events Disclosure is prohibited Nature should be both: (a) Infrequent (b) Unusual Disclosed separately on the face of Income Statement net of Taxes after results from operations Distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly. The nature and the amount of each

extraordinary item should be separately disclosed in the statement of P&L in a manner that its impact on current profit or loss can be perceived. AUDITING 323 Cash Flow Statement Basis of IFRS USGAAP IGAAP Difference 5.9 CONCEPT OF MATERIALITY IN AUDITING The concept of materiality is fundamental to the process of aggregation, classification and presentation of accounting information. It is an important and relevant consideration for an auditor who has to constantly judge whether a particular item of transaction is material or not. Obviously an auditor requires more reliable evidence in support of material items. He also has to ensure that such items are properly and distinctly disclosed in the financial statements. According to AS 1, materiality means, the knowledge of the items disclosed in the financial statement, which might influence, the decision of the user of the financial statement. According to SA 320, information is material if its misstatement (i.e. omission or erroneous statement) could influence the economic decision of user taken on the basic of the financial information. Materiality depends on the size and nature of the item, judged in the particular circumstances of its misstatement. The following are some of the specific requirements in the form of Balance Sheet based materiality consideration implicit in the very process of prescribing the format in Part I of Schedule VI. 1. Loans from directors to be shown separately. 2. Nature of interest if any, of any director with the bankers or other officers of the company at any time during the year should be disclosed by way of a note. 3. The maximum due by directors or other officers of the company at any time during the year should be disclosed by way of a note. Exemptions No Exemptions Limited exemptions for certain investment entities Unlisted enterprises, enterprises with a turnover less than ` 500 million and those with borrowings less than ` 100 million Direct/Indirect Method

Both allowed Both allowed Both allowed. Listed companies- Indirect method Insurance companies- Direct Method Periods to be presented 2 years 3 years 2 years Interest paid Operating and financing activity Operating activity (to be disclosed by way of a note) Financing. In case of a financial enterprise, operating activities Interest received Operating or investing activity Operating activity Investing. In the case of a financial enterprise, operating acitivity. Dividends paid Operating or financing Financing Financing Tax payments Operating Operating (to be disclosed by way of a note) Operating Dividends received Operating or investing Operating Investing. In the case of a financial enterprise, operating activity. 324 AUDITING AUDITING BASICS I Further whenever there is any change in the basis of accounting, the effect thereof must be disclosed. Audit Materiality requires that the auditor should consider materiality and its relationship with audit risk when conducting an Audit. Circumstances of Materiality According to the ICFAI the circumstances of materiality are as under (i) Mistake discovered like valuation of stock, calculation of depreciation, calculation of interest, estimation of liability etc. (ii) Non-disclosure of abnormal and unusual items or non-recurring income or expenditure etc. (iii) Non-disclosure of items violating the statutory provisions etc. Materiality and Audit Risk A risk occurring due to insufficient or incompetent evidence collected by the auditor to express his opinion on the financial statement is called as an audit risk. In case of debtors appearing on balance sheets, auditor has to express

whether the figure is materially correct or not and for that he should collect the reliable confirmations from almost all debtors. According to International Federation of Accountants, audit risk includes : (i) Internal Risk- Risk that material error will remain (ii) Control risk- Risk that clients internal control system cannot prevent or make up for such error. (iii) Detection risk- Risk that material errors though they are there, will not be detected. Audit risk means, the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. This audit risk had three components as stated above by IFA. There is an inverse relationship between materiality and the degree of audit risk i.e. the higher the materiality level, the lower the audit risk and lower the materiality level, the higher the audit risk e.g. the risk that a particular account balance or class of transactions could be misstated by an extremely large amount might be very less, but the risk that could be misstated by an extremely small amount might be very high. The auditor takes the inverse relationship between materiality and audit risk into account when determining the nature, timing and extent of audit procedure e.g. if after planning for specific audit procedures, the auditor determines that the acceptable materiality level is lower, audit risk is increased. The auditor compensates for this by (i) Reducing the assessed degree of control risk, where this is possible and supporting the reduced degree by carrying out extended or additional test of control. OR (ii) Reducing detection risk by modifying the nature, timings and extent of planned substantive procedures. If the aggregate of the uncorrected misstatements, that the auditor has identified, approaches the materiality level or if auditor determines that the aggregate of uncorrected statements cause the financial information to be materially misstated, he could consider requesting the management to adjust the financial information or extending his audit procedures. In any event, the management may want to adjust the financial information for known misstatements. The adjustment of financial information may involve application of appropriate accounting principles, other adjustments in amounts or the addition of appropriate disclosures of inadequately disclosed matters. If the management refuses to adjust the financial information and the results of extended audit procedures do not enable the auditor to conclude that the aggregate of uncorrected misstatements is not material, the auditor should express a qualified or adverse opinion, an appropriate. AUDITING 325

Study Note 6 AUDITING BASICS II This study note includes ! Verification of items in the Profit & Loss Account. ! Verification of Fixed Assets, Investments, Inventories, Debtors, Loans & Advances, Cash & Bank Balances Debentures and Creditors, Provision for Taxation, Proposed Dividend & Gratuity, Contingent Liabilities, other items in the Balance Sheet. ! Disclosure of Accounting policies, practice, expenditure during the period of construction. ! Adjustments for Previous year. ! Provisions of the Companies Act, 1956 regarding accounts. ! Statistical Sampling in Auditing. ! Use of Ratios and Percentages for comparison and analysis trends. ! Inter firm and Intra firm comparison. 6.1 VERIFICATIONS OF ITEMS IN THE PROFIT AND LOSS ACCOUNT To verify the correctness of Profit or Loss exhibited by the Profit & Loss account, it is essential to check the items in the Profit & Loss account; these items are firstly verified from the ledger balances but this is not sufficient, the ledger balance of each item be verified from the original book of entry and the transactions regarding each item appearing on the original book of entry be checked from the original source documents. Generally, these basic documents, on the basis of which the accounting record gets created is called as Vouchers. Voucher : By vouching we mean examination of entries in the books of prime entry with the documentary evidence. This is necessary to verify the genuineness of the document, (authenticity) legitimateness of a transaction, appropriateness, existence of approval (authorisation) and correctness of recording. From the above definitions one can understand that, vouching means (i) An examination by the auditor (ii) Examination of Supporting documents (iii) To authenticate the transactions entered in the books of Accounts Importance of Vouching : The most important step in all types of audit is vouching of business transactions as a voucher is a foundation stone on which whole of the accounting structure stands. The importance as well as the objects of vouching can be explained as under (a) Detection of Errors & Frauds Careful vouching assists the auditor to detect errors & frauds. (b) Reduce liability of Auditor An efficient vouching reduces the auditors liability to considerable extent. (c) Moral check on employees Detailed vouching also acts as a moral check on employees.

(d) Back Bone of Auditing Vouching done with care and caution makes an auditor to proceed well further in his work as it helps in carrying out further scrutiny with ease to satisfy him that the financial books reveal the true position of the business. (e) Compliance with Law Auditor gets satisfied that the transactions are complying with the provisions of different laws, in particular the Companies Act. (f) Capital & Revenue Expenditure Vouching ensures the proper allocation of expenditure into Capital and Revenue. 326 AUDITING AUDITING BASICS II (g) Genuineness of Transactions Auditor ascertains that no dummy transactions are recorded. (h) Nature of Transactions Auditor ascertains that the transactions are related to the nature of the business carried on by the client. (i) Accounting period It enables auditor to verify the transactions related to other periods other than the period under audit. (j) Accounting Auditor can verify whether whole accounting work is properly carried through. (k) Easy conduct of Audit The efficient vouching creates a picture regarding organizational frame work in the mind of auditor facilitating easy conduct of audit. Important points to be considered while vouching (1) All the vouchers are serially numbered & filed in order of the entries in the accounts. (2) Attention should be paid to the dates which must correspond to the audit period. (3) The auditor should see whether the voucher is in the name of client. (4) He should see whether the amount written in figures and words is correct. (5) He should ensure whether the account head is properly written or not. (6) He should also see whether the voucher is signed by the recipient of the amount. (7) He should ensure whether the voucher is properly authenticated. (8) Auditor also see whether the expenditure shown is reasonable or not. (9) He should see whether the expenditure is for the cause of the business. (10) In case of expenditure exceeding `5,000/- auditor should ensure whether the revenue stamp is affixed on the voucher or not. (11) Auditor should see whether the voucher is properly accounted in the books or not. Verification of certain items in Profit & Loss Account : (1) Sales (a) Cash Sales Sales is the most important area where chances of errors & frauds are greater, hence, while verifying the cash sales, the auditor should go through the following steps (i) Initially, the auditor should carefully verify the effectiveness of existing internal check system

regarding cash sales. (ii) If he finds that the internal check system is efficient, he may rely thereon and may use test checking system. (iii) If the internal check system is not reliable, he may resort to exhaustive verification of cash sales transactions. (iv) The auditor should verify the carbon copies of cash memos and should check date, particulars of goods sold, their rates, calculation, taxes etc., (v) Check & reconcile summary of cash sales and cashiers report (vi) Check whether the proper entries for Cash Sales have been passed in the cash book or not (vii) Similarly, auditor may also, verify transactions in store register to ensure proper delivery of goods sold on cash basis. (b) Credit Sales Auditor must be more careful while verifying the credit sales as documentary evidence is not as conclusive as in the case of Purchases. Following steps prove useful while verifying credit sales (i) See that the internal check system in regard to credit sales is efficient. (ii) If the internal check system is efficient auditor may apply test check. (iii) If the internal check system is not efficient or not in existence, the auditor should disown his liability. AUDITING 327 (iv) Compare the invoice with sales book to ascertain whether dates appearing on both the documents is same or not. (v) See that all sales invoices are recorded in the Sales book to ascertain whether payment made by the debtor is not misappropriated. (vi) To ensure the current recording of all credit Sales, check the order received book, goods outward register, Gate keepers register, Delivery notes, Invoices, Railway Receipts or Transport Receipts etc., (vii) Check that the sale of assets is not included in the Sales book. (viii) Check the return inward book, to ascertain the returns, with reliable supporting documents. (ix) To ascertain the fictitious sales or returns, check the Sales Book of few weeks prior to the closing of the year and check the Return Inward Book for few weeks after the close of the year. (x) See that all credit sales from sales register are posted to respective ledger accounts. (xi) Check the total of sale Book & ledger accounts.

(xii) Get the confirmation certificates / letter from the debtors and compare them with the ledger balances. (xiii) Cancelled invoices be checked with the duplicate copies of the invoices. (xiv) See that Sales Tax / VAT, insurance, transport charges are properly accounted for. (xv) Check the sales shown to subsidiaries, interested parties to ascertain fictitious sales with intention to inflate profit. (xvi) Enquire if the discount rates are different to different customers. (2) Purchases Auditor should examine whether the cost of purchases have been properly computed, in accordance with AS2. Special attention should be paid to related party transactions as explained in AS 18. A Management certificate be obtained regarding compliance with legal and regulatory requirements. Compare current years quantity and value, ratio of output to input etc., with that of previous year. He should examine the selected entries in the purchases book with invoice; goods receipt note and other supporting documents. Auditor should also examine the payments after balance sheet date to ascertain unrecorded purchases. He should also, look into the following points (i) Check first of all, the efficiency of internal check system. (ii) Verify whether purchase orders are properly authorized or not. (iii) Verify the purchase requisitions & quotations at random. (iv) Check the purchase invoices to ascertain whether they are in name of client, whether they tally with purchase orders, goods received notes, stock register and whether from the concerned supplier. (v) Compare the invoices with quotations to ascertain if the prices changed are according to quotations or not. (vi) See that all invoices are recorded in register or not. (vii) Check the posting from purchasers register to respective ledger accounts. (viii) Get confirmation letters from creditors and verify the ledger balance. (ix) See that purchases of capital assets are not included in purchases register. (x) Check the totals of purchases register & ledger accounts. (xi) Verify whether credit purchasers are properly exhibited in final accounts. (xii) Verify selected entries in purchases return book with reference to goods return note, debit note and concerned entries in creditors account. (xiii) Verify Bill of Lading, Customs clearance document in relation to imported goods. (3) Wages (i) Auditor should satisfy himself about the efficiency of the internal check system in operation. 328 AUDITING AUDITING BASICS II

(ii) Compare the current years total wages, monthly wages, wages of each dept., ratio of wages to Sales, ratio of wages to cost of production, ratio of P.F. Contribution and E.S.I. contribution to wages etc., to that of previous year. (iii) Check selected entries in the wages sheet with attendance record. (iv) Check different deductions for I. Tax, P.F. E.S.I. etc., with the challans or returns submitted to the concerned departments. (v) Examine the agreement with trade union, specific awards of courts, provisions of different labour laws to ascertain their compliance. (vi) Examine the sanction of Casual Labour by a competent authority; check the attendance record, and also the terms of appointments. (vii) See that retired, expelled and resigned workers are not included in the wages sheet and for that get a list of such workers. (viii) See that the preparation of wages sheet and payment of wages sheet is not done by the same person. (ix) Disown his liability if he finds any loophole in the system of payment of wages. (x) Check the totals, sub totals of wages sheet. (xi) Check the calculations of few items here and there. (xii) Compare the total amount payable per wages sheet and the cheque drawn for the purpose to see that more money is not drawn than required. (xiii) See that the amount of unpaid wages is paid into bank immediately. (xiv) Compare the names of some workers, appearing in the wages sheet with the Time Cards, Job Cards, Foremans Register and find out whether dummy workers are included in wages sheet. (xv) Verify whether the wages sheet is authenticated by the persons who prepared it. (xvi) If possible he may pay surprise visit at the time of actual disbursements of wages and see whether internal check is followed properly and whether wages are paid to the workers on presentation of their identity cards. (xvii) Compare the sanctioned strength of workers with the wages sheet. If the numbers of workers in wages sheet found are more, he should enquire into by verifying the respective files of personnel department. (xviii) Detect ghost workers appearing in wages sheet by comparing it with ESI Cards, P.F. deductions etc. (xix) Compare the current months wages sheet with that of last month, if increase in number of workers found enquiry must be made. (xx) Signatures or attested thumb impression etc., be checked.

(xxi) Examine the leave register to find out whether leave is sanctioned with pay or without pay. (xxii) To examine the genuineness of the workers signatures, compare them with Past two-three wages sheets and if required ask few workers to sign before you. (xxiii) See that wages are properly allocated and accounted. (4) Salaries Along with the above points for verifying salaries, following points should also, be considered (i) Compare current years salary, ratio of salary to sales, ratio of salary to production cost, ratio of P.F. contribution to salary, with that of last years. (ii) Examine terms of contract and pay special attention to stock option, leave encashment, ex-gratia payment etc., (iii) Check the Salary register to ascertain the actual payment of salary (iv) Calculate & check that deductions made from Salary are properly accounted for and paid to the appropriate authorities in time. (v) Verify the genuineness of the signature of employees in salary register by comparing them with previous two-three months. AUDITING 329 (vi) Check whether the salary of each employee gets credited directly to the employees personal bank account and if paid in cash see whether cheque drawn tallies with that of payment made to the employees. (vii) See whether proper accounting of the payment of salaries is done. (viii) Check whether increment given to employee was actually due; examine the copies of appointment letter and approval. (ix) Check the Return on payment of salaries and TDS therefrom submitted to Income tax department to ascertain, whether total tax deduction from employees salary tally with the returned amount or not. (5) Retirement Benefits (i) Auditor should examine that amount payable for retirement benefits like P.F., Pension, Gratuity etc., is in accordance with the provisions of the concerned laws and also the agreement with the employees. (ii) Auditor can use the work done by an expert in this regard i.e. can use the certificate got by the client from actuary. (iii) If actuarial certificate is not available he should examine the rationality of the method used in calculating the various benefits. (6) Interest Paid

(i) Check that amount of interest with the loan agreement. (ii) Compare current years ratio of interest to average loans outstanding with that of previous years. (iii) Verify the interest in accordance with the principles laid down in AS 16 (7) Depreciation (i) Verify the rates and methods of depreciation used with reference to generally accepted accounting Principles, particularly, as laid down in AS 6. (ii) Check the Calculations of depreciation. (iii) Compare current years amount of depreciation with that of previous year. (8) Income Tax (i) Check the calculations of Income Tax paid and provided and its disclosure in accordance with AS 22. (ii) Verify whether appropriate Provision is made for MAT, FBT etc., (iii) Check the adjustments relating to assessment completed upto the audit. (iv) Verify whether the accounting treatment and disclosure of disputed tax liability is made with reference to the concerned accounting standards. (v) Check the accounting treatment relating to the Pending tax matter. (vi) Verify the challans of Income Tax paid. (vii) Check the accounting year for which Income Tax is paid. (viii) Verify the assessment order. (ix) See the interest and / or penalty for late payment of tax and filling return of Income is also accounted properly. (x) Check the calculations & Payments of advance tax with challans and last years liability and instruct the client accordingly. (xi) See whether tax audit is applicable and done accordingly. (9) Excise Duty : (i) Check the Daily Stock Account to verify the excisable value and calculation of duty. (ii) Compare the current years ratio of excise duty to the cost of Production with that of previous year. (iii) Verify the different circulars of CBE & C exempting certain goods from duty. (iv) Check the CENVAT record to ascertain whether credit taken is right or wrong. (v) Vouch the challans for payment of duty. 330 AUDITING AUDITING BASICS II (vi) Verify the deposits against payment of duty kept with the government and its utilization. (vii) Compare the Excise Returns with the actual payments made. (viii) Check the invoices here and there to verify the duty paid and cenvat credit availed. (ix) Check whether the payment of excise duty is duly authorized by the responsible person. (x) See that the refunds if any are taken into account while providing for Income Tax. (xi) See that the related items are exhibited in final accounts.

(xii) Calculate the undisputed excise duty, but outstanding for more than 6 months and see that it is properly exhibited in the final accounts. (xiii) See Whether at the time of accounting the guidance note issued by the ICAI is properly followed (10) Custom Duty (i) Check the payment of duty with the bill of entry, challans, clearing Agents bill etc., (ii) Check whether proper accounting is done. (iii) See that the consumption of imported material is properly exhibited in final accounts. (iv) See that undisputed custom duty outstanding for more than 6 months has been properly exhibited in final accounts. (v) See that deduction claimed for import duty on the materials used for production of exported goods from income tax is correct and after considering the amount of refund of custom duty. (11) Sales Tax / Vat (i) Compare the current years ratio of Sales tax / VAT to Sales effected with that of previous year. (ii) Vouch the payment of Central Sales tax and VAT with challans and return of payment. (iii) See whether VAT audit is applicable if so is the audit completed within prescribed time limit. (iv) See that the accounting of set off if any, of payment of tax is properly made and exhibited properly in final accounts. (v) Verify the assessment order to calculate the short or excess payment and accounting done accordingly. (vi) Check the assessment year in regard to payment of tax. (12) Know How (i) Check the minute book to see that acquiring Know how is properly sanctioned. (ii) Auditor should see that Know How is properly accounted in the books(a) If it is related to Plant & Machinery, it should be capitalized. (b) If it is regarding manufacturing process, it must be debited to P & L A/c. (c) If lump sum amount is paid for both the amount be allocated between capital & revenue appropriately. (d) Regular payment like royalty etc. be charged to P & L A/c. (13) Dividend / Interest Received (i) Compare the current years ratio of Dividend / Interest to the average investment with that of previous year. (ii) Interest received on fixed deposit be vouched with the fixed deposit receipt and the pass book. Auditor should satisfy that the Pass book presented is genuine one. (iii) Check the Dividend received with the Counter Foil A Dividend warrant and the covering letter and Pass book entries.

(iv) Interest received on Securities be vouched with the securities certificates for the calculation of interests. (v) Ensure that the outstanding interest is properly provided in accounts. (vi) Check the brokers note and confirm whether the interest or dividend received subsequently in case of investments purchased or sold Cum-Dividend or Ex-Dividend, Auditor should also see whether in this case proper allocation is made between capital and revenue. (vii) Interest received on loans granted can be vouched with the borrowers agreement. AUDITING 331 (14) Commission Received (i) Compare the current years ratio of commission received on the sales with that of previous year. (ii) Commission be verified with accounts of the parties from whom it is received. (iii) The rate of commission be verified in the agreement with the Parties. (iv) Amount shown in cash book be checked with the counter foil of the receipt. (v) Calculations of the amount of commission also be checked. 6.2 VERIFICATION OF ASSETS AND LIABILITIES Only the vouching to ascertain the arithmetical accuracy is not enough, the auditor is supposed to go beyond that while doing audit. In all types of transactions vouching is must, but in case of capital items the auditor is required to go beyond that and verify the physical existence and evaluate the assets and liabilities to arrive at true and fair view of the state of affairs of business. Now a days it is statutory liability of the auditor to verify assets & liabilities and if he fails he is held liable for negligence. e.g. in London Oil Storage Co. Ltd., Vs Seear Husluck and Co., (1904), Acct. L.R. 30-93, it was held that an auditor, who fails to verify the existence of assets as shown in the balance sheet of the company, is liable. In another case, Arthur E. Green & Company Vs. The Controller, Advances & Discount Corporation (1920) Act, LR xiii, it was held that an auditor is guilty of negligence, if he fails to detect time barred debts within the schedule of debts. Verification, as defined by Spicer and Pegler, is An enquiry into the Value, Ownership, Title, Existence, possession and presence of any charge on the assets, while according to Lan Caster, The verification of assets is a process by which the auditor substantiates the accuracy of the right hand side of the balance sheet, and must be considered as having three distinct objects (a) the verification of the existence of assets (b) the valuation of assets and (c) the authority of their acquisition. Meaning Verification means Proving the truth. An auditor has not only to see the arithmetical accuracy and

bonafides of the transactions in the books of accounts by vouching only, but has also to see that the assets as recorded in the balance sheet actually exists. The fact that there is an entry regarding purchases of an asset and has been found to be currently recorded, is not a proof that the asset is in the possession of the concern at the date of balance sheet. It is possible that after the asset had been acquired and the necessary entries made in the books of accounts, the asset might have been disposed of or pledged or mortgaged and no entry had been made regarding these facts in the books of accounts before the closing of the financial year. He has also to see whether a particular asset as appearing in the balance sheet exists or not. Verification of liabilities is also as important as the verification and assets. If the liabilities are overstated or understated, the balance sheet will not represent a true and fair view of the state of affairs of the Company. In short, verification is a function of examining assets & liabilities to check (i) Value (2) Ownership (3) Title (4) Existence (5) Possession and (6) to see whether the assets are free from any charge or encumbrance etc. Importance of Verification Verification is very important function from view point of both, the auditor and the client as it gives clear idea as to true and fair view of balance sheet. The importance of verification may be described as under (a) True and fair view of Balance Sheet verification of assets and liabilities enables the auditor to comment on true and fair state of affairs of the business. (b) Valuation verification enables the auditor to determine whether the assets or liabilities are overstated or under stated. (c) Omissions verification facilitates the act of confirming the omission of any asset or liability in the balance sheet. Scope of Verification verification includes confirming of whether the assets were in existence on the date of balance sheet, whether assets had been acquired for the purpose of business only, whether the assets had been acquired under a proper authority, whether the right of ownership of the assets vested in the enterprise, 332 AUDITING AUDITING BASICS II whether the assets were free from any charge and whether, the assets were properly valued and disclosed in the balance sheet.

Objects of Verification verification of assets and liabilities is done with the following objects (i) To know whether the Balance-Sheet exhibits a true and fair view of the State of affairs of the business. (ii) To find out whether the assets were in existence (iii) To find out the ownership and title of the assets (iv) To show correct valuation of assets and liabilities (v) To verify the arithmetical accuracy of the books of accounts (vi) To ensure that the assets have been recorded properly (vii) To detect frauds & errors, if any (viii) To find out whether there is an adequate internal control regarding acquisition, utilization and disposal of assets. Advantages of Verification Careful verification of assets fetches the following advantages to the client (a) It avoids manipulation of accounts (b) It guards against improper use of assets (c) It ensures Proper recording and valuation of assets. (d) It exhibits true and fair view of the state of affairs of the Company. Technique of Verification Auditor may adopt the following techniques for verification of assets & liabilities. (1) Inspection This means physical inspection of the assets like counting cash in hand, measuring inventory, inspection of securities, share certificate etc., (2) Observation The auditor may observe or witness the inspection of assets done by others. (3) Confirmation This means obtaining written evidence from outside parties regarding existence of assets like, confirmation from Debtors and Creditors about the balance outstanding etc., How to conduct the verification work (I) Examine the documentary evidence and see that the assets are properly recorded in the books of accounts. (2) Verify the opening balance from the schedule of fixed assets, ledger or register. (3) Verify acquisition on the basis of orders, invoices, title deeds etc., (4) Verify the self constructed assets on the basis of contractors bill, work order etc., (5) Ensure that the fully written off fixed assets are properly recorded. (6) See the authority of disposal of fixed assets. (7) Follow a proper procedure to ascertain the omissions, if any. (8) Verify ownership of the fixed assets on the basis of title deeds. (9) Verify existence of assets by physical verification. He should ensure that the physical verification of assets is carried out by the management. (10) Test check the records of fixed assets with physical verification reports and see that discrepancies, if any, are properly dealt with.

(11) See whether the assets are charged. He should verify the Loan Agreements, Register of charge, Board Resolution, Share Holders Resolution etc., (12) He should keep in mind the following points while verifying the assets & liabilities (a) Whether the assets and liabilities are properly traced from ledger to Balance Sheet (b) Whether the assets are acquired for the business and liabilities got created for the purpose of business and are clearly stated in the Balance Sheet. AUDITING 333 (c) Whether the assets and liabilities are properly grouped under specified heads in the balance Sheet. (d) Whether the assets & liabilities are in actual existence on Balance Sheet date. (e) Whether along with ownership the possession of assets lies with the client. (f) Whether the assets are properly valued in the Balance Sheet (g) Whether the liabilities stated in the Balance Sheet tallies with the confirmation certificate. Actual Verification of Assets & Liabilities : (1) Plant & Machinery : As in case of industrial concern out of total assets 20% to 50% cost is that of Plant & Machinery and hence the auditor is required to take much more precaution while verifying the Plant and Machinery and for this he should give attention to following points (i) He should get the detailed list of all Plant and Machineries and asset wise accumulated depreciation. (ii) He should trace the opening balance in the Plant & Machinery register with the help of last years audited balance sheet. (iii) He should verify quotations, invoices, cost etc., in connection with Purchase of Plant & Machinery. (iv) If there are sales of Plant & Machinery in audit period he should verify the invoice to that effect. (v) He should check the Board Resolution authorizing Purchases of Plant & Machinery. (vi) If any machinery is disposed off and sold as scrap during the audit period, he should check the authorization and valuers report in that connection. (vii) He should check the rates and calculation of depreciation and ensure these are according to the provision of Section 205 of the Companies Act, 1956. (viii) He should check whether related expenses incurred on purchases of machinery are duly capitalized. (ix) He should check whether proper accounting of profit earned or loss suffered on Sale of Machinery, during the audit period, is done. (x) If any machine is manufactured by the client it self, auditor should verify that capitalization of material, labor and other expenses is properly done.

(xi) He should obtain from the Company management certificate about the verification of all items as required under CARO. (xii) He should scan the Plant register and physically inspect some of the major plants by visiting to the works. (xiii) He should, finally, ensure appropriate disclosure of all information on the balance sheet as required by the Companies Act. (xiv) He should obtain a certificate from the local auditor to that effect, if Plant and Machinery is kept abroad at a distant place. (2) Freehold Land and Building : (i) He should see that Freehold Land and Buildings are shown separately and not mixed with lease hold or other assets. (ii) He should see that separate accounts for land and for buildings are mentioned because on land usually no depreciation is provided. (iii) He should see that the balance shown on Balance Sheet is directly traceable from respective ledger account. (iv) He should examine the title deeds of the property and see that the asset is in the name of the client and in the free and fair possession of the client. (v) He should examine that the title deed is genuine. (vi) The Purchases during the year be examined with the related correspondence, brokers note, auctioneers note. 334 AUDITING AUDITING BASICS II (vii) In case of construction of the building auditor should examine the various certificates such as Builders certificate, Contractors certificates, Architects certificate, Local authority certificate where needed. (viii) He should verify the sale, if a part of property has been sold during the period under audit. (ix) He should obtain a certificate from mortgagee if the property has been mortgaged and the deeds are with the mortgagee to verify the property. (x) Land is not subject to depreciation but see that proper depreciation is provided on building as per the provision of Sec 205 of the Companies Act, 1956. (xi) See that the fluctuation in the value is not to be considered on Balance Sheet but if it has been considered then see that this is properly disclosed on Balance Sheet.

(xii) Auditor should physically verify the existence of asset. (3) Imported Plant & Machinery : (i) The Auditor should examine the directors Minute Book for the resolution passed authorizing the purchases. (ii) The Auditor should check the RBIs permission and the import License. (iii) The Auditor should examine the agreement with the foreign supplier, particularly check the terms of payment, interest rates and the basis of deferred Payment. (iv) The Auditor should vouch the bills & receipts relating to purchases, customs duty payment, clearing & shipping charge, insurance premium etc., (v) The Auditor should check the entries made in the books of accounts. (4) Lease hold property : (i) He should see that the leasehold property account is separately maintained in the books. (ii) See that the property is in possession of client. (iii) Examine the lease deed to find out its value & period. (iv) See that the lease deed is properly registered with the Registrar. Because a lease exceeding one year is invalid unless it has been granted by a registered document. (v) See whether sublease is valid as per sublease agreement, in case it is granted by referring to lease agreement. (vi) Ascertain those conditions, the failure of which might result in the forfeiture or cancellation of lease and see whether they have been properly complied with. (vii) See that the lease rent and other expenses like insurance etc., regularly paid. (viii) In case any provision is required to be made for dilapidation (Payment on the expiry of the term of lease) see that the same is properly and continuously provided and amortized over the period of the lease. (ix) See that the depreciation on lease is provided by Straight line method including that of land too. (x) See that the written down value of lease is properly shown on Balance Sheet. (xi) Though lease property cannot be mortgaged, it can be sublet and if it is so, the auditor should check the agreement with the sub-lessees. (5) Furniture & Fixtures : (i) Generally, furniture, fixtures and fittings are shown as one asset in the Balance Sheet, but auditor should remember that there is a distinction between them. Furniture, is movable e.g. chairs, fixture is tightly fixed to the ground e.g. science laboratory, while fittings are fitted on the walls e.g. electric wiring.

(ii) See that furniture, fixture & fittings register is properly maintained. (iii) Verify that the balance from the register is correctly posted on the Balance Sheet. (iv) See that proper depreciation is charged in each class as per the provision of section 205 of the Companies Act, 1956. AUDITING 335 (v) Check the invoices, quotations, orders and authorizations in regard to new purchases of furniture during the years. (vi) Verify the sale of furniture and authorization for sale. (vii) Check whether proper accounting is done for any profit earned or loss suffered on sale. (viii) Physically verify the existence of the furniture, fixture & fittings. (ix) If acquired on lease, examine the conditions of lease and see whether these are followed duly or otherwise the lease will be forfeited. (6) Motor Vehicles : (i) Ensure whether the concern is maintaining proper and separate register giving full particulars of vehicles. (ii) Check up whether opening balances have been properly traced in the register or not. (iii) Check up whether the entries regarding new purchases and sales of old vehicles have been properly recorded or not. (iv) Check up various documents such as agreement, invoices, bills, orders, authorizations etc., relevant to purchases & sales. (v) Check the auctioneers statement, valuers report etc., in case of sale of vehicle as scrap. (vi) See profit earned or loss suffered on sale is properly accounted. (vii) Verify whether fair depreciation on vehicles is provided or not. (viii) Verify registration & license to see all the vehicles are in the name of the auditee or not. (ix) Verify physically all the vehicles by inspecting their registration numbers. (x) Check the certificate from lender in case R/C book of any vehicle is lying with the lender. (xi) See whether proper insurance on vehicles are paid or not. (7) Goodwill : Goodwill is intangible but not a fictitious asset and as such has value so long it remains with the business. Therefore its value depends upon the earning capacity of the business and fluctuates accordingly. Auditor, while verifying the goodwill, will take into consideration the following points (i) Auditor should see how the goodwill gets created, if there was no opening balance, verify the value from the agreement of purchasers of business, minute books etc., (ii) Opening balance be verified from last years audited Balance Sheet.

(iii) He should check the accounts and compare goodwill account with the Balance Sheet to ensure that goodwill account is clearly stated in the Balance Sheet and no other asset is mixed with it. (iv) Satisfy himself by making a reference to the Articles of Association or Partnership Deed, as the case may be, if value of goodwill is enhanced or reduced during the year under audit. (v) Since goodwill is an intangible asset, verification of charge on it doesnt arise. (vi) As goodwill is always valued at cost, a question of providing depreciation on it doesnt arise. (8) Investments : (i) Insist on a schedule of investments, when number of investments held by the auditee is very large. (ii) Examine the investment schedule with reference to the relevant ledger accounts. (iii) See that the investments have been shown properly in the Balance Sheet (iv) He should verify the existence of investments by inspecting the certificate, deposit receipts etc., (v) Obtain a certificate from bank of certain securities given to the bank for safe custody. (vi) Examine the transfer deed, brokers contract note if certificate of investments is not received upto the date of audit of the securities purchased during the year under audit. (vii) Examine the trust deed if securities are held by a trust on behalf of the client. 336 AUDITING AUDITING BASICS II (viii) Verify the Sales proceeds from pass book of the sale of any securities made after the date of Balance Sheet but before the audit. (ix) Verify relevant vouchers and certificates whether securities are free from any charge or not (x) See whether investments are properly valued or not giving consideration to the provisions of the Articles of Association in case of trust companies as they are valued at cost but in case of finance companies they are valued, being traded as current assets, at cost price or market price, whichever is less. (xi) See that regarding the investments in subsidiaries, disclosure requirements of section 212 are complied with. (xii) Check the balance in the schedule of investments in the name of the client and compare it with the general ledger and Balance Sheet. See that the investments are in the name of the client. (xiii) See that investments made by the company are not contrary to the provisions of section 372 of the Indian Companies Act, 1956.

(xvi) In case of application money paid for shares which are still to be allotted, the fact is to be specifically disclosed in Balance Sheet. (xvii) Confirm that uncalled amount on partly paid shares held as investment is shown as contingent liability in Balance sheet. (xviii) The auditor has to report, as per section 227 of the Companies Act, whether any shares, debenture sold at price lower than their cost, in the case of finance company, whether proper records of investments are kept. (xix) While auditing the investments the auditor should keep in mind the provisions of AS 13. (9) Patents, Trade Marks and Copy Rights : (A) Patents (i) Examine the patents and verify them with the help of the certificate from the party granting the patents. (ii) Ensure that the patents are duly registered in the name of the auditor. (iii) Verify the voucher, pass book, agreement, authorization etc., in case of outright purchases of patents and see that the cost is fully capitalized. (iv) Check the renewal fees, if any, paid is debited to Profit and Loss Account. (v) In case of patents developed by the client, expenditure incurred on its development, should be capitalized. (vi) Call for schedule in case the number of patents is large and examine the dates and acquisition, description and expiry date etc., (vii) Question of charge on patents does not arise as it itself is a right in use. (viii) See that proper depreciation is provided on patents as per the provision of the Companies Act. (B) Trade Marks (i) See that the trade marks are registered in the name of the auditee. (ii) See whether it is shown distinctively in the Balance Sheet. (iii) Check the Assignment Deed to ascertain the Terms and Conditions of the acquisition of Trade Marks to see whether the terms are followed properly. (iv) Obtain a schedule of Trade Marks if those are in large numbers. (v) See that the renewal fee is regularly paid. (vi) Verify the valuation of Trade Marks to see whether it is properly done or not. (C) Copy Rights (i) Verify copyrights with agreements. (ii) See whether revaluation of copyrights is made properly and profit or loss is properly accounted. AUDITING 337 (iii) Obtain the certificate of approved valuer to that effect.

(iv) See that the balance exhibited on balance sheet can be traced from ledger account. (v) Verify the opening balance from last years audited balance sheet. (10) Sundry Debtors (i) Trace the opening balance from last years audited Balance Sheet. (ii) Obtain Sundry Debtors schedule from the management and compare it with ledger accounts. (iii) See the debtors are shown properly on Balance Sheet. (iv) See that the provision for bad debts, discounts etc., is properly made. (v) Examine the relevant vouchers, minute book for verifying whether bad debts written off are correct or not. (vi) See that the legal requirements of schedule of the Companies Act, 1956 are duly complied with. For this purpose the debtors are to be classified as (a) Debtors outstanding for a period exceeding six months and (b) Other Debtors also, particulars to be given separately of (c) Debts considered good and in respect of which the Company is fully secured. (d) Debts considered good for which the Company holds no security other than the debtors personal security. (e) Debts considered doubtful or bad. Over and above these requirements, Debts due by directors or other officers of the Company or any of them either severally or jointly with any other person or debts due by firms or Private Companies respectively in which any director is a partner or a director or a member to be disclosed separately. Debts due from other Companies under the same management to be disclosed with the name of the Companies. The maximum amount due by directors or other officers of the Company at any time during the year to be shown by way of a note. (vii) If the customers have purchased the goods on hire purchase basis and some of the installments are not due, the same is not to be shown as debtors, instead they are to be shown on Stock out on hire purchase at cost. (viii) If the goods are sold on Sale or approval basis, such customers cannot be shown as debtors unless they have agreed to purchase the same before the date of the Balance Sheet. (ix) Whenever there are credit balance in debtors accounts, the same should not be deducted from other debtors debit balance. Such credit balance is to be shown on the liability side separately. (x) Enquire whether there is any dispute regarding any balance included in debtors. The auditor should verify the document regarding any dispute.

(xi) The auditor should ascertain that there are no unrecorded debtors and for he has to examine the cut off transactions. He should examine the cut off procedures to ensure separation of transactions of the current year from the next year. Sale of the current year should be separated from the sale of next year. He shall ensure that sales bills are prepared for goods dispatched. No sales bills are raised unless the goods are actually dispatched and sold during the accounting year. (xii) The auditor shall check collection from debtors in the next year to decide whether the year end balances are good or not. If debtor has become insolvent, after the date of Balance Sheet, such debtors should be provided for. (xiii) The auditor should arrange to send the letters of confirmation balance by the client as per clients record and see that the reply of confirmation is forwarded to his office directly, usually this should be sent within 15 or 20 days of year ending date under the supervision of audit staff. After the reply is received, the same should be tallied with the balance shown in the debtors ledger and differences, if any, be reconciled. 338 AUDITING AUDITING BASICS II (11) Stock in Trade This is an important asset and may be used to fabricate profit and give misleading Balance Sheet and hence an auditor is required to take lot of care and caution while verifying stock in trade and for following points be considered (i) Verify whether an efficient internal check system regarding stock is in operation or not. (ii) Compare the stock register with purchases and sales book, in regard to question (iii) Check the gate keepers outward register to find out whether any fictitious sales has been entered in Sales Book. (iv) Check the Stock sheets and Calculations, additions, costing etc., there in. (v) See that goods sold but not delivered are not included in Closing Stock. (vi) See that goods purchased, invoices received but delivery yet to be received are included in the Closing Stock. (vii) See that goods received from others to be sold on their behalf are not included in Closing Stock. (viii) See that furniture, tools etc., are not included in Closing Stock. (ix) Compare the balances of Stock Register with the Stock sheets.

(x) Method of stock taking may be enquired into, to find out possibilities of frauds and errors. (xi) Examine the principle followed in the valuation of stock to ensure that those were followed in previous years. (xii) Check whether stocks are valued on the basis of Cost price or Market price whichever is less or not. (xiii) Compare the Gross Profit rate of current year with that of previous years, if considerable variation is found, that should be enquired into in detail. (xiv) Determine the obsolete, slow moving, non-moving and damaged item and ascertain their treatment in accounts. (xv) Obtain a certificate from the management to the effect that the stock sheets are accurate and confirming that they have been signed by responsible person. (xvi) In case of the manufacturing concern the goods may be of following categories and should be valued and verified after taking above points into considerations and checking the relevant cost recorded like purchases requisitions, material requisitions, goods received notes, bin card and stores ledger etc., a] Raw materials b] Work in Progress c] Finished goods d] Stores & Spare parts. (xvii) Ensure that the various components of Stock have been separately disclosed in the Balance Sheet with their mode of valuation. (12) Loose Tools Loose tools at the end of the year should be checked by the auditor as follows : (i) The auditor should see that the cost of loose tools is properly determined and certified by the Chief Engineer. (ii) If the loose tools are manufactured by the organization, the authorized officer shall certify the value of such tools. (iii) He should physically verify these tools or obtain a list of tools duly certified by the responsible officer. Any discrepancies shall be investigated. (iv) Ensure that the closing stock of tools is valued at cost. See that the valuation is done on the basis, which is consistent taking in to consideration obsolescence, damage, brokerage etc., (v) See that the loose tools are disclosed in the Balance Sheet on asset side under the head Current Assets. AUDITING 339 (13) Live Stock

(i) See the live Stock Register and note down carefully the particulars like breed, year of purchases, purchase price, depreciation etc., for various categories of animals. (ii) See that some identification number is given to identify the animals. (iii) Examine the basic of valuation of animals. In case the animals are purchased at the age of maturity the cost will include Purchase Price plus freight. If the animal is reared from its conception and then brought to Maturity the cost includes cost of calving, cost of fodder etc., consumed till maturity and the suitable share of overheads. (iv) See that the cost up to the maturity stage of animal has been written off once the earning capacity of the animals starts declining over the remaining life. (v) Ensure that disposal value at the end of the life of the assets has been adjusted properly. (14) Bills Receivables (i) Get the schedule of bills receivables from the management. (ii) Check the total of the Schedule with the ledger. (iii) Check each bill to ascertain whether it is properly drawn, signed by the drawee and properly stamped or not. (iv) Verify the Cash received on the matured bills after Balance Sheet date. (v) Check the bills discounted with the B.R. Book and Cash Book. (vi) See that relevant foot note by way of contingent liabilities regarding bills discounted but yet not matured, properly appears on Balance Sheet. (vii) Verify the bills deposited with bank for safe custody or for collection or for securities of loans, with the bank certificate to that effect. (viii) Check the cash book and rebate / discount in connection with the proceeds received from retired bills before maturity. (ix) Trace the balance shown in Balance Sheet from the ledger account. (ix) Check the opening balance from last years audited Balance Sheet. (15) Cash at Bank (i) Compare the balance as shown in the Pass Book with balance of Cash shown in the bank column of Cash Book. (ii) Prepare Bank Reconciliation Statement to ascertain the reasons behind the difference between Pass book balance and Cash book balance. (iii) Obtain a balance certificate from the bank in case of suspicion of presentation of fictitious pass book and compare the balance with Cash book. (iv) Obtain separate certificates for different accounts or deposits with the bank for proper verification

of different balances. (v) See that The charges not yet collected are genuine and not made up in order to conceal the deficiency. (16) Cash in Hand (i) Visit the auditees premises and physically count, whole of the cash at a time and compare it with the balance shown on Cash Book. (ii) He should not accept IOUs as cash. (iii) If cash could not be counted on last day of the year he may visit as per his convenience and count the cash and check the cash book from the end of the last year to the date as and when cash is counted to verify the correctness of each balance at the end of last year. (iv) If actual cash counting is not possible ask the auditee to deposit whole of the cash in hand at the close of the year into bank, then the Closing Cash Balance gets automatically checked. 340 AUDITING AUDITING BASICS II (v) Whatever it may be, auditor should pay surprise visit to auditee and count the cash to prevent the cashier to borrow money and make up the deficiency which was due to embezzlement in the past. (vi) Get certificates from the auditors of the branches about the cash balance in hand and their correctness. (vii) Check the documentary evidences in reference to the cash in transit. (viii) See that the cash in hand is properly shown on the Balance Sheet. (17) Petty Cash (i) Count the cash physically on the closing date of the year and compare it with the balance shown on Petty Cash Book. (ii) If not possible, visit on any day and count the cash balance at the time of balance on main Cash Book simultaneously and check the accounts from the year end to the date of counting. (iii) See whether it is shown properly on Balance Sheet including Cash in hand. (18) Loans and Advances Loans and advances may be of different types like (a) Loans against the security of Land & Building. (b) Loans against the security of goods. (c) Loans against the security of stocks & shares (d) Loans against the security of Insurance Policies (e) Loans against the personal Security of the borrower. Therefore, in each case the duty of auditor in general is as under: (i) Examine whether a proper loan ledger has been maintained upto date or not. (ii) Examination of the Security ledger against each loan.

(iii) Examine the loan agreement and find out the rate of interest, due dates of installments, penalty, interest etc., (iv) Ascertain whether any loan is doubtful of recovery. In case it is doubtful, a provision for the expected loss is to be made. (v) Verify that loans have got proper sanction from the authority. (vi) Obtain a letter of confirmation from the parties to whom loans are advanced. (vii) In case of loans to directors, prior approval of the Central Govt. is obtained. (A) Loans Against The Security of Land & Buildings (i) Examine the mortgage deed in depth and to confirm that the mortgage has been properly executed in favour of the lender. (ii) Examine the title deeds deposited. (iii) Examine the Valuers certificate, in order to verify the value and see that the value is adequate. (iv) Confirm that the property is properly insured and insurance premium has been paid in time. (v) Examine the title of the borrower in connection with property etc., (vi) Take the acknowledgement of title deeds from the first mortgage in the case of second mortgage. (vii) Confirm that the mortgage is properly registered. (viii) The amount of loan should not be more than two thirds of the value of property. (ix) The auditor should enquire the rated interest and the date on which it is payable; if the loan has been outstanding for a long time, he should make an enquiry when the interest has not been paid. (x) In the case of loan on mortgage of lease hold land, the auditor should see that the ground rent has been paid regularly by the borrower on the due date. (xi) In the case of part repayment of loan, the auditor should get the loan confirmed. AUDITING 341 (B) Loans Against The Security of Goods (i) Examine the nature of the goods and confirm that the goods are belonging to the borrower. (ii) Verify whether loan is granted against railway receipts, lorry receipt, dock warrant, godown keepers receipt etc., (iii) See that the rent of godown is paid in full and the goods are fully insured if the goods are stored in godown. (iv) Examine the value of goods by comparing them to the present market value. He may rely on the inspectors report regarding quantity and quality. (v) Examine the turn over of the client if the goods are perishable. (C) Loans Against Security of Stocks & Shares (i) Call for a statement of stocks and shares given as security.

(ii) Confirm that all shares are fully paid up (iii) See that an instrument of transfer, properly stamped is available for his checking. (iv) See that the value is properly disclosed as per the market rates. (v) Ensure that there is a sufficient margin for the loans advanced. (vi) Ensure that the charge is properly registered. (D) Loans Against The Security of Insurance Policies (i) See that the policy has completed at least two years from the date of the first premium. (ii) Confirm that all the premiums have been properly paid and policy is in force. (iii) Ascertain that the due notice has been given to the insurance company. (iv) See that loan has been advanced on the basis of surrender value of the policy as certified by the insurance company. (v) Confirm that the premium, if any, paid by the lender to keep the policy in force is debited to loan account of the borrower. (E) Loans Against Personal Security of The Borrower Examine the documents like promissory note, guarantors details and income certificate of the borrower. (19) Trade Creditors (i) Ask for a schedule of creditors and check the same with purchase ledger already examined by him. (ii) Verify posting in the purchase ledger (iii) Ensure that all purchases made during the year especially at the end of the year are included in the accounts of the creditors. (iv) In case of suspicion, ask for the statement of account to be sent and verify the same along with scrutiny of ledger account and reconcile the differences, if any, (v) See the various debits given for discount, goods return etc., are genuine (vi) Enquire into the reason for non payment of overdue creditors. It is possible that amount might have been misappropriated. (vii) Examine some purchase invoices and confirm that they are relating to the year under audit. (viii) Test check returns and see that they are supported by credit notes of the suppliers. (ix) Obtain confirmation from the parties. Also, the auditor should keep in mind the following guidelines about audit of creditors. (I) Internal control The auditor should review the following aspects of internal control relating to creditors (A) Proper recording of transactions and linking of payment with outstanding. (B) Periodical schedule of creditors. 342 AUDITING AUDITING BASICS II (C) Follow up action on overdue accounts (D) Payment to creditors as per the approved policies. (E) Statement of accounts obtained from creditors.

(F) Proper adjustments in creditors accounts regarding purchase returns, cash discount, trade discount etc., (G) Cut off Procedure regarding creditors. (II) Verification The auditor should employ the following procedures Examination of Records (A) Carryout appropriate procedure to judge the adequacy of cut off procedure. Ensure that documents relating to receipt of goods before the year end are recorded. (B) Look into the difference between total of creditors balance and the control account balance (C) Examine relevant correspondence for verification of validity, accuracy and completeness of creditors. (D) Pay attention to outstanding items claims for short supply, poor quality, discount etc., (E) Examine correctness of transfer from one account to another. (F) Examine any unusual payments at the end of the year. (G) Confirm material liabilities at the end of the year. Confirmation The direct confirmation for creditors is similar to that adopted for debtors. Disclosure The auditor should examine whether creditors are disclosed properly in the financial statements. Certificate from the Management Obtain a certificate from the management that all the known liabilities have been recorded in the books of accounts. Working Papers The auditor should verify all the working papers relating to creditor. (20) Debenture (i) Examine the provisions regarding the powers of the company to issue debentures as contained in Memorandum and Articles of Association. (ii) Examine the terms of debenture issue as contained in Trust Deed and ensure that the same have been properly complied with. (iii) Verify cash received on this account with the help of Cash Book entries. (iv) Verify whether the interest on debentures is paid properly at regular intervals. (v) Confirm redemption of debentures on the basis of minutes of Board of Directors, counter foils of the cheque books, Bank Pass Book and Cash Book, returned debentures certificates etc., (vi) Issue of debentures as a collateral security should be disclosed in the Balance Sheet. (vii) Confirm whether the debentures are secured or unsecured and see that the same is disclosed properly.

(viii) The auditor should see that there is a proper board resolution passed regarding issue of debentures. (ix) The auditor should check the limit on borrowings including debentures as per section 293. In case the limit is likely to be crossed, the share holders in the annual general meeting can pass an ordinary resolution to increase the limit. (x) The auditor should see that necessary permission of the SEBI has been obtained by the company before issue of debentures. (xi) The auditor has to see that in case debentures are offered privately, the statement in lieu of prospectus is filed with the Registrar of Companies. In case of public offer the prospectus is issued. AUDITING 343 (xii) The auditor should verify the charge and its registration with the Registrar of Companies. 49 (xiii) See that a Sinking Fund has been created if it is and the terms of issue of debentures and the transfer from Profit & Loss account is under each year as per following SEBI guide lines (A) Fully convertible debenture having conversion period more than 36 months is not permissible unless conversion is made optional. (B) In case of Non-convertible debentures or partly convertible debentures credit rating from credit rating agencies is to be obtained before issue, if the maturity period exceeds 18 months. (C) In case of issue of debentures with maturity period above 18 months appointment of debenture trustee or creditor of Debenture Redemption Reserve each year is a must. (D) Period of maturity, redemption amount, yield on redemption shall be indicated in the prospectus. (E) Premium amount at the time of conversion for PCD shall be determined and stated in the prospectus. (F) While raising money by way of debentures the present and projected debentures equity ratio, servicing behavior of existing debentures, payment of interest on due dates on term loans and debentures, certificate from financial institution about their no objection for a second charge are to be disclosed. (G) Debenture Redemption Reserve should be created either in equal installment for the remaining period of debenture life or at a higher amount of profits permit. (H) In case of PCDs, the DRR should be created for a sum equivalent to non-convertible portion of debentures.

(I) The trustees to the debenture holders will supervise implementation of the conditions regarding creation of security for debentures and regarding the debenture redemption reserve. (21) Provision for Taxation (i) See that the provision for taxation made in the current year is adequate taking into account the profit made, deductions and any other allowances as per Income Tax Act. The auditor should see that suitable adjustment is made in respect of additional demand or refund as the case may be. Material Tax liability for which no provision is made should be disclosed in the report. (ii) Get a Statement of Income. (iii) Vouch advance payment of Income tax referring to the challans and bank statements. (iv) Ensure that Provision for taxation for the current year is shown separately in the Profit and Loss account and in the Balance Sheet. (v) In case the tax liability determined is more than that provided for against which the company might prefer an appeal before the high authority, a reference to this effect should be made in the accounts. Where an application for rectification of mistakes u/s 154 of the Income tax Act, has been made the amount of tax decided is considered or disputed. As per AS4, the disputed tax liability may require a provision and suitable disclosure. The auditor should enquire from the management, review minute of the meeting of the BOD and correspondence with the lawyers for determination of the Provisions. (vi) Examine the assessment completed, revised or rectified during the year. (22) Provision for Proposed Dividend (i) See that there is an adequate Profit for declaration of dividend. (ii) Check the minute books recommending dividend to ascertain the rate of dividend recommended. (iii) Verify the calculation of proposed dividend and see whether it is provided on the paid up share capital only, excluding the calls in arrears and forfeited shares. (iv) See that it is properly exhibited in the final accounts. 344 AUDITING AUDITING BASICS II (23) Provision for Expenses Not Allowable Under Income Tax Act (i) The expenses not deductible in the calculation of tax liability can be debited to profit and Loss account, hence auditor should verify if any of such expenses appear in Profit and Loss accounts. (ii) Verify the correctness of the amount.

(iii) See whether those not allowable expenses are re-added in the profit of the year to calculate the expected tax liability and the provision for taxation is made accordingly or not. (24) Secret Reserve: Any reserve not appearing on the Balance Sheet is called as a Secret Reserve. The existence of the reserve may be inferred from an intelligent verification of the accounts by the auditor even though the amount cannot be ascertained. Generally such type of reserve appears in financial institutions and insurance companies. Secret reserve may be created by (i) Writing down the assets much below their cost (ii) Providing excessive depreciation (iii) Providing more reserve for doubtful debts etc., (iv) Writing down the goodwill considerably (v) Omitting certain assets from Balance Sheet (vi) Charging capital expenditure to revenue account (vii) Over valuing the liability. (viii) Showing contingent liabilities as real liabilities etc., According to the Provisions of Companies Act, 1956, creation of Secret Reserve is prohibited except in the case of banking, financial, insurance and electricity companies. To verify the secret reserve, if any, the auditor should keep in mind the following points : (i) Carefully enquire into the necessity of creating such reserve. (ii) Dont qualify audit report if it is found that the intention of the company is honest and the amount is reasonable. (iii) May pass a remark in audit report that the assets are understated, (iv) Discuss the fact, if found, that the directors intention behind creating secret reserve was not honest and only to facilitate improper dealing in shares. (25) Contingent Liabilities : The liability which depends on happening or not happening some thing is called as contingent liability. This liability may involve payment of revenue nature incurring losses or involves the acquisition of asset. Examples (i) Disputed claims by workers for compensation (ii) Bills Discounted (iii) Guarantees given in favour of others (iv) Amount on incomplete contracts (v) Calls unpaid on partly paid shares (vi) Payment of gratuity under Industrial Dispute Act, (vii) Preference dividend in arrears. Verification

Auditor should carefully verify contingent liabilities as it may become actual liability on happening or not happening certain events and while verifying keep in mind following points. (i) Obtain certificate about the contingent liabilities disclosed in the Balance Sheet, from a responsible officer. (ii) Carefully examine whether such liabilities are in existence or not. AUDITING 345 (iii) Check relevant documents to confirm the existence of contingent liability. (iv) Verify the certified list given by responsible officer to ascertain whether there exists any contingent liability which may turn to be an actual liability. (v) Verify whether proper provision is made or not for the contingent liability turned out to be an actual liability. (vi) Verify bill discounting register, investment register, minute book and other relevant records to establish the amount of contingent liability. (vii) See whether contingent liability is properly disclosed in the Balance Sheet. (26) Capital Reserve : It is not defined by the Companies Act, 1956. It may be defined as any profit or reserve earned on sale or purchase of capital asset and / or business and which cannot legally be distributed among share holders. It is created out of abnormal and non-trading profits like premium received on issue of shares, balance remaining after reissues of forfeitured shares on share forfeited account, profit earned on amalgamation, absorption or reconstruction of companies, Capital Redemption reserve, Profit prior to incorporation etc. While verifying this reserve an auditor should keep in mind, following points (i) See whether the capital profits transferred to this reserve are really surpluses of capital nature or not. (ii) See whether the Capital Reserve is utilized according to the provisions of Articles of Association or not. (iii) See whether it is properly exhibited on Balance Sheet or not. (27) Gratuity: (i) Auditor should see that proper provision is made for the gratuity and if not whether the auditee has disclosed the amount not provided for (ii) As provided in the Companies Act, amended in 1988, the auditor should qualify his report if the company has not provided for gratuity either wholly or partly.

(iii) He should check the calculation made for provision of gratuity and confirm whether it is based on the periodical actuarial valuation or not. (iv) See whether gratuity is provided for on a net of tax basis then the gross amount is properly disclosed. (v) See that the method used for calculating the provision for gratuity is disclosed and see the significance of such cost to the company. (vi) Auditor should keep in mind the provisions of AS 15 while verifying the provision made for gratuity. (28) Valuation of Assets Along with vouching and verification of assets and liabilities, valuation is an important task auditor has to perform, without which verification of assets cannot be said as complete and the Balance Sheet cannot be taken as showing true and fair view of the state of affairs of business. Valuation, here, does not mean actual calculation and determination of the value of each and every asset by the auditor but it implies the testing and checking of the values of assets shown in Balance Sheet, which also, included to see whether values of assets are based on generally accepted accounting principles. Valuation Procedure For Valuing the different assets, shown on Balance Sheet; the auditor has to follow following steps (i) Obtain the schedule of valuation prepared by the management (ii) Examine and critically analyze all figures (iii) Get information about the valuation process adopted by the auditee (iv) Test the values of different assets given by management at random 346 AUDITING AUDITING BASICS II (v) Ensure whether the valuation is done on the basis of Generally Accepted Accounting Principles e.g. fixed assets at value of cost less depreciation, current assets at cost or market price whichever is less etc., (vi) Verify if the valuation process adopted by the auditee is followed from year to year. (vii) Enquire about variation, if any, in the process of valuation. (viii) Take, if necessary, assistance of technical persons, approved valuers for the purpose of ascertaining the current values of assets. (ix) Verify the accuracy of depreciation provided, capitalization of revenue expenditure etc., (x) See that proper value of assets be exhibited on Balance Sheet. 6.3 DISCLOSURE OF ACCOUNTING POLICIES AND PRACTICES

Under the Indian Companies Act, 1913 the annual accounts were required to exhibit a true and correct view of the State of Affairs of a company. According to the Companies Act, 1956 however the annual accounts are required to disclose a true and fair view of the state of affairs of the company. The changes from Correct to Fair is very significant. The Indian Companies Act 1913 laid emphasis on mere reproduction and required preparation of annual accounts strictly in accordance with the books of accounts. The Companies Act, 1956 has however used the term Fair in a completely different sense. The word denotes a representation on the state of affairs of the company. Thus the emphasis has been shifted from arithmetical accuracy and reproduction, to the presentation of annual accounts in such a manner as to disclose a fair view on the Balance Sheet concerned, of the state of affairs of the Company on the date of the Balance Sheet and in case of the Profit and loss account, of the profit or loss for the financial year concerned. This shift has brought on the shoulder of the auditor much more responsibility from what he had previously. The auditor must be careful to see that the accounts show a fair picture to the share holders and others concerned. To achieve this objective, the auditor today is also required to look into and comment upon the accounting policies followed by the management in the preparation of financial statements. Accounting Standard-1 (AS1) The view presented in the financial statements of an enterprise of its financial position and of Profit earned can be significantly affected by the accounting policies followed in the preparation of the financial statements. To appreciate the position presented, it is necessary to disclose the accounting policies adopted. The AS1 recommends the disclosure of certain accounting policies like foreign currency translation. Some Indian enterprises are disclosing their accounting policies by way of a separate statement in their annual report to share holders but in many cases accounting policies are not fully and regularly disclosed. Many enterprises give the description of some of the accounting policies by way of foot note to the Balance Sheet. Disclosure of the fundamental accounting assumption as their acceptance and use is not required but if they are not followed then the disclosure is must. e.g. the principles of going concern, consistency and accrual of revenues and cost.

The specific principles and methods adopted by an enterprise while preparing financial statements need to be disclosed. These different accounting policies adopted by different enterprises may be in different areas like (1) Methods of Depreciation (2) Treatment of expenditure during construction (3) Conversion of foreign currency (4) Valuation of inventory (5) Treatment of goodwill (6) Valuation of investment (7) Treatment of retirement benefits (8) Recognition of Profit on long term contracts (9) Valuation of fixed assets (10) Treatment of contingent liabilities etc., Disclosure of all significant accounting polices adopted in the preparation and presentation of financial statements shall form a part of the financial statements and should not be scattered over several statements, schedules and notes. Any change in an accounting policy which has a material effect should be disclosed. The amount by which any item in the financial statements is affected by such change should also be disclosed to the extent ascertainable. Where such amount is not ascertainable, wholly or in part, the fact should be indicated. Of course, the disclosure of accounting policies cannot remedy a wrong or inappropriate treatment of the item in the accounts. AUDITING 347 In short as per AS1, all accounting policies adopted in the preparation and presentation of financial statement should be disclosed. Expenditure During The Period of Construction Apart from the direct expenditure on fixed assets, which has to be capitalized, an enterprise incurs various other expenditures during the period of construction. The research committee of the ICAI, has published a report of the study on the accounting treatment of such expenditure. According to this study (1) A cut off date should be fixed to segregate expenditure during construction period from subsequent expenditure. It is on this date, that the project is officially recognized as being ready for commercial production i.e. the trial runs are completed and the project is capable of producing commercially feasible quantities. (2) The Selection of cut off date acquires specific importance due to the fact that there is often a delay between the date when the plant is ready for commercial production and the date of actual commencement of commercial production.

(3) All expenditure, other than direct capital expenditure, should be debited to Profit & Loss account, once the plant is ready for commercial production since a delay in commencement of production after this date is neither related to the acquisition of fixed assets nor does it add to the utility thereof. However, depreciation on fixed assets need not be provided if the fixed assets are not utilized due to delay in commencement of production. In case, the delay in commencing production is prolonged, the expenses of this period may be treated as deferred revenue expenditure and be written off subsequently. (4) Preliminary project expenditure, incurred in connection with the preparation of project report, conducting feasibility studies and handling preliminary negotiations with foreign collaborators and government authorities should be capitalized as part of the indirect construction cost of the project. The amount of such expenditure is to be apportioned over the individual assets in an equitable manner. (5) Financial expenses like interest and commitment charges incurred during the construction period on loans for financing the construction of the project should be included in the capital cost of the projects as indirect construction cost. The cost of procuring loans or the interest paid to the Shareholders under Section 208 of the Companies Act, 1956 should also be treated in the same way. However, once the production starts, no interest or other financial expenses or any borrowings should be capitalized. Interest and other charges on loans taken for providing working capital during construction period should be treated as deferred revenue expenditure and be written off over a period of three to five years after the commencement of production. (6) Notional or imputed interest charges should not be capitalized since they are not incurred. (7) Indirect expenditure relating to the construction of the project should be capitalized or part of the construction cost if it is incidental to the construction activity. Thus, expenses on office incidental to construction should be apportioned over individual assets on equitable basis. (8) General expenses un-related to the construction activity, like expenses on staff training programmers, building up sales and office organization as also publicity and sales promotion campaigns should be treated as deferred revenue expenditure, to be written off within a reasonable period after the

commencement of production. (9) Advance payments to contractors and others should not be shown under the specific fixed assets. These should be disclosed in the balance sheet under the general heading of Fixed Capital Expenditure or as separate item under the heading Loans and Advances. (10) Capital expenditure on incomplete construction work should be shown under the heading Construction Work in Progress. The complete unit of fixed assets should be shown in the accounts under the heading Fixed Assets. Any facilities or equipment built specially for the purpose of construction should be capitalized. (11) Abnormal losses during construction period should not be capitalized but should be written off over a period of 3-5 years after commencement of production. 348 AUDITING AUDITING BASICS II (12) Expenditure on commissioning the project including the cost of test runs and experimental production may be capitalized as an indirect construction cost. (13) The financial statement prepared during the construction period should contain appropriate disclosures of construction work-in-progress, fixed assets, advances to contractors, supplies & others, preliminary expenses and deferred revenue expenses. 6.4 ADJUSTMENTS FOR PREVIOUS YEAR Adjustments for previous year for outstanding expenses like arrears payable to workers as a result of revision of wages with retrospective effect during the current period are made as usual and auditor has to verify it as a normal item, but in regard to income or expenses which arise in current year as a result of errors or omissions in the preparation of the financial statements of one or more prior periods, the provisions of AS-5 should be observed. Errors in the preparation of the financial statements of previous year may be discovered in the current period. Errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies, misrepresentation of facts or oversight. Previous years items are normally included in the determination of net profit or loss for the current period. An alternative approach is to show such items in the statement of profit and loss after determination of current net profit or loss. In either case, the objective is to indicate the effect of such item on the current profit or loss.

6.5 PROVISIONS OF COMPANIES ACT, 1956 REGARDING ACCOUNTS (A) Books of Accounts to be kept by Company (See-209) Every company shall keep at its registered office proper books of accounts with respect to (i) All sums of money received and expended by the Company and the matters in respect of which the receipt and expenditure take place. (ii) All sales and purchases of goods by the Company (iii) The assets and liabilities of the company and (iv) In the case of company pertaining to any class of companies engaged in production, processing, manufacturing or mining activities, such particulars relating to utilization of material or labour or to other items of cost as may be prescribed, if such class of companies are required by the Central Government to include such particulars in the books of accounts. All these books may be kept at such other place in India as the BOD may decide and the company shall within seven days file with the Registrar a notice in writing giving full address of the other places. Proper summarized returns at intervals of not more than three months are to be sent by the branches in or outside India to the company at its registered office or the other places. The books kept by the company and its branches should give true and fair view of the state of affairs of the company or branch offices and should be kept on accrual basis and according to the double entry system of accounting. The books of accounts and other books and paper shall be open to inspection by any director during business hour. The books of accounts of every company relating to a period of not less than eight years immediately preceding the current year, including the vouchers relevant to any entry in such books of accounts shall be preserved in good condition. Any of the person who fails to take all responsible steps to secure compliance of the above by the company or has by his own willful act been the cause of any default by the company there under, he shall, in respect of each offence, by punishable with imprisonment for a term which may extend to six months or with fine which may extend to ten thousand rupees or with both. (B) Inspection of books of account etc., of Companies (Section 209A) The books of accounts and other books and papers of every company shall be open to inspection during business hoursAUDITING

349 (i) By the Registrar or (ii) By such officer of the Government as may be authorized by the Central Government in this behalf or (iii) By such officers of Securities and Exchange Board of India as may be authorized by it. Such inspection does not require any prior notice to the Company. The Company should make available all such books etc., as required within such time and at such place as the person so specify. The Company should give all assistance in connection with the inspection. The person making the inspection may get copies of accounting books etc., and also may place mark of identification thereon in token of the inspection have been made. The person making inspection shall have the same powers as are vested in a Civil court under the Code of Civil procedure 1908 in respect of (i) the discovery and production of books of account and other documents at such place and such time as may be specified by such person (ii) summoning and enforcing the attendance of persons and examining them on Oath. (iii) Inspection of any books, registers and other documents of the Company at any place. The person making inspection shall make a report to the Central Government or SEBI as the case may be. If default is made in complying with above provisions every officer of the company who is in default shall be punishable with fine which shall not be less than fifty thousand rupees and also with imprisonment for a term not exceeding one year. Any director or officer convicted of an offence under this provision shall on and from that date of conviction be deemed to have vacated his office as such and on such vacation of office, shall be disqualified for holding such office in any company for a period of five years from such date. (C) Annual Accounts and Balance Sheet (Section 210) At every Annual General Meeting the Board of Directors of the Company shall lay before the company a Balance Sheet and a Profit and Loss account for the financial year. The person who fails to take reasonable steps to comply with shall be punishable with imprisonment for a term which may extend to six months or with fine which may extend to ten thousand rupees or with both. (D) Constitution of National Advisory committee on Accounting Standard (Section 210A) The Central Govt. may, by notification in the official Gazette, constitute an Advisory Committee to be called

the National Advisory committee on Accounting Standards to advice the Central Govt. on the formulation and laying down of accounting policies and accounting standards for adoption by Companies or class of Companies under this Act. The Advisory Committee shall consist of the following members :(i) A Chairperson, who shall be a person of eminence and well versed in accountancy, finance, business administration, business law, economics or similar discipline. (ii) One member each from ICAI, ICWAI and ICSI. (iii) One representative of the Central Govt. to be nominated by it. (iv) One representative of the R.B.I. , to be nominated by it. (v) One representative of the Comptroller and Auditor General of India, to be nominated by him. (vi) A person who holds or has held the office of Professor in accountancy, finance, business management in any University or deemed University. (vii) The Chairman of the Central Board of Direct Taxes (viii) Two members to represent the Chambers of Commerce and Industry to be nominated by the Central Government. (ix) One representative of the SEBI of India to be nominated by it. The Advisory Committee shall give its recommendations to the Central Govt. on such matters of Accounting Policies and Standards and Auditing as may be referred to it for advice from time to time. 350 AUDITING AUDITING BASICS II (E) Forms and Contents of Balance Sheet and Profit and Loss Account (Section 211) Every Balance Sheet of a Company shall give true & fair view of the state of affairs of the company as at the end of the financial year and shall subject to the Provisions of Sec. 211, be in the form set out in Part VI of Schedule I or as near thereto as circumstances admit or in such other form as may be approved by the Central Govt. either generally or in any particular case and in preparing the Balance Sheet due regard shall be had, as far as may be, to the general instructions for preparation for Balance Sheet under the heading Notes at the end of that Part I. But this form does not apply to Insurance or Banking or Electricity Company etc., to which separate form is specified under the Act under which the company is formed. Every Profit and Loss Account of a company shall give a true and fair view of the profit or loss of the

company for the financial years and shall, comply with the requirements of Part II of Schedule VI. Every Profit and Loss Account and Balance Sheet of the company shall comply with the Accounting Standards. If the company does not comply with the accounting standards, it shall disclose in its Profit and Loss Account and Balance sheet, the following (i) The deviation from accounting standards (ii) The reasons for such deviation and (iii) The financial effect, if any, arising due to such deviation The Balance Sheet and the Profit and Loss Account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the Company merely by reason of fact, that they do not disclose (i) In the case of Insurance Company, any matter which are not required to be disclosed by the Insurance Act, 1938. (ii) In the case of Banking Company, any matter which are not required to be disclosed by the Banking Companies Act, 1949. (iii) In the case of a company engaged in the generation or supply of electricity, any matters which are not required to be disclosed by the Indian Electricity Act, 1910 and the Electricity (Supply) Act, 1948. (iv) In the case of company governed by any other special Act for the time being in force, any matters which are not required to be disclosed by the special Act, or (v) In the case of any company, any matter which is not required to be disclosed by virtue of the provisions contained in Schedule VI or by virtue of a notification. Any person who fails to comply with the provisions of section 211 be punishable with imprisonment for a term which may extend to six months or with fine which may extend to ten thousand rupees or with both. (F) Balance Sheet of Holding Company to Include Certain Particulars as to its Subsidiaries (Section 212)There shall be attached to the Balance Sheet of holding company the following (i) The copy of the subsidiary companys Balance Sheet, (ii) The copy of the subsidiary companys Profit and Loss Account (iii) The copy of the subsidiary companys Board of Directors Report. (iv) The copy of the subsidiary companys Audit Report (v) The statement of the holding companys interest in the subsidiary (vi) When the financial years are different, the statement containing information about whether there has been any, and, if so, what change in the holding companys interest in the subsidiary between the

end of the financial years of the subsidiary and the end of the holding companys financial year and details of any material change which have occurred between the end of the financial year or of the last of the financial years of the subsidiary and the end of the holding companys financial year in respect of (a) The subsidiarys fixed assets (b) Its investments (c) The money lent by it (d) The money borrowed by it for any purpose other than that of meeting current liabilities. AUDITING 351 If any person fails to comply with the provisions of Section 212, he shall be punishable with imprisonment for a term, which may extend to six months or with fine which may extend to ten thousand rupees or with both. (G) Financial year of holding company and subsidiary (Section 213) Central Govt. may if it appears to it desirable, extend the financial year of Holding Company or subsidiary company so that the financial years of both the companies may end on same date on the application or with the consent of the Board of Directors of the company whose financial year is to be extended. (H) Rights of Holding Company representatives & members (Section 214)A holding company may, by resolution, authorize representatives to inspect the books of accounts of its subsidiaries. Members of holding company may exercise their rights as conferred by Section 235 in respect of any subsidiary. (I) Authentication of Balance Sheet and Profit & Loss Account (Section 215) Every Balance Sheet and Profit and Loss Account of a company shall be signed on behalf of the Board of Directors, by Manager or Secretary and by not less than two directors of the company one of whom shall be a Managing Director but when there is only one of its directors for the time being in India, the balance sheet and Profit and Loss Account be signed by such director and an explanation to that effect explaining the reason for non compliance be attached to the Balance Sheet. In case of Banking companies it is signed by the persons specified under Section 29(2) of Banking Companies Act, 1949. The Balance Sheet and Profit and Loss Account shall be approved by the Board of Directors before they are signed on behalf of the Board.

(J) Profit and Loss Account to be annexed and Auditors Report to be attached to the Balance Sheet (section 216) The Profit and Loss Account shall be annexed to the Balance Sheet and the Auditors Report shall be attached there to. (K) Boards Reports (Section 217)There shall be attached to every Balance Sheet laid before a company in General Meeting, a report by its Board of Directors, with respect to (i) The state of companys affairs. (ii) The amount it proposed to carry to any reserves. (iii) The amount of dividend it recommends. (iv) Material changes affecting the financial position of the company, which have occurred between the end of the year and the date of the report. (v) The conservation of energy, technology absorption, foreign exchange earnings and outgo. (vi) The Directors Responsibility statement indicating that in the preparation of the annual accounts, the applicable accounting standards had been followed, selected accounting policies are applied consistently, proper and sufficient care taken for the maintenance of adequate accounting records etc., Any person, being a director of a company fails to take all reasonable steps to comply with the provisions of Section 217 be publishable with imprisonment for a term which may extend to six months or with fine which may extend to twenty thousand rupees or with both. (L) Penalty for improper issue, circulation or publication of Balance Sheet or Profit & Loss Account (Section 218). The Company and every officer of the company who is in default, shall be punishable with fine which may extend to five thousand rupees. (M) Right of Member to copies of Balance Sheet and Auditors Report (Section 219) Before 21 days of holding the Annual General Meetings, the copies of the Profit and Loss Account, Balance Sheets and Auditors Report be sent to each member of the Company, every trustee of debenture holders and to all person other than such member or trustee being persons so entitled. 352 AUDITING AUDITING BASICS II On demand the company should provide the respective copies to the member of the company within seven days.

The officer and the Company in case of failure to comply with the provisions of Section 219 is punishable with a fine which may extend to five thousand rupees. (N) Three copies of Balance Sheet etc., to be filed with the Registrar (Section 220) Within thirty five days from the date of presenting before Annual General Meeting three copies of the Balance Sheet and the Profit and Loss Account signed by the Managing Director, Manager or Secretary of the Co. be filed with the Registrar. In case of default the company and every officer of the company who is in default shall be liable to like punishment as is provided by Section 162 for a default in complying with the Provisions of Section 159, 160 or 161. (O) Duty of Officer to make disclosure of Payments etc., (Section 221) Where any particulars or information is required to be given in the Balance Sheet or Profit and Loss Account of a Company or in any document required to be annexed or attached thereto, it shall be the duty of the concerned officers of the company to furnish without delay to the company, and also to the companys auditor wherever he so requires, those particulars or that information in full as possible. This information may relate to payments made to any director or other person by any other company, body corporate, firm or person. If any person knowingly makes default in performing duty in this regard, he shall be punishable with imprisonment which may extend to six months or with fines which may extend to fifty thousand rupees or with both. (P) Certain Companies to publish statement in the form in Table F in Schedule I (Section 223) Every company which is a limited Banking company, an insurance company or a deposit, provident or benefit society shall before it commences business and also on the first Monday in February and the first Monday in August every year during which it carries on business, make a statement in the form in Table F in Schedule I or in form as near there to as circumstances admit. A copy of the statement, together with a copy of the last audited Balance Sheet laid before the members of the company, shall be displayed and until the display of the next following statement, shall be kept displayed, in a conspicuous place in the registered office of the company, and in every branch office or place where the business of the company is carried on.

If default is made in complying with any of the requirement of section 223, the company and every officer of the company, who is in default, shall be punishable with fine which may extend to five thousand rupees for every day during which the default continues. Of course, this section 223 shall not apply to a life assurance company or provident insurance society to which the provisions of the Insurance Act 1938 as to the Annual Statements to be made by such company or society, apply, with or without modification, if the company or society complies with those provisions. 6.6 STATISTICAL SAMPLING IN AUDITING Sampling is the selection of a part of the population representing the total affairs. The term statistical sampling refers to the whole process of carrying out a test on a scientific basis. This is framed in such a way to determine the degree of accuracy of a particular set of transaction rather than to discover individual errors. The Statistical Sampling may be applied in auditing where in great number of transactions are involved e.g. Purchases, Sales, payrolls, salaries, inventories etc., Audit sampling is the application of a compliance or substantive Audit Procedure to less than 100% of the items within an account balance or class of transactions to enable the auditor to obtain and evaluate evidence of some characteristic of the balance or class and to form or assist in forming a conclusion concerning the characteristic, of course it should be noted that certain testing procedures do not come under this. Tests done 100% of the items within a population do not involve sampling, also the technique of selecting all items within a population which have a particular characteristic does not qualify on Sampling with respect to the portion of the population examined nor with respect to the population as a whole, since the items were not selected from the total population on a basis that was expected to be representative. Such items might have some characteristic of the remaining portion of the population but would not be the basis for a valid conclusion about the same. AUDITING 353 At the time of actual start of audit the auditor has to decide whether all transactions be checked or only part of them be examined. If it is practicable to check each and every transaction then there is no need to think about statistical sampling. But in large scale organizations it would be almost difficult to check the huge volume of

transactions due to the available limited time, that is why some kind of selective checking becomes inevitable. Effective auditing depends upon the proper selection of transactions. Therefore, the auditor should be very careful at the time of selecting his audit samples and evaluating the results of audit procedure and hence he shall consider the time and efforts his staff can spend, past experience, the degree of confidence gained from few surprise sample checks, existence of internal control system and of internal auditing, Generally Accepted Accounting Principles and auditing standards while selecting audit samples. The statistical sampling have advantage over judgment sampling as the statistical sampling provided mathematical base when judgment sampling is based on intution. When an auditor is concerned with the design of compliance, the statistical sampling is appropriate. The difference between the test check approach and the statistical sampling approach can be illustrated through the example of an auditor who wishes to obtain confirmation of debtors. Suppose that there are 5000 debtors and that the internal control system has been found to be quite effective. If the auditor undertakes a test check, he may decide to obtain confirmation from ten percent of the total debtors. He would then prepare a list of 500 debtors. It is quite likely that being in a hurry to complete the audit, he selects consciously or unconsciously only local debtor or those who he knows would reply. It could be that he included in his list the names of those debtors with whom he got acquainted during the examination of Sale invoices. In doing so he may be unconsciously leaving out those debtors whose accounts are static for a long time. Thus, his list may not be representative of the debtors as a whole. Again when the confirmations are received, he would not be able to assess as to how far the confirmations from 500 debtors selected arbitrarily represent the truth of all debtors balances. Suppose the same auditor decides to under take confirmation of debtors through statistical sampling and for this, he will first determine the size of the sample. Instead of just taking an arbitrary figure of 10%, he would determine the sample size through statistical tables. These tables show different sample sizes depending upon how confident the auditor wishes to be regarding the accuracy of his sample. The auditor would then select the debtor to be included in the sample on the basis of random number tables. Since he has to take only those

accounts whose number is shown up by random number tables, there will be no element of bias in the sample and statistically the accounts so selected would be more representative of the debtor account as a whole. Once the confirmations are received from the sample debtors, the auditor can reach a more scientific conclusion with the help of statistical tables. This indicates that statistical sampling helps in a scientific verification of transactions on a selective basis. While applying statistical sampling techniques for successful auditing the auditor should consider the following(i) Use this technique only when the audit objective necessary so warrants depending on the circumstances. (ii) His opinion should be based only on the sample population. (iii) He should not be influenced by personal bias at the time of selecting samples. (iv) The Patterns in the population should not be permitted to influence the random of the sample. (v) He should base his estimates of maximum error rate on realistic grounds. (vi) He should not set un-realistic and unachievable goals. (vii) He should find out the reasons behind the variance after obtaining the sample results and then recommended corrective measures and express his opinions. Designing Audit Samples Auditor should consider the following important factors at the time of designing the audit sample (a) Audit objective (b) Population (c) Risk and Assurance 354 AUDITING AUDITING BASICS II (d) Tolerable error (e) Expected Error in the Population (a) Audit Objective First of all the auditor should think about the specific audit objective he is going to achieve, which will enable him to decide upon audit procedure. When, according to him, audit sampling is appropriate, the nature of audit evidence to be gathered and positive error conditions etc., relating to that evidence will help him in what population be selected for sampling as well as what constitute as error. (b) Population The population is the entire set of data from which sample is drawn to reach a conclusion. He should be careful while selecting sample that the population is appropriate to reach his audit objective. (c) Risk and Assurance

Auditor, while planning the audit uses his skill and judgment in assessing the level of audit risk, which include inherent risk, control risk and detection risk. Inherent risk and control risk remain irrespective of audit sampling procedures. He should consider detection risk arising from the uncertainties due to sampling. Sampling risk arises from the possibility that the auditors conclusion may be different from the conclusion based on entire population. (d) Tolerance Error Tolerance error is the maximum error in the population which auditor accepts and still concludes that the results from the sample has achieved his audit objectives. For minimizing the tolerance error auditor has to select the larger sample size. (E) Expected error in the population When auditor expects the presence of error, normally he examines a larger sample. Smaller sample sizes are justified in the case when the population is expected to be error free. To determine the expected error in population, the error levels found in previous audits, changes in accounting and other procedures adopted by the auditee and evidence available from evaluation of internal control system etc., proves useful. Method of Sampling The sample selected should represent the population and for all items in the Population must have an equal opportunity of being selected. The following are the common methods used for selecting the samples (a) Random Number Selection (b) Systematic Selection Method (c) Haphazard Selection Method (d) Stratified Selection Method (e) Cluster Selection Method (a) Random numbers Selection Method In this method, all items in the population have equal opportunity of being selected. Under this method random number tables or computer generated random numbers are used. (b) Systematic Selection Method Under this method, the first number is selected at random and then other numbers are selected using uniform interval for e.g. every ` 50,000/- in the cumulative value of the population is selected. (c) Haphazard Selection Method This method is an alternative to random selection method, here auditor draws a representative sample

with no intention to either include or exclude specific items. AUDITING 355 (d) Stratified Selection Method Under this method the population is subdivided into sub population and all items in each sub-population have same characteristics and from each sub population samples may be drawn but auditor direct his effort toward the items which contains greater monetary error. (e) Cluster Selection Method In this method division of total items is made into sub groups and then at random few subgroups are selected entirely as samples. Evaluation of sample Results After verifying, examining, checking the sample selected the auditor should evaluate the sample results as under (a) Analyze the error detected (b) Project the located error in sample to the population (c) Assess the sampling risk (a) Analyze the error detected The error found should be rechecked by using other method and after that the error still remains, auditor should treat the error as an error. He should also consider the qualitative aspects of the errors and the possible impact of error on other phases of audit. (b) Project the errors found in sample to the population The auditor should project the error of sample to the population, where from the sample was drawn when number of subgroups are made, the projection errors is done separately for each subgroup and the results are accumulated. (c) Assessing the sample risk The auditor should see whether error in population exceed the tolerance limit and for he should compare the projected population error to the tolerable error and also compare the sample results to the evidence gathered from other relevant audit procedures. If the projected error approaches tolerable error the risk incorrect acceptance increases, if the auditor determines that the risk is unacceptable he should extend his audit tests. 6.7 USE OF RATIOS AND PERCENTAGES FOR COMPARISON AND ANALYSIS TRENDS A ratio is a quotient of two numbers and is an expression of relationship between the figures of two amounts. The relationship between the two accounting figures is known as accounting ratio. Thus, accounting ratios are

relationship, expressed in Mathematical terms, between figures which have a cause and effect relationship or which are connected with each other in some other manner. Obviously no purpose will be served by working out ratios between two entirely unrelated figures, such as discount on debentures and sales. According to J. Batty, the term accounting to ratio is used to describe significant relationships which exist between figures shown in a Balance Sheet, in a Profit and Loss Account, in a budgetary control system or in any part of the accounting organization.. It indicates a quantitative relationship which is used for a qualified judgment and decision making. The auditor can use ratio analysis to identify anything abnormal or anything which deviates from the expected and the known. Absolute quantity can be easily manipulated. However, it may be difficult to manipulate all the figures which are inter-related. Such manipulation normally causes widespread repercussions and can be detected easily. Ratio analysis is a useful tool for assembling the related but unorganised data into a meaningful and orderly pattern. By analysing the changes in the ratios and the trends so perceived, an auditor can spot variations in the normal pattern of transactions e.g. there is a direct relationship between the figures of gross profit and sales. The relationship would change if certain underlying business conditions change. Hence a change in the ratio of gross profit to sales in a particular year would indicate that either relevant business conditions have changed or that the figures are not reliable. Ratio analysis is thus a valuable tool, of overall assessment. 356 AUDITING AUDITING BASICS II Ratio analysis only highlights symptoms. It is for the auditor to study the symptoms properly, correlate them and reach definite conclusions or identify for further enquiries. Some of the common ratios are as under (A) Balance Sheet Ratios (i) Return on Investment Net Capital Employed = Net Profit before Interest andTaxes It can be split up Net Capital Employed Sales Sales = Net Profit

(ii) Current Ratio or Working Capital Ratio Current Liabilities = Current Assets This indicates short term liquidity. An ideal current ratio is 2:1. The excessive current ratio is treated as a sign of managerial inefficiency. Window dressing or presence of mounting stocks may show a good current ratio. Low ratio shows the weak financial position. (iii) Quick Ratio or Acid Test Ratio or Liquidity Ratio Quick Liabilities (except B.O.D.) = Quick Assets (except stock&Prepaid expenses) This indicates a short Term liquidity. Normally Quick Ratio should be 1:1. If there is a low quick ratio, the concern may be put into difficulties of the maturity date of quick liabilities. (iv) Debt Equity Ratio Debt Equity = OwnersEquity This indicate a long term solvency. This ratio is acceptable as 1:1 Higher the ratio, the better would be the working capital position. (v) Inventory to Working Capital Ratio Current Assets Current Liabilities Stock at End = The ratio is an index of the position of over stocking. It shows that the part of working capital is blocked in the closing stocks. The mounting stock represents the blocking of circulating assets. (B) Income Statement Ratios : (i) Gross Profit Ratio 100 Net Sales = Gross Profit Low ratio would put the management into difficulties in the realization of fixed overheads. Low ratio indicates unfavorable purchasing polices, inability of management to develop Sales volume, over investment in plant facilities etc., (ii) Net Profit Ratio 100 Net Sales = Net Profit It indicates operating efficiency. It is extremely useful to the management being an indication of cost control and sales promotion. This ratio is a guide to efficiency or otherwise of operating the business. (iii) Expenses Ratios to Sales Material to Sales = 100 Sales

Materials Wages to Sales = 100 Sales Wages AUDITING 357 F.O.H. to Sales = 100 Sales F.O.H. Office expenses to = 100 Sales Office Expenses Financial cost to sales = 100 Sales Tax provision Debt Interest + If these ratios are compared with ratios of previous year or with some other business organization, gives very important indication whether these expenses in relation to sales are increasing or decreasing or are stationary, which in its turn reflects the Profit earning Capacity of the concern. Lower the ratio, the greater is the profitability. Combined Ratios : (i) Inventory Turn over Ratio Average Inventory = Cost of Goods Sold A higher ratio suggests efficient business activity, while lower rates suggest that some steps should be taken to push up the sales. This ratio is used for measuring profitability. A low inventory ratio may reflect dull business, over investment in inventory etc., (ii) Turnover to total Assets 100 Total Assets = Sales This ratio is important measure of overall performance of the business. It aims to point out the efficiency or inefficiency in the use of total assets or capital employed. (iii) Debtors Turn over Ratio 360 Net Credit Sales = Total Debtors + BR It is an index of the number of days for which the accounts of Debtor and Bills Receivable remained uncollected. (iv) Account Payable to Turnover Ratio Average net sales permonth = Crs.+ BOD + Other Current Liabilities This ratio shows what period will be required to retire the current liabilities at the current rate of turnover.

(v) Return of Total Assets and interest TotalAssets NetOperating Profit BeforeTaxes = This ratio measures the profitability of total assets. It is the significance of the employment of fixed assets and current assets in the business. (vi) Return on Net Profit Total Asset Current Liabilities Net Profit before Tax and Interest = This ratio is intended to measure the earning power of the Net capital of the business. Analysis has certain limitations like it concentrates on the past performance and deeds in aggregate and serves only as warning signs but though proves helpful in discovering trouble spots when applied in trend analysis. While using this technique auditor may use above ratios or other relevant ratios on the basis of his acquaintance with the clients business. 358 AUDITING AUDITING BASICS II Following illustrations will explain the calculation of different ratios and drawing conclusions Illustration No. 1 : Following is the trading account of Mr. Niranjan for the year ending 31st March 2010 with the corresponding figures for the previous year. Trading Account 2009 2010 2009 2010 ```` 12,500 To Opening Stock 13,300 60,000 By Sales 74,800 48,000 To Purchases 58,400 13,300 By Closing 12,800 To Gross Profit 15.200 Stock 12,100 73,300 86,900 73,300 86,900 And, following is the Balance Sheet of Mr. Niranjan as at 31st of March 2010. Liabilities Amount Assets Amount `` Premises 7,400 Liabilities Plant and Machinery 14,000 Capital 24,000 Motor Vehicle 3,800 Add, Net profit 4,500 Stock 12,100 Less, Drawings (6,000) 22,500 Debtors 502 Bank Loans 10,000 Bank Current A/c 650 Creditors 6,000 Cash in Hand 48 38,500 38,500 Calculate (i) Gross Profit Ratio (ii) Current Ratio

(iii) Acid Test Ratio And, answer the following (i) Is Mr. Niranjan Solvent ? (ii) Is he over trading ? (iii) Is there fall or rise in Gross Profit ratio ? (iv) What can cause a rise or fall in the G.P. Ratio ? Solution : (i) G. P. Ratio = 100 Sales Gross Profit 2006 = 100 60000 12800 = @ 21.33% 2007 = 100 74800 15200 = @ 20.33% AUDITING 359 (ii) Capital Ratio Current Ratio/Working = Current Liabilities Current Assets = 16,000 13,300 = 0.83:1 (iii) Acid Test Ratio / Liquidity Ratio = Liquid Liabilities LiquidAssets = 6000 12000 = 0.5:1 Answers to the queries raised (1) Mr. Niranjan is not a solvent business man. The Solvency Ratio i.e. working capital Ratio and Acid Test Ratio, both are not satisfactory. The ideal working capital Ratio is 2:1 but here in this case the working capital Ratio is 0.83:1, it is too low. Hence, Mr. Niranjan may be put into difficulties at the maturity of current liabilities. The accepted Acid Test Ratio is 1:1, but here in this case it is 0.5:1. Indicating Mr. Niranjan is unable to meet his current liabilities out of his liquid funds immediately. (2) Over trading is the result of excessive Sales. Over trading is the curse to the business. Increasing tendency of Credit Sales, Piling of Stock, Price Spiral, reduction in turnover, poor Cash position are the signs of over trading. In overtrading credit period taken is more than normally allowed.

The over all liquidity declined and the net working capital position becomes precarious. There is increase in current liabilities to a great extent. These are the signs of overtrading. The above signs are applicable in the case of business man Mr. Niranjan. Hence Mr. Niranjans business is over trading. (3) G.P. Ratio of 2009 is 21.33% and that of 2010 is 20.33%, hence we can conclude that there is a decrease in G.P. Ratio by 1%. (4) A Low Gross Profit Ratio may indicate unfavorable purchasing policies, inability of management to develop Sales volume, over investment in plant facilities etc., (1) Capital Gearing Ratio = Fixed Income bearing loans ShareHolders Fund I Year = 11,00,000 12,40,000 = 1.14 : 1 II Year = 8,00,000 13,20,000 = 1.53 : 1 (2) Total Investments to long term liabilities = Long TermLiabilities ShareHolders fund& Long TermLiabilities (i) Year = 11,00,000 23,40,000 =2.13:1 (ii) Year = 8,00,000 20,20,000 = 2.53:1 Trend analysis Trend analysis shows the relative changes between two or more periods. The trends are analyzed for each item of income and expenditure included in Profit and Loss account. The auditor uses this technique to detect unusual decline, to arrive at a conclusion before expressing his opinion in the Audit Report. This trend analysis involves (a) the selection of base period (b) the Computation of different percentages of the current years figures on figures of base year (c) The comparison of current years percentages with base years percentages (d) the analysis of unusual changes in percentages of current year on the basis of base years percentages. The Trend analysis can be understood well from following illustrations 360 AUDITING AUDITING BASICS II

Illustration No. 1 As an Auditor give your Analysis and suggest auditing procedure in relation to the following: ` Credit Sales for the year under consideration 25,00,000 Accounts Receivables at the end of the year 4,00,000 Days Sales in Account Receivable during the last year. 44 Solution : Average Daily Sales = 360 (25,00,000)= ` 6,944 Days Sales in Account Receivable = 6,944 (4,00,000) = ` 57.60 Previous years Days Sales in Account Receivable (given) = ` 44 This shows that, during current year the Company is not collecting its receivables as rapidly as it did in the previous year. This increase in the days Sale in account receivable indicates towards a signal that there is some problem in receivables collection, may be increase in bad debts or inefficiency of collecting machinery or wrong policies adopted by the management. Auditing Procedure to be followed (1) Auditor should review cash receipts and remittances advices for the subsequent period. (2) He should obtain credit reports on significant past dues. (3) He should analyze year end sales to determine any abnormal Sales, determine its nature and see whether properly recorded in relevant period. 6.8 INTERFIRM AND INTRAFIRM COMPARISON Inter firm comparison is a technique of comparing the performance, efficiencies, costs and profits and various concerns in an industry for assessing its own performance and ascertaining the reasons for any difference in performances/efficiencies etc. Inter-firm comparison has been used on a large scale with the objective of making choice of investment by potential investors or to assess the stage of performance of a particular organisation vis-a-vis that of others. The British Institute of Management has explained this aspect as follows : Inter-firm comparison is concerned with the individual firm, its success and the part played by the management in achieving it. The end-product of a properly conducted inter-firm comparison is not a statistical survey but the flash of insight in the might of the Managing Director of a firm which has taken part in such exercise. The results of this give him an instant and vivid picture of how his firms profitability, its cost, turnover and other key factors

affecting the success of a business compared with those of the other firms in this industry. The term intra-firm comparison means comparison of two or more departments or divisions belonging to the same firm with the objective of making meaningful analysis for the purpose of increasing the effectiveness or efficiency of the departments or divisions involved. Thus both inter-firm and intra-firm comparison have the same objective with the difference that while the former compares the performance of the firm with other firms, the latter compares the performance of the firm within itself. The comparison may cover the financial position or operating results or both. Inter-firm comparison, is one of the main techniques, available to management of the day for higher management control and planning. Progressive management always asks itself the questions. (1) How is our unit performing in comparison to that of others? (2) Are we operating as efficiently as we might? (3) Are there areas of our business where improvements might be made? (4) If we are successful, what are the strong points on which our success depends? (5) How can we increase our efficiency and profitability? AUDITING 361 Study Note 7 COMPANIES ACT PROVISIONS RELATING TO AUDITS This study note includes ! Statutory Auditor Appointment, Remuneration, Removal, Rights, Duties & Liabilities ! Joint Audit ! Branch Audit ! Audit Certificate ! Audit Report ! Relevant Provisions of the Companies Act, 1956 and the Income Tax Act 1961. ! Interface between Statutory Auditor and Internal Auditor. ! Corporate Governance 7.1 STATUTORY AUDITOR The Companies Act 1956 has made the audit of accounts of companies in India compulsory. Section 224 to 233 B provided for the qualifications, disqualifications, appointment , removal, rights, duties ,& liabilities of company auditors. Qualification of Company Auditor (i) A person shall be qualified to be an auditor of a company, if he is a practicing Chartered Accountant within the meaning of the Institute of Chartered Accountants Act of India 1949.Sec.226(1)

(ii) A firm shall be qualified to be appointed as auditor of a companies, if all the partners of the firm are practicing Chartered Accountants within the meaning of Chartered Accountants Act 1949,- Sec. 226(1) (iii) A person holding a certificate in an erstwhile part B State Act 1951 which entitled him to act as an auditor of companies in the territories of that state, is also entitled to be appointed as an auditor of companies registered any where in India . Sec.226(2) (iv) A person shall be qualified to be appointed as an auditor to audit cost records maintained u/s 209 (1) (d) by the companies , if he is a practicing Cost Accountant within the meaning of Cost & Works Accountant Act, 1959. Sec. 233 B. (v) A firm shall be qualified to be appointed as cost auditor of company if all the partners of the firm are practicing Cost Accountants within the meaning of Cost & Works Accountants Act 1959 - Sec.233 B COMPANIES ACT PROVISIONS RELATING TO AUDITS Disqualification of Company Auditor Certain persons and/or firms even if they are qualified as above or otherwise, are disqualified from being appointed as auditors of company (i) Chartered Accountant from other countries not being a member of the ICAI Sec.226 (1) inferred meaning. (ii) Cost Accountant from other countries not being a members of the ICWAI sec. 233 B (inferred meaning). (iii) A body corporate Sce.226(3) (a) (iv) An officer or Employee of the Company (b) Sec 226 (3) (b) (v) A person who is either a Partner or employee of an officer or employee of the company Sec. 226(3) (c) 362 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS (vi) A person who is indebted to the company or has given any guarantee or provided any security in connection with the indebtedness of any third person for amount exceeding `1000 Sec. 226(3) (d) (vii) A person holding any security of that company after a period of one year W.E.F. 13.12.2000 - Sec 226 (3) (c) (viii) Other disqualification as per sec of the ICAI Act, 1949 (e.s. a person who is a minor, lunatic, convicted of guilty, insolvent) A person who is disqualified as above is also disqualified for appointment to be an auditor of (A) its holding Company (B) its subsidiary company

(C) a subsidiary of its holding company. Sec 226.(4) In addition to above, if an auditor of a company holds audit of more than 20 companies (based on paid-up capital), he is deemed to be disqualified for appointment as an auditor of other companies Sec.224 (1 - B) If an auditor attains any disqualifications after his appointment he shall be deemed to have vacated his office as such Sec226(5) Appointment of a Company Auditor A person qualified to be appointed as an auditor of the company can be appointed as auditor of the company as provided by section 224 of the Companies Act, 1956. The provision regarding appointment of Company Auditor can be explained as under(A) First Auditor: The first auditors of the company is to be appointed by the Board of Directors within the period of 30 days from the date of incorporation of the company and he shall hold the office up to first Annual General Meeting. If the Board of Directors fails to appoint the auditor/s the first director the company in general meeting may appoint the first anditor/s. - sec.224(5) (B) Appointment of Subsequent Auditors: Every appointed auditor holds office till the conclusion of the Annual General Meeting and therefore, every Annual General Meeting has to appoint subsequent auditor. Immediately after receiving the intimation of appointment from the company, the auditor within 30 days intimate his acceptance or refusal of the appointment to the Registrar of Companies in form No-23-B Usually, the retiring auditor shall be re appointed as an auditor of the company, except, when (i) He is not qualified for re- appointment or (ii) He has shown his unwillingness by way of a notice in writing to get reappointed or (iii) A Resolution, not appointing retiring auditor or to appoint somebody else in his place is passed by the company. Sec.224(2) (C) Appointment by Special Resolution : In case of companies in which not less than 25% of the subscribed share capital is held whether singly or in any combination by (a) A Public Financial Institution or a Government Company or Central Govt. or any State Govt. or any financial institution or other institution in which a State Government hold not less than 51% of the subscribed share capital, or (b) A nationalized bank or an insurance company carrying on general insurance business

The appointment or re- appointment of auditor under this section must be made by passing a special resolution. If company fails to pass a special resolution, it shall be deemed that, no auditor is appointed by the company,Sec.224A. (D) Casual Vacancy Vacancy in the office of auditor caused by death, insolvency, or disqualifications of auditor can be filled up by Board of Directors of the company However, in case of vacancy caused by resignation of auditor is only to be AUDITING 363 filled by general meeting of the company. An auditor appointed in casual vacancy shall hold office until conclusion of the next Annual General Meeting Sec.224(6) (E) Appointment by Central Government : Where at an Annual General Meeting no auditor is appointed or reappointed the company must inform to the Central Govt. about its failure within a period of 7 days. On receipt of information the Central Government may appoint a person to fill the vacancy in the office of auditor Sec.224(3) and 224 (4) COMPANIES ACT PROVISIONS RELATING TO AUDITS (F) Appointment of Auditor of Government Companies & Certain Other Cos The auditors of Government Companies shall be appointed or reappointed by the Central Govt. on the advice of the Comptroller & Auditor General of India- sec.619, notwithstanding the provisions contained in section 224 & 233. The provision of sec. 619 shall apply to a company, in which the Central Govt. or State Govt. hold either singly or jointly not less than 51% of the paid up share capital, be appointed or reappointed by the Central Govt. on advice of the Comptroller and Auditor General of India. (Sec. 619B) (G) Appointment of Auditors in the case of a company in voluntary liquidation No question of fresh appointment of auditors for this specific purpose envisaged by sec 224 of the Companies Act.1956. But if the winding up proceeding continues for more than one year, then it is left to members or creditors, as the case may be, to decide whether or not the auditors are to be appointed to audit the liquidators account. (Sec.496) Remuneration of Statutory Auditors (a) Remuneration of Statutory Auditor will be fixed by the directors when auditors are appointed by them before the first Annual General Meeting or to fill up a casual vacancy other than the one caused by the resignation by the auditor.

(b) In case of the auditor appointed by Annual General Meeting, remuneration will be fixed by the shareholders. (c) In case of the Govt. Company Auditor, whose appointment is made by the Central Govt. the remuneration will be fixed by CAG. (d) In case of the Auditor appointed by AGM fixing of remuneration entrusted upon the Board. The Board of Directors will fix the remuneration. For this purpose, the expression remuneration should be deemed to include any sums paid by the company in respect of the auditors expenses. Students may note that the Act does not specifically require that the remuneration should be fixed at the same meeting of the company at which the appointment is made. It may, therefore, be fixed at a subsequent meeting. Where a retiring auditor has been reappointed, his remuneration in the absence of any resolution fixing a different remuneration is considered to be the amount already fixed, in respect of the previous appointment. Where, in addition to the normal audit, the auditor is also required to render services as may be required, he is entitled to receive remuneration in addition to the normal fee for the audit. Such additional remuneration is a matter of arrangement with the directors. But any remuneration paid as fees, expenses or otherwise for such service must be disclosed in the Profit & Loss Account. The remuneration paid to the auditor is required to be shown in the Profit & Loss Account separately : (a) As auditor: (b) As advisor or in any other capacity in respect of: (i) Taxation; (ii) Company law matters; (iii) Management service; and 364 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS (c) In any other manner (Sch.VI - Part - II - Clause 4-B) The Council of the Institute of Chartered Accountants of India in the Statement on Payment to Auditors for other Services has recommended that the fees paid to the auditors for other services rendered should be disclosed in the Profit and Loss Account of the companies under the following head in order to give precise and correct information to the shareholders and others who read the accounts pertaining to (i) Tax representation (ii) Company law matters (iii) Management services

(iv) Internal auditing (v) Other services In case of joint audit, if other services were rendered by one of the joint auditors or in case of a company having a branch, the other services were rendered by the branch auditor disclosure should be made accordingly. Removal of an Auditor (1) First Auditor : By implication first auditor appointed by the Board of Directors can be removed by passing ordinary resolution in the first annual general meeting of the company. Sec. 244(1) (2) Subsequent Auditors: The subsequent auditors can be removed either before the expiry of his office or after expiry of his office. (a) Removal Before Expiry of office: If the company wants to remove the auditor before the expiry of his office, the company must obtain the prior permission of the Central Govt. and then give 14 days notice to shareholders of the company and copy of such notice shall be forwarded to the concerned auditor and the auditor may send his representation to the company. The company on receipt of such representation either circulate it amongst the shareholders of the company or read it in front of general meeting. If the general meeting after considering his representation, passes a resolution, to remove the auditor, then the auditor stands removed form his office. (Sec. 224(7) and Sec. 225) (b) Removal After the Expiry of the office : At every Annual General Meeting the office of the auditor expires and hence either the reappointment of retiring auditor or appointment of new auditor is necessary, usually the retiring auditor is reappointed, but if the company wants to remove the retiring auditor the company has to give 14 days notice to its members and forward its copy to the retiring auditor. The retiring auditor, if he so desires, send his representation to the company and the company on receipt of such representation may circulate it among its members or get it read in the meeting and if the meeting after considering the representations passes a resolution to remove the auditor, the auditor stands removed. (Sec 224(7) and Sec. 225) Rights of Company Auditor To enable the company auditor to perform his duties efficiently, Sec.227 of the Companies Act 1956, has given some rights as well as imposed certain duties on company auditor. The provisions relating to rights can be

explained as under(A) Access to books of accounts & voucher etc : Every auditor of the company shall have a right of access at all times to the books accounts, vouchers, records of the company, whether kept at the head office of the company or elsewhere. The auditor has a right to inspect books, accounts, vouchers and supporting documents at any time. This right of the auditor is absolute & unconditional and the same cannot be restricted by the company through its Articles of Association (Newton VS Birminghams Small Arms Co. (1906) 2ch 378) (B) Obtain Information & Explanation : Every Auditor is entitled to obtain all information & explanation necessary for his audit work from office bearer of the company. This power to obtain information is wide enough to cover any information or explanation at his discretion. If it is denied by any body, auditor may report it to the shareholders. (C) Report to members : Company Auditor has right to communicate his comments & remarks to the members through his report complying with the provisions of the Companies Act and made thereunder. AUDITING 365 (D) Receive Notice : The auditor of the company has a right to receive all notices to any general meeting of the company. (E) Attend General Meeting : The company auditor has right to attend the general meeting of the company, as well as he can participate in the discussion relating to accounts & audit of the company as provided u/s 231. (F) Branch Accounts: Auditor, if he desires, can visit the branches & inspect the book of accounts of the branch as u/s 228 of the Companies Act.1956. (G) Advice: The auditor can take legal or technical advice relating to the accounts of the company & while reporting on the matters where in he has obtained such advice , he should clarify it but should give his own opinion & not that of the expert (London & General Bank 1895.) (H) Lien: The company auditor has right of lien on working papers, these are the property of the auditor & can retain the same with him, (Chantrey Martin and Co. VS Martin 1953. 2 All ERG 91.) (I) Remuneration: The auditor has a right to receive remuneration of the audit work completed by him. And

also, if, he is removed during the year, he is entitled to a full years remuneration (Homer VS Quilter , 1908.) (J) Signature: The auditor has a right to sign the audit report as provided u/s 229 of the Companies Act 1956. (K) Indemnity: The Co. auditor has a right to be indemnified out of the assets of the company against any liability incurred by him in defending against any civil & criminal proceeding by the company if it is provided that the auditor worked honesty while performing his audit work, as per section 633. (L) Correct Wrong Statement: If the auditor s advice to amend faulty P& L A/c . and/or Balance sheet ,not followed by the directors, he can report it to share holders by way of qualified report. Duties of Company Auditor The auditor owes large number of duties as explained below: (A) Duties to Share Holders: (i) Report shareholders about the true & fair state of affairs of the company u/s 227 (2) (ii) Ensure that the Balance Sheet and Profit & Loss A/c gives the required information as per sec. 227 (2) (iii) State in his report that he has obtained all the necessary Information u/s 227(3) (iv) State in his report that whether the Co. has maintained all required books of accounts u/s227(3). (v) Report whether the Balance Sheet and Profit & Loss A/c agrees with the books of accounts u/s 227 (3). (vi) State in his report whether the B/S and Profit & Loss A/C comply with the Accounting Standards or not. (vii) Give the reasons behind qualifying his report u/s 227(4) (viii) Report whether he has received the audit report on the branch accounts audited by other auditor & how he has dealt with the same in preparing his report u/s 227(3) (ix) Auditor shall state in his report whether (a) The loans are properly secured & the terms are not against the interest of the company. (b) The transactions merely representing book-entries as recorded in the books are not against the interest of the company. (c) The securities have been sold by Co.s other than Banking Investment Co., at a price-less than purchase price. (d) Loans made by Co. have been shown as fixed deposits. (e) Personal expenses have been charged to revenue account sec . 227(1-A) (f) Report whether the company has complied the requirements of CARO-2003 (Sec. 227 (4A) (B) Duties towards company : (i) Prospectus: Auditor has to certify profits or losses, assets & liabilities, dividend paid etc. disclosed in

the prospectus (sec 56.) 366 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS (ii) Statutory Report: Auditor has to certify the statutory Report of the company which requires to present it in its Statutory Meeting (sec. 165.) (iii) Public deposits: Auditor has to report about whether the Company has complied with the requirement, of RBI in regard to public deposits or not. (Sec. 58AA) (iv) Signature Auditor should sign the audit report prepared by him (Sec. 229.) (v) Insolvency: Auditor should make a report on the Companys Profit & Loss A/c. for the period from last audited P & L Account to the date of declaration required to be accompanied with the declaration of solvency by the company (sec 488(2).) (C) Duties towards Government : (i) CARO-2003: It prescribes verification of large number of corporate activities & this order imposed various responsibilities on auditor & it is the duty of the auditor to verify the records of the company from these angles & ensure that the scarce resourses of the company are properly utilized. (ii) Investigation: It is the duty of the company auditor to assist the investigator appointed by the Central Govt. u/237 to investigate into the matters regarding the affairs of the company. (D) Duties towards general public : (i) Auditor has to bear in mind the interest of general public as his office is of public confidence & faith. (ii) While conducting audit he should see that his report does not fail to disclose material information, which may affect the companys state of affairs. (iii) While certifying prospectus he should see that it does not include misleading statements which may cause the general public to subscribe to the Companys share issue & may suffer a financial loss in future, (Hadley Byrney & Co.LTD VS Hiller & Partners) Liabilities of Auditor Auditors liability is most dynamic & always changing from time to time. In past auditors were held liable to their principals only but now a days they are liable to third parties too. Auditors liabilities can be classified as under. (A) Liabilities for Negligence. (B) Liabilities under the Companies Act 1956 (C) Liabilities for misfeasance. (D) Liabilities under Penal Code.

(E) Liabilities under Chartered Accountants Act,1949 and under Cost & Works Accountants Act 1959. (under specific reference) (F) Liabilities under the I.Tax Act 1961. (G) Liabilities to the third parties. (A) Liabilities for Negligence: Negligence means carelessness, failure to use standard degree of care & skill while doing audit and whenever it is proved that auditor is guilty of negligence he is held liable to compensate the loss sustained by others , may be appointing company or any third party like Bank or I.Tax Deptt. as decided in the casesCANDLER VS Crane Christmas and Co. 1951. Hedlery Byrne and Co. LTD. VS Heller & Partners 1964. Anns VS Merton London Borough Council.1978. Junior Books Ltd. VS Veitsschi Co.Ltd.1982. London Oil Storage Co.LTD.VS. Seear, Has Luck & CO.1904. (B) Liabilities under Companies Act 1956 Sec. 62: Prospectus Auditor is liable for certifying misleading statement in the prospectus and he has to compensate equivalent to damages suffered by the parsons (civil liability) AUDITING 367 Sec. 233: Signing false report. or document- Auditor is liable for signing a false report or any other document u/s 227 & u/s 229 and if proved, he shall be punishable with fine which may extend to ` 10,000 (civil liability). Sec 539 : Falsification of Books If with intent to defraud or deceive any person, auditor of a company which is being wound up, destroys, alters, falsifies any books, papers or securities he shall be punishable with imprisonment for a term which may extend to seven years and shall also be liable to fine (Criminal liability). Sec 628 : False Statement If in any return, report, certificate, balance sheet, prospectus, statement or any other document required under Companies Act, a false statement is made and knowing it to be false, if auditor certifies it as true, he shall be punishable for a term which may extend to two years and shall also be liable to fine (Criminal Liability). (C) Liabilities for Misfeasance: The term misfeasance means breach of trust or duty and auditor is liable for equivalent damages suffered by the company to third party (Sec.543.) This liability was well decided in following casesThe London & General Bank Ltd. 1895. The Irish Woolen Co. Ltd. VS Tyson & Others1900. The City Equitable Fire Insurance Co. Ltd, 1925.

The West Minister Road Construction & Engg. Co.Ltd. 1932. The Official Liquidator of Palai Central Bank Ltd. VS Joseph and others 1963. (D) Liabilities under Indian Penal Code : Auditor is liable under Indian Penal Code for frauds, furnishing false information etc. Sec 177 : Prescribe simple imprisonment up to 6 months & fine upto ` 1000 for furnishing false information. Sec 188 and Sec. 199: A false statement on oath & false declaration attracts criminal liabilities under these sections of Indian Penal Code and attracts imprisonment up to seven years & fine. Sec 193: For giving false evidence in judicial proceedings attracts imprisonment up to seven years or fine or both. Sec 197 Signing any certificate or documents knowing it to be false, attracts imprisonment upto seven years or fine or both. In following cases auditor was held liable for criminal offencesForrows Bank Ltd.,1921 Official Liquidator Karachi Bank Ltd. VS The Directors Of Karachi Bank. (E) Liabilities under Chartered Accountants Act , 1949 and Cost & Works Accountants Act 1959 : (I) Chartered Accountants Act. 1949: For professional misconduct, the council may either withdraw the certificate of practice or remove name of the Chartered Accountant from its Members Register or forward the case to the High Court. (II) Cost & Work Accountants Act 1959 : For professional misconduct, the council may either withdraw the certificate of practice or remove name of the Cost Accountant from its Members Register or forward the case to the High court. (F) Liabilities under I.tax Act 1961: Sec 288 : Authorized Representative : If an auditor or a person has been convicted of an offence connected with any I. Tax proceeding or on whom penalty has been imposed under I. Tax Act, shall be disqualified to act as a representative of an assesses for a certain period. Sec 278 : FALSE REPORTS If an auditor or a person who certifies or induces other person to make & deliver to the I. Tax authorities false accounts, reports certificates etc., he shall suffer be rigorous imprisonment and / or with fine. Rule 12A : Chartered Accountant : If prepares false I. Tax Return of an assesses in the capacity of an authorized representative or prepares false tax audit report to be accompanied with the I.T Return, it attracts, punishment by way of rigorous imprisonment. 368 AUDITING

COMPANIES ACT PROVISIONS RELATING TO AUDITS (G) Liabilities to third party: (i) Generally, it appears that as there is no privacy of contract between auditor & third party, he cannot be held liable and as he is never appointed by third party he has nothing to do with such a party & this was confirmed by the case of Le Lievre & Dennes VS Gould 1893. (ii) No doubt there is no privacy of contract, the third party can hold the auditor liable for any fraud. (iii) Auditor has moral responsibility to third party. (iv) If any body relying on the audited statement of a company, takes any decision & suffers any loss because such statements were false, the auditor will be responsible to them. (v) If auditor had authorized the issue of a prospectus containing misleading statements, he would be held liable for damages to third party, which has purchased the shares of the company on the strength of such a misleading statement even though there might not have been any privacy of contract between the auditor & the shareholder. 7.2 JOINT AUDIT Two or more auditors are some times appointed, specially in the case of large concerns such as banking or insurance companies or where the regulations of the company require such appointment. In the absence of specific provisions in the Companies Act 1956, The Institute of Chartered Accountants of India has issued a statement on the Responsibilities of Joint Auditors to provide a clear idea of the professional responsibilities under taken by the Joint Auditors. According to the statement it would not be correct to hold an auditor responsible for the work of another and each joint auditor will be responsible only for the work allotted to him. In coming to these conclusions, the council considered that the extent of work to be carried out is a matter of professional judgment and that no two firms, whatever be their standing and competence, will necessarily exercise their judgment in an identical manner so as to perform the same volume of work in the same manner. Where joint auditors are appointed, they should divide the work of audit between them by mutual discussion. Such division of work would usually be in terms of identifiable operating units or specified areas of work and, in such a case, it is a good practice to communicate to the client, wherever possible, the actual division of work. Where auditors have been allotted the work of separate units or branch it would be desirable for each auditor

to prepare a separate report on the financial statement of the branch or the unit for which he is responsible. When a natural division of work is not possible, the statement suggests that some division of work, by classification of assets or liabilities or income or expenditure or period of time, should be made. It is the responsibility of each joint auditor to determine the extent of audit test to be applied in relation to the area of audit allocated to him and the manner in which it is to be performed. Consequently, it is the separate and specific responsibility of each joint auditor to enquire in to the review of the prevailing systems internal control relating to the work allocated to him. Not with standing allocation of the job between the joint auditors on some agreed basis, it is possible that certain areas and matters may continue to be of common concern. Consequently, each auditor should bring to the attention of his co-auditors the matters which require discussion, the disclosure or application of judgment, by the submission of a report or a notice prior to the finalization of audit. Each joint auditor is to assume that his co-auditor have carried out the audit in accordance with the auditing and assurance standards, laid down by the Institute. It is not necessary for a joint auditor to review the work performed by his co-auditor or to perform any tests in order to ascertain whether the work has actually been performed. Each auditor is entitled to assume that his co-auditors will bring to his notice any departure from the Generally Accepted Accounting Principles or any material error noticed in course of the audit unless corrective action has already been taken before the accounts are finalized. Where separate financial statements of a branch or an unit are reported upon by one of the joint auditors, each joint auditor is entitled to assume that such financial statements comply with all the legal & professional requirements regarding the disclosures to be made and also present a true and fair view of the state of affairs of the unit audited. AUDITING 369 As regards the report, where joint auditors are in disagreement with regard to the report, each one of them would be justified in expressing his own opinion through a separate report. Even when more than two joints auditors are appointed, there is no question of minority with regard to audit report. It can be argued that though, in so far as the delimitation of professional responsibility is concerned the pronouncement has adopted a practical approach to the problems posed by joint audit, all the questions of

practical relevance specially those relating to allocation of the audit work might not have been adequately answered. Accounting after all involve complex process. It may not be a simple proposition to rationally allocate the work and to ensure overall truth and fairness on the basis of piecemeal work carried out by different auditors adopting an equal standard. The statement also does not answer the question of civil liability of joint auditors to the client or the third parties. For the purpose of computation of the number of company audits pursuant to the Sec 224 IB of the Companies Act each joint auditorship in a company will be counted as one unit. Advantages of Joint Audit Joint Audit basically implies pooling together resources and expertise of more than one firm of auditors to render an expert job in a given time period which may be difficult to accomplish acting individually. It essentially involves sharing of the total work. This is by itself a great advantage. In specific terms the advantages that flow may be the following : (i) Sharing of expertise (ii) Advantage of mutual consultation (iii) Lower work load (iv) Better quality of performance (v) Improved service to the client (vi) Displacement of the auditor of the company often obviated. (vii) In respect of multinational companies the work can be spread using the expertise of the local firms which are in a better position to deal with detailed work and the local laws and regulations. (viii) Lower staff deployment cost (ix) Lower cost to carry out the work (x) A sense of healthy competition towards a better performance Disadvantages of Joint Audit The following may be the disadvantages of a joint audit (1) Sharing of fees (2) Psychological problem, where firms of different standing are associated in Joint audits (3) Superiority complex of some auditors may affect the work of co-auditor (4) Problem arises regarding co- ordination of the work (5) Areas of work of common concern being neglected (6) Uncertainty about the liability for the work done. 7.3 BRANCH AUDIT In accordance with the principle of independent audit of the company accounts, the Companies Act in Section 228 has provided for the audit of accounts of branches. Section 2(9) of the Companies Act defines a branch

office in relation to a company as : (i) any establishment described as a branch by the company; or (ii) any establishment carrying on either the same or substantially the same activity as that carried on by the head office of the company; or (iii) any establishment engaged in any production, processing or manufacturing but does not include any establishment specified in any order made by the Central Government under Section 8 of in Companies 370 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS Act (Viz. Branch Audit Exemption Rule) Section 228 of the Companies Act provides that where a company has a branch office, the accounts of that office shall be audited either by the companys auditor appointed u/s 224 or by another auditor possessing qualifications prescribed u/s226. In the case of a branch situated outside India, any of the above or an accountant qualified to act as auditor in the country concerned can be appointed as the branch auditor. The scheme of Section 228 presumes that normally the company auditor shall be appointed as the branch auditor. However a company may decide to have the branch accounts audited by a person other than the company auditor in a general meeting. In such a situation, the company is required to appoint the branch auditor out of the eligible categories in the same meeting or it has to authorize the Board of Directors to appoint one in consultation with the companys auditor appointed u/s 224 (Statutory Auditor). The appointment of branch auditors in consultation with the companys statutory auditor should not be taken to mean that the statutory auditor is in any way taking responsibility in respect of the work done by the branch auditor. The provision regarding consultation with the statutory auditor only implies that statutory auditor should be satisfied that prima facie, he is not aware of any reason why the proposed auditor should not be appointed as branch auditor. The branch Auditor shall have the same powers and duties in respect of the audits of the branch accounts as the company auditor has in relation to the company accounts. The powers that the company auditor enjoys in relation to branch accounts are the rights (i) to have access at all times to the books of accounts and vouchers of the branch (ii) to visit the branch and (iii) to obtain information and explanation considered necessary for the audit of the branch accounts.

But the branch auditor, unlike the company auditor will not have the right to attend the general meeting of the company or to receive the notice and other related communications in connection with the general meeting. The branch auditor is required to prepare a report on account of the branch examined by him and forward the same to the companys auditor. It is obvious that when the company auditor himself is the auditor for the branch accounts, there cannot be any question of any report being made on the branch accounts audited. He, as the auditor for the company, is under duty to make a report on the consolidated accounts in accordance with Section 227 of the Companies Act. The branch auditor shall receive such remuneration as may be fixed for him by the general meeting appointing him or by the Board of Directors, if so authorized by the General Meeting, subject to the terms and conditions specified Naturally, it is reasonable to presume that the branch auditor will not necessarily hold office like the statutory auditors under section 224. Though independent professional scrutiny of the branch accounts is the principle in providing audit, the legislature, having regard to the element of materiality and other considerations, has provided that under certain circumstances the accounts of the branch may not be audited. Companies (Branch Audit Exemption) Rules 1961 have been issued under sec 228 (4A) to provide for the exemptions, a branch of a company carrying on manufacturing, processing or trading activity, account for average quantum of activity not exceeding higher of ` Two lakhs or 2% of the average turnover of the company shall be exempt form the purview of audit of branch accounts. Quantum of activity means the highest out of the following :(i) the aggregate value of the goods or articles produced, manufactured , or processed or (ii) the aggregate value of the goods or articles sold and services rendered or (iii) the amount of the expenditure, whether of a revenue or a capital nature, incurred by a branch office during a financial year. There may be exemption also on other grounds. But these exemptions are discretionary subject to the satisfaction of the Central Government viz : (i) If there are satisfactory arrangements for the scrutiny and check at regular intervals of the accounts of the branch office of a company, not carrying on manufacturing or processing or trading activities, by a

person who is competent to scrutinize and check the accounts. (ii) If arrangements are made for the audit of the accounts of the branch office by a person possessing the qualifications necessary for appointment as branch auditor even though such person is an employee of the company. AUDITING 371 (iii) if a branch auditor is not likely to be available at reasonable cost, having regard to the nature and quantum of activity carried on at the branch or having regard to any other reason. (iv) If for any other reason, the Central Government is satisfied that exemption may be granted. The company auditor in his report is to make a mention about exemption form audit granted to any of the branches of the Company under the Companies (Branch Audit Exemption) Rules, 1961 Companys Auditor in Relation to Branch Accounts, Branch Audit And Branch Auditor. When the companys auditor himself is auditor for the branch accounts, he treats the whole company as audit unit and ensures that the branch accounts have been properly incorporated in the main office account for consideration. Also there remains no question of any separate and distinct right to visit branch or to have access to the books, accounts and vouchers. When the branch accounts are audited by a person other than the companys auditor, it is necessary to define the position of the company auditor in relation to branch accounts and branch auditor. The Companies Act, u/s 228 (2), has given a right of the companys auditor to visit the branch and to have access to the books of accounts and vouchers maintained at branch when the branch audit is conducted by a person other than the companys auditor. Also, the Companies (Branch Audit Exemption ) Rules, 1961 has retained this right for the companys auditor in respect of branches granted exemption from audit this is a right given to the company auditor and not a duty cast on him. If in his own assessments of the situation, he considers it necessary for the proper audit of the accounts of the company, he may visit the branch and may have access to the books, accounts and vouchers maintained there: but it is not compulsory that he must visit the branch or branches. Under Section 228(3) (c), the companys auditor is required to deal with the branch audit report received from the branch auditor, in preparing his own reports. The manner in which to deal with report is left to him. This

requirement is supplemental to the main duty cast on him under section 227(3)(bb) to state in his report whether the branch audit report has been forwarded to him and how he has dealt with the same. Full freedom of judgment has been given to the company auditor to decide the prima facie relevance and impact of the branch audit report on the total company accounts. Certain matter may appear material and important in limited context of the operations of the branch may be considered not much significant in setting of total company accounts. He, therefore, may incorporate the points, if any, made in branch audit report if he considered the same relevant in making the Consolidated Accounts true & fair. He at his discretion may drop any or all the qualifications made in the branch audit report. However, if the branch audit report contains qualifications on matters specially required to be disclosed in the Companies Accounts pursuant to the Schedule VI requirement, then it is obvious that the company auditor is left with no choice but to incorporate them in his own report after confirming the accuracy of the report, if he so feels. The Companys auditor has a certain measure of responsibility in respect of the accounts and papers of the branch. This is shown by the fact that he has a right to visit the branch and has access to the papers and documents he has to make disclosure of anything in regard to the branch which he thinks is not in order and which has come to his notice. The Statutory Auditor and Branch Auditor and has come the conclusion that the Statutory Auditor would not be responsible in respect of the work entrusted to the branch auditor. However, sufficient liaison between the two auditors is needed to ensure that the work is performed expeditiously, and expresses the view that statutory auditor will be within in his right to issue written communication to the branch auditor to that end. The statutory auditors are entitled to make such enquiries as they think fit from the branch auditor. In making those enquiries, the statutory auditor will have regard to the materiality of the branch and any other circumstances affecting the operations of the company. The auditor of the branch office should comply with request for information from the statutory auditors recognizing that such a request results not from a doubt as to competence of the branch auditor but for legal duty cast upon the statutory auditors to ensure that the accounts give a true and fair view and also gives

information required by the Companies Act. 372 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS The statutory auditor may require the branch auditor to answer a detailed questionnaire regarding matters on which the statutory auditors required information that he considered necessary for an expeditious and proper audit but nevertheless keeps him free from any responsibility as regards the audit work performed by the branch auditor. In effect the statutory auditor is positioned to supervise to the branch auditors work and to this extent, it is in his accordance with the provision of the Companies Act. It has however, absolved the auditor from any responsibility connected with the work supervised. 7.4 AUDIT CERTIFICATE Some times apart form an audit report for general use, an auditor is often called upon to give a certificate for special purpose. The certificate should include the following : (a) Auditor should see that there is a suitable declaration by the management about the subject matter. (b) Auditor should give the certificate on his letter head or on stationary carrying his name and address to avoid misunderstanding . (c) Auditor should clearly state his limitations and indicate the extent to which he has relied upon a technical expert if any. (d) Auditor should indicate the specific record covered by the certificate. (e) Auditor should mention the manner in which the audit was conducted. (f) Auditor should indicate in the certificate if he has made certain fundamental assumptions. (g) Auditor should make a reference to the information and explanations obtained. (h) Auditor should give clear title to it, indicating whether it is a report or a certificate. (i) Auditor should mention whether he has used any general purpose statement like Profit & Loss Account for his investigation and also, state whether that general purpose statement has been audited by other auditors. (j) Auditor should be careful while interpreting any law related matter, he should clearly mention that he is expressing merely his own opinion. (k) Auditor should see that the certificate should be self contained documents. (l) Auditor should clearly mention the responsibility assumed by him. (m) Auditor should, if he has referred the audited statements, clearly mention that the figures are used from the audited statements and relied upon. (n) Auditor should address the certificate to the client or the Public Authority or the person requiring it as

the case may be. In appropriate circumstances it may be issued by using the words as to whom so ever it may concern . Examples and Specimens of Auditor Certificates There are many more circumstance, where for, auditor is called for issuing a certificate, e.g., (i) Deposits Return Certificate. (ii) Ability to Refund Depositors Certificate. (i) Deposits Return Certificate : As provided under rule 10(1)of the Companies(Acceptance of Deposits), Rules , a non banking, non financial company has to file periodical return in prescribed form containing the information about deposits accepted and the copy of the return is required to be filed with the R.B.I. This return is to be certified by the Company Auditor. AUDITING 373 The specimen of the Certificate may be as under :CERTIFICATE We certify that to the best of our knowledge and according to the information and explanation given to us and as shown by the records examined by us, the figures of deposits and interest rates under parts A, B and C of the return of the Co.Ltd. are correct. We further certify the correctness of the particulars of the paid up capital and free reserves etc. given in the managers certificate. Signature & Seal of Date: Chartered Accountant /Cost Accountant Place: Full Address (ii) Ability to Refund Deposits Certificate: As per the provisions of the Non Banking Financial Companies(Reserve Bank)Directions, issued from time to time every non banking financial company is required to furnish to the RBI a certificate from its auditor to the effect that, the full liabilities to the depositor of the company including interest are properly reflected in the Balance Sheet and that the company is in a position to meet the amount of such liability to the depositors. As prescribed by the RBI, the certificate shall be in following format CERTIFICATE We certify that, on the basis of the checks carried out by us and the information and explanations given to us , I am of the opinion that full liabilities to the depositors of the company including interest payable thereon have been reflected in the financial statements as on 31st March........ of the company, as per the

said financial statements and on a going concern basis and based on information and explanation given to me, is in a position to meet the liabilities to the depositors, as on that date. Also, an auditor is required to give certificate under various provisions of the Companies Act 1956, for example, u/s 56 for matters in the prospectus, U/s 58 A for public deposits, U/S 165 for accuracy of the statutory report, etc. In short, Audit Certificate is a written confirmation of the accuracy of the information stated therein but does not involve any opinion. Signature & Seal of Date: Chartered Accountant /Cost Accountant Place: Full Address 374 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS 7.5 AUDIT REPORT Audit Report While conducting every audit auditor has to go through three phases(a) Preliminary work for audit. (b) Conduct of actual audit, and (c) Conclusion of audit , which means submission of Audit Report. Therefore, Audit Report is called as the ultimate and final product of every audit. The meaning of Audit Report can be well understood from the following selected definitionsLanCester A Report is a statement of collected & considered facts, so drawn up as to give clear and concise information to persons who are not already in possession of the full facts of the subject matter of the report. J.B.Ray-The Report shall either contain as expression of opinion regarding the financial statements, taken as a whole or an assertion to the effect that an opinion cannot be expressed when an overall opinion cannot be expressed, the reason therefore should be stated. In all cases, where auditors name is associated with financial statements the report should contain a clear cut indication of the character of the auditors examination, if any, and the degree of responsibility he is taking. In short, the Audit Report is nothing but a statements of observation gathered & considered while proving conclusive evidence of companys financial position. It is a medium through which an auditors expresses his opinion on the financial statement under audit. It is an important part of the audit as it provides the results of the audit conducted by the auditor. 5.1.2. Importance of Audit Report-

1. An Audit report is the end product of the auditing and is very important & concluding part of the audit process. 2. Audit report gives the auditors opinion on the accounts & record of the company, as examined by him. 3. Audit Report reflects the work done by the auditor. 4. Audit report is the instrument which, measures the auditors responsibility in regard to the true & fairness of the financial statement of the company. 5. Audit Report indicates the real position of the financial status of the company & which is used by different people as a reliable document. Contents of Audit Report The Audit report generally shows the nature and scope of audit conducted by the auditor and his opinion on the final accounts of the company. Companies Act, 1956 and International Auditing Guideline has laid down certain guidelines relating to the contents of auditing reports as under 1. Title The report has certain title like Audit Report to enable the readers to identify the report & distinguish it from reports issued by others. 2. Address The audit report should appropriately addressed e.g. in case of company audit, it should be addressed to the shareholders. 3. Observations (a) Auditor should state whether he has obtained all the information & explanations which to the best of his knowledge & belief were necessary for the purpose of his audit. (b) He should state whether proper books of accounts as required by law have been kept by the company or not. (c) He should mention whether Balance Sheet and Profit & Loss Account attached there to give a true & fair view of the state of affairs of the company. (d) He should state whether the Balance Sheet and Profit and Loss Account annexed there to are in agreement with the books of accounts. AUDITING 375 (e) He should state whether the Balance Sheet and Profit & Loss Account read with notes there on give the information in the manner required by the Companies Act. 1956. (f) He should also, state whether the provision of section 227(1A)and 227(4A) of the Companies Act, and also that of a CARO are complied with or not and gives separate statement on that to form part of the audit report.

4. Auditing Standards : In the audit report the auditor should make a reference to the Standard on Auditing (SA) to ensure that he has carried out the audit in accordance with the established standards. 5. Opinion: The Audit Report should clearly set forth the auditors opinion on the companys financial position and operational results like the Financial Statements give true & fair view of the state of affairs. The opinion may be either i) Unqualified ii) Qualified iii) Adverse or Negative iv) Disclaimer (i) Unqualified : When an auditor gives an opinion without any reservation, it is an unqualified opinion. (ii) Qualified: When an auditor gives an opinion with certain reservation, it is said that he has given a qualified opinion. (iii) Adverse or Negative: When an auditor states that he does not agree with the true & fair state of affairs exhibited by the final accounts, then it is an adverse or negative opinion. (iv) Disclaimer: When an auditor states that he is unable to express an opinion as he has not received necessary evidence to form an opinion then it is a disclaimer of opinion. 6. Signature: The audit report is required to be signed in the name of the firm of auditors or the personal name of the auditor or both as appropriate, in keeping with terms of appointment (whether on Individual or a firm) 7. Auditors Address: The report should contain the auditors postal office address. 8. Date of the Report : The auditor report should carry the date of the report. Qualified Audit Report When auditor gives his report with certain reservations, then the report is called a qualified audit report. In following circumstances the auditor has to qualify his report. (a) He cannot conduct audit satisfactorily due to non availability of certain books of accounts or records, information or explanations necessary for conduct of his audit. (b) He finds that the Balance Sheet and Profit & loss Account have not been prepared in accordance with accepted accounting principles. (c) He detects that provisions for Bad & Doubtful Debts, Depreciation etc. are not adequate. (d) He detects that the company has created certain secret reserve. (e) The stock in trade has been valued at market price which is more than cost price. (f) He finds that the contingent liability for bills discounted has not been disclosed. (g) If in his opinion provision for taxation made is not proper. (h) When he finds any embezzlements of cash or misappropriation of goods or manipulation of accounts which considerably affects the financial position of the company. Specimen of Qualified Audit Report: Auditors Report

To the Members of ABC Ltd. 1. We have audited the attached balance sheet of ABC Ltd. as at March 31, 2010 and also the Profit and Loss Account and the Cash Flow Statement for the year ended on that date annexed thereto. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit. 376 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS 2. We conducted our audit in accordance with auditing standards generally accepted in India. Those Standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. 3. As required by the Companies (Auditors Report) Order, 2003 issued by the Central Government of India in terms of Sub-section (4A) of Section 227 of the Companies Act, 1956, we annex hereto a statement on the matters specified in paragraphs 4 and 5 of the said Order. 4. Further to our comments in the Annexure referred to in paragraph 3 above, we report that : (a) We have obtained all the information and explanations, which to the best of our knowledge and belief were necessary for the purposes of our audit; (b) In our opinion, proper books of account as required by law have been kept by the Company so far as appears from our examination of those books; (c) The Balance Sheet, Profit and Loss Account and Cash Flow Statement dealt with by this report are in agreement with the books of account; (d) In our opinion, the Balance Sheet, Profit and Loss Account and Cash Flow Statement dealt with by this report comply with the Accounting Standards referred to in subsection (3C) of section 211 of the Companies Act, 1956; (e) On the basis of written representations received from the directors and taken on record by the Board

of Directors, we report that none of the directors is disqualified as on March 31, 2010 from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956; 5. Subject to the reservations noted below, in our opinion and to the best of our information and according to the explanations given to us the accounts give the information required by the Companies Act 1956, in the manner so required and give a true & fair view, in conformity with the accounting principles generally accepted in India. (i) The sum of ` 20,00,000 has been advanced to a director of the company in contravention of the companies Act 1956. (ii) The provision for bad & doubtful debts has been understated by ` 50,00,000 (iii) The contingent liability for bills discounted for ` 6,00,000 has not been disclosed. (iv) The provision for I.Tax payable is made short by ` 19,00,000. Gokul Sd/May 1 , 2010 DEF Partner XYZ & Co. Chartered Accountants Clean or Clear or unqualified Audit Report When auditor doesnt insert any reservation or qualification in his audit report then it is called a clean or unqualified audit report. As provided u/s 227 (2) of the Companies Act 1956, certain questions which the auditor of the company must inquire and report on specified issues in his audit report. When these questions are answered positively without qualification and also, the Balance Sheet and Profit & Loss Account exhibits true and fair view of the state of affairs of the company, the auditors gives a clean or unqualified report. AUDITING 377 Specimen of Clean or Unqualified Report Qualification in The Auditors Report The statutory provisions in the Companies Act relating to qualifications in the Auditors Reports are contained in section 227(4) of the Act which provides that where the Auditors are required , in their report, to answer any of the statutory affirmations in the negative or with a qualification, their report shall state reasons for such an answer. It is therefore, necessary for the auditors to give the reason for any qualifications or reservations in his report. Beyond this, the Companies Act does not mention anything about the form and manner of qualification

in the audit report. In a majority of cases the auditors report on the accounts examined by them are found to be unqualified. This is due to the fact that the right of a statutory auditors to make a qualified report is a great deterrent, and prevents the managements of companies from resorting to accounting principles and methods of disclosure which are not in accordance with the law. The result is that the auditor of a company is in a position to persuade the management of the company to accept his views and modify the accounts or make such disclosure as are required by the law, as in the absence of these he would qualify his report. A qualified report is not necessary unless the issues involved are material. However, items requiring disclosure under the law, such as the directors remuneration, whether material or not, have to be specifically disclosed. If this is not done, it is the duty of the auditor to qualify his report. (Sch. (VI) Part I, II & III) Further, as an auditor is appointed by the shareholders to perform certain statutory functions and duties, it is expected of him that he will in fact perform these function and duties by following what is known as generally accepted procedure of audit. Aspects to be Considered in Qualifying Audit Report While qualifying a report, it is important to : (i) Ascertain the various items the statement of fact and opinion referred to above) that required a qualification. (ii) Realize whether the auditors are in active disagreement with something which has been done by the company or merely unable to form an opinion, say, for lack of adequate information about an item. (iii) Establish whether the matters in question are so material as to affect the presentation of a true and fair view of the state of the affairs of the company, or are of such a nature as to affect only a particular item disclosed in the account; and (iv) See whether the matters constituting the qualification involved a material contravention of any requirements of the Companies Act which have a bearing on the accounts. In a majority of cases, item which are the subject matter of qualification are not material as to affect the truth and fairness of the whole of the Accounts but merely create uncertainty about a particular item. In such cases, it is possible for the auditor to report that, in their opinion, but subject to the specific qualification mentioned, the

accounts present a true and fair view. Sometimes however, the items which are the subject matter of qualifications are so material that it would be meaningless to state that, subject to the qualification , the accounts disclose a true and fair view. An extreme example would be where the auditors were not able to examine a substantial part of the books of account, e.g. when they were in police custody. In such case , it would not be proper to express an opinion on the truth and fairness of the accounts after stating that the books of accounts were not examined. In such cases the auditors must report that either : (i) They are unable to state whether the accounts present a true and fair view; or (ii) Makes a categorical statement that in their opinion the accounts do not present a true and fair view. Which of the above two alternatives should be followed would depend upon the facts of each case. Finally, the auditor of well established principle that they must give full information about the subject matter of the qualification and not merely create grounds for suspicion or inquiry and leave it to the shareholder to call out the facts by diligent inquiry. The distinction between information and means of information made in the London and General Banks case is still valid. 378 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS Nature of Auditors Opinion An opinion must be unqualified or adverse. An auditor may also be unable to express an opinion. In many cases an opinion may be limited only to certain aspects. Where an auditor gives an opinion on the various matters without any reservations. It is an unqualified opinion. An example of an unqualified opinion would be a statement by the auditor that in our opinion and to the best of our information and according to the explanation given to us, the Balance Sheet and the Profit and Loss Account give a true and fair view of the state of affairs and working results.. In the case of companies in India, if the auditor makes the various statutory affirmations without reservations, he is said to have given an unqualified opinion . In practice a large number of audit reports of public limited companies contain unqualified opinions. This is probably due to the fact that the right of the auditor to qualify his report, often persuades the managements to agree to the modifications in disclosed accounts as suggested by the auditors. Qualified Opinion

Where an auditor gives an opinion subject to certain reservations, he is said to have given a qualified opinion. A qualified opinion implies that the auditor states that the financial statements reflect a true and fair view subject to certain reservation. Thus, an auditor may give his particular objection or reservation in the audit report and state, Subject to the above, we report that the Balance Sheet shows a true and fair view ........, where an auditor has no alternative but to give a qualified opinion, he must clearly express the nature of the qualification in his report. The reasons of the qualification should also be stated. In the case of companies, this is a legal requirement under section 227(4) of the Companies Act, which provides that, where the auditors answer any of the statutory affirmations in the negative or with a qualification, their report shall state the reasons for such answers. And to the extent possible indicate the financial implication on the Statement of Account of the year under report and in the following/subsequent years. Adverse or Negative Opinion An auditor gives an adverse opinion when he states that the financial statements do not represent a true and fair view of the state of affairs and the working results of the company. An adverse opinion is appropriate where the reservations or the objections of the auditor are so substantial that he feels that the accounts do not give a true and fair view. Where the auditor gives an adverse opinion he should disclose all the material reasons therefore. Disclaimer of Opinion Where an auditor fails to obtain sufficient information to warrant an expression of opinion, he can give a disclaimer of opinion. Accordingly, the auditor may state that he is unable to express an opinion because he has not been able to have sufficient evidence to form an opinion on the financial statements. An example of the disclaimer of the opinion can be a statement by auditor that, we have been unable to state that whether the Balance Sheet shows a true and fair view.......... The necessity of disclaiming an opinion may arise due to many reasons. In certain circumstances the auditor may not get access to all the books of account for certain reasons. There may also exist very material items, the value of which may be totally uncertain. In many cases certain material information or explanations may not be forthcoming. Wherever an auditor disclaims an opinion he should give reasons for the same.

Difference between Audit Report and Audit Certificate (i) Meaning : Audit Report is a statement of collected and considered information so as to give a clear picture of the state of affairs of the business to the persons who are not in possession of the full facts. While Audit Certificate is a written confirmation of the accuracy of the information stated there in. (ii) Opinion : Audit Report contains the opinion of the auditor on the accounts, while Audit Certificate does not contain any opinion but only confirms the accuracy of the figures with the books of accounts. (iii) Basis : Audit Report is made out on the basis of information obtained & books of account verified by the auditor, while Audit Certificate is made out on the basis of the particular data capable of verification as regards accuracy. AUDITING 379 (iv) Guarantee : Audit Report may not guarantee correctness of financial statement in absolute terms, while Audit Certificate guarantees absolute correctness of the figures & information mentioned in the certificate. (v) Coverage : Audit Report always covers entire accounts of the concern, while Audit Certificate covers only certain part of the accounts of the concern. (vi) Responsibility : Audit Report does not hold auditor responsible for any thing wrong in the accounts, while Audit Certificate makes an auditor responsible if any thing mentioned in the certificate found as wrong later on. (vii) Suggestion : Audit Report may provide certain suggestions for improvement while Audit certificate does not provide any such suggestion. (viii) Nature : Audit Report is based on the vouching & verification of books of accounts, voucher, assets & liabilities, while Audit Certificate is based on checking arithmetical accuracy of the facts. (ix) Scope : Audit Report covers all transactions done during the year, while the Audit Certificate is very specific. (x) Characteristics :Audit Report is subjective as it is opinion oriented, while Audit certificate is objective as it is fact oriented. (xi) Form : Audit Report is required to be presented in the prescribed format, while Audit Certificate, except in few cases, is not required to be presented in any standard format. (xii) Address : Audit report is addressed to the members of the company at large or appointing authority, while Audit Certificate is addressed to particular person or sometimes may include the words like To

Whomsoever it may concern. 7.6 RELEVANT PROVISIONS OF THE COMPANIES ACT, 1956 AND THE INCOME TAX ACT 1961 (I) Appointment and Remuneration of Auditors Section 224. (1) In each Annual General Meeting auditor is appointed and within seven days the appointed auditor is to be intimated; before that a written certificate indicating that the appointment is within the limits of sub-section 224 (1B) (1A) Within 30 days of the receipt of the intimation of appointment the auditor should inform the Registrar of Companies in writing his acceptance or refusal. (1B) No company or its Board of Directors can appoint or reappoint a person who is in full time employment elsewhere or a person or a firm is holding appointment as auditor of 20 companies in case of companies each of which has a paid up share capital of less than ` 25 lakhs or 20 companies in other cases where in companies having more then 25 lakhs paid up capital does not exceed 10. The number of companies shall be counted by taking into account the companies where audit is under taken singly or jointly with any other person. The ceiling of 20 companies does not apply to the private companies since 13.12.2000. (1C) The auditor whose limit is expired should with in 60 days of the intimation of appointment inform the company and Register his unwillingness to accept of the appointment (2) In any Annual General Meeting a retiring auditor shall be reappointed unless he is not disqualified otherwise. (3) If Annual General Meeting fails to appoint or reappoint an auditor, the Central Govt. may appoint a person to fill the vacancy the company within seven days of the AGM give notice to the Central Govt. about non- appointment of an auditor, otherwise every officer of the company who is in default shall be punishable with fine. (4) The first auditor of a company shall be appointed by the Board of Directors within one month of the registration of the company and the auditor so appointed shall hold office until first AGM. In AGM new auditor may get appointed. If Board of Director fails to exercise its power the company in general meeting may appoint the first Auditor. 380 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS

(5) The BOD may fill any casual vacancy in the office of an auditor but if the vacancy is caused by the auditors resignation, it will be filled only in general meeting. The auditor so appointed will hold the office until the conclusion of next AGM. (6) Any auditor may be removed before the expiry of his term by the company in general meeting after obtaining previous approval of the Central Govt. (7) The remuneration of an auditor appointed by the BOD or Central Govt. may be fixed by the BOD or Central Govt. In the case of an auditor appointed by the Comptroller and Auditor General of India under section 619 shall be fixed by the company in general meeting and in case of other auditors by the members. (II) Auditor not to be appointed except with the approval of the company by special resolution in certain cases section 224A (1) In case of a company in which not less than 25 percent subscribed capital is held by any Govt., Govt. Company, Financial Institutions, Nationalized Bank or Insurance Company, then the auditor in AGM will be appointed by special resolution. (2) If the company fails to pass the resolution in the AGM, then the Central Govt. will make the appointment. (III) Provision as to resolutions for appointing or removing auditor section 225 (1) Special notice by a member u/s 190 shall be required for appointment of auditor other than retiring or providing expressly that the retiring auditor shall not be reappointed. (2) On receipt of notice of such a resolution, the company shall send its copy to the retiring auditor. (3) On receipt of representation from the retiring auditor, the copy of it be sent to every member of the company and if it is not sent, then it shall be read out at the meeting. (4) The above provisions shall apply to a resolution to remove the first auditor. (IV) Qualifications and disqualifications of Auditors u/s 226 (1) He must be a Chartered Accountant with in the meaning of Chartered Accountant Act 1949. A firm of C.A. is also qualified for appointment provided all the partners practising in India are qualified as aforesaid. (2) Holder of a certificate granted under a law provided all the partners practising in India an gratified as afaresond (restricted states) (3) None of the following person shall be qualified for appointment as Company Auditor (a) a body corporate (b) an officer or employee of the company

(c) a person who is a partner or employee of an officer or employee of company. (d) a person indebted to the company for an amount exceeding ` 1000 (e) a person holding any security of the company (4) A person who is not qualified for appointment as an auditor of the company, also not qualified for such appointment of the subsidiary company or holding company of such company or subsidiary of its holding company. (5) If after appointment the auditor becomes disqualified he shall be deemed to have vacated his office as such. (V) Powers and Duties of Auditors Section 227 (1) Every Auditor shall have a right of access at all times to the Books of Accounts etc of the Company whether kept at head office or elsewhere. (2) Auditor shall make a report to the members, whether the Balance Sheet gives a true & fair view of the state of affairs of the company and the Profit and Loss Accounts give a true and fair view of the profit or loss. AUDITING 381 (3) Auditor in his report shall state whether he has obtained all required information and explanations and whether the company has maintained proper Books of Accounts as required by the law, whether the report on the audit of a branch, not audited by him is received by him or not, whether the Balance Sheet and Profit and Loss Account is in agreement with the Books of Accounts of the company, whether the P&L account & Balance Sheet comply with the Accounting Standards, whether any director is disqualified from being appointed as director etc. (4) If the answers to above are negative, the auditors report should contain the reasons thereof. (4A) The Central Govt. may by general or special order direct that the auditors report shall also include a statement on such matters or may be specified in the order. (CARO, 2003) (VI) Audit of accounts of a branch office of company (1) Accounts of companys branch be audited by Companies Auditor or by a person qualified to be appointed as company auditor or by a person qualified under the local law in case of foreign branch. (2) In case branch accounts audited by other auditor, the Company Auditor is entitled to visit the branch office and has a right to access all books of accounts, records etc of the branch. (3) The Branch auditor be appointed in AGM or by the BOD if authorized by the AGM with consultation of

companys auditor. The branch auditor shall have the same powers and duties as the Company Auditor has, he should send a report on the audit of the branch to the Companys Auditor. The remuneration and the tenure of his office will be fixed by the AGM or BOD if authorized so. (4) The Central Govt. may give exemption to any branch from the provisions of this (section.) (VII) Signature of Audit Report etc. (section 229.) Only the person or a partner of the firm of Chartered Accountants appointed as Auditor may sign the Auditors Report or any other document of the company required by law to be signed by the auditor. (VIII) Reading and Inspection of Auditors Report (section 230) The auditors report shall be read before the company in general meeting and shall be open to inspection by any member of the company. (IX) Right of Auditor to attend General Meeting (section231) Auditor has a right to receive the notice and related documents of general meeting and is entitled to attend the meeting and being heard as any part of the business concerns him as auditor. (X) Penalty for non compliance with section 225 to 231 (section 232) If default is made by a company in complying with the above provisions the company and every officer of the company who is in default shall be punishable with fine. (XI) Penalty for non-compliance by auditor with section 227 and 229- (section 233) If any auditors report is made or any document is signed otherwise than in conformity with the requirements of section 227 and 229; the auditor concerned and the person, if any, other than the auditor who signs the report or document, shall if the default is willful, be punishable with fine. (XII) Power of Central Govt. to direct special Audit in certain cases (section 233A) (1) If in the opinion of the Central Govt, the companys affairs are not being managed in accordance with sound business principles or prudent commercial practice or if the company is managed in such a way that it will cause a serious injury or damage to the interest of trade, industry or business, the financial position is such as to endanger its solvency, the Central Govt. may at any time by order direct a special audit by a person whether in practice or not or by the companys auditor. (2) The auditor appointed above is termed as a special auditor. (3) The special auditor have the same power and duties as an auditor of a company, but he is required to

submit his report to the Central Govt. instead of the members. (4) The special auditors report include all the details as that of Company Auditors Report and also on the matters specified by the Central Govt. 382 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS (5) The Central Govt. may direct any person to provide all required information to the special auditor and in case of failure the person shall be punishable with a fine. (6) On receipt of the special Auditors Report the Central Govt. may take such action in accordance with the provision of Companies Act or any other law for the time being in force. (7) The expenses including special auditors remuneration be determined by the Central Govt. and payable by the company and in default of such payment shall be recoverable from the company as an arrears of land revenue. (XIII) Audit of Cost Accounts in certain cases (section 233 B) (1) If Central Govt thinks it is necessary, may order the audit of Cost Accounts of a company which is required to maintain Cost Accounts u/s 209(1)(d) by a Cost Accountant. (2) The auditor under this section shall be appointed by the BOD of the company with the previous approval of the Central Govt. Before appointment the company shall get a certificate from the auditor that if the appointment made it is in accordance with the provision of section 224(1B). (3) The Cost Audit is in addition to that conducted by an auditor appointed under section 224. (4) The Cost Auditor has same powers & duties as that of Company Auditor and shall make his report to the Central Govt. in such form and within such time as may be prescribed and also send a copy of the same to the company. (5) A person referred under section 226(3) and (4) shall not be appointed or reappointed as Cost Auditor. (6) It is companys duty to give all facilities and assistance to the person appointed for conducting the Cost Audit. (7) Within 30 days of the receipt of the Cost Audit Report the company shall furnish the Central Govt. with full information and explanation on every reservation or qualification contained in such report. (8) After the receipt of the Cost Audit Report and Companys explanation, the Central Govt. can call any further explanation and information within such prescribed time. (9) After receipt of above explanation etc. the Central Govt. may take such action on the report in

accordance with the provision of the Companies Act or any other law for the time being in force, as it considers necessary. (10) The Central Govt. may direct the company whose Cost Accounts have been audited to circulate to its members, along with the AGM notice, the whole or such portion of the said report as directed. (11) If default is made in complying with the above provisions the company and every officer of the company shall be liable to be punished with fine and fine with imprisonment respectively. (B) Provisions of the Income Tax Act, 1961 1. Audit of accounts of certain persons carrying on business or professionsection 44(AB) Every person if his total sales or gross receipts exceeds `40 lakhs in any previous year Or Carrying on profession if his gross receipts exceeds `10 lakhs in any previous year Or Carrying on business, the profit and gains from the business are deemed on presumptive basis to be the profit of such person who is engaged in the business of civil construction or supply of labour for civil construction or owns and ply for hiring not more than 10 goods carriages, engaged in retail trade, engaged in the business of providing service in connection with production of mineral oil or foreign company engaged in civil construction or erection of plant and machinery if claimed income lower than the profit or gains so deemed to be the profit and gains of business in any previous year. Get his accounts of previous year audited by Chartered Accountant before specified date and furnish the report of such audit in the prescribed form duly signed and verified by the Chartered Accountant. The provision does not apply to Non resident assessee engaged in the business of operation of ships or operation of air crafts. AUDITING 383 In the case where the assesses is required to get his accounts audited under any other law, it shall be sufficient compliance with the provision of Income Tax Act, if the audit is completed before the specified date and the report is furnished by that date along with a further report in prescribed form under signature of a Chartered Accountant. 2. Report from an Accountant to be furnished by persons entering into international transaction- section 92E

Every person who has entered into an international transaction during a previous year shall obtain a report from a Chartered Accountant and furnish such report before specified date in the prescribed form duly signed and verified in the prescribed manner by such C.A. and setting forth such particulars as may be prescribed, otherwise it will attract penalty u/s 271 BA. 3. Maintenance and audit of accounts of shipping companies section 115vw An option for tonnage tax scheme shall not have effect in relation to a previous year unless such company (i) Maintain separate books of accounts in respect of the business of operating qualifying ships and (ii) Furnishes, along with the return of income for the previous year, the report of a Chartered Accountant, in the prescribed form duly signed and verified by such Chartered Accountant. 7.7 INTERFACE BETWEEN STATUTORY AUDITOR AND INTERNAL AUDITOR In accounting matters the internal auditor and the statutory auditor operate in the same field. Both would have a common interest in determining that there is (i) An effective system of internal control to prevent or detect errors and frauds and that it has been operating efficiently. (ii) An adequate accounting system to generate information for preparation of true and fair financial statements. However, there are fundamental difference between the two forms of audits in terms of the status, responsibility, approach and scope of operation of an internal auditor and a statutory auditor. (a) Status and Scope : The internal auditor is a representative of the management and the nature and scope of his operations are determined by the needs and perception of the management. The statutory auditor on the other hand is independent of the management, his scope of operations and rights and duties are defined by the statute. (b) Approach : The statutory auditors approach would be governed by the duty placed on him to satisfy himself that the accounting statements presented to the shareholders shows a true and fair view of the profit and loss during the year and of the state of affairs of the company as on the date of the Balance Sheet. The internal auditor on the other hand would operate with a view to ensuring that the accounting system is efficient and that the accounting information presented to the management are correct and disclosed material facts.

(c) Responsibility : The internal auditor is responsible to the management who is his master. The statutory auditor is on the other hand is responsible directly to the shareholders. The internal auditor has not got the independent status like the statutory auditor. The technique of audit adopted by both the auditors are common such as (i) Verification of internal control system to see whether it is sound in principle and effective in operation (ii) Verification of accounting records and statements. (iii) Verification of assets and liabilities. (iv) Statistical comparison, enquiry etc. (d) Appointment : The appointment of the internal auditor depends entirely on the wishes of the management. The management may not have own internal audit. After promulgation of the CARO, 2003 it is obligatory 384 AUDITING COMPANIES ACT PROVISIONS RELATING TO AUDITS for certain companies to have internal auditor. It is obligatory for the statutory auditor to comment in respect of certain companies as to whether they have internal audit system commensurate with its size and nature of business. The qualification of the internal auditor is not guided by any statutory provision. This is determined by the management. As regards the internal arrangements between the statutory auditor and the internal auditor in the performance of their respective duties, reference may be made to SA-610 Using the Work Internal Auditors issued by the Institute of Chartered Accountants of India. The role of the internal audit function within an entity is determined by the management and its prime objective differs from that of the external auditor who is appointed to report independently on financial information. Nevertheless, some of the means of achieving their respective objective are often similar and thus much of the work of the internal auditor may be useful to the external auditor in determining the nature, timing and extent of his procedures. Thus, before deciding to place reliance upon the work of the internal auditor, the statutory auditor should, as part of his audit , make a general evaluation of the internal audit function. Such evaluation will help him in deciding to what extent he can rely upon the internal auditors work and whether he may adopt less extensive procedures than would otherwise be required. In this connection, the statutory auditor should

consider the following aspects : (a) Status of the internal auditor in the organization-to whom does he report- whether any constraints or restrictions placed upon his work by management- whether he is free to communicate with the statutory auditor. (b) Scope of the internal auditors function and whether recommendations of the internal auditor are acted upon. (c) Technical competence of the person carrying out the internal audit work. (d) Exercise of such professional care regarding internal audit work- whether there has been proper planning, supervision, review and documentation of internal audit work. Considering the results of general evaluation of the internal audit function, the statutory auditor may decide to rely upon the internal auditors work. It would be helpful if the statutory auditor ascertains the tentative plan of internal audit for the year and discusses the same with the internal auditor. However, the degree of reliance that a statutory auditor can place on the work done by the internal auditor is a matter of individual judgment. Finally, it must be emphasized that the report of the statutory auditor is his sole responsibility and that responsibility is not by any means reduced because of the reliance he placed on the internal auditors work. 7.8 CORPORATE GOVERNANCE Corporate governance is the manner of governing a company, corporate governance is the mantra of Board managed Corporate. Although as a principle it goes beyond merely complying with the legal procedure under the corporate and regulatory bodies, on paper it has remained as a procedure and compliance oriented concept. Clause 49 of the Listing Agreement of SEBI requires listed companies to comply with certain conditions of Corporate Governance and to obtain a certificate from its statutory auditor regarding such compliance .This certificate is required to be annexed to the directors report and is to be sent to the stock exchange along with the annual return. Report on Corporate Governance (i) There shall be a separate section on Corporate Governance in the Annual Report of company, with a detailed compliance report on Corporate Governance. Non Compliance of any mandatory requirement

with reasons there of and the extent to which the non mandatory requirements have been adopted should be specifically highlighted. (ii) The companies shall submit a quarterly compliance report to the stock exchanges within 15 days from the close of quarter in the prescribed form. The report shall be signed either by the Compliance Officer or the CEO of the company. AUDITING 385 For examining compliance with the above requirements the auditor should examine the (i) Minute book of Board of Directors (ii) Minute book of General Body Meeting (iii) Minute book of Audit Committee (iv) Corporate Governance Report (v) Mandatory Annual intimations filed by each director about the Directorships in other companies (vi) Consistency of segment wise information with the segment information disclosed in financial statements in accordance with AS 17. (vii) Discussion on internal control system and their adequacy and consistency with the opinion expressed by him under CARO, 2003. The Auditor, in this regard, is required to issue his certificate as follows, as suggested by the ICAI. CERTIFICATE To, The members of the ________________________________Co. ltd We have examined the Compliance Condition of the Corporate Governances, stipulated under clause 49 of the listing agreement of the said company with the ____________________________Stock Exchange, by the _________Co Ltd, for the year ended on __________. The Compliance of Conditions of Corporate Governance is the responsibility of the management, our examination was limited to procedures and implementation there of, adopted by the ___________ Co. Ltd for ensuring the compliance of the conditions of the Corporate Governance. It is neither an audit nor an expression of opinion on the financial statements of the _____________Co. Ltd. In our opinion and to the best of our information and according to the explanations given to us, subject to the following (a) ________________________________________________________ (b) ________________________________________________________ We certify that the ______________Co. Ltd. has complied with the Conditions of Corporate Governance as stipulated in the above mentioned Listing Agreement.

We state that out of ______________no of investors grievance ________ are pending for a period exceeding one month against the ______Co. Ltd as per the records maintained by the Share Holders/ Investors Grievances Committee. We further state that such compliance is neither an assurance as to the future viability of the _______Co. Ltd nor the efficiency or effectiveness with which the management has conducted the affairs of the _____ Co.Ltd. Place :_________________ Date :_________________ For and behalf of XYZ and Company Chartered accountants Partner/ Proprietor 386 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Study Notes 8 REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM This study note includes ! Nature and Scope of Internal Auditing, Financial versus Operational Audit, Concepts of Efficiency Audit, Propriety Audit, Voucher Audit, Compliance Audit, Pre and Post Audits, Audit in depth. ! C. A. R. O. ! Internal Auditing Function ! Planning and Process of Internal Auditing ! Detailed checking versus Sampling plans, Flow Chart Technique ! Internal Control, Nature and Scope, Internal Auditor and Internal Controls ! Field work collecting evidences, interviews, memorandum ! Audit Notes and Working Papers ! Audit Reports and techniques of effective reporting, follow up of Audit Report ! Summary Reports of Top Management ! Communications in Internal Auditing. ! Scope of Audit Committee ! Internal Audit and Investigation of fraud 8.1 NATURE AND SCOPE OF INTERNAL AUDITING NATURE OF INTERNAL AUDITING The Institute of Internal Auditors has defined Internal Audit as - Internal Auditing is an independent appraisal activity within an organization for the review of operations as a service to management. It is a managerial control which functions by measuring the effectiveness of other control. There are various definitions of Internal Auditing prevailing, which can be stated as follows:1. Internal Audit is a management tool, performed by employees of the organization to ensure correctness

in accounting data and to detect fraud by way of periodical review of organizational system and procedures. 2. Internal Audit is a continuous and systematic process of examining and reporting the operations and records of a concern by its employees or external agencies specially assigned for this purpose. It is, in essence, auditing for the management and its scope may vary depending upon the nature and size of the concern. 3. It is a control system concerned with examination and appraisal of other control mechanisms. 4. Internal Audit is an extension of and as such is complimentary to Statutory Audit. In short Internal Audit means appraisal of control techniques employed by a firm and its performance. Necessity of Internal Audit to Management Internal Audit has become an important management tool for the following reasons :1. It ensures compliance of Companies (Auditors Report) Order 2003. 2. Internal Auditing is a specialized service to look into the standards of efficiency of business operation. 3. Internal Auditing can evaluate various problems independently in terms of overall management control and suggest improvement. AUDITING 387 4. Internal Audits independent appraisal and review can ensure the reliability and promptness of MIS and the management reporting on the basis of which the top management can take firm decisions. 5. Internal Audit system makes sure the internal control system including accounting control system in an organization is effective. 6. Internal Audit ensures the adequacy, reliability and accuracy of financial and operational data by conducting appraisal and review from an independent angle. 7. Internal Audit is an integral part of Management by System. 8. Internal Audit can break through the power ego and personality factors and possible conflicts of interest within the organization. 9. It ensures compliance of accounting procedures and accounting policies. 10. Internal Auditor can be of valuable assistance to management in acquiring new business, in promoting new products and in launching new projects for expansion or diversification of business. Scope of Internal Auditing The Institute of Internal Auditors defines scope of internal auditing as The examination and evaluation of the adequacy and effectiveness of organisations system of internal control and the quality of actual performance.

Therefore, internal auditing is concerned with an evaluation of both internal control as well as the quality of actual performance. According to The Institute of Internal Auditors, internal audit involves five areas of operations, which can be discussed as follows :(a) Reliability and Integrity of Financial and Operating Information :- Internal Auditors should review the reliability and integrity of financial and operating information and the means used to identify, measure, classify and report such information. (b) Economical and Efficient Use of Resources :- Internal Auditor should ensure the economic and efficient use of resources available. (c) Compliance with Laws, Policies, Plans, Procedures, Regulations :- Internal Auditor should review the systems established to ensure compliance with those policies, plans and procedures, law and regulations which could have a significant impact on operations and should determine whether the organization is in compliance thereof. (d) Accomplishment of Established Goals for Operations :- Internal Auditor should review operations, programmes to ascertain whether results are consistent with established objectives and goals and whether the operations or programmes are being carried out as planned. (e) Safeguarding of Assets :- Internal Auditor should verify the existence of assets and should review means of safeguarding assets. The business transactions of an organization may be broadly divided into phases. 1. Planning stage : It usually culminates in an authorization from the appropriate level of management in the organization. At this stage, the decisions are issues like whether or not to make or buy, whether or not to undertake a new project or export etc. These are more of managerial decisions and the scope of internal audit is often not much practical, in the initial stage unless it takes to what is called management audit. 2. Execution Stage : This stage is the stage of recording in the various books of accounts, which only for correctness and classification of expenditure under the same heads as those mentioned in the project report. At this stage the scope of internal audit emerges out of need for correctness of accounts and proper classifications of heads in a designed manner. 3. Reviewing Stage : The third and final stage deal with reviewing the transaction and here internal audit is

intimately concerned. At this stage internal audit embraces the following main functions :(a) Scrutiny of the records of an undertaking to assess the reliability of the information contained therein. (b) Examination of the documentary evidence from which the records are written up. (c) Detection and prevention of error and fraud (d) A general examination of the financial statements prepared from the records to ascertain whether a true and fair view has been given about the financial position at a specific date. 388 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Internal auditing therefore, is a function distinct from authorization and recording. It is concerned not only with examination of the transaction as recorded in the Books of Accounts but also with appraisal of procedure with a view to effecting change for better efficiency, where possible. A proper organizational status for the Internal Auditing Department ensures its relative independence so that it can carry out its work freely and objectively and render impartial and unbiased reporting. The functions, responsibilities and authority of the Internal Auditing Department should be clearly and specifically laid down in a written document. The Chief Internal Auditor should have a direct communication with the Board of Directors, or CEO. He should submit periodic reports to the Board highlighting the various significant audit findings. Financial Audit and Operational Audit Financial Audit The Institute of Internal Auditors has defined financial audit as under :Financial Audit is a historically oriented, independent evaluation performed by the internal auditor or the external auditor for the purpose of attesting to the fairness, accuracy, and reliability of the financial data, providing protection for the entitys assets; and evaluating the adequacy and accomplishment of the system (internal control) designed to provide for the aforementioned fairness a protection. Financial data, while not being the only source of evidence, are the primary evidential source. The evaluation is performed on a planned basis rather than a request. Financial Audit takes care of the protective aspect of the business and it does not normally carry out any constructive appraisal function of the business operations. It helps in detection and prevention of fraud. It also

verifies whether documentation and flow of activities are in conformity with the internal control system introduced and developed within the organization. It helps coordinating with statutory auditor to help them in proper discharge of their function. Besides, financial audit also ensures compliance with statutory laws especially in financial and accounting matters. Operational Audit Operational Audit has been defined by the Institute of Internal Auditors as follows an Operational Audit is a future oriented, independent, and systematic evaluation performed by the internal auditor for management of the organizational activities and controlled by top, middle and lower level management for the purposes of improving organizational profitability and increasing the attainment of the other organizational objectives, achievement of programmes, purpose, social objectives and employees development areas in which efficiency and effectiveness may be improved and identified and recommendations made that are designed to enable realization of the improvements. The measure of effectiveness includes both an evaluation of compliance with prescribed entity, operational policies and of the adequacy of them. Financial data may be a source of evidence, but the primary source is the operational policies as related to the organizational objectives. Operational Audit is a scientific tool and technique adopted by the auditor in progressive business concern with the following objectives :(i) To ensure that operational activities are in line with the objectives of the organization. (ii) To assure management that MIS has been functioning properly to attain organizational objectives. (iii) To assure management that the management control system is functioning efficiently and effectively. The operational audit is more of a technical analysis for appraisal and review rather than a financial cum accounting analysis under financial audit. In Operational Audit the audit functioning and objectives reach out beyond the financial control aspect into the operating areas of the business. Difference Between Financial Audit and Operational Audit A clear cut difference between financial audit and operational audit cant be drawn in many cases. Both are not mutually exclusive. They are interconnected and interlinked. However, difference between the two may be stated as under :Financial Audit

(a) To see that established systems and procedure are complied with. AUDITING 389 (b) To see that proper records have been maintained for the fixed assets of the concern. (c) To look into the correctness of financial data and records alongwith correctness of the accounting procedure/standards followed. (d) To see whether scrap, salvage and surplus materials have been properly accounted for etc. (e) To see the Internal Control System has been working properly. (f) To see that any abrupt variation in sales, purchases etc. with respect to immediate previous year are not due to any irregularity. (g) To see that the credit control has been strictly followed. (h) To see that all payments have been made with proper authorization and approval. (i) To see that preparation of salary and wage payroll has been properly done. (j) To see that all statutory obligations have been complied with. Operational Audit (a) To examine whether the accounting operational functions have been true with the management objectives. (b) To see that Internal control system has been working properly. (c) To see that the financial accounting records have been properly designed and maintained to furnish management with timely information to help them of judging to what extent the profitability goals have been achieved. (d) To study whether scrap/loss of materials have remained within the permitted limits. (e) To see the Internal Control System has been working properly. (f) To study the reasons for unfavourable variances. (g) To study the credit control system for suggesting better means where considered necessary. (h) To study whether the expenditure has remained within budgetary provisions. (i) To see that the payments are well within budgeted amounts and there is proper utilization of manpower. The operational audit is more of a technical analysis for appraisal and review rather than financial analysis. In Operational Audit, the audit functioning and objective match out beyond the financial control aspect into the operating areas of business. Concept of Efficiency Audit The term efficiency audit means studying competence to achieving goals. The objective of efficiency audit is to ensure that management controls are functioning effectively and efficiently in every functional or operational areas of business. The appraisal and review under efficiency audit be divided into following two segments :-

(a) Adequacy of qualities and qualification of the personnel working to attain business objective. (b) Effectiveness of the tools and techniques applied in achieving the objectives. Audit appraisal under efficiency audit includes the following : (i) Reduce the areas of uncertainty in business. (ii) Remove the bottlenecks to achieve the goals and objectives of the organization (iii) Safeguard against the causes of business failures. (iv) Remove the inefficiencies and ineffectiveness of operations resulting in cash drainage or other losses. (v) Strengthen the factors for survival and prosperity of the business. The internal audit, under efficiency audit, is to find out whether :(a) Any delay in decision making has led to additional financial costs. (b) Any operation of managerial process has led to ineffective or delayed operation of a project. (c) The area of operation has been managed in an economical and efficient manner in terms of appropriate utilization of man power, plant and machinery, finance, time and material. (d) Inefficiency has led to non-achievement of targeted production and productivity. 390 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM The efficiency and the effectiveness of an executive in discharging his obligation towards the attainment of organizational objectives and goals will also form part of efficiency audit. Propriety Audit Kohler has defined propriety as that which meets the test of public interest, commonly accepted customs and standard of conduct and particularly as applied to professional performance, requirements of Govt. regulations and professional codes. Propriety Audit would mean whether the transactions have been done in conformity with established rules, principles and some established standard. The Propriety Audit would mean the verification of following main aspects to find out whether :(i) Proper recording has been done in appropriate books of accounts. (ii) The assets have not been misused and have been properly safeguarded. (iii) The business funds have been utilized properly. (iv) The concern is yielding the expected results. The system of Propriety Audit is applied in respect to Government Companies, Government Department because public money and public interest are therein involved. It is an essential function of Audit to bring to light not only cases of clear irregularity but also every matter which in its judgement appears to involve improper expenditure or waste of public money or stores, even

though the accounts themselves may be insufficient to see that sundry rules or orders of competent authority have been observed. It is of equal importance to ensure that the broad principles of orthodox finance are borne in mind not only by disbursing officers but also by sanctioning authorities. Voucher Audit Voucher is a piece of paper or a written document which confirms the truth of anything. As for example, a receipt obtained from the payee after disbursement is a voucher. Any audit with reference to some documentary evidence may be termed as voucher audit. The financial Audit is mainly carried out with reference to voucher. Statutory Audit certifies the Statement of Accounts including the Balance Sheet after carrying out audit which is mainly with reference to documentary evidence. However, it should be remembered that after promulgation of the Manufacturing and Other Companies (Auditor Report) order 1988, a Statutory Auditor has also to carry out some audit which is not directly based on documentary evidences. Compliance Audit It is common to us that the business undertakings require some certified statement on various matters and the auditors certify such statements after carrying out audit which might be necessary under the particular cases. All such audits are called Compliance Audit. Suppose when a company applies to a bank for some loan, a certified statement showing the turnover of the company for the past two or three years along with the current year might be necessary, and for this purpose the certified statements are to be attached with the application, otherwise the application will be rejected. So these certified statements showing the turnover of the company fall under the category of compliance audit. Internal audit for compliance could be more broad base to include compliance which documented procedures / policies, compliance with statutory requirements in the relevant areas etc. Pre and Post Audit When payments are made by the business or non-business entities, proper scrutinisation should be made before making such payment. This is know as Pre-audit. For e.g. when certain payments are made by the business undertakings such as salary, medical bills, traveling expenses etc, these payments should be disbursed after making proper scrutiny by the employees of the concern who are not normally the internal auditor.

But there are some payments, which are to be disbursed within a very short period, and within that time proper scrutiny could not be undertaken by the employees of the concern. Such as, when incentive payments have to be made by a large undertaking to its employees within a day or two then the bill is generally prepared and paid AUDITING 391 immediately without carrying out any major scrutiny by the employees of the concern. So after making payment the verification can be made. This is known as Post Audit. Auditing in depth In view of large number of transactions of an organisation, it becomes practically difficult for an auditor to undertake detailed vouching and post audit of the large volume. He can conduct a more effective audit, if he concentrates on intelligently selected areas. In such a situation Auditing in depth comes in handy. This means the tracing of a transaction through its various stages from origin to conclusion, examining the supporting records at each stage and ascertaining whether all the requirements laid down in the system of internal check have been complied with e.g. purchase of an item from indent stage to receipt/issue of material, verifying all related activities. 8.2 C A R O COMPANIES (AUDITORS REPORT) ORDER, 2003 The earlier order MAOCARO Manufacturing and Other companies (Auditors Report) order 1988, superseded by the new order C A R O COMPANIES (AUDITORS REPORT) ORDER, 2003 issued by the Central Government as per the power granted under section 227(4A) of the Companies Act, 1956 is applicable to an auditor report submitted after 31st December 2003. According to 227(1A), the auditor is required to report on certain matters only if he is not satisfied after his examination of the accounts but after this new order, the auditor has to make a statement on each of the specified matters likewise in case of Govt. companies, this order is in addition to the directions of the Comptroller and Auditor General in India. This new order is applicable to every company except, 1. A Banking Company 2. An Insurance company 3. A company licensed to operation as per the provision of Section 25 of the Companies Act. 4. A private limited company which has a paid up capital and reserves of not more than `50 Lakhs. If the

paid up capital of any company is more than ` 50 Lakhs but having accumulated loss double than the paid up capital or paid up capital and reserves are more than `50 Lakhs but the miscellaneous expenditure to be written off are to the tune that if written off paid up capital and reserve balance together will go below ` 50 lakhs, then this order is applicable. 5. Private Ltd. Company whose turnover does not exceed ` 5 crores. The order is applicable to foreign Companies incorporated outside India but having a place of business within India. The branches of the Companies liable to this order also come under the purview of this order. The following matters are required to be dealt in the Auditors Report :1. Fixed Assets : Auditor should comment whether the company is maintaining proper records of fixed assets, the management verified the fixed assets frequently and the material discrepancies found accounted properly, the substantial dispose of fixed assets has affected considerably the going concern. 2. Inventory : The auditor has to make following statements on verification and valuation of inventories. (a) Whether physical verification of Inventory has been conducted at reasonable intervals by the management. (b) Are the procedures of physical verification of inventories followed by the management reasonable and adequate in relation to the size of the company and the nature of its business ? If not, the inadequacies in such procedures should be reported. (c) Whether the company is maintaining proper records of inventory and whether any material discrepancies have been noted on physical verification and if so, whether the same have been properly dealt with in the books of account. 392 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 3. Loans : In the case of loans revised, organized to firms etc. covered in the register maintained under Section 301 of the Companies Act, auditor has to make comments on the following :(a) Has the company either granted or taken any loans, secured or unsecured to/from companies, firms or other parties covered under the register maintained under Section 301 of the Companies Act. If so, give the number of parties and amount involved in the transactions. (b) Whether the rate of interest and other terms and conditions of loans given or taken by the company, secured or unsecured are prima facie prejudicial to the interest of the company.

(c) Whether the payment of the principal amount and interest are also regular. (d) If over payment is more than one Lakh, whether reasonable steps have been taken by the company for recovery/payment of the principal and interest. 4. Internal Control on Purchases of Assets and Sale of goods : Is there an adequate internal control procedure commensurate with the size of the company and the nature of its business for the purchase of inventory and Fixed Assets, and the sale of goods? Whether there is a continuing failure to correct major weaknesses in internal control? 5. Transactions in which Directors are interested : Auditors statements are required on the following :(a) Whether transactions that need to be entered into register in pursuance of Section 301 of the Companies Act, have been so entered. (b) Whether each of these transactions have been made at prices which are reasonable having regard to the prevailing market prices at the relevant time. These should be commented only in the cases of transactions exceeding the value of ` 5 lakhs. 6. Public Deposits : In case the company has accepted deposits from the public whether the directions issued by the Reserve Bank of India and the provisions of Sections 58 A and 58 AA of the Companies Act and the rules framed there under where applicable, have been complied with, if not, the nature of contraventions should be stated; if an order has been passed by Company Law Board, whether the same has been complied with or not. 7. Internal Audit System in certain companies : In the case of listed companies and other companies having a paid up share capital and reserves exceeding ` 50 lakhs as at the commencement of the financial year concerned, or having an average annual turnover exceeding ` 5 crore for a period of three consecutive financial years immediately preceding the financial year concerned, whether the company has an internal audit system commensurate with its size and nature of its business. 8. Maintenance of Cost Records : Where Maintenance of Cost Records has been prescribed by the Central Government under Section 209(1)(a) of the Companies Act whether such accounts and records have been made and maintained. 9. Deposit of Statutory Dues : The Company Auditor has to report that (a) Is the company regular in depositing undisputed statutory dues including Provident Fund, Employees

State Insurance, Income Tax, Sales Tax, Wealth Tax, Custom Duty, Excise Duty, Cess and any other statutory dues with the appropriate authorities and if not, the extent of arrears of outstanding statutory dues as at the last date of the financial year concerned for a period of more than six months from the date they seem payable, shall be indicated by the auditor. (b) In case dues of Income Tax, Sales Tax, Wealth Tax, Custom Duty, Excise Duty, Cess have not been deposited on account of any dispute, then the amounts involved and the forum where dispute is pending may be mentioned, but he should, while reporting, remember that a mere representation to the department should not constitute a dispute. 10. Sickness : Where in case of a company which has been registered for a period not less than 5 years, its accumulated losses at the end of the financial year not less than 50% of its net worth and whether it has incurred cash losses in such financial year and in the financial year immediately proceeding such financial year also. AUDITING 393 11. Default in Repayment of Dues : Whether the company has defaulted in repayment of dues to a financial institution or bank or debenture holders? If yes, the period and amount of default to be reported. 12. Documents and Records for Secured Loans : Whether adequate documents and records are maintained in cases where the company has granted loans and advances on the basis of security by way of pledge of shares, debentures and other securities. If not the deficiencies to be pointed out. 13. Compliance with Special Provisions : Whether the provisions of any special statute applicable to chit fund have been complied with, in respect of nidhi, mutual benefit fund or societies (a) Whether the net owned fund to deposit liability ratio is more than 1 : 20 as on the date of Balance Sheet. (b) Whether the company has complied with the prudential norms on income recognition and provisioning against sub-standard, doubtful or lost assets. (c) Whether the company has adequate procedures for appraisal of credit proposals/requests, assessment of credit needs and repayment capacity of the borrower. (d) Whether the repayment schedule of various loans granted by the nidhi is based on the payment capacity of the borrower and would be conductive to recovery of the loan amount.

14. Records of Dealing in Securities : If the company is dealing or trading in shares, securities, debentures and other investments, whether proper records have been maintained of the transactions and contracts and whether timely entries have been made there in, also, whether the shares, securities, debentures and other investments have been held by the company in its own name, except to the extent of the exemption if any, granted under section 49 of the Companies Act. 15. Guarantees for loan taken by others : Whether the company has given any guarantee for loans taken by other from bank, or financial institutions, the terms and conditions where of are prejudicial to the interest of the company. 16. Application of Term Loans : Whether the term loans were applied for the purpose for which the loans are obtained. 17. Financial Management : Whether the funds raised on short term basis have been used for long term investment and vice-versa, if yes, the nature and amount is to be indicated. 18. Preferential Allotment of Shares : Whether the company has made any preferential allotment of shares to parties and companies covered in the Register maintained under Section 301 of the Companies Act and if so whether the price at which shares have been issued is prejudicial to the interest of the company. 19. Creation of Security in Respect of Debentures : Whether the securities have been created in respect of debentures issued. 20. Disclosure of End-use of money raised from Public issue : Whether the management has disclosed on the end use of money raised by public issue and the same has been verified. 21. Fraud : Whether any fraud on or by the company, has been noticed or reported during the year, if yes, the nature and the amount involved is to be indicated. The order stipulates that if the auditor given negative qualified answer to any of the above questions on which a statement is required on his report, he should give the reasons for that and where he is unable to give any opinion he should indicate this fact with reasons. The unfavourable answers to any of the question does not mean that the opinion of auditor on the true and fairness qualified answer the auditor can give an unqualified audit report, if the qualified answer does not materially affect the financial position discussed in the Profit and Loss Account and for Balance Sheet. The Board of Directors is supposed to give comments, in its annual report,

on the adverse statements made by the auditor under the order. In short, the order provides a different orientation to a company audit. Unlike traditional auditing, due to the provisional Section 227(1A), the auditor was required to offer his comments as an expert on certain transactions of the company and to enquire 394 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM whether certain transactions were prejudicial to the interest of the company. The order under Section 227(4A), extend the scope of audit even further e.g. Auditor has to comment on the internal audit system, internal audit system, records of fixed assets etc. 8.3 INTERNAL AUDITING FUNCTION It is an accepted fact that internal auditing function to be effective, must be independent of the activities to be audited. For this, Internal Audit Department must have some accepted standing in the organization. But it cannot be a fully independent department for obvious reasons. Total independence would be as elusive as a perfect vacuum. Complete independence would imply freedom from all types of dependency including financial dependency. Hence as long as Internal Audit Department would remain a part of the organization and receives its life blood from the enterprise, it must forgo some independence. A compromising situation is, therefore, desirable. The department must have the greatest amount of practical independence in the real world situation to protect it from having to compromise with audit objectives. The necessity of the practical independence is being recognized more and more by the modern business concerns and the percentage of firms where the auditing organization reporting to vice-president/the board is on the increase. A very convenient agreement would be auditing organization answerable to an officer whose own status would be sufficiently high to enable him to consider the internal audit report and taken action on the audit recommendations. Preferably such officer should be a member of a Boards Auditing Committee. The role of internal auditor is in the process of being properly recognized. The growing size, technological advancement and the complexities in running an organization has made it imperative on the part of the progressive management to recognize and utilize the services of the internal auditor as a tool of management control. Many of the constraints and bottlenecks in proper management of business can be overcome through

the constant appraisal and review of the operations with the help of the internal auditor. The auditors role should be defined in the written document to be approved by the management and the Board of Directors. Such a documentation should include, inter alia, the following vital aspects :(a) Organisational status and position to be indicated in the organization chart. (b) Defining the scope of internal audit operations. (c) Authorise the internal audit department to have access to all records, personnel and properties. (d) A declaration to be known to all personnel in the organization at all levels, for their cooperation and coordination for all activities of internal audit operation. At times there is an uneasy feeling that the internal auditor is an interloper, reporting to management of the inefficiencies or deficiencies of the departments audited by him. The internal auditor a helping tool to management in prompting efficiency and cost reduction and hence, if he cannot drive away the resentment and/or criticism of others, the purpose of audit may get frustrated. In fact the internal auditor has to get cooperation from employees of other departments, who have to sincerely believe in his honesty of purpose. The internal auditor should be placed in such a status in the organizational set up so that he can be an effective instrument of management control process. We often remark, the tree is known by the fruits it yields. Internal audit department by virtue of its important position, have access to all books and records. If like a professional doctor, the department can ascertain the ill health of the organization related through various area of inefficiency and can suggest medicine-like tips in the form of recommendations, which give positive result, the status of the department is bound to go high, and the CIA would definitely occupy a key position in the management team. The chief of internal auditor should submit annually to management for approval and to the Board for its information a summary of the departments audit work schedule, staffing plan, and financial budget. He should also submit all significant interim changes for approval and information. The chief of internal auditing should submit activity reports to management and to the Board annually or more frequently and recommendations and should inform management and the Board of any significant deviations from approved audit work schedules, staffing plans and financial budgets, and the reasons for them. AUDITING 395 Auditing The Functions of An Enterprise

Pay Roll Salary and Wages Administration The basic documents that would be examined in this connection would be as follows :1. Appointment letterauthority to appoint. 2. Service rules, has pay scales. 3. Circulars issued by the Government and the management 4. Attendance records 5. Employees history cards 6. Accounting manual 7. Payment vouchersstatutory and other deductions. 8. Statutory laws and rules etc. The following may be stated to be the objectives of Internal Auditing in this area :1. Accuracy of pay roll 2. Effectiveness of Internal Control System 3. The functioning of the management information system 4. Accuracy and adequacy of documentation 5. Observance of statutory laws and rules. 6. Accuracy of the financial and cost accounting system The audit steps that would be taken as under :(a) Check the records, appointment letters, personal files etc. for examining authorization for employment and rates of pay dearness and other allowances should also be checked as to whether revision in rates of pay or increments are properly authroised. In case the dearness allowance is based on cost of living index, examine whether such DA has been calculated correctly. (b) Check whether deductions from pay roll are properly authorized (c) Check the correctness in recording attendance and time shown as spent on jobs whether some production bonus etc. might have been billed for. (d) Examine the accuracy of records starting with engagement of workers and ending with disbursements of salaries etc. (e) Examine whether the employment, rates of pay, promotions and increment are in agreement with the policy declared by the company. (f) Check the clock-cards with the total number of workers on the pay roll. (g) Check the hours shown in the clock-cards with the hours as per timecards or job cards. (h) As a test-check, physically verify the number of workers when they are at work in a department and see whether the same tallies with the pay roll and the employments records. (i) In case there is an incentive scheme, examine the procedure and control thereof. Check the incentive payments with production/sales figures. (j) Examine the leave records and see whether the leave has been duly sanctioned. (k) Examine the authority and responsibility in sanctioning overtime, study whether the overtime payment is

justified. Examine whether overtime has been properly accounted for. See, whether the overtime expenditure has remained within the budget provision. (l) See, whether there is compliance with the provisions of the statutory laws and rules like Factorys Act, Minimum Wages Act, Industrial Disputes Act, Payment of Wages Act, Payment of Bonus Act, Workmens Compensation Act etc. (m) Is the payroll prepared well in time? Is their proper coordination between the accounts department, pay roll section, personnel section and production department ? 396 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM (n) Check whether proper record is kept with regard to unpaid wages. See whether the subsequent payments are properly controlled and accounted for. (o) Find out the reasons for significant variation between actual cost and budgeted cost. (p) Examine the procedure for termination of employment either by resignation, discharge, retirement etc. See whether the names of such employees are eliminated from the records to avoid their inclusion in the pay roll, examine also the final settlement made in such cases. (q) Study (if desired by management) the extent of mechanization of accounting possible, in case of pay roll. In case there is the existence of mechanization, study its correctness. The Internal Audit may also conduct O & M study if so desired by the management provided it is equipped for the purpose. The study may include the improvement of the following by changing work flow, mechanization etc. Pay roll form, recording by production department, time-office etc., collection of data for management from primary records etc. (A) Fixed Capital Assets Basic document for review would be as under :(i) Authorisation for acquisition and sale (ii) Purchase order/contracts (iii) Policies on depreciation, amortization (iv) Asset Register (v) Account Manual/Plant Operation Manual. The objective of internal auditing would be :(i) Effective utilization of assets. (ii) Make or buy decisions from the point of view of economy (iii) Adequacy of security and safety measures (iv) Compliance with Accounting/Plant Operation Manual. Manufacturing and Other Companies (Auditors Report) Order, 1988 guidelines issued by the professional accounting bodies etc. (v) Adequacy of insurance coverage

(vi) Correctness of fixed assets schedule - Verification of assets (vii) Verification of Payments and accountingverification of assets. (viii) Verification as to the correctness of the depreciation schedule and its accounting etc. The audit steps would be as under :(B) Authorisation (a) Examine the procedure of capital expenditure authorization. (b) Does the cash flow statements reflect the amount as authorized for capital expenditure so that fund is available at the appropriate time ? (c) Whether the actual expenditure has exceeded amounts authorized? If so whether the additional expenditure has been authorized subsequently? (d) In case, there is expenditure for some additional facilities to increase production, examine the result achieved with reference to actual production and sale. (e) Verify the purchase order of acquisition of capital assets. See, whether the purchase orders include protective clause like guarantee/warranty, keeping of retention money etc. (f) Examine the credit contract and see whether the terms and conditions thereof have been duly complied with. (g) Assess the productivity and profitability of fixed capital expenditure. (i) Examine whether the title deeds to the properties like land, building etc are in order. (j) Examine whether distinction is made as between capital expenditure and revenue expenditure. AUDITING 397 (k) In case some assets have been acquired through hire-purchase scheme, review the terms and conditions of hire purchasing agreement and examine the accounting aspects of capitalization in that light. (l) In case there is some make or buy decision, examine the results on the basis of the actual. (C) Depreciation (a) Examine the policy of the company for charging of depreciation. (b) Examine whether the method of depreciation and the rates of depreciation are reasonable and sound considering the nature of assets, its operation and estimated life. (c) Examine whether the rates of depreciation applied and the assets classification are correct according to accounting manual, in case such manual exists. (d) Examine the depreciation schedule prepared for annual accounts to see whether depreciation for all the existing assets in operation has been included. Also see whether advantage has been taken of the provisions of Income Tax Act and Rules to get maximum depreciation allowable.

(e) Review the compliance of Schedule VI of the Companies Act 1956. Compliance of Section 205 Payment of dividend out of profit only and Section 350 (Ascertainment of depreciation) of the Companies Act 1956. (D) Physical Verification (a) Examine whether there is any system of physical verification of assets at regular intervals. (b) Examine and compare the equipment history cards as maintained by the Engineering Department with the assets register as maintained by the Accounts Department (c) Obtain a list of the obsolete/discarded assets and see whether the assets declared obsolete or discarded have been deleted from the Asset Register. See whether these assets have been disposed off promptly at the best price. (E) Retirements (a) Examine the procedure of retirement of assets and the authority and responsibility of persons connected therewith. (b) Has any asset been transferred to another location, has any asset been discarded even though its life has not expired ? If so, study the reasons thereof. (c) In case of sale of any asset, examine whether the sale has fetched the best price and been done under proper authority. (d) See whether proper records are maintained in respect of assets discarded. (e) See whether accounts adjustments have been carried out in respect of discarded assets. (f) See whether the accounts department get timely information regarding assets discarded. (g) See whether assets retired during the year tally with the Assets Schedule prepared for the year of accounting and taxation purposes etc. (F) Idle Facilities (a) Find out the reasons for idle facilities. (b) Review the plans, procedure for control of idle facilities. (c) Examine the scope for utilization of the idle facilities. Can the facility be leased out? (d) See whether any review report is made periodically for facilities remaining idle etc. General Points (a) Examine the insurance policy covering the risk against fire, storm, riot etc. (b) Ascertain the reasons for non-insurance of some assets, if any. (c) Examine whether there is proper scheme for carrying out preventive maintenance. (d) Examine whether there is any procedure for periodical assessment of the productivity of the assets in operation. (e) Study whether installation of assets/additional facilities are based on projection report etc.

398 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Audit of Receivables : Where the maximum business of the undertaking is the sale of goods or products on credit, the balances due from the customers at the Balance Sheet date would be presented by the debit balances in the Sales A/C on that date. This would generally be the most important of receivables. The audit of the balances would comprise :(a) An examination of the system of internal check for regulating the sale of goods, the receipt of remittances from the debtors, the granting of discount, the writing of bad debts etc. (b) Vouching to establish the accuracy of the entries recorded in the sales ledger. (c) Testing to establish the arithmetical accuracy of the balance shown by the sales ledger. (d) Study of the age and other factors to assess the possibility of bad or doubtful debts. Sometimes, credit balance might be noticed in some individual debtors accounts. This should be scrutinized with care because their existence may signify the omission of debit postings. If their authenticity is established, the auditor should see that they are grouped with the current liability and not deducted from the total trade debtors. The audit of sales ledger should be linked with the audit of stock of finished goods with a view to preventing or detecting :(a) Duplication of inclusion against sale of some goods (b) Omission of posting of some sale. Such errors are common where goods are invoiced in advance of delivery or there is some delay in invoicing following deliveries from the stock as gross profit is affected by such transactions efforts should be made to relate the sales to the correct period and then to make adjustment of inventories to avoid duplication or omission. The internal audit may also consider whether there has been any window dressing by accelerating deliveries to the customers during the closing days of the financial year. The internal auditor must also see that the sales ledger does not include any sales not occurring under the ordinary course of business. As for example sale of fixed assets should not be included in the sales ledger. Verification of balances arising from sale of by-products, scrap etc. would depend to a large extent on the efficiency of Internal Check for controlling such transaction. It should be noted that Sundry Sales is an area where defalcation is common.

The internal auditor therefore, should see that such transactions have passed through a requisite internal control system. Audit of Inventory Purchases See whether there is a purchase manual. The Internal Auditor should then, jot down the important factors that has been prescribed in respect of purchase of raw materials etc. Normally purchases are based on five important factors given below :(1) Right Price. (2) Right quantity (3) Right quality (4) Right delivery and (5) Right supplier The auditor therefore, has to see that these principles have been duly followed. Based on the above principles the audit steps would be generally as follows :Inventory Control Receiving : (i) Examine the systems and procedures of receiving, checking and recording of stores, materials and the authority and responsibility of the persons involved in the process. AUDITING 399 (ii) Examine the procedure of inspection of materials see whether there is proper coordination between the Inspection Department and the Receiving Section of the Stores Department. (iii) Examine the procedure of preparing Material Report How many copies of the report are prepared? To whom these are endorsed? Are all necessary? What is the time lag between receipt of material and its inspection? (iv) Has any demurrage been paid to the railways for late clearance of materials? (v) What is the procedure of receipt of materials returned from the Production Department? Keeping of Stock :(i) See whether the physical condition of the stores in stock is periodically verified. (ii) Study the arrangement to facilitate receiving, storing and issue of stores (iii) Study whether heavy materials / materials for immediate consumption are delivered directly to the work - sites. (iv) Study the arrangements and precautions taken in respect to hazardous handling, safety measures to prevent theft, fire, deterioration etc. (v) See whether any sub-stores / site-stores exists. (vi) See whether facilities exist in storing materials in well-arranged bins etc. Procedure of issue and recording :(i) Examine the procedure of issue and records maintained in the stores section.

(ii) What is the time lag between placing the issue requisition and actual issue to the consuming department? (iii) Review the frequency of issues to the consuming departments. Is it possible to reduce the frequency? (iv) Has there been issue without properly authorized requisition? If so, ascertain the reasons thereof. (v) Does the person drawing the material signs the issue voucher? Similarly does the assistant issuing the materials from stores similarly sign the issue voucher? Examine the authority and responsibility of the persons involved in the process. (vi) Review the issue procedure and documentation in respect to issue to contractor engaged in construction/ maintenance jobs. (vii) Did the production suffer due to non availability of materials from stores? Ascertain the reasons therefor. (viii) Has there been any sale of stores materials to employees? If such system exists, review the systems and procedures in issues, recording, accounting and realization of money from the employees. (ix) Examine the procedure and documentation in respect to materials returned. Is any Stores Return Note issued for the purpose? Are the information adequate for the purpose of accounting and receipt of materials in the stores? (x) Review the procedure of recording and return of empty containers. (xi) In case a stores manual exists, see, whether instructions contained therein have been followed in issuing the materials and their documentation etc. Physical Verification:(i) Review the procedure of physical verification of stores? Is it done in the year end? Or the physical verification is done on perpetual inventory system basis. (ii) If a system of perpetual inventory exists, see whether the stores are covered at least once in a year and important stores are covered more than once. (iii) Does an independent stock verification wing carry out physical verification of stores? (iv) What records are prepared in respect to recording of stores found short / surplus? (v) What is the procedure in making adjustment of stores records / financial records on the basis of shortage / surplus report ? 400 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM (vi) Under whose authority this discrepancy report is issued. (vii) To whom physical verification department reports ? Stores Accounting :(i) Is there any Stores- Accounting Manual duly approved by the management ?

(ii) Who maintains the stores ledger ? If maintained by the stores people in addition to bin cards, is it periodically reviewed and reconciled with accounts by some accountants working in the Accountants Offices? (iii) Examine whether accounting/recording of stores received/stores returned from production department, stores issued for consumption has been done as per procedure of the Stores Manual. (iv) See whether the stores ledger/bin cards contain all the required information like unit price, maximum, minimum, reorder, economic order quantity etc. (v) Examine whether the system of receiving / issuing of stores etc. ensure that only the authorized transactions are recorded. Inventory Control and Management :(i) Has the inventory been classified for proper control ? Is A, B, C system of inventory classification followed? (ii) How the inventory levels maximum, minimum, reorder, economic order quantity fixed? (iii) Is material budget prepared in advance to regulate purchase ? (iv) Study the opening/closing stocks of the last few years. (v) Study the procurement of materials for the last 2/3 years and see whether the same compares favourably with production. (vi) Is there any regular system to assess slow-moving/non-moving stores items for early disposal in cases considered necessary ? (vii) Who is the person to declare some material as surplus ? Who authorizes its disposal? (viii) Review whether value analysis, PERT etc. are applied for better management of stores. (ix) Work out inventory ratios to judge the reasonableness of inventory build up (a) Working Capital to Store Inventory (b) Current Assets to Store Inventory (c) Inventory Turnover. Some General Aspects :(i) Sometimes used materials are returned to stores. In such cases procedure for recording would be the same as followed in case of unused materials except that these may or may not be priced. Usually separate stores ledger / bin cards are opened. See whether the procedure in this regard has been observed. (ii) Review whether any study has been made in regard to mechanization in stores receipt/issue, store accounting.

(iii) Review whether proper numerical accounts have been kept in respect to stand by spares. (iv) See whether there are any Material Receiving Report pending disposal recording valuation in stores ledger/bin card, accounting the accounts records etc. (v) Review the mode of valuation of closing stock. (vi) How soon the stores schedule is prepared for annual accounts purpose ? (vii) Are the stores materials adequately covered by insurance against loss from fire and other risks ? (viii) Is there proper coordination between (a) Central Purchase Department AUDITING 401 (b) Local Purchase Department (c) Stores Department (d) Stock verification Department (ix) In case there are number of factories producing same / similar products make comparative study regarding (a) Surplus materials (b) Obsolete/slow-moving materials. (c) Finished/work-in-progress stock (d) Opening/closing stock of raw material, etc. Apart from the above, O and M study may be carried out for standardization of forms, modification of work flow for improvement in efficiency in various directions etc. Production Planning and Control The objectives of Internal Audit in this area would be to see whether :(i) Records maintained are adequate and reliable. (ii) Production planning and control is effective. (iii) Management reporting system is adequate. (iv) Utilization of facilities has been done efficiently. (v) Financial and cost accounting including reconciliation between production, work-in progress, sales and inventories have been done correctly. Keeping in view the above, the different audit steps would be as under :(i) Review the nature of the business, its operation, plans policies and objectives of the management which would be a guide for appraisal and review of the adequacy of production planning and control techniques. (ii) Study whether any inter-firm and intra-firm comparison is made to assess efficiency in production and productivity. (iii) Is there any industrial engineering department to look after plant performance, utilization of man, machine and material. (iv) Examine whether proper coordination exist between the following departments. (a) Production Planning Department.

(b) Industrial Engineering Department. (c) Material Management Department. (d) Commercial or Accounts Department (v) Examine whether a sale forecasting is made in advance to control production. (vi) Study the actual production with the requirement as per sales forecast. Study whether the time schedule has been maintained in achieving the actual production. (vii) Review the existing production planning, scheduling and control system, examine whether production planning and scheduling have been applied to production process efficiently. (viii) Examine whether the production planning and control are within existing facilities. (ix) Examine whether any production control flow chart is in operation. Such flow chart would show the sequence and scheduling of production process from receipt of the order to dispatch of the finished goods. (x) Examine the actuals with reference to the production flow chart and suggest improvement to the flow chart based on the actual study. Study production scheduling, inventory control, extent of machine and labour utilization from the point of view of control of production. (xi) Review whether delivery schedules as given in the sales order have been complied with. Analyse the reasons for non delivery according to delivery schedule. Recommend remedial measures. 402 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM (xii) Has any job been given on subcontract, if so, analyse the reasons thereof. Study whether these could have been done by utilising the existing facilities. Has the subcontractor delivered the goods within the time schedule agreed upon ? Has the goods supplied by the subcontractor been found satisfactory from the point of view of quality, specification and other related matters ? (xiii) Does any Inspection Department exist ? If so, review the records of inspection maintained by the inspection department. Study whether the inspection has been done expeditiously. Suggest improvement of the present records when considered necessary. (xiv) Examine the file containing complaints from the customers. Examine, whether proper action has been taken on the basis of the complaints lodged. Assess to what extent there has been financial loss for supplying defective goods (production defects). See whether any comprehensive report in this regard is placed to the management. If so, who is responsible for the job ? Has he discharged his responsibility

satisfactorily. (xv) Review the records in general and recommend simplification/improvement if possible etc. Marketing Marketing would include mainly sales, sales accounting and credit controls. The main objectives of internal audit in that area would be as under :1. Adequacy and reliability of sales record and accounting 2. Accuracy of Customers A/c. 3. Effectiveness of sales planning and control. 4. Compliance with statutory requirement, payment of Sales Tax, Excise Duty etc. 5. Adequacy and effectiveness of existing management information system and internal control system. Based on the above, internal audit function in respect to important aspects is being discussed below :Sales Order :Examine and review :(i) Whether the terms and conditions of sales effected covers all the important aspects like terms of payment, delivery charge, discount for payment within the time schedule etc. (ii) The procedure of issue of sales order. (iii) Whether sales orders are booked on the basis of written requests. (iv) The time lag between receiving the customers letters and issue of sales order and actual dispatch of goods. Is the time lag reasonable ? (v) At what point the customer is allowed to cancel an order ? (vi) Whether any customers request is still pending ? (vii) Whether any customers order is rejected ? Ascertain the reasons. (viii) The authority and responsibility of signing the sales orders. Whether different officials have been authorized for signing sales orders of different amounts ? If so, the limitations imposed have been properly adhered to by the officials authorized for the purpose. (ix) Whether any revision of the sale prices are promptly notified and acted upon etc. Despatch :Examine and review :(i) The systems and procedures of despatch and the records maintained for the purpose. (ii) The despatch dates with the dates given in the despatch schedule and sales orders. (iii) When the despatch documents with invoices are sent to the customers after despatch of goods ? Is the delay unusual ? If so, suggest remedial measures. Whether there is any complaint from any customer on account of receipt of despatch documents after arrival of the goods. (This might mean that the customer might have been required to pay demurrage charge). (iv) Authority and responsibility for signing despatch documents etc. AUDITING 403

Sales Invoice :(i) Review the systems and procedures of invoicing; who prepares the invoices. Is there any second person to check it ? (ii) Review the time lag between despatch, invoicing and mailing the same to customers. (iii) Check the invoices (test check) with reference to price list, agreement with customers, and other terms and conditions of sales. (iv) Check whether trade discounts, cash discount and rebates are allowed as per allowed price list, terms of agreement etc. (v) Examine whether Sales Tax/Vat has been correctly charged both in cash memos and credit sales invoices. (vi) Ensure that for all goods despatched, sales invoice have been raised. Review the internal control system in operation in this regard and suggest change if considered necessary. (vii) Do the invoices show terms of payment and due date of payment? Credit Control :(i) Examine the procedure of determining of credit worthiness of the customers. Is there any system of reassessing the credit worthiness of the customers ? (ii) Examine and review the factors taken into consideration in the following cases : (a) Cash against delivery. (b) Limitations of credit as to payment and amount (c)Documents through bank (payable on presentation of letters of credit, against draft etc) (d) Collection of cash/cheque by salesman. (iii) Is there any procedure of reviewing the debtors ledger periodically ? Is any Debtors List prepared according to Age ? Is there any procedure of charging interest for delayed payment ? It is often noticed that sales terms include payment clause authorizing charging of interest for delayed payment. But usually this is not acted upon. In such cases some report is sent to the management to ensure early payment by them etc. Debtors Ledger :(i) Examine whether the debtors ledger is kept up-to-date. (ii) See whether the debtors ledger balances are periodically reconciled with the control as in general ledger. (iii) Examine whether adjustment entries debits/credits have been correctly posted (journal entries may be referred to for the purpose) (iv) See whether there is a system of confirmation of the balance owing by the customers. Examine whether statutory auditors insist on confirmation of the balances by the debtors.

(v) Examine the amount written off as bad debts and the amount provided for against doubtful debts. Compare the figure with the same in earlier two-three years. In case the bad and doubtful debts provided for the current years is unduly high, carry out a thorough examination to ascertain the reasons therefor. (vi) See whether there is any system of accepting advances or security deposit from the customers. In case such system exists examine the policy followed in this regard. Also see that the advances have been promptly adjusted or the security deposit refunded etc. Receipt of Cash/Cheque : (i) Examine and review the system of receiving cheque/cash. Review the management policy in regard to cash collection. If the policy followed in this regard is one that encourages cash collection, suggest its modification so that cash collection can be avoided to the extent practicable to examine the procedure of issuing receipts after getting cheque/cash against sales. See whether cash collection is against printed receipts. In case of receipts of cheque see whether a provisional receipt is issued which is confirmed after clearance of the cheques received. 404 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Review time-lag between clearance of cheque issuance of pukka receipts. (ii) See whether the cash collection is banked at the earliest convenient and the same is not utilized for expenses. If there is no clear management policy in this regard, suggest a policy in the above line etc. Credit Notes :(i) The credit notes are issued for the following reasons : (ii) Examine and review the system and procedure of issuance of credit notes and its recording and accounting. (a) Return of materials (b) Excess/incorrect charges in invoices (c) Cash discount for prompt payment (d) Short delivery/wrong delivery/delivery of defective materials (e) Examine the authority for signing the credit notes (f) See whether the credit notes are promptly issued, documented and accounted for etc. Debit Notes : Examine and review whether debit notes are issued in all cases where there has been undercharge in the invoice, recovery of further charges not included in original invoice, delivery of excess material accepted by

the customers etc. See also whether debits have been signed by some official authorised for the purpose. Sales Return : (i) Examine and review the procedure adopted in receiving and recording of the sales return. (ii) Compare the sales return with total sales. If the amount of sales return is considered high ascertain the reasons therefor and suggest remedial measure. (iii) See whether freight charges incurred in returning the sales are borne by the customer for the concern. Examine whether there is clear policy in this regard. Stock records and accounting:(i) Review the stock card and other records maintained and assess whether they are adequate? (ii) Examine the system and procedure of recording entries and accounting. (iii) Is stock holding as per sales budget ? (iv) Is there any procedure of making age analysis of stocks held ? (v) At what intervals stocks are physically verified ? (vi) Review whether valuation of stock is being made on some consistent basis etc. After Sales Service :(i) Examine the policy and procedure followed in respect to after-service. (ii) Examine the administrative control to make sure that proper service has been rendered to the customers. Branches and Depots :(i) Examine the system of administration of sales through depots/branches. Is there any written policy in this regard? (ii) What records maintained by the branches/depots? (iii) Are the record maintained in respect to entries made for resale? If so, under what circumstances? Has the requirement in this regard been complied with by the branches/depots? (iv) Is any cash book maintained for receiving cash/cheque on account of sale and for expenditure authorized to be incurred by the branches/depots? Examine whether such records have been maintained properly? AUDITING 405 (v) What is the procedure of remittance of sale receipts to the Head Quarters by the branches/depots ? Examine whether remittances have been done according to the instructions in this regard. (vi) Are the expenditure/income of the branches/depots regulated by budget provision? If so, examine the performance of the branches/depots with reference to the budget provision. In case of significant variation, ascertain the reasons therefor. (vii) Are the branches/depots authorized to make sales on credit? If so, review the debtors ledgers and

ascertain old debtors. (viii) At what intervals, stock at branches/depots are physically verified? Is there any procedure for verification of stock by the staff of the branches/depots? etc. Research and Development :(i) Examine the organisatinal structure of the Research and Development Department. Are the research projects undertaken in time with the management objectives? (ii) Are the research projects covered by the budget provisions? (iii) Are the personnel engaged in the research project duly qualified and experienced ? (iv) Examine the completed research projects in the last 2/3 years. How many of them have become successful? What benefits had been derived commercially by the concern out of successful research projects ? (v) Is there any procedure of continuous review of the research projects in-progress ? To discontinue those, the possibility of success of which would be found definitely doubtful. (vi) How the cost of the research projects accounted for ? Is there any definite management policy in this regard ? (vii) What records are maintained by the department in respect to projects undertaken and the cost incurred on them ? Are the records adequate ? (viii) Examine whether research and development department has been provided with all necessary facilities for successful research operation. (ix) Have proper precautionary measures been adopted to keep the research and development work confidential. (x) Review whether Research and Development department has been provided with all necessary facilities for successful research operation. (xi) Is there cooperation between Research and Development Department with engineering and other departments? (xii) Review the Incentive scheme adopted for motivating the research personnel for carrying out research jobs to the best interest of the organization. (xiii) Does the Chairman /Vice Chairman meet periodically with the Head of the Research and Development Department to encourage him in research jobs and to solve the difficulties he might be facing in this connection etc? Auditing The Internal Auditing Function Internal audit carries out audit functions to see that the objectives of the management in running the business

operations are achieved through realization of some optimum profit. It is a management tool which helps the management in running the business efficiently in accordance with the policies followed at present. Not only that Internal Audit helps to modify the business policies for improvement in efficiency of business operations in future. Actually Internal Audit departments in different business organizations in U.S.A. and other countries have been playing vital role in this regard. It would, therefore, be apparent that it is necessary to ensure that the Internal Audit Dept. discharges its functions in a desirable manner to be useful as a management tool. It is in this context necessary that an eye is kept on the Internal Audit functions to see whether the same are being done efficiently. Therefore, audit of Internal Audit functions is considered necessary. However, it should be appreciated that keeping another audit department to carry out such audit does not seem to be a practical proposition. 406 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 8.4 PLANNING THE INTERNAL AUDIT PROJECT The advantages and disadvantages of a standard audit project is a subject of continuous debate amongst Internal Auditors. No planned audit project can be totally applicable without any variation in accounting procedures that are found, in an organization even if there exists a reasonable measure of standardization. However, it has been experienced that in a well established organization where system of internal checks are adequate, the most effective auditing can be conducted by apportionment of audit time approximately 2/3rd. over a Standard Internal Audit Programme adopted to local circumstances and 1/3rd to whose accounting features that appear to auditor the merit of special audit attention. The advantages of a standard project are as follows :1. It provides the internal audit staff, a framework for his activities in logical sequence. 2. It indicates lesser test checking which is necessary on the assumption that the internal check system is adequate. 3. It is of a big help and support to the external auditor who chalks out his own audit programme auditable, avoiding duplication area. 4. It enables a balanced audit to be achieved at each accounting point, also in the entire organization. 5. It also guides the Internal Auditor on the subject of recommendations.

It must be remembered that planning the audit project is mental process but a planned audit project is not a substitute for thinking. Audit Programme :An Audit Programme is a detailed plan of audit assignment to be completed, specifying the methods and procedures to be followed for completing the work of vouching and verification satisfactorily by available staff within stipulated period of time. Audit Programme is nothing but a plan or programme prepared by auditor for completion of audit specifying the responsibilities of each staff. In short, before the work of an audit commenced, the auditor should chalkout a programme as to what work is to be done by his assistants and by himself and the time by which the work is to be finished. Audit Programme is a guideline to the internal auditor wherein he wishes out for himself his strategies i.e. how to go about the audit work he is going to perform. The audit programme serves as a guide in developing the appraisal and review techniques suitable to meet the organizational objectives and results expected by the top management. Because of the organizational objectives and results expected by the top management. Because of the usefulness it also serves as permanent comparison to indicate the lines on which management can implement and exercise overall controls. Developing The Audit Programme The auditor should prepare a written audit programme, setting for the procedures that are needed to implement the audit plan. The programme may also contain the audit objective for each and should have sufficient under standing to control the proper execution of the work. In preparing the audit programme, the auditor, having an understanding of the accounting system and related internal controls, may wish to rely on certain internal controls in determining the nature, timing and extent of required auditing procedures. The auditor should also consider the timing of the procedures, the coordination of any assistance expected from the client, the availability of assistance, and the involvement of other auditors or experts. The audit planning ideally commences at the conclusion of the previous years audit, and along with the related programme, it should be reconsidered for modification as the audit progresses. Such consideration is based on the auditors review of the internal control, his preliminary evaluation thereof, and the results of his compliance

and substantive procedures. AUDITING 407 8.5 DETAILED CHECKING VERSUS SAMPLING PLANS The approach of the auditor would be influenced by the size of the concern he is going to audit. In case of a small or medium sized concern horizontal vouching may give quite satisfactory result. But in big concerns there would be very large number of transactions and hence accounting entries would be huge. It is therefore necessary to have a precise and comprehensive technique in vouching to be applied to a comparatively small sample of transactions without in anyway reducing the effectiveness of the examination. This is actually known as auditing in depth. Under it, extremely small sample of transactions of a particular type (i.e. purchase) would be selected and subjected to a critical check in all stages from initiation to conclusion. Stores requisitions, purchase orders invoices, goods receipt notes, prices etc. might be covered under such depth checking technique. The auditor might continue his examination by reference to entries in the cash book and bank scrolls as regards payment for the purchases. The returned cheques would also be examined. The posting would be checked from the books of prime entry to the ledger. Finally the auditor would examine the stock records which would reflect receipts after issues. This procedure is extremely flexible and may be applied in varying circumstances. If the examination of the successive stages reveals satisfactory results as regards accuracy of recording and the operation of the internal check, the auditor may progressively reduce the number of items to be examined at subsequent stages. This technique virtually leads to the flow chart technique. Biased Errors :These errors arise from bias in selection, estimation etc. For example, if in place of random sampling, deliberate sampling is used in some particular case, there is likelihood of some bias introduced in the result. Such errors are known as biased sampling errors. Unbiased Errors :These errors arise because of a chance errors between the members of population included in the sample and those not included. Thus, the total sampling error comprises of errors due to bias and the random sampling error. Method of Reducing Sampling Errors :The simplest way of increasing the accuracy of a sample is to increase the sample size, i.e. the number of units

in the sample. Flow Chart A flow chart is a graphic representation of a system. It depicts the various operations control and stages involved in a system with a help of graphic symbol. A flow chart thus, provides a concise and comprehensive view of what takes place in an organization, i.e. what documents are raised, how they are dealt with, what the flow of goods and cash is, what the various operations are, etc. A flow chart enables one to understand even a complicated system easily. Lengthy narrative can often be confusing and unwieldy. A flow chart on the other hand, can depict the same situation in a simple and concise manner. Suppose a visitor to Delhi wishes to reach India Gate from the railway station. If the route is described to him by way of narratives, he may not be able to reach his destination on his own. This is because he will have to write down the names of a number of roads, places, and turnings. Also, he will have to comprehend the direction and connections of various roads and areas. Instead, a simple road map may be more helpful to him since he can follow exactly the directions indicated in the map. Similarly the utility of a flow chart lies in its capability of depicting not only the various phases of a system in a simple manner but also in showing their relationship and relative importance. A system which has various phases of varying importance with interconnection links can best be understood through flow chart. An auditor requires certain specific symbols for all processes which have an effect on the internal control system. He may used are separate symbols for different types of operations such as signing or checking the totals, or comparison with basic document. Preparing A Flow Chart A Hypothetical Example Suppose an auditor is preparing a flow chart regarding the purchases made by a manufacturing enterprise. Purchasing involves at least four different sections. i.e. stores, purchase department, goods receipts sections 408 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM and accounts. The basic stages are :1. Preparing requisition for requirement of materials. 2. Issue of orders. 3. Receipt of goods. 4. Payment to suppliers. The depiction of all these four stages in one flow chart may result in the chart becoming too complicated and

cumbersome. Hence the detailed procedure regarding payments to suppliers may be shown by a separate chart. The auditor will approach each person involved in the first three stages of the purchasing function and chart the procedure on the basis of information so obtained. 8.6 INTERNAL CONTROL NATURE AND SCOPE The system of internal control may be defined as Plan of organization and all the methods and procedure adopted by the management of an entity to assist in achieving managements objective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to management policies, the safeguard of assets, prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The system of internal control extends beyond those matters which relate directly to the functions of the accounting system. In a financial audit, the auditor is concerned primarily with the accounting controls. In an operational audit, however, the auditor reviews all operational controls. From this point of view, internal controls can be classified into two broad categories : accounting controls and administrative controls. Accounting Controls comprise primarily the plan of organization and procedures and records that are concerned with the safeguarding of assets, prevention and detection of fraud and error, accuracy and completeness of records, and timely preparation of reliable financial information. Administrative controls include all other managerial controls concerned with the decision-making process. Significance and Objective of Control For the administrative control and attainment of objectives of an organization, formulation of policies and procedures is a must. Such policies and procedures must be communicated to all levels so that accomplishment of objectives becomes a reality. To administer such a process of management, a business concept called internal control has been evolved. The importance and the manifold necessities of this term are as under :(a) To control the operations particularly where the organizational structure has become complex and widespread. (b) To bring business functioning or activities within the broad formulated plans, policies, objectives and goals. (c) To bring to light any misuse or misappropriation of the companys assets (whether of current or fixed

nature) and to take corrective measures in safeguarding assets. (d) To take corrective measures whenever there are symptoms of weakness or flaws in the management of the business. (e) To ensure that operational controls are fully effective. (f) To assess the adequacy and accuracy of control measures. (g) To create appropriate climate for efficient organizational functioning. (h) To safeguard the interest of the organization as well as guarding against the dishonesty; temptations, apathy, lethargy and inefficiency of the men at work through proper effective control measures which will act as deterrents to the occurrence or happenings of unhealthy situations. (i) To prevent and detect frauds and errors. (j) To ensure adequacy and reliability of management information and control systems. (k) To ensure timely preparation and presentation of various reports for decisionmaking. (l) Efficient system of internal control saves the statutory auditor from an impracticable exhaustive audit. AUDITING 409 (m) Absence of or ineffective control will lead to chaos in the organizational working and will be damaging to the morale of the people working for the organization. This will in turn jeopardize the leadership in management. (n) Due to the growing complexity of running a business, management will have to depend on various reports, facts and figures for decision-making. Internal Auditor and Internal Control The internal auditors objective is to evaluate the performance, methods and systems of working on a continuous basis. In order to help management as to the effectiveness of controls, the auditor is to report : (a) Whether there are signs or symptoms of breakdown of the control systems. (b) Whether necessary changes are warranted. (c) To make management control system more effective so as to ensure that results are obtained for which the controls are established. The internal auditor while making appraisal and review will have to examine the following aspects : 1. Documentation and work-flow 2. Objective analysis of the business situation 3. Organization structure and charts. 4. Systems of communication. 5. Performance assessment 6. Internal check system. Through the process of evaluation and appraisal, the internal auditor will contribute towards effective control

practices. Internal control would cover both internal checks, internal audit and other forms of control, internal auditing is to a great extent an appraisal and review of internal control as discussed earlier. Internal control embraces or comprises the whole system and procedure of managerial control of any nature, be it financial, non-financial or accounting. Internal Auditing is an independent appraisal activity within an organization for the review of operations as a service to management. It is managerial control which functions by measuring and evaluation of the effectiveness of other controls. This goes to show that the very nature of internal audit functioning and objectivity is the appraisal and review of control measures. Now it follows that internal control includes internal check, internal audit, organization and methods (O & M) study and other operational controls. But internal audit is not a part of internal check nor part of any accounting or financial control system. Internal control is broader than internal check and the latter is an essential element of internal control. In internal auditing the appraisal, review and evaluation have been to begin with the study of control because it is essential that there must be a complete knowledge of the management control system. In an organization, it is a fact that such a situation seldom exists. Management usually look for someone who can assure them that control systems are being followed and tested regularly for their suitability so that management can act confidently in managing the business. This is so far the management side of the picture. Then the question arises as to the scope of appraisal by the internal auditor to aid management in keeping up confidence in running a business and in achieving organisational objectives, The internal auditors function is to an extent the determination of effective control measures he is to appraise and assess the extent of implementation of the management control system. He is to ensure as well as to assure management that control system are as effective as these are expected to be and thereby changing hopes and aspirations of the organization into accomplishments. The internal auditor in order to succeed in his objectives should also have the cooperation of others in the organization since it is on them that the efficiency of control measures depends

to a large extent. So it naturally follows that the appraisal of performance of personnel is to be done alongside the appraisal of the control measures itself. The pattern and degree of control may vary between organization to organization due to certain variable factors. These factors are again listed here for convenience : 410 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM (a) Magnitude of Organisation (b) Facilities available (c) Nature of business operations (d) Type of business (e) Nature of organizational structure (f) Capabilities and future potentialities of personnel Due to such variables, the formulation and effectiveness of control measures will not be the same in all the organizations. Because of this, the pattern of appraisal and recommendation by the internal auditor will also vary. Each situation, under which control measures are formulated, adopted and developed, must form part of the subject for separate study. Internal Check and Internal Control Internal check system is organized to achieve the following objects :1. To prevent the commission of any errors or fraud. 2. To prevent the misappropriation of cash or goods by keeping a check on the receipts and payments of cash and receipts and delivery of the goods. 3. To throw responsibility when the fraud or mistake is detected. 4. To detect a fraud or an error quickly and easily 5. To have an accurate record of all business transactions. Auditors Duty In Regard to Internal Check System In the case of a big concern where there is a good internal check system the auditor may, to a great extent, presume the accuracy of the accounting. But he must not be negligent. He should apply a few test checks, i.e. he should check a few transactions here and there at random or check fully the accounts for a few months, and carry out a through check of the whole of a certain class of transactions taking place during that particular period, e.g. cash sales, or cash received or credit purchases during that period. In selecting certain transactions are representative and true specimens the auditor should see that such sample transactions are representative and true specimens of such entries throughout the year. If he finds that there is no mistake and there is nothing to arouse his suspicion, he may presume that the

accounts are correct. It must be remembered that in such a case, the auditor is not relieved of his responsibility. Therefore, it would be better for him to probe the matter thoroughly if there is the slightest suspicion. If later on, it is found that a fraud had been committed which the auditor failed to detect as he had not checked all the transactions, he would be held liable. The existence of a good internal check system reduces to a great extent the work of the auditor but does not reduce his liability. To what extent an auditor should depend upon the internal check system will depend upon his tact, skill, experience and judgement. The internal check is said to have the following fundamental aims : (1) To pin down to definite persons responsibility for particular acts, default or omission, by the segregation of tasks. (2) To obtain confirmation of facts and entries, physical and financial, by the creation and preservation of necessary records. (3) To facilitate the breakdown of routine procedures so as to avoid bottlenecks and to establish an even flow of work. (4) To reduce to a minimum the possibility of fraud and error. Check list is usually a questionnaire set, designed to draw attention to important aspects of the system of internal check. The question should be phased in such a way that an affirmative answer would normally reveal a satisfactory position. If the answer is negative, enquiry should be made to see if there is a satisfactory substitute for the procedure referred to in the questionnaire. A negative answer always merits further examination. All the items on the questionnaire cannot be of the same importance and an unhealthy position might be revealed either by a single negative answer or by a number of such answers. AUDITING 411 No questionnaire for the appraisal of a system of internal check can ever be considered to be complete. Although every effort should be made to make such a questionnaire as comprehensive as possible, it is primarily a stimulation to thinking along recognized channels. Internal Control Questionnaires The evaluation of internal check system in an organization is of great concern both to the statutory auditor as well as to the internal auditor. The guiding factor for audit operation by the statutory auditor depends to a great extent on the soundness or otherwise of the internal controls in business. Due to the limitation of time a

statutory auditor can spend on a companys audit, he has to decide the extent of indepth audit of many areas, particularly the checking and verification of routine aspects of financial transactions. The evaluation of the internal check system including internal accounting control gives an opportunity to the statutory auditor to have a clearer insight into the operational systems and an overall view of the organizational workings to spot weakness in the systems and procedure both in respect of financial and operational areas of the business The internal check system questionnaire is a list of systematically and logically prepared questions designed to find out and evaluate the effectiveness of the internal check system regarding various aspects and accounting transactions of an organization. The questionnaire are to be as comprehensive as possible in nature to make sure that all aspects and accounting transactions are covered which are to be replied by the official of the department or division concerned. During the course of the audit statutory auditor will submit to the organization a complete questionnaire for reply by concerned official which will help the former to form an opinion as to the adequacy and reasonableness of the internal check system. The statutory auditor during the course of his audit may make test checks or in-depth checking depending on the circumstances to make sure that the replies to the questionnaire are accurate and complete. In respect of many of the replies, the statutory auditor may have to make sure that the internal check system are really in operation through proper verification. In respect of negative replies, he may have to qualify his audit report depending on the seriousness of the situation. The internal auditor in their pre-audit i.e. before taking up real internal audit operations may require the officials concerned to reply to the questionnaire. This will help the internal auditor in shaping his programming. The department or divisional heads should also make use of such questionnaire, solely on their own initiative, by directing the personnel to prepare replies to such a questionnaire for the benefit of the department itself. This procedure will enable the department head to evaluate the existing internal control system and thereby to suggest management to review the said systems to further strengthen the organizational controls. Internal Control Questionnaire For Cash And Bank Receipts 1. Is inward mail opened by persons not connected with handling cash or the Accounts Department ?

2. Is the inward mail date stamped ? 3. Is there a detailed record of receipts prepared ? 4. Are all cheques specially crossed by employees opening mail ? 5. Are bank deposits prepared and made by some one other than those responsible for cash receipts and/or personal ledger. Are duplicate (or counterfoils of) receipted deposit slips received from the bank ? 6. Is there any comparison of items listed on the duplicate (or counterfoils of) deposit slips with the amounts of cheques recorded in the cash receipts records ? 7. Are receipts given for over-the counter collections ? 8. Is there reconciliation of such proofs of collection with amounts banked? 9. Are collections of branch offices and sales offices deposited in special bank accounts subject to withdrawal only by the head office ? 10. If collections are made by representatives of the company in cash, have serially numbered been issued to them ? 11. Is there a system of issuing permanent receipts in lieu of the temporary/provisional receipts issued by bill collections etc. 412 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 12. Are such collections promptly received and banked? Are the receipts forms : (a) Serially numbered ? (b) Kept in safe custody ? (c) Controlled by register ? (d) Unused stocks checked regularly ? (e) Made out by one employee and dispatched by another ? (f) Accounted for, including those cancelled in respect of partially used receipts, books not intended to be used, cancelled. Are cancelled receipts preserved ? 13. Is the opening of bank accounts authorized by the Board of Directors ? 14. Are sundry items, such as, dividends, interest, rent, commissions etc. regularly checked by responsible official to satisfy that correct amount are received ? 15. Is there a procedure to ensure that Hundi borrowing as only by cheques crossed Account Payee? 16. Is the cash balance verified frequently (incoming money orders. VPP receipts etc.) 17. Are they listed immediately ? 18. Are such lists compared with the Cash Book regularly ? 19. Is there an arrangement with the postal authorities to receive cheques instead of cash ? 20. Are the cashiers duties taken over for a few days, by some one else, occasionally ? 21. If rough cash book is maintained : (a) Is a fair cash book written up promptly ?

(b) Is the fair cash book checked with the rough cash book, by a person other than the cashier ? Internal Control Questionnaire for Purchase And Creditors 1. Is purchasing centralized in the Purchase Department ? 2. Are purchases made only from approved supplier ? 3. Is a list of approved suppliers maintained for this purpose ? 4. Does the master list contain more that one source of supply for all important materials ? 5. Are the purchase orders based on valid purchase requisitions duly signed by persons authorized in this behalf ? 6. Are purchases made on behalf of employees ? 7. If so, is the same procedure followed as for other purchases ? 8. If special approval required for purchases from employees, Directors and Companies in which Directors are interested ? 9. Purchase of capital goods ? 10. Are purchases based on competitive quotations from two or more suppliers ? 11. Is comparative quotation analysis sheet is drawn before purchases are authorized ? 12. If the lowest quotation is not accepted, is the purchase approved by a senior official ? 13. If the price variation clause is included, is it approved by a Senior official? 14. Are purchase orders pre-numbered and strict control exercised over unused forms ? 15. Are purchase orders signed only by employees authorized I this behalf ? 16. Do purchase orders contain the following minimum information : (a) Name of the supplier ? (b) Delivery terms ? (c) Quantity ? (d) Price ? AUDITING 413 (e) Freight terms ? (f) Payment terms ? (g) Any extra applicable ? 17. Is revision of terms of purchase orders duly authorized ? 18. Are copies of purchases orders and revisions forwarded to Accounts and Receiving Department ? 19. If yes do the copies show the quantities ordered ? 20. If no, is there an adequate procedure orders complied by Receiving Department to be notified to accept deliveries ? 21. Is a List of pending purchase orders complied by purchase department at least office every quarter ? 22. Are all materials, supplies, etc. received only in the Receiving Department. ? 23. If they are received directly by User Department/Processors/ Customers, is there a procedure of obtaining acknowledgements for quantity received and the conditions of the goods ?

24. Are persons connected with receipt of materials and the keeping of receiving records denied authority, to issue purchase orders or to approve invoices. 25. Are materials, supplies etc. inspected and counted, weighted or measured in the Receiving Department ? 26. Are quantities and description checked against purchase order (or other form of notification) and goods inspected for condition ? 27. Does the Receiving Department deliver or supervise the delivery of each item received to the proper Stores or Department location. 28. Are acknowledgements obtained from suppliers for goods/containers returned to them ? 29. Are all receipts of materials evidenced by pre-numbered Goods Received Notes ? 30. Are copies of Goods Received Notes forwarded to Accounts Department and a list of goods received to Purchase Department? 31. Are all cases of materials returned, shortages and rejections advised to the Accounts Department, for raising Debit Memos on suppliers or claim bill on carriers/insurance companies as the case may be ? 32. Are all debit notes :(a) Pre numbered ? (b) Numerically controlled ? (c) Properly recorded in the financial accounting or in memorandum registers ? 33. Are all suppliers invoices routed direct to the Accounts Department ? 34. Are they entered in a Bill Register before submitting them to other department for check and/or approval? 35. Are advance and partial payments entered on the invoices before they are submitted to other departments? 36. Does the system ensure that all invoices and credit notes received are duly processed ? 37. In respect of raw materials and suppliers, are reconciliation made of quantities and or values received, as shown by purchase invoices, with receipts into stock records ? 38. Are duplicate invoices marked immediately on receipts to avoid payment against them ? 39. If payments are made against duplicate invoices even occasionally are adequate precautions take to avoid duplicate payments ? 40. Does the Accounts Department match the invoices of suppliers with Goods Received Notes or acknowledgements received as per Q.17 and purchase orders ? Are Goods Received Notes and receiving records regularly reviewed for items for which no invoices have been received ? 41. Are all such items, investigated and is provisions made for the liability in respect of such items ?

42. Is such review/investigation done by a person independent of those responsible for the receipts and control of goods ? 43. Do all invoices bear evidence of being checked for prices, freight terms extensions and additions ? 414 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 44. Is the relative purchase order attached to the invoice for payment ? 45. Where the client both buys from and sell to a person regularly, is a periodic review made of all amounts due from him to determine whether any set off is necessary ? 46. Is a special request used for making payments in advance or against documents through Bank ? 47. Thereafter, are the invoices processed in the normal course ? 48. Are all advance payments duly authorized by persons competent of authorize such payment ? 49. Is a list of pending advances made at least every quarter and is a proper follow up maintained ? 50. Are all adjustments to creditors accounts duly approved by those authorized in this behalf ? 51. Is a list of employees by designation with limits of authority in respect of several matters referred to in this section maintained. 52. Are all suppliers statements compared with ledger accounts ? 53. Is there any follow up action to investigate differences, if any between the suppliers statements and the ledger accounts ? 54. Is a list of unpaid creditors prepared and reconciled periodically with the General Ledger Control accounts? 55. Is there a system of ensuring that cash discounts are availed of, whenever offered ? Internal Control Questionnaire for Sales And Debtors Section 1. Are standard price lists maintained ? 2. Are prices which are not based on standard price lists, required to be approved by senior executive outside the Sales Department ? 3. Are written orders from customers received in all cases ? 4. If oral/telephonic orders are received, are they recorded immediately in the clients standard forms ? 5. Is there a numerical control of all customers orders ? 6. Are credit limits fixed in respect of individual customers ? 7. Are credit limits approved by an official independent of the Sales Department ? 8. Are credit limits reviewed periodically ? Are customers credit limits checked before orders accepted ? 9. Is this done by a person independent of Sales Department ? 10. If sales to employees are made at concessional prices ? 11. Is there a limit to the value of such sales ? 12. Is there an adequate procedure to see that these limits are not exceeded?

13. Are the amounts recovered in accordance with the term of sales ? 14. Are dispatches of good authorized only by Despatch Notes/Gate passes or similar documents ? 15. Do such Despatch Notes/Gate passes or similar documents bear preprinted numbers ? 16. Are they under numerical control ? 17. Are they prepared by a person independent of : the Sales Department ? 18. The processing of invoices ? 19. Except when all documents are prepared in one operation, are the Despatch Notes/Gate passes matches with : (a) Excise Duty Records? (b) Sales invoices (applicable)? 20. Are the goods actual dispatched checked independently with the Despatch Notes/Gate passes and Customers Orders? 21. Are acknowledgements obtained from customer for the goods delivered ? 22. Are the Customers orders marked for goods delivered ? 23. Are shortages in goods delivered to the customer investigated ? AUDITING 415 24. Are credits to customers for shortage, breakages and losses in transit matched with claims lodged against carriers/insurers ? 25. Are all invoices pre-numbered ? 26. Are sales invoice numbers accounted for ? 27. Are invoices checked for price ? 28. Calculations including (a) Excise Duty and sales tax ? (b) Terms of payment ? 29. Are no charge invoices authorized by a person independent of the custody of goods or cash ? 30. Are invoices mailed direct to the customer promptly ? 31. Are credits to customer for remittances posted only from the entries in the cash book (or equivalent record)? 32. Does cashier notify immediately (a) Sales Department (b) Debtors Ledger Section and (c) Credit Controller (i) Of all dishonoured cheques or (ii) Other negotiable instruments of all documents sent through bank but not retired by the customers? 33. Is immediate follow up action taken on such notification ? 34. Are bills of exchange etc. as per such record periodically verified with the bills on hand ? 35. Is record of customers claims maintained ? 36. Are such claims properly dealt with in the accounts ?

37. Does the Receiving Department count, weigh or measure the goods returned by customers ? 38. Does the Receiving Department record them on a Sales Returns Note ? 39. Are copies of Sales Returns Notes sent to (a) Customer ? (b) Sales Department ? (c) Debtors Ledger Section ? 40. Are the returned goods taken into stock immediately ? 41. Is a Credit Notes issued to the customer for the goods returned ? 42. Are all Credit Notes pre-numbered ? 43. Are Credit Notes numerically controlled ? 44. Are Credit Notes authorized by a person independent of : (a) Custody of goods ? (b) Cash receipts ? (c) Debtors Ledger ? (d) Are Credit Notes (i) Compared with Sales Returned Notes or other substantiating evidence ? (ii) Checked for price ? (iii) Checked for calculations ? Are corresponding recoveries of sales commissions made, when Credit Notes are issued to customers ? 45. Are units of sales (as per sales invoices)s correlated and reconciled with the purchases (or production) and stocks on hand ? 46. Is the Sales Ledger balanced periodically and tallied with the General Ledger control account? 416 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 47. Are ageing schedules prepared periodically ? 48. Are they reviewed by a responsible person ? 49. Are statements of accounts regularly sent to all customers ? 50. Are the statements checked with the Debtors Ledger before they are issued ? 51. Are the statements mailed by a person independent of the ledger keeper? 52. Are confirmation of balances obtained periodically ? 53. Are the confirmation verified by a person independent of the ledger keeper and the persons preparing the statement ? 54. Is special approval required for payment of customers ? 55. Writing off Bad Debts ? 56. Is any accounting control kept for bad debts written off ? 57. Is any follow up action taken for recovering amounts written off ? 58. In the case of export sales, is a record maintained of import entitlements due ? 59. Does the record cover the utilization/disposal of such entitlement ? 60. Are sales of scrap and wastage subject to the same procedures and controls as sales of finished goods ? 8.7 FIELD WORK COLLECTING EVIDENCE ETC

The internal auditors duty is to collect, classify and appraise information so that he is able to form an opinion and to make necessary recommendations for effective improvement in operation of the business. This job would consume a larger part of the auditors time. Two factors are mainly involved in this work :(a) Measurement (b) Evaluation The Institute of Internal Auditors defines this field work as, It is a managerial control which functions by measuring and evaluating the effectiveness of other controls. First we shall discuss the concept of measurement. The internal auditor would be able to examine any operation in the company if he is able to grasp this concept. He must examine the operations in terms of units of measurement and standards applicable in such cases. The units of measures would be some discreet elements e.g. the rupees, days, degrees, documents, machines and some other quantifiable material. So the units of measurement would be such by which success or failure of the operation can be judged objectively. The standards on the other hand are those quantities of acceptability with which the measured things may be compared. Hence each audit job would have to be approached with the idea that it can be dealt with by :(a) Determining its size, extent or other quality in terms of some units of measurement. (b) Comparison of the results with acceptable standards. Then only the auditor would be able to carry out the audit objectively and intelligently. If however, the audit job is such that it can not be approached as above, if would not be possible for the auditor to make an objective observation. In such cases perhaps he would be able to produce only some subjective observations. It should be remembered that measures is only one aspect of the field work. After making the measures the internal auditor would have to evaluate the results. The auditor would have to evaluate the data obtained through measurements to form his opinion and recommendations. Evaluation would mean arriving at correct judgment and to express such judgment in terms of what is known. In a few cases monetary worth of something may be determined. Measurement Standard The auditor must be able to evaluate the standard as they are applied in the field work. The auditor may need some modification in the light of future changes. Standards which are developed yesterday might not be

AUDITING 417 applicable today. There may be some changes in the statutes, procedures, contracts etc For these reasons the standards have to be changed. The adequacy of the standards must be assessed. The measures of standards by the auditor should be done from the point of view of quality, cost and time schedule. Interviews The internal auditor has to send his report to the management on the assigned areas. The report to be meaningful, informative and effective, has to be definite in every observation it contains. To have definiteness and authentication, sometimes the internal auditor interviews the functional people in an honest endeavor to have elucidation in respect of facts collected by him or his representative during the course of audit. In his report, the internal auditor would point out the facts observed by him during audit and would also mention the facts revealed during the interview for explaining the real position to the management. Internal Audit Report is precious informative reports to aid the management in deciding the right course of action. Memoranda are often found very useful in passing some additional information to the internal auditor, in making his reports more informative and purposeful. 8.8 AUDIT NOTES AND WORKING PAPERS Audit Note Book is a book, which is maintained by the audit clerk. During the course of audit, the clerk comes across several difficulties or new points, which he has to discuss with his seniors or auditor. He makes several enquiries which he thinks, have not been satisfactorily answered. Least he might forget, he notes down these points in a book which is called by different names such as Audit Note Book or Audit Memoranda. Such a book is written record of queries made, replies received thereto, correspondence entered into it. This book may be of great help to the auditor preparing his Audit Report from such a record. A separate Audit Note Book is maintained for each concern. Some of the points which are noted down in an Audit Note Book are given below :1. A list of books of account maintained by the client; 2. The names of the principal officers, their powers, duties and responsibilities. 3. The technical terms used in the business; 4. The points which require further explanation and clarification; 5. The particulars of the missing vouchers, the duplicates of which have to be obtained; 6. The mistakes and errors discovered; 7. Totals or balances of certain books of account, Bank Reconciliation Statement; 8. Notes and queries which might be required at a subsequent audit;

9. The points which have to be incorporated in Audit Report; 10. Any matter which requires discussion with the senior or with the auditor; 11. Accounting method followed in the business; 12. Dates of commencement and completion of the audit; 13. Provisions in the Articles and Memorandum of Association affecting the accounts and audit. If notes have been properly made in the Audit Note Book, it might prove to be of great value to the auditor later on, in case a suit is filed against him for negligence or misfeasance. Such a book will be a documentary evidence in favour of the auditor even after several years by which time the auditor might have forgotten everything about that particular audit. The importance of such Note Book was emphasized by Lord (then Mr.) Justice Vaughan Williams in the London and General Bank case. Similarly the Audit Note Book which contained detailed information was of great assistance to the auditor in the case of the City Equitable Fire Insurance Company. Such a book should be clear, concise and complete so that it may be quite intelligible to the clerk who audit the accounts of the same concern next year. In fact it would be a guide to such a clerk. 418 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Audit Working Papers Working Papers are those papers which contain essential facts about accounts so that the auditor may not have again to go over the accounts of his client in case he wants to refer to them later on during the course of his audit e.g., 1. Audit programme duly completed, showing the nature of work, the extent of checking and the initials of the persons who have done that work. 2. Working Trial Balance 3. The schedules of the debtors and creditors, fixed assets, investments etc. 4. Correspondence between the auditor and the debtors, creditors, bank etc., 5. Certificate regarding Cash in hand and at Banks. 6. Certificate regarding the stock-in-trade, and its valuation; 7. Adjusting journal entries; 8. Abstracts from minute books; 9. Particulars of investments; 10. Particulars of depreciation; OBJECTS OR AIM OF WORKING PAPERS 1. In order to support the auditors report these papers show in detail the work performed by the audit clerks 2. The auditor can form an opinion about the efficiency or otherwise of the audit clerks. 3. As the working papers remain with the auditor, as we shall see later on, they are the permanent record and,

therefore, in case of any suit against him for negligence, he can defend himself on the basis of these working papers. 4. The preparation of the working papers is a means to give training to audit clerks as to how to summarise the work done by them. 5. The working papers enable the auditor to point out to the client the weaknesses of the internal control system in operation, and deficiency of the accountancy system. He may therefore, be in a position to advice his client as to how to avoid such pitfalls. 6. The working papers help the auditor to plan for the succeeding year. 7. The working papers enable the auditor to prepare the report to be issued without much waste of time. 8. He can know that his assistants had followed his instructions. 9. If changes and transfer of staff are very frequent and in case such working papers exist the audit work can be assigned to others with minimum of dislocation with least possibility of duplication and omission of any work. 10. Future audit work can be carried on in the same sequence on the basis of the previous working papers. 11. Items left outstanding during the previous year, e.g. any document not produced, may be paid particular attention in the future. Essentials of Good Working Papers 1. Completeness i.e. they should contain all the essential information so that they may be of maximum utility. Facts which are not important should be omitted. 2. Organisation and Agreements. The working paper should be so arranged that one may not find any difficulty in locating a particular matter. If they are not properly arranged it will entail loss of time in finding a particular fact while preparing the Report. 3. Clearness. The facts in the working papers should be set out clearly. 4. The facts stated should be readily apparent to the reader later on, e.g. schedules, where necessary, should be fully explanatory so that it will not be necessary to puzzle over the various sections. 5. Papers should be clearly fastened together, arranged in a logical order, properly and adequately referenced and the subject matter clearly marked on the top. AUDITING 419 6. Sufficient space should be left after each note so that any decision taken by the auditor may be taken down in that space. 7. It is therefore felt that if audit working papers are handed over to the clients, an auditor may not be able to

defend himself, if any dispute arises in future. 8.9 AUDIT REPORT Audit report will be an indicator of the usefulness of the internal audit functioning in the organization. TECHNIQUES OF EFFECTIVE REPORTING Before setting out the report writing as well as in the process of report writing the following should be the guidelines : Clear thinking To whom the report is directed Purpose and aim of reporting At what stage the report writing to start Pattern of presentation Keep the reader uppermost in mind Translate technical matters to laymans language To visualize the readers viewpoint Unbiased approach To mention the view point of the auditee Impact of the report or, in other words, what be the probable reaction to reporting whether action or decision will follow in quickest possible time or to be treated as of academic interest only. To remember the universal saying dont jump to conclusions Facts and figures to be in proper sequences Cool and calm thinking to have logical and coherent presentation Proper setting out of internal audit report can be significant if it contains complete and logically developed appraisal with ample background facts and figures. It will be heartening to note if the top management accepted the significance and importance of the internal audit report as a useful tool for future improvements. The main factors to go into the consideration for the various ways of presentations of written reports are : Nature of business of the organisation. Nature of subject or aspect appraised. For whom the report is intended. Purpose for which the report is prepared. Management attitude, directives and needs. Internal auditors approach and caliber. Extent of emphasis on audit findings and recommendations. Extent of details required by auditee and management. The usual modern trend in presentation of internal audit report is as follows : Detailed report about the findings, observations and recommendation is submitted to the auditee. Aspects which are of minor importance do not appear in the detailed report but discussed with all

concerned and action taken by the auditee for implementation. These aspects can take the shape of a letter form of report to record the recommendations and the implementation thereof. Matters of major importance and on which top management has to take action for implementation of the recommendations are reported as highlights of the report to top management. 420 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM Internal auditor convey his thought and action through discussion and reporting; internal audit reports to be effective, must comply with such fundamentals as : objectives, correctness, conciseness, clarity, courtesy, character (auditor must stand for what he believes), tact and timeliness. An audit report should contain deficiencies, irregularities and scope for improvement as well as aspects which are efficient and effective. One view is that the Internal audit reporting should follow the principle of exception i.e. the report should deal with only such aspects which are deficient and need improvements. Management cannot afford to spend time on matters which are in order. Another view is that only reporting the deficiencies or irregularities without giving credit for aspects which are in order may damage the selling the idea approach or advisory role of the Internal auditor. This sort of reporting may even endanger the Internal audit objectives. In other words, both bad and good need to be reported otherwise the implementations of the recommendations may be adversely affected or delayed. In such a situation, it will be prudent that top management, operating management and the internal auditor must sit in a meeting to decide the pattern of Internal audit reporting. In significant reporting or the highlights of the reporting should be summarized briefly at the beginning of the report separately. By explaining findings in non technical language, the Internal auditor gets better results. Many executives have developed the habit of looking for summaries of report, conclusion and recommendations in summary form which will act as a snapshot of the entire findings of the report. The report should never give an impression of uninteresting, lengthy details of tediousness. The auditor should not get too engrossed in detail. Every effort is to be made to give a concise and to-the-point appearance to the report. Audit report should stimulate thought and action on the part of

management and the operating personnel i.e. report is to infuse ideas to pave the road to solution of problems or inefficiencies. Follow-up of Audit Report Following are the aspects to be taken into account with regard to the follow-up of the Audit Report :(a) Action taken on report-implementation of recommendations ; (b) Difficulties faced by auditee in implementing audit recommendations ; (c) Importance of follow-up. The importance and necessity of follow-up arises due to the fact that human tendencies is resistance to change and to delay the adoption of audit recommendations. That is why, to reap the full benefits of audit, recommendations are to be implemented without any loss of time. The sooner the recommendations are put to action the better for all in the organization. Unless the observations and recommendations are considered, the objective of appraisal is dissipated. To avoid such unhealthy tendencies, the auditor will have to close and constant follow-up so that : 1. Challenging the validity of recommendations may receive due and timely attention by the auditor. 2. If the auditee finds practical difficulties in implementing audit suggestions may come out with his facts and figures for discussion with his superiors and the internal auditor. 3. Deficiencies and lack of control measures may be rectified without putting the organization into loss monetarily or otherwise. To ensure that the recommendations being actually put into action, the internal auditor may have to pay a visit to the department/location, which is known as follow-up visit if the circumstances warrant. It must be remembered, in this connection, that the auditor does not have line authority to enforce the recommendations. Hence, the auditor in the case of follow up has to act in an advisory capacity, i.e. auditor is to pursue that the recommendations are adhered to if the management so desired. 8.10 SUMMARY REPORT TO TOP MANAGEMENT It may be the policy of the management to have copies of the Internal Audit Report in which there might be important findings. In such cases, the copy that might be endorsed to the top management should contain a AUDITING 421 summary sheet giving gist of the audit report. It should be appreciated that top people are busy and have not much time to spare to go through the detailed report. The list should highlight the conclusion and the remedial

suggestions to correct the deficient conditions. The management would then be able to get an idea of the audit findings easily with minimum loss of time. The necessary details might also be referred to from the detailed report. Summary reports to management usually would have two distinct functions (i) They would tell what the internal audit department has accomplished when compared to what was planned. (ii) They would show conclusions of the auditors in a summarised form. The signficant ones may be advised to be corrected immediately, leaving the less important ones for taking action a bit later. Such report should be under distinct subheads like the following :(i) Major irregularities needing immediate attention. (ii) Routine irregularities of consequence. (iii) Case of supervisory lapses which may result in heavy loss etc. In the first category irregularities like non-maintenance of stock account of receipt books, meeting departmental expenditure from cash collected in violation of the instructions in this regard may be included. In the second category may come non-posting of entries to make records like stock cards etc. up to date, non-reconciliation of control accounts with the subsidiary ledger etc. In the third category may be included absence of supervisory check in the cash books, bill register, absence of supervisory percentage checking of the suppliers/contractors bill etc. 8.11 COMMUNICATION IN INTERNAL AUDITING The Dictionary meaning of the word Communication is correspondence a means of communicating a connective passage or channel. The Internal Auditor remains engaged in auditing various functions and report on different segments of the business organization. His audit findings are reflected in the audit report which is submitted to the departmental heads as well as to the Chief Internal Auditor. These reports, therefore, serve as connecting channel between him and the authorities to whom such reports are submitted. The Chief Internal Auditor and other auditors should, therefore, be well versed in the art of communication. Not only the auditors submit the report, they are also required sometimes explaining some matters included in the Audit Report sometimes offering clarification to the recommendation made in the audit report etc. Improving The Auditor-Auditee Relationship It may be appreciated that for carrying out internal audit functions properly and efficiently, there should be a cordial relationship between the Auditor and the Auditee.

The maintenance of good relations between the two would, however, be like a two way traffic. The auditor must kept in mind that he is to sell a product viz the audit service and the customer i.e. the management must be ready to accept the product if it is of standard quality. If the management is really interested in improving the efficiency of the business operation by utilizing this important management tool (Internal Audit), it must appreciate and take action on the Internal Audit Report and findings, if however, the products of audit are useful. The Internal Auditors campaign must be aggressive and dynamic. Each audit performed in traditional financial area must be thorough and sound. Each audit report should show the imprint of professional quality both in terms of form and substance. Such audit report would be more useful to the management if the audit is carried out keeping in view the managements view point. It may, therefore, be said that even in the traditional, financial accounting area there is scope for improvement of the audit products. If the Internal Audit Department can continue its effort in making the audit report more attractive, by carrying out audit keeping in view the managements requirements, the cordial relationship between the two, that has once grown would continue providing newer scope to the Internal Audit Department for offering better service to the management. 422 AUDITING REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 8.12 SCOPE OF AUDIT COMMITTEE An Audit Committee consists of three to five members formed to serve as communication link among various departments. Audit Committee has a four fold relationship and therefore has to interact with management, internal auditor, statutory auditor and the public. The Scope of Audit Committee can be discussed as follows :(i) Review of annual financial statements before submission to the Board of Directors. (ii) Selection of the Statutory Auditor (iii) Act as lies on between the Statutory Auditor and Board of Directors (iv) Administrative control of the internal control functions through the feedback between the Internal Auditor and the Audit Committee. (v) Over seeing internal central operation. (vi) Over seeing internal audit operations and feedback between internal audit committee and developing the internal auditing authority through broad based internal audit programming. (vii) Review and approval of financial information for publication

(viii) Review proposed changes in accounting system and procedures. (ix) Help resolve differences between management, internal and statutory auditor. (x) Report on the audit committee acting in the Annual Reports of Board of Directors. (xi) Ensure reliability of organisations financial statements and operational activities. To be effective and purposeful, the audit committee should maintain the following :(a) Audit Committee should have the independence of management, Statutory Auditor and Internal Auditor. The Board of Directors allow full freedom to the audit committee to investigate into any areas of operation. (b) The relation between the audit committee and management should be cordial and congenial towards optimum efficiency and healthy growth of the organization. (c) There should be a regular line of communication through occasional meetings with the management. (d) There should be good communication relationship interwoven among management, internal auditor and Statutory auditor. 8.12 INTERNAL AUDIT AND THE INVESTIGATION OF FRAUDS In the minds of the public at large and of many clients, the discovery of frauds is the principal function of the auditor, overshadowing his other duties entirely, and although this is far from correct, there can be no question that it is of great importance. Fraud may be divided broadly into two classes 1. Defalcation, involving either misappropriation of money or goods. 2. The fraudulent manipulation of accounts not involving defalcation. As regards the first, where accounting staff are not subjected to any form of check, the opportunities of committing fraud are so frequent, and the methods necessary to conceal it so comparatively simple, that it is safe to say that no business of any size could be carried on under such conditions for very long without the risk of fraud taking place. In small business where the individual proprietor is in touch with the whole of the detail, and is able to supervise it effectively, the possibilities of concealing fraud may be remote. As soon, however, as the business increases in size and the proprietor is no longer able to do this the a check is to be carried out by members of the staff themselves assisted by an independent auditor. Where the staff is sufficiently large to enable the whole of the work to be sub-divided, the auditor should examine carefully the system in force and ascertain its deficiencies, if any. The auditor, should pay particular attention to those classes of transactions which offer scope for fraud, the principal of which are cash transactions of one kind or another. AUDITING 423

As general principles only are under consideration here, the actual way in which these transactions should be verified will be dealt with in due course but it may be noted that there are two methods by means of which the misappropriation of money may be concealed, the first is by the inclusion of fictitious payments, and the second by the omission of cash received, the latter class being much more difficult to detect. The second class of fraud entailing the falsification of accounts without corresponding defalcations, is naturally considerable less frequent than the class of fraud above mentioned, but when it does occur it may involve very large amount. It may be done for the purpose of bolstering up a business which is in an insecure condition, in order to maintain the confidence of shareholders, creditors or the public; or it may be done by a manager for the purpose of increasing the apparent profit of the business, thus showing that he has been successful in his management, and possibly increasing the commission on results payable to him; or by directors for the purpose of enabling them to pay dividends which would otherwise not have been possible. Several notable cases of this sort of falsification have occurred. It need only be pointed out here that this form of fraud is often very ingeniously and skillfully concealed, and is in many cases carried out by persons holding positions of the highest trust, and having the entire confidence of directors and shareholders. The Internal Audit Department has a big role to play in preventing fraud in different organizations, as a part of protective functions. Every big organization has an internal audit manual and such a manual usually outlines the internal audit function in detail vulnerable areas where loss through fraudulent means may arise frequently. Examples of vulnerable areas are stores receipt/consumption, Cash expenditure, sizeable receipts of cash, civil maintenance jobs etc. The internal audit manual prescribes in detail the manner and procedure as to how internal audit function would be carried out in these areas. The manual also directs the frequency of such audit. If internal audit of such areas is done accordingly, the possibility of occurrence of both visible and invisible frauds get eroded. In discharging his functions in sensible areas as mentioned aforesaid, the auditor has to be extra intelligent and imaginative to enable him to think ahead of many others. However, it needs to be mentioned that the success

of internal auditor in preventing fraud is also depending on the cooperation from other departments of the organization. 424 AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT Study Note 9 INFORMATION SYSTEM AUDIT AND MANAGEMENTAUDIT This study note includes ! Information System Audit Information System Audit Computer Auditing Computer Information System & Environment Computer Information System and Internal Control Audit Risks Steps in an Audit Computer Assisted Audit Techniques Auditing in a Computerised Information System (CIS) Audit in the case of EDI Audit in case of E - Commerce Environment Audit in Online system Environment Audit in the case of Environment of personal computer Audit in case of data processing. ! Introduction To Managemant Audit Definition Need Scope Management Audit Process Advantages of Management Audit Limitations of Management Audit 9.1 INFORMATION SYSTEM AUDIT Formerly the information system audit was called as Electronic Data processing (EDP) audit. Information System Audit is also known as Informational Technology Audit. The information technology audit was introduced in mid 1960 and has gone through numerous changes due to advance in technology and the incorporation of technology into business. (A) Information System Audit When it is an information technology audit the auditor is required to have a detailed knowledge of information system and alongwith a general understanding of accounting. System System means the instrumentality that combines interrelated interacting artifact designed to work as a coherent entity. Information- It is a knowledge derived from study, experience or instruction in simple words. Information is message received and understood.

AUDITING 425 Information system or Information Technology Audit It is an examination of the control within an information technology infrastructure. These receivers may be performed in conjunction with a financial statement audit, internal audit or other from of attestation engagement. This is a process of collecting and evaluating evidence of an organisations information systems practices and operations. The evaluation of obtained evidence determines if the information system are safeguarding assets, maintaining data integrity and operating effectively and efficiently to achieve the organisations goals or objective. The information technology audit is also known as automated data processing (ADP) audit and computer audit. Purpose An I.T. audit is not entirely similar to that of a financial statement audit. An evaluation of internal control may or may not take place in an I.T. audit. Reliance on internal control is a unique characteristic of a financial audit. An evaluation of internal controls is necessary in a financial audit, to place reliance as on internal control and therefore substantially reduce the amount of testing necessary to form an opinion regarding financial statement of the company. An I.T. audit may take the form of a Central control review or an Application control review. The review of different control measures by using different audit tools to examine system programming and data central procedure in order to determine the efficiency of computer operation, such as data base central, Encryption tools, fire wall tools, forensic tools, NEWS, NMAP, steganography tools, VOIP tools, War driving tools, WEP cracking tools, Wireless tools etc. Regarding the protection of information assets, one purpose of I.T. audit is to review and evaluate an organisations information system availability, confidentiality and integrity by answering question like (1) Will the organisations computer system be available for the business of all times when required (Availability) (2) Will the information in the system be disclosed only to authorised users (Confidentiality) Approach There are three systematic approaches to carry out an I.T. audit which are (a) Technological Innovation Process Audit : The aim of this approach is to construct a risk profile for existing and new project by asserting the length and depth of company experience in it.

(b) Innovative Comparison Audit. (c) Technological Position Audit. This review the technologies needed by the business and places them in one of the four categories of base, key, packing and emerging Types of I.T. Audit (1) System and Application An audit to verify that system and application are appropriate, efficient and adequately controlled ensure valid, reliable, timely and secure, input, processing and output at all levels of a system activity (2) Information Processing Facilities An audit to verify that this processing facility is controlled to ensure timely, accurate and efficient processing of applications under normal and potentially disruptive conditions. (3) Systems Development An audit to verify that the system under development meet the objectives of the organisation and to ensure that the systems are developed in accordance with generally accepted standards for system development. (4) Management of I.T. and Enterprise Architecture An audit to verify that I.T. management has developed an organisational structure and procedures to ensure a controlled and efficient environment for information processing. (5) Client Tele communicator, lnternets, Extranets 426 AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT An audit to verify that controls are in place on the client, server and on the network connecting the client and server. As in case of other audits, the IT audit process too take the following basic steps (1) Planning. (2) Studying and Evaluating control. (3) Testing of evaluating control. (4) Reports. (5) Follow up. (B) Computer Auditing In information processed on computers the one way of auditing is to get the printouts of all records, accounts and information and then check it as usual , but this is very time consuming and cannot evaluate the system of internal controls and certain errors found etc, remains undetected. The other more acceptable way is to evaluate the controls in the computer information system and then decide the nature of timing and extent of

the substantive procedure to be followed and make use of computer in conducting compliance tests as well as substantive test, but and the auditor must have sufficient knowledge of computer system even in certain of cases specialised skills in operations of computer system. (C) Computer Information System The computer information system environments may be diffrent in cases of different computer system used and there are certain common features of all computer information systems environment, like. Organisation Structure :-The organisation structure includes knowledge, programme, data & different kinds of jobs at one place. Nature of processing : Sometimes without having any document as a base, some particular transactions like interest directly credited to particular account by the system itself as per the programme instruction. Apparently in computerised accounting unlike manual accounting the transaction trials are not available but auditor can find it in machine readable from. Unless appropriate control are installed, there is a great possibility of unauthorised access to the computer system. Unless appropriate control are installed the data can be accessed and altered through terminals from remote locations. Designs : The computer information system work more consistently because computer performs exactly according to its program. A program can incorporate automatic checks, which locate abnormal transactions and get included in a report to be reviewed by the concerned officer. Password techniques is used to avoid unauthorised access. A Single transaction entered in the system automatically makes entry in all related records. The program installed in the system, initiate particular transaction on its own. The program and data is stored on hard disc or any other portable media like CD, floppy etc. which can face intentional or accidental destruction. (D) Computer Information System And Internal Controls An auditor is concerned with the control from the point of view of authenticity, accuracy, completeness, assets safeguarding etc. Though the internal control in computer information system are based on the principles same as those followed in manual system which means the system of authorisation and allotment of duties etc. are determined on the same basis as in the manual system. Some of these controls are as under -

(1) Password - This control is used to identify the person before the computer information system starts processing the task. This control assures that the data fed into and the processing done by the computer information system are authorised. (2) Edit Test - Edit test, Financial control test etc. help in correct data entry and the accurate processing by the computer information system. (3) Batch Cancellation Stamp - This control keeps check on the processing of data only once and the repetition is avoided. AUDITING 427 (4) Financial Control Total - Along with edit test, this control helps in saving of the data and complete processing of the data. (5) File Libraries - File libraries, locks on computer installation etc. are used to safeguard the computer information system from destruction and corruption. (6) Audit Trails - Ensures that all those record and process are maintained within the system from which financial statement are derived. (7) General Control - These control establish overall control of the activities of computer information system. These controls include a) Organisational Control b) System & Documentation Control c) Access Control d) Hardware Control e) Procedural Control etc. (8) Application Controls - Over and above general control, control over the application of the computer information system is very important. These controls include a) Input control b) Processing control and c) Output control The Auditor should evaluate the above control measures to ascertain the effects of them on the system. A clear audit trial assists the auditor to audit on it, allows the Auditor to trace the transaction from input to output data. The proper electronic trial helps in tracing the transaction properly. (E) Audit Risks : Information System Auditor is concerned with following objectives(a) Asset Safeguarding (b) Data Integrity (c) System Effectiveness (d) System Efficiency Auditor collects necessary evidences to assess whether the audit achieves the above objectives, but due to the nature of verification, auditor might fail to detect real material losses or errors. To reduce this risk, the appropriate

audit approach is selected and is designed accordingly. The American Institute of Certified Public Accountants in 1988 determined the level of audit risk to be adopted by using the following RiskModel. Desired audit risk - Internal risk X Control risk X Detection risk. Internal risks represent the material loss or errors existing in some segment of the audit, before the reliability of internal controls is considered. Control risk means the likelihood of internal controls in some part of audit can not present, detect or correct the material losses or errors. Detection risk means the audit procedures used in some part of audit will fail to detect the material losses or errors. While applying this model auditor select his level and desired audit risks, along with that he assures the short term and long term consequences upon the Auditor of the material losses and errors, he fails to detect. Afterwards, an auditor considers the internal risk in which he takes into consideration the nature of organization, the industry in which it operates the nature of management and accounting system and application systems. To evaluate the level of control risk, auditor considers the reliability of management and application controls, which include management controls which cover all the application systems and if it is absent it is a serious concern for the auditor. Lastly, auditor calculates the level of detection risk and for that he designs procedures for evidence collection on the basis of his understanding of how likely this procedure is to detect the existing material losses and errors and while designing the audit procedure he must ensure that it is properly executed. In short, the audit risk model is an effort focused on the areas where the auditor has the highest payoffs, in most cases he cannot collect sufficient evidence and hence he must be clear in mind in terms of where he applies this audit procedure and how he interprets the evidence. Auditor, throughout the audit, makes decisions on what to do next and his notions of materiality and audit risk guides him in making the decision. (F) Steps in an Audit After understanding the importance of system factoring to reduce complexity, the nature of audit risks and its consequences, the types of audit procedure, auditor can carry out actual audit as shown in the following flowchart as the approach advocated by the American Institute of Certified Public Accountants in 1990. 428 AUDITING

INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT Preliminary audit work Understanding of control systems Evaluation of control systems Rely on controls Test of controls Re-assess control risk Still rely on controls Increase reliance on control Extended Substantive Test Form audit opinion and issue report limited Substantive Test Stop Start AUDITING 429 Both external and internal auditors will follow the above approach, the decisions they take at each step may vary because of having different rules like internal auditors may spend more time than the external auditors in testing controls as they are more concerned with the efficiency of the controls. (G) Computer Assisted Audit Technique (CAAT) Computer assisted audit technique uses computer to process the information, required for audit, stored in the auditees information system. This technique is used for testing general controls and application controls and also for substantive procedures. This technique is also helpful in getting data from auditees record as well as for analytical procedures. The auditor must have expertise and experience in executing and using the results of the Computer Assisted Audit Technique. Before applying this technique auditor should get reasonable assurance of its integrity, reliability, usefulness and security through appropriate planning, designing, processing and review of documentation. He should see that this technique is properly controlled. Auditor should maintain sufficient documents describing the application of the technique and regarding planning, execution, inputs, processing, output, source code, technical information about the auditees accounting system, audit evidence and suggestions, if any, for use of

the technique in future etc. Auditor should make necessary arrangements for data files to minimize the effect on auditees routine activities. Different Computer Assisted Audit Techniques available are as under. (a) Test data (b) Integrated Test Facility (c) Audit Software (d) Audit Automation (e) Core Image Comparison (f) Data Base Analysis (g) Embedded Code (h) Log Analyzers (i) Mapping (j) Modeling (k) Online Testing (l) Program Code Analysis (m) Program Library Analyzers (n) Snapshots (o) Source Comparison (p) Tracing (H) Auditing in Computer Information Systems (Approach to Information Systems Audit) The overall objective and scope of audit is not different in computer information system environment but the use of computer changes the processing, storage, retrieval and communication of financial information and also affects the accounting system as well as internal control system used by the auditee. The CIS environment may affect a. The procedures followed by the auditor in obtaining a sufficient understanding of the accounting and internal control system. b. The auditors evaluation of internal risk and control risk through which the auditor assesses the audit risk. c. The auditors design and performance of tests of control and substantive procedures appropriate to meet the audit objective. The auditor should consider the following to determine the effects of computer information system environment on the audit430 AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT a. The extent to which CIS environment is used to record, compile and analyze accounting information. b. The system of internal control in existence in the entity with regard to1. Flow of authorized, correct and complete data to the processing centre. 2. Processing, analyzing and reporting tasks undertaken in the installation.

c. The impact of computer based accounting system on the audit trial that could otherwise be expected to exist in an entirely manual system. The auditor should have sufficient knowledge of the computer information systems to plan, direct, supervise, control and review the work preformed. The sufficiency of knowledge would depend on the nature and extent of the CIS environment. The auditor should consider whether any specialized CIS skills are needed in the conduct of the audit. These specialized skills are needed to a. Obtain sufficient understanding of the effects of the CIS environment on accounting and internal control systems. b. Determine the effect of the CIS environment on the assessment of overall audit risk and of risk at the account balance and class of transaction level. c. Design and perform appropriate tests of control and substantive procedures. The inherent risks and control risks in a CIS environment may have both a pervasive effect and an accountspecific effect on the likelihood of material misstatements, as follows: (a) The risks may result from deficiencies in pervasive CIS activities such as program development and maintenance, system software support, operations, physical CIS security, and control over access to special-privilege utility programs. These deficiencies would tend to have a pervasive impact on all application systems that are processed on the computer. (b) The risks may increase the potential for errors or fraudulent activities in specific applications, in specific databases or master files, or in specific processing activities. For example, errors are not uncommon in systems that perform complex logic or calculations, or that must deal with many different exception conditions. Systems that control cash disbursement or other liquid assets are susceptible to fraudulent actions by users or by CIS personnel. As new CIS technologies emerge for data processing, they are frequently employed by clients to build increasingly complex computer systems that may include micro-to mainframe links, distributed databases, end-user processing, and business management systems that feed information directly into accounting systems. Such systems increase the overall sophistication of computer information systems and the complexity of the specific applications that they affect. As a result, they may increase risk and require further consideration.

The Auditor should consider C.I.S environment while designing audit procedures to reduce audit to an acceptably low level. He should make enquiries and particularly satisfy himself whether : (a) Adequate procedures exist to ensure that the data transmitted is correct and complete. (b) Cross-verification of records, reconciliation statements and control systems between primary and subsidiary ledgers do exist and are operative and that accuracy of computer complied records are not assumed. The auditors specific audit objectives do not change whether accounting data is processed manually or by computer. However, the methods of applying audit procedures to gather evidence may be influenced by the methods of computing process. The auditor can use manual audit procedures, or computer-assisted techniques, or a combination of both to obtain sufficient applications, it may be difficult or impossible for the auditor to obtain certain data for inspection, inquiry, or confirmation without computer assistance. The auditor should document the audit plan, the nature, timing and extent of audit procedures performed and the conclusions drawn from the evidence obtained. In an audit in CIS environment, some of the audit evidence may be in electronic form. The auditor should satisfy himself that such evidence is adequately and safely stored and is retrievable in its entirety as and when required. (I) Audit In The Case of Electronic Data Interchange (EDI) EDI means transfer of structured data between organizations in electronics form. This is widely used in western countries and expected to grow in India too within a very short period. This transfer is done on the basis of AUDITING 431 certain accepted standards having legal base, like EDI FACT standard. Audit in such situations really requires advanced knowledge of computers. To establish the authenticity of the data exchange and also of the parties exchanging data the digital signatures are used, in this case it is extremely difficult to forge digital signature. These signatures are created and verified by the computer programs. The Information Act, 2000 has laid down legal framework for digital signature and electronic records. Auditor, with usual procedures, should give consideration to the following aspects while auditing in case of electronic data interchange environment : (a) There should be detailed and clear cut agreement for electronic data interchange, between the concerned parties. There should be clear provision for ordering, delivery, acceptance, rejection of interchange of

electronic data. It is also clearly mentioned in the agreement that the supply of electronic data through this interchange system shall have the same effect on an ordinary supply made on the basis of a purchase order. (b) There should be full proof controls in the system to avoid modifications in the data by third party while the data interchanged is in transit and for encryption, i.e. mixing of data and making it unreadable to third party, is used and the receiver can decrypt the data for his use. (c) Due to the in built control in the EDI system the recipient acknowledges the receipt of the data and in his confirmation certain key information of original data is repeated. (d) The parties exchange the logs frequently and used for logging the receipted and sent data, this proves helpful and nobody can deny the receipt or transmission of data. (e) To avoid adverse effect on the business due to failure of hardware, proper controls for contingency planning are introduced in the EDI system. (J) Audit in the Case of E-commerce Environment E-Commerce denotes the buying and selling transactions through internet using computers. It may pose certain difficulties in accounting, revenue recognition etc. While accounting in such ecommerce environment, an auditor should consider the following guidelines contained in the International Auditing Practical Statement : (i) Evaluate the changes in the auditees business environment as an effect of ecommerce. (ii) Examine the business risk affecting the Balance Sheet due to e-commerce transactions. (iii) The officers including chief information officer are enquired to get the real picture of e-commerce and its effect on the state of affairs of the auditee. (iv) Evaluate the extent of risk addressed by the auditor due to use of e-commerce. (v) In case the auditee is using services of an Internet Service Provider, certain records of such service providers relating to the auditee be asked for and verified. (vi) Measure the risk involved in e-commerce transactions in the case of use of public network. (vii) See whether appropriate accounting policy is adopted for recording development costs and revenue recognition. (viii) Verify the non compliances of taxation and legal matters in the case of international ecommerce. (ix) Verify the controls established to reduce the risk associated with e-commerce transactions.

(x) Verify the efficiency of physical, logical and technical controls established for authorization, authenticity, confidentiality, security for information etc. e.g. passwords, firewalls, encryption etc. (xi) Evaluate the reliability of the system to check the completeness, accuracy, timeliness and authorization of information. (xii) See that adequate controls regarding validation of input, prevention of transactions to be omitted or duplicated, acceptance of terms of agreement before order processing, prevention of acceptance of order if all steps are not completed by the customer, ensuring proper distribution of transaction details across multiple systems in a network and ensuring the retention of backup and security of the related record. (K) Audit in Online System Environment In online computer system the data stored on a central computer can be used by number of persons through the number of terminals. In some organizations distribution system is used where in computers are distributed 432 AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT throughout the network and data processed at various stages. In some online systems, computer files are updated to give immediate effect to the transactions entered through terminals; this is called as online realtime system. The controls used in such systems depend upon the specific hardware and software used. The auditor, while auditing in such environment should consider the following points (i) He should get acquainted with the computer network, entry points from other organizations and for collecting the network diagram. (ii) He should review the network control system. (iii) He should verify whether proper control measures are in use to avoid unauthorized transactions, unauthorized changing in the data or program. (iv) He should review the internal controls as source documents are not available for every transaction, processing results are not available in printed form, and the reports required by the auditor are many times not available in printed form. (v) He should see into the procedures to ensure proper authorization of data fed into the computer. (vi) He should insist upon the retaining of important links in audit trials. (vii) He should verify the effectiveness of separating the transactions accounting period wise to avoid confusion in the situation of overflow of online transactions.

(viii) He should see that proper measures like establishment of appropriate controls to detect and correct line errors, cryptographic controls etc. are introduced in the system effectively to avoid the loss of data by accident or corruption. (ix) He should test the sample transaction derived at random from the addition of audit instructions to the programs used in data processing for continuous monitoring the system. (L) Audit in the Case of Environment of Personal Computer The environment where in personal computers are used is different from the environment where in large computers are in use and that is why auditor has to adopt different approach to audit in such environment. According to the guideline issued by International Federation of Accountants, the auditor has to consider following points while conducting audit in such environment of personal computers : (i) He should understand that P.C.s generally do not have controls as many as those in large computers, the program and data can be saved on portable media like C.D.s and also on hard disk. The storage media is prone to accident. Portable storage media are also subject to damage or theft or misplacement. (ii) He should know that inadequate control measures can create serious problems like theft or alteration of data due to unauthorized use of P.C. (iii) He should see whether proper controls are introduced to avoid unauthorized use of P.C.s, downloading data, improper documentation, improper use of storage capacity etc. (iv) He should ensure that software are not subject to manipulation. (v) He should examine the control procedure like cross checking the results, testing of application programs, documentation of processed data, and range test of data to strengthen the software and data integrity. (vi) He should verify whether proper arrangement is made for back up copies of all data and important programs. (vii) He should concentrate on substantive tests and not waste his time in detailed examining of the computer information systems controls effectiveness. (viii) He should use computer assisted audit techniques. (ix) He should examine larger samples of transactions. (x) He should verify the effectiveness of different control measures utilized and report about that. (M) Audit in the Case of Data Processing through Computer Service Centers Small organizations get their data processed through computer service centers due to their incapability of

investing huge amount in establishing the computer systems. In this case the organization provides documents to service center, which processes it and hands over the final output documents. AUDITING 433 In such circumstances auditor should : (i) Verify that the vendor is reliable and suitable having the skills, experience and reputation. (ii) Evaluate the suitability of the contracted terms with regard to fixed cost, variable cost, the scope & timing of audit activities, the service centers responsibility in terms of maintaining data integrity and providing suitable back up and recovery. (iii) Check the compliance with the terms of contract. (iv) Seek to ensure that his ability to collect and evaluate evidence in relation to the attainment of the objectives of outsourcing is not inhibited. The Impact on auditing is as follows : (i) Wide spread end user computing could sometimes result in unintentional errors creeping into systems owning to inexperienced persons being involved. Also coordinated program modifications may not be possible. (ii) Improper use of decision support systems can have serious repercussions. Also their underlying assumptions must be clearly documented. (iii) Auditors participation to a limited extent in systems development may become inevitable to ensure that adequate controls are built in. (iv) Usage of sophisticated audit software would become a necessity, since conventional methods of auditing would no longer be sufficient. (v) The move towards paperless electronic data interchange would eliminate much of the traditional audit trail, radically changing the nature of audit evidence. The rapid advancements in information technology would no doubt have a dramatic impact - on auditing. Auditors must adapt themselves to the changing environment much and acquire necessary additional skills. 9.2 INTRODUCTION TO MANAGEMENT AUDIT (A) Definition Management audit is the audit to examine, review and appraise the different policies of the management on the basis of certain prescribed standards. It is not like a traditional audit but is a comprehensive and critical review of all aspects of management performance. The Management Audit may be more specifically defined as being an investigation of a business from the

highest level downwards in order to ascertain whether sound management prevails throughout, thus facilitating the most effective relationship with the outside world and the most efficient organization and smooth running internally- Taylor and Perry. The Management Audit is an informed and constructive analysis, evaluation and series of recommendations regarding the broad spectrum of plans, process people and problems of an economic entity- Camp Field. The Management Audit may be defined as a comprehensive and constructive examination of an organization structure of a company, institution or branch of Government or any component thereof, such as a division, or department, and its plan and objectives, its means of operation and its use of human and physical facilities.William P. Leenard. In short the Management Audit is a forward looking audit. It emphasizes on problem identification rather than problem solving, it pinpoints the areas requiring attention of management, it evaluates the existence of well defined objectives and examines whether policies are consistent with objectives and understood properly at all functional levels, it goes far behind the areas of financial accounting and cost accounting, it seeks to review, appraise and evaluate the corporate plans and policies based on certain standards of objectivity. Though this type of audit is made mandatory in Sweden and USA, it is yet to take appropriate momentum in India. (B) Need of Management Audit The following are the circumstances wherein the management audit is useful(i) To overcome the human limitations of Top Management. 434 AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT (ii) To improve the managements production. (iii) Circumstances of corporate planning deficiencies, organizations structured defects, ineffective management control system etc. warrants the necessity of management audit. (iv) In the circumstances of acquisition of another business entity, the acquiring organization needs to evaluate financial aspects, technical aspects and management aspects and analysis of these aspects takes the form of management audit. (v) Society at large likes to be assured that the top and middle level management discharge their functions efficiently and to the best advantage to the society, the management audit satisfy the different interest of

groups like customers, employees, citizens, government etc. of the society and also guide the management in the application of scientific methods of business management for social well being. (vi) The statutory financial audit is generally annual and concerned with the past without having any forward approach. Statutory financial audit and internal audit along with statutory cost audit are essentially legalistic in terms of time given for its completion and nature of certification fails to provide the insight to the management in regard to unsuitability of structure to meet the entitys needs, poor leadership, inability to make decisions, poor vision and the enlightened managers realizes this fact and feels the need of management audit to identify the problems and guidance to overcome them. (vii) Foreign collaborators, while investing in other organizations feel the necessity of management audit to ensure that the funds invested are to be used properly for growth and expansion. (viii) Financial institutions conduct the management audit, while participating in equities of a company to avoid possible losses arising from inefficient management. (ix) Company itself feels the need of management audit to assess its managers performances and link an incentive system to the results of such assessment. (x) While advancing loans, banks like to get the management audit conducted. (C) Scope of Management Audit The scope of management audit can be as broad as the management process itself. It is concerned with the whole field of activities of a business concern from top to bottom of a management hierarchy. Management audit concerns with the appraisal of management policies, methods and performance, it includes review and appraisal of an organization to determine 1) Better means of control. 2) Greater improved methods. 3) More efficient operations. 4) Greater use of human and physical facilities and 5) Waste and deficiencies. (D) Management Audit Process Fundamentally the activities to be undertaken by management auditor in its review of material management, production management, industrial engineering management, sales management, financial management, general administration etc. include(i) Collection and analysis of relevant statistics and reports used by the management. (ii) Establishment of priorities for various functional activities to be reviewed. (iii) Interviews and meetings with the senior, middle and supervisory management levels in order to ascertain 1) How plans are developed. 2) How resources are controlled and 3) How performances are evaluated.

Who can conduct the management audit? The management audit can be conducted by (A) Company Talent- Which may include(1) An administrative staff. (2) An audit committee. (3) An officer on special duty. These personnel have sufficient knowledge of operations and talent necessary for the study, have no vested interest and are acceptable to other persons responsible for the area. (B) Outside Management Consultants- Who may be Chartered Accountants, Cost Accountants or Management Consultants having no vested interest in the company management, having no loyalty to any individual in the organization, having an impartial and objective approach, having wide range of specialties, have already developed the skill to carry on management audit. AUDITING 435 (C) Company Talent as well as Management Consultants- Considering the prevailing circumstances in a company a combination of company talent and outside management consultants would be a best team to conduct the management audit. The advantages of each compliment the other. Whoever maybe appointed as management auditor, should possess the following qualities(i) Ability to understand the problems of the business. (ii) General understanding as to nature and objects of the organization. (iii) Expert knowledge of the principles of delegation of authority, management by objectives, management by exception, management control, budgetary control, internal control, flow charts, use of computers etc. (iv) Sufficient knowledge and experience in preparing different reports for presentation to the different levels of management including top management. (v) Background of engineering, costing, statistics, management accounting, financial accounting, industrial psychology, managerial economics etc. (vi) General understanding of different laws and regulations like company laws, tax laws, etc. (vii) Tactfulness, perseverance, pleasing & dynamic personality. (E) Advantages of Management Audit(i) The companys personnel know the organizational policies, plans, personnel operations, personalities and working relationships, the political climate, the functional importance, and some of the problems themselves. (ii) The audit team need not spend an unduly long time for familiarizing themselves with the background

information for study. (iii) It may be easier to get the support of the higher management, because such audit in the form of selfappraisal apparently involves no extra cost. (iv) The acceptance of the findings may be comparatively easier because the concerned personnel may readily accept the recommendations from the internal management audit team (consisting of co-workers) than from the external management auditors (or consultants). (v) The implementation of the new method of operation or organizational arrangement may be easier because the personnel who designed and advised it are on the premises. The constant cooperation necessary in the implementation phase are greatly facilitated. (vi) The experience and expertise gained by the company personnel in the conduct of management by selfappraisal could be gainfully utilized for subsequent audits. (F) Limitation of Management Audit (i) The company personnel possess experience limited only to their organization. The company might have faced difficulties and constraints due to limited experience of the company personnel. (ii) They are more likely to take facts for granted and may not probe into the details to unearth problems. (iii) There may be a tendency to suppress unfavorable facts relating to some of the fellow personnel. (iv) The company may not have the talent necessary to conduct such management audit involving complicated studies. (v) It may not be possible for the company to spare personnel for the studies as these may take long time. (vi) It may be possible, due to conflicting interests that the audit work may be prolonged and as a result, the action on findings and recommendations may be delayed. (vii) The vested interests of the operational executives may prevent the management audit team from being objective. (viii) In a management audit scheme, the areas of investigation should fruitfully cover the entire management system, and so the situation demands the audit team to complete the studies under a time constraintwhich may result in not covering some of the important appraisal areas. 436 AUDITING QUESTION PAPERS - AUDITING QUESTION BANK - AUDITING AUDITING BASICS - I 1. State with reasons, whether following statements are true or false :

(i) The concept of evidence is fundamental to all auditing situations as an auditor basically seeks to obtain sufficient appropriate evidence to form his opinion. (ii) In all auditing situations, the only evidence available to the auditor is books of accounts and vouchers. (iii) Not only statutory provisions but also technology and economic changes have influenced auditing to a great extent. (iv) The decisions given by Hon. Courts in different cases do not affect the Generally Accepted Accounting and Auditing Practices and Standards. (v) Auditing is generally associated with only accounting and financial records. (vi) The scope of audit depends upon the nature of appointment. (vii) The statutory audit provides the best means of enhancing the credibility of the accounts. (viii) Auditor cannot gather sufficient appropriate audit evidence without performance of compliance and substantive tests. (ix) Inspection and observation are not only the ways to obtain audit evidence. (x) US-GAAP are not different than that of INDIA-GAAP. (xi) Percentage test and past trends are the only criteria to establish the materiality of an item in financial statements. (xii) The risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated is called as an audit risk. 2. What is Auditing? Explain the evolution on auditing. 3. Define audit. What are the factors which drastically changed the present day auditing practice and auditors responsibilities? 4. Write short notes on : (a) Nature of auditing (b) Change in scope of auditing (c) Compliance Procedure (d) Substantive Procedure 5. What is audit evidence? Explain the different types of audit evidence and different methods of obtaining them. 6. Audit Technique is the device available to the auditor for obtaining competent evidential matter. Explain. 7. Write short notes on: (a) Audit procedure (b) Audit practices (c) IFRS (d) GAAS (e) Concept of materiality in auditing (f) Materiality and Audit Risk

8. Audit practices demands the thorough knowledge of different legal provisions and different pronouncementsDiscuss. 9. Explain the important contents of US-GAAP. 10. Explain the important contents of INDIA-GAAP. AUDITING 437 AUDITING BASICS - II 1. State with reasons, whether following statements are true or false : (i) Items in the profit and loss account are verified from the ledger balances and this is sufficient to verify the correctness of Profit or Loss. (ii) Comparing the voucher with the transaction recorded in the book of original entry is called as vouching. (iii) While verifying the Sales appearing in the Profit and Loss Account, it is important that auditor, first of all should carefully verify the effectiveness of existing internal check system. (iv) To verify the excisable value and calculation of duty the auditor checks the Daily Stock Account. (v) Only the vouching to ascertain the arithmetical accuracy is not enough. (vi) When proper purchase order, voucher, tenders etc., are available then auditor should not waste his time in checking concerned board resolution while verifying Plant and Machinery purchase. (vii) Auditor is not required to get the inventory valuation certified by the companys management; he himself is qualified to ascertain the value. (viii) Auditor is a watchdog and not a bloodhound. (ix) Reserve not appearing on the Balance Sheet is a Secret Reserve and an auditor is not supposed to verify it. (x) Section 210A of the Companies Act, deals with the constitution of National Advisory Committee on Accounting Standards. (xi) All members of Accounting Standard Committee are the members of the Institute of Chartered Accountants of India. (xii) The form of Balance Sheet given in Schedule VI of the Companies Act does not apply to the Insurance Companies, Banking companies and Electricity Companies. (xiii) Auditor opting for the statistical sampling makes a big mistake. (xiv) Auditor should not depend on the results derived from Ratio Analysis as the ratios are offspring of the Statistics, which is not a perfect science. (xv) Auditor, for proper reporting, avail of the Inter Firm as well as Intra firm comparison. 2. How would you verify the following items (i) Sales (ii) Wages

(iii) Retirement benefits (iv) Excise Duty (v) Commission Received 3. How would you verify the following items (i) Plant and Machinery (ii) Goodwill (iii) Investments (iv) Sundry Debtors (v) Stock in Trade 4. Throw light on any of the following Two Case-Laws(i) Kingston Cotton Mill Co. Ltd., (C1896) (2CH 729) (ii) Deputy Secretary, Ministry of Home Affairs Vs. S.N. Das Gupta (iii) Irish Woolen Co. Ltd., Vs. Tyson and Other (1900) 438 AUDITING QUESTION PAPERS - AUDITING 5. What do you mean by the Disclosure of Accounting Policies and Practice Discuss in brief. 6. Write Short Notes on (i) Expenditure during the period of construction (ii) Adjustments for previous year (iii) Books of Accounts to be kept by companies 7. What is Statistical Sampling? What are the methods of Statistical Sampling to be used in auditing and explain how the results of sampling are evaluated? 8. P LTD. BALANCE SHEET AS ON 31.03.2010 LIABILIITES ` ASSETS ` Equity Share Capital 2,00,000 Goodwill 1,20,000 Capital Reserve 40,000 Fixed Assets 2,80,000 8% Loan on Mortgage 1,60,000 Stock 60,000 Trade Creditors 80,000 Debtors 60,000 Bank Overdraft 20,000 Investments 20,000 Taxation current 20,000 Cash in Hand 60,000 Profit and Loss Account Profit after taxation and Interest 1,20,000 Less, Transfer (40,000) 80,000 6,00,000 6,00,000 You are required to calculate Ratios for Testing (i) Liquidity or Short Term Solvency (ii) Long term Solvency (iii) Profitability (iv) Capital Gearing 9. What are Trend Analysis, Inter firm comparison and Intra-firm comparison? How can these be made useful while carrying on an audit assignment. AUDITING 439

COMPANIES ACT PROVISIONS RELATING TO AUDIT 1. Fill in the blanks : (a) A person is qualified to become a company auditor if he is ________________ Chartered Accountant. (b) A person is not qualified to become a Company Auditor, if he is convicted ________________ for any offence. (c) It is _____________ who has right to appoint Company Auditor annually. (d) Casual Vacancy of any auditor can be filled by the ______________ (e) Auditor can be removed by the _______________ of the Company. (f) Co. Auditor has a right to receive all notices to any _____________ of the company. (g) Co. Auditor has a right of lien on ____________ (h) Auditor should report the share holders about the ___________ and _________State of Affairs of the company. (i) For guilty of negligence auditor has to _____________ the loss sustained by others. (j) Signing false audit report is the ____________ liability of Co. Auditor. (k) Falsification of books of accounts is the_____________ liability of Co. Auditor. 2. State whether the following statements are True or False. (a) A firm shall be qualified to be the Co. Auditor if any of the Partner is practicing Chartered Accountant. (b) Miss Rosy, a Chartered accountant and member of the Institute of Chartered Accountants of England & Wales and holding certificate of practice too is fully qualified to be an auditor in a company in India. (c) A joint stock company of Practicing Chartered Accountants is qualified for appointment as an auditor of a company in India. (d) An auditor can audit any number of companies, beyond 20. (e) First auditor is always appointed by the Board of Directors of a company. (f) Auditor of a Govt. Company is appointed by the Central Govt. on the advice of the Comptroller & Auditor General of India. (g) First auditor can be removed by the first General meeting, though appointed by the Board of Directors. (h) Company Auditor has no right to obtain all the information & explanations needed at the time of the conduct of the audit. (i) Auditor cant take any legal or technical advice from outside expert but can give advice to auditee company. (j) Auditor is not supposed to report whether the company has maintained all required books of accounts. (k) Auditor shall sign the Audit report , prepared by him . (l) Nobody is allowed to practice as an Auditor unless he is a member of the ICAI & holds a Certificate of Practice.

(m) Nobody is allowed to practice a Cost Audit, though is a member of the ICWAI & holds a Certificate of Practice. (n) Liability for misfeasance means liability for breach of trust. 3. Answer in one sentence only. (a) What is the professional qualification of Company Auditor? (b) Who can become a Cost Auditor of a company? (c) A person disqualified for any reason to be a Co. Auditor is also disqualified to be an auditor of which companies? (d) When Central Govt. appoints a Company Auditor? (e) Who can remove the Co. Auditor? 440 AUDITING QUESTION PAPERS - AUDITING (f) Give any two important rights of Co .Auditor. (g) What is an important duty of Co. Auditor to shareholders of the co.? (h) To whom the auditor performs his duty of signing an Audit Report? (i) What is the duty of Co. Auditor in case of investigation? (j) What is liability of a Co. Auditor in case of negligence of duty? (k) What are the civil liabilities of a Co. Auditor under Companies Act 1956? (l) What are the criminal liabilities of a Co. Auditor under Companies Act 1956? (m) What is the liability of a Co. Auditor u/s 197 of the Indian Penal Code? (n) What is the punishment for professional misconduct under the Chartered Accountants Act, 1949? (o) What is the punishment for professional misconduct under the Cost & Works Accountants Act 1959? 4. Discus Liabilities of an Auditor under the Companies Act 1956? 5. What are the duties of Company Auditor? 6. Write Short Notes. (a) Qualifications of Company Auditor. (b) Disqualifications of Company Auditor. (c) Appointment of a Company Auditor. (d) Removal of a Company Auditor. 7. Mr A a practicing Chartered Accountant is attending to the tax matters of XYZ Ltd.And for that purpose has to regularly attend to the Company from 10.00 a.m. to 2.00 p.m on all working days . He is paid Rs 5000 p.m for the same. XYZ Ltd. intends to appoint Mr A. as its auditor at the ensuing general meeting. Advice Mr A. giving reasons whether he can accepts the appointment. 8. What Qualifications are required for being appointed as an auditor in the case of limited company, a partnership and a proprietary concern? 9. When does an auditor becomes disqualified for an appointment? Discuss. 10. Discuss the liability of an auditor of a limited company to third parties for his negligence? 11. Write Short Notes.

(i) Liability of an Auditor for misfeasance under Companies Act. (ii) Auditors Liabilities for misstatement in the prospectus. (iii) Duties of Company Auditor. 12. Briefly discuss the Auditors liability to third parties in relation to issue of a prospectus. 13. State the Provisions of the Companies Act 1956 with regard to the appointment of an Auditor. 14. Discuss the rights ,duties & liabilities of the auditor of a company. 15. Discuss the statutory powers &duties of a company auditor. 16. What qualifications are necessary for the auditor of a Public Limited Company in India? Can the following be appointed as auditor of Limited Co.? (a) Mrs. X (b) A partner of the Director of the company. (c) A person of unsound mind. (d) Mr. Y, who owes Rs. 500 to the company. (e) A firm of which the Secretary of the Company is a member. AUDITING 441 17. Who can be and who cant be appointed auditor of a company? Who can dismiss an auditor & how? 18. Fill in the Blanks. (i) Audit report gives__________ and ____________ information. (ii) Audit report shall contain an expression of opinion regarding ____________ (iii) Audit report is the _______ product of the auditing. (iv) Audit report gives the auditors _____________ on the accounts of record of the company. (v) Auditor should state in his report whether he has __________ all the information for his audit. (vi) Opinion in the audit report may be a) un-qualified b) qualified c) adverse (vii) Auditor should not give the certificate on his ____________ (viii) Auditor should address the certificate to ____________ (ix) Audit certificate is a written ____________ of the accuracy of the information stated there in. 19. State whether following statements are true or false. (i) Audit Report is addressed to the persons who are already in possession of the full facts of the subject matter of the report. (ii) Audit report is not a medium of expressing auditors opinion. (iii) Audit report doesnt reflect the work done by the auditor. (iv) Audit report mentions whether Balance Sheet & Profit & Loss Account attached there to gives a true & fair view. (v) The opinion stating that the auditor does not agree with the true & fair state of affairs exhibited by the final accounts is called as a Disclaimer opinion. (vi) Report with certain reservations is called as a qualified audit report. (vii) Auditor should clearly state his limitation in the certificate.

(viii) Auditor is not expected to indicate the extent to which he has relied upon a technical expert, in the certificate. (ix) Auditor guarantees absolute correctness of the figures in the certificate. 20. (A) Answer in One sentence only. (i) What is an Audit report? (ii) What is Audit certificate? (iii) List down the contents of Audit Report? (iv) State the different opinions either of which is included in Audit Report. (v) What is qualified Audit report? (vi) What do you mean by an unqualified Audit report? (vii) To whom Audit certificate is addressed ? (viii) To whom Audit report is addressed ? (ix) Whether Audit Report or Audit certificate may provide suggestions for improvements? (B) Describe Clean and Qualified Audit Report. 21. Write Short Notes. (i) Contents of Audit Report (ii) Qualified Report. 22. When should an auditor make a disclaimer of opinion in his audit report? 23. The Company had set-up a factory on coastal land. In view of the corrosive climate, the machine life was reducing faster and, therefore, it wanted to charge a higher rate of depreciation. What should be the opinion of the auditor? 24. What are the circumstances under which an auditor cannot issue an opinion other than a qualified opinion? 442 AUDITING QUESTION PAPERS - AUDITING 25. What aspects should an Auditor consider in expressing a qualified opinion in his report. 26. Under what circumstances is a disclaimer of opinion issued by an auditor? 27. What are Audit Reports and Audit Certificates? Discuss their importance? 28. Draft a qualified audit report, inserting three qualifications therein. 29. Draft an unqualified audit report. 30. State whether following statement are true or false (1) In companies other than Banking and Insurance, the Joint Auditors are appointed as per the regulations of those Companies. (2) Branch Audit should be conducted by the Company Auditor. (3) Branch Auditor need not be a Chartered Accountant. (4) Branch Auditor, if appointed separately, submit his report to the H.O.only. (5) No Government has any power to direct any special audit. (6) Internal Auditor should be appointed by the Board of Directors. (7) Corporate governance is nothing but only a paper work. 31. What do you mean by Joint Audit? Explain the advantage and disadvantage of Joint Audit.

32. What are the Power, Duties and Rights of a Company Auditor towards Branch Accounts and Branch Auditors. 33. What are the provision of the Income Tax Act, 1961 regarding Audit of Accounts of certain person carrying on business or profession. 34. Explain the interface between Statutory Auditor and Internal Auditor. 35. Draft the specimen of Auditors certificate on companys compliance of corporate governance as per the clause 49 of The Listing Agreement. AUDITING 443 REVIEW AND AUDIT OF INTERNAL CONTROL SYSTEM 1. State with reasons whether the following statement are TRUE or FALSE. (i) Internal Audit is entrusted to the employees of the organization. (ii) When there is a Statutory Audit, introduction of Internal Audit is not necessary at all. (iii) Evaluation of the performance is called as operational audit. (iv) To examine whether the transactions have been done in conformity with the established standard is nothing but the Proprietary Audit. (v) Certified statements showing turnover of the company fall under the category of the compliance audit (vi) The Companies (Auditors Report) order 2003 applies to all companies. (vii) The CARO extend the scope of audit even further than that of traditional approach. (viii) To be successful, the internal audit department must have adequate management support. (ix) Audit to internal audit function is considered necessary. (x) Statistical sampling in Auditing relieves an auditor from the load of work but not from the risk. (xi) Internal Audit is similar to that of internal control. (xii) Internal check is necessary only to comply with the provisions of the CARO. (xiii) Audit Committee is only the luxury to the company. (xiv) Detection of frauds is the duty of the Statutory Auditor and not necessarily that of an internal auditor. 2. What is an Internal Audit ? Explain the necessity and scope of Internal Audit. 3. Write short notes. (i) Financial Audit And Operational Audit. (ii) Efficiency Audit and Propriety Audit. (iii) Voucher Audit and Compliance Audit (iv) Audit Programme and Audit Note Book 4. What do you mean by CARO? Explain what is expected under the CARO regarding (a) Inventory (b) Internal Audit (c) Internal Control (d) Deposit of Statutory Dues. (e) Frauds 5. As an Internal Auditor, how would you examine the payment of wages and salaries.?

6. As an Internal Auditor, explain in detail the verification of Inventory Control System. 7. Write short notes : (a) Flow chart (b) Statistical sampling in Auditing (c) Internal Auditor and Internal Control. 8. What is an Internal Audit ? Explain the constituents of field work of Internal Audit. 9. What do you mean by an Audit Report ? Explain the different techniques of effective reporting. 10. Define Internal Audit and explain in detail the role of Internal Auditor in investigation of frauds. 11. What is Audit Committee, what is the scope and function of audit committee? 444 AUDITING QUESTION PAPERS - AUDITING INFORMATION SYSTEM AUDIT AND MANAGEMENT AUDIT 1. State whether following statements are true or false : a. When information system audit is an information technology audit, the auditor is required to have the detailed knowledge of accounting rather than information system. b. Information system audit is the audit of the accounting controls. c. At the time of preparing information system audit program, auditor must understand the system. d. Audit in the case of Electronic Data Exchange is a difficult task. e. Auditor should test check controls established to reduce the risk associated with commerce transactions. 2. What is information system audit? Explain the audit procedure in system audit to determine the material losses. 3. Define computer information system audit and explain the nature of risks and internal control characteristics in CIS environment. 4. Write short notes on (a) Types of IT audit (b) System audit (c) Computer audit (d) Input controls (e) Processing controls 5. What is computer assisted audit technique? Explain the different computer assisted techniques available. 6. What is CIS audit? Explain its application in case of E-commerce. 7. Explain : (a) Audit in online system environment. (b) Audit in case of environment of personal computer. 8. Define management audit. Discuss need of Management Audit. 9. What are the advantages and limitation of Management Audit?